Compass April 2012

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.

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The Mother of All Bubbles

We wrote a few years ago that there were a series of bubbles rolling through the global economy. Bubbles are driven by, among other things, easy access to credit. It is very hard to imagine a genuine bubble that does not involve easy credit – the ability to get more money in your hands than you really have a sensible right to.

The rolling bubble started with the so-called Asian Tigers in the mid-1990s. This was an economic bubble, largely in real estate and other assets controlled by ruling elites. The leaders of those countries put into place policies that encouraged massive lending from foreign banks. The bubble began to inflate.

When the Asian bubble burst in 1997, there was widespread fear of a global economic meltdown. The Dow dropped 7.2% (or over 900 points at today’s levels) on October 27, 1997. In response to that (and the collapse of Long Term Capital Management), Alan Greenspan put in motion Federal Reserve policies that continue to today: flood the system with cheap, easy credit any time the going gets rough.

As the Asian bubble popped and dissipated, the tech and super-cap stock bubble got rolling in the US, right about the same time. Greenspan again flooded the system with cheap credit due to “Y2K” fears. Cheap, easy access to capital allowed stock prices to rise to unimaginable heights. The true price-earnings ratio rose to 44 (and we consider today’s figure of 23 to be high). As that bubble burst, the Fed once again hit the stimulus pedal hard in 2001-02. At the same time, the federal budget went from a surplus equal to 2.4% of GDP in 2000 to a deficit of 3.5% of GDP by 2004 – a swing of $650 billion per year. The resulting deficits, along with easy-money Fed policies, also serve to stimulate bubbles. The now-popped tech bubble dutifully rolled forward…
By 2005, the housing bubble was in full expansion. At the bursting of the housing bubble, the average American finally began to really pay the price of over-exuberance.

When the Asia bubble and then the tech bubble burst, the economic implications increased each time. In hindsight, the 1997-98 crisis and 2000-2002 crisis now look mild in comparison to the aftermath of the housing bubble. Our memory is forever seared with the panic in the Fall of 2008 when entire global financial market seemed about to collapse. The crises of 1997-98 and 2000-2002 were largely limited to the financial sector. But the collapse of the much larger housing bubble has had serious ripple effects throughout the entire economy.

So…the Asian bubble rolled into tech; the tech bubble rolled into housing; the housing bubble popped and then…? That last bubble did not actually collapse – it got bigger and it has now rolled into the final corner: the public balance sheet.
The balance sheet of the Federal Reserve has grown from $925 billion in mid-2008 to $2.9 Trillion today – an increase of over 200%. Over the same period, the Federal budget deficit has risen from $458 billion to $1.3 trillion today – an increase of over 180%. The effect of these dual cannons of economic stimulus has been to moderately stabilize the economy, but mainly to boost corporate profits to unprecedented heights. The profits of the S&P500 companies has soared tenfold since the recession officially ended.

A recent paper by James Montier of Grantham, Mayo, van Otterloo & Co. showed that nearly 70% of currently corporate profits can be attributed to government deficit spending. Another major driver of profits is the low interest rate environment created by the Fed (which reduces interest expense, increasing net profits).

The housing bubble was not the final act in the story of the rolling global bubbles – the bubble is now a bubble of government stimulus. And like all bubbles, it will burst. It might happen sooner; it might happen later. The massive economic stimulus programs currently under way cannot be sustained forever (just ask the Greek government).

The bursting will present itself in the form of (1) growing austerity in the Federal budget, and/or (2) rising inflation and rising interest rates. By austerity, we mean a smaller deficit. For our purposes here, it doesn’t matter if that is accomplished by lower spending or higher taxes. We’ll let the candidates argue over that split.

Right now the federal deficit is about 8.5% of GDP. That amount goes directly into the corporate profits equation. Some of that amount is then spent by corporations on expenses and payroll (meaning, not all of it ends up as profits). But given the high profitability of the “last dollar in the door” for most companies, that stimulus gives an enormous boost to overall profits. Budget austerity means sharp downward pressure on profits.

Rising inflation will erode the true value of interest and dividend payments. Rising interest rates will wreak havoc with everything. We reach into our box of quips every now and then, so here is it again…

If something can’t go on forever, it won’t.

We are experiencing a “bubble of good times” due to massive government intervention. The intervention serves to move future income and wealth into today’s balance sheets and checkbooks. Every dollar that is moved from the future up to today makes us temporarily richer, but ultimately poorer.

Policymakers are not clueless about this effect. They go forward with it on the assumption that faster economic growth will soon follow, and faster growth will swamp over the long-term bad effects of the policies. After WWII, several decades of fast growth (and steady inflation) made the deficit and Fed stimulus of the war years fade down to very small figures, as a percentage of GDP. The hope, in Washington, is that we can do it again.

The strongest contributor to any nation’s real GDP growth is growth in the labor force. China’s 8+% growth rate is in large part fueled by the fact that it can add millions of people to the labor force, year after year. They move from farms to cities, and the labor force grows rapidly even without rapid population growth.

We experienced rapid labor force growth after WWII — the baby boom. That helped produce a 40-year party of effortless and relentless real economic growth.
We are now entering the early years of the demographic hangover.

In an average year from 1946 to 1976, GDP grew at 7.2%. Of that, 3.5% was simply inflation. Another 1.9% was due to growth in the size of the labor force. That leaves only 1.8% of real, actual per-capita economic growth, per average year. Over the past decade, the labor force has grown at barely 1% per year, and it is expected to continue to trend downward as the baby boom retires.

It becomes very difficult to grow the top-line GDP of the economy by 7% with slow labor force growth and low inflation. The government might not have as much success with deflating the current stimulus bubble as they did with the wartime bubble. The implications for investors in financial assets is the prospect of low returns that are eaten away by persistent inflation. On the following page, we discuss our strategy for achieving satisfying investment returns in the face of this environment.

Coping With Austerity and Inflation

In the main article to the left, we make the argument that the future for most stock and bond investors is unlikely to be as rosy as the past. Even setting aside the larger issues discussed in that article, stocks and bonds are currently priced to yield nearly record-low returns moving forward.

The traditional approach for a retirement-oriented investment portfolio is to put 60-70% of the money in stocks, and the rest in bonds. Yes, there are various flavors of stocks (domestic, foreign, large, small, etc.) but, ultimately, stocks are stocks. That portfolio might look like this:

Stocks and bonds portfolio

What should we expect from this mix of 65% stocks and 35% bonds? We don’t look at the average returns across all eras — we instead look at the averages that occur from starting conditions like today’s. It doesn’t matter if bank CDs have averaged 4% over the past 50 years — if
they only pay 0.5% today, it’s silliness to expect 4%. In the table below, we show the average annual return on stocks and bonds over the 7 years following periods when stocks and bonds were trading at prices like today’s. The total expected portfolio return is then computed.

For a reality check: If we had prepared the same table in, say, 1985, we would have computed an expected 7-year average return of 11.0%, based on market conditions at that time. Investors did, in fact, achieve those nice high returns. The expectation proved to be realistic and rational.

Prepare the same table looking forward from the year 2000, and our expectation should have been 3.5% (in stark contrast to polls showing the vast majority of investors expected returns above 12% per year). And 3.5% is about what investors in balanced portfolios actually achieved in 2000-2007. Again, the expectation proved realistic.

Using this methodology that has proved reliable in the past, we get a forward-looking return expectation of 3.8% for the next 7 years. Even if taxes were as low as 25%, after inflation that is a net-net real return of about zero.

So…what to do about this bleak outlook? The solution, as we will implement it, is to be flexible and tactical. It will be important to begin to loosen our longstanding adherence to the traditional pie charts. We will need to stop comparing our results every single quarter to the pie-chart at left, and instead look past the short-term gyrations of the markets.

To be flexible and tactical means to temporarily accept the mundane results that are available in a portfolio that has a low risk of capital loss, and that is liquid (“liquid” meaning you can convert any part of it to cash quickly and cheaply). At present, that means to turn the 65/35 portfolio on its head and have less stocks and more bonds. Importantly, the bonds cannot be long-term bonds; short and medium-term only since they have lower risk and greater liquidity.

The objective of this approach is to wait for one or another asset type to become cheap. An asset that is cheap means that it has less risk and offers higher returns. In late 2008, junk bonds got very cheap and we loaded up. In late 2010, muni bonds sold off badly and we started buying. These windows of opportunity are fleeting and prices often move back to fair levels quickly. A flexible and tactical investor will wait patiently until such opportunities arise. And opportunities always arise. At this writing, there are no obvious opportunities. But, in order to do better than the mundane forecast in the table to the left, we must wait for the right opportunities.

In times of low returns (i.e., expensive assets), investors will reach too far and take too much risk to eek out a little extra return. But, that follows the old parable about trying to squeeze blood from a stone. The only blood you’ll find coming out will be your own.

These are times to move our portfolios slowly and safely ahead, while we wait for the inevitable opportunities to rise above the low baseline we otherwise face.

Major Asset Classes Valuation

Market Behavior — Who’s Driving?

Despite our pessimistic view of the prospect for stocks over the next 7-10 years, prices are high and have moved higher this year. Based on the reaction of the market to the short-term news cycle, it is apparent that the daily price-voting machine is taking its cues primarily from the Fed. Economic news and data releases take two forms: good or bad. If an employment data point hints at a weak labor market, that is bad. And so on with other information. Stock prices have starting exhibiting the short-term inverse behavior long common to the bond market. That is, when bad economic news comes out, stocks are more likely to rise that day than fall. This doesn’t make intuitive sense at first. But it makes sense when you realize that what stock investors really want to know is whether or not Ben Bernanke and the Fed are going to declare the low-interest-rate party over or not. At some point, Chairman Ben will take away the punch bowl, turn on the house lights and shut down the music. Investors will have to run for the exits. As long as the economy is sputtering along (i.e., bad news), stock investors are going to keep dancing.

The Value Investor’s Curse (or, These are the times that try men’s souls.)

Following on to the article above, as long as stock investors keep dancing, there will be no rush for the exits. The singular curse of being a value-driven investor — or investment manager — is that your discipline will mean that your portfolio (and those of your clients!) will not rocket upwards in lockstep with the market when it extends gains far past fair value. The value investor will get out early, habitually . I experienced this in my personal account as I sold all my stocks in the fall of 1998 and did not participate in the next 18 months of relentless gains. Our firm experienced it in early 2006 when we started reducing stock holdings, 20-some months in advance of the market peak in October 2007. In both of those instances, I was ultimately pleased with our decisions since we dodged the full brunt of ensuing market corrections and came out ahead, overall. As our great Revolutionary hero and founding father, Thomas Paine, wrote, “These are the times that try men’s souls.” Should stocks move relentlessly higher from here, the value investor will face the test of his or her principles.

2011 Calendar Year Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Muni Bonds

Taxable Bonds

Inflation

(year-over-year February 31)

12.54%

12.91%

11.54%

13.94%

1.81%

0.24%

2.7%

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.