The four most dangerous words in investing are “This time it’s different.”
Sir John Templeton, founder Templeton Mutual Funds
As we approach the end of October (this is authored on Thursday, October 29th) we continue to examine the events of the past 18 months (to gain perspective on those dramatic events) and to consider what can be reasonably expected for the future. First, the returns on the S&P 500 are 1% month-to-date for October and 20% year-to-date for 2009. These returns indicate a US stock market that has bounced back dramatically from the March 9, 2009 lows (when the S&P 500 was down 24.6% YTD), but where the bounce back gains would seem to have largely occurred. Now the market would seem to be trying to determine where the economy and stock prices are headed over the next year or more.
Last week saw a new book released by author (and NY Times business reporter) Andrew Ross Sorkin with the title “Too Big to Fail”. About 600 pages in length, this is a fascinating, behind the scenes look at how government and Wall Street dealt with last year’s events. We are left with a number of impressions from this read:
1. Until the September 14, 2008 Lehman Bros. bankruptcy filing few of the players realized the severity of what was happening.
2. The quality of information on asset values at some of the biggest financial companies in the world was extremely poor, particularly at Lehman and AIG.
3. The primary component that holds the world’s financial system together is trust, and when that is removed there is systemic failure.
4. The road from riches to rags can be a very short one once trust is lost, or in street parlance once others will “no longer take your name”. The 580 million of Lehman Brothers shares outstanding (of which ¼ was owned by their 28,000 employees) traded at $65/sh starting 2008 ($38 billion total market value), $20/sh in August 2008 ($12 billion total market value) and was virtually worthless by September 15, 2008.
Turning to the economy and stock market in the future, we generally see two schools of thought: (1) “New normal” economy of reduced consumer spending, high levels of unemployment, increased government involvement, lower household and corporate borrowing, and reduced company revenue and earnings leading to low stock returns. The “new normal” theory has be put forward by the highly respected people at PIMCO (who manage the largest bond mutual fund in the world). (2) “Traditional economic recovery” (our term) with inventories being rebuilt as consumers start to spend again leading to increasing corporate profits. The “traditional economic recovery” approach has a number of proponents, including Dr. David Kelly, who is chief market strategist at JP Morgan funds.
Referring to the quote at the beginning of this, the “new normal” would fall into the category of “This time it is different” thinking and should be closely examined in comparison to the “traditional economic recovery” arguments of Dr. Kelly and others. We present each below and then give our conclusions. As a preview, at Payne Wealth Partners we really do think this time it is different, at least over the long-term.
Dr. Kelly provides the following to support his belief in “traditional economic recovery” with GDP growing at an annual rate of at least 4%:
• Credit spreads (level of corporate interest rates as compared to US Treasury instruments) have returned to normal levels
• GDP logged solid 3.5% growth in the 3rd quarter after four quarters of decline
• Over past 50 years there have been 7 recessions and GDP growth for first full year after these recessions has averaged 5%
• Bigger recessions result in bigger recovery; 1st year after two biggest recessions of past 50 years saw GDP grow average of 7%
• Four areas of the economy that are severely depressed could be expected to provide over ½ of economic growth in a traditional expansion (even though they only account for 17% of long-term GDP growth): Autos, housing starts, inventory rebuilds, business equipment spending
• Unemployment can be expected to grow into mid-2010, but then come down at a rate of about 1%/yr over the next five years thereby adding a full 1% to each of those years GDP growth
Bill Gross and Mohamed El-Erian of PIMCO support their case of the “new normal” with:
• The US entered last year with Federal debt to GDP at 45%, but is presently adding to this at a rate of 10%/year. This trend must eventually result in higher interest rates which will slow the economy. At some point the US government credit rating can be expected to be lowered from AAA if the deficits continue at these high levels.
• Consumer indebtedness in US and UK is still too high relative to income expectations and will reduce future consumer spending.
• Banks are holding more reserves at requirements of both regulators and their management, and will not provide the necessary credit needed for recovery in areas such as residential and commercial real estate
• Unemployment has risen beyond expectations, and is expected to remain high for years and eventually settle back at a higher “natural” rate than experienced in the past
• The high levels of public debt will inhibit future fiscal stimulus and will greatly complicate how governments eventually exit their private sector support
At Payne Wealth Partners, we must choose a set of future expectations against which to make our portfolio decisions. As to those future expectations, we see a likely short-term to intermediate-term environment much like that expressed by Dr. Kelly, but with the positives of such an environment already largely reflected in today’s pricing of equities and in levels of corporate interest rate spreads over Treasuries. When we look out longer term we lean to the “new normal” arguments and the lower returns for stocks (and certain bonds) such an environment would bring. For this reason we have our portfolios generally targeted to stock allocations at the low end of our allowable ranges. Specific steps we are taking now in client portfolios:
1. Slightly reducing our allocations to high-yield bonds which have experienced year-to-date returns in excess of 35% as markets normalized. Although we still feel this category has additional future return potential, now is time to eliminate some risk and lock in profits.
2. Slightly increasing our allocations to emerging market equities (with a reduction in developed market international equities) to reflect our plan to continue to increase the exposure of portfolios to the high levels of economic growth we believe emerging economies will experience.
• Consumer indebtedness in US and UK is still too high relative to income expectations and will reduce future consumer spending.
• Banks are holding more reserves at requirements of both regulators and their management, and will not provide the necessary credit needed for recovery in areas such as residential and commercial real estate
• Unemployment has risen beyond expectations, and is expected to remain high for years and eventually settle back at a higher “natural” rate than experienced in the past
• The high levels of public debt will inhibit future fiscal stimulus and will greatly complicate how governments eventually exit their private sector support
At Payne Wealth Partners, we must choose a set of future expectations against which to make our portfolio decisions. As to those future expectations, we see a likely short-term to intermediate-term environment much like that expressed by Dr. Kelly, but with the positives of such an environment already largely reflected in today’s pricing of equities and in levels of corporate interest rate spreads over Treasuries. When we look out longer term we lean to the “new normal” arguments and the lower returns for stocks (and certain bonds) such an environment would bring. For this reason we have our portfolios generally targeted to stock allocations at the low end of our allowable ranges. Specific steps we are taking now in client portfolios:
1. Slightly reducing our allocations to high-yield bonds which have experienced year-to-date returns in excess of 35% as markets normalized. Although we still feel this category has additional future return potential, now is time to eliminate some risk and lock in profits.
2. Slightly increasing our allocations to emerging market equities (with a reduction in developed market international equities) to reflect our plan to continue to increase the exposure of portfolios to the high levels of economic growth we believe emerging economies will experience.
3. Establishing a position in alternative investments that will bring to portfolios return that is somewhat uncorrelated to the stock and bond markets. We are funding this with the reduction in high-yield bonds and a reduction in investment grade bonds (that are again at normalized spreads to Treasuries). Specifically we will have positions in a managed futures mutual fund (Rydex/SGI Managed Futures Strategy) and an option-collared stock fund (Gateway).
Longer term, we can see continuing increases in allocations to the emerging markets, although we would note that it is now commonplace to see emerging markets investments recommended by many, so we would not be surprised to see some short-term struggles for an area that today seems somewhat overdone. Further, we likely will continue to build investments in alternative types of investments that will provide some absolute levels of returns and with correlations designed to offset some of the ups and downs of traditional stocks and bonds.
Longer term, we can see continuing increases in allocations to the emerging markets, although we would note that it is now commonplace to see emerging markets investments recommended by many, so we would not be surprised to see some short-term struggles for an area that today seems somewhat overdone. Further, we likely will continue to build investments in alternative types of investments that will provide some absolute levels of returns and with correlations designed to offset some of the ups and downs of traditional stocks and bonds.
