Compass October 2014

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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Speculating v. Investing

The Pay it Forward theory of investing.

We’re not investing anymore…we’re just guessing what the Fed is going to do.

Some years back, we made the observation that there is a difference between investing and speculating. Investing is the process of allocating your money to some productive purpose or enterprise, with the inherent expectation that the enterprise produces cash flows and returns those cash flows to you. If you do little other than sit back, money will flow to you. Eventually, you are returned your original capital plus some profits. Even if you will need to eventually sell the asset to recover all of your capital, the odds of finding a buyer are high because the asset produces consistent income. Someone that values that income will probably come along in the future and pay some reasonable price for it.

Speculating is the process of allocating your money to some purpose, and then hoping someone will come along later and buy out your position. The asset or instrument to which you have allocated your funds might or might not be designed to return any money to you. Or, you might have paid such an extreme price for the asset that the income is relatively minuscule.

In a speculation, you are not betting on the success of the business opportunity, per se. You are betting that the next person coming along later will think that she can, in turn, find someone to pay more. And that person will think they can find the next person that will pay more. In order for speculations to move ever-higher, there must be an infinite loop of ever-higher prices.

But corporate earnings streams can’t be priced ever-higher. For, as the price goes higher, the yield comes down.

If a share of stock pays $1 per year, a stock price of $25 provides the investor a yield of 4% ($1/$25 = 4%). If the stock moves to $50, the yield is now just 2%.
In a speculative environment, an investor buying at $50 isn’t betting the stock becomes intrinsically more valuable.

No, that investor is betting that the next fool will accept a yield lower than 2%. And that fool is expecting that there will be another fool to accept an even lower yield.

When investment markets turn speculative, participants are no longer investing in streams of income. They are placing bets that successive waves of investors will come along, with each wave accepting ever-declining yields.

It has become readily apparent that stocks are now trading as speculative bets on yields. If the market thinks the Fed will keep rates low (and yield expectations low), stocks rally. If the market thinks the Fed will allow rates to rise, stocks fade. It’s not about earnings anymore. It’s about guessing what the next fool down the line will pay for stocks.

At some point in every market-peaking-cycle, the chain is broken. A new fool cannot be found; the only new buyers are those that want higher yields, not lower yields. At that point, attention returns to the nature of the inherent cash flows or earnings. Only then will normalcy reign and speculating give way to investing.

Macro Conditions & Central Banks

The close of the third quarter saw a general decline in global stock markets. Smaller company indexes took the worst of it, down about 6% in September. For the year, there is a double-digit gap between large-cap stocks and the small caps.

On the global front, foreign developed and emerging market stocks both declined in the quarter, with emerging taking the biggest hit in September, down more than 7% in dollar terms. Part of this decline was due to the strength of the US dollar. A strong dollar has a mixed blessing…it provides for cheaper imports (good for consumers and owners of financial assets), but cuts into exports (bad for jobs).

All of this took place against a now-familiar backdrop of macroeconomic and geopolitical concerns. While the US is holding steady on a path of modest, if uneven, recovery, Europe has stalled; China continues to struggle with runaway credit growth and speculative real estate investing. In these three regions, central bank policies have diverged.

At the same time the US Fed is winding down bond-buying programs, the European Central bank is modestly expanding their buying. The Chinese central bank doesn’t operate quite the same way, but is taking steps to reign in expansionary bank activities.

Geopolitical issues are now familiar, as well. Tension over Russia’s interference in Ukraine has resulted in modest, but growing, economic sanctions. Russia’s potential response to those sanctions has investors in Europe on edge due to Europe’s dependence on Russian oil and gas. The escalation of US military action in the Middle East carries the usual risk of higher oil prices and/or a flight to quality assets.

All in all, our longer-term investment outlook has not changed this quarter.

Macro Economic Factors

Central bank actions continue to be the tail wagging the economic dog. We have written in our last few newsletters about the actions of the US Fed. We have become more “dovish” (as opposed to “hawkish”) regarding the US Fed. We were skeptical of the gloom-and-doom predictions of a few years ago, and our careful study has overturned some long-held assumptions. While we are certainly in unprecedented times, it is not a given that the Fed’s current oversized balance sheet will lead to an inflationary calamity any time soon.

In its September meeting, the Fed indicated its intent to end its net purchases of bonds, while at the same time signaled its firm commitment to keeping the overnight bank lending rate near zero through at least mid-2015.

In Europe, the central bank (ECB) signaled plans to not only cut inter-bank lending rates, but to also buy private-sector bonds (unlike the US Fed which has been limiting its purchases to government bonds). The ECB is hinting at a 1 trillion euro purchasing program. In theory (and theory has proved remarkably weak), this frees banks to make new loans to businesses. The experience in the US these past five years has shown that banks might or might not increase lending. The Fed and ECB cannot force banks to lend. This isn’t China.

The key risk that the ECB is worried about is deflation. Deflation is the train-wreck scenario for a capitalist system. Investment and spending can grind to a halt. Typically, the only quick way out is for massive government deficit spending, something for which there is no political appetite on either side of the pond.

So, for now, it is left for the central banks to deal with deflation risk. Unfortunately, central banks are not as well equipped to stop deflation as they are to stop inflation. Stopping inflation is easy – push interest rates up. Paul Volker stopped the high inflation of the early 1980’s within months. The deflation of the 1930’s took years to reverse.

Contrary to popular commentary and belief, when the Fed “prints money” to buy bonds, that money does not flow directly out into the economy. It’s a special form of money that must remain locked up in bank vaults. The banks are free to use that special money to back additional deposits and loans…but the banks might choose not to, if business conditions don’t support new lending. So the Fed money sits there in the vault doing nothing but providing banks risk-free interest income. Your tax dollars at work…

Inflation

As mentioned just above, the Fed’s job is to fight inflation – and fight deflation. The core CPI rate fell to 1.7% through August; the core PCE figure (which the Fed prefers) was just 1.5%. These figures are below long-term targets, and are too close to zero for comfort. These low rates are helping to keep bond interest rates low, and are not showing signs of accelerating any time soon.

Wages

Without rising wages, you can’t have sustained inflation. Real wages showed a mere 0.4% growth rate; Chairman Yellen has said she would like to see wage growth of 1% prior to concluding that the labor market is tightening. Wages and salaries as a percentage of GDP are at 50-year lows; corporate profits as a percentage of GDP are at all-time highs. That is not an environment conducive to big wage gains.

Employment

The US economy continues to generate jobs at a reasonable rate. Rather than cause any labor market tightness, these jobs are largely being filled by idle, under-employed and new workers. Labor force participation (the % of the adult population in the labor force) remains at a 36-year low, a trend that was well underway prior to the 2008 meltdown. The unemployment rate has come down to 6.1%, but that is still far above the target rate of 5% or so. As chair Yellen put it,
“There are still far too many people who want jobs but can’t find them.”

Outlook

In sum, business conditions in the US are pretty good. Not so much in Europe and the rest of the developed world. Even so, US stock prices fully reflect every possible piece of good news, including continued low interest rates. There just isn’t a lot of upside. We remain at cautious stock allocations; we remain bullish on muni bonds; overall, we are keeping bond maturities in the short/intermediate range.

Mainly, we are waiting patiently. Sooner or later, a sector or two of the global equities markets sells off due to some trigger or another. Such an event often leads to an opportunity to buy good assets at cheap prices. While there are no such opportunities at the moment, we are optimistic that investors will do what they always have, and panic at some point.

Year-to-Date Index Returns (ending 9/30/14)

Total Market U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds

Inflation (year over year)

6.84%

-0.07%

0.22%

6.78%

4.00%

1.70%

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.