Given the events of the past 8 weeks, we felt it prudent to communicate with you regarding our outlook on the economy and financial markets. We do not intend to drive you toward putting all of your money in gold and cash, nor toward putting all of your money in stocks. It is simply to communicate our thoughts on the near term outlook, the long term outlook, and what we are currently advising our clients to do as we meet with them. This is the longest communication you have received from us to date; you have been warned!
Backdrop
We are witnessing and experiencing the consequences of more than two decades of over spending as consumers incurred record amounts of debt. The significant debt on personal balance sheets has been enabled by financial institutions providing incentives to its managers that have emphasized short-term profits in an environment of declining interest rates and rising asset (especially home) prices. The meltdown in the global financial markets triggered the rapid economic reduction that cost many prudent investors’ significant investment losses and many employees their jobs. Well known financial institutions no longer exist – whether from bankruptcy or mergers. Housing prices across the nation have fallen and continue to fall – something many believed would never happen.
The 24/7 reporting as these events rapidly unfold provokes a sense of anxiety and in some, anger. We may ask, “Will things return to ‘the way they were’?” “Are sound financial principles still valid?” In short, “What’s changed, what hasn’t?”
Worldwide capital markets, the large financial institutions, and the regulation of these companies will continue to change. The massive cash infusions by governments worldwide mean that the U.S. government and European governments have large claims on the major companies; more restructuring is inevitable. To try to avoid similar crises in the future, either the company’s will be limited to a size where they are no longer “too big to fail” or a regulatory regime will emerge to reduce risk to the taxpayers and returns to the shareholders. What else has changed? Individuals recognize that a high credit score means little when an individual or family’s net worth is minimal or consists mostly of home equity. Thriftiness is back in vogue. Over the foreseeable future, spending will fall until we are safely within our means and carrying less debt – both individually and at the government level. Middle and upper income earners who have recently experienced the lowest marginal income tax brackets and the lowest capital gains tax rates in decades are certain to face tax increases at the federal and state level.
What hasn’t changed? The technological changes driving globalization will not be undone. The U.S. economy will remain intertwined with economies worldwide. Increasing dependence on individual savings for retirement will continue. Individuals who acted prudently will better weather the crisis than those who did not, though some of the money the government will spend will benefit irresponsible borrowers. The increase in life expectancy over the last two decades means that many will have to work longer to save more and reduce the number of years they will rely on savings, increasingly rare pensions and social security. The pace of change is unlikely to slow.
Near Term Outlook
To be perfectly blunt, 2009 is going to be a very rough year. It is anticipated that the rate of corporate bankruptcy will accelerate, and with that a spike in unemployment that could reach double digits. The unbelievable levels of spending at the governmental level will also have an impact. The jury is still out as to whether the outcome will be positive or negative, but will likely be some of both. Nevertheless, the most recent stimulus bill is unlikely to be the last one, and the level of spending will invariably lead to inflation. With all of this, when will we reach a bottom? Most analysts believe that, from an economic standpoint, we are feeling the worst now in terms of rate of decline. The optimists are looking for a quick bounce back in the second half of 2009 while the pessimists see a recession lasting several years. We expect the truth, as usual, to be somewhere in the middle with the economy declining at slower rates throughout this year and turning positive early in 2010. From a financial markets perspective stock valuations seem to have factored in much of the carnage. However, from a psychological standpoint, the answer is unclear. Markets tend to overshoot both to the upside and downside. We could continue to see ‘headline volatility,’ a hypersensitive market that responds positively and negatively depending on the day to what is reported by the press, and this may continue longer that we would wish. Also, most individuals are wired to extrapolate current conditions endlessly into the future, which simply intensifies unwise behavior.
We wish the picture were both clearer and more positive, but it is not. We do believe that all crises create opportunity, and we don’t believe this is an exception.
Long Term Outlook
We have spent a substantial amount of time researching market and economic history during troubled times to get a sense of what might come. Our best guess (and yes, while we consider ourselves relatively well-informed, it remains a guess) is that the economy will remain weak and manage to turn positive (in terms of GDP and employment) in the first half of 2010. We do expect the subsequent recovery to be drawn out with sluggish growth. We believe the most significant headwind to future economic growth is the retrenchment of consumers as we (and many economists) expect personal savings rates to revert from recent levels that have been negative back to 6%-8% on average. This process could easily take one or two decades. We view this as very positive in the long-term but will be felt negatively in terms of broad measures of economic growth, especially during the early stages of the transition.
Our study of long-term stock market valuations leaves us more positive than our near and intermediate-term economic viewpoint may suggest. We are seeing the most favorable long-term valuations, and thus likely future equity returns in over a decade. We generally agree with the analysis performed by Dr. John Hussman that from current levels, averaged annual stock market returns in the 8%-12% range are likely over the coming decade or two. This absolutely DOES NOT mean the stock market cannot fall another 30% or more from here. While we do not assign a high probability to this outcome, it is by no means out of the realm of possibility and would be in line with valuations at other major bear market lows in history. In the same analysis, he states that if we were to reach such levels, index investors in the likes of the S&P 500 could expect future averaged returns from that point of about 15% or more COMPOUNDED over the coming decade or two.
We do have very significant concerns about the long-term impacts of near-term decisions being made by our political leaders. However, we view negative policy decisions as leading to a slower economic (and stock market) recovery, not the absence of a recovery. The challenge is to align your portfolio in a manner that does not subject that portion of your portfolios that cannot wait for the recovery to equities.
We have never believed in our ability to time the market. If we could, we’d be managing what would certainly already be millions of dollars of our own money instead of doing our best to provide clients sound financial planning advice regardless of the direction of financial markets. We have attempted to provide you some guidance on our thinking and viewpoint on the economy to let you in on our thinking, but we encourage you not to view this as a prediction but as one possible set of outcomes. As Charles T, Munger, Vice-Chairman of Berkshire Hathaway, once said, “People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts.” Regardless of what the future holds, the actions we believe you should consider (or be reminded of) are detailed below.
What Are We Recommending NOW
Facing and evaluating our individual situations then focusing on what we can control and taking action is still vital. The fundamentals of personal financial management have not changed. Building and maintaining an emergency fund, avoiding consumer debt, buying an affordable home that does not presume and require rapidly increasing income to maintain, paying off the mortgage before retirement, and consistent tax-efficient long-term saving strategies remain critical. Setting goals and saving targets based on reasonable long term rate of return assumptions also makes a financial plan less sensitive to portfolio declines. These steps are still foundational, and we are fortunate that the majority of our clients have exhibited these behaviors for years.
In the area of investing, some things have changed, others have not. One area that has changed is our allocation recommendations. Those who have worked with us for years have seen us consistently increase into alternative types of investments. We started with REIT’s in the early part of this century, expanding into commodities, currency, long-short strategies, and the like. We believe that in a shrinking world, traditional stock investments alone will no longer provide the diversification you need to moderate risk. Therefore, we have continued to research a number of strategies that are now available on a no-load, retail investor platform. Many have been rejected, but several have been added to broaden this segment and are now at work in client’s portfolios, with the most recent additions coming at the beginning of 2009.
In addition, we have increased our exposure to specific bond opportunities across all investment profiles. This is a result of opportunity, not defensiveness. Several types of fixed income products, from municipal to corporate bonds, have experienced dramatic deviations from historical norms, creating opportunities. Treasuries, on the other hand, have dropped to levels we believe are not likely to be sustained and could create problems if/when inflation occurs. CD rates have also dropped to levels that risk loss of purchasing power.
There are also some mutual funds that have been closed to new investors for some time that have finally reopened. This is a sign that they believe there are buying opportunities to take advantage of. We are selectively making changes accordingly.
What hasn’t changed? Our belief that a portfolio constructed based on client goals, risk tolerance, and time horizon in a diversified fashion will serve a client well over the long run. How the capital markets will be restructured or when the economy will begin to improve cannot be predicted with certainty. Historically, the equity market is a leading indicator and values rise anticipating economic recovery. Those with long time horizons and the tolerance for risk to persevere are likely to be rewarded. Investors have to balance the risks of falling asset prices in the near term and the potential of longer term inflation and dollar devaluation over the longer term.
In conclusion, we do not believe that ‘not doing anything’ or not acknowledging the market losses by keeping your statement envelopes closed is the answer. We believe that a consistent, proactive, disciplined, long term approach balanced with near term liquidity and conservativeness can help our clients towards their goals. We appreciate the trust you have placed in us to provide sound financial planning and investment advice.