March 1, 2012 TPWC Newsletter

March 1, 2012

The Beat Goes On

It is definitely a sign of my age that I can remember Sonny and Cher singing The Beat Goes On when it was first released in 1967. For those who are not so privileged as to remember that time, the essence of it is a celebration of how things don’t really change. The heart of the song goes like this:

The beat goes on, the beat goes on

Drums keep pounding a rhythm to the brain

La de da de de, la de da de da

The grocery stores the super mart, uh huh

Little girls still break their hearts, uh huh

And men still keep on marching off to war

Electrically they keep a baseball score

Grandmas sit in chairs and reminisce

Boys keep chasing girls to get a kiss

The cars keep going faster all the time

Bums still cry, “Hey buddy, have you got a dime?”

At the end of 1967, the Dow Jones Industrial Average (“the Dow”) closed at 905. Sonny’s line, “Hey buddy, have you got a dime?” is now, “Hey buddy, could you spare a dollar?” While inflation is reflected in that cry, the standard of living for bums has apparently risen as well since what a dime bought in 1967 costs, on average, about 67 cents today.

While the dollar shrunk, the Dow grew. The dividends paid by the stocks in the Dow over that 45 years more than equaled inflation, and that $905 hit $13,000 Wednesday. Inflation averaged about 4.3% per year while the Dow’s total return averaged about 10.4% per year (including dividends).

The average annual total return of 10.4% is almost identical if we start back in 1926. 1967 marked the end of a historic bull market, and while the Dow managed to bump along near that same level until the end of 1973, it wound up plunging about 50% in 1974 and did not recover to the 1967 levels until 1982. 1926 was pretty near the end of a bull market too. It was the late 1930s before it recovered.

The stock market, at least as represented by the Dow, has multiplied the real purchasing value of invested money by about thirteen times since 1967. Meanwhile, the real average wage earned by an American worker is slightly lower today than it was then. The average new home price in the United States has managed to about keep pace with inflation.

How about bonds or bank deposits? Once again, over that more than four decades a careful saver or bond holder would probably still have almost exactly the purchasing power of the money invested in 1967, assuming that every penny of interest was carefully reinvested and not spent. If we factor in taxes, the saver or bond investor winds up in the hole. The consistency of those various asset class results over long periods is amazing. They are about the same without regard to where one starts in history. I have had the opportunity to review land values that have been in a family for six decades or more. Despite the apparent huge gain in value from the original purchase, after inflation the land is usually worth almost exactly what the current owners’ great-grandparents paid for it.

Finally, there is gold. Back in 1967, federal law forbade the ownership of gold except in a limited quantity as jewelry. If we start in 1974, when investor ownership of gold was legal for the first time in the 20^th century, the average annual appreciation was 6.48% through 2011. After the 4.4% average annual inflation and taxes on the sale, an investor selling today would lose money. (Profit on the sale of gold, or even gold-based securities, is taxed as regular income rather than as a long-term capital gain.)

A Critical Lesson

“The more things change, the more they are the same.” That quote comes from the writings of Alphonse Kerr who lived from 1808 to 1890. It is never “different this time.” I like the quote from Mark Twain, “History doesn’t repeat itself but it rhymes.” Even King Solomon, the reputed writer of Ecclesiastes states, “What has been will be again, what has been done will be done again; there is nothing new under the sun.” (Ecc 1:9, NIV)

Owning an interest in a productive company, or better yet, a well-diversified portfolio of productive companies, is and has been the prime creator of wealth in the United States. I mentioned above that the average worker’s income in the United States has fallen slightly since 1967, but the Gross Domestic Product of our nation has grown, after inflation, by about 3% per year. The gross output, the wealth, of the United States has increased in real terms, by a factor of 3.78, while the average worker’s wage has slightly shrunk. Someone made a lot of money over the past 45 years but it was not the average worker.

The huge difference between the wealth created in the United States and the average wage is in a single area. Those who accumulated and continued to own productive companies became far wealthier over the last four decades. Those who did not own what professional investors call “equity” did not participate. Yes, they, on average, managed to hold their own as long as they were working, and that 1967 standard of living is nothing to be scorned, but they did not get ahead. Many families today have a higher income than the average family did in 1967, but that higher income is a result of an average of two workers per family instead of one. Notably the average household income is only about 30% higher than in 1967, even with an average of two workers per household versus one back then.

It is also critical to note that holding one’s own requires steady employment as well. A person who does not have a substantial interest in productive companies when they cease working will either become dependent on government handouts or face a significant deterioration in income. Unfortunately, the relatively generous payments by the federal government to people no longer working is extremely unlikely to be sustainable over the long term.

Problems with Applying that Lesson

It would be nice if that average annual rate of return of 10.4% in equities was constant year after year, but it has not been so. The real gains of the entire 45-year period occurred from 1982 through mid 2000. Anyone who has been awake and investing since 2000 is very likely to be painfully aware that the Dow today is only fractionally higher than it was at its peak back then. The Dow plunged by 50% in 1974 and by a like amount after adjusting for inflation from 1980 to 1982. It repeated its 50% swoon from 2000 to 2002, and in the second leg of this secular bear market, plunged 50% again from 2008 to 2009. In order to enjoy having one’s money multiplied thirteen times after inflation, an investor had to tolerate four events in which the market value of their portfolio probably dropped by about half! If in even one of those events, an investor bailed out of the market from fear of loss, the potential gain was gone!

The choice seems to be between a set of investments, better defined as “asset classes,” which over time have had relatively little variation in value, but in the end didn’t actually increase an investor’s wealth, and another set of asset classes which over the long term have greatly increased wealth but have had huge variations in value.

The traditional way of adjusting for that scary variation found in stocks has been to mix in a percentage of bonds. The long-standing rule of thumb published by writers who really have not put much thought into it, is that an investor should have a percentage of stocks equal to 100 minus the investor’s age with the rest in bonds. If we assume the historical 6% (after adjustment for inflation) return on stocks and current yield to maturity on 10 year bonds of about zero after probable inflation, then an investor following that rule of thumb when retiring at 65 would have about 35% of his or her portfolio in equities (stocks) and 65% in bonds. From that portfolio, he or she could reasonably expect a net, real return of about 2.1% per year. Even if we ignore inflation (not a good practice), the gross return of that rule of thumb portfolio mix would probably be about 4.9% per year.

If a couple would like to retire on a total income of $50,000 per year that can be adjusted for future inflation, and they will receive the average couple’s total Social Security annuity each month, using the rule of thumb portfolio, they will need to have about $1,400,000 invested. I suppose somewhere there is someone who is using those figures, but in my experience, a couple with nearly one and a half million dollars would not be too happy with an expected real return of around 2.1%.

Inflation has the potential to be a real spoiler here. The long-term average inflation rate in these United States of America has been about 3%. Because we have had higher inflation over the last four decades or so, odds are that it will be a little lower for a couple of decades into the future, but there are no guarantees. Bursts of inflation have suddenly emerged even in the midst of a long-term deflationary period. The buying power of the dollar dropped by nearly 50% in the four years from 1915 to 1919, despite the fact that we were solidly on the gold standard for the entire period! Could that happen again? One would certainly hope not, but the same 50% decline in dollar buying power hit us again between 1972 and 1980. We do seem to be hit by a short but intense burst of inflation about every 50 years, which would put the next surge somewhere around 2030. Before you give a sigh of relief, 2030 is only eighteen years from now!

The current rush is to some form of “guaranteed” income, generally from annuity companies. Not coincidentally, the years leading up to those sudden bursts of inflation that halved the purchasing power of a dollar domestically were also eras when guaranteed dollar income contracts were very popular. I remember seeing an advertisement in 1962 covering a whole page in Life Magazine promising an abundant retirement income to anyone who would purchase an annuity from some life insurance company. The assumption was that a person would make payments for 30 years and from that point receive so much money each month that they could live a life of leisure well into the 21^st century. The promised payout was $300 per month. In 1962, today it would take an annual income of over $27,000 to buy what $300 per month bought when that advertisement ran! Sadly, I have met people who did purchase those annuities forty or fifty years ago. Some lost their money when insurance companies failed, but most now recognize that the promised high income is often not enough to pay the electric bill!

How we apply the lesson

In 1952, Harry Markowitz, a doctoral student at the University of Chicago School of Finance, was working on the problem of how to manage market risk in an investment portfolio. In his seminal paper, “Portfolio Selection,” published in the March 1952 Journal of Finance, he theorized that by studying the historical relationships between many asset classes over at least three decades, one could create a portfolio of investments that had the potential for a reasonable return but avoided much of the variance that made stock investing so unpleasant.

Markowitz’s theory encountered general disbelief and it was thirty-eight years later before he received the Nobel Prize for his paper. Over the sixty years since its publication, no better way has been found to obtain a comfortable return while reducing the variations of value in a high performance portfolio to a tolerable level.

Pension funds, such as the Texas Teacher’s Retirement Fund, commonly create an investment policy statement with an expected average annual return of 8% or more for a conservative investment portfolio. More importantly, over the decades since those investment funds put Markowitz’s theory into practice, the expected return set by the fund managers has proven to be not only achievable but often exceeded.

Historically, a reasonably well-diversified investment portfolio designed in accordance with Markowitz’s portfolio theory has been able to provide a long-term performance that is capable of matching that of the major stock market indices over a multi-decade period, but with a substantially lower market risk. It takes patience, discipline, and a commitment to the underlying principles to make such a portfolio allocation work, but over the past six decades, it has worked.

Two elements prevented it from use in individual investors’ portfolios until recently.

First, the computing power necessary to design such a portfolio was, until recently, only to be found in mainframe computing systems. The advent of high powered gaming personal computers has finally brought the computational cost of creating a Markowitz optimized portfolio down to a level where it could be reasonably applied to smaller portfolios.

The second reason is less well defined but just as critical. Markowitz portfolios are profoundly counter-intuitive. They, almost by definition, invest in asset classes and individual investments that are anything but what the popular press or the mass of investors would choose. I have read articles suggesting that may be why they work so well. In the words of John Templeton, perhaps one of the most successful investors of the 20^th century, “Success in investing comes from buying what everyone else is selling and selling what everyone else is buying.”

It is hard for an individual investor to fight off the waves of greed and fear that have the potential to devastate long-term returns. Today we are in a fear period, but the time will come when it is greed that threatens to drive your portfolio into the ditch.

What not to do

No commentary on effective investing would be complete without at least some discussion of what not to do. First, never consider accepting a claim that it is possible to obtain a good return on a “risk-free” basis. Any return above that of a FDIC insured certificate of deposit contains risk. Understanding the risk and managing it is critical, but when a salesman or anyone claims that you should invest in a “low-risk” or “no-risk”, investment, then steer clear. Low or no risk positions have a return at or near zero after inflation.

Along with any potential for a higher return, the risk is there. If the purveyors of that investment have hidden the risk, then the risk is probably so high that if you were aware of it, you would not buy. I recently received an enticement to sell a fixed annuity with a “guaranteed” 8.5% return the first year and 4.5% thereafter. What’s more, the company would pay me 15% of the invested money to sell it! The real return, presuming the purchaser was willing to stay around for the twenty years or so it would take to get it, and the insurance company did not go out of business, was actually about 1% per year according to my calculations. The devil was in the details buried in the fine print. Then, there was the unstated assumption that company would remain solvent for the next thirty years. Remember, there generally is no federal insurance agency covering your investment in a regular annuity. Variable annuities are different and generally secured under the Investment Company Act of 1940 against insolvency.

Stay away from “privately managed accounts,” hedge funds, and non-traded investments. Brokers, salesmen, and others often refer to this set of investments as “alternative investment programs.” In my many years of experience, those programs have had only one thing in common: they pay a very high reward to the people who create them, market them, and sell them. In all my experience, I have never met an investor who experienced a good outcome from such investment products.

As always, your comments, questions, or suggestions are welcome.

February 10, 2012 TPWC Market & Economic Update

Of course, your portfolio is not the same as the S&P 500 stock index. Generally, our allocations right now include Mid-Cap Value domestic stock funds, Real Estate stock funds, Diversified Emerging Market funds, and GNMA or general Bond funds as well as some cash positions in regular brokerage accounts. Here are the returns for those asset classes. The 3-year number is the average annual rate of return. The asset classes used here are from Morningstar Categories or funds.

The reason for including this table here is to demonstrate the need for diversification into different asset classes over time. For example, over longer periods the Diversified Emerging Markets asset class has produced the highest return. Even in this relatively short-term sampling, it has well outperformed the S&P 500, but over the last year has done very poorly. The reality of this picture is that either by reallocating more money to that asset class by rebalancing or by simply staying put in an asset class that has recently underperformed its historic norms, an investor has a much higher potential return than in the recently better performing classes.

As an example of why we use asset allocation, if an investor had an allocation of 33% Mid-Cap Value, 7% Real Estate Stock, 24% Diversified Emerging Markets, 33% Intermediate Term Bond, and 3% in cash, over the last three years that allocation results in an average annual return of about 20% per year. For one year, the return was 1.71%, and for the last three months it was about 5%. Those results compare very favorably with the S&P 500 but the portfolio was only 64% invested in stocks. As a result, the ride was smoother with the downturns taking a far smaller bite out of the portfolio than they did out of the S&P 500 Index.

Another aspect of the numbers listed above is the fact that Real Estate Stock funds did better than any other asset class. That was certainly counter-intuitive. Three years ago, the consensus was that real estate as an investment was a horrible idea. Looking back from today, we can see that having a bit of that “horrible” asset was an excellent move.

The future is always uncertain so the best we can do is noting that over the long-term asset classes have had some consistent behaviors. Of all the methods to predict where one should have money invested, to date, asset class history is the one that has worked the best. If I had made the asset allocation choices three years ago based on my “gut-reaction” I can assure you I would not have chosen this particular allocation. The discipline of following the science of Portfolio Theory, once again seems to be working.

The Economy

GDP and Employment

The Commerce Department reported the U.S. Gross Domestic Product (“GDP”) to have risen to an annualized rate of 2.8% in the fourth quarter of 2011. In January, the official unemployment rate dropped to 8.3%. The official number of new jobs expanded by 243,000 in January as well. Quite significantly, in the Household Survey the Labor Department reported an estimated 491,000-job growth.

The difference is not insignificant, and is consistent with the reduction in unemployment. The official number, known as the “Establishment Survey” asks state employment agencies and major corporations how many jobs they saw created. The Household survey involves calling residences and asking questions about how many people have jobs of those in the household who want to work. Historically, when the economy starts to seriously grow, self-employment and hiring by small start-up companies leads the way. Those new jobs do not show up in the Establishment Survey. Over time, those jobs show up in the data, but it takes a while.

Another good indicator is present in the revisions. The Labor Department revised the job number up about 211,000 for the last two months of 2011. Upward revisions tend to mean that smaller businesses are hiring more people. Generally, there visions to the employment numbers go in the direction employment is likely to go in the future; upward revisions indicate future job growth while downward revisions indicate future job shrinkage.

Manufacturing numbers are up, as are the number of hours worked. The entire employment picture is very consistent with a steady growth in productive employment. There are negatives though. The two areas where the most jobs are being lost is in finance and government. At all levels, governments are reducing employment. Given the mandated federal government funding cuts scheduled to hit at the beginning of next year we could see the overall employment picture slip into reverse. That will not necessarily be a bad thing, but it will increase spending for unemployment and sound ominous when it happens.

Meanwhile the private sector is adding jobs. In that area, the business and the jobs are growing in consumer durable goods and other necessities. People are replacing their larger appliances and their worn out cars. What they are not yet doing is buying a lot of clothes and non-necessities.

Debt

From the numbers I see, it appears that the reason the consumers are not driving this recovery is quite simple. They are still paying down outstanding debt, and many are trying to sell a house somewhere. In order to find work, more than a few people had to relocate. The house where they lived before is in many cases empty and for sale. That is both a potential time-bomb and a sign of responsibility. At some point those absentee home owners may just give up and stop pouring money down that particular black hole. If they do, a new but manageable financial crisis will be upon us. As the economy recovers, at some point in the next few years, it may be possible to sell those houses. However, I suspect that the price they may bring may be still below the mortgage owed in many cases.

In some ways, this situation is like the European debt crisis. The lenders, assisted by the government, can agree to take a partial loss on the debt, or they can get little or nothing from their loan. Since there is much discussion on this subject right now. An announcement came out this morning that the state attorneys general and the major banks reached a $26 billion settlement that may assist at least some of those homeowners to reduce their mortgages. We will have to see the details before determining whether or not this is likely to help. One of the problems with forgiven debt, like those mortgages, is that it creates "phantom income" for tax purposes. If a bank knocks $100,000 off of a mortgage, it may be that the out-of-work homeowner will owe income taxes on that $100,000. Far from being a solution, that might make a bad problem far worse.

The government debt is still growing. In mid-December, the Republican controlled House of Representative passed an “Omnibus Spending Bill” that was quickly approved by the Senate and signed by the President. Federal spending was thereby set for 2012 at a bit over $3.2 trillion. The House Ways and Means Committee estimated that total federal revenues would be about $2.5 trillion. Given that the federal government is already running over budget for this year, we are likely to see a trillion dollar or so deficit. That is the bad news. The good news is that a one trillion dollar deficit is a lot less than the ones we had the past two years!

The better news is that beginning next year, the “sequestration” law that Congress passed last summer goes into effect. The spending cuts required by that law are “draconian” and include a very substantial reduction in defense funding. That is about the time that the economy should be kicking into a serious, sustained growth mode. The combination of the two, unless of course Congress or some outside event derails them, will very likely set us on the course to federal fiscal responsibility. The Congressional Budget Office (“CBO”) also estimates that, if no exceptions are passed by Congress, tax revenues will rise quickly, not only because of a reversion to the “pre-Bush” tax levels, but because an improving economy will push many people into higher tax brackets. Very critically, the CBO also noted that the Alternative Minimum Tax, unless it is repealed, will start producing a great deal of revenue and be critical in paying down our federal debt.

I actually do not think anyone seriously considered that law when it was crafted to be likely to take effect, but today it looks more and more like there will be no compromise. We will get our budget cut, but we probably will not like it.

There is an area we are watching that is worth being concerned about. The ten-year Treasury note continues to trade at an annual interest rate of around 2%. Effectively, regular Treasury securities out to about ten years are trading at a real yield to maturity that is below zero. Insurance companies, banks, and individual investors have poured quite literally trillions of dollars into those debt instruments. At some point as our economy gets into a more rapid expansion, the broad interest rate environment will rise. When that happens, the market value of those Treasury bills, notes, and bonds will fall accordingly. That could easily result in a new set of problems. Again, the Federal Reserve and a lot of people are aware and concerned about this. The most critical effect may be on insurance companies. Many of the major life insurance/annuity companies appear to still be on shaky ground. Following the crisis in 2009 they stocked up on Treasury securities as they traded in their mortgage bonds to the Federal Reserve. That was a life saver then but may have some potential for difficulty going forward.

You may remember that back in the early 1990s, banks and savings and loan institutions that were in the worst shape offered unreasonably high rates on their CDs in order to get more money to stay afloat a little longer. Today, insurance companies are offering high commissions and interest rate guarantees that do not appear to be possible to sustain. It could be they have some magical set of securities to back those rate guarantees, but it appears more likely to me that they are scrambling to get investors' money transferred to their books to stave off possible default. Financial companies tend to do that in hope that things will get better if they can just hang on a little longer. Only time will tell. Remember that any interest rate offered that is higher than an FDIC insured bank CD or a U.S. Government backed debt instrument carries a distinct risk. The higher the rate supposedly "guaranteed" the higher the risk of default. Any organization issuing a rate guarantee of 4% or higher in this environment is at a heightened risk of failure.

One of the difficulties with non-variable products issued by insurance companies is that the underlying portfolio backing the interest rate and principal guarantees is not available for public review. Recently MF Global declared bankruptcy only about a week after being audited by at least one ratings agency. The Congressional testimony in the hearings related to that collapse and the disappearance of about $1.2 billion of supposedly secure customer money revealed that MF Global did a masterful job of hiding their "off balance sheet" risks in Greek and other distressed Eurozone bonds. Insurance company internal portfolios are commonly far less open to scrutiny than was MF Global's portfolio. One of the reasons MF Global got so big so fast was that it was offering higher than standard market interest rates. That is a story that has been repeated as long as there have been markets.

Taxes

This Congress and to a lesser degree, the last one, seemed to be enamored with passing bills that they were confident would not actually go into effect. As one of the last acts of the last Congress, it passed a bill extending the “Bush tax cuts” until the end of 2012, but which raised taxes dramatically on January 1, 2013. Unless this Congress can agree on a compromise, in my opinion a rather unlikely event, next January the tax code will substantially revert to what we had in 2000.

That means taxes will go up, and do so significantly in 2013. When we add the tax increase to the mandated “sequestering” in last year’s budget bill, it means we will be getting out of debt. The difficulty is that we all may suffer some withdrawal pains. Then, in 2014 the Medicare portion of the payroll tax applies to “investment income” for those making over $250,000 per year. The net result is that we need to be aware that taxes are going to be higher in the future. That, in turn, means that we will need in some cases to adjust your portfolio expected rate of return to accommodate the reality of that situation.

As the Congressional Budget Office ("CBO") noted in its 2012 budget analysis, a key element in whether we move toward a long-term reduction in federal debt as a percentage of GDP or tip over into a rapidly increasing debt load is the Alternative Minimum Tax ("AMT"). For many years, Congress has deferred the imposition of that tax, even though it passed at the urging of Ronald Reagan in the 1980s! It is extremely unpopular among wealthy Congressional donors in both parties, but Congress has not repealed it because it is critical to keep it on the books else the CBO will announce that the federal debt will spiral out of control. In short, according to the CBO, the Congress will either allow a big tax on higher income Americans (which is already on the books) to take effect or face a near certain Greek-like debt crisis in the future. Between the AMT, the extension of the Medicare tax to investment income over $250,000, and the increase in regular tax rates, the "millionaire tax" is a moot point. Higher income recipients will pay a much higher portion of their income to the IRS (unless of course Congress passes a tax cut aimed solely at upper income filers).

Note that the CBO has also assumed that the “draconian” spending cuts passed into law last summer that were to take effect unless the “super committee” came up with an acceptable solution in 2011 will go into effect. The result of what appears to be a series of laws passed that were proclaimed publically to be very unlikely to actually take effect is that we actually do have a route out of the debt trap. The question is whether Congress and the President will blink. If they hold to this course, we will suffer some collective pain, but be headed in the right direction. If they relent we can look forward to a much bigger problem in a few years.

We will be watching this carefully, but in the meantime, it is probably a good idea for you to consider that taxes on investment income this year will almost certainly be less expensive than income deferred until next year. The really good news about higher taxes and reduced government spending, as painful as that will be in the short term, is that it will put us on the path to a better economic situation several years from now.

Europe

The European debt crisis sometimes seems like a never-ending story. Greece teeters in and out of a total collapse, but at least in my opinion, it is mainly for dramatic effect. The Greeks have managed to get their creditors to agree to about a 70% reduction in Greek government debt. Admittedly, the Greeks will have to cut their collective life style for a bit, but I would be quite surprised if they did not cheat on the rules as soon as everyone looks the other way. In reality, it is very questionable that the Greeks can even pay back the 30% of the debt remaining. The key is to make it all appear to be “voluntary” to not trigger the credit default swaps held by banks all over Europe. The Portuguese have already used the Greek crisis to their advantage by getting their creditors to agree to a debt reduction before their situation becomes another Greek crisis.

Following a last minute resolution of the Greek debt crisis, watch for the other countries with overwhelming debt to follow suit. One thing that appears clear to me is that each of the involved nations has already anticipated the moves. Each nation is maneuvering to get the maximum advantage either in debt reduction or in legally mandated control over the rest of the Euro-zone. There is still not any resolution as to where all the money will come from to reduce the debt load of the Eurozone countries that are in trouble. The final solution is still an unknown, but at least they are talking about it very seriously.

The risk factor is parallel to the one generated by our Congress. By continuing to hold out the threat of default until the last possible minute in order to terrorize those in power, a slight miscalculation could push things over the edge. I frankly do not like this kind of brinkmanship, but I do believe that the participating parties are not likely to intentionally “blow-up” the situation. I also see evidence that the banks and the Federal Reserve here in the United States have made contingency plans for the collapse of the Euro. The British have also reportedly drawn up plans for that event. It may yet happen.

It is critical to understand that any crisis we see coming for months or years is very unlikely to do much damage. Lehman Brothers’ collapse was unexpected, and the world economic and financial systems were unprepared. In this case many and possibly most players think that a collapse of the Euro system is quite possible. As a result the fire-walls are in place and the fire extinguishers have been passed out. Meanwhile, the rest of the world looks to the dollar and the American system as the most secure in the world. Never lose sight of the fact that as dysfunctional as we may seem to us, we are far, far ahead of and better than anywhere else!

The Future

I continue to believe that the rolling crisis scenarios will fizzle out in 2012 and we will begin to see a perceivable return to a more normal economy. In 2013, I expect to see the economy and the equity markets move very positively. Whomever we elect President will get the credit for a delightful growth surge in the market and the economy. I believe that by the time this decade ends we will see a significant reduction in the portion of our GDP represented by government debt, a stock market far higher than any of us can imagine today, and an economy in great shape and moving forward.

Meanwhile, all the evidence in the short term points to a steady improvement with little or no inflation. Many things could go wrong, but so many people are aware and worried about them that the corrective plans are already on the books. That means that even if something happens, it will not be devastating. The bottom line is that I believe we will look back in a few years and wonder why we were so worried.

As always, your comments, questions, and suggestions are welcome.

Sincerely yours,

Jeff McClure

12-8-2011 TPWC Market & Economic update

By Jeff McClure

 December 8, 2011

The Drama Continues

 A Pair of Shakespearian Dramas

Over the last couple of years there have been two major productions underway, one as a traveling dramatic presentation appearing at various capitals in the Eurozone and the other in that greatest of theaters, the American capital. The European version is playing out as a tragedy while the American theatrical production appears to be a comedy.  Perhaps some form of reality TV show would be even a better analogy. The initial episodes were not too exciting but beginning in early August of this year the stakes were raised and the media hype jumped accordingly.

The European Tragedy

The Eurozone is in a mess. I have written this before, but there is no record in history of a common currency surviving if there is no strong central government to control that currency. Here in the United States we had a currency debacle not too unlike the one going on in Europe. Before that we had the infamous Continental Dollar. Back in the now ancient 1950s and ‘60s it was not uncommon to hear one of my elders refer to some worthless thing as, “not worth a Continental.” We Americans initially addressed the problem by creating a Constitution but did not really resolve the issue until the Civil War. It took us nearly 100 years to conclude that a strong federal government was needed and that only that federal government should issue and control money.

Too Many Languages, Too Much Democracy

In Europe the governmental evolution is much like America before the Constitution. In fact, things are even less organized there than they were here. That is not too surprising when one considers that there are about twenty official languages used in the European Union (EU). Even the smaller European Monetary Union (EMU) has around 15 languages.

The Europeans did have a constitution drawn up last year and it was rejected. The problem was too much democracy.

Our Constitution was drawn up in the Philadelphia Convention from March to December of 1787. It was not ratified by the states until 1791, four years later. Two imperatives drove us to “Form a more perfect Union.” First, Great Britain was threatening to invade and reclaim her 13 rebellious colonies.  Second, the collapse of the common currency (the Continental) had plunged the new United States into a depression from which it was having a very difficult time emerging.

Today, Europe is not directly threatened with invasion from without, although anyone with an eye for history can see that Russia is a potential threat. It is however facing the demise of its common currency and quite possibly a depression.

So, why did the European Constitution fail? To put it quite simply, when the various United States ratified our Constitution (including the Bill of Rights) in 1791, we had already suffered a collapse of our currency, and the threat of invasion was a “clear and present danger.” Importantly, we did not put it to a common vote. In each state the final decision was made by a simple majority of its legislature, not by a popular vote of its citizens. Notably, in several states, including New York, the ratification was accomplished by a margin of only one or two votes!

The delegates from the EU nations took several years to craft a constitution they could all accept, but rather than take it to their parliaments, several nations decided to hold a public referendum on the new treaty/constitution. The popular vote went against the new Union first in Ireland. There is little doubt that the Irish would love to rescind that decision today so as to have the rest of the EU assume their debt.

The Likely Outcome in Europe

It appears to me that things will have to get a whole lot worse in Europe before they can get better.  There are only a few European states that are willing to give up much in the way of sovereignty (states’ rights) in return for a “more perfect Union.” A collapse of the Euro, accompanied by a continent-wide economic contraction will probably have to become a reality before the ancient European nations will be willing to surrender some of their national pride and sovereignty.

While I hate to even contemplate such a thing, it may well take a major war to finally unite Europe. Sadly, even then, the solution may come too late. The Europeans are confronted with a demographic dilemma. They are not having enough children. As a result the population is aging quickly. The strikes that have worsened the situation there are largely about governments attempting to increase the retirement age for government pensions.

There are several major trends underway on the Continent, some or all of which may mark the early stages in what is to come.

• Russia is rearming. Vladimir Putin is about to return to the Presidency and he has already pushed a bill through the Duma dramatically expanding the military budget. Since the rest of Europe is busily cutting military readiness, Russia’s rearming move reminds me of Germany’s similar move in the 1930s.
• Poland, Sweden, Germany, and France are discussing a political and economic union. This could be the beginning of a new Eurozone, but with the political authority to make it work. It could be the core of a United States of Europe.
•  Europe has held together and avoided a major war for a generation because the United States has kept troops stationed there. Budget and political pressures may cause the United States to pull out. If so, then history suggests the nations of Europe will soon be rearming and preparing for war.

In the Short Term

In the shorter term, the Euro, at least as we know it today, is on life support. I would give it a less than 20% probability of survival. Presuming that it fails, there will likely be a short term panic in the markets.

Unlike the unexpected failure of Lehman Brothers, which could have resulted in a total worldwide financial meltdown, the failure of the Euro is widely anticipated in the financial community. The surprise would be if it didn’t fail.

Banks and other financial institutions have been and are running scenarios and drills for just that event. Here in the United States, the impact would be minimal and short. The Federal Reserve has made contingency plans and set up the channels by which it would supply dollars for use by European companies that owed money to American companies.

The upshot of this is that there is a very real possibility that the dollar could effectively replace the Euro as the European common currency, at least for the short term. European companies and nations are purchasing dollars at a record rate. A potential freeze-up in the European banking system was averted last week with the announcement that there would be a coordinated effort by all the major banks in the world to supply European banks with U.S. dollars in order to facilitate the orderly continuation of commerce. That was a major step and amounted to an acknowledgement of the American Dollar as the European backup reserve currency. At the same time it provided a means to get the surplus dollars being held in China, India, and other major exporters into Europe where they are needed.

That, in turn, allows those same dollars to be used to purchase oil, food imports, and equipment needed to keep Europe running. As you may guess, the suppliers of those things whether they happen to be in Africa, Asia, or America, insist on being paid in dollars.

There is a certain irony in all of this considering that Russia, China, Iran, and several other countries were calling for the Euro to replace the dollar as the standard currency for oil purchase a few years ago.

This week the heads of state of EU will meet. If they do not come up with a definitive resolution to the problems they are facing, then it may all be downhill from there.

The Bottom Line

The odds are very high that the Euro will collapse, and even if the system is somehow patched together, Europe will have a very long-term and severe recession. Unless the Eurozone breaks up, the debt load of the insolvent countries will drag down the rest of the continent for years to come.

If the Eurozone comes unraveled, expect a short term market panic, very likely followed by a relatively quick “relief recovery” here in the United States. Every economic indicator here (except for housing) is pointing upward. The reverse is true in Europe and even in China.

Our major trading partners are in North America with our secondary market along the Pacific rim and India. We can not only survive without Europe, we very probably will prosper if the Euro fails. Meanwhile give thanks you are in America rather than Europe. $$.

 The Markets

From Recovery to Expansion

November was a microcosm of what we have seen both over the last decade and even over the last year. If we look at the pure numbers for the month, the S&P 500 Stock Index (S&P 500) was very slightly down. At mid-month it was down more than 5%, but recovered with a 7% jump in the last week of the month.

I have been asked why we do not attempt to get out of the market when we think it is likely to decline and then jump back in before it rises. Last week provided a good example of why.

It was pretty clear that the Euro was in deep trouble for the past several years, and more particularly since the second quarter of 2009. It doesn’t take a great deal of imagination to see that when the Euro finally fails the markets are likely to react negatively. Had we jumped out of the market in March of 2009 awaiting the failure of the Euro before reentering, we would have missed the S&P 500 rising about 80%. Had we jumped out when the Italian bond market indicated that the demise of the European currency was imminent, we would have missed that 7% rise in value we saw last week.

The Economy and the Markets

Growth in real gross domestic product here in the United States is ratcheting up to the 2.5% to 3.0% annualized rate based on November data. Unemployment dropped from 9.1% to 8.6%. I know that many commentators have attributed that to people giving up on attempting to find jobs, but the underlying details of the Labor Department report do not support that.

The Wall Street Journal reported that U.S. auto sales in November were at a 13.6 million annual pace. That is the highest rate since the recession hit in 2008 and up 13.9% from a year ago. During the third quarter of 2011, consumers increased their “durable goods” purchases at an annual rate of 5.5%.

Perhaps the most important number for those with domestic stock investment portfolios is the degree of corporate profitability. According to Mark Zandi, the chief economist at Moody’s Analytics, who has been uncannily accurate in his assessments over the past several years, publically traded corporations are averaging a 15% profit margin today. That is the highest level since 1969.

If the economy is growing at a meager 2.5% rate, how are corporate profits the highest they have been in over 40 years? Like most other things, there are several factors at work here. First, corporate productivity has risen dramatically.  More specifically, here in the United States our manufacturing productivity has been rising at an annual rate of about 5%. At the same time, expenses per employee in the U.S. work force have been declining at a 2.5% rate.

That is both good news and bad news, depending on whether you are a wage earner or an investor. It also explains why our GDP is now officially higher than it has ever been, but we still have 8.6% unemployment.

Businesses are still purchasing new equipment for the long term. That includes computers and machinery that increase their productivity. The net result is that even in this environment in which prices on manufactured goods are actually falling, corporations are able to make things for less and thereby able to maintain their profits.

Our biggest driver in the economy today is a surprise for most people who hear of it. It is exports. Quietly in the background of all the noise and excitement our exports have been rising and our imports have been falling. Each quarter the Commerce Department reports that we are getting closer to being a net exporter of goods and services.

One milestone that was either hit or to which we are very close is the energy trade. We are now exporting about the same dollar value of petroleum products as we are importing. Our imports are primarily in the form of raw crude oil but we are exporting large quantities of gasoline and other end user products.

A Normal Recovery & Expansion

There are business-cycle recessions and there are financial-recessions. The recession we officially emerged from in 2009 was a financial recession. The recovery and expansion following a financial recession is different from that of a business cycle recession.

Business cycle recessions are generated by an excess accumulation of inventory by businesses. They end when the businesses unload their inventory and people resume buying new “stuff.” Financial recessions are very different. First they can easily become depressions. In this case the Federal Reserve and Treasury executed a school-book rescue to halt the banking melt-down that sometimes results from such events.

The Cause and Effect

Financial recessions result from an excessive accumulation of debt, mainly at the corporate and individual level. A key component in that debt before a financial recession is that much of it will be used to speculate. A study released by the Bureau of Economic Analysis last month indicated that the largest single contributor to the housing mortgage crisis was not poor people buying too much house, but speculation by otherwise well-off people.

That speculation was enabled by mortgage companies and banks willing to loan money to people with good credit ratings so that they could buy houses with little or nothing down. In many cases the borrowers stated that they intended to move into and occupy the house, at which point they would sell their previous home and apply the sale price to the new mortgage.

In fact a significant number of those borrowers had no intention of living in the house they were having built or buying. They intended to “flip” the house to someone else at a profit.

The result was that home prices rose across the board, including for those who were legitimately buying or building homes in which they were going to live. The same thing was going on in Ireland, Spain, and other countries. Now we are facing the results.

With the rise in real estate values, taxes collected by local governments rose and those same governments increased staffing and borrowing. The mortgage bonds which resulted from those speculative purchases were assumed to be for primary residences, and as such were considered to be a “safe” investment for banks, insurance companies, pension funds, and everyone else.

With the realization that far too many people and institutions were “gaming the system” in a speculative frenzy, the house of cards came down. Now we have a lot of debt on the books of a lot of institutions, people, and governments.

Recovery and the Benefit

We are now well into the real recovery from that debacle. A financial panic and recession can be a good thing; that is, if the companies in the economy use it to “tool-up” and get better technology to become more competitive. That idea is the subject of the classic book, Creative Destruction. Here in the United States we have done a very reasonable job of recognizing our errors and are well on the way to correcting them.

Corporate debt is at historic lows. Personal debt is coming down fast. While it may be hard to accept, even our national debt is at a not-unhealthy level. Yes, we do need to figure out how to deal with the projected expenses of our entitlement programs for the elderly, but that had little or nothing to do with the current crisis. The key is that the crisis is causing us to debate the issue.

The Congressional Budget Office has noted that if we do nothing and allow the Bush tax cuts to expire at the end of 2012 we should be well on the road to paying down the national debt a decade later. Only time will tell.

The Market

Meanwhile the S&P 500 is low. Historically, the average forward price to earnings (P/E) ratio of that Index has been about 17. Today it is about 10. That means that when we finally get the Congressional reality show and the European tragedy behind us, even if corporate earnings were to remain flat, we would likely see a rise in market values of about 70%. That equates to a Dow of about 20,000. I know that sounds absurd, but if anyone (other than me) had told you in 2009 that we would see a double in market value three years hence, you would have thought that was crazy too.

In 1982, the last time the P/E ratio was this low, the Dow was at 1,000. $$

11-3-2011 What a Difference a Month Makes

November 3, 2011

The Dow Jones Industrial Average (The Dow) ended September and the third quarter of 2011 at 10,913, about where it was back in 1998. Despite its drop at the end of the month, it ended October at 11,955. That 1,042-point increase equates to a 9.55% gain in the Index. As I write this on the third day of November, the Dow has risen above the magical 12,000 mark and ended the day up 208 points at 12,044.47.  That puts it up about 10.4% in just over a month.

Note that what has changed since the end of September is that the probability of Greece defaulting on its sovereign debt in the near future has actually risen, but the value of the Dow is up over 10%. So what happened?

In the last week or so, the Commerce Department announced that the Gross Domestic Product (GDP) of the United States rose 2.5% in the third quarter, even as the stock market reflected values that seemed to signal a return to recession. We now know that automobile sales rose 7.5% in October. Sales at Chrysler rose 27%. Toyota, Honda, and Nissan all reported that the reason they did not hit high sales levels was that they had a shortage of cars! You may recall that about a year ago, I wrote that based on a J.D. Powers survey, Americans were likely to be in the position of wanting to purchase more cars than we had the capability of producing sometime within the next few years.

In the GDP report, the Commerce Department noted that consumer spending rose 2.4% in the third quarter, even as the consumer confidence polls reported that those same people stated they were not increasing spending. A closer look at the rise in consumer income and spending reveals the reality. In both August and September, American saved or paid down debt to the tune of just under half a trillion dollars per month ($479 billion in August and $417 billion in September). Americans increased their purchases primarily in the area of “durable goods” at a rate of 4.1%. We effectively did not spend more on buying prepared food at restaurants and decreased our spending on clothing and footwear. The biggest increase in dollars was on “Furnishings and durable household equipment.” Apparently, those surveyed people who were so gloomy considered buying washing machines and cars as something other than spending money! The same appears to apply to at least some credit card purchases.

Yesterday, the MasterCard Corporation reported its profits rose 28% in the third quarter. MasterCard and Visa derive the lion’s share of their income from transaction fees on credit card purchases. Given that the card companies have very real dollar data to report and the Commerce Department makes estimates, my guess is that the economic activity of the American consumer is rising a lot faster than the government recognizes.

It’s the Debt Service…

So what does all of that mean? As I wrote last year, we have been paying down our debt. Most of that half trillion dollars per month we have been “saving” has really been going toward reducing debt. The latest month for which the Federal Reserve has released data on consumer debt is August. In August, consumers were reducing their total debt load by 4.6% per year. Since late 2007, consumers have reduced the debt load they are carrying by about 18%.

The amount of debt we are carrying on our credit cards, mortgages, car loans, and everything else is not as important as the percent of household income that is going to service that debt. The graph below reveals where we were as of the end of the second quarter of this year (June). As of the end of June, consumers had reduced their collective monthly debt service from 14% of income to around 11%. All the evidence suggests that the decline continued through the third quarter and into October.

There is a very important message in the graph. The last time we had a recession and unemployment like the one we see now was in the 1980-1982 period (resulting in the election of Ronald Reagan). We had another economic rough patch around 1992-1994 (resulting in the election of Bill Clinton). Our debt load is very nearly down to where it was at the bottom of each of those recessions. It also means that our next President will likely be a Republican. We typically over spend and create too much debt under on President, and then pull back and have a “debt-hangover” under the next one and, of course, blame him.

If history is any guide, then we are now about where we “bottom out” in our debt reduction binges. In other words, the carrying cost of household debt rises and falls with our perception of how well we think things are going to be in the future. When we are pessimistic, we like to get our debt load below 11% of income. When we are euphoric, we can push it up as high as 14%. When we redirect our income to reducing that debt load, we dramatically reduce the things we are buying in the economy and we have a recession.

Another clear message that the graph above reveals is that the greater and more steep the decline in household debt, the more severe the economic decline appears to be. Note that I wrote, “appears.” As of last month, the GDP of the United States was back to the same level it was at its peak in 2007. That officially signals that we are no longer in “recovery,” but now have moved into “expansion” in the total economy. With over 9% official unemployment and probably around one in five persons who want to work either unemployed or “under-employed,” the consumer side of the economy (where we live and experience) does not feel “recovered.”

Consumer Debt is the Key

While the total percentage of our incomes that go to pay on our mortgages has fallen a bit, the big decrease has been in “Consumer” debt, which includes car payments, credit card payments, and the like. Once again, note that the data here only goes through the end of June. At that point we were at the consumer debt level of the early 1980s and were working our way down to where we were in the early 90s. If the trend continued, and all the evidence I can find suggests it did, then we should now be about at the point where we will start buying again. Sure enough, in the last part of the third quarter we started buying cars and other “capital” items and the credit card companies reported significantly increased activity.

Perhaps the most important thing to take from this chart is the trend line. At the current rate of debt pay-down, we will hit the 4.5% level by the end of next year. That is the point where we opened our pocket-books and started spending in 1994, triggering one of the greatest economic booms in our history. Because of the nature of the way things change, we should actually see a leveling off starting this year, accompanied by an increase in consumer spending.  In fact, we may have just seen the beginning of that reversal with MasterCard and Visa reporting record earnings. Based on the debt service load data, I would not be surprised to see the bottom in the housing market occur in 2012. When houses begin again to appreciate is another story, and a very difficult thing to predict.

Federal Debt Service

There is a lot of light and noise about the federal debt. From what I have seen it is the most popular ring in the political circus right now. Factually, it is not at all what it is made up to be. Just as with consumer debt, the quantity of dollars is not the important number to watch, rather it is the cost of that debt as a percentage of income. The most common way that a country’s “sovereign debt” is measured is by the relationship of the total governmental debt as a percentage of the total output of the nation (GDP).

The reality is that the debt-to-GDP relationship, within limits, is irrelevant. Using numbers we can get our minds around, let’s discuss a debt in the thousands instead of trillions. If a family has a net, take-home income of $80,000, but has a total debt (including home mortgage, car loans, credit card balances, and perhaps student loans) of $100,000, your first impression might be that they are in deep trouble. In fact, presuming they are a relatively young family with children, a house, and all the things that go with that, they may be in great shape. The key to determining whether they are in danger or quite well off is to know the interest rate on that debt and the number of years they have to pay it off.

If the debt they are carrying has an effective interest rate of about 3.75% (gross interest minus the tax deductions), and an average debt maturity (payoff) of 12 years, then they are actually carrying an annual debt service load of just over 13%. That, by the way, is the historical norm, and really quite healthy.

Now let’s switch perspectives and think of the federal government as if it were our hypothetical family. In terms of billions of dollars, our government takes in about $2,250 per year ($2,250 billion). The crucial number is the debt cost to the government on debt held by someone other than another government agency, or as it is officially called “debt held by the public.” The interest rate on that debt averages 2.886% per year. The public debt stood at $1,256 billion as of the end of October. That means that the interest the U.S. Government is obligated to pay is just under $300 billion per year, or about 13% of its revenues. Yes, that is only the interest on the debt, and eventually we will need to pay down some (but not all) of the principal.

One more detail and I will move on. Government revenues are down, way down. When tax rates were a bit higher and the economy was humming along in full expansion mode in the 1990s, the federal government took in about 20% of the total GDP. Currently, federal revenues are down to about 15.5%. Part of that is the income tax reductions that were passed and signed into law during the last decade and part is the fact that it is the taxable part of the economy that is still at below normal growth. In very real terms, the government took a pay cut of about 1/3 at the same time it needed to increase spending to support some of its children (citizens) who lost their jobs. It is also facing a growing cost to take care of its ailing parents (senior citizens). Since our government has a truly outstanding credit report, it can borrow money at less than 3% per year, so that is where it turned to get the difference. Its condition is not a heck of a lot different than many American families.

In short, the federal public debt could get out of hand if we do not address it, but it is currently not a serious problem. It is a popular issue to worry about though. There are actually quite a few ways to get it under control. Unfortunately, they all equate to a combination of cutting entitlements, mainly to older people (which the Democrats will not allow) and increasing taxes (which the Republicans will not allow), so we are stuck until we conclude that both are necessary. Just as in our hypothetical family, there may be a need to reduce spending and if that is combined with a change in employment somewhere in the family, leading to higher income, then things will probably turn out well.

As much as I hate paying taxes, and I write checks to the IRS each year that make me shudder, the fact is that we tend to do best as an economy at about the 18% (of GDP) federal tax level. A 3% increase in revenues combined with the economic recovery that is likely to be about to take place will go a long way toward getting us out of the woods. We also need to deal with the issue of health care for terminally ill patients. At present the largest single expenditure of our spending on health care is done in the last two years of a person’s life. There is no evidence that the people on whom that money is being spent are benefiting from it, but we can say for sure that the rest of us are likely to suffer from the expenditures. We have a system that cannot refuse a next-of-kin’s demand to spend an effectively unlimited amount of money on a very elderly dying person. I don’t know how we can fix that, but we must.

The Stock Market

As I write this, the Standard & Poor’s 500 Index stands at about 1,261. So far this quarter with 327 of the 500 companies on the record for the third quarter, 218 had better than expected earnings, 72 were below expectations and 37 hit the estimate. That puts 67% of the reporting companies with earnings higher than expected. More, the reporting so far indicates that both operating and “as reported” earnings are going to break all previous records. In short, corporate earnings are at an absolute record high. Meanwhile, the Index itself is about 20% below where it was in 2007 despite the fact that reported earnings are 20% higher than they were in 2007!

In rough terms, that means that the stock market value is effectively 40% below where it was in 2007. Here’s the most fascinating thing, at least to me, about that set of numbers. The stock market was not overvalued in 2007. If the market was at the same, quite reasonable, price to earnings (P/E) ratio it was in early 2007, the Dow Jones Industrial Average would be at nearly 17,000 and the S&P 500 would be at about 1,700. Just for the record, the price to earnings ratio back in 2007 was 17. In 2001 it was at 45! The historical normal level is between 17 and 20. The current P/E ratio is around 10.

Translated into percentage yield, the Standard & Poor’s is currently yielding a whopping 8.26% per year in the form of corporate profits (earnings). The vast majority of that yield is being reinvested back into the companies, as it well should be, but still that is a heck of a high yield. In fact it is the highest it has been since 1982. By any definition, the stock market is the cheapest (most undervalued) it has been in thirty years. Oddly, because of the amazing increases in annual profits, the stock market in the United States is actually lower in terms of absolute value than it was in March 2009!

That value imbalance is present not only here in American, but is even more pronounced in the the emerging market countries. Emerging market funds fell further than the major U.S. Indexes in the third quarter, and as they tend to do, appear to be coming back faster. The Vanguard Emerging Markets Stock Index is up about 14% in just over a month.

One last piece of good news regarding the market, although perhaps not too good if you are out of work: Companies in the United States reportedly increased their productivity by 3.1% last quarter. That fits quite well with the news that companies have continued to purchase capital goods; things like computers, machine tools, and the like. It means we are capable of making more goods and providing more services for less expense, which increases the profits of publicly traded corporations, but means they can make more with fewer workers. In effect, it means that the stock market will probably do much better than the job market in the near future.

Greece and the Eurozone

So, what does that have to do with Greece and the Eurozone? As I have written before, Greece is going to default on its debt. The agreement that was reached last week among the member nations of the European Union was that each nation would supply a Euro guarantee amount to a fund that would back-stop the bonds of the other troubled nations, Italy, Spain, Portugal, Ireland, and Belgium. Second, the agreement was that each nation would put the pressure on local banks to take around a 50% “haircut” on the value of Greek sovereign debt. That meant that the various nations would step in and shore up the banks’ reserves to compensate for the losses they would book from the debt write-down. Because the write-off of half of the Greek national debt was to be “voluntary” there would be no triggering of the credit default swaps (CDS), which are, in effect, insurance policies against the failure to pay in full by the Greek government.

Another thing that initially sounded quite good was the agreement by the EU countries to “guarantee” a fund that was intended to attract outside investors to boost the value of the internal fund. In essence, the European financial stability fund would borrow money by issuing bonds to backstop the bad debt of the southern tier of Eurozone countries. Unfortunately, the European Union only reached an agreement to “guarantee” those new bonds at 25% of their face value. Frankly, I don’t think they are going to get a lot of takers.

It is those CDS obligations that have markets running scared. It is good to remember that it was the CDS obligations issued by AIG (a life insurance and annuity company) that nearly took the whole system down in 2009. AIG had assumed that Lehman Brothers would make good on their obligations or that the Federal Government in some form or fashion would “bail them out.” When the decision was made by the Bush administration to let Lehman Brothers go down, it caught quite literally everyone by surprise and the ripple effect nearly took the entire world financial system down too. Note here that it was not the failure of Lehman Brothers that nearly brought the house down, but the potential for failure by a United States life insurance company that was making a fortune selling annuities to risk averse investors.

The concern is that either one of the Eurozone countries or now perhaps Greece itself will pull out of the deal and in doing so effectively render the Greek sovereign bonds worthless. That very fear was the deciding factor in the failure of MF Global Investors, LLC this week. There will be repercussions from that failure as well, but note that in the ensuing days, the Dow has risen about 5%. MF Global, as it turns out, took a big position not in Greek debt, but in Italian and Spanish bonds. Worse, the attempted sale of MF Global fell through at the last minute because of “discrepancies” found in MF Global’s books. Those discrepancies now have been admitted to as illegal use of client funds by the firm.

There are two very large lessons here.

First, the decision by the Greek government to hold a referendum on whether or not to accept the terms of the Euro bailout (which has now been rescinded) meant that Greece would probably default in a very uncontrolled manner and is pretty much a worst-case scenario. On that news, the Dow dropped 5% over two days before starting to rise again. The lesson from that event is that the traders on Wall Street have finally figured out that just about everyone concerned has made provisions for the Greeks to default. When it happens it will not be a Lehman Brothers. It also shows that The folks on Wall Street have concluded that the Germans and the other Eurozone nations with a few Euros to spare will not allow the Greek failure to spread to Italy, Spain, and so on.

In short, the first lesson that we can learn here is that the movers and shakers in the stock markets of the United States have concluded that a rolling series of defaults across Europe will not mark the end of the world. Sure, we do some business with Europe, but not a heck of a lot. Our main trading partners are here in the Western Hemisphere and across the Pacific, not the Atlantic.

The second lesson is far closer to home, and extremely critical to understand. MF Global had attracted a lot of investor money because they offered a promise of much higher interest rates than were available elsewhere. They were proud of their “managed futures” program, which offered the lure of a mystical ability to make money in falling markets.   Those “high net worth” investors who took the bait are now listed as “unsecured creditors.” Sadly, some of the investors will probably turn out to be anything but “high net worth.” because MF Global also was heavily marketed as a source of “privately managed accounts.” They often marketed their programs to “reduce portfolio volatility” through other firms and individual “advisors.”

The Greek tragedy and MF Global’s collapse are two faces of the same coin. There are no secret ways to get a high return while eliminating market risk. There are just ways to raise your risk of total loss as an alternative to seeing the volatility, or variance that is part of the price we must pay to potentially have a higher return in the long run.

The Germans, among others, allowed Greece into the Eurozone because they concluded they could very profitably sell what was made in Germany to the Greeks, along with the Irish, Portuguese, and others. They also concluded that German banks could loan money to the Greeks to buy those expensive German goods and would earn above normal returns because the Greeks would be so thrilled to be allowed to borrow and buy that they would pay the high rates. If that sounds familiar, all you need to do is substitute one of the now failed Wall Street firms names in place of “Germans” and substitute “Americans who couldn’t afford them” for the Greeks. Here we sold houses. They did that in Europe too, but they also sold a lot of anything made in Germany on one of the other “rich” countries.

The money to do all of this came from investors who wanted a high return without risk. The idea was that by buying Greek sovereign bonds they were able to get a much higher return, but that Germany would ultimately back the Greek government if anything went wrong. The search for high returns without market risk that is probably the single most deadly investment error that anyone can make.

Here in the good old United States of America, the marketing blitz is on to get people who have had a dismal return in the market for a decade to turn their money over to privately managed accounts so that genius managers using secret formulas can work their wonders. Bernie Madoff certainly did a magnificent job of that. The other siren song is coming from the insurance companies that are promising a completely secure, steady return via the plethora of “guaranteed” annuities they are offering. The problem is that if the insurance company goes under, who will replace your money? In most cases, the answer is “no one.”

Again, the rescue of AIG by the Treasury is what stopped the collapse. What the news media did not well publicized is that many of the major annuity-issuing life insurance companies also required a rescue by the Treasury or the Federal Reserve in the weeks that followed.  Since then, the Congress has effectively blocked the Treasury from doing that again. I strongly suspect that the next time a major insurance holding company is on the verge of failure, the government will not step in and rescue it. There will be a lot of pain associated with that inaction. My recommendation is that you avoid that trap.

If you are afraid of market variance and want security, go to the bank and buy a certificate of deposit. Yes, you will get at most about 1.6% per year, and that only on “jumbo” CD offerings for five years. If you are willing to put up with market variance to have the opportunity to get that higher rate of return, then stick to mutual funds. Yes, the market may move around, both up and down, a lot, but if your money is in mutual funds, you have the protection of the Investment Company Act of 1940 against having the creditors of some management company getting first shot at your money. More, make sure if you use a brokerage account to hold the funds that the account is fully insured by someone other than the company running the account.

These are basic issues, but it is now, just as things seem darkest, when through greed, fear, or both, charlatans will be more than happy to take your money and promise you the world. Beware, because they are out there. The stock market is cheap and (in my opinion) due for a rather significant increase in value in the not too distant future.

Until next time, take care. Enjoy life. Give thanks for all our blessings.

As always, feel free to write or call with your comments or questions.

Jeff McClure

Two Texans talk turkey about moving from IBD model to RIA model

 Jeff McClure was able to bring Sean Kernan closer to his way of thinking by letting him in on his experience

Something Wicked This Way Comes

October 7, 2011

The Force of Fear

The stock market decline in the third quarter of this year (July-September), are a proof of the force of fear. Even as corporations report increased earnings and the GDP is revised upward, the market has continued to act as if the end of the world was at hand. The Dow Jones Industrial Average fell about 12% for the three months. The S&P 500 Stock Index fell about 14% for the same period.

Last week, the stock market seesawed up and down as much as four or five percent per day. The Reuters News Service headlines at the end of each market day were quite revealing as to why. Two of those headlines (the bolding is mine):

• Stocks Drop, led by Commodities on Economic Fear
• Stocks rally on Europe Debt Optimism

Traders are vacillating between Fear and Optimism. I want you to consider that neither of those is real. They are feelings. In the end, the values of things we own do not depend on our emotions, but on the hard-nosed reality of economic principles.

Even the fear itself is not at all well defined. The number one “wicked” something that people seem to fear is the default of Greece. I have written this before and I will probably get to write it again. Greece is going to default. The numbers are very clear. Greece absolutely cannot afford to pay its debts.

The fear appears to be that if (when) Greece defaults, European banks and nations will become insolvent because they have large holdings of Greek bonds. Investors seem to fear that the chain of defaults that follows will be more severe than that following the Lehman Brothers default back in 2008-2009. Greece is not Lehman Brothers. With Lehman, there was a massive worldwide unpreparedness. There is ample evidence that preparations are being made in every institution and nation across Europe and the United States.

The second “wicked” thing we seem to fear is that something terrible is about to happen here in the United States. Among those who express that fear, the consensus seems to be that it will come because of the nefarious activities of the President. Beyond that, I have been unable to nail down any specific terrible event that they fear.

When John Kennedy was President, I listened as conservatives insisted that the Pope would set himself up as the ruler of America (Kennedy was our first Roman Catholic President). I again listened as very intense, left-leaning college students insisted that Richard Nixon was going to stage a coup and become dictator. While Jimmy Carter was President, conservative friends of mine insisted that the Trilateral Commission was a front for the “one world government” that would take over and enslave us all. During George W. Bush’s presidency, the conspiracy theory (from the left) was that Halliburton was secretly running the government and the wars in Iraq and Afghanistan were solely for Halliburton’s profit.

In this age of 24 hour news channels, cell-phones, and mass email forwarding, conspiracy theories and urban myths can easily “go viral” and be widely believed. That does not make them more real or less damaging.

The Wicked “Something”

I have taken the title of this letter not from its origin in Shakespeare’s Macbeth, but from Ray Bradbury’s novel by that name. In Bradbury’s novel, fear gradually settles over a small town as a carnival arrives late in the year. It opens with a lightning-rod salesman warning that, “A storm is coming.” The scene is set quite literally in the “fall” of the year. The carnival is indeed an evil mechanism that exists to imprison the carefree souls of young boys. Very critically, fear is the only weapon Mr. Dark, the master of the carnival, has at his disposal. Laughter, dancing, and singing free the children’s souls and the loving embrace of a father destroys the power of the carnival master.

The “something wicked” that comes in the novel is fear. Securities markets tend to be moved in the short-term by the twin emotions of fear and greed. The highest levels of volatility in the market come near the top and the bottom of market cycles as the adherents of those two emotions battle it out. If in the relatively recent past the optimists have been the dominant force, then market values are likely to reverse course and decline substantially. If in the past couple of years there has been a great deal of pessimism and fear, then it will not be long before the market starts back up. These reversals can take months, and sometimes many months, but the end of the high fluctuations is almost always a mark of the reversal of sentiment.

Right now, it is clear that as a whole, those corporations listed on the exchanges are doing quite well. That is where we invest. We do not invest in the unemployment rate or the GDP. Those are indicators, and they are important indicators, but even in times when unemployment is high and the GDP is in bad shape, there will be companies that are turning a nice profit. As an example, the employment reports consistently reveal that companies are hiring and the government is laying-off workers. The net result is high unemployment, but it is mostly in local and state governments where that is occurring. Fortunately, our investments are not in governments!

The Thing That is Really Coming

At some point, the greed factor will overcome the fear factor in the markets. If history is any guide, that will happen sometime between now and the end of this year. I only say that because it is such a consistent pattern in history. If we analyze the data again at the end of the year we may find that nothing has actually changed. What will likely make the market indices rise is simply a reversal of sentiment.

When there is a legitimate reason for concern evident in the underlying economy, the pattern we commonly see is gains in the summer followed by a decline beginning in October. When the underlying economic reality is solidly profitable, but baseless emotion forces the market values down, then we typically see losses in the summer and a reversal to the upside in late October. The stock market peaked in October, of 2000 and again in 2007. In retrospect, during the summers we now can see as the ends of the bull markets, values rose in spite of bad economic data. During the summers at the end of bear markets, market values tended to fall despite improving economic data. “It’s Déjà vu all over again.” *

My reading is that the car and truck count on I-35 is growing. The parking lots at the outlet malls are full. Here in Salado, we just had what appears to be a record-shopping weekend. If that pattern holds, then things are getting better and the stock market will respond. It is not so much a matter of “if” as “when.”

As always, if you have any questions or comments we are available.

Sincerely yours,

Jeffrey W. McClure, CFP®

*Quote from that wise sage of New York, Yogi Berra.

Market & Economic Update 9-28-2011

September 28, 2011

A Bumpy Road

Last week the Dow Jones Industrial Average (the Dow) dropped 6.4%. So far this week it is up over 5%. It is basically where it was back at the end of 2010. The purported reason for the decline last week was the same non-news about the potential default of Greece. I call it “non-news” because there is no alternative to a default by Greece on its sovereign debt, at least there is none that I have seen.

In reality there is another element here even as there was at the end of July and into early August. Congress failed to pass a bill funding the government beyond the end of September. A stop-gap measure was passed by the Senate which looked like it would be acceptable to the House Republicans and the stock market immediately rallied over 5%. Today, the news is that the House will hold a “pro-forma” voice vote tomorrow (Thursday) to extend current funding for four days. If even one Congressman objects then the bill dies. The reason is that Congress is formally not here, but on a short vacation to celebrate Rosh Hashanah. Congress is scheduled to be back at work on Tuesday when they will vote on whether or not to keep the government doors open. Each of these votes is coming at the last possible moment. If either of them fail to pass, as did the bill last week, then the federal government stops paying its workers and stops paying its bills.

If this sounds familiar, it is because it is. In this case the battle is over whether to provide sufficient funds to allow FEMA to fund disaster relief in the Northeast following the hurricane damage there. No matter that the grand compromise that was passed on August 2 actually allows for exactly that funding, the House conservatives insisted that defunding of a relatively small federal research grant for automobile fuel efficiency research and development be eliminated or they would not agree to fund FEMA. Whether or not you agree with the demand, the fact is that when funding bills finally pass, just before a scheduled vacation by Congress, the market rises. When funding bills fail at or near a deadline, the markets fall.

The Greek default drama makes for some good background to all of this melodrama in Congress, but at least in the short term, when the biggest customer of publicly traded companies in the world threatens to not pay its bills, it does have an effect on the prices of the stocks of those companies.

The Real World

Last week as the market fell, news reports I read claimed that part of the fall was because of disappointment with FEDEX. I found that at least as amusing as the Greek story. FEDEX did report its earnings last week. They were up 22% when compared with this time last year. Going forward, the CEO warned that earnings for the next four quarters would probably not grow as fast as some were expecting. His explanation was that with the threat of the federal government default hanging over their heads, businesses and consumers were holding off on purchasing electronic components and products.
FEDEX is one of the best barometers of what is happening in the economy, both domestically and world-wide. So, I took a look at the consensus of earnings estimates for the next year. FEDEX is expected to have about a 33% increase in earnings between now and one year from now. That was disappointing? That estimate is right in the middle of the CEO’s estimate as well. The story at UPS is the same, great growth in the last twelve months and even better growth ahead. Of course in both cases the stocks have fallen.

The FEDEX CEO warned that while he expected good growth in the domestic market, a slowing in China was hindering their total financial growth. That sounds pretty bad so I turned to the East Asia area to examine what was happening. Mainline China considers any information about GDP growth to be highly sensitive data and puts people in prison for talking about it, so there is not a lot to learn in that area. Taiwan, on the other hand, is pretty open on the subject. It appears that a sort of slowdown in growth is indeed forecast there. The Taiwanese economy is widely forecast to only grow about 5% over the next year and exports to the US are only forecast to be up by about 7%, based on manufacturing orders they have already received.

The FEDEX CEO was asked in his earnings call if he expected a recession to occur in the near future. His answer was a simple, “No.” The earlier answer from UPS was the same. Back when the Dow Jones Transportation Index was really just transportation companies (railroads) it was an excellent forecaster for the Industrials. The logic went that if companies were going to have earnings they would need to sell and ship things, and that would reveal what was really happening. UPS earnings are currently forecast to rise only about 26% in the next twelve months. That too was apparently disappointing.

The Economy

Greece is teetering on the edge of default. Their parliament is scheduled to vote this week on a major property tax increase. If it does not pass, then theoretically the rescue money will not go to Greece and they will finally default on their government bonds. Even if it does (and I think it will) the bill calls for the tax to be collected through electric bills. The electric workers union has stated firmly they will not allow it to be collected.
In some form and in the not-too-distant future, Greece will default on its debt. The Germans could stave off the date for a while by loaning more money, but the reality is that the Greeks will need a cratering experience to realize that this all is for real. The public response to the recognition that great sacrifice must be made else they will default was and is to go on strike. It is not too different from our Congress which at each crisis climax votes to allow all the borrowing and spending needed and then takes some time off. We can afford to do that because we have the wherewithal to pay the bills, albeit with borrowed money. The Greeks don’t have that luxury.
When Greece finally does default the markets will probably act as though the end of the world has finally arrived. Then, someone will look east and see the sun rising and exclaim, “Wow, the earth is still turning!” at which point people will rush back into the market to purchase stocks. Unfortunately as the people who need to notice the sun rising live in New York City where they can’t actually see the eastern horizon, it may take them a while to realize that the world has not ended after all. They may notice that the European Central Bank (ECB) has been flooding the banks around Europe with cash (mainly dollars) to ensure that they can weather the storm. The ECB has also served notice that it will buy as many Italian and Spanish bonds as are needed to stave off the short sellers who will attack those markets.
In short, Greece will probably default. The markets will panic. Then, after a bit of soul searching and hand wringing, business will head back toward normal. Meanwhile American and many foreign companies will continue to have record earnings, high earnings growth, and immense quantities of cash on hand.
That will only leave three problems to solve.

1. We will still have a few million more houses than we have households to live in them.
2. We will still have more personal debt on the books than we are comfortable with… and
3. We will still have a faction (or two) in Congress that will keep threatening to blow everything up if they don’t get their way.

Numbers one and two will solve themselves over time.

Sales of existing homes were up 18% in August over last year. Given a couple of years and the phenomenally low mortgage rates being engineered by the Federal Reserve, the housing overhang will be getting close to gone.

We will see a slow growth economy and high unemployment probably through next year as we Americans buy down our debt. At that point, probably in early 2013, the economy will surprise all the pundits as it kicks into overdrive.

Forecasting the American electorate’s behavior is a loser’s game, but let us all pray that we can come to our collective senses and get some folks into the halls of Congress who can work together. More, let’s pray for a President, of whatever persuasion, who can inspire and lead us.

Europe is going to be in a shambles for a while. This is an amazing opportunity for the United States to cement itself as the sole economic super-power in the world. We the people will make that decision next year in November. I have faith in us that we will make some good decisions. No matter what, we will be on top of the world. Our system has its warts and pimples, but it is so much better than anything else on the planet that there is no real comparison. We Americans are at our best when we are faced with a challenge. Good times are hard on us. We have a challenge, –actually more than one. I firmly believe we will triumph over those challenges and emerge as a guiding light to the world. That is what we have done over and over. We are still who we are.

Forecasts

I am going to make some forecasts here that frankly scare the bejibbers out of me. I don’t like making forecasts but right now that is what I believe we all need.

1. Greece WILL default. Germany will ride to the rescue but in return demand that the Euro-zone countries turn over a lot of what they currently believe is their sovereign right to spend other people’s money to the European Central Bank, which will be placed under the control of some hard-nosed Germans. If the other countries don’t go along, the Eurozone will shrink to include only those who will. Greece will be kicked out and will suffer horribly. This will not be a pretty picture, but will be necessary.
2. Russia will elect Vladimir Putin as its President. He will then begin to rebuild the military strength of Russia with an eye on reestablishing the old Soviet empire. We will have the option of facing him down or things will be very interesting in a few years.
3. Congress will not wreck the Republic. Yes, they will continue to posture, but following the elections in 2012 people will be completely tired of such foolishness and Congress will get the message.
4. We will pay down our personal debt and suddenly start to spend like mad. That process is already started and will accelerate though 2013 at least.
5. The Dow Jones Industrial average will reach 20,000 in the next five years (or sooner).
6. The world will not end anytime soon.

Meanwhile those who keep invested and/or invest in the shares of well run companies here and around the world will see that appreciation they have been waiting on for so long.

Your thoughts and comments are always welcome.

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.

Market & Economic Update 08-26-2011

August 26, 2011

The Perception Recession

I read an article this week written by Joe Duran in which he called the economic and market events that have roiled the markets in August, “The Great Perception Recession of 2011.” It was such a good description and had such a good sound that I had to use it!

The Chart below shows the S&P 500 Stock Index from July 11 through last Friday, August 26. As of July 22, the index stood at about 1,350, and was cruising along with good gains from both last year and year to date. It started down from there and by the beginning of August was in what appeared to be an apocalyptic free-fall. As of Friday’s close that “end of the world” market crash really amounts to a decline of about 12.8% from the high in July. So, what happened between the beginning of the last week in July and two weeks later that so spooked the traders?

Identifying the Cause

The answer is not going to make very many people happy. From an economic and business perspective, “nothing” happened. Actually there were a few bits of news here and there, but when we distill the news reports so as to remove the opinion and sentiment information, almost all of the factual data were good news. The facts match up quite well with a rising market, just as we saw for the first half of the year.

The gray bars on the chart are the number of economics and market related news stories published each day. There is an interesting correlation there. There were relatively few stories around mid-July as the market continued to rise, then as the news stories began to increase, the market began to fall. A careful examination of the stories does indeed reveal what was generating the newsprint surge and the market decline. It was the debt ceiling battle in Congress.

Chairman Bernanke spoke Friday at the annual Federal Reserve retreat in Jackson’s Hole. The centerpiece of his speech was not about economic data or the money supply or any of the other technical issues on which Chairmen of the Federal Reserve have waxed eloquent for so many years. He did mention those items, but most of the data, as I have noted, are positive. No, he commented that the principal reason for the sudden surge of fear, increase in layoffs, and general perception of economic distress was the threatened default of the United States of America.

Note here that the level of debt we owe is not the issue. Huge quantities of money have been rushing to Japan as a “safe haven”. Japan’s market has even done better than ours over this period. At the same time, Japan has twice the debt to GDP ratio of the United States! Let me state that again: Japan has twice the debt for every dollar (or yen) of GDP that we have. More, their economic situation is far worse than ours and they have been changing Prime Ministers about once every two years for quite a while. In essence, they don’t have a glimmer of a plan to dig their way out of the mountain of debt that has buried their economy. Worse, their population is aging so fast that even holding their own will be a major challenge. Again, note that a goodly portion of the money that has been exiting the U.S. Stock market has been seeking safety in Japan.

So what do the Japanese have that caused a rush of money into the Yen? First, unlike the Euro, the Yen is the result of a functioning governmental system that is extremely unlikely to collapse. Second, the Japanese have made it very clear that they will repay their debts no matter how much it hurts. We, on the other hand, just threatened to not repay our debts it if hurt too much.

As I wrote in my last letter, the big decline in U.S. stocks happened around and almost certainly because of the downgrade of the United States credit rating from AAA to AA+ by Standard & Poor’s. Again, as I wrote last time, the vast majority of the money exiting the stock market was used to purchase those same downgraded U.S. Treasury securities.

Have investors lost all sense, or is there something else going on here? From all the research I have done, it appears that there is a certain level of logic to the market movements. The selling was an expression of both emotion and opinion. It involved ignoring the current and even projected economic data and instead focused on the statements made by supposedly responsible men and women who have the ability to wreck the world economy. In other words, the market did not decline because of a fear of a slowing economy, a possible recession, or any of the other elements that might reduce earnings for the corporations represented in the index. It has declined almost 13% out of a fear that the conservatives in Congress will keep their word. S&P’s downgrade statement said very much the same thing. It was not the degree we are in debt, or even the deficit that resulted in the downgrade, but the demonstrated potential that members of the House of Representatives might decide that the United States of America would not pay its legal obligations.

I have recently read some very thoughtful commentaries which have suggested that we may well be headed back into a recession. They all agree that if we do see an actual contraction of the economy it will be a recession created solely by the fear generated by the politicians and media personalities who have been so loudly preaching the end of the world as we know it. Another point here that is worthy of repeating is that most Americans seem to believe that the Germans have their act together while we Americans are in debt up to our eyebrows. In fact the public debt owed by the German government equates to about 87% of GDP while ours is about 68%. The bond market is demanding about a 50% higher interest rate from the Germans for more borrowing than it is charging us.

We, as investors, have to determine whether we are going to act out of fear that our elected members of the House of Representatives will knowingly wreck not only our economy but that of the world or simply believe that they are blustering and threatening but in reality will accept whatever compromise is necessary to allow us to muddle through. Of course that is exactly what they did at the last minute before taking off for their summer vacations.

Reality or Perception? 

We have the choice to look at the reality of the economic data and conclude what it indicates or to pay attention to the fear and dire warnings being poured out by some TV and radio talk show hosts and politicians. As has been far too common lately, the two different perspectives do not have a lot in common. History is quite clear on what we should do. At any point in the recorded history of investing over the last two hundred years and longer, those investors who were later seen to have been successful have made the conscious decision to follow the measurable reality rather than either the fear or the euphoria published in whatever form of public communication that was popular at the time.

Another note regarding recent history: Two years ago Glenn Beck and other media commentators of similar persuasion warned of massive runaway inflation that would set in within twelve months. High inflation is automatically matched by high interest rates. Inflation has been very nearly zero as are interest rates. Some food prices have risen since then, but fuel is down as are houses, electronics, cars, and many other items. We are indeed at risk for deflation, but there is no sign of high inflation (unless you live in China).

Before we move on I want to point out that back in March of 2009, where there really was something to worry about, the S&P 500 Stock Index stood at 676. Today with it just below 1200 we are frightened and perceive that it has fallen. At today’s levels the Index has (including dividends) risen well over 80% in under two and a half years. Despite that rise in value, the real price of the market, as measured by the price divided by corporate earnings, has actually fallen. In other words, the U.S. Stock Market is up 80% but still cheaper than it was in 2009! Every study that has been made on this subject agrees that the following decade’s market performance is directly related to the P/E ratio. The lower the ratio, the greater the performance over the next ten years. Ten years ago the P/E ratio was 45. Today it is about 10. That is exciting!

Why, in light of all of this, is unemployment high and consumer spending low? There is more to follow, but the single largest reason is that we Americans are paying down our debt and that debt is about 24% higher than our comfort levels. Once we get down to a level with which we are comfortable, which should take about another two years at the rate we are going, then we will return to “spending as usual.” Until then, slow growth, high unemployment, and negative commentary are likely to be the rule of the day. In other words, whoever is elected as our next President will get the credit for a “miracle recovery” that has everything to do with getting to the bottom of the debt pit and little to do with politics.

I want to emphasize at the same time that are are some very real problems facing the world economy. None of them are new. Over the past twenty to thirty years there have been many, many articles in which serious thinkers warned that we were on a route that would eventually lead to a major crisis. We, the people of these United States quite literally elected to not only ignore those warnings, but to elect to office a series of governments composed of those who promised to give us more government benefits while charging us less taxes.George H.W. Bush’s presidency was limited to  four years because he signed into law a bill that slightly raised taxes on the highest incomes and slightly reduced entitlements for those who had ample incomes prior to age 70. Largely because of those changes, combined with a reduction in military spending, we arrived about ten years later in a position where we were actually on track to pay down the national debt.

The 2000 political campaigns were centered on whether we needed to pay down the debt or allow it to rise into the future by cutting taxes. We the People elected to not deal with the debt in return for lower taxes. If everything had gone smoothly and without unexpected events that might have worked out just fine. Unfortunately, unexpected events do happen with alarming regularity.

After 9/11 we had a dramatic increase in military spending, but again rewarded those who favored even more tax reduction. In order to avoid a violation of the Balanced Budget Act, President Bush and Congress kept the budget for the wars we were fighting “off the books” by passing an “emergency” funding bill each year separate from the budget. That worked so well that the President pressed for and Congress passed a huge increase in entitlements, the Medicare Prescription Drug Benefit. Again, that was officially listed as an off-budget “emergency” bill.

Had the economy hummed along at the high rate of growth projected at the time, even those expenditures could have been self repairing, however yet another tax reduction went into effect at about the same time. Then, we had a collapse of the financial infrastructure that had arisen around an intentionally unregulated sector of the securities markets. That collapse necessitated some rapid action including significant expenditures to prevent the collapse from becoming another Great Depression.

We are now facing some rather significant levels of unemployment and reduced consumer spending. Those elements dramatically reduce revenues to the government. An unusually large number of families have been reduced to poverty levels where they become eligible for state and federal aid at the same time as revenues have decreased. Those are not at all unusual events. What is unusual is that our federal taxation level is about the lowest it has been since before World War II. Not coincidentally, the percentage of the Gross Domestic Product of the United States that is being taken as revenue by the federal government is about the lowest it has been since the 1930s.

Now, we the People are faced with a problem of how to prevent our governmental debt from rising to the levels that the rest of the world seems to accept as normal. The solution is relatively simple. We need to decrease benefits and military spending while at the same time increasing revenues (taxes) back to the level they were when Newt Gingrich was Speaker of the House. Unfortunately, we have elected enough members of Congress who either are dead-set against any increase in taxation or alternatively dead-set against any decrease in benefits that we are dead-locked. Dead-set and dead-lock do not make for good governance. Presuming that the brief wave of sanity that appeared when Congress agreed to raise the debt ceiling returns as the members of Congress come back from their summer break, we can and will get through this.

That does not change the reality of what we face. Cutting benefits will not get us on a stable fiscal footing. We the People have decided that old people and children starving or the uninsured dying outside a hospital door is not an acceptable outcome. We have elected officials who have passed laws providing for money to prevent that from happening. We have also decided that fighting those who would like to destroy us needs to be done somewhere else and that we should have a relatively expensive defense policy that emphasizes taking the battle to those who would harm us before they can bring it here. Those are both rational, but expensive policies. Can we trim some expenses from both of those budgets? Yes, but to still accomplish those objectives we cannot cut a whole lot, and certainly not enough to make up for the difference between revenues (taxes) and expenditures.

Thus, a combination of unpopular benefit cuts for people with higher incomes will need to be combined with equally unpopular tax increases. Both will tend to be directed at those with more than $250,000 annual income (for a couple). If, and that is a critical “if”, we can agree to those provisions, then we can easily emerge from this self-imposed crisis as a very healthy and growing economy. If we continue to flail about and reduce ourselves to threatening to wreck everything unless we get our particular demands met without compromise, then we will indeed face a crisis. In that crisis we will almost certainly take the same actions that we could have taken before the crisis. Either way we will finally emerge a better People with a stronger economy. That is just the way we are. Why do I believe that to be true? Read on.

Our Strength

We the People of these United States of America are by nature entrepreneurs. We invent things, we engineer things, and then we move on to something else. Most of the time we don’t worry too much about the future because we are too busy making it better. That spirit is still alive and well in America. Industrial production in the United States for the month of July was up almost 1%. That follows about 18 months of rising industrial production. General Motors is seeing dramatically increased demand both here and overseas for its vehicles. Across the board, corporate profits are at record levels and have been growing at near record rates.

Quietly, while very few were paying attention, American corporations used the recent recession to capitalize their processes. As assembly lines were rendered idle in 2009, many companies invested a lot of money into automating the processes carried out on those lines. The unpleasant side of that is that the people who were laid off in many cases will never be hired to to their previous tasks again. The resulting decrease in manufacturing costs has enabled American companies to increase their already impressive world lead in exports. Farmers have been doing the same thing. China is purchasing corn by the millions of bushels here in the United States. China is primarily an agricultural country, but the efficiencies of America’s corporate farmers is so great that it is cheaper to purchase corn from us than it is to grow it at home. Profitable farms have become corporate food factories.

Much of the rest of the world has passed laws designed to stop industrial progress in agriculture. The bucolic image of the farming family with its cows, horses, pigs, and chickens is so appealing that in many countries it is protected by law. That makes about as much sense as prohibiting automobiles and computers from being made in anything other than someone’s private garage. As of this year, America’s annual corn production alone equates to 1/12 of all the dollar holdings of the Chinese. Our corn production is rising much faster than the amount of debt held by China. We may look with envy at those nations that have oil to export, but that oil will eventually run out. Our corn exports can keep growing as long as there is demand. Noticeably the price of oil has fallen from $140 per barrel a couple of years ago to about $85 today; about a 40% decline. Over the same period corn has risen from about $3.39 per bushel to well over $7.00. In short, from the iPhone to corn, we Americans are the most productive and innovative population on the planet. Part of that, by the way, is from exporting the more labor intensive manufacturing tasks to other places where labor is cheap. We can’t export the labor in agriculture, so we automate it. As overseas labor becomes more expensive, we invent ways to automate what we are doing here. We, as a culture have been doing that for about 350 years and are getting better and better at it.

We, as a culture, are focused on making a profit, making money, and rising above our current circumstances. We will continue to do that.

The Short-Term Threats

Over the long term, our national character will cause us to emerge as winners. In the shorter term, we may be in for some unpleasant bumps. Presuming we can come to grips with ourselves politically and get a plan in place to correct fiscal problems at the federal level over the long haul, we will do just fine, however we do face a couple of very real potential crisis abroad.

There are two other major socio-economic units in the world that are comparable with the United States in terms of size and wealth generation, the Euro-zone and China. We have a lot of trade with those entities and should either or both of them suddenly degenerate into chaos, we would feel the pain.

The Euro-zone has at best a 50:50 chance of surviving over the next few years. It suffers from the same issues that are bedeviling our economy and ability to function, the combination of partisanship and a lack of effective leadership. Partisanship is a condition where minority parties in a government or economy put their individual desires ahead of the welfare of the whole. We saw that play out in late July and early August here in the U.S. The second element, lack of leadership, is part of the institutional makeup of the Euro –zone and the European Union. The EU has a government, but the government must have the approval of all the member states before it can do anything. That form of government was one we tried under the Articles of Confederation in the 18th century. The South tried it during the American Civil War. It doesn’t work. The poorer states have wracked up huge debts buying things from the more wealthy states and now the more wealthy states are balking at returning their profits to keep their customers from defaulting. If the Germans get tired of assuming responsibility for the loans they made to Greece, Italy, Spain, Ireland, and Belgium, then the house of cards will come down. That is going to be very unsettling to the markets, but in the longer term will resolve a host of difficulties and “clean the slate” to allow the European Union to restructure and perhaps create something that does work.

China is another version of the same potential crisis. The leadership there is certainly strong, but the centralized control and information (or perhaps more properly “misinformation”) control is about all that is holding China together. China is an empire masquerading as a nation. There are five major languages spoken and it has a migrant worker population larger than the entire population of the United States. One stumble and the odds are that China will erupt into chaos. The leadership in Beijing is intensely aware of that potential and working very hard to get past this stage. Time is not on their side. Their population is aging and has a lower economic output per capita than Mexico. The infrastructure is already at its limits in many areas but in order to maintain stability their economy has to grow, and grow fast. Like the Euro-zone, China faces structural challenges that have proven throughout history to be insurmountable. The odds are that at some China will very suddenly erupt into chaos and revolution. That is why the Chinese government is so totally intolerant of free information flow and any form of organized protest. In a fundamentally unstable empire it would not take much to create a disruption that would quickly spread to engulf the entire structure.

 The Good News

The good news in all of this is that the United States, where all of us currently live, is positioned to once again be the beacon of prosperity and propriety to the world. Should Europe and China collapse, it will have a short-term negative effect on our economy. We are blessed though by being right in the middle of the North American Free Trade Zone. Our two largest trading partners (by far) are Canada and Mexico. One provides an almost unlimited supply of raw materials, including, if we are willing to pay for it, oil reserves as large as any in Southwest Asia, while the other provides a very nearly unlimited supply of cheap labor, again presuming we are willing to use it. They are also the two entities that buy more goods and services from us than any other of our export customers.

In the event of a collapse and restructuring of Europe, China, or both, if we here in the United States are willing to assume the mantle of world leadership that we bore following World War II, then the resulting world order will indeed be a new one and we will profit even as we did following that war. The new entities that arise (and they always do) will need to purchase finished goods, and we will be undamaged and actually better prepared than ever before with our newly automated and capitalized factories, management centers, and organizations. It was in the recovery from the Great Depression of the 1930s that we reorganized and unknowingly positioned ourselves to be the industrial support for the free world. A new free world is emerging in North Africa and West Asia. Birth is chaotic, bloody, and not at all pretty. Still, it is a beginning and not an end.

As I have said many times on the radio and in print. Our real economy is in great shape. Yes we are angry at our elected politicians because they are not leading and unifying us but dividing and appealing to our lower, selfish natures, but we are ripe for a leader that will reawaken our belief in ourselves. Whenever we have faced that situation in history a leader has come along and We the People have elected him to lead us. In each of those dark times we have emerged to be a greater, more prosperous, and better People than we believed was possible. That has not changed.