Compass January 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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Are We Recovered Yet?

When I think about the term “recovery,” I can’t help making an instinctive connection to athletic training and endurance sports. Having dabbled in long-distance cycling and running, I think of “recovery” in physical terms.

Endurance training (cycling, swimming, running) involves the art of pushing yourself pretty hard, getting tired, and then allowing just enough recovery time to go out and do it again. The goal is to get to an ever-higher level of fitness. It’s not one smooth line on the graph, but rather a series of rises and falls. Ideally, the rises outpace the falls and you eventually stand on an Olympic podium. Or at least keep the middle-age waistline from expanding.

Veteran coaches and athletes will tell you that, while the actual hard training is important, equally important is the recovery. If you don’t recover properly, you can’t move on and you don’t get any better. Recovery isn’t the end-goal, it is a process of preparing for additional growth. It is a process that is only complete when you are ready to dive back into the business of progress.

AIn economic terms, we tend to ask whether the economy has “recovered” — and we mean, “Is everything now terrific and back to normal?” I think it is more interesting to ask whether or not the period since the recession first started three years ago has properly prepared us for the growth path to which we’ve become accustomed.

Consumers wildly outran their ability to keep going during the ten years preceding 2008. Households needed to spend their recovery period restoring their personal balance sheets to some sense of prudence. The latest figures indicate that they have — household debt figures, as a percentage of income, have reverted back to the levels of 1998. There remains enormous trouble in the housing market (some 30% of mortgages are underwater), but the consumer sector is on the right track. Consumer spending accounts for nearly 70% of US economic activity, so financially healthy consumers are essential to the resumption of normal growth.

Corporations, particularly in the financial sector, also outran their fitness level. A rest, or recovery, period was required. How did they fare? At the top of the financial food chain, your government helped a select few firms by eliminating their competition and providing financial support. Those companies didn’t really need to recover the old-fashioned way. They got a governmentsupplied steroid injection and are now running off over the horizon with superhuman profits and market dominance.

As a whole, the companies in the S&P500 index have seen earnings rise to nearly pre-recession highs. Earnings have risen so high that they are now well above what we consider the long-term trend line. Recall (from past newsletters) our contention that, in the fullness of time, earnings per-share cannot grow faster than the larger economy. It’s a mathematical truth that cannot be violated for very long.

While consumers recovered by doing what they must in their “rest period” (i.e., reduce debt), the financial industry skipped the rest period entirely and relied on artificial means. The remainder of corporate America seems to have used the break wisely by improving productivity and strengthening balance sheets.

The question is: Have these efforts left the economy poised to resume its upward progress? If we have recovered properly, we will resume our climb to that Olympic podium.

While average households and the financial industry have recovered reasonably well, large numbers of households have not recovered at all. Joblessness remains the theme of the ongoing recovery. Corporate profits are on the verge of record highs, but we have not begun to make the slightest dent in the record number of people without suitable employment. It is estimated that, at the current rate of job creation, it will take upwards of six more years of recovery to reemploy those who lost jobs in the recession. That says nothing about creating jobs for the 5 million new workers created by simple population growth over the next 5-6 years.

So the consumer sector (70% of the economy!) is not quite recovered, and it probably has a long way to go.

What about corporate profits? If profits truly are expanding, those companies will eventually ramp up hiring and we’ll all win medals. Jobs follow earnings, and if earnings are back to historic highs…where are all the jobs?

Justin Fox, of the Harvard Business Review, pointed out back in November that the share of national income represented by after-tax corporate profits is approaching a high previously touched only in 1929 and 2006. Good times, to be sure!

But, there is a cloud hanging over these figures: If we break out only the domestic pre-tax earnings of nonfinancial companies — it is nowhere near historic highs. That figure (consistently north of 10%; barely 7% now) does not jibe with the premise that corporate American is fully recovered.

If the domestic non-financial pre-tax earnings aren’t strong — what companies are making all the money? We can simply take the adjectives from the preceding sentence and pull their opposites:

Mundane Profits Record Profits
Domestic Operations Foreign Operations
(earings not repatriated)
Pre-Tax After Tax
(firms receiving tax breaks)
Non-financial Financial
(it’s good to work on Wall Street!)

This gives us a better sense of why the jobless “recovery” continues. Unless you’re earning much of your money overseas, or work in the financial industry, or have benefitted from a good tax lobby, your company probably hasn’t finished recovering.

So, while the process of economic recovery continues, let’s examine what the policy-makers are up to…there are two flavors of policy: Monetary and Fiscal.

It is a simple matter to recognize the monetary policy of the moment: Roll the presses! Pedal to the metal! As we have commented off and on for two years now, the Federal Reserve is taking unprecedented and extraordinary steps to trigger money supply expansion. This would (in theory) provide a stimulus to the economy since the extra money sloshes around and is (eventually) spent. So far, the Fed’s efforts have done little other than to stabilize (and enrich) big banks.

On the fiscal side of the economic policy machine sits the federal government in the form of the Administration and Congress. A new majority was swept into the House, running in large part on a platform to reduce government borrowing. Within weeks of gaining power, the new majority did what a new majority party always does: increase spending and cut taxes. This provides benefits to voters who want benefits, and tax cuts to voters who want tax cuts. Everybody happy! But, these gifts just raised the projected deficit by $800 billion.

So much for fiscal prudence. The bottom line is that both the Federal Reserve and the Administration/Congress are pulling out all the stops in an attempt to stimulate the economy. All else equal, this provides a strong tailwind for stocks. However, neither of these efforts can go on forever. The Fed cannot balloon its balance sheet to the moon. The government cannot run deficits that grow without end. Eventually, the brakes must be applied.

If history provides any guidance, the only way the brakes will be applied to the stimulus programs is if forces outside the government make it happen. Those forces are interest rates. If and when bond investors begin to demand aboveaverage interest rates for US debt, Congress, the Fed and the Administration will finally need to get serious about reining it all in. Until that time, we expect a continued tailwind from policymakers.

It is highly likely that both flavors of economic policy have used up much of their ammunition, and economic stimulus efforts will wane in 2011. The tailwind will soften and the ship will have to move forward on its own.

Given our concerns about joblessness (above 16% by the broadest measure), the weak quality of corporate earnings and the softening of government stimulus, we don’t think our economic athlete has fully recovered yet. There is still some down-time ahead of us before we are again prepared for the onward and upward climb.

Rick Ashburn & Andy Hempeck

Major Asset Valuation

2010 Recap: Did we add or subtract value? It’s January of another new year, and time once again to look back at our tactical asset class decisions of the prior year. We manage portfolios by, in large part, under– or over-weighting asset classes based on our assessment of valuation and economic conditions.

Stocks. We were underweight stocks in 2010 and this bet detracted from portfolio performance. Stock gains were particularly robust in the small cap sector; we made no specific allocation to small cap. All of the stock market’s gains were had from mid-September onward. We added value in the stock category via an overweight to energy and natural resource stocks.

Bonds. We kept our bond maturities on the short end of the scale. For the first half of the year, we lagged the broader market as interest rates continued to creep downward. In the fourth quarter, the bond market sold off significantly and we were rewarded for our caution.

All in all, our more conservative portfolios largely kept up with market index benchmarks (since we did very well in bonds). Our more aggressive portfolios lost some ground to the indices due to our underweight to stocks. These more growth-oriented portfolios also benefitted from good bond performance, but hold fewer bonds. We remain confident that, in the fullness of the business cycle, our stance on stocks will be rewarded.

Economic Factors
Headwind or Tailwind?

Inflation. Inflationary pressures remain low in the near term. Overall slack in the use of economic resources remains high. We are seeing some upward movement in energy and food prices. However, it is important to note that the price of any given commodity (like energy and food) might rise, and not be the result of broader inflation pressure. Inflation of the genuine kind is driven by money supply expansion, which is quite low at the moment. Energy and food price hikes are painful, to be sure. But, the consequence is not true inflation, but rather a squeeze on our household budgets and standard of living. We’re not betting on imminent high inflation, but we have placed modest bets on energy and natural resource stocks.

Bond Interest Rates. Longer-term bond rates rose a bit in Q4 but remain low by historic standards. There are two ways to seek extra return in the bond market — either buy longer-dated bonds and risk losing out to inflation, or buy bonds that are perceived as having lower credit quality, and risk losing out to defaults. We will not be buying longer-dated bonds, and we will be buying safe credit bonds. Municipals are an attractive credit perception play at the moment.

Yields on municipal bonds are very attractive. The prospect of locking in after-tax returns of 5% over the next 6-7 years is compelling. You would need to earn around 7.75% on taxable bonds, or 6.75% on stocks, in order to equal that figure. And — despite what you read in the papers, there are plenty of muni bonds that are not at risk of default.

Corporate Earnings. As discussed in the main article, some corporate sectors are earning record profits, and some are grinding along. On an overall basis, the share of national income represented by after-tax profits is now touching a level reached only twice before: 1929 and 2006. Astute readers will consider what sort of market movements followed those peaks. Do you want to be buying in when earnings peak out, or taking some chips off the table?

Real Estate. Housing remains in bad shape and ain’t coming back any time soon. Nearly a third of US household have a mortgage that exceeds the value of the house. That is not the setting for a robust move-up market, which is a major driver of house prices. Huge numbers of foreclosures have yet to be processed. The recovery of the housing market is far from over and will continue to be a drag on the economy for the foreseeable future.

Employment. Last fall, Rick Ashburn appeared on CNBC and used the phrase, “circling the drain” to describe the jobs situation. Economic growth such as we are experiencing now is barely creating enough jobs to keep up with population and workforce growth. The rolls of the truly unemployed and under-employed are not shrinking. 8.4 million jobs were cut in the recession; only 1.1 million were added in 2010 — despite near-record corporate profits.

Peacocks, Market Forecasters and Meteorologists

This time of year the prognosticators are in their full glory. It reminds me of a large group of male peacocks displaying their feathers for all to see. It can be entertaining, but is it helpful to investors? The majority of these highly paid peacocks stay fairly close to the consensus because there is safety in numbers. Occasionally they are right, but the majority of the time they are wrong.

The only thing they have to avoid is being wrong and alone. Being wrong, along with everybody else, is fine. Being wrong, and alone, gets you fired.

Abby Joseph Cohen became a famous peacock in the late 90’s and served as Goldman Sachs’ lead stock forecaster until 2008 when Goldman Sachs finally admitted she had been wrong too many times. The scary part is that, according to CXO Advisory (a market research firm), she was slightly more accurate than most forecasters and she was very consistently very wrong. She was usually wrong, but never alone.

She never issued a bearish forecast of any kind.

In December 2007, she forecasted that the S&P500 would reach 1675 by year end. It finished at 903. That’s real money, you know…

Abby was replaced by David Kostin in 2008. His 2011 forecast is for the S&P to rise over 20%. We have to give him credit for being bold and that is what forecasters do. Investors tend to remember good market calls, but tend to forget the bad ones. Thus the forecasters keep talking up the market as a sales tool for their respective firms so they can sell more products and keep their own companies’ stock price propped up.

The average professional stock forecaster had an average annual error of 17% over the past decade. That is an error of 17 percentage points >per year during a time when market returns have averaged about zero.

How many of us would believe a weather forecaster on the news who told us he or she knew what the weather was going to be for the whole United States at the end of next December? Is stock market forecasting really any different? At Creekside we try to add value for clients by looking out the proverbial investment window and checking the weather; but it is foolish to pretend that we know what other investors are going to do over the next 12 months. We remind readers: The stock market doesn’t drive itself up and down — people do.

Clients and friends ask us at this time of year what we foresee for stocks in 2011. First, we will point out that stocks don’t know about the calendar — they will do what they are going to do without regard to arbitrary starting and ending dates. Second, stock prices in the short term are driven almost entirely by what Keynes called “animal spirits.” That is, people bid the price up and down based on their in-the-moment reactions, biases, neuroses, misinformation, good information, what Oprah says, and what their barber thinks.

So what should an investor do this time of year instead of listening and reading about the latest peacock antics? Our recommendation would be to evaluate your portfolio and determine if it can hold up in a storm. Sunny days are great and we are fortunate to have a lot of them in California, but how does your portfolio hold up when the rain comes down? Some costly damage can happen very quickly as anyone who has had damage to their home or portfolio can attest.

We have no idea what will happen to stock prices in the coming weeks and months — and neither does anybody else.

Then, what can we know? We can know what the companies are earning, how much they pay in dividends and how fast either of those things are likely to grow over the coming 5-7 years. Investors might decide to pay $15 for a dollar of earnings; they might decide to pay $40. Nobody knows such things in advance. All we can know is that we are buyers at $15 and sellers at $40.

As one of my old bosses used to say, “accumulate regret and shun pride.”

All the prognosticators would be prudent to heed such advice, but they get paid too much so I doubt they will stop. Enjoy the entertainment from them, but try and frame the information properly.

Andy Hempeck

2010 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 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