Chicken Little Is Alive and Well
August 8, 2011
Greetings from the Personal Wealth Coach.
As the subject line suggests, Chicken Little is indeed alive and well and pretty clearly running around screaming, “The sky is falling! The sky is falling! A piece of it just hit me on the head!” The other barnyard animals, pigs, turkeys, ducks, and the other chickens are running about screaming, “SELL! SELL! The market is falling!”
For us humans out here in the real world, the fear those barnyard animals are expressing is causing some deep concern. Obviously, if the barnyard animals are running about squawking, snorting, and grunting in obvious terror, shouldn’t we join them? I mean, if all those traders are panicking, shouldn’t we be afraid too?
Let’s take a look at what happened leading up to Chicken Little getting bashed on the head.
In the U.S. House of Representatives a group of Congresspersons threatened to block the ability of the United States Government from borrowing the money necessary to pay its ongoing obligations. Interestingly enough, those same Congresspersons had passed a “Continuing Resolution” (budget) earlier this year which not only authorized but mandated about $3.7 trillion be spent by the Treasury. Since in that Continuing Resolution it was clearly stated that revenues were expected to be around $2.2 trillion, the difference would have to be generated through the sale of U.S. Treasury securities. Then, those Congresspersons warned they were going to refuse to authorize that borrowing unless there were some rather large budget cuts in unspecified areas. The House did indeed pass a budget (the Ryan Plan), unfortunately the idea of basically eliminating Medicare in ten years did not go over well and did not pass the Senate.
After a great deal of heated discussion, the President and Speaker Boehner appear to have agreed on a plan that would meet Standard & Poor’s warning that they must either reduce the projected deficit by $4 trillion or face a downgrade. When Speaker Boehner took that proposal back to the House, because it included elimination of some favored tax breaks and some tax increases in the upper income brackets, it was rejected.
In the waning minutes before the U.S. Treasury was to default on its legally mandated obligations, the Senate cobbled together a compromise that changed little, but passed the responsibility to a committee of twelve members of Congress. That Senate compromise was finally passed by the House as well and signed into law by the President on Wednesday. The committee is to be composed of three members of each party from the Senate and the House. If the 12 cannot get at least a 7-5 majority on what to do to cut the deficit by about $2.4 trillion, then draconian cuts hit automatically. Here is the rub. If those draconian cuts hit, then there will be contractual obligations that the United States will not fulfill. Contractors with valid contracts funded by laws passed by this Congress will not get paid. Presuming the committee comes up with a plan that can garner a majority, then the plan will be presented to the House and the Senate for an up or down vote with no amendments allowed.
In either of those steps there is the potential for failure. If the committee determines that there are just not enough places to cut and as a result eliminates some tax deductions and credits or in any way increases taxation, a lot of Republicans have already said they will vote it down. If the committee cuts Medicare, Medicaid, or Social Security in any way, then there are Democrats who have stated they will vote it down.
On Wednesday night following the passage of the bill raising the debt ceiling, representatives from S&P arrived at the Treasury Department to brief the Secretary and warn that they were going to downgrade the sovereign obligations of the United States. The Treasury folks found a $2 trillion error in the S&P calculations, which would negate what S&P was going to announce as the shortfall. S&P changed their press release to read that the downgrade was because of the political gridlock and the potential for the United States to not pay some of its obligations as well as the long term deficit problem.
The bottom line here appears to be not just that we (the federal government) are spending about five dollars for every three we are collecting in taxes, but that a large enough block of Congressional representatives appear to be willing to default that it just might happen. No one questions the ability of the United States to pay its bills, but the fact that Congress might choose simply to not pay those bills as a means to reduce our federal debt is something that any credit agency has to take seriously.
So What Comes Next?
The fact is that while our political leaders appear to be behaving in a less than ideal manner, the rest of the economy is busy doing the right thing. We are paying down our debts and balancing the books on the individual level while corporations are making the capital investments needed to keep us competitive. This is not fun, but it is the kind of activity that produces great returns a few years down the road.
About 70% of the S&P 500 member companies have reported their second quarter earnings. So far about 78% have come in with profits greater than expected. On Thursday, as the Dow dropped 500 points, General Motors reported that earnings were up 92% on good global demand for new cars. It also announced that it was going to be increasing the price of the 2012 models by 1%. The forward price to earnings ratio (P/E) of the S&P 500 is currently the lowest it has been since 1982. In fact this August sell-off almost perfectly mirrors the one in August 1982. Unemployment in August 1982 was about the same as it is today. The time before that when all the numbers line up is 1952. These things seem to come in about 30 year intervals. And, yes there was one in 1922 as well, and for that matter in the early 1890s too.
The stock market went on to rise by the end of 1982 to break all previous records. I don’t know if that will happen this time around, but I can say that this sell off is an irrational panic in which owners of stocks, which have not been downgraded, are selling in order to purchase Treasury securities, which were downgraded. If you can find any logic in that please let me know what it is. But that is it. Panic is an extreme version of the emotion “fear.” Fear is not rational but it is contagious.
My advice is the same as it was when the S&P 500 was at 676 and the Dow Jones Industrial Average was at 6627, just over two years ago: “DON”T PANIC.” As Rudyard Kipling wrote over a hundred years ago, “If you can keep your head when all about you are losing theirs…. then the world and all that is in it will be yours…”
Only a short while ago I was getting challenges for keeping bonds, gold, and other such things in portfolios to a higher degree than some wanted. I sort of suspect they will have a better understanding now why we do that.
As always if you have questions or thoughts, don’t hesitate to call or email (or if you are so inclined to write on paper).
The Federal Debt Ceiling Crisis and Your Portfolio
July 27, 2011
First and foremost, I think the words found on the cover of The Hitchhiker’s Guide to the Galaxy are appropriate here: “DON’T PANIC.”
This game of fiscal “chicken” in Washington is childish and dangerous, but it is critical to remember that the United States economy is a heck of a lot more than the federal government. We really do not know what will happen if the debt ceiling is not raised other than that a lot of federal payments to people and organizations will not be made. Companies dependent on the feds for their business will certainly take a hit. I would reasonably expect that interest rates would rise across the board on U.S. Treasury securities, with a corresponding decline in their market value. At the same time a lot of money that otherwise would be loaned to the federal government will need to find a place to earn interest, so we could see the high grade corporate bond market actually rise. One thing for sure is that a lot of economic assumptions will go out the window.
Members of Congress are commonly elected after promising pie in the sky and everything from jobs to great wealth for everyone. It has always been sort of a game in which they would make unrealistic promises and then come home later to explain that they fought the good fight but were overcome by the system. This time, a majority of Republicans in the House of Representatives made some promises, and even signed a pledge that they would not raise the debt ceiling of the United States Government until some things happened over which they have no control. As a result, they are now honor-bound to do their best to crash the system.
In the midst of this crisis, I think it is good to review what the real issue is here. As recently as 2000, we had a substantial surplus revenue flow into the federal government when compared with the expenses. Our elected representatives made the decision to reduce the revenue rather than using it to pay down the debt. After 9/11 we increased spending to fund the new Department of Homeland Security and got very thoroughly involved in two (and now maybe three) wars. The mortgage security meltdown and the ensuing financial crisis were halted with another batch of spending, although not anywhere near as much as we have spent on the wars. We then had a relatively severe recession and now some relatively high unemployment. Recessions and unemployment decrease the revenue coming in to the government while mandating a greater outflow. Somewhere in the midst of all of that our elected representatives also passed into law the largest entitlement program, at least in terms of dollars, in our history, the Prescription Drug Benefit.
We are facing several problems at the same time. First, we failed to use the surplus in the early 2000s to pay down debt, instead opting for a tax-cut. Not too surprisingly, the deficit came back the next year. Second, we piled on quite literally trillions of dollars in legally mandated spending (the wars, Drug Benefit, Homeland Security, and three stimulus bills) without spending cuts and then we lowered taxes again. The only thing surprising about the current situation we have now, is that the members of Congress who voted for those spending laws without any visible source of revenue appear to be both surprised and angry that spending more than we take in has resulted in a lot of debt.
Don’t get me wrong, I am one of those people paying lower taxes today than I would have under the old law, and I don’t like writing checks to the IRS any more than anyone else. I recognize though that wars are expensive and we have to pay for them somehow. I also recognize that getting expensive medication into the hands of people over 65 was a critical issue in some cases. What I don’t understand is the rationale behind supporting those high dollar spending bills while at the same time demanding that taxes be cut and the government not spend more than it makes.
Now we have some of the same members of Congress who championed all of those spending laws threatening to not pay the bills they ran up unless someone else agrees to somehow make it all go away. Frankly, the issue at hand is the wrong issue. Congress passed the laws mandating the money be spent. Most of the big tickets that are breaking the bank were passed when the same party had control of the House that has it today.
That is where we stand today. The conservative Republicans in the house will not tolerate any removal of the tax cuts and frankly, there is simply not enough discretionary spending in the whole budget to bring it into balance. As Jake has pointed out, the current revenue stream the federal government takes in could support Social Security, Medicare, Medicaid, and the Defense Department, and then we would be out of money; nothing for air traffic control, nothing for the Border Patrol, the Coast Guard, education, or anything else. That is where we stand.
Regarding your portfolios, we started exiting Treasury obligations months ago and our exposure to direct treasury risk is quite small. That does not mean that the stock market and the bond market might not take a plunge, but the reality is that American companies are doing quite well. As second quarter earnings have come in, the vast, vast majority of publicly traded companies are reporting they are earning much more profit than was estimated. Once a fix of some kind on the debt issue is in place the markets will rebound and I am convinced at some point investors will recognize that the world is not coming to an end and that stocks are cheap.
Meanwhile, my strong recommendation is to “hang in there.” If the worst-case scenario plays out, then there will be no place to hide. If, as I suspect, our elected representatives come to their senses, then we will emerge stronger and better off than we are today. Either way, the best thing to do is to continue to invest for the long term and ignore the short-term craziness.
If you have comments or questions, don’t hesitate to write.
Second Quarter 2011 TPWC Report
July 13, 2011
The second quarter of 2011 was punctuated by the Japanese tsunami, fear about Greece, and the threat of a political default by Congress. Adding to the worry was the report that the overall economy was growing at less than 2% per year. During the quarter a spike in oil and food prices dampened the hoped-for surge in the economy further. Rather obviously, if people are spending more money on food and fuel, they are likely to spend less in other areas, and they did!
Underneath all of this relatively temporary turbulence, the American consumer is still hard at work paying down the personal debt load. When things appeared to be stable and “normal”, meaning before the financial crisis of 2007-2009, Americans were very confident that their net-worth and income would be generally rising into the foreseeable future. Here in 2011, that attitude has shifted to the far more pessimistic view that bad things have happened to other people and bad things could happen to me!
We live in an interconnected world. I don’t think that very many of us considered that a Tsunami hitting a relatively small section of the Japanese coast would have had a serious effect on the American economy, but it did. Factories in the affected areas were the prime or sole producers of a host of small but vital components in automobiles, computers, airplanes, and more. To the degree that those vital components were not available, manufacturing all over the world ground to a halt. Car sales dropped significantly for lack of small, high-quality, fuel-efficient cars at a time when gasoline prices were spiking. Combine that shortage with the underlying belief that prices will probably be lower in the future (deflationary thinking) and people will simply put off that car purchase, waiting for the right car at a lower price.
There was yet another surprise that appeared at the end of the quarter. The typical, reasonably balanced portfolio came out at a near-breakeven value from where it was three months before. That same performance was reflected in the mix of broad indexes. The Dow Jones Industrial Average was ahead about 1.4% while the S&P 500 Stock Index was down about 0.4%. The Morningstar Diversified Emerging Markets Category declined about 0.87%, while the Domestic Mid-Cap Value Category declined about 0.79%. In the end, it was the Intermediate-Term Bond Category that kept us above water as it had a total return of 1.84% for the quarter.
In short, the various asset classes behaved pretty much as they should in the face of bad economic news. The long-term asset appreciation classes dropped in the face of less than expected growth while the asset protection classes cushioned those losses. The good news in all of this continues to be that corporate earnings appear to be holding up at levels generally well above what was expected. In the end, stock values reflect earnings. If corporate earnings rise the market will follow, sooner or later.
Exports continue to shine and while the growth in manufacturing output is slowing, we are still hitting monthly records for the dollar value of manufactured goods in these United States of America. Much of that manufacturing is being exported and we remain by far the largest exporter on the planet.
As the second half of the year gets underway I am optimistic. As a nation, our savings, both in the form of cash and in things like 401(k) retirement accounts is at an all time high. Once we get some reasonable degree of certainty about the future of taxes, federal budgets, and the status of the fiscally troubled nations in the Euro-zone I suspect we will see a lot of pent up demand take hold and growth that will shock most people.
As always, if you have any comments or questions, don’t hesitate to contact us!
Jeff, Jake, and the team at The Personal Wealth Coach®
TPWC Market and Economic Update – May 2011
Of Markets, Economies, and Debt
Confusing News
According to the Commerce Department, as well as virtually every economist whose comments I have read, the recession and recovery are now over and we are in “expansion.” As a recent article in Time magazine put it:
“The good news is that the American economy is back to its pre-crisis size. The U.S. GDP is now about $13.5 trillion, a bit above where it was in 2007, before the financial crisis. The bad news is that we are producing the same amount of goods and services as in 2007 with 7 million fewer workers.”1
Meanwhile, the Federal Reserve Board continues to execute “QE2,” a program designed to provide emergency stimulus to the economy. Conservative talk show hosts and politicians are proclaiming imminent doom for the nation unless we dramatically cut federal spending. State and local governments are doing just that, cutting as property and sales taxes fall. Last, but not least, every month brings a new announcement that some aspect of the housing market or consumer spending is sinking.
All that bad news could easily convince any reasonable person that we are sinking into an economic depression. Then someone notes that corporate earnings are at record levels, manufacturing is not only at a record level, but is expanding faster than at any point in the last half century, and the stock market has very nearly doubled in two years.
If that weren’t enough, about a year ago it appeared that Greece was going to sink the Euro. That crisis was proclaimed as “resolved.” Then it was Ireland’s turn and again “mission accomplished” was announced by the European Central Bank (“ECB”). Just as things seemed to be getting back to “normal” Portugal was “discovered” to be facing an unsustainable debt load and would need an immediate rescue. Now it is Greece again. This time the ECB and the Germans are expressing a great reluctance to loan good money after bad and it looks like a Euro Zone country may go into default.
Just as I was digesting all of this, Standard and Poor’s revised Italy’s outlook to “negative.” Concern is now being expressed about the status of Spain’s economic stability and the ability of its banking system to survive without assistance.
What is Really Going On?
Historically about twice per century post-medieval western civilization goes through a relatively large economic displacement. Typically one of those is inflationary and one is deflationary. Most of us are at least vaguely familiar with the deflationary event we commonly refer to as “The Great Depression” which occurred in the 1930s. We are also mostly familiar with the fact that we had a bout of market decline and inflation during an economic event that started in 1973 and lasted at least until 1983. Those were the two episodes of the 20th century.
In my opinion, we are now well into the deflationary event of the 21st century. We are also into some uncharted water in that we are not in a depression. Historically, the type of financial collapse we have seen in the last two years and which is still underway in Europe has resulted in a major socio-economic depression. The traditional solution to that depression has been a major war in which a phenomenal quantity of debt is generated by the winners and total collapse by the losers.
The situation in Europe is not terribly out of line with that historic scenario. Those countries that appear to be coming out of this crisis on top, led by the United States, are doing so with an uncomfortable debt load. At the same time those countries which propped up their government’s popularity by lavishing excess benefits on their populace are being rendered insolvent with all the pain associated with it.
The Markets in Perspective
If a picture is worth a thousand words (and I think it is) then the top graph on this page tells a story about the return of the stock market over the past ten years. A decade ago, in 2001, the S&P 500 Stock Index was around 1300. Today it is around 1300. As you can see from the red line on the second chart, with dividends reinvested, the Index really rose from 1256 in 2001 to 1656 in 2011. That equates to about a 2.8% average annual rate of return for the period. Unfortunately, the Consumer Price Index (CPI) rose at an annual rate of 2.38% for the same period, effectively reducing the gain to zero.
There is also a second, blue line on the bottom chart. That represents 
a Markowitz asset allocation2 with an expected rate of return of 10% created based on the historic data available in April 2001. The actual nominal return of that allocation was around 6.5% for the period.
Lessons to be learned
What can we learn from this? Probably the most important lesson is that the future is always uncertain. The ten years leading up to April 2001 saw the S&P 500 rise by almost 15% per year. Looking back ten years at that point one could easily conclude that high double digit returns were to be the norm going forward. Another lesson might be that when market returns are either unusually high (as they were in the 1990s) or unusually low (as in the last decade) the next decade is likely to reverse that trend.
We are not chained to some market index return. The major stock market indexes represent only a portion of the investment universe. Markowitz’s Mean Variance Optimization demands a far wider diversification. That diversification, applied in a rigorous, disciplined manner has historically resulted in either a higher return with similar variation or as good a return as the indexes with less variance.
Relating Markowitz to All Else
You may quite reasonably be asking at this point, “Why the lesson on Markowitz, diversification, and asset allocation at this moment when the media focus is on debt, default, and multiple financial crises?” My point is that despite all that has transpired over the more than half century since Markowitz wrote his paper, an investor who followed that discipline has not only survived but prospered in the face of crisis after crisis.
Currently the crisis du jour is either the U.S. federal debt and deficit or the threat of financial collapse in the Euro zone. Both are very real problems, but neither is actually a serious threat. That is a bold statement, but all I know about history and the system in which we function argues that I am right.
Meanwhile, the odds are that you, gentle reader, are very confused and more than a little worried about the state of our nation, the economy, and the world financial system. Perhaps I might be able to shed a little light on those dark subjects. Fair warning is in order here. The evidence as I see it will be in harsh contrast with the headlines and, for that matter, the talking heads that seem to be continuously proclaiming the end of the world.
The End of the World
Harold Camping, a Christian fundamentalist radio talk show host, recently declared that the beginning of the end of the world would be on May 21. The final culmination and the end-of-the-end were to occur in October of this year. As May 21 passed with at least most of us still here, he has now announced that the Rapture actually happened, but no one noticed. He is still predicting the end will come in October.
We humans seem to be unduly fascinated by these things. I, just for the record, announced on our radio show that the world would not end as predicted by Mr. Camping. As far as I can tell, that was the really unnoticed announcement!
Momentarily the budget deficit, the President’s policies, or the Euro crisis is, according to no small number of pundits, going to bring about the end the world as we know it. I have heard Glenn Beck announce the end of the financial world was at hand more than a few times. All of those prophets have something in common. End of the world forecasts get a lot of attention. Even when they are completely wrong, we keep coming back for more.
Mr. Camping was at least as adamant about the imminent demise of earth back in 1994 as he was recently. Mr. Beck very firmly stated back in 2009 that by now the dollar would be worthless and we would be in a massive depression. Still, I get calls every time he updates his doom prediction. Notably he never admits he was wrong.
So, here is my prediction. The world is not about to end. Even the world financial situation, which has some very real issues right now, is not about to collapse. More, I predict that a decade from now we will look back at a far better economic record than even the most optimistic of us can imagine today.
Having shared my conclusions, here are the issues we face and the real implications of those issues.
The Federal Debt
The Treasury of the United States owes $9.654 trillion in redeemable debt as of April 23, 2011. The Gross Domestic Product (GDP) of the United States for this year is estimated at $15.5 trillion. That means we have a public federal debt equal to about 64% of our GDP. The actual interest being incurred and paid by the Treasury on that debt is at 2.498%. That means we are paying about $241 billion in interest payments per year.
The rest of the $14(+) trillion federal debt is owed not to any holder of Treasury securities, but to ourselves in the form of obligations to pay future Social Security, Medicare, and other domestic “entitlements.”
Now for the perspective: Germany is considered by many to have the healthiest of the European major economies. Its public debt equated to 80% of GDP at the end of 2010 according to the International Business Times February 21, 2011 edition. The German Federal Statistical Office announced that the public debt stood at $2.72 trillion dollars and had risen 18% in one year. In the previous year it had risen 21.9%.
More importantly, Greece is on the verge of default. The largest holder of Grecian sovereign debt are German banks followed by the European Central Bank (“ECB”) While the exact numbers have not been released, if Greece executes any kind of default or “restructuring” its debt will no longer be eligible to be held by German banks or the ECB. Germany is the only major nation in the Zone which has the wherewithal to bail-out those banks. In doing so Germany could easily wind up with public debt greater than 100% of GDP. More on that later..
In short, the United States does not have a current debt crisis. The interest on our federal debt amounts to just over 11% of our budgeted expenditures for FY2011.
Two Aspects of the Real Problem
First, we are indeed borrowing a heck of a lot of money each month. Our actual borrowing needs this year will run about $500 billion. The good news is that there appear to be plenty of very willing lenders, and the growth in our GDP may well be quite sufficient to cover the real borrowing.
U.S. GDP is estimated by several economists, who I believe are very realistic, to be about 3.5% for the year. If that is a reasonable number, then tax receipts should rise by about $110 billion. If we could limit our future expenditure growth to no more than the CPI (inflation) then over the next three decades we would not only eliminate the deficit, but get a real handle on paying down the debt.
The problem is that unless major laws are changed and taxes are increased, that will not happen. If one considers the future obligations of Social Security, Medicare, the Prescription Drug Benefit Program, and Military Retirements, then all the numbers I cited above get radically different.
Note that I have not mentioned the general Defense Budget. That is a current expenditure and I consider it one of those areas where a spending cut now would mean a huge cost increase later.
The long term problem is that we owe ourselves a truly staggering amount of money in the form of Social Security, Medicare, Drug Benefits, and Military Retirements.
We currently owe those programs about half as much as the total public debt. Worse, we owe interest on the debt we owe ourselves. If we include the funding we are theoretically making for all the future benefits to be paid to Americans by the federal government, the federal debt rises to very nearly 100% of GDP.
Just a few years ago (2003), a Republican President in concert with a Republican controlled Senate and House of Representatives passed the Prescription Drug Care Benefit into law without a single penny of cost cutting or new revenue. In fact, the Congress and the President lowered taxes that year. More, that same law prohibited the administrators of the Benefit from negotiating with the pharmaceutical companies to get the kind of discounts that even corporate plans have achieved. The total cost of that program alone is estimated at $19 trillion over the next thirty years. I find it quite ironic that Representative Boehner voted for and publically supported that program but is now demanding budget austerity and threatening to put the government into default unless spending is cut immediately.
There are some hard choices that need to be made in the near future. Those choices must include a reduction in retirement benefits and an increase in taxes. No matter what the politicians say, the reality of the numbers is there.
The Immediate Domestic Crisis
There is a potentially much larger crisis facing us right now. Frankly, if we are to believe that the bond market investors have it right, then there is nothing to fear. Interest rates on U.S. Treasury obligation have been falling for the past several weeks.
The risk is that if the House of Representatives does not increase the debt ceiling in a couple of months, then the federal government will be forced to cut spending by about 38%.
In all likelihood the Treasury would continue to pay interest and principle on Treasury securities as it was due. We can easily afford to do that. What would cease would be things like payments to federal contractors, military personnel, payments to states for Medicare, and a host of other payments and services that we have come to accept as part of the life we live.
I also believe that the ensuing collapse in services and payments would throw us into a relatively severe recession which in turn would dramatically reduce tax revenues. If it were to continue, that would require yet further cuts in spending, which would worsen the recession. Would we survive that scenario? Yes, without a doubt. I am also sure that the ensuing economic pain would cause the elections in 2012 to result in a landslide for the Democrats.
The Conservative Caucus in the House is pretty radical, but I doubt that their idealism extends to political suicide!
The Crisis in Europe
The European fiscal crisis is not going to be as easy to either predict or solve. If Greece defaults or “restructures” its debt, it will leave the European Central Bank as well as many other banks in Germany and France in a worse financial condition than Lehman Brothers was in as it collapsed!
It is quite clear that Greece is incapable of functioning under the 20 %(+) interest rates it is paying for short term borrowing. Its austerity measures have put it in a severe recession and as a result tax revenues are collapsing even as interest rates on its obligations are soaring. Both the Germans and other “wealthy” countries will intervene with non-recourse loans (bail-outs) or the results will be very, very unpleasant for all of us.
We are the world’s largest exporter. Europe buys a lot of what we sell. If they derail, our train will be severely delayed. It will be educational to see what that herd of cats comes up with.
The Source of the Debt Crises
We here in the United States are tending to treat our debt crisis as if it somehow is ours alone. The two government chartered (and now largely government owned) mortgage institutions, the Federal National Mortgage Corporation (FNMC or “Freddie Mac”) and the Federal National Mortgage Association (FNMA or “Fannie Mae”) are often blamed for the whole debt crisis. If there were any truth in that assertion, then the crisis would be contained in the United States.
Factually, the residential real estate crisis is far worse in Ireland and Spain than here. The size of the real estate collapse in Ireland would have literally bankrupted the entire country had the European Central Bank and the International Monetary Fund not stepped in with low interest loans. As bad as our crisis was, and is, we were able to handle it with our own funds.
The source of the now world-wide credit crisis is a repeating story that goes as far back as we have historic records. It is actually far worse in Europe than in the United States. While our problem is very real and very painful, the sovereign and mortgage debt crisis in Europe has the potential to be devastating to the Euro and will affect every nation, person, and company in Europe. As to what effect it will have on us here in the United States, only time will tell, but we have survived European devastation before and certainly can again.
Stay tuned. This drama is not over.
TPWC Market and Economic Update – February
Building the Optimal Portfolio
Greetings from The Personal Wealth Coach®!
In this letter I depart a little from my tradition and confined myself to a single story. I believe that it is very important that you read these four pages of my prose carefully, because what is presented here is at the core of what makes for success or failure in most investment portfolios.
Over the 12 months ending in January of this year, the S&P 500 Stock Index rose 22%. Its compound average annual return for the past couple of years has hit a whopping 40%! As a result from March 9th of 2009 through here in mid-February of 2011, the Index has risen 100%!
Most people’s first thought at this point seems to be that a 100% rise in less than two years must mark an overpriced market. The facts argue otherwise. First, we are not back to where the Index was in 2007, so for most people who invested four years ago, their portfolios still show a loss. Second, the Dow Jones Industrial Average and the S&P 500 Indexes are barely back to the levels they reached eleven years ago. The fact that the market has risen 22% is dwarfed by the fact that the average reported earnings of S&P 500 companies with about three3-quarters of them having reported, is up 30% from last year. The price to earnings ratio (P/E) of the S&P 500 is still substantially below its long term average. In short, the market is still well below its normal historical valuation.
The long term trend in the broad U.S. Stock Market is still well above where that market is valued today. Today’s market levels are actually about 44% below their long term averages. That does not mean the rise to “normal” historical valuations will be either swift or smooth. If history is any guide, the second half of the recovery will be considerably more bumpy than was the first.
Further reinforcing my view that we have a ways to go was Chairman Bernanke’s testimony that he expects the U.S. economy to grow at about 3.9% per year for the next several years. That kind of growth only comes from a very undervalued economic environment.
At the same time, core inflation is running at about as low a level as any of us have ever seen it at just about 1.5% for the year 2010. Despite rising prices on food and fuel, there is no evidence that we are likely to see any significant inflation in the near future. In order for inflation to get a toe-hold, wages have to increase. The reality is that wages are not only holding steady, but are in many areas falling. As long as there is a large number of unemployed people in the country, there will be little likelihood that employers will be raising wages. Municipal employers are actively cutting positions and wages at the same time.
In short we are in an improving economy that is currently running ahead of the market with little suggestion of anything that looks like inflation. The danger at this point is probably more from attempting to get a higher return than is safe than from economic problems. At the same time though there are situations in Europe and Asia that could damage the global recovery. Still, when I add everything up, the positives look a lot bigger than the negatives.
As always, your comments, questions, and opinions are welcome!
Jeff McClure
Click the link below to see the newsletter. It is in PDF format, so you will need to have Adobe Reader or some other software that can read PDF files to read it. You can get a free Adobe Reader download from: http://get.adobe.com/reader/
TPWC Market & Economic Update – December
As usual, I have two stories in this missive which are separate, but related. The one immediately below, A Decade of No Return addresses both the apparent lack of return in the broad U.S. stock market over the first decade of the 21st century and the reality of where there was ample return if one simply refuses to believe the popular market pundits.
The second story, Recovery and Danger, is about the excellent economic data that has started coming in, particularly following the recent passage of the Job Recovery Act by Congress, perhaps better known as the extension of the Bush tax cuts. Factually, there was a lot in that bill that amounted to an economic stimulus of about $1 trillion. More, the stimulus was at least well targeted at the lowest economic levels where people tend to spend every penny. The Danger part of the story is a list of the things that easily could happen in 2011 and beyond that might cause us some difficulties.
A Decade of No Return
The Market that Went Nowhere
In my recent reading I have seen little evidence that much attention is being paid to the fact that we are at the end of the first decade of the 21st century. Part of that may be because we don’t know what to call it. The ‘90s or ‘80s are a simple matter to name, but what do you call the first decade of a century, the “Ought’s?”
The venerable Dow Jones Industrial started the decade having closed on December 29th at 10,769. This year on December 29th it closed at 11,585 having gained 7.6% in ten years. On January 14 of 2000 it had closed at 11,723, but the consensus was that this was a temporary downturn and we would soon again be seeing high double digit rises in the Dow each year. After all, we had just elected George W. Bush, a staunch conservative Republican as President of the United States following a bruising battle ultimately decided by the Supreme Court.
On the last market day of 2000, the S&P 500 closed at 1,320. As I write this, on December 31, 2010, it is at 1,258, 62 points below where it was a decade ago!
What that means for those who faithfully followed the dictates of the “efficient market” pundits and held faithfully to their S&P 500 Index fund of whatever brand, is that they effectively have seen a zero return after ten years of patient faith in index investing. After inflation the return goes negative.
It continues to amaze me that despite a decade of loss, the popular financial media still proclaim that investing in a broad market index like the S&P 500 to be the best and most efficient method to accumulate wealth for retirement.
The Management Advantage
The S&P 500 Stock Index is the prime example of what Morningstar Mutual Funds calls a Large Cap Blend index. While one cannot actually invest in the Index, there are funds that make a valiant effort to emulate the S&P 500, the largest of which is the Vanguard 500 Index Fund. The Investor class of that fund, primarily through reinvested dividends, managed to eke out an average annual rate of return of 0.71% for the last ten years ending in November. For every $100 held in the fund over the last decade, the largest and least expensive publically traded Index fund would have produced $107.33.
Now for the real news. The average large-cap blend mutual fund tracked by Morningstar would have produced $135.05 for the same period. In other words, over the last ten years the average large-cap blend manger outperformed the most efficient Index fund available to the public by a whopping 25.8%!
As the late night commercial announcers so famously say, “But wait! There’s more!” If instead of believing in the Efficient Market Hypothesis, which claims that no fund can beat the market for an extended period of time and that an index will always beat a managed fund, you had been a bit more rational and researched the best long-term asset class, and used active management, you probably would have done even better.
Over the really long term (30+ years) the best performing asset class has been Mid-Cap Value U.S. Stocks. Let me clarify that just a bit. It was not the highest return, but does have the best return for the risk level it brings. The actual best return record is held by Diversified Emerging Markets but the price paid for that return is the requirement to tolerate large, sudden downturns with sometimes many years until new highs are reached.
Mid-Cap Value has several indexes that claim to represent the class, but generally the average annual ten year return was around 7.5%. Ten years ago there were simply not any index funds to use in that class, so an investor could not have “indexed” there. What an investor could have done was to select from the better long term performers in that asset class from the active management funds. Had an investor done so back at the end of 2001, the hypothetical $100 would have become $241.78 by the end of last month1.
The Lesson to Learn
That number is drawn from the average of the historically better performing funds that were available ten years ago1. Unfortunately for them, with the barrage of publicity claiming the S&P 500 Index funds were the only reasonable choice for an intelligent investor, it is unlikely that there were many who diversified among the better Mid-Cap Value managers.
Today the consensus seems to be that gold or some form of bond investing or even guaranteed return investing is the only rational approach to the market. Given the near certainty that interest rates will rise at some point in the next decade, that belief may well be at least as flawed as the faith in the Index was a decade ago.
The critical lesson here is that whatever the popular media declare to be the absolutely best and only reasonable investment class is probably due for a massive fall within the next few years.
Here at the end of 2010 we are starting to see investors move out of bonds and into equities (stocks), which bodes well for all of us. The money continues to pour into gold though and given the generally unregulated and currently irrationally priced market for that metal, it is likely that at some point in the next few years a sudden “crash” in gold prices will occur.
Another truth about asset class manias, or bubbles as they are sometimes called, is that they can go on for a very long time. The same applies to asset classes that are irrationally undervalued. Just as the S&P 500 large-cap stocks were first overpriced and then massively overpriced in the late 1990s, during that same period smaller sized companies in many cases had stock prices that were at a ridiculously low valuation for several years.
No Need to Rush
There is both good news and bad news in those observations. The good news is that there is no rush to move into or out of any given asset class. Yes, Mid-Cap Value as an asset class had magnificent performance over the past decade, particularly when compared with the broad U.S. equity markets, but the window to move into that asset class and profit from the move was actually several years long.
The bad news is that it is very, and sometimes, extremely difficult to have one’s invested money in a set of asset classes that are undervalued while some other class has year after year of outsized gains! That was certainly true in the late 1990s and for some it is very true today when gold is soaring to absurd heights.
At this moment in time we are moving from European Large-Cap Value stocks into other areas. While the danger is very real of a European market collapse as the still unresolved sovereign debt crises slowly unfolds, the key is that the danger is well understood and the time frame is measured in months, not days or hours.
In essence, recognizing that any class of investment that rises rapidly to absurd levels will likely come down very fast combined with the recognition that good management generally outperforms no management are two keys to long term success. $$
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Recovery & Danger
The U.S. Recovery Gathers Steam
A couple of weeks ago the GDP growth in the third quarter was retroactively adjusted to 2.6%. That, by itself is not a big issue. 2.6% is still below the long term norm and not fast enough to get the unemployment numbers down. What is encouraging is that the first numbers released were closer to 2%.
Economic change initially occurs at the margins, not in the middle. What that means is that it is in the nooks and crannies of the economy where the future can be seen. In a slowing economy the successive updates for GDP come in lower and lower while in an accelerating economy those later numbers come in higher.
Sure enough, here at the end of December new jobless claims fell to a seasonally adjusted 388,000 nationwide for the week. Now the thing to watch is the four week moving average of net jobs added. While all of 2010 saw job gains of about 90,000 per month, we need over 100,000 to just break even. Surveys of business owners and decision makers indicate that the number should creep up to around 160,000 for 2011.
The other number we need to watch for is the 4th quarter GDP number. If as it is widely predicted the annualized domestic growth of the U.S. economy jumps to 4% we are on the way to full recovery.
Stimulus and Response
There have been many pundits who have loudly proclaimed that the government stimulus measures have not worked. The reality is that they have. Inflation is and has been effectively at zero for the last two years while we have been inching back to a growing, healthy economy.
Compare that with the Europe Union where there was no coordinated effort to create a stimulus package because there was no central government to coordinate that action. As recently as a month ago the head of the European Central Bank (ECB) was criticizing Federal Reserve Chairman Bernanke for the announced plan to purchase Treasury Notes on the open market. Since then the ECB has had to plunge full force into purchasing sovereign debt of Ireland and will almost certainly have to do the same think for Portugal in the near future.
Absent stimulus, the economic recovery in Europe is in severe danger of collapsing into a series of defaults, high interest rates, and possibly a failure of the Euro. At the very least the ECB, backed by the German government has the unpleasant choice of cranking up the money machine at full capacity or seeing Europe sink one nation at a time.
A New Round of Stimulus
The passage of the extension of the “emergency” tax cuts originally enacted under the Bush administration combined with an extension of unemployment insurance and a significant reduction in Social Security taxes for 2011 will put about $1 trillion into the pockets of Americans that otherwise would not have been there. That increase in spendable income coupled with the $600 billion being pumped into the banks by the Federal Reserve may be just what the doctor ordered.
It is notable that only with all of those actions in place are we seeing banks start lending again, employers suddenly willing to hire more employees, and consumers beginning to spend on durable goods.
Perhaps most encouraging of all the data is the reading of the Chicago Business Barometer, a survey of regional purchasing mangers which is one of the most reliable long term leading economic indicators. Last Thursday it was announced to be at 68.6, the highest it has been in 22 years! Once again the signal is in place that business decision makers are reaching the conclusion that we have turned the corner.
Last but not least in the good news area is one of my favorite indicators, tourism spending. The Commerce Department announced that domestic tourist spending, which is Americans spending tourism money in America, is up 8% year over year. People who are afraid of financial failure tend to cut vacations first. Once expenditures on domestic tourism go up things are getting back to running on a more normal track.
Things to Concern Us
The issues that could knock us back into troubled territory are largely out of our control. What we can do is watch and hope the central bankers and national governments involved make wise decisions.
1. The Euro Zone
The Euro Zone is in deep trouble. The ultimate result lies in a combination of willingness of the German voters to, in essence, bail-out several countries, and those countries willingness to in effect submit to German financial rule. Greece is now effectively subject to executive orders from Germany regarding its every economic move. Ireland has submitted to the reality that its government and its banking system are under the authority of its German creditors, and will be for many years to come.
Next on the watch list are Portugal, Spain, and Belgium. Belgium has the advantage of having a reasonable rate of growth, but is carrying a sovereign debt that is rapidly becoming a multiple of its annual GDP. Portugal, like Greece, has little growth, an aging population, and more debt service Euros to pay than it can make in a year.
In each case it is ultimately Germany that must come to the rescue of those nation-states. The Germans are unhappy that their hard earned savings are being shoveled out to free-spending countries facing financial collapse, but much of the debt those countries have accumulated resulted from the purchase of German goods and services. Germany’s recovery from its reunification and strong growth since has largely been based on exports to Euro-Zone nations who before the common currency introduction were simply too poor to afford all those finely made German goods.
Like GM, Germany not only was willing and ready to sell them the goods, but had a great long term finance package to allow them to make the purchases. Unfortunately, like many another entity that was in the business of financing its own sales to less well off customers, Germany got caught in its own export trap. Failure to prop up its customers would result in a huge blow to the German economy and banking system.
The big question is whether the German people will be able to keep shelling out Euros to people and nations who are not longer going to be able to buy those goods. If the voters in Germany determine that as a matter of principle they need to stop propping up the “deadbeats” then Europe could easily find itself in a serious financial crisis.
For better or worse, we live in a very closely interlinked world. A major financial crisis in Europe would have implications here. This is not news to either the Federal Reserve or the Treasury Department. As a result, both are doing what they can to provide support to the ECB in its efforts to stabilize the situation.
If the Eurozone partially collapses it will be a negative for our economy as we export a lot of goods and services to the Europeans. On the other hand, because our economic leaders are and have been so aware of the risks we have almost certainly made preparations for the possibility.
2. The Economy Doesn’t Get Better by the end of 2012.
The effective stimulus passed by Congress and signed into law by the President in the form of the Job Creation Act which extended the Bush tax cuts and created several stimulative cash-flows to lower income people appears to have pushed the economy past the tipping point into self-sustaining growth. The combination of the remainder of the 2009 stimulus bill with the bill just passed will pump over a trillion dollars into the economy before 2013.
The problem arises when the stimulus runs out. Either at that point we have an economy ready to go off of life support or we could be in for a big fall. Just ending the stimulus effect by itself will probably be sustainable at that point barring some unexpected shock. The critical issue is that we have just elected a set of fiscally conservative members of the House of Representatives. Under the Constitution, spending bills must originate there and I would be quite surprised if the Republicans did not follow through on their pledge to cut spending.
Cutting spending is a nice concept, but it means that people will lose their jobs. It will require new laws to be passed by both the House and the Senate and signed by the President to touch the bigger areas, and that will not happen. All that is left are things like the federal funds in the “No Child Left Behind” program. That means that school districts will be laying off teachers.
If municipalities have not seen a fairly significant increase in revenue between now and then the current rising lay-off rate of local government employees will become an avalanche as federal funds dry up. If the private sector is up to speed the local taxes will cushion that and some of those local employees will be able to find employment in the private sector. If not, things could get dicey.
3. China has a Hard Landing
China injected about twice the stimulus money into its economy that we did in terms of a percentage of GDP. As a result the downturn virtually did not happen there. What did happen was a lot of economic activity and loans that had little or no economic validity. In other words, a bubble.
China is today experiencing a real estate boom that looks an awful lot like the one we had five years ago. While annual inflation for the first six months of the year only ran at about 5.5%, in the third quarter it jumped to 10%. That has the Chinese government worried, with good cause.
Unfortunately, for the Chinese banking and government authorities, this is a new phenomenon. The driving factor in all things done by the Chinese government is the maintenance of stability at all costs. As a result, the increase in rates of only 0.25% by the Central Bank of China is probably far, far too little. If inflation starts to get out of control, a typical governmental response would be to clamp down hard. If that happens it could result in a sudden, hard recession in the Chinese economy. The Chinese buy a lot of goods from us (and a lot of bonds). The potential is there for a problem in our economy.
The Bottom Line
If our economy gets rolling again, we can weather all of those issues, and the mere fact that we are up to speed may just prevent any of them from happening. The odds are in our favor, but we need to keep watching. Meanwhile a combination of Markowitz asset class optimization and careful observation of valuations and managers appears to be the best option for all of us.
Stock Market has best Month in more than a Year
July of 2010 is an example of how the U.S. stock market works. The Dow Jones Industrial Average (the Dow) oscillated up and down, often as much as 200 points in a day, and on a couple of days moved around 300 points. The Dow started the month with the print and broadcast media loudly worrying about a “double dip” recession and an accompanying decline in the markets at 9,773. It ended the month at 10,466, up 7.1%. (more…)