September 2011

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Market and Economic Update 09-12-2011

September 12, 2011

The Dow Jones Industrial Average fell 303.68 points Friday, or about 2.69%. Today, Monday, the stock market opened lower. At the same time, the sales price of U.S. Treasuries, which is to say U.S. Government debt, has been rising. Since the interest paid on those government debt securities is a fixed dollar amount, the yield, as a percent of the Treasury securities, has fallen to levels that have not been seen since World War II. In short, money is flowing from stocks into Treasuries.

Because of the size in the two markets, it is also apparent that far more money is flowing into Treasury securities than is flowing out of stocks. Much of the money that is being used to buy those U.S. Treasury obligations is clearly coming from Europe.

This is the physical reality of what is happening. Now, if you will, I would like you to stop for a moment and recall why the stock market dropped so dramatically a little over a month ago. In retrospect we can see that the proximate cause of the stock liquidation was a downgrade in the long-term credit rating for U.S. Treasuries from AAA to AA+ by the Standard & Poor’s rating agency. Once again, the apparent short term logic (or illogic) of those moves makes no sense. Treasuries can go up as long as interest rates can go down. Unfortunately, for shorter term Treasuries interest rates are effectively zero. It is really, really, hard to get lower than that. The Chinese have managed to purchase a large block of two to five year Treasuries that do actually have a below zero yield to maturity, but like I said, that is really, really hard to do.

Looking at these moves from a different perspective provides the underlying cause of all that is happening in the markets. I carefully searched the news reports from Friday and over the weekend for a cause and the proximate reason for the market decline was relatively obvious. Jũrgen Stark, chief economist of the European Central Bank (“ECB”) turned in his resignation in protest against the bank board’s decision to purchase Italian and Spanish Sovereign bonds. Now, if that sounds like a pretty weak reason for the equity markets of the world to decline as much as they did, your sense of that issue is correct.

The key to the reaction is that Mr. Stark is German. A couple of months ago the ECB Vice Chairman resigned as well. He too was German. He was also the person scheduled to be the next ECB Chairman. Then rumors came out on Friday that Germany was making preparations to recapitalize their larger banks to cover a Greek default.

If you have read my missives for any length of time you will recall that I have repeated my warning that the amount and interest of Greek sovereign debt was so great that there was no realistic possibility that the Greek government could do anything but default at some point. There is absolutely nothing new about that realization. That is not an issue. What was (and is) the issue is that the ECB is purchasing bonds on the open market to reduce the interest rates on Italian and Spanish bonds. The irrational fear driving the decline in European markets is that a panic ensuing from Greece’s default might cascade out of control and create a financial crisis not unlike the collapse of Lehman Brothers in September 2008.

The collapse of Lehman Brothers was almost totally unexpected. Bear Stearns, another Wall Street investment banking firm that had issued, and still held, immense quantities of unregulated mortgage derivative securities, had been purchased by J.P. Morgan with U.S. Treasury and Federal Reserve support. The assumption was that Lehman Brothers would be treated the same. When the Bush Administration determined that Lehman Brothers should simply be allowed to fail and bear the effects of its unwise investments, the ripple effects very nearly took down the entire world financial system.

In today’s environment, a Greek default should not surprise anyone. Yes, there are those who assume that the European Central Bank will somehow find a way to rescue the Greeks from themselves and it will do so because the wealthy northern nations of the European Monetary Union (“EMU”) will understand that it is in their best interest to “bail out” Greece. A careful examination of the cost that would probably ensue from such a “bail-out” is finally revealing that the Greeks are not likely to change their ways. Any rescue of Greece is very likely to create a worse problem in the future. More, if the EMU arranges to, in essence, “give” the Greek government hundreds of millions of Euros because it lied when applying for admission to the EMU and then lied about the rate it was spending money, why should the other troubled countries not be similarly rewarded?

The EMU is very much like the bird of the same name (the emu). It is, in essence, a rather large chicken. It has a very tiny head and has a tendency to behave in a notably irrational fashion. It is the emu that actually does stick its head in a hole in the ground when frightened. As I have noted before, chickens can live for quite a long period of time without a head. Obviously, so can the EMU.

So why is there a panic in the U.S. markets, because the EMU is having a problem, and more specifically, because the Germans are prudently preparing for the losses that will ensue from a Greek financial default? Here in America, we too are largely headless. We are embroiled in severe partisan political battles with the Republican leader in the Senate openly stating that his primary objective is to create so much unhappiness that the sitting President will not be reelected. We are fearful because we have heard so much gloom and doom repeated again and again in the broadcast and print media and from the Congress that we expect the worst. Any time we expect a disaster, any hint of bad news tends to cause us to panic.

If we want to be successful investors, then we must invest, and even more critically, stay invested, when the market is cheap (low). The actual economic metrics are repeating the same message over and over. That message is that corporations are more profitable today than at any other time since we have been measuring such things. Those same corporations are more productive than ever before. America, the largest exporter in the world, is increasing its exports as fast as or faster than at any time in its history. It is a simple fact that our supposed competitors for world financial dominance are not seeing an inflow of money to their sovereign debt. We are seeing that inflow here in the United States. If you want to see an example of just how different reality is from the media perception, take a look at the Real-Estate Stock asset class which many of you have in your portfolios. It has consistently been one of the better performing asset classes in your portfolio over the past several years. The news media paints the entire real estate market as a disaster. The reality is that there are parts of that market that are making a very good profit.

Yes, we, both as households and as a government, have more debt than we would prefer. That is creating a slow recovery as we focus on debt repayment by “buying down” our personal and business debt. Money we expend paying off credit card debt does not create jobs and in fact causes a decline prices (deflation). That gives greater incentives for retail companies to lay off more workers. The good news is that we are well on the way to reaching a point where we are comfortable with our debt levels. We had a couple of reports last week that reveal a lot about that. The total household debt actually rose for the first time in years, but how it rose was important. Credit card (revolving) debt continued to fall. What increased was non-revolving debt. That type of debt is used to purchase cars and other capital items. It tends to be very low interest debt, and it is what we refer to as “economically healthy” debt.

In short, the U.S economy is recovering, and recovering nicely. Unhappily, that recovery is largely based on a huge growth in productivity and exports. Since the vast majority of employment is in service-related areas, it is not much of a help to the average worker. One of the biggest employment sectors in America is construction, and the biggest part of that sector was residential construction. Right now we have literally millions more residences in American than we have households to occupy them. That metric alone will ensure that we are going to have relatively high unemployment for some time. That same decline in residential value is hurting local governments. The result is very predictable. Private employers are creating far more jobs each month than are being lost in the private sector. Governments are laying off people about as fast as private employers are hiring. Those who wanted less government are getting their wish fulfilled.

This is not a simple or easy recovery, but it is both necessary and healthy. We are shrinking government at all levels while at the same time both making our businesses more productive and competitive and paying down our higher interest debt. This behavior lays the foundation for a serious recovery in the not too distant future.

So what should we be doing now? The answer is also quite simple. We should look at this situation based on the facts and history. We humans have not changed very much in the last few centuries. We are very fond of reacting emotionally and then justifying our actions with some form of rationalization. In short, we are collectively scared and pessimistic. We are primed to panic and make some really bad decisions. Of course the sales force from the financial industry are out in legion promising us “safe, secure, guaranteed” income and growth. The reality is that those promises are bait to lure us into places where the real dangers are carefully hidden.

As for attempting to “time” the market by getting out now and then attempting to jump back in just before it goes up, all I have to say is that quite literally every study on that subject reveals that it does not work. Joe Granville may be a familiar name to some long term investors. He was quite correct in predicting and action on his prediction of the 1987 market crash. Unfortunately, he continued to predict another crash over the following decades and lost all credibility. At any given moment there will be someone who is accurately predicting the next crash. That person will be given great credit when it occurs. Unfortunately, those who have accurately predicted market declines are, almost without exception, absolutely unable to recognize the recovery when it comes. Factually, we are in the recovery now. The S&P 500 closed at 676 on March 9, 2009, two and a half years ago. As I write this that same index is “down” to only about 1,150. That is a 70% rise in two and a half years. Think of the irrationality that goes with considering a 70% increase in value to be a “loss” and a “down” market.

A well diversified and well allocated portfolio remains the safest long-term investment strategy. The difficulty is that we can actually see the variance in market value. We are tired of that disclosure. What we want is for someone else to take responsibility for that and for them to make us some promise. That they may be unable to keep the promise is less important when we are really afraid than the short relief of the façade of security.

Frankly, I am tired of encountering bad news and fear too. I could change the way I do business right now and start selling something like indexed annuities and create, quite literally, millions of dollars for myself in a short period of time. I don’t do that because I am convinced that those millions of dollars I would receive would be at the expense of my clients.

I am also very, very tired of this drought. I am tempted every day to go out and adjust my sprinkler system to dump great quantities of water on my yard. Our grass is dying. We are losing trees. We are and have lost some really beautiful plants. Still, I hold to minimal watering on the days when our local water authority tells me I can do so. What I will do as the drought ends (and it will), is to replace those dead, wet climate plants with dry weather plants that can thrive in dry, hot weather. It is a moral decision. I believe over the long term it will also be a good economic decision.

The world is changing. Change is uncomfortable, but it does not need to be disastrous unless we panic. The future is uncertain and anyone who claims to be able to eliminate that uncertainty is either lying or terribly mistaken. We can look at history and at the real numbers underlying the emotional rhetoric and then follow people like Warren Buffett in creating a rational, value-based portfolio or we can run for shelter down the fox’s hole with Chicken Little.

As always, the choice is ours.

If you have comments or questions, don’t hesitate to write.

Market and Economic Update 09-07-2011

September 7, 2011

The (Retirement) Income Conundrum

The stock market is behaving irrationally. On Tuesday the Dow dropped several hundred points and then on Wednesday retraced the majority of that back upward. If you carefully followed the daily reasons the market went up or down according to the media reports, you would have to ultimately conclude that Mr. Market was a delusional paranoid schizophrenic. If we are to believe the somber and confident assertions that “Today the market (surged, collapsed, rose, fell, crashed… etc.) because of (fill in whatever you want here),” then we have to conclude that Wall Street is an insane asylum being run by the inmates. Why would any rational person entrust their future to a mob of traders who are rushing to and fro in a manner that makes chickens in a barn yard seem to be acting with the essence of cool-headed wisdom? That question deserves asking, and deserves an answer.

In order to answer that question we have to start far from the trading frenzy of Wall Street, and for that matter the various bourses and exchanges around the world (they all act pretty much the same way). It is important to stop and consider what we are doing and why we are doing it as we plan how to employ our investment portfolios in a manner that will hopefully sustain us through decades of retirement. We must start by examining our assumptions.

Over the last half of the 20th century we Americans developed some rules of thumb, or if you will, assumptions, concerning portfolios orienting on retirement. One of them was that an ideal portfolio would be composed of a percentage of equities (stock related investments) equal to 100 minus one’s age. Another was the more or less standard 60% equities and 40% bonds mixture. Alternatively, one could always use FDIC insured certificates of deposit (CDs) in bank accounts. Yet another option would be to purchase an immediate annuity from a life insurance company.

How well do those options, and the assumptions behind them, hold up today?

Let’s start with a standard scenario just as a benchmark. In our model I am going to assume that we are considering a couple who will have Social Security as part of their income. In this case I am going to assume that both the husband and the wife will receive about $1,400 per month in Social Security payments for a total of $2,800 per month. That dollar amount, by the way, is based on a person born in 1950 who retires and begins drawing Social Security at age 66 and who was earning about $50,000 per year in the years leading up to retirement. That makes the combined earnings of the couple before retirement about $100,000 per year.

Their combined Social Security then equals $33,600 per year. Using another old “rule of thumb” we will assume that they can get by on about 60% of their pre-retirement income, or about $60,000 per year. To do that we will need to generate $26,400 per year to make up for the difference. This scenario may or may not be applicable to yours, but it gives us a point to start from. It might be interesting to note that the median annual household income in the United States, as of 2010, was just over $50,000, so our retired couple is still making about 20% more than the median working household.

The question that comes to mind is just how much money does our retired couple need to have invested to earn that extra $26,400 per year?

Safety of Principal

Let’s start with a very outmoded concept that originated in the 1930s, that of, “Keep my principal secure.” It is not at all unusual for people to ask to get a relatively high return on investments while at the same time insisting that their “principal” not be put “at risk.” Since upon further questioning that generally means that they do not want to see any fluctuation in their invested dollar amount to the down-side, that leaves only bank certificates of deposit. There is another alternative, which is an interest-payout only immediate annuity, so we will take a look at that as well.

FDIC insured certificates of deposit are the only vehicle that provides the kind of security that most people mean when they say, “Don’t risk my principal.” Insurance companies may offer a “guaranteed” principal, but that normally means only if you leave it with them for 15 or more years. If you attempt to recover the “principal” before that time it is not unusual for them to subtract as much as 15% or in other cases to simply tell you that you can’t have it! There is also the risk with an insurance company, no matter how secure it is today, that in 15 years it may not be there, and you may simply be an unsecured creditor of the company. During the financial meltdown of 2008-2009, quite a few major insurance companies, many of them rated AAA just months before, had to turn to the government to avoid insolvency. It is unlikely that if a scenario like that happens again that the Treasury will have the ability to “bail out” those companies.

According to Bankrate.com the highest Jumbo, 5 Year CD in the nation today will pay a whopping 2.32% of income per year. So, if our hypothetical couple didn’t mind that they would not be able to make any adjustments for inflation, to get that annual income of $26,400 all they would need to do is deposit $1,137,931. Of course, the FDIC only insures up to $250,000 per account so they would need five of those CD accounts and two of them would probably need to be at a different bank. The money would be safe from just about everything except inflation and the penalty for early withdrawal would only be six months interest, or about $13,200.

Even though an insurance company inherently carries a risk, at least our couple would not see the value fluctuate, so they would feel secure if their money were held there. Some of the better companies are offering as much as 3% per year and some of the less well-capitalized companies are offering up to about 3.5%. At the 3.5% rate, in order to get that $26,400 per year, the couple would only need to entrust the insurance company with about $754,286!

The big issue here is two-fold. First, interest rates (and thereby annuity rates) are at record lows. Getting a guaranteed low interest payout in exchange for a total loss of any ability to recover your money in the meantime may well be a decision you will live to regret. The second issue is that rising interest rates are very damaging to bond portfolios. Insurance companies mainly hold bonds. The next few decades may well see more than a few insurance companies in the same kind of trouble as we have seen in other financial institutions over the past few years.

Before we move on, a word of warning is in order. As I searched for fixed annuity rates, I found that there is apparently a market for “Secondary Market Fixed Annuities.” The advertisements I saw stated they were “currently as high as 7.5%.” Don’t be taken in by that number. Those higher interest fixed annuities are priced with a yield-to-maturity that is actually a bit lower than the new annuities. What that means is to purchase one of those “7.5%” annuities, you would need to pay a lot more than the maturity value of the annuity.  At maturity, you would get back a lot less than you invested. There is no such thing as a free lunch. Any time that you see a higher than standard interest rate on anything, there is a hook, and sometimes it is a really big hook.

It is probably unnecessary to mention this here, but do be aware that there are many, many people who will offer you a higher interest rate than anything I am going to discuss. If they do, then you can be assured that you stand to lose money, and quite conceivably all of your money. Ten year Treasury notes are currently yielding around 2% per year. In the final analysis that is the base-line for “safe and secure.” It is possible to achieve a long-term return as much as 6% to 8% above that but there is a price to pay in terms of market volatility, and there are no guarantees. Anyone who offers more than the local CD rate and at the same time guarantees safety, security, and stability is either lying or a fool. Run, don’t walk in the other direction.

Guaranteed Return of Principal

The next best thing to “safety of principal” for some is a guaranteed “return of principal.” That is what the bank CD and immediate annuity promise too. Unfortunately, there is a problem with that promise. Inflation is a real issue. Currently we are in an economy that has little or no inflation and we are probably in a period of time when inflation will remain quite low. If we have 2.25% inflation over the next 15 years and you had that $754,286 back in your hand at that point, you could buy with it about what $536,000 buys today. You would have effectively seen a loss of over $200,000 in buying power in return for the guaranteed return of your principal.

You could avoid that problem by purchasing Treasury Inflation Protected Securities or, “TIPS.” The most recent set of 10 year TIPS sold by the Treasury were auctioned at 2.15%. The nice thing about TIPS is that the underlying principal value rises (or falls) with the Consumer Price Index. The only problem is that you would need about $1,228,000 to generate that extra $2,200 per month! Note too that your income will be paid out every six months, and it will not increase with inflation. Only the principal will rise with inflation. If the low interest rate was not enough of a deterrent for using TIPS it is important to realize that the additional dollar amount of your principal accumulated to keep up with inflation is fully taxable each year or when you remove it from an IRA or other retirement account. Ouch!

The problem with an insurance company guaranteeing your return of principal, even after inflation has reduced it by 1/3, is the same one I mentioned above. There is no guarantee that the insurance company will be there to return the principal. With a Treasury security or FDIC insured CD you may lose value because of inflation, but your dollars will be returned. Is there a risk that the U. S. Government will not pay you back? Actually no. It is in the Constitution. If the government does not honor that obligation, then the dollar becomes worthless and it really doesn’t make any difference where you had it saved or invested. By the way, I consider that particular scenario so unlikely that it is not even worth considering. It falls in the same category as the risk that an asteroid will fall out of space and wipe us all out: extremely unlikely and something that we can to nothing about. So, don’t worry about it.

What Should We Then Do?

Now let’s get back to the stock/bond scenario. As I wrote earlier, one of the supposedly “tried and true” portfolio allocations that newspaper writers like to repeat is that a person should have a percentage of stocks equal to 100 minus his or her age. Our hypothetical couple is 66, so if we assume that aphorism to be true they should retire with a portfolio composed of about 66% bonds and cash and 34% equities (stock).

Again we need to take a hard look at what we can reasonably expect in the way of long term returns in those categories. The Barclay’s Aggregate Bond Index has a yield to maturity of about 2.59% currently. Standard & Poor’s currently estimates the growth in earnings (profits) of S&P 500 component companies to average 10.76% per year. The dividend yield on that Index is 2.08% per year.

For starters, if we combine 66% Bonds (using the Barclay’s Index as a proxy) with 34% S&P 500 (again as a proxy for stocks) we get an actual cash yield of about 2.42% per year. If we were to “not touch the principal” in accordance with the old saying, once again we are going to need to have well over a million dollars to generate that $2,200 per month. The good news is that even at the relatively low price to earnings ratio of the market today, we could reasonably expect that portfolio to appreciate at about an average rate of 3.66% per year. The net result is that the overall portfolio has a reasonable probability of being able to generate a combination of income and appreciation of about 6% per year. In fact, it would not be at all unreasonable to draw about 3.5% per year from that portfolio over the long haul, and still have a very high probability of keeping up with inflation.

Our couple still needs about $750,000 to generate that $2,200 per month, but (and this is important) they have a very good chance of being able to increase that income with inflation. There is no pretense of a guarantee here other than the fact that by diversifying so broadly they are, in effect, investing in the entire economy of the United States. Again, if that fails, then all bets are off anyway. More, their portfolio has a very good chance of being worth as much, in buying power, fifteen years from now as it is today.

I don’t know how you see those figures, but to me having to invest $750,000 just to generate $2,200 per month is not a pleasant idea. More, along the way if (or perhaps I should write “when”) interest rates rise, that 66% of the portfolio invested in bonds is not going to do very well. Yes, it will still generate income, but the market value of low interest bonds as interest rates go up is very likely to decline, and to do so a lot.

Let’s move on to the 60/40 scenario. That produces an expected return of about 6.46% per year. Now our hypothetically retired couple can probably draw about 4% per year from the portfolio over the very long term. That means the investment needed to earn that $2,200 per month (and increase for inflation) is reduced to $660,000.

The Price that Must be Paid

There is no free lunch. In our hypothetical retirement scenario we have managed to reduce the amount of investment needed by half as we have moved from certificates of deposits and TIPS to a mixture of 60% Large Cap U.S. Stocks and 40% high grade domestic intermediate term bonds. Had our retired couple had that portfolio over the past 34 years or so, they would have seen eight or nine bear markets. The average decline in value they would have seen in those bear markets would have been just over 16%. In the worst of them, at least in terms of depth, they would have seen their total portfolio end-of-month value drop by over 37%. Having started 35 years ago at $2,200 per month, their monthly draw today would have needed to rise to $8,158 just to keep up with inflation, but their portfolio value at the end of July would have been ten times that of when they started. Now before you get too excited, most of that gain was inflation. The real purchasing power of their portfolio would have risen to a bit more than twice what they started with.

The price we must pay to have a return that can support us over the long term, unless we have millions to invest and want to live at a relatively low standard of living, is something we in the investment community call “variance.” That is a nice way of saying that in order to get a good-long term return, an investor must be willing to tolerate some really, really scary bear markets and not bail out.

Over that 34 year period the S&P 500 Stock index (including dividends) averaged 6.85% per year after accounting for inflation. Bonds averaged about 3.85% per year after inflation. Those are relatively pleasant numbers, but it is critical to understand that the next 34 years will be different. Interest rates were declining over most of that time. That meant that bonds were performing well above “par.” Interest rates, as I mentioned earlier, are at record lows today. That means that bonds will underperform relative to their historic norms over the next several decades as interest rates return to a more normal level.

The Choice Before Us

In short, we have a choice. We can accept the wild swings of the stock market as the price we must pay to have a reasonable return, or we can accept a 2% to 3% return in less volatile asset classes and just live at a lower standard of living. If we choose to accept the rough ride in return for a better standard of living there are some things we can do to smooth out some of the bumps as well as give ourselves a leg up on the old market.

Of course, there is still the valid question as to why we should believe that the stock market will provide a good return into the future. The popular argument is that stocks have had a long-term average annual performance of about 10% per year for a couple of hundred years. Unfortunately, the same argument is often applied toward investing in bonds and in the paragraphs above I stated that just because bonds have done well over the past several decades is no evidence they will do well in the next several. In fact, the better bonds have done over the past 30 years or so, the worse they likely will do over the next couple of decades.

The Danger in High Interest Rates

Stocks are a very different thing than bonds. Bonds constitute loans to some corporate entity. With a loan there are relatively few variables and some very real certainties. Bonds can be evaluated based on two simple numbers, yield to maturity, and credit worthiness. In essence, an FDIC insured certificate of deposit is a “bond.” While we normally think of them as what we get when we actually deposit money in a bank, we can buy them on the secondary market, just as those “7.5% annuities” are available on a secondary market. If you were to find a $100,000 7.5% CD (or annuity or Treasury bond) on the secondary market that would pay out its principal in five years, given today’s interest rates, the price to purchase that instrument would probably be around $125,000. In other words, you would pay $125,000, receive $7,500 per year for five years (and likely pay taxes on that amount) and then get back $100,000 at maturity. The “yield to maturity” on that instrument is 2.17%, before we figure in the extra taxes. While you were receiving about three times the income per year that you could get from a new bond you probably would be quite happy. When you only got back $100,000 from your $125,000 investment you might not be quite as pleased.

Bonds, Cds, annuities, and anything else with a fixed payout and a maturity date can be calculated with precision. Unfortunately, those same instruments can be advertised in such a way that they seem to be something they are not. The standard against which all interest bearing financial instruments are measured is the U.S. Treasury obligation. As of today the ten year Treasury note (the benchmark of benchmarks) is yielding 2.05% per year. Anything, and I mean anything that has the potential to provide a higher average rate of return than that carries risk. Risk is manageable in most cases, but when a salesperson or advertisement suggests that a higher interest rate is available without risk, then you can be absolutely certain that “false and/or misleading” information is being presented.

It is important to recognize that the higher the “guaranteed” rate offered above that of a U.S. Treasury obligation, the higher and greater is the risk to your investment. Bernie Madoff was producing an average annual rate of return of about 10% to 12% with the perception of little or no volatility in the value of the original investment. Here is possibly the most interesting thing about that; those same investors could have achieved about the same return in a legitimate investment portfolio had they been willing to tolerate some rather severe short term declines in market value. Rather than accepting the short term and often quite scary, market plunges and spurts, they opted for a “safe” solution and in many cases lost everything. There is a fundamental truth there.

Stocks

So, now we are back to stocks. Frankly, that is the only option if you want to have a return higher than about 2% to 3% per year. I know that commodities are out there, and more particularly, gold. Suffice to say that gold will have to rise to about $2,300 per ounce to merely break even (before taxes) with where it was 30 years ago. Considering that most of us do have to pay taxes, it will need to get closer to $2,750 per ounce just to return the net buying power of the amount of money it took to buy an ounce of gold in 1981. Any investment that is still in a loss position after 30 years is not one I can suggest is going to be much help for a long-term retirement program.

Stocks, as individual issues, are risky. Stocks as an asset class over a long period of time are as safe as anything you can own. If you were to have bought the 30 individual stocks in the Dow Jones Industrial Average 30 years ago and hidden the certificates away in a safe deposit box, today your losses would be staggering. There are only a very few of those companies that have survived those three decades. On the other hand, had you somehow been able to invest in the Index itself (you really had no way of doing that back then) you would today have an investment that was worth about 12 times what you paid for it. That works out to an average annual rate of return of about 9%. Over that same time period we had just under 4% average annual inflation, so you would have netted about 5.2% per year in terms of a real return. To do that you would have had to reinvest all the dividends you earned as well as retaining all the capital gains from stocks as they were eliminated from the Index. Over that same period the real (after inflation) return on bonds was about 3.43% per year.

So, why am I claiming that stocks will tend to do better than bonds (or anything else) into the future? The reason is actually fairly simple. Stocks, as an asset class, represent companies that are focused on making a profit. Their executives generally have their future well-being defined by how profitable the company is. Successful people (like corporate executives) tend to behave in a manner that will make them better off in the future if they are given the chance to do so. Sometimes they get greedy, as we saw as Enron, Lehman Brothers, AIG, and Bear Stearns (among others) collapsed into ruin. In other cases they get lazy and far more concerned about their take than the company’s profits. We saw that as Montgomery Ward, Dell, Kodak, and other sank with a whimper rather than a bang. Still, as an asset class, investing in stocks tends to produce better returns over the long-term than any other asset class.

At this particular moment in time, investing in that asset class is particularly attractive. Why? Simply put, because stocks have done relatively poorly over the last ten years. Historically when they have done that, they tend to make up the difference in the next ten. That by itself is not a sufficient reason, but it is an indicator. It is when we look at the numbers that we can see the real, “Why.” The S&P 500 Stock Index today is priced at about ten times next year’s earnings, or profits (P/E ratio of 10). That means that stocks are effectively yielding about 10% per year. The key issue here though is that independent analysts pretty much all agree that that “yield” will not remain steady, but will rise by about 10% per year over the next five years. That means that in about 7.2 years the earnings of the S&P 500 Stock Index will very likely double.

Even if we stay as pessimistic about the future as we are today, meaning that the P/E ratio stays at about 10, then it would be reasonable to expect to see the Dow at about 24,000 at the beginning of 2018. History indicates that it will be a lot higher than that because we tend to swing from pessimism, where we are today, to outsized optimism. If we do that we will likely push the price of stocks up to something closer to 30,000 on the Dow. That number, by the way, would put that stock index right in the middle of the historical price to earnings relationship we have seen over the past century or so.

There then is the question of whether to believe the analysts or not. I have been watching those analysts for quite a while now. They are still very much aware that overestimating future earnings not only will cost them their jobs, but in some cases will result in prosecution. As a result, earnings analysts tend to rather severely underestimate future earnings since about 2000. More, corporations are sitting on absolutely record quantities of cash. That cash is earning nothing. When they do finally regain some confidence in the direction that regulation and the economy is going those corporations will very likely suddenly start spending that money in an effort to stay ahead of their competition. That will be a bigger stimulus than anything the government could do.

Where We are, Where We are Going

We have been here before. We, both as a government and as individuals, are carrying more debt than we are comfortable with. We are in the process of figuring out how and actually doing the job of paying that debt down to a more comfortable level. My best guess is that in about two or three years we will be there. Between now and then we are likely to see growth come in fits and spurts. As we get the debt down (and we are) we will see the economy and the market recover. It is now, at the point of maximum uncertainty when things are the lowest, that the opportunity is the greatest. I am very comfortable in saying that five years from now we will look back and wonder what it was that was so scary.

Meanwhile, there are other equity asset classes that have a better and more stable long-term return than that of the S&P 500 Stock Index, and that stability gets better if we mix the right ones together in the most appropriate way. We can’t offer guarantees and we can be sure that the ride will have some bumps and grinds that are anything but pleasant, but we can be sure that we are on the track that history and science tells us is the most likely to provide what we need.

As is always the case, a good asset allocation plan is the best policy.

If you have questions or thoughts on any of this, don’t hesitate to email or write.