Compass April 2010

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

Download Print
Short Bonds vs. Long Bonds

The first quarter was relatively uneventful. Domestic stocks slid downwards for a while and then recovered near the end of the quarter to produce a solid gain of about 6%. Foreign stocks did less well as the Euro zone suffered some pressure due to its continuing efforts to bail out Greece and maybe a few other southern European governments. Muni and taxable bonds held up reasonably well and paid about what we would expect.

All in all, a benchmark “plain vanilla” 60/40 index portfolio returned 2.72% on the quarter. This is a very strong return for the current environment and we should not expect to string a bunch of these together over the next couple of years.

Our outlook is unchanged from the last quarter. We’ll summarize a few points briefly and then spend a little more time talking about our current positioning.

  • We feel that domestic stocks (represented by the S&P 500) are trading at above fair value. We peg “fair value” to be around 950; See Page 3 for details.
  • We continue to worry that emerging markets stocks have overshot fair value. China in particular looks worrisome, primarily due to the property bubble. More on Page 3. (On a related note, we pass on a headline from a Bloomberg News article: “China on ‘Treadmill to Hell’ Amid Bubble, Chanos Says.” James Chanos is a hedge fund manager who achieved some fame by correctly foreseeing the collapse of Enron in 2001)
  • Government debt issuance continues unabated, and will continue for some time.

For these reasons, we continue our underweight positions in stocks and long-term bonds. The sensible reader asks, “Well, if you’re not in stocks and long bonds, what’s left?” With cash paying about zero percent after taxes and expenses, what do you do if you’re not in stocks and bonds?

Our solution has been (since November 2009) to move all that extra money into short-term bonds. We are strongly overweight to high-grade shortterm bonds. While we worry that rates will rise across the maturity spectrum as the economic recovery gains stability, short-term bonds will significantly outperform longer-term bonds during a rate increase cycle. Bond prices fall when rates rise, but such price changes are always temporary. Here’s why…

Let’s say you bought a two-year bond for $10,000, and it carries a 3% coupon rate. You get your first Schwab statement showing that bond at a value of $10,000. Then six months later you look at your statement and it says the bond is worth only $9,800. You just suffered a 2% loss on that bond! Or did you…?

Why did the bond decline in value? Because interest rates rose. Six months later, it is now an 18-month bond, and market yields on 18-months bonds must have risen. To cause a 2% decline in the value of the bond, those rates would have risen from 2% to about 3.4%. Even though the bond is reported on your statement as only worth $9,800 today, you still get the full $10,000 when it matures in 18 months. You really haven’t lost anything as long as your plan is to hold the bond to maturity. This is the basic math of bonds – any movements of price, up or down, during the bond’s lifetime are temporary.

We will stress here the fact that the same phenomenon occurs in mutual funds that hold diversified portfolios of bonds. A mutual fund might own thousands of different bonds, and we can compute the average maturity of the whole portfolio. Bond mutual fund portfolios behave very much like a single large bond. Mutual funds and ETFs publish their “average duration” figures regularly. In the same way that a bond’s market price will move back to 100% of par value as it moves through its maturity, so too will a mutual fund’s (and ETF’s) reported share price move back to the par value of its holdings as it moves through its average duration.

While this should give comfort to bond owners, we still acknowledge that these short-term price movements can be large and disruptive. Further, if the movement upward in interest rates is driven by higher inflation, then the true purchasing power of the money that has been tied up in the bond can be seriously eroded over time. If you owned a 10-year bond that paid 4% during its lifetime, but inflation averaged 5% during that time, you lost a compounded 1% per year on the bond, or 10.5%.

So, while we are patient enough to ignore temporal price movements in longer-term bonds that we own, sometime those price movements are signals that we are genuinely falling behind the inflation curve.

Creekside’s outlook is for rising interest rates as the economy recovers and employment improves. We expect rising rates whether or not inflation moves materially higher.

The table to the right shows the price decline of bonds of various maturities if interest rates move by two percentage points. How often does that happen? It happened in the months leading up to the stock corrections of fall 2007 and summer 2004, and again in 1999 before the stock market topped out in early 2000.

As you can see, the longer the bond maturity, the more it declines in price when rates rise. Accordingly, we are taking a risk-avoidance stance and keeping most of our assets in shorter-term bonds. If rates rise, our holdings will still suffer small declines. But we will have the opportunity then to move into longer-dated bonds when their declines present attractive opportunities.

Bond Maturity Current Rate Price Drop after 2% Rate Rise
2 Years 2.00% -3.8%
5 Years 3.00% -8.8%
10 Years 4.00% -14.9%
20 Years 5.00% -21.4%
30 Years 5.50% -23.7%

Read page 3 for more detailed thoughts on the broader range of issues and asset classes.

Rick Ashburn, CFA

Major Asset Classes Valution

Economic Factors
Headwind or Tailwind?

Inflation. Inflation has averaged about 3.6% in the post-war era. That’s not an accident, but rather a result of specific targets and policies by the Federal Reserve. Despite conjectures, theories and ivory-tower thought experiments arguing the contrary (see Friedman, Greenspan and the other “natural rate” theorists) there has been a persistent tradeoff between the unemployment rate and the inflation rate. When inflation gets too low, unemployment tends to rise. When we allow a little inflation, unemployment tends to decline. Again, there are powerful theoretical arguments that “prove” that this should not be so — I learned these ideas just like all Econ majors — but the data is the data. And so, we have a balancing act to manage. Give me a little inflation and I’ll give you a little employment growth.

Right now, our Fed is desperately trying to trigger some core inflation. In the fullness of time, they will get what they want. However, that can hard to achieve in the face of such low resource utilization. Capacity utilization is reported at around 70%. In contrast, the late-70’s/early 80’s inflation took place in an environment of 80+% utilization. We expect persistent inflation in the long-term, but low inflation until the economic recovery is fully entrenched and unemployment begins to fall. As soon as we see bank lending/leasing activity begin to accelerate, we expect inflation to accelerate. We will not be surprised to see this “get away” from the Fed and for inflation to spike rapidly when it does begin to gain speed.

Does this present a macro headwind or tailwind? It’s really tough to say. If “stable prices” tip over into “declining prices,
we could have a recessionary shock. On balance, the Fed’s efforts to grow the money supply (and increase inflation are
probably giving the economy a bit of a tailwind. Note that this wind could turn around 180 degrees in a heartbeat.

Bond Interest Rates. As noted below under Yield Curve Shape, longer-dated bonds are paying attractive interest rates relative to shorter bonds. It’s tempting to move out there and make 5% instead of 2%. However, supply factors — such as a looming 2010 Treasury borrowing of $1.5 trillion+plus — do not bode well for the interest rates on long bonds. We moved into shorter maturities in Q4 2009, bringing our average maturity down around 2 years. Even without inflation, long bond rates are in trouble. As is the usual plan in such an environment, we have to be patient and earn measly short-term interest rates and then pounce when long bond rates are high enough to compensate us for our long-term inflation outlook (as discussed just above).

Corporate Earnings. Earnings recovery has been nothing short of stunning. So stunning, in fact, that we have pretty much recovered back to pre-crash earnings numbers for the non-financial companies in the S&P500. The catch is that we thought those earlier high earnings levels were too far above trend and were unsustainable. We were correct back then, and we are again of the opinion today that profit margins will suffer pressure as the recovery unfolds. Even as earnings have risen, top-line revenues are still stagnant.

Real Estate. The housing market is a basket case with no relief in sight. There are million or two foreclosures yet to happen. This is the driving story of consumer consumption, and could be for another decade. The commercial property market is also in a tailspin, characterized by a huge overhang of underwater “zombie properties” that aren’t generating enough cash to pay the mortgage, yet have not been written down and re-offered at a new and proper cost basis. While this hurts banks and real estate investors, it is ultimately an economic good as plentiful and cheap office space is available to growing companies. So, we call this one a split — housing is a headwind; commercial property will turn into a tailwind sooner or later.

Yield Curve Shape. The shape of the yield curve is defined by how much rates rise as we move from shortterm rates (e.g., money markets) out to longer term rates such as 5– and 10-year bonds. We lamented the flatness of the yield curve back in early 2007, arguing that a flat yield curve is a precursor to economic slowdown (hardly anyone believed us!). Now we have a steep yield curve again — the essential ingredient to productive business investment and a growing economy. An upward-sloping yield curve is the mother’s milk of capitalism.

The Healthcare Bill, GDP & Employment

The recent healthcare bill has generated a level of volatile emotions in our country that has not been witnessed since perhaps the Civil Rights Movement. It is the biggest change to healthcare in the United States since Medicare was enacted in 1965.

Outside of the moral, political and constitutional debates, we at Creekside must assess the bill’s impact on the economy and our investment strategy. The growth of an economy is dependant in large part on two factors, (1) the quantity and quality of the labor pool and (2) the amount of available investment capital. Investment capital is primarily a function of the savings of individuals and businesses, both domestic and foreign. We believe this new program will have a negative impact on sustained GDP growth primarily because (1) it increases the cost to employ and (2) it most likely will decrease the available investment capital.

The bill increases the cost to employ by requiring companies to either offer a government-mandated level of coverage, which may be more expensive than what was previously offered, or pay punitive taxes. The resulting increased cost to employ will lower the number of employees companies can afford, which hampers growth and in turn depresses GDP. Additionally, more individuals will continue to be unemployed or underemployed than would have otherwise been the case, and can increase the federal deficit as payroll tax receipts decrease and unemployment claims fail to decline as rapidly as would be the case under a normal recovery.

So how does this affect investment capital? The total amount of domestic savings available for investment as a percent of GDP has fallen sharply over the past decade, as a direct result of twin deficits: government spending and foreign trade. The U.S. government is now consuming 40% of the nation’s savings to finance its deficit spending. Our economy has not yet suffered in full the economic consequence of this drop in personal savings because foreign individuals, businesses and governments have in recent years invested trillions in the U.S., supplementing the domestic supply of savings and allowing the U.S. economy to grow much faster than it otherwise would. If the US economy becomes less attractive to foreign investors, the loss of this supplemental investment capital could have adverse effects on interest rates.

Prior to the passage of the healthcare bill, the United States’ net liabilities were just over 400% of GDP: $46 trillion in net social insurance liabilities (primarily Social Security and Medicare; Source: 2009 Financial Report of the United States) plus the current U.S. Debt of $12.6 trillion (Source: U.S. Treasury). GDP was about $14.26 trillion in 2009 (Source: Bureau of Economic Analysis). According to the Congressional Budget Office (CBO), the sum of Social Security, Medicare and Medicaid and interest expense are projected to exceed total federal revenue by 2028. According to the CBO, Social Security, for the first time in history, will run a cash deficit in 2010, a full 6 years earlier than the Social Security Administration projected just last year.

There will be future increases in annual deficits if federal tax receipts are not increased to compensate. Increased tax receipts OR higher deficits would lower the total amount of domestic savings available for private investment as the government uses more of the nation’s savings to finance its spending. There is considerable concern in the market that the full impact of this bill will not only increase costs to private industry, but will also increase the national debt, which means further declines in domestic savings available for private investment. Since the long-term impact of the bill is difficult to predict, perception is of vital importance.

If foreign investors question our economy’s growth prospects, they will reduce their investments in our economy. Reduced foreign investments can weaken GDP growth.

We do not take a position on the social or political issues that the healthcare bill attempts to navigate. Whether a universal coverage objective is desirable or affordable – those are private questions for each citizen to ponder. We are solely concerned with the hard, cold accounting of the matter and it is our view than any costly program that the nation chooses to undertake will, in the fullness of time, serve as a drag on GDP growth, household earnings and employment.

This is true of both this new program and of the vastly more expensive expansion of Medicare — adopted with widespread and bipartisan support in 2003.

Accordingly, we view this bill as reinforcing our already established view that GDP growth over the next generation will be slower than in the post-war period to date.

2010 First Quarter Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

REITs

High-Yield Bonds

High-Grade Bonds

Inflation

(year-over-year February 28)

5.35%

9.65%

1.26%

2.47%

10.08%

3.60%

3.37%

+2.10%

Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at info@creeksidepartners.com.