Compass January 2013

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 Forest vs the Trees

If you were reading the paper or watching the news a couple of weeks ago, you might be under the impression that congress and the White House reached an agreement on the "fiscal cliff." And you would be right, in a sense. They did, in fact, reach a deal to forestall automatic tax increases and automatic spending cuts.

We don’t analyze these tax and spending changes from the perspective of whether they are "good" or "bad" for taxpayers (the "Trees"). That gets into political and philosophical realms we
prefer avoiding. Clearly, the Trees don’t like higher taxes. Our analysis focuses on the largerscale effects on investment return potential (the "Forest"). Our job is to select that mix of assets
that provides the highest return, given the limitations on risk that our clients require. The question is whether or not unhappy Trees will result in an unhealthy Forest.

The new law has four principal highlights:

1. Raise the highest marginal tax bracket, on married-couple incomes over $450k, to 39.6% (up from 35%);

2. Raise the tax on stock dividends and long-term capital gains from 15% to 20%;

3. Limit the amount of itemized deductions that a family earning over $300k can take. At least that’s how it’s been reported. It always helps to read the actual bill…

The actual bill does not "limit" itemized deductions or phase them out. The new rule adds 3% of every dollar over $300k to taxable income. If a family earns $400k, $3,000 (3% of $100k) is added to their taxable income.

The "itemized deduction limit" works out to be a tax increase of 1% to 1.2% on income over $300k. It has nothing to do with itemized deductions. Charitable donations, mortgage interest and other itemized deductions still provide taxpayers with the same dollar amount of tax savings as before. It has been reported as a "deduction limit" since the $3,000 is entered on a line on the itemized deduction form. But placing it on the deduction form is political cover for what is simply a tax rate increase.

4. Repeal the 2% cut in payroll (Social Security) taxes. The payroll tax applies to the first $113,700 of wage and salary income (including self-employment income). Since more than 95% of the American work force falls into that income range, this 2% tax increase will be broadly — and immediately — felt.

While the first three of these tax increases are certainly painful to the Trees paying them, we don’t believe they will make a material difference to the Forest, or the potential return on investment assets. The Forest doesn’t really react to changes in such tax rates. The higher payroll tax also makes for unhappy Trees. However, this tax increase also puts stress on the Forest, at least in the short term.

In our assessment, the payroll tax increase will have the most immediate economic effect. Most American households spend nearly every dime they make every paycheck. Starting right now, the payroll tax increase will negatively affect spending. Taking $25-50 out of more than 150 million paychecks every two weeks will create an immediate headwind to consumer spending. We had long been expecting a headwind to consumer spending as the federal deficit began to be reined in. While high deficits can’t go on forever, and while government spending decisions are often inefficient, one thing is certain: In the short term, high deficits stimulate the economy. Strongly. In our April 2012 Compass1, we referenced a paper that showed that the total amount of the government deficit finds its way onto the earnings statements of companies, virtually dollar-for-dollar. Higher deficits equal higher earnings. Higher earnings sometimes means economic growth and high employment. But not always, and not this time.

The slow ratcheting downward of the deficit presents a headwind to earnings growth. We’re not saying that lower deficits are bad — quite the opposite, in fact. But still, lower deficits can put short-term stress on the Forest and investors need to factor that into their decisions. Is the deficit actually coming down? That brings us to the punchline of the ongoing joke in Washington. The answer is, not yet. The key feature of the fiscal cliff legislation is that congress and the President agreed to kick the more-difficult spending discussion down the road. Conveniently, they gave themselves a deadline that coincides with the time frame during which the government’s borrowing authorization is set to hit its cap.

If you thought the fiscal cliff deadline was stressful, stay tuned. The last precipice was a modest seaside knoll; the next one has us standing at the edge of a catastrophe. Is the nation really ready to tackle Medicare reform? (The word "reform" here being polite shorthand for "massive cuts.") We have our doubts, which leaves us fretful for the health of the Forest as we move into February and March.

We look out over the next 6 weeks of budget/tax negotiations and consider three outcomes. The investment implications of those outcomes are summarized on the page to the right. In the longer run, we still anticipate slower US growth than over the past 50 years, but with continued solid growth globally. The "budget deal that wasn’t" resolved a few things, but left all the truly important issues to further fighting. The American people have some tough choices to make. We’ve gotten too much, without paying for it, for too long. One or the other has to give, and any combination of choices presents an economic headwind.

Rick Ashburn & Andy Hempeck

Asset Class Return Outlook

We are always sensitive about publishing forward-looking analysis. Thoughts about the future can quickly morph into "forecasts" and we most certainly are not forecasters. We have expectations about the future, and expectations are by nature somewhat uncertain and might or might not come true. Still, one cannot make an investment into any asset class without first forming some expectations. With that disclaimer, here are ours under three scenarios.

Base Case: A comprehensive deal is reached before March. Like any good compromise, both sides will say they won, and both sides will have unhappy supporters. But at least it’s a deal, and the deficit will come down. This scenario assumes a continued subpar recovery, but at least we move forward. Employment gradually improves, eventually leading to normal inflation of 2.5-3.0%. Interest rates move up as unemployment rate moves down.

Alternative One: A deal is reached, but it’s another fake deal (see lead article). Some unrealistic projections will show that the deficit comes down, sometime out in the distant future. But the government continues to borrow a trillion or more, indefinitely. This scenario keeps the music playing in the short term, but sets us up for more pain in the long term. The government will borrow without shame, until the bond market one day wakes up and says, "enough." The music stops; everybody runs for chairs and there aren’t enough. It’s 1981 all over again.

Alternative Two: No deal is reached; government shut-down or slow-down occurs. A cop-out deal (see Alternative
One) is reached a few days or weeks later. After initial chaos, longer-term outlook is not good. (repeat: see
Alternative One)

There is, in theory, a fourth path. That is the Goldilocks path of no serious budget deal, yet a fast-growing economy that bails us out of trouble. This happened in California during Schwarzenegger’s reign (due to housing bubble), but we don’t think it’s likely on the national scale.

We will point out that, of all the factors that go into our return expectations, by far the most important is the valuation level of assets today. The future is unpredictable, but the price and yield at which assets are priced right now is known with certainty. The price we pay for an asset is, without question, the predominant driver of returns

Asset Class Return Expectations, Next 7 Years (after inflation)

The table makes our current strategy apparent: High-dividend global stocks and muni bonds form the core of our portfolios. Tax-deferred accounts that do not benefit from the muni tax deduction have holdings of mortgage and other high-yielding bonds.

The Economic Wild Card

In the scenarios presented on the first three pages of this issue, the one constant theme is that the US economy will not grow as rapidly as it has over the past hundred years. To explain in more detail…economic growth has only two components. These are broadly referred to as extensive vs. intensive growth. Extensive growth is what you get when you throw more resources at the economy. When the baby boomers hit the workforce, the economy grew proportionately. When women entered the workforce in larger numbers, the economy also grew. Exploitation of new natural resources can drive extensive growth.

Intensive growth is what you get when the same number of workers produce more stuff. This reflects primarily technology advances. The railroad, the electric grid, assembly lines, computers, etc. These advancements allow us to do more, with less. Intensive growth — or productivity — is what allows widespread advancements in standards of living. It’s what allows an economy to grow even after it reaches full employment. Robotics probably holds the greatest promise for productivity growth in the US. With sharply slowing workforce growth over the past three decades, extensive growth prospects are not very good in the US. Fewer young people entering the workforce; more older ones leaving it. This is the primary reason for our expectation of below-trend growth going forward. Yet, there is one potentially powerful driver of growth lurking in the shadows: Fracking technology.

The stunning success of horizontal drilling technology over the past decade has turned the US energy outlook completely on its head. The sudden availability of cheaper, cleaner and plentiful energy changes assumptions about the slowdown of extensive growth. Any industrial process that requires high inputs of heat or other energy will be cheaper to perform on American soil than overseas in the coming years. That could serve to drive employment higher, and continue to absorb both new workers entering the economy and those currently unemployed or under-employed.

Calendar Year 2012 Index Returns

Total Market U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds









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