Compass April 2011

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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Bedtime Stories: The CALPERS Way

History might not repeat itself, but it does rhyme.

Since early 2008, when the financial crisis moved into full tilt, we have been largely occupied with rapidly changing market conditions. We sold risk assets, then bought some of them back. We sold foreign bonds, then bought them back. We bought muni bonds, sold them, and bought them back again. For the most part, those moves added value to portfolios by reducing risk, adding return, or both.

At long last, we now feel it is time to focus once again on the longer term. And the longer-term question is an asset allocation question. Asset allocation means to divide up investment capital among the major asset classes:

Stocks, Bonds & Cash

Within these major classes, we would make furthe distinctions between, for example, domestic or foreign stocks, and taxable or tax-exempt bonds. Still, the basic decision among the “Big Three” will account for the vast majority of the difference between any two investors’ results — more than 90% of the difference, according to one classic study.

The standard approach to the asset allocation decision is so entrenched that it is, for all practical purposes, dogmatic. Dogmatic in the sense that, if you don’t do it this way, we might defrock you and send you to the salt mines. Or, the way you do it if you are a political animal appointed to the board of an enormous public pension fund.

That asset allocation method is known as “Modern Portfolio Theory” (or, MPT). It is an elegant theory on paper, but has failed to explain the real world —and failed spectacularly. One wonders when the Nobel committee is going to ask for its prize back.

MPT requires that we compute the average historical returns of the various asset classes, and compute some figures on how they relate to one another over time. We plug those numbers into a nifty software program and, voila, it spits out the “optimal” asset allocation. A variation on this trickery uses so-called Monte Carlo simulation.

The critical (and, ultimately, fatal) element of this process is the assumption that our database of historic returns tells us what the asset class returns will be in the future. If bonds have paid an average of 5.7% in the past, they will do so in the future. If stocks have paid an average of 9%, then they will do so in the future.

Let’s say this process leads us to determine that a client’s optimal asset allocation is 60% stocks and 40% bonds (we’re leaving cash requirements out of it for simplicity). This 60/40 asset allocation will, on paper, provide the family with the optimal combination of risk and return over time, and would be expected to deliver the historic average results from our database.

Stocks have returned an average of 9.8% annually from 1926 through 2010. Diversified bonds have returned about 5.7%, on average. With that, we can compute the expected return for our 60/40 client:

60% of 9.8% = 5.9% from stocks – plus – 40% of 5.7% = 2.3% from bonds – equals – Expected return: 8.2%

If you believe in MPT, you then go out and buy that mix of investments. You make a note to rebalance it in a year, and then get on the phone and make a tee time reservation. Who wouldn’t be happy with 8.2% per year over the next 10 years?

Now we turn our attention to the key flaw in the MPT approach. MPT assumes that markets are never over or under-valued; that investors always make perfect and rational decisions about what to pay for stocks. But, out here in the real world, investors routinely drive stocks too high and too low. Bonds don’t pay “average” returns; they pay what they pay. And today, a diversified bond portfolio pays around 4.2% for 10 years. Not the 5.7% in the historic average.

Likewise, the stock market doesn’t pay “average” returns. Even if corporate earnings grow at an average rate, the price of stocks rises and falls in an unrelated pattern. In our view, the most reliable way of forming expectations for stocks is to examine the price of stocks in relation to the longterm earnings trend of the companies — the“normalized P/E.”

Bedtime Stories

By that measure, stocks are today trading at a 30-35% premium to their historic average. The question we need to ask is not, “What has been the average 10-year return on stocks?” but rather, “What has been the average 10-year return on stocks following a time when they were priced 30-35% above average?”

If I am a farmer choosing a crop to plant this summer, I don’t want to know the average long-term monthly rainfall. I want to know the average monthly rainfall in the summer months. The average year-round monthly rainfall might be 2 inches per month, but if the average for the summer months is only 0.2 inches, I’d better not plant a wet weather crop.

Likewise with portfolios. If current conditions have typically produced low returns, then we might be served better by taking that fact into account.

In the 10 year periods following P/E conditions like today’s, the average annual stock return has been 3.0%. That is a far cry from the 9.8% long-run average and, like the farmer, we should plan properly. If we re-do our math from above by taking into account current conditions for stocks and bonds, we get this result:

60% of 3.0% = 1.8% from stocks – plus – 40% of 4.2% = 1.7% from bonds – equals – Expected return: 3.5%

MPT tells us to expect 8.2% from a 60/40 portfolio. The actual investment markets tell us to expect 3.5% — less than half! That, frankly, is not an acceptable outcome given our long-term inflation expectations of 3.0-3.5%. What to do?

We could do what the board of CALPERS just did …pretend. We could tell our clients and readers a fairy tale with a happy ending and tuck them to bed (and keep that tee time!). CALPERS recently decided to set its longterm investment forecast at 7.75%. While its own staff and outside consultants recommended a lower number, the board caved in to pressure from its “clients” — cities, counties and their workers — and used the higher figure. The higher figure justifies the continued under-funding of retirement benefits by those clients. It’s as if the CALPERS board simply pulled a figure out of thin air.

We reviewed CALPERS’ own staff and consultant reports. The 7.75% return forecast for its diversified portfolio essentially boils down to an expected return on stocks of around 9.9%. We ask our earlier question a little differently: “What has been the average P/E of stocks at the start of a 10-year period when stocks paid 9.9% or more?” The answer: A price more than 40 percent cheaper than the present market! In other words, CALPERS is assuming that they can buy stocks at about 40% below today’s market prices. The only other way to earn 9.9% on stocks for the next 10 years is if the market P/E expands to the nosebleed levels last seen during the tech bubble in 1998- 1999. As you know, that episode ended badly.

We find ourselves in a quandary. Do we buy the 60/40 portfolio, then sit back and resign ourselves to expecting 3.5%? Or do we ignore reality and move forward under fairy-tale assumptions?

We do neither of these things.

We believe that the proper asset allocation is a dynamic target. There is no single “set it and forget it” asset allocation that is “optimal.” Why? Because conditions change. Back again to the farmer…is there a single optimal crop? No…there is a crop for wet conditions, another for dry conditions and a third for uncertain conditions.

Today’s investment conditions are this:

  • Stocks are expensive relative to normal levels; today’s P/E is 23. The long-run average is around 17. (see the facing page for our definition of P/E)
  • Long-term corporate and treasury bonds don’t provide enough after-tax yield to compensate us for inflation risk.
  • Medium-term muni bosnds do compensate us for inflation risk.

If we ignore these conditions and buy the “single optimal portfolio” as dictated by MPT, we are doomed to disappointing returns. Instead, we will wait for conditions to change, and we will change with them.

Today’s market conditions mandate an underweight to stocks, an underweight to long-term taxable bonds, and an overweight to municipal bonds. To the extent we own any bonds, we are strongly biased to short term. Why? So we can sell them when conditions change and buy assets that have become more attractive.

You can be sure that conditions will change over the next 3-5 years. When stocks become normally priced, we’ll buy more. When bond yields exceed inflation by a comfortable margin, we’ll buy more. If cash pays a decent yield, we’ll hold some cash. (See the section to the right for some insight regarding the value of patience.)

We are confident that, as the business cycle rolls on, we will be presented with a far more attractive purchase price for stocks. When that time comes, we will reverse our underweight position and have a better chance of reaching those high return expectations that the CALPERS board has plucked from the air.

Rick Ashburn & Andy Hempeck

Major Asset Classes Valuation

The Value of Patience

Naturally, we cannot predict the timing of market price movements. However, history provides some guidance. We would like to buy more stocks if the P/E comes down to 17 or lower (or, about 25% below today’s market prices). How often does that price point occur?

Over any given 5-year period since 1926, the P/E has moved to 17 or lower at some point 83% of the time. The average low “entry point” for stocks in any random 5-year period is 12. Here’s a rundown on the returns to stocks over the 10 years following a certain entry-point P/E prices:

P/E Ratio* Average Annual Return for the
10 Years Following that P/E Ratio
23 (i.e., today) 3.0%
17 (i.e., long-term avg.) 11.3%
12 (i.e., avg.low point every five years) 12.5%

*P/E ratio means the stock market index price, divided by the average earnings for the preceding 10 years; all as adjusted for inflation. If you want even worse news for buying at today’s price, we would add another twist to the question: What has been the 10- year average annual return following prices like today’s and following interest rate conditions like today’s? A very disappointing negative 1.9%.

What all of this tells us is that we are not well-served by holding the portfolio mandated by MPT (and the one CALPERS is buying). We will be best served by waiting until stocks get cheaper. In the meantime, we will make our money in other assets.

Economic Factors
Headwind or Tailwind?

Inflation. The money supply grew about 4% over the past year. Real GDP grew by about 2.8%. As discussed on the back page of this newsletter, the difference is an approximate measure of inflation: 1.2%. Despite sharp increases in oil and food prices, inflation pressures remain low in large part due to slack in the labor and manufacturing markets. We still anticipate higher long-term inflation and believe that wise investors are not making long-term investment decisions while counting on today’s low inflation rates. Still, rising oil and food prices are working against the recovery.

Bond Interest Rates. Long-term taxable bond rates remain unattractively low. That is, they are unattractive for investors like us, but very attractive for companies and their earnings. Municipal bond yields remain attractive for investors, and we continue to add to positions. We are staying in shorter maturities due to our expectation that higher inflation will return. Low borrowing costs are, on balance, beneficial to the ongoing labor market recovery.

Corporate Earnings. Big-company earnings on the whole have recovered in heroic fashion. While those earnings gains are still dominated by financial companies, the breadth and depth of the earnings rebound is truly remarkable. So remarkable as to be unsustainable, in our view. Profit margins have moved to their highest in history, levels that have never been sustained for very long. The correction back to normal levels would present the stock market with a strong sell signal. While earnings recovery has helped carry the economic recovery, a reversion to the mean will present us with significant headwinds.

Oil — Where Do We Go From Here?

There have been many headlines about the Middle East in the last few months. Is this the only part of the world with unrest? Of course not, but the region is so critical to the world economy it becomes headline news quickly. Even if you try ignoring the news while living in your mountain cabin, the Middle East would catch your eye when you are filling up the gas tank on your snowmobile. The US requires a large amount of energy to maintain our standard of living and produce the items to which we’ve grown accustomed.

While digging into the BP World Energy statistics I was surprised to learn the US actually consumed less oil in 2009 than we did in 1978. Yes, we still use more than any other country, but we have been able to extract more and more efficiency from each barrel of oil when putting it to use. So obviously the future of oil is not a problem for the US with a 30 year trend of less oil consumption right?

Let’s take a look at some numbers and see if we can draw any conclusions. Also from BP, below is a list of Proven Reserves as of the beginning of 2010. (Stated in Thousand Million Barrels)

North America 73.3
South & Central America 198.9
Europe and Eurasia 136.9
Middle East 754.2
Africa 127.7
Asia Pacific 42.2

With a staggering 57% of known reserves it is easy to understand why the Middle East is on the front page of the newspaper. What happens there directly affects our standard of living in the US over the long run. Yes, oil is still being discovered, but not at the same pace we’ve seen historically. Therefore, the proven reserve percentages probably will not change much in the years ahead.

The original question – Oil, where do go from here? At Creekside we cannot predict the future. If the world avoids supply disruptions from the Middle East, we’ll probably be able to chug along for a few more years without much worry. The long term trend appears to be clear though: The global economy requires the black gold to keep it lubricated. Playing the probability game, the cost will most likely increase in the years ahead. Energy is a critical part of the global economy and we believe it is a critical part of a diversified investment portfolio.

When Are Price Increases Not Inflation?

Like you, we have noticed the rising prices of food and fuel. Oil prices have risen by 30% in the past year. Food prices are also moving sharply upwards. These translate to higher costs at the gas station and grocery store, and are immediately felt by all families.

Higher prices must mean inflation, right?

No, not necessarily. First, we have to make clear just what we mean by “inflation.” Inflation is a general rise in all prices. Importantly, among the prices that rise are wages and salaries. Inflation of the genuine kind is driven by an expansion of the money supply at a faster rate than the output of goods and services. If the nation’s output rises by 2%, and the money supply rises by the same 2%, we have no inflation.

This is true even if gas prices are jumping upwards. Gas prices can (and do) rise due to the supply/demand dynamics for petroleum products. The price increases that cause us pain at the pump might have nothing to do with the money supply or generalized inflation.

At present, we see little evidence that generalized inflation is picking up. With industrial capacity utilization at 25-year lows, and unemployment at 25-year highs, it is hard to imagine workers successfully demanding raises. Without increases in wages and salaries, a true inflation spiral cannot take hold.

Absent general inflation, the rise in price of a particular product (e.g., gasoline) will cause a combination of two effects: One, we will start consuming less of that product. We might drive less or vacation closer to home. Two, now that fuel consumes more of our budget, we buy less of everything else. The net result is that we aren’t doing and spending like we used to. Our standard of living has gone down a little.

In fact, rising oil prices can actually be deflationary as they can contribute to an economic slowdown as consumers re-balance their budgets by cutting spending on everything else.

We’re not suggesting these price increases are not serious — they can and do affect everyone materially. We are simply pointing out that, under current conditions, they are not driven by true inflation pressures.

We continue to worry about the eventual return of inflation and are taking steps to minimize its effect on portfolios.

2011 Q1 Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds


(year-over-year Feb 28)








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