January 2014: Observations

 

                            “You don’t need a weatherman to know which way the wind blows"                                                                                                          – Bob Dylan, Subterranean Homesick Blues

 

Nearly everyone we talk with has a similar impression of our economy: Things aren’t quite right. While the impression is consistent, the reasoning varies: persistent high unemployment, stock prices outpacing profits, protracted easy-money policies with artificially low interest rates, reports of low inflation while the prices of everything you buy increases, government deficits and soaring national debt.  Still, the conclusion ends up the same: Something isn’t quite right.

Here’s our take on what’s not quite right, what’s behind it, its impact on investment markets, and our investment strategy to contend with it.

Recap of 2013

Over the past year, investment markets were driven by the Federal Reserve’s extreme policies of “Quantitative Easing” (explained more fully in our April 2013 and October 2013 Commentaries).  The Fed purchased $85 billion of bonds per month, thereby injecting a trillion dollars of near-zero-interest-rate cash into the financial system. The Fed’s objectives were:

  1.  Keep interest rates low by flooding the financial system with cash, hoping to stimulate increased borrowing and spending, and
  2.  Boost stock and bond prices higher, expecting that investors would spend their gains and reignite a lackluster economy. 

The Fed achieved their objectives of low interest rates and higher stock and bond prices, but failed to stimulate borrowing and spending. The Fed’s policies have produced marginal results.

Few creditworthy people or companies are interested in taking on more debt, and soaring stock and bond prices have provided very little “trickle down” of newly found financial wealth into greater spending and consumption.

After $3.5 trillion of Quantitative Easing over five years, the economy is still growing at the slowest pace of any economic recovery since WWII.

The Fed’s Impact on Investment Markets

In response to the Fed keeping interest rates at near-zero levels, investors and savers have been chasing better paying investments, hoping to make up for their diminished investment income.  In doing so, they have been “climbing the risk ladder,” shifting into riskier investments than they would normally seek.

The Fed has been injecting more and more money into the financial system every month. As hard as people tried, the growing supply of cash could not be “used up.” It was a big game of hot potato—with cash as the hot potato. Investors grew anxious to get rid of zero interest cash, swapping their cash for other investments. But the cash simply changed hands; people with cash and people with stocks and bonds simply exchanged places. In aggregate, cash cannot be “used up.”

With paltry interest rates dragging on year after year, and more and more cash being injected into the financial system, investors became increasingly desperate for better returns—reaching ever higher on the risk ladder and driving prices higher. Now, overpriced stocks and bonds and zero-interest cash are equally distasteful.

As an example of this distortion, “junk bond” prices have been bid up so high that their average yield at the year-end was just 6.0%, a rate comparable to an insured Certificate of Deposit prior to Quantitative Easing.  (Note: Standard & Poor’s defines “junk bonds” as having highly speculative characteristics “that could lead to the obligor's inadequate capacity to meet its financial commitment on the obligation.”)

In essence, the Fed has coerced investors to abandon prudence and caution, inducing them to take on more and more investment risk, risk they would normally shun.  In the process, stock and bond prices have been temporarily driven to unsustainable, artificially high levels.  The result is an investment landscape in which investors are transformed from cautious to bold, risk-aversion has been replaced by risk-seeking, and stock and bond prices have been pushed to ever-higher levels—that is, prospective future returns have been pushed to ever-lower levels. In summary, investment risks are elevated and the prospective rewards for bearing additional risk are inadequate. 

The Disconnect

Real wealth is the ability to produce goods and services. Financial wealth is the price tag of the means to produce those goods and services.  The relationship between these two variables is an indicator of whether the stock market is under-valued, fairly-valued, or over-valued.

This indicator can be measured and graphed.  The proxy for financial wealth is the total value of the stock market in the U.S.—that is, the price tag of owning the means of producing goods and services.  That’s called “Market Cap” (short for “Market Capitalization.”)  The proxy for the nation’s ability to produce goods and services is the sum total of all goods and services produced in the U.S annually. That’s called “Gross Domestic Product” (GDP).

Look at this relationship over the past 60 years.

From a historical perspective, the stock market is overvalued.  There’s a disconnect between economic fundamentals—the ability to produce goods and services—and the price of owning the means of production, i.e., the stock market. Getting back to the historical median level of “fair value” would require either: (a) GDP grows 92% with no increase in the stock market, or (b) a 48% stock market decline.

Today’s stock market is more overvalued than prior to the October 2007-March 2009 stock market decline, although not as overpriced as observed at the peak of the internet/technology bubble in the late 90’s. 

Of course, with the Fed pumping a trillion dollars a year into the financial system (recently reduced to $900 billion per year) there’s nothing that guarantees that an already artificially inflated, over-priced stock market can’t become even more inflated and over-priced.  Nonetheless, banking on an overpriced market rising even higher can only be described in one word: “speculation.”

Our Mission and Responsibilities

Our mission is two-fold: seeking profits for you while protecting your capital.  We act on your behalf as a fiduciary. Our responsibilities to you are to serve and protect you. In the face of unprecedented government monetary policies, our ongoing labors to manage the capital you have entrusted to us is both challenging and humbling.

We treat your money as carefully as we treat our own.  That’s why we invest our company pension plan in the same way we invest the portfolios of our moderate allocation clients. We make investment decisions for your (and our) portfolios based on the application of our knowledge of history, decades of experience, and our judgment.

Upon weighing and assessing the gross market distortions created by unsustainable Federal Reserve policies, there is only one prudent choice; there is no justification for joining what has become an arena of speculation.  

Current Investment Strategy

We believe ongoing prudence and caution are required in today’s environment of market distortions.  Knowing the cause of these distortions, and the inevitability of their eventual unwinding, we can only take the path of prudence. 

Our client portfolios have been positioned conservatively, embracing an aversion to risk and shunning speculation. We refer to this as “turning down the risk dial.” Our usual portfolio allocation to stocks has been scaled back, dedicating roughly 45% of the typical moderate allocation portfolio to stocks, instead of a normal 60% allocation.  The offset is greater allocations to cash and short-term maturity bonds.

The race is long, the challenges are many, and the ultimate outcome is yet to be known. We are reminded of Aesop’s fable, “The Tortoise and the Hare.”  We believe that slow and steady wins the race and that speculators will end up the way they always do… with losses and regrets.  On your behalf, we have chosen a steadier, more prudent path.  ***

Thank you for entrusting us with your investment capital, and thank you for your loyalty and friendship.   We wish you and your loved ones, a healthy, happy and prosperous New Year! 

Respectfully,

            Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2014