Compass January 2012

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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But on the Other Hand…

Among the first lessons taught in an introductory economics class is the notion that most economic changes have outcomes that simultaneously pull in separate directions.

A company might decide to raise its prices by 10%. If its customers continue to buy the same quantity of product, the company’s revenues go up 10%. However, customers will usually buy less of the product, pulling revenues down. The trick for the company is to figure out whether the upward force on revenues (price increase) is offset by the downward force on revenues (decline in sales). Just how large a response customers make to price increases is known as the “elasticity of demand.”

We sometimes call this principle: Be careful what you wish for. We figure this lesson was learned recently by the folks at Netflix, as a price increase drove away so many customers that total revenues began to fall.

A strongly related principal is that nothing is free — there is no “free lunch” in economics. Businesses can’t simply raise prices with impunity and expect revenues to rise. Likewise, an economy can’t enjoy growth — and rising prices/wages — without interest rates rising to at least normative levels.

As we survey the global economic landscape at the turn of the year, we worry about the interest-rate implications of a genuine economic recovery.

In the same sense that rising widget prices can trigger the backlash of reduced widget sales, a rising level of economic activity can trigger the backlash of rising rates. Just as the widget maker must assess the net implications of pricing decisions, we must assess the net implications of an improving economic — and employment — environment.

Interest rates are today held down to artificially low rates due to combined actions by our Fed, the European Central Bank and the currency policies of China and Japan. Among the few universal truths of economics is the notion that…

If something can’t go on forever, it won’t. Governments and central banks cannot keep a lid on interest rates forever, and surely not in the face of economic expansion and inflation. Should the recent good economic news sustain and repeat over a couple of quarters, and if employment levels begin to improve materially, we find it hard to imagine that interest rates do not begin to move back to normative levels. By “normative,” we mean that medium-term risk-free (i.e., government) bonds offer a return to investors at least equal to inflation. At present, the 10-year US treasury bond yields a full 2% below the inflation rate. Again, if something can’t go on forever…

So, we find ourselves neck-deep in a welldeserved cliché of economics commentators. We say, “On the one hand, this…and on the other hand, that…”

The economy is improving. On the other hand, a rise of interest rates will clobber bond investors. That clobbering often spills over into markets for stocks, real estate and other risk assets. The clobbering sometimes gets painful enough that it even slows down the nascent recovery.

In the summer of 1994, as the recovery from the ‘91 recession gained traction, interest rates rose a full two percentage points. Bond portfolio losses were so extreme as to cause the failure of a few large bond-heavy endowments and county investment pools. Prices did not fully recover for about three years. The key protection one would deploy against such a price shock would be to keep bond maturities short — say, inside of five years.

The probable shock to prices of longer-term bonds is the “on the other hand…” scenario that concerns us. Most of our client objectives are to achieve balanced, consistent returns that keep them ahead of inflation. At present, it is not possible to buy high credit-quality bonds with maturities inside of five years that provide an after-tax yield higher than the current rate of inflation.

Note the implications of this market condition:
It is not possible for any investor to make immediate progress toward their long-term investment objectives by buying safe, medium-term bonds, in the current market.

Period. This is not just our opinion. It is a fact of life, and reflects the current policy objective of the Federal Reserve. Yes, investors can move into junk bonds or extremely long-dated bonds (20+ years) and have the illusion that they are getting paid properly. But it is only an illusion.

Our view is that bond investors need to keep portfolios prudently short. That means accepting a below-inflation rate of return for the time being, and preserving capital for the eventuality of one of two events: A rise of interest rates to above the rate of inflation; or a decline of inflation itself should the economic recovery falter.


On the one hand, stocks are very attractive relative to bonds.

On the other hand, stocks are somewhat expensive relative to their own history.

An investor thinking about the longer term (say, 10+ years) will recognize that he/she can buy bonds that pay 2-3%, or dividend stocks that pay 3-4%. As a further bonus, dividends tend to rise with inflation. And…you get the upside as the stock value goes up with the companies’ earnings. This “spread” of return above the rate available on treasury bonds is called the “equity risk premium,” and it is nearly as high as it has ever been.

So, why not load up on stocks? Because stock valuations have already fully recovered back to the long-term trend line for corporate earnings growth. Over the course of business cycles, corporate earnings grow at about 1.5% to 2.5% above the rate of inflation (per share). This is both factual and consistent with what we know about productivity growth. Importantly, earnings per share grow slightly slower than the growth rate of the broader economy. The recession was declared “over” in June 2009, with corporate earnings at a low point. Within six months, earnings had fully recovered back to the longterm trend line. Since that recovery, they have grown another 70%.

Over the same time period that earnings have grown 70%, GDP has grown by only 4.5%; and per-capita GDP has not grown at all (all figures after adjusting for inflation). Our eyes gravitate to the long-term trendline for earnings growth. If long-term economic growth averages a normal 2.5-3.5%, can corporate earnings really grow at 3-4 times that rate? The answer is, no, they cannot. Profit margins and earnings growth rates are highly mean-reverting, meaning that they move back to long-term trendlines as surely as the swallows return to Capistrano. We expect that reversion process to begin in due course. See the chart at the top of the page opposite.

Importantly — there does not need to be a recession in order for corporate earnings growth to slow down or even reverse course. Just as earnings can explode upwards in the face of economic malaise (as has happened these past 30 months), so too can earnings moderate and move back to the trendline in the face of economic recovery.

It is simplistic to think that the corporate earnings cycle can only follow the broader economic cycle — and follow it in lockstep. At our October 2011 program, we introduced the notion that the earnings cycles of the largest, globally-operating companies (e.g., the S&P500) can and will probably exhibit less of a connection to the domestic economy going forward than they have in the past. This “disconnect” was amply demonstrated these past 30 months. Large portions of earnings are generated overseas, and reported back here in America. The cash is offshore; the accounting is onshore. A large global company based in the US can report growing earnings that have little effect on US GDP and employment. The gist of this is that our moderately bearish outlook for stocks is not driven by a bearish outlook for the US economy. It is driven by a bearish outlook for continued earnings growth.

In the longer run, we want our clients to own full allocations of global dividend-paying stocks. In the immediate term, we are hesitant to fully invest in stocks since we expect that those stocks will be available at lower prices once the earnings moderation takes hold.

Rick Ashburn & Andy Hempeck

Like Water in a Tub

At the start of 2011, an index of intermediate-term high -grade bonds was yielding about 4.5%. An investor that bought bonds yielding 4.5% would normally expect to earn 4.5% over the ensuing year. Yet, the bond indexes showed a total return of about 9% in 2011. How did the bond return double…and is it likely to happen again?

The 9% total return is a combination of the 4.5% income earned, plus a “paper” capital gain of 4.5%. The capital gain occurred because the interest rate on those bonds declined from 4.5% to 3.25% by year-end. When interest rates fall, the market value of bonds you already own rises.

However, this is a temporary paper gain. Bond returns are like water sloshing back and forth in a tub. The total amount of water is fixed — as is the total amount of money you are going to get from the bond over its life. If the water in one end of the tub suddenly rises, you might think for a moment that you suddenly have more water. But the water inexorably sloshes back the other way. It can also slosh far enough away to make you think you now have less water than you had before. A bond portfolio exhibits an analogous behavior — if you are holding bonds to maturity, the dollar figure on your brokerage statement can slosh up and down. But you always still have the same total amount of income coming to you. As the bond gets closer to maturity, its price sloshes less and less, and it matures at its face value no matter how much sloshing it did along the way.

In order to repeat the total bond return of 2011 in 2012, interest rates on these type bonds would need to fall from 3.25% to 2.2%. We find that unlikely and, in any event, the price will slosh back to face value eventually.

Major Asset Classes Valuation

Taking Stock of 2011 — What Worked? What Didn’t?

A year ago, we presented our outlook for the key investment asset classes, and we positioned portfolios accordingly. Our tactical positioning then was similar to today:

  • Keep an underweight to stocks since stock prices looked too high relative to an anemic economic recovery; stay out of emerging market stocks;
  • Keep bond maturities short since the rapid growth in the money supply foretold rising inflation and rising interest rates;
  • Strongly favor municipal bonds over corporate and government bonds;
  • Keep a reasonable position in non-dollar assets as another hedge to the rising domestic money supply.

The S&P500 index returned just 1.97% last year, all of which was from dividends. Our underweight to stocks did not cost us anything, as that cash was instead allocated to bonds. We avoided the large selloff in emerging market stocks.

Our bond positions mostly did well this year, with the glaring exception of our PIMCO holdings. We bought the PIMCO bond funds since we agreed with their assessment that US interest rates were likely to rise (given the explosive growth in the money supply). PIMCO, and Creekside, were wrong. Interest rates fell and our short bond maturities meant that we did not profit from the capital gains in bonds.

However, as the article on the preceding page notes, unrealized capital gains on bonds are temporary and are never truly earned over a full holding period. While we fell behind the index returns in our bond portfolios in 2011, we are confident that prices will slosh back in our favor going forward.

Our focus on municipal bonds yielded great results, as municipals proved to be among the best performing assets classes of all last year.

Our decision to hold foreign currency-denominated assets proved to be a detractor from total performance. In spite of the double-digit growth rate in the US money supply, the dollar strongly increased against almost every global currency. This was largely due to the continuing uncertainty in Europe and other geo-political risks. Despite the inherent weakness in the US money supply, we remain better off than most of the developed world and the dollar remains the world’s safe-haven currency.

But, as with bond prices, currency rates slosh back and forth and eventually end up where they belong. In the long run, we remain bearish on the dollar and will restore our foreign holdings in due course.

2011 Calendar Year 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 November 30)








Wherever applicable, 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