Compass January 2009

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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On Thermodynamics and Investing

Much of the mathematical underpinnings supporting classical economic theory derive from a longabandoned effort in physics using roughly the same approach: Create a set of equations and solve for conditions of “equilibrium.” This approach gained some ground among physical scientists for a while in the early-mid 19th century. It led pretty much nowhere and was abandoned.

However, the abandoned equations were picked up by economists with not much else to work with, and we still use them today. You can follow that family tree of equations forward a century or so as it morphed and evolved into “modern portfolio theory” and whatnot. Eventually, you find yourself in a conference room at Moody’s in 2006, concluding that a big bundle of sub-prime mortgages was somehow the credit equal of Berkshire Hathaway.

I took a bit of physics in college — more than the average econ major. I had three physics professors during that time, and each of them gave an entirely different explanation of what is called the Second Law of Thermodynamics. Before you conclude that I’ve really run off on a tangent this time, I assure you there is an investment lesson in all of this. Physics deals with forces; markets deal with forces. Physics deals with the tendency of things to end up a certain way; so too do markets.

The Second Law deals with entropy, usually described as the tendency of all things toward disorder — something we surely hope does not happen in the economy! But that description is really not quite right; a more general and useful way of describing the Second Law, and a useful way of thinking about markets, is:

A system will tend to move toward its most probable state.

What do we mean by “system?” Physicists mean molecules and atoms and such. We in the investment business mean stock markets, interest rates and profit margins and such.

An example from physics: If you put some blue water and some red water in a bucket, the molecules start moving around willy-nilly to random spots in the bucket. Now, it is theoretically possible that all the blue molecules will end up on the left side of the bucket, and all the red ones on the right. But that outcome is exceedingly unlikely. The most probable result is that they are smoothly mixed and you have purple water. The water “wants to be” evenly mixed.

Now imagine you have a special battery-powered magnet that strongly attracts only blue water. You hold it up to the side of the bucket and soon your water is organized: blue in one half and red in the other. You moved the water from its most probable state to some other state by applying an outside force, or energy. Sooner or later, your magnet battery runs out of juice and the water returns to the way it really wants to be. The only way to keep the water in the “wrong” state is to apply some outside force to the bucket.

At Creekside, we hold the view that broad asset class prices and certain economic variables also have a most probable and desired state. However, there are ever-present forces that conspire to push these systems away from that state. The farther the forces pull the system away from its most probable state, the more effort is required of that force. Eventually, the force will falter.

It takes a lot of force to move average house prices to a level that is only supported by 150 percent of the income that the average household actually earns. The more likely price for houses is the price that people can actually afford.

What was this mysterious force? There were a few, but mostly greed and fear. Greed to make money; greed to have a bigger family room. The fear of missing out. The forces of greed never really go away, they just get overcome by reality. Reality cancelled out the greed; the force was removed; the system of house prices is now mov-ing sharply back toward its most probable state.

And so it goes, on down the line through stocks, bonds, real estate and nearly every asset class.

“Fair value” is the value that we think is most probable.”

We have written extensively about our process for determining the “fair value” of the stock market. To put it another way, “fair value” is the value that we think is most probable in the fullness of time. Naturally, we rarely see stock prices actually settle on that value since there are always forces pulling one way or the other. Those forces are almost entirely related to investor behavior — fear, greed and faulty reasoning.

When we believe that a particular system — or asset class market — has moved away from its most probable state, or price, we begin to suspect that the forces that have driven it there will eventually give way. In 2005 and 2006, we thought that stocks had started to move too high relative to their fair value. Our opinion grew stronger by mid 2007 and we further reduced our stock holdings.

Over the past year, stocks have returned nearer to their fair value/most probable level. In fact, they have overshot slightly and are today about 5-8% below fair value. The net forces holding them there are not strong and we expect they could really go either way from here.

By net forces we mean that there are forces pulling strongly up and strongly down at the same time. Plenty of investors and writers think stocks are the deal of a lifetime right now and that economic recovery is just around the corner.

An equal number thinks that things are going to get worse and that life is best spent on the sidelines for a while.

Recognizing this precarious balance, we will err on the side of caution and remain under-weighted for the time being.

Our caution with respect to stocks had another element to it: The condition of the average house-hold’s balance sheet. The most probable (and perhaps most desirable) state of a household “system” is that of a positive net worth: assets should exceed liabilities by a comfortable margin. With a string of a dozen years or so with a zero savings rate, while debt burdens continued to skyrocket, it was obvious that the forces of greed and irrational decision-making were pulling the system of household solvency farther and farther from its most probable long-term state.

Deriving from our Second Law analogy is a corollary: If something can’t go on forever, it won’t.

And it didn’t. For the first time in a long, long time, the household savings rate turned significantly positive in late 2008. That means less spending and more saving (or paying down debt). That means a serious recession and continuing downward pressure for stocks.

In the bigger picture, the most probable state of the whole entire system is that people will go to work and find ways to be productive and support their families. Corporations will earn a particular share of the national income; the rest will be taken home by households. The economy will grow with population and improvements in productivity. Productivity will grow at a modest rate so long as we keep funding public education. Interest rates will settle down a few points above inflation. Interest rates paid by corporations of varying credit quality will fall into a sensible hierarchy. People will pay for a house only what they can afford and they will save for their retirements.

The forces that have, at present, pulled us away from this most probable state will run out of gas eventually. For now, we will focus our tactical investment decisions on those assets that we feel have been pulled farthest away from fair value, as those are the assets most likely to begin the move back the quickest. More details on those tactical decisions are on the back page.

Best Regards, Rick Ashburn

Bonds Offer Bonus Returns

During the wild and historic selloff in the equity markets in 2008, what got less notice was an equally historic selloff in the “credit” part of the bond market. The “credit market” means (for us) any bond that is not a direct US treasury obligation. While treasury bonds performed nicely on the year, virtually every other major bond category declined sharply.

The Vanguard muni bond fund that we benchmark against was down -2.14% in 2008; corporate highgrade bonds were down -6.2% and high-yield bonds were down -21.3%.

However, if we are cautious in our choice of credit quality, these bond categories should produce high returns over the next year or two. Not only are we getting high interest payments, but bonds trading at such deep discounts still have to repay at the face amount.

Let’s say we buy a 10-year bond for 70 cents on the dollar; the bond pays a 5% coupon rate. The “current” yield is 5 divided by 70, or 7.14%. That’s more than 2% above the “face” coupon rate on the bond. Further, we get the 30 cents of discount back over 10 years — another 3% per year on average. That brings the total return over the life of the bond to almost 10% — double what the coupon rate shows.

As a final bonus, we might not have to wait the full 10 years to get the 30 cents. The bond can rally in price back up toward 100 cents (or “par”) at any time. We expect these discount bonds to rally back toward par sooner rather than later.

We have made a tactical overweight to highgrade mortgage and corporate bonds, high-yield muni bonds and high-yield corporate bonds.

“We expect deepdiscount bonds to rally back toward par sooner rather than later.”

Helping or Hurting? (accountability time…)

Did our investment decisions in 2008 help or hurt our clients? We will never claim or expect to be right all the time. However, in the fullness of time, we have to add value, and adding value means that we at least keep up with broad market benchmarks.

Stocks. Our decision to underweight stocks over the past 2-1/2 years paid off handsomely in 2008. The broad global stock benchmark was down 38%. Our average client held less than half their “normal” allocations to stocks in 2008. Added value.

Bonds. Our decision to own primarily nontreasury bonds detracted from overall performance in 2008. As mentioned in the article above, nontreasuries suffered badly in the year and some of our favorite bond funds declined by double digits. Since we benchmark to a bond fund (Vanguard) that is heavily invested in treasuries, we underperformed in 2008. Still, we are highly confident in recovering those paper losses in 2009 and 2010. Subtracted value.

REITs and High-Yield Bonds. We sold our REIT and taxable high-yield positions over two years ago. REITs had their worst year ever in 2008, and we were happy to not own any. Added Value.

Natural Resources and Gold. We sold most of our natural resources and all of our gold investments in early June. By year end, the gold fund was down 20% from our exit price, and the natural resources fund fell over 60% from that date forward. We have since bought back small positions in an energy-oriented fund.

Added value.

Foreign vs. Domestic. We sold about half the foreign bond positions in May and the rest in late October. While these sales avoided sharp declines in foreign bonds, the proceeds were placed into domestic bond funds that performed nearly the same. We never did get into emerging markets, and so avoided the 52.8% decline in that sector. Neutral overall.

“REITs had their worst year ever in 2008, and we were happy to not own any.”

Asset Class Overview – What we’re doing right now.

The value ranges stated below are on a scale of 1-5, with 1 being cheap and 5 being expensive.

Domestic Stocks. Value range: 2.5. In our valuation methodology, stock valuations are slightly cheap, for the first time since 1990-91. Returns over 7-year periods following valuations like we see right now have almost always been satisfying. Due to fundamental economic risks, we remain underweight domestic stocks by 30-40%, depending on client risk objective.

Foreign Stocks. Value range: 2. The fundamentals point to attractive values. Currency factors are perhaps moving in our favor, and we are neutrally-weighted in foreign stocks. Within the category, we are not making a special allocation to emerging markets at this time.

High-Grade Bonds. Value range: 5. Government bonds are expensive — meaning low yields. We are not buying treasury bonds. High Grade corporate bonds offer very attractive yields and are a 2 on the scale. We have meaningful exposure to high-grade corporate and mortgage bonds.

Municipal Bonds. Value range: 1.5. Muni bonds are very cheap right now due to overblown fears about municipal defaults. We know how to pick the wheat from the chaff and have been buying over the past two months.

High-Yield Bonds. Value range: 1.5. On the basis of yield relative to higher-quality bonds, high-yield (“junk”) bonds are very attractive. After holding off for over two years, we have added a significant position in high yield bonds.

REITs. Value range: 3. REITs have gone from wildly over-valued to the middle of the range. There is still far too much uncertainty in order to justify a purchase at this time. We’re not buying now, but we’re starting to keep an eye on them. We see broad indications that commercial real estate is in a very tough position.

Foreign Bonds. Value range: 3. We are essentially neutral on foreign bonds from a pure valuation perspective — meaning yield and income potential. We do not at present have a dedicated foreign bond position. We do have some foreign currency exposure via stocks.

Rick Ashburn & Andy Hempeck

Don’t Add Financial Sector Spice

As you have probably learned from our prior emails, we reference a large set of historical numbers on the S&P 500 when contemplating market valuations. These numbers are like ingredients to an old family recipe and give us a framework to create a portfolio.

A gourmet chef doesn’t always follow the recipe and in many cases makes up his own recipe, but still has a methodology for what the end result should look and taste like. Portfolio management is an inexact science and we would be the first to admit the recipe changes over time. Some of the ingredients are still a bit concerning. For instance, even after the incredible drop we saw in 2008, the financial sector still makes up 13.25% of the S&P 500 as of December 31st.

What can we learn from sector blow-ups? The energy sector in 1972 was 7% of the S&P 500, by 1980 it was 28% of market. That sector lagged the market for the next 22 years.

The technology sector was 6% of the index in 1990, by 1999 it was almost 30% of the S&P 500. I think most of us know about the technology sector; it has lagged the broader market since 2000.

Oh, and of course the financial sector….Before the age of extreme leverage, back in the early 80’s, the financial sector was about 5% of the S&P 500. By 2006 it had reached 22.3%. That is a rather large chunk of the market for the amount of value added to society through the speedy transfer of payments. This was a much slower growing bubble, and it has popped. Don’t expect a quick rebound in financial stocks. The odds are high that financials will lag in the years ahead.

Our recipe tells us not to add extra financial sector spice to the mix at this point.

Andy Hempeck

2008 Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks


High-Yield Bonds

High-Grade Bonds

High-Grade Corporate Bonds


(year-over-year Nov. 30)










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