Economic and Market Commentary

July 2010 

For those who just want a concise summary of our thoughts, we have begun this version of our quarterly commentary with the "Cliffs Notes" version of our economic thoughts, followed by a lengthier discussion of our investment posture:

• Our view of the big picture environment we face in the next few years remains unchanged.  The recovery continues but is not inspiring, and we see above average risk in spite of being early in a recovery cycle.
• The United States and other countries with excessive household sector debt are in the early stages of what is likely to be a long process of deleveraging.
• Most of these countries must also dramatically reduce public sector (government) debt growth and in some cases they will need to reduce the absolute amount of debt. This huge challenge has not yet begun.
• Three variables critical to improvement in private-sector consumption and a normal recovery—the labor markets, credit growth, and housing—remain weak.
• With the debt crisis in Greece occurring when Europe’s recovery was already weak, the continent faces a real risk of falling back into recession.
• Fortunately, key parts of the developing world (emerging markets) are in much better shape with stronger balance sheets, higher growth rates, younger populations, and slowly emerging consumer sectors. Their strength is an important source of support for the global recovery.
• Real time update:  Intel reported earnings and revenues last night that beat expectations, which indicates that the recovery isn't falling apart as some "permabears" prognasticate on TV.

For these reasons and a few others, we are sympathetic to the view that we may be experiencing a paradigm shift into a difficult period that does not include the robust economic recoveries we’ve come to enjoy after recessions.   It’s also an environment that requires a high degree of intellectual honesty to think through the ramifications, risks, and opportunities without being constrained by a frame of reference based on the typical cycles, return assumptions, and risk assessments that have characterized most of the post-WWII period.

Capturing Returns and Protecting Capital—Our Investment Posture 

Regardless of how good or bad the macro picture, investment opportunities are determined by whether they are priced attractively relative to their ability to generate future growth and/or income. For this reason an investment can still be attractive even if the macro outlook is dark, or unattractive even in an extremely positive macro environment. In fact, it is common for investment prices to be compelling in terrible macro environments due to investor pessimism and poor in wonderful macro environments due to excessive optimism. Unfortunately, today, as we face difficult macro issues, most asset classes don’t currently reflect excessive investor pessimism.

In assessing the potential returns, our scenario analysis approach has been invaluable, and, we believe, a superior approach to traditional valuation analysis. Traditional analysis does not take into account possibilities for future earnings and dividend growth, changes in interest rates, and a range of possible risk appetites that can impact investment pricing. Our scenario analysis allows us to be forward-looking so that we can factor in a number of possibilities that impact earnings growth, interest rates, and risk appetites—which can vary significantly over any five-year period (our decision horizon). One of the advantages of the scenario approach is that it allows us to consider a range of outcomes when we make investment decisions, rather than require us to correctly identify one specific forecast, which we believe no one can expect to do consistently.  

Stocks 

We often hear arguments about stocks looking very attractive relative to low interest rates. At first glance this seems true, and it might fuel stock market returns in the short run. But it is important to understand that interest rates are low because the economy is very weak. Valuations in future years (which will influence stock market returns over the next few years) will be impacted by the future level of interest rates. If interest rates remain very low three or five years from now it will mean that the economy continues to be weak, which would not bode well for corporate earnings growth and would be bad for stock returns. On the other hand, if the economy picks up, rates will surely be higher and with risk of higher inflation there is the potential for sharply higher rates. While moderately higher rates would not be dangerously harmful to valuations, sharply higher rates will make stocks less attractive versus other investments.  Our scenario analysis forces us to think about these relationships, their impact on price/earning ratios (P/E), and their ramifications for stock returns over our five-year investment horizon. 

Emerging-markets stocks, on average, offer somewhat better returns than developed-market stocks in all scenarios we’ve analyzed. But currently the return premium is not high enough to justify the higher volatility inherent in this asset class.

Bonds 

High quality investment-grade bonds such as U.S. Treasuries and the highest quality corporate issues offer minimal return potential over our five-year horizon. What they do offer is a defensive investment that could perform well if the economy is very weak or falls back into recession.  

For this reason, our fixed-income positions are not traditional. In total they are more aggressive and potentially more volatile than a typical investment-grade bond portfolio. However, compared to a traditional bond portfolio, we believe our fixed-income positions will capture materially higher returns and provide much better protection against unexpected inflation and in a rising rate environment. And even though we expect more volatility in market downturns, we don’t believe we are taking on much more risk in more extended time periods such as two years, unless it’s an extended period of deflation, which is a possibility though we believe the odds are still relatively low.  

Alternative Investments 

We have found two open ended mutual funds with non traditional investment techniques that we are interested in; however, we have not yet included them in client portfolios.   The potential attraction is that we believe the funds could offer mid to upper single digit returns over a 5 year period with relatively low correlation to stocks and bonds.  But if the markets turn more pessimistic in the short term, we would view equities as a more attractive option.  So we are being patient with making a final decision on these funds.    

Conclusion 

Though we recognize a positive investment scenario is possible, as is a temporary period of strong market performance that could be driven by improving economic news and impatience with the near zero return offered by money markets, we are clearly not placing a high probability on a sustained bullish environment for the next few years.

For some time now, our view of the opportunities and risks for investors hasn’t been very encouraging. The story is what it is. It is important to remember it’s not forever—there will be better risk adjusted opportunities at some point, probably sooner than later.

But if need be, we’re prepared to be patient, and believe that our patience and willingness to think outside of the box will be rewarded.  In the meantime we are working hard to ensure that when opportunities do present themselves, we are in a position to recognize and take advantage of them, while also being highly attuned to the potential risks in this uncertain environment.

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