Friday, January 22, 2010

2010 Report Commentary

I'm posting this early even though I have not fully edited it given the recent market volatility. I was planning on finishing the editing and mailing out before month end, but figured now is a good time to get the information out to my clients, my edits will come later (so forgive the grammar) and in your mailbox (if you're a client).


Margin of Safety, Hyperinflation, Deflation and Experts

The Lost Decade

As we start a new decade and leave behind a “lost one” (is it ironic that the TV show Lost became a hit this last decade?), many are wondering how they should position their money for the future. The answer as always is not so simple, but my purpose here is to provide a framework for how I have come to the decisions for my clients portfolios going forward.

A lot has happened in the past eighteen months, we’ve seen spectacular losses and spectacular gains. A lot has also changed, much of it for the worse, though you wouldn’t know it by the gains in the stock market. One thing that is clear is that the stock market continues to be a very volatile place to put one’s money and volatility is not your friend in retirement. While things appear to have returned to normal, all is not well and in my opinion their is more risk than potential return in the stock markets (generally).

Margin of Safety

Warren Buffet and Benjamin Graham preach(ed) that one should obtain a “margin of safety” when purchasing any asset. The reasoning being is that things can and do go wrong and if you include a cushion, you (or the asset) can survive. This concept is why home lenders used to require a down payment of 20 - 30% - if real estate prices became depressed the lender would still have a cushion to soften the blow in the event of a default. The same concept applies when you are driving a car, the faster you are driving the further distance you should keep from the vehicle in front of you in case that car does something unexpected. We’ve become a society of “margin-less asset purchasers” or MAP’s for short. We buy something regardless of price with the “hope” of selling to a greater fool should prices begin to fall, however at that point in time the greater fool doesn’t exist to sell to.

The Tens Aren’t the Eighties

Many have compared today’s market environment to the early 80’s and contend we are at the beginning of another great boom for stock prices, yet this thinking ignores many differences between then and now. Back in 1980 we had less than $1 Trillion in national debt (in terms of GDP less than half of today), almost exclusively held by Americans (in one form or another), a billion was a lot of money even back then. Today our national debt is approaching $13 trillion and will likely be $14 Trillion sometime in 2011. This does not include entitlement debt which has a present value north of $60 Trillion, nor does it include municipal or personal debt.

Back in the 80’s we began running deficits and we have never looked backed (no we did not ever have a balanced budget during the Clinton years, that was an accounting trick). We will never again be able to balance the budget, it is not possible and we may be stuck with a budget deficit of close to $2 Trillion annually for many, many years.

Back in 1980 the trailing ten-year average P/E Ratio (a measure of stock valuation, the lower the ratio the lower the value) on the stock market was about 8, today it is over 20 (close to where it was in October 2007, before the crash started). Back in the 80’s states and municipalities were not nearly as leveraged as they are today. Currently unemployment is running close to 22% according to Housing is not fixed, in fact we are facing a foreclosure crisis worse than we faced just last year as an avalanche of option-ARM mortgage are set to adjust and as the four government programs set up to stop foreclosure have failed miserably. Banks are allowed to borrow at next to nothing from the Federal Reserve and invest in risk-free treasury bonds earning a nice spread while ignoring small business who need access to credit. The housing market is being propped up by the government in a manner never before witnessed in the United States, they have attacked on four fronts:

FHA continues to make loans with little or nothing down to people with less than perfect credit

The Congress passed a law that gives free money (up to $8000) to people who buy a home.

The Federal Reserve embarked on a program that doesn’t appear to be legal to print money to buy mortgage backed securities of Fannie and Freddie (government controlled mortgage agencies) in order to push down interest rates for borrowers and new home buyers.

Finally, accounting rules have been relaxed in order to allow mortgages to be carried on bank balance sheets at essentially whatever the banks want, thereby making insolvent institutions look solvent and delaying the purge in homes that are delinquent.

This never before attempted government intervention in housing has kept housing from falling further and even helped prices in certain areas, though new home sales have yet to recover and high-end homes are having severe issues. Fixing housing has not been a priority, pumping it back up has been the order of the day, but it won’t work. I contend that unless housing is fixed we won’t have a meaningful recovery. This doesn’t mean we won’t have a recovery or that stock prices won’t go ever higher. The coming resets in Option-ARM mortgages will peak once in 2010 and again in 2011, these peaks will rival the sub-prime mortgage peaks and if not dealt with properly will pose a major headwind for real-estate and all other things financial.

In my opinion there are several things that need to be done in order to fix our financial system.

First, we must reinstate some version of Glass-Steagal, the Great Depression era law that essentially separated investment banks from commercial banking.

Second, we must separate out the risk taking hedge-fund like trading from the investment banks. The investment banks have leveraged themselves up to the point that if they are wrong on their speculations they could bring down our entire financial system, yet we continue to allow them to exist with an implicit guarantee that we will bail them out if they get it wrong. This allows them to borrow at lower interest rates as investors believe they will be defended by the government in the event of a blowup. This hurts competition as the government essentially provides a subsidy to one set of financial institutions, those that get big enough.

Third, we must remove the doctrine of Too-Big-Too-Fail, allowing institutions that take on to much risk and get it wrong to fail. Taxpayers should not be on the hook for losses that should be taken by stock and bondholders. The TBTF doctrine has failed and its the taxpayers who are paying the price all while those who benefit (Wall Street) take home massive, record bonuses. This is not only morally reprehensible, it is bad economics.

Fourth, in implementing Too-Big-Too-Fail we must breakup many of the large banks (Citibank, BofA, etc) and reduce the amount of FDIC insurance that is provided. Smaller institutions provide more competition and if regulated properly will not be able to take on the leverage and poorly underwritten assets that the large banks have purchased.

Fifth, we must reign in the Federal Reserve. The Fed has done more to devalue our currency than most understand. Since the creation of the Fed the dollar has fallen over 95% in value. While the Fed has been credited with saving the economy (Bernanke was named Time Man of the Year), it is more likely he has simply delayed the inevitable and made things much worse.

Sixth, we must fix housing. There are several solutions, some that include taxpayer money, others that don’t. We should make economically sound financial decisions like offering Principal Reductions when it makes sense to do so. John Hussman of the Hussman Funds has also come up with a system to deal rationally with this problem. This is essential.

Seventh, we must fix our entitlement problem (medicare, medicaid, social security). Our total national debt including entitlements is nearing $120 Trillion, of this over $100 Trillion is the present value of the short fall in Social Security and Medicare (Part D included). Did you know that Medicare Part D, which was just passed into law a few years ago under the Bush Administration already has a present value deficit greater than that of Social Security?

Eighth, we need to regulate Credit Default Swaps and make the system more transparent.

Implementing the above fixes will be politically difficult given the enormous amount of money that finances the campaigns of our politicians, but without these reforms and others we are destined to be on a boom-bust cycle for decades or be thrust into a greater depression than we are in currently. In addition, it is many of the current politicians that have created much of the chaos by passing budgets that are unsustainable. This is not unique to one-party. Perhaps throwing the bums out and starting over should be number one on my list above.


At this point you are probably wishing you hadn’t read this commentary, you might think I’m overly pessimistic and that perhaps I’ve thrown in with the crazies. I assure you this is not the case. My goal with this letter is not to upset you, but simply to let you in on my current thinking and take you where my research has taken me. I will say that I believe I am in the minority in my opinion. It is the above analysis that has led me to being more defensive in our portfolios.

You might be wondering just who I read and listen too. A few of those that shape my view are Jeremy Grantham, Janet Tavakoli, Robert Arnott, Bill Gross, Brian Wesbury, Jeremy Siegal, Robert Schiller, John Williams, James Grant, John Mauldin, John Hussman, Amity Shlaes, Nouriel Roubini, John Talbott and many, many others.

Given the depth of experts that I look too and read as often as they will write you might think that they’ve all come to an opinion, a consensus, you would be wrong. The experts I read have predictions that range from hyper-inflation to hyper-deflation and from a massive stock market boom to a massive stock market bust. Many of these experts lay out almost the same case, yet come to the exact opposite conclusion.

What is a person to do when the experts, some of who saw the last crash coming simply don’t agree or even have predictions that are diameterically opposed? The answer is you don’t bet on any one of them being right, you pursue several strategies that hedge against one another and attempt to build in enough flexibility that you can adapt and that is what we have done with your portfolios.

Risky versus Less Risky (used to be Non-Risky)

All of my client portfolio’s are made up of a mix of Risky and Less-Risky assets. I used to use the terms Risky and Non-Risky, but I’m not sure a “non-risky” asset exists. The portion of your portfolio that is placed into risky assets is dependent upon your need and ability to take risk in order to attempt to generate a higher return. Some of you will have no or little allocation to risky assets, others will have a substantial allocation.


The risky asset portion that I am recommending consists of three strategies:

Long-only Global Equity
Hedged Equity
Tactical Asset Allocation

The three strategies are designed to be more defensive in nature with the hope of capturing a reasonable return for the risk taken. These assets WILL fluctuate in value and sometimes wildly, however the hedged-equity and tactical portfolio’s are designed to fluctuate much less than the long-only portfolio.

The long-only portfolio is a simple buy-and-hold global stock index allocation. This portion of the portfolio will fluctuate the most. Given my above thoughts you may wonder why I include an allocation to stocks, the reasoning is that the stock market doesn’t obey me. Long-only stocks are a hedge against being wrong about the direction of the market and potentially a long-term hedge against inflation. Should we see another crash in stocks, you should expect to hear from me with the advice of increasing the assets in this strategy.

The hedged-equity strategy is managed by John Hussman ( and he utilizes macro-economic analysis combined with valuation measures to determine how much of the risk of the market he would like to assume. When he believes there is more risk than potential return he will buy insurance (in the form of options) to hedge the portfolio against downside risk. When he believes stocks represent a good risk he will take those hedges off and potentially add some leverage. His prescient calls this decade have made his fund a steady performer, however it will underperform in major rallies. The price of underperformance during exuberant rallies is gladly paid for with a more limited downside. The goal is to outperform the market over a cycle with considerably less risk.

The final strategy is managed by Rob Arnott of Research Affiliates through PIMCO. Arnott believes that stocks are not priced to earn a reasonable premium and thus his fund is designed to find asset classes that offer a reasonable return for a given level of risk. This fund will fluctuate and can be invested in just about any type of asset class you can imagine depending on how the manager views the risk/return tradeoff. The goal is to provide a better return than the market with less risk, but more importantly to beat inflation by 5% annually.

The combination of these three strategies should reduce, not eliminate fluctuation in the portfolio which in the longer term can help your money compound quicker. In addition, the defensive nature will hopefully protect against market crashes. There is no assurance any of these strategies will work, however they have a demonstrated track record.

Less Risky

Less Risky means little to no fluctuation. For this portion of your portfolio my advice is to be short-term and high-quality. This means anything from FDIC insured savings accounts to highly rated and liquid fixed annuity products. Right now I believe flexibility is key and this means you want to keep your fixed income assets available to reinvest should inflation rear its head or interest rates rise. I do not believe now is the time to take on additional credit risk, though this may change. This strategy will hurt in the short-term as interest rates are terrible. You, the saver, are paying the price for the Wall Street bailouts, but at some point these rates must rise and being able to take advantage of this will be the reward of low short-term interest rates. If we end up with deflation you are well positioned, if we get inflation you are well positioned.

A portion of the fixed income or “less risky” part of your portfolio is invested in Treasury Inflation Protected Securities. While they have risen in value recently I don’t recommend selling, though their is potential for downside and I actually hope these securities fall in value as I’d like to own more, just at better prices than today.

So that is my strategy for your portfolio in general, each of you will have a slight variation due to the fact that I design portfolios to fit the individual. I hope that the changes we made will help in meeting your goals and I am available to speak or meet with you to discuss anything I’ve written more in depth.


I cannot say what 2010 will bring, it might be a boom, it might be a bust, what I can say is that I’ve done my best to position your portfolio according to my macro-economic outlook.