Compass July 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.

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Living in an Austerity World

We are living in a material world and I am a material girl. – Madonna, 1984

We started floating the term “Austerity” around here at the office late in 2009. At first, we kept it to ourselves since it’s not the kind of thing proud Americans would ever think applies to themselves. Economic analysts of a certain age (ahem) cut their teeth by looking down their noses (to mix metaphors) at the hapless developing market countries in the 70’s and early 80’s. These countries were in the habit of spending more than they had and of borrowing from big western banks and of devaluing their currencies. We were outraged — outraged! — when they would propose lessthan-payment-in-full with this devalued scrip.

The standard medicine for this irrational behavior? Why…Austerity Measures!

These nations were told to shape up. Cut spending or raise taxes. Or both. Balance your budget. Stop printing money and get your act together! Stop living in Madonna’s material world and start living in an austerity world.

In late 2009, we chuckled nervously when thinking about Austerity Measures for the great American economy. But, by February, we went public with our outlook/prescription at our semi-annual investor program. Even then, throwing that phrase up on an overhead slide felt oddly dated — like I was flashed back to an Econ classroom two score and five years ago.

Today, not six months later, Austerity is the buzzword of the day. It seems half the weekly op-ed content of the WSJ and NY Times contains “austerity” in it somewhere. And they’re not just talking about Greece, Italy or Mexico circa 1984. They’re talking about you, me and us.

Our outlook for an austerity world is largely driven by our expectation for a sustained period of low real economic growth. Despite trillions in stimulus spending, the recovery has been anemic. Unemployment remains high; debt burdens remain high; the average household is behaving more frugally than any time in a couple of generations.

At the same time, the fiscal stimulus programs are winding down. The government cannot continue to provide cash gifts to peopl who buy cars and houses. As those programs have ended, sales of cars and houses dropped accordingly. Households are saving more and spending less.

In the grand fullness of time, these are good things. Financial prudence and thrift provide the foundations for long and sustained economic growth. But — it’s not a smooth adjustment for the material girl.

The austerity world is one of stagnant top-line economic growth, which translates directly to slow growth of earnings per share. That gives little reason for stocks to go up in price very quickly. The austerity world is also one in which interest rates stay low, throwing a wet blanket over our hopes for high interest income. Similarly, real estate and other income -producing assets will not experience fundamental upward price pressures.

What is an investor to do in a world of low single-digit returns? After all, we’ve become accustomed to expecting high single digit, or even low double digit, returns from even conservative balanced portfolios. The standard financial planning assumption is that you’ll earn 7-8% in your sleep. Well regarded pension plans assume returns of 7-8%. Just how do you get 7-8% returns in a world of 3% bond yields and 2.5% dividend yields? It just doesn’t add up.

The only way to achieve these more satisfying rates of return is to be a value-driven tactical investor. When income sources yield but half of what you seek, capital appreciation must fill up the cup.

Capital appreciation of assets only occurs for two reasons: Either the asset becomes inherently worth more because it produces more income. Or, it goes up in price because people are, for some reason, inclined to pay more for it. The first reason makes perfect sense, the second is…well…less reliable.

In a world where inflation-adjusted (or “real”) corporate earnings per share are growing at about 1% (and they have averaged only about 2.5% real growth in the post-war era), stocks cannot be rationally expected to go up in price any faster than 1%.

But — and here’s the good news — stock investors aren’t rational. Despite what the textbooks and mathematical models say, investors make bad decisions and occasionally gather up as a herd and head off a cliff. While the long climb might average a meager 1%, the actual journey will involve peaks and valleys that are far steeper.

If stocks fall down a ravine to a price below the long-term fair value trend line, we are confident they will rise back up. And that becomes a good time to buy. Conversely, if stocks climb a great but unstable peak, we are confident they will return to the trend. That would be a time to either hold on to what we have or even to sell stocks.

We view the bond markets in a similar light. We do not find the prospect of earning 3-4% to tie up our money for 20+ years very appealing. While we live in an austerity world now, we have noted that we believe the Fed and the [fill in the blank from either party] presidential administration will eventually succeed in restoring persistent inflation. Persistent inflation of 3-4% renders such bond yields zero.

Accordingly, we are not tempted to move out into long-term bonds simply to pick up an extra couple points of interest. The inflation-driven capital destruction of bonds that will occur as the age of austerity inevitably comes to an end worries us.

Say we own a long-term bond for three years, picking up an extra 8% of total interest along the way (versus what we could have earned on a shorter term bond). That 8% of extra profit will disappear if long-term interest rates move up by only 0.50%. That sort of move can happen in a couple of hours.

Long-term bond interest rates have, on many occasions, moved up by 2-3% in a matter of weeks. That can translate into a 25-30% loss of capital if the bond were sold, and result in the total erosion of purchasing power if the bond were held to maturity.

We will buy long-term bonds if and when their yields exceed our long-term inflation expectations.

For the time being, we are in the unenviable position of asking our clients to be patient and content with low current yields. We are quite confident that our patience will be rewarded as the inevitable market volatility and turmoil with present us with classic value-driven tactical opportunities.

Rick Ashburn & Andy Hempeck

July 2010

Major Asset Classes Valuation

Economic Factors
Headwind or Tailwind?

Inflation. Inflationary pressures remain low. Inflation is, in large part, a tug-of-war between the demand for “stuff” and the demand for “money.” When demand for stuff is high, prices will inexorably rise. Demand for stuff is high when factories are humming at capacity and consumers are whipping out their debit/credit cards and filling up the back of their SUVs at Costco. Contrary to first intuition, when businesses and consumers are borrowing, that’s not demand for money — they borrow because they want stuff. The pull money out of banks and buy stuff. Inflation ensues.

At present, the demand for money is winning out over the demand for stuff. To the extent people and businesses get their hands on some money, they are using much of it to save and to pay down debt. At the very least, they are not borrowing at levels of the past 30 years. The Federal Reserve is trying to lay the groundwork for increased borrowing (and money creation) but big money-center banks are content to take the Fed’s zero-percent handouts and fund trading operations instead. The profits of the member firms of the New York Stock Exchange (i.e., mega-banks) in 2009 hit a singular historic high. And they achieved these profits without ramping up lending to businesses and consumers.

We do not anticipate any significant inflation in the near-term. However, the Fed will eventually get what it wants, and what it wants is inflation. 20 years of 4% inflation pays off more than half of today’s national debt. And that, my friends, will ultimately be the choice of policy makers from all political stripes. The monetarist/Austrian School economic theorists can wring their hands in anguish in ivory towers all they like, but voters ultimately force politicians to be practical. Voters want the easy way out, and mild persistent inflation is the easy way out.

Bond Interest Rates. Longer-term bonds staged an impressive rally last quarter, and we pretty much missed it. 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 longterm inflation outlook (as discussed just above).

Corporate Earnings. Earnings recovery is flattening. The only “good news” is that big banks are making a fortune. But, they’re not real profits — the type banks traditionally earned by lending and servicing customers. Big bank profits are a massive transfer payment program from the Federal Reserve and US Treasury over to banks. We (the taxpayer) lend banks money at 0% to 0.25% and pretty much require they use the money to buy Treasury bonds at 2% to 4%. We pay them 2-4% and they pay us back 0-0.25%. Good deal if you’re a bank! Bad deal if you’re you and me.

The rest of corporate America is muddling through, making money but not expanding or hiring. I will also highlight the fact that these taxpayer-subsidized bank profits are not being directed toward the types of banks that lend to small and mid-size businesses. Community business banks are being ignored by the policy-makers who are only concerned with huge banks.

Real Estate. Housing remains in bad shape. In many parts of the country, house prices still don’t fit into a genuine healthy long-term household financial plan. History and math tell us that a household should spend no more than 2.5 to 3 times its annual income on a house and still have enough lifetime earnings left over to put kids through college/trade school and save for retirement. In California, the median home price is still about 5 times the median household income — despite the spectacular drop in home prices.

Yield Curve Shape. The shape of the yield curve is defined by how much rates rise as we move from short-term 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.

Treasuries or TIPs? Breakeven Analysis

Treasury Inflation Protected Securities, or TIPs, offer investors a unique combination of current income and principal that grows with inflation. TIPs carry a stated rate of interest that is paid out semi-annually. The face value of the TIP that you own is adjusted up or down with inflation every six months. If inflation goes up by 1%, the $10,000 TIP you bought is now $10,100. The next time you get paid interest, the interest is computed against that nowlarger principal amount. Note that the principal amount can go down if inflation falls, reducing your interest income accordingly. However, at maturity, you always get at least the original $10,000 back.

Investors and advisors often compare TIPs to the same maturity treasury bond for reference. If a 10-year TIP is quoted as paying 1.5%, that means you will earn 1.5% plus inflation over 10 years. Let’s say a 10-year treasury bond is yielding 3.25%; you will earn 3.25% whether inflation is high or low.

From these two market quotes, we can say that the “breakeven” rate of inflation is 1.75%, or the difference between the two. If inflation averages 1.75% over the 10-year holding period, you would achieve the same result with either bond. If you earned 3.25% on the treasury, you would lose 1.75% of that to inflation and net out at 1.50%. If you owned the TIP, you’d get 1.50% plus the 1.75% inflation adjustment. Net-net, it’s a tie.

But what happens if we also consider the effect of taxes? Taxes on the treasury bond are pretty much fixed. You pay the marginal federal tax rate (say, 28%) on the interest income and nothing on the returned principal at maturity.

TIPs are more complicated. Not only is the interest income taxable, but so too is the increase added to the principal amount each year. In the example above, that $100 added to your principal is taxed in the year it is computed, even though you don’t get that money for maybe another 9 years.

The real breakeven question we want to examine is, what is the breakeven rate between these two securities at a range of different inflation rates, after taxes? The chart below provides the answer.

As the chart shows, TIPs and treasury bonds are a breakeven (at today’s market prices) if inflation stays around1.5%. At any higher rate of inflation, TIPs prove to be a much better investment. Taxes conspire to drive treasuries into negative-yielding territory if inflation rises to 2.5%. TIPs continue to provide a positive net return all the way up to an inflation rate of nearly 5.0%.

While this chart shows the clear advantage to TIPs if inflation rises, we are still not yet ready to buy 10-year TIPs. As with most of our bond allocations, we are keeping maturities shorter, and our TIPs exposure has average maturities in the 3-4 year range.

2010 Year to Date 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 May 31)

-6.71%

-1.37%

-13.54%

-6.87%

5.61%

3.58%

5.33%
+2.00%

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.