3rd Quarter 2009
My 401(k) was hammered during the recent credit crisis down to a 201(k), and has recently rallied all the way back to a 301(k). This feels good for the moment, but where are we going from here?
I have been searching for solutions. I have visited with dozens of clients, I have read numerous technical journals, and I have listened to a seemingly unlimited number of podcasts and seminars by professionals that I respect. Most everyone is feeling a bit better, but the diversity of opinions is astonishing.
One current view expressed by individuals is that they are certain that the floor is going to fall out from under them again. This is an understandable thought as we have experienced a 100 year flood twice this last decade. Most of the individuals expressing this viewpoint are basing their thoughts on feelings rather than facts, but that doesn’t mean they are wrong. In fact, I believe the next 50 or even 100 year flood will occur again several times during my lifetime. Volatility is a new way of life that we are unfamiliar with in the U.S., but is not all that uncommon in Latin America and Asian economies.
My outlook is being heavily influenced by two individuals: Schwab’s Chief Investment Strategist, Liz Ann Sonders and Pacific Investment Management Company’s (PIMCO) Co-CEO Mohamed El-Erian. I had the recent pleasure of hearing both of these individuals at Schwab’s National Conference. I have also fully devoured Mr. El-Erian’s book “When Markets Collide”.
Ms. Sonders is cautiously optimistic and describes our economy as a coiled spring. Here is her analysis:
Negative Factors:
1. Debt levels for consumers and the government are stratospheric.
2. The consumer is under continuous pressure.
3. Resident real estate has bottomed, but commercial real estate is still weak.
4. Budget deficits are horrendous.
5. Inflation will be a big risk, but for the moment the economy is still recovering.
6. Our government is taking anti-growth initiatives.
7. Unemployment rates are extremely elevated. (As a counter thought unemployment never improves until after a recession is over).
8. The U.S. dollar is weak.
Optimistic Factors:
1. The number one encouraging factor is that inventories are extremely low as companies have cut back production in light of low demand. Eventually the shelves have to be filled again, even with a weak consumer.
2. Both consumer and business demand is pent-up and building.
3. Global stimulus is very large, and largely unspent. Only 1/3 of the U.S. stimulus package has been spent.
4. Residential housing has likely bottomed.
5. Foreign economies have recovered sharply, spurring global production.
6. U.S. exports are up sharply, assisted by the weak dollar.
7. Credit markets have recovered.
8. The yield curve (which compares short rates to longer term rates) indicates a positive and steep slope. This is typically an indicator of healthy times ahead.
9. Consensus remains skeptical. This may seem illogical but is actually bullish as investors and consumers are still holding back and have not put many of their resources to work.
10. Cash levels are at historical highs. In addition to the cash levels, a lot of money has been placed in bond funds for safety. These resources could rotate to the stock market when confidence returns.
11. Employment declines are moderating.
12. Household net worth is rising again.
13. Inflation is currently extremely tame.
Mr. El-Erian has coined the term the “New Normal” to express his conclusion that the recent crisis has permanently and structurally changed the world. Things will not return to the normal that we have become accustomed to in the past few decades.
The New Normal Story is:
- The U.S. economy will grow at a much slower pace of 0 to 2 percent as opposed to 3 to 5 percent.
- The U.S. consumer is no longer able to utilize their home as an ATM to finance all their desires and drive the worldwide economy. Growth will come from government spending.
- The Asian Economies will grow at a much quicker pace as foreign consumers desire to westernize their way of life. China, for example, is anticipated to grow at 6 to 8 percent as millions of citizens are moving from a rural environment to urban environment.
- Greater volatility in the future.
- The U.S. dollar is not the single world currency, but one of several. This is a critical point. As the world’s currency reserve, when we needed extra money we could simply print a little bit more or issue some IOU’s. When the rest of the world got scared they would invest their money in Treasury Bills. They sent us their cold hard cash and we sent them IOU’s. If the rest of the world stops using the U.S. as their safety net, if they stop buying our debt when we run budget deficits, we will be forced to turn on the printing presses at an alarming rate which will produce high inflation. The worst case situation is to experience high inflation while your economy is stagnant. Can you imagine high unemployment and double digit inflation at the same time? This is not the most likely scenario but it is a possible one.
- The public sector (i.e. the government) will drive the economy rather than consumers.
As negative as Mr. El-Erian sounds he does believe we can be competitive, prosper, and invest profitably in this new environment. It’s just that the old rules have changed.
I find it interesting that many of the previously outlined factors fit fairly closely with the evolving thoughts I have had over the past year. In past letters I have mentioned rebuilding the investment approach. This newer approach would not be radical and wild, but rather, be designed to recognize our apparent changing realities. I have been rearranging my model portfolios to incorporate the “New Normal” environment. I will title these new models as “Inflation Hedged Models”. The major thrusts in the new models include:
- Reduced exposure to U.S. stocks and bonds. These asset classes are still predominate but will only represent up to ½ of the portfolio as opposed to 80 percent in my traditional models.
- Increased exposure to international markets, with a renewed emphasis to the emerging markets of China, India and Brazil, along with other Asian economies.
- Increased exposure to Real Assets. These real assets will provide greater diversification and an inflation hedge.
- Real Estate including Global Real Estate.
- Commodities (Gold, Silver, Oil, Natural Gas and Agriculture) all held in a widely diversified portfolio.
- Inflation Index US Bonds.
- Infrastructure Assets (Old fashion utilities, new forms of energy producing and transmission, durable materials, etc.)
I now have my traditional models and recommended funds using classical allocation between stocks, bonds, and international assets, and I have the newly formed inflation
hedged portfolios for low, medium and higher risk. When I back tested the new inflation models with real investment over the past terrible ten years, they actually result in a simulated return in excess of 8 percent on average with fewer losses in the poor years. These models were not designed to do well in the past environment, but rather are positioned to reflect what we anticipate tomorrow.
I will be introducing these concepts as we meet throughout the next year. I don’t feel it is urgent that everyone convert from the traditional concepts to the inflation hedged concepts immediately, as I feel inflation will be tame for the near term. But I do want to begin to introduce the concept so you become familiar with how I think we can protect ourselves for the new realities of tomorrow.
I’m currently adding a new feature to my web site. Starting soon I will be writing a weekly blog (of only a paragraph or two) to further express my current views on the market. Be on the lookout for this, and if you know of anyone who would be interested in this information, have them enter their email address at the web site www.dickinsoninvestments.com
Sincerely,
Ron Dickinson, CPA, CFP®, MPA-tax