Please note - this commentary is on the way in paper form to clients this weekend.
A Will Rogers Market
Volatility Returns to the Market
About a year ago as the Standard and Poors 500 (commonly referred to as “The Market”) crossed the 900 and 950 threshold after hitting a low in March 2009 of 666 I began to call my clients and urge them to prepare for rougher times ahead. Generally, I advised that we reduce “Risky” allocations and change the Risky allocation to become less risky (in my last quarterly commentary I explained each strategy). My reasoning for this was I did not believe the recovery was real and that the probabilities of another crash or prolonged decline were high. As it turned out, the markets and most prognosticators disagreed with me, and stocks continued to soar, hitting a high of 1,186 in late April 2010. While we did capture some of this move we didn’t capture all of it, but capturing the upside of the stock market while limiting the downside is not possible and it isn’t our goal (but don’t get me wrong, if I could do it I would!). Will Rogers once said “I am more concerned with the return OF my money, than the return ON my money” (actually Mark Twain was the first to say this), this is a Will Rogers market.
My analysis led me and leads me to believe that stocks are still overvalued significantly, which of course did not stop them from hitting higher and higher levels. My belief was that if housing wasn’t dealt with in a meaningful fashion and when the stimulus ran out that the party would be over - essentially that thesis is playing out right now. The S & P has since slipped below 1,030 and may be headed back below 1,000 and the market has been very volatile - losing 10% in the 2nd quarter of 2010. The goal of the portfolios I’ve been building has been to reduce the day-to-day fluctuation without missing out entirely on higher returns. This has meant missing out on some market gains in the short-term, but I believe the downside protection has been more valuable. Having said that, one of the funds that I utilized to replace “market exposure” actually beat the market over the past twelve months with considerably less fluctuation.
Cash is King
I also believe that Deflation is a big risk, though longer term as the government prints more and more money to deal with deflation the risks will turn instead to Inflation. So far the data has proven this out. Money Supply has been falling and as of late, interest rates have fallen below key levels. My approach of holding cash or cash-like securities has caused some pain and generated not a few protests, but I believe this is the best route for right now. Holding cash and equivalents in a low interest-rate environment hurts and the government does this (keeps rates low) purposely to make you feel pain and to move your money out of lower-risk securities into higher-risk securities, essentially in order to bail out the more risky securities (find buyers for them). The more the government can get you to move up the risk spectrum, the more support risky assets will find and the less support the government has to provide and the less likelihood of risky assets collapsing. While the government believes this is good, it isn’t necessarily good for you - you should not be bearing the risk of over-indulged entities.
What Have I Been Up To?
As you know I take my job managing your money very seriously. I also am responsible for helping you with your financial planning needs. The last two years I have spent more time on economic and financial analysis than ever before and it consumes much more of my time than it ever has. This is due to several reasons, but primarily because I no longer believe that simply buying and holding the market is appropriate for most individuals. My point being is that I recognize we haven’t met as often as I or perhaps you would prefer. This isn’t lost on me and I want to assure you that I will make myself available for meetings and conference calls whenever you want to meet in addition to our regular meetings. I don’t want you to think I’ve forgotten about you if you don’t get a call from me for a few months. This is why I write my blog (please follow it at http://themeridian.blogspot.com) and this quarterly commentary - to keep you updated on my latest thinking. The amount of research I consume on a daily basis is truly extraordinary and I couldn’t do it without my new iPad (yes, I had to put a plug in for it!). My hope is that this additional work and research will allow me to make better decisions with your money. I believe it has paid off so far, but only time will tell.
What Can We Expect Going Forward In The World Economy
I am still not convinced that what we experienced (or are experiencing) is not a Depression. The term that has stuck with most news organizations and pundits is Great Recession, but I think they are using that term in order to avoid what has actually occurred, a Depression.
The problem with this thinking is that if we deal with the current economic environment as if it’s a garden variety Recession we end up not dealing with the fundamental issues that face our economy- we spend money we don’t have and bail out everybody except those on Main Street. This thinking makes the situation worse and prolongs it. Instead of intense pain that ends in a short-time period, we have opted for a less, but constant pain over a long time period.
I don’t know what the future holds for stocks, bonds or commodities. I have ideas and I try to build your portfolio around those ideas, but I am not convinced we have dealt with our economic problems sufficiently. If stocks were priced much lower and we had the same issues I could justify adding more risk to the portfolio, but not at these prices. Please understand as much as I WANT to be right, I might not be. Our economy could pick right back up and begin cruising along again with stocks hitting new highs, but I believe it would be artificial. The question remains for your retirement money - do you want to take extra risk to squeeze out a little extra return or would you be more comfortable taking less risk and ensuring that you retain most of your capital? My job is to attempt to align risk and returns, it is not easy and I won’t be right all the time, but my hope is that I am not so wrong as to cause unnecessary losses.
So where are interest rates heading? Your guess is as good as mine, but here are my thoughts.
I believe interest rates are headed down and may stat there - unless we get an oil shock. If you have been reading my blog you will have noticed that I’ve tilted more toward the Deflation camp and have been warning that interest rates may fall further. In fact, that is what has happened. Could they fall even further? It is possible. Just look at Japan. For this reason, I don’t expect the Federal Reserve to raise interest rates until 2011 (or longer), meaning more pain for investors looking for income. Income investors are paying the price for the bailouts. Having said all that, I cannot rule out an Oil price shock. War and more fallout from oil leaks could put a crimp on supply or expected supply which could lead to high oil prices (right now prices are falling due to unexpected lower demand globally) and those higher oil prices could have inflationary effects on the economy (please note that this is not true inflation).
Longer term I believe there is a high probability the Federal Reserve will resort to another round of Quantative Easing or money printing. While many believe this will lead to inflation or a hyper-inflation (hence the Gold-bugs) I am not yet convinced. If all the printing simply ends up back on bank balance sheets and thus not in the economy it may have no affect (other than to take bad assets off the balance sheets of Too Big Too Fail banks). For money printing to work the money must circulate in the economy (referred to as the Multiplier), as of now it is not. While this does present an opportunity to be in high-grade intermediate bonds, I’m not convinced there are not risks there as well, but you can be assured I will continue my quest for appropriately priced income-risk assets (note, “income-risk assets” is a term I just made up).
Optimism: The Case For It (and a teeny bit of cynicism)
I don’t believe we will have a double-dip recession for two reasons:
1. I don’t believe we ever got out of the first recession, this is just a continuation
2. I don’t believe we are in a recession, I believe it is a depression
There is your cynicism! Like I’ve said in the past, I believe we are in a depression. When one fifth of the work force is unemployed or underemployed it is a depression. It just is.
You need to realize a few things about a depression, first, they are not new to Americans (but they are new to most current Americans) and two, they are not all “Great”. The Great Depression was considered “Great” because it was so bad in comparison to previous depressions. Unemployment was double what it is today. We are NOT in a Great Depression or a Second Great Depression or a Greater Depression. Great is a modifier of the word “depression” and Americans experienced many Depressions in our 234 years of existence. You must also understand that not everyone experiences a depression. Some thrive or simply don’t get hurt as much – hence Gershwin’s famous line “Nice work if you can get it”. Finally, this depression is, so far, very different from the Great Depression in turns of living standards and government safety nets. It should not be lost on us, however, that it is these safety nets that form part of the reason for our current economic malaise.
Now. for some good news. I know many of you have expressed your concerns to me that my commentaries can be a bit....depressing. I understand, but my obligation is to tell you what I see and not sugar coat it. In my heart I am an eternal optimist and I do see things that make me believe there is still.....pardon the overused expression....Hope.
First, as with the Great Depression, American’s attitudes toward spending, savings and family changed. Americans turned more inward and focused on taking care of one another. Americans also rediscovered the lost virtue of savings. My hope is that these lost virtues are found again (though the evidence on savings is not good right now). It is hard to save when you don’t have a job and you are over-leveraged and over-taxed. Further optimism is based on the continued technological and biological developments that are being made daily and the continued spread of the internet (and hopefully with it - knowledge), which unites people and ideas. If you think about the changes our world was on the verge of during the Great Depression that were positive, we are positioned in an even better manner now.
I’m convinced we can avoid another Great Depression (though not convinced we won’t avoid another World War), but not convinced we won’t. Regardless of how the next ten years play out, the next fifty will likely witness the greatest leaps forward ever witnessed by the human race. Things we never thought possible today will be commonplace for our children, grandchildren and great-grand children. Lessons learned today will hopefully not be forgotten easily (even though it feels like we learned nothing from 2008).
We continue to face major headwinds and currently face a lack of leadership to effectively deal with the structural issues our nation and much of the world face (please don’t think I am only referring to Democratic leadership, there is a leadership vacuum in general). My goal is to navigate you through these treacherous waters, knowing full well that we will float off course sometimes and will not always be correct, but with perseverance we will make it through.
Scott Dauenhauer CFP, MSFP, AIF