Compass October 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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Signal-to-Noise Ratio

Scientists and engineers in the business of sifting through streams of data struggle with picking out the useful bits of information from the torrent of not-useful information. Is that a planet orbiting a star out there, or is the atmosphere above my telescope turbulent? Is that a new bacterium I see or dust on my microscope lens? To help resolve this problem, practitioners will design systems and apparatus to deliver observations with the most possible useful information — the signal — and the least possible confuddling information — the noise. You want the signal/noise ratio to be as high as possible.

The practice of investing is also subject to the signal/noise problem. Economic data releases come out every few days; earnings announcements go up and down; the Fed does this; Congress does that; etc. The information stream comes at us so fast and furiously that it is hard to find the useful bits. This is especially true in a presidential election year where diametrically opposed economic claims are in the air at the same time. Political passions run high, and can cloud sound investment judgment.

Our mission is to sift through the stream and pick out the information that can lead us to investment decisions: What we call “actionable” facts. We readily acknowledge that people have plenty of good reasons to vote one way or the other; we also acknowledge that a given person’s financial well-being can be directly affected by the result of the election. We are confident that a well-functioning democracy will find the best solutions to its challenges. But, by design, our particular democracy makes big decisions slowly and a bit messily. Running through a quick list of the most common questions we get these days…

What do you think about the economy?

The economy is growing slower than we had gotten used to these past 60 years. That is not the result of some particular government policy set in place today. It is the cumulative result following a 30-year stretch where we all believed the economy was growing faster than it was actually growing (due to borrowed money). A hangover in the morning is not caused by anything happening in the morning — it’s the result of what happened last night. Cure for a hangover? Time and patience. Cure for the American economy? Not much different.

What do you think about the election?

From an investment perspective, not much other than advising clients about dealing with the potential tax implications for their particular situations. Naturally, each client would prefer to achieve the highest after-tax returns possible, and we will do what we always do in that regard.

OK, but really…what do you think about the election?

May the best candidate win.

Come on! Really…

When we look at the larger picture… that is, the size of the total economic pie and how fast it might grow, we see little difference resulting from the outcome of the election. In our view, claims made by either candidate to the contrary are political claims, not economic facts. A loose and disingenuous reference to economic “theory” can support almost any political viewpoint. But in the end, they’re just words. To our dismay, we see this presidential campaign skirting the larger decisions that will take decades to play out — policies and decisions that could, in fact, increase the total size of the economic pie. Instead, the arguments between the sides are primarily concerned with questions of economic justice, and competing points of view of what constitutes a “just” sharing of the national good fortune. While we, like any voters, have our opinions about such things, those opinions stop at the office door and we need to concern ourselves solely with the investment implications from the point of view of our clients. We don’t see any near-term economic effects (good or bad) arising directly from the choice voters will make this November.

But won’t higher taxes kill job creation…or lower taxes spur job creation?

After almost 30 years of hearing the drumbeat that marginal personal tax rates either increase job creation (when they go down) or kill job creation (when they go up), we are not convinced by the actual data. There appears to be no reliable correlation between GDP growth, employment and marginal income tax rates. That is, of course, not to say that we favor them going higher! It’s just that we don’t believe that if a particular election outcome results in higher marginal tax rates, that GDP and job growth will slow down as a result. Likewise, we don’t think lower income or capital gains tax rates will boost the economy. (We qualify those viewpoints with the observation that we are starting from tax rates that are low by post-war standards.)

Tax rates serve to move money around within the economy, but don’t much affect the total size of the economy. Hence, there is no obvious investment tactic to take advantage of the election going one way or the other. We apologize for disappointing the partisans from both sides of the aisle.

What about the “fiscal cliff” — when automatic spending cuts start in January?

We are skeptical that Congress — with constitutionally-mandated responsibility for the nation’s purse strings — will surrender that duty over to a formula adopted more than a year ago. We remember earlier laws that “mandated” budget cuts and various balancing formulas. When deadlines approach, Congress meets, unwinds the earlier agreement, and heads back to the lobbyist dinners. Some compromise will be struck to keep things humming along. We think that Congress will only take the budget seriously when investors begin to demand high interest rates on US Treasury debt. That day could be a long time coming.

What do you think about the Fed?

The Federal Reserve announced a program to buy an additional $40 billion in mortgage bonds monthly through the end of the year. The lead article in our July issue of this newsletter detailed our view that these efforts by the Fed are largely pointless and potentially dangerous. The Fed cannot push up the money supply, because it doesn’t control the money supply. Its current attempt to manage the economy upward is beginning to hint at the type of futile central-planning that we usually associate with the old Soviet Union. The current Fed buying program is a wealth transfer from future conservative savers to financial institutions today. In that regard, higher earnings at banks could potentially provide a rounding-error-size boost to the economy, but at great cost down the road.

The main investment implication is that interest rates are likely to remain low for some time. We continue to be comfortable keeping client bond portfolios at a 4-5 year average maturity. Longer term, the Fed’s efforts will have a backlash of higher inflation if and when the economy gets back to higher growth rates.

Signals and Noise

Most of the current “hot button” issues in the campaign and on the financial news headlines do not rise to the level of affecting our investment decision-making — there are few true signals. Our asset-class weighting decisions are driven by fundamentals of valuation and the headwinds and tailwinds of large-scale economic forces that act independently of governments and elections. If stocks are expensive, it doesn’t matter who we choose as President. On the facing page, we detail our outlook for the major asset classes and describe our current tactics.

Current Outlook and Tactics

US stocks are expensive. We use a valuation discipline when evaluating stocks. We believe that paying the right price for stocks tilts the longer-term odds dramatically in your favor. This means that we don’t much concern ourselves with the impossible task of getting short-term market predictions right. A direct result of the last 4-5 months’ stock rally is that the S&P500 index is now priced at 22.7 times normalized earnings. By “normalized” we mean company earnings that are smoothed out over a ten-year period, and adjusted for inflation. We use this smoothing technique because earnings rise and fall in the short-term and have a strong tendency to revert back to an average growth line that matches the overall economy. If the economy is growing at, say, 2%…and earnings grow for a while at 8%…we know with certainty that earnings growth must slow back down so that the average matches overall GDP growth. Hence, our smoothing approach works. The long-term average S&P500 valuation is about 15 times normalized earnings. Today’s 22.7 figure has been exceeded only by four periods in the past 100 years: Late 1920’s, Late 1990’s, Late 1960’s & 2007.

You might recall that all of those periods ended badly. Further compounding the risk of an over-priced stock market is the fact that earnings reports have already begun their inevitable mean-reversion and are moving back down. We are strongly underweight to US-domiciled large cap stocks (i.e., the S&P500). Our stock exposure is concentrated in global (mostly European) large-cap stocks that pay high dividends. We are also over-weighted to the energy and natural resources sectors. The world’s long-term energy and resource needs are going to continue to grow, despite current economic softness.

Most bonds are expensive. With the Federal Reserve artificially pushing interest rates down, most categories of high-quality bonds offer such low after-tax yields as to doom bondholders to returns below the long-term rate of inflation. We own almost no Treasury bonds or high-quality corporate bonds. Where we do see opportunity in bonds is in privately-issued mortgage bonds and selected municipal bonds. Yields in those two sectors continue to provide after-tax returns that exceed our longer-term inflation expectations. We are strongly overweight to municipals and moderately overweight to mortgage bonds. Our base-case scenario anticipates weak growth and low interest rates. The combination of demographic trends and deleveraging provides a strong headwind to robust real economic growth. This is the key outlook that leads us to continue to seek high dividends on the stock side of portfolios, and high after-tax yields on the bond side. The two alternatives to our base-case are not good. If the economy slows significantly, or even goes into recession, we would expect a major correction in global stock markets. Our overweight to bonds will serve us well, as bonds will continue to provide good income and price appreciation. But overall, slower growth will not be
good for investors and savers.

Conversely, if the economy accelerates rapidly, inflation will jump and interest rates will follow suit. In the near term, this could wreak havoc on stock and bond markets. For this reason, we are keeping our bond maturities short and allocating capital to high dividend, value stocks. In the rapid-growth scenario, we will need to grit our teeth and suffer short-term volatility. We can then re-allocate capital into fallen asset classes.

Sure-Fire Strategy for Improving Returns

Investing is the art and science of making decisions in the face of great uncertainty. There is no “sure thing.” Even the iron-clad guarantee inherent in a US Treasury bond is fraught with uncertainty. While you are sure to get your principal back, together with all interest payments, inflation might have eroded the true value of your money by the time you get it back. We need not even dwell on the uncertainty of stocks, commodities and real estate.

While we do our best to make good investment decisions in the face of this uncertainty, there is one investment tactic that produces a sure result: Keeping investment expenses low.

According to the financial industry software firm Pricemetrix, the typical affluent client at a brand-name large advisory firm pays close to 3% per year in total investment expenses. The base advisory fee averages 1.3%, and that’s what most clients think they pay. But, mutual fund fees, commissions, custody charges, managed account fees, “access” fees total an average of another 1.7%.

Two independent money managers we admire expect portfolios invested in a prudent balance of stocks and bonds to average only 3-5% over the next 7-10 years. (We cite that range because we agree with it.) If investment expenses eat up 3% of that return, investors will be paying 60% to 100% of their investment
gains in fees!

Over the past two years, Creekside has implemented a comprehensive initiative to reduce investment fees. We have shifted core asset classes to low-cost ETFs and index funds. We have shifted most actively managed mutual fund positions (which typically cost more) to institutional shares with lower costs. We buy municipal bonds directly from small specialty dealers, rather than via more expensive mutual funds and brokers. These efforts have cut the total investment expenses of our clients to less than half the industry average — and even lower in some cases. That money is a sure-thing, and goes right to the bottom line.

2012 Calendar Year Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

High-Yield Bonds

High-Grade Bonds

Inflation
(year-over-year August 31)

16.08%

14.88%

10.48%

11.08%

4.27%

3.94%

1.7%

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.