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Economic Observer 2010-Q1 PDF Print E-mail
Written by John D. Buerger, CFP®   
Wednesday, 06 January 2010 13:37
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John Buerger

It's a good thing that advisors aren't paid to predict the future. Then again, predicting what the markets (which involve millions of independent agents and hundreds of government entities) will do is far more complicated than trying to predict the weather ... and we all know how accurate meteorologist predictions are.

Reading through some finanical literature back issues, we find that at this time two years ago, nobody, anywhere, was predicting a 4th quarter meltdown in the investment markets for 2008, or the global economy tottering on the edge of disaster. In fact, not a single one of 2008 prognosticators seems to have realized that the U.S. economy had already fallen into a recession (which officially started in December, 2007). Oops.

"... we have little to no control over the future, and the investment markets tend to be far less predictable than other areas of our lives."

This procession of bad predictions continues through September, 2008 when nobody expected the massive drop in equity prices that followed the collapse of Lehman Brothers. Even Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson, who are closer to more economic data than any other people, totally missed it.

Fast forward through 2009 and you find inflection points like March's equity market bottom and the short term peaks in commodity prices or dollar strength and you find that a vast majority of those who pose to be "in the know" were dead wrong in their predictions. They didn't know any more than you or I ... because NOBODY really knows anything about the future.

And that's a basic truth - we have little to no control over the future, and the investment markets tend to be far less predictable than other areas of our lives. Remember that the next time it rains on you but you don't have a jacket or umbrella because the guy on TV said it would be sunny and nice ... or the next time you look at your investment account statement and note the balance is lower than it was three months ago.

Wealth Building For the Rest of Us

There is a great deal of energy focused on the importance of getting good investment returns. That's too bad because your investment returns (especially short term) are not something that are generally within your control. Yes, we can, should and do pay attention to expenses and tax consequences. Proper diversification and a good asset allocation do get rid of some of the volatility in your portfolio performance (more on this in a moment).

"You can control your Cash Flow ... and you can control your Investment Choices.  You can't control the Market."

There is nothing you can do to immunize your portfolio completely from movements in the market that are completely out of your control, but there are important elements of your financial future that you CAN control.

TWO THINGS IN YOUR CONTROL

1 - What IS in your control is Cash Flow.

You can do things to spend less money. There are other things you can do that greatly improve the chances of bringing in more income. This is how wealth is really built. The New York Times ran an article earlier this week that showed that an individual who was saving and investing 10% of their income each year (in a well balanced portfolio) actually built wealth over the last 10 years - a lot of it. This compares well to the stock market which has lost money (especially after factoring in inflation) over that same period.

If you want to build wealth and improve the financial future for your family, start with something over which you DO have control - Cash Flow.

2 - You ALSO have control over your Investment Decisions

On the investment side of the coin it is best to set up a strategy that keeps you from making dumb mistakes. The hardest part about investing is not predicting what the market is going to do. Again, we have no control over that. We DO have control over the natural urge to sell when the market has cratered, or to buy when the market is euphoric and running sky high.

The Dalbar studies have reviewed the data for decades and have proved that the average investor "enjoys" performance that is about 7% below the market returns. The explanation of this is simple. Most investors are buying when they should be selling and unloading securties when they should by buying up more. In that story from the New York Times, one reason these people were able to build so much wealth is that they were consistently following a simple strategy - buy a little each month. It's called "Dollar Cost Averaging" and it works in all kinds of markets.

STORY - A YOUNG PERSON'S BUSINESS - PROFIT BASICS

When I was in high school and college, I loved stereo equipment. I was known for having the biggest, baddest (in a good way) sounding stereo of anybody in the school. Each summer I would go shopping for new equipment. I would haggle and bargain until I felt I couldn't get a lower price. I would then use that stereo all year and eventually sell it to someone else (used) for as high a price as I could find someone willing to pay me - usually more than what I paid for it.

Buy low ... sell high (plus I got free use of the equipment, too). That's called making a profit. That's how a business stays in business. That's how an investor builds wealth. When you go shopping, you should do your best to pay as little for whatever you want as you can. You try to buy things when they are on "sale."

Investments and the Cycle of Emotion

But the average portfolio investor doesn't do that. Most people buy on momentum - the stock has been going up for months or years. It has a great track record. Everybody tells you that if you don't buy it, you're losing money. Eventually you give in and buy it ... Invariably, that's when the price starts dropping.

After the prices have dropped for a (long) while (like all of 2008), the average investor gets disgusted or fearful and sells in a panic. That is usually at or very near the bottom. We saw this in March 2009 as net outflows from equity mutual funds were massive. The market bottom was on March 9. Net outflows from mutual funds continued through May as people cashed out of their investments ... at precisely the worst time.

The average investor buys HIGH and sells LOW - When the item is on "sale" they are selling it. They wait to buy something else until it's back up to regular price (or even selling at a premium). It isn't rational, but it is what human beings do all the time. Ask my wife and she'll tell you that this behavior makes for a terrible shopper.

What's Going on Now?

One of the most important jobs that we do at my firm (that you never see) is research, reading and analysis. This is an age of communication. Our lives are awash in a constant flood of information. It's tough enough to make sense of all the data but to make matters worse, the main stream media is woefully lacking on sticking to a balanced view of the facts.

"There is lot's of data to process ... but the real challenge is sifting through all that data to get to the truth."

On an average day, our research includes reviewing the headlines from all the major news sources AND search blog posts and articles from a wide range of economists and financial analysts.  We digest reports, papers and speeches from the brightest minds in academia and devour books and articles from a wide range of researchers and authors.

We do all this because it matters to you and how we treat your investments - although frankly, the changes to our portfolio management process are far smaller than this sizable amount of information we process might suggest. As such, there are times of low turbulence where asset allocations don't change a lot from quarter to quarter. While it is not completely a "set it and forget it" process during these quiet times, it is comparitively easy in relation to the amount of work that is required during more recent, turbulent periods.

The next few years have a high probability of being marquee years - ones that will go down in history as notable for stunning returns, both positive and negative. If the economy were a Six Flags theme park, we just stepped on "The Scream" in 2008 and are only part way through the ride. And while we can't predict whether we'll be going up or down in the near term, we can be sure you are securely strapped in and that we have taken every precaution possible to make the ride as painless as possible.

GDP AND EMPLOYMENT

Here is a perfect example of how much (mis)information is floating around out there. Recently, we've heard some good news that fewer jobs are being lost right now than a year ago or even six months ago. We aren't adding jobs, but we aren't losing as many as before.

The Titanic is still sinking ... just at a slower pace. Great!

What is rarely reported is that the break-even benchmark here is not zero, but adding 150,000 jobs. Every month that 150,000 jobs are not ADDED, we go deeper into the hole because 150,000 Americans are moving into the work force every month. And how big is this hole? We've lost about 8 million jobs since the start of the recession. That's lot. If you do the math, in order to get unemployment back to reasonable levels (less than U3 8% unemployment) would require at least 300,000 new jobs each month for FIVE YEARS (according to Paul Krugman - and I think his estimates are way short of the mark).

Meanwhile, the Bureau of Labor Statistics optimistically estimates that the economy will create 15.3 million new jobs in the next ten years. That works out to about 125,000 per month -- not even enough to keep up with the new entries into the job market.

The US Government knows this and they will pull out all the stops (can you say "another trillion in stimulus, please") to get the employment rate to start moving in the other direction. They know if they don't get workers back to work by the mid-term elections in November 2010 (just 10 months away), they won't keep their cushy jobs in Washington DC.

Better to kick that can down the road a ways and worry about paying for it later.

Meanwhile, after trillions in stimulus and bailout money have been spent, the best we can do with GDP is grow at an anemic 2.2% rate. This does not bode well for the a vibrant recovery either.

We fully expect the government to throw everything they have at stimulus and job creation. This could add trillions of dollars to our national debt which will have long-term implications, but in the short run it will just mean more programs and more efforts to prop up any big business that looks like it might be in trouble, especially those with large union labor employment.

We're in the vote-buying portion of the program right now.

THE CONSUMER - DIGGING OUT

Consumer attitudes towards credit have shifted. Banks aren't lending - this is true ... but consumers also are not borrowing. The U.S. Government is more than making up for it with their own largesse, though. On Christmas Eve, the limits on the Fannie and Freddie bailouts were completely lifted. That means that no matter how bad things get and how many more loans default (or re-default since more than half of this year's loan modifications are already deliquent again), taxpayer dollars will be thrown into the cesspool to keep things afloat.

It is entirely likely that private sector credit will be nearly shut down - there is no room to compete with GSE's that will loan to anybody or forgive any debt, no matter how ridiculous the situation. For now, this means that investments in government GSE bonds will be propped up. This could be the next big bubble.

While we predict a serious problem in the bond markets in the future, we have no idea when that problem will surface.   We don't think it will happen for a while, but interest rates could rise sharply when it does.  At that time, bond prices will tumble. Before it happens, bond yeilds (especially on GSE debt) will be fabulous. As such, we continue to be exposed to a wide range of fixed income and bond products, although we are setting stop loss orders at peak minus 4-5% to protect the downside. Since average bond yeilds are above 5%, this means a worse case scenario of break-even for a one-year investment.

SMALL BUSINESS

I think the area of greatest concern to me (and the one NOT reported in the media at all) is the plight of the small business. For this, I will turn to Dave Rosenberg who says:

"If you are big bank, don't ever worry - Uncle Sam will bail you out. It you are small - the FDIC will shut you down. If you are a big company - don't worry, yield-hungry investors will buy your bonds. If you are a small business reliant on bank credit - forget about it." And I'll add my own, "If you are a Government Sponsored Entity or Uncle Sam himself - don't worry, Helicopter Ben, Tiny Tim and the U.S. Taxpayer will prop you up."

The ISM Small Business Optimism index is at it's lowest point since 1980 - lower than any point in the 1982, 1991 or 2001 recessions. When I survey small business owners I hear they are hanging on, but not looking for much improvement. If we can't get small business going (more than 60% of our economy), we won't be digging out of this recession any time soon.

What does this mean for equities? Who knows. Since March 9, equity prices have soared more than 60%. Price / earnings ratios are back in the stratasphere (anywhere from 27 to 147 depending on who's earnings figures you are using). No matter how you look at it, equity prices are frothy and expensive. But how are we to know they aren't going up even more? We don't know.

From a portfolio construction standpoint, we have trimmed equity allocations (both US and foreign) to levels that are half their normal level (gauged for risk tolerance). While we don't believe there is much headroom in equity prices, the core strategy always involves modest exposure to this asset class, so we won't trim these allocations further.

To protect the downside, however, we have placed stop-loss orders on all equity positions at a point 5-9% below recent peaks. This will limit the downside in the short term and allow us to reassess the situation should the orders trigger.

GLOBAL ECONOMICS

The U.S. Government is hell bent on propping up anything that even looks like it could be "too big to fail." Meanwhile, our cousins in Europe are showing signs of fatigue in this area. Account deficits between Eastern and Western countries are at worse than 2008 levels. Japan is a mess. The European Union continues to be under mounting stress and the U.S. printing presses are just spreading our problems around the globe.

While we think the Emerging Markets are poised to continue to enjoy growth, there are so many variables and so much volatility, it is hard to commit resources to this asset class for fear of being whipsawed. While we don't buy into the Global Depression theory that is running around (at least not yet), there is a good possibility that enough poor decisions could be made in the ensuing months to turn the theory into reality.

INFLATION AND PRECIOUS METALS

This is the last part of this analysis. We do not see inflation in the near future. There may be modest price rises (<2% per year), but the velocity of money will remain slow. No matter how much the U.S. Government throws at the problems there will be (a) limited traction for their efforts and (b) limited short term pressure on prices.

In fact we suspect there is a better chance for deflation in the next 9-12 months than inflation.

This is the short term outlook. Somewhere along the line, though, all this money being printed and injected into the system globally will create massive inflationary pressures. When you look for parallels in history, you find that every time countries or regions get to the level of deficits that we are seeing in many countries (including and especially the U.S.), massive inflation eventually sets in. Our government has every incentive to inflate the currency. We are debtor nation and would prefer to pay off those debts with cheaper dollars in the future.

This is a cardinal rule of inflation: Inflation punishes savers and rewards debtors. Deflation punishes debtors and rewards savers.

Eventually, we will be in an inflationary period, not unlike what we went through in the 1970's. It will be prolonged and painful and could mean the end of the dollar as the reserve currency. Then again, we won't be the only country with inflation problems so while we will be in bad shape, we may end up being the best horse in the glue factory.

With this in mind ... carrying debt through the next few years will likely prove to be very rewarding. If inflation averages 4% for a period of 10 years (and that is a very tame inflation level), it turns a 4% interest rate on debt load to zero in real dollars. Remember, inflation rewards debtors because you can pay off your debts in the future with much cheaper dollars.

Summary

Caution is in order. Due diligence and a constant monitoring of the situation is required. From an investment standpoint we are:

  • Maintaining an asset allocation that is shifted towards fixed income and away from equities
  • Placing stop-loss hedges on both equity and fixed income positions to minimize the downside
  • Monitoring all asset classes on a day-by-day basis - looking for clues regarding inflection points and short term direction
  • Financial Planning factors include keeping debt at reasonable but higher levels and restructuring debt into long-term, low interest fixed rate vehicles (30-year fixed mortgages)
  • Keeping balance between qualified retirement accounts, regular investment accounts and Roth-type accounts
  • Helping you improve your cash flow, save more and build wealth for your family's future

Yours truly,

John

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Last Updated on Friday, 29 January 2010 00:22