He that goes a-borrowing
goes a-sorrowing.
Benjamin Franklin

In the fall of 2010 we stated the following:
It is our contention that 2007 to some yet to be determined future date marks the third period since World War II of abnormal deviation from the country’s usual cycle of lengthy, steady prosperity marred by short-lived modest economic and profit contraction.

We went on to say that:
In our opinion the stock market will be primarily ruled by the macroeconomics of the next few years and an expansion in price/earnings ratios from current levels is not warranted under the emergency financial measures still being undertaken by many governments.

Since the fall of 2010 corporate profit growth of major public corporations has been very strong, but, as we anticipated, price/earnings ratios for the stock market have continued to decline in the face of the poor macroeconomic environment confronting the western world.

Everyone is very familiar now with the debt crisis in the United States and western Europe. It is imperative that it be solved in a rational, equitable and uniform fashion for failure to create a credible long term plan threatens the social fabric of the U.S. and presents the danger of a major weakening in American economic and military power. The explosion of debt to finance growth often presages the decline of a country’s stature.

Contrary to the beliefs of many investors, investment success over a long period of time does not come from individual investment selection. Instead about 85% of investment returns are a result of correct asset class allocations and only about 15% come from actual investment selection within a specific asset class. In other words, getting the big picture right is critical to investment success.

We have stated for the last two years that economic growth after the federal and monetary stimulus of 2009 and 2010 is completed will be disappointingly slow for the next five to ten years and may be marked by reoccurring recessions and financial crises. The cornerstone for our concerns is debt accompanied by the, to date, lack of political will to fashion a long term agenda to gradually separate the country from its current debt crisis.

Any agenda to rein in the debt explosion will cause hardship. It will cause slow economic growth for years to come. Quite possibly it will cause stagnation or decline in our standard of living for the general populace. It will involve sacrifice among the populace which has been raised on the myths of “plenty” and “more” while in the absence of sound financial practices. More than any time in memory the future of the country’s economic prosperity lies in the hands of its politicians, principally Congress and the White House. Confidence in skilled, equitable leadership is not high and we share this concern. As the three to four month debt ceiling debate revealed, the political ideological divisions are great but neither side is willing to take decisive action to resolve the debt crisis beyond self-serving rhetoric. The last minute debt ceiling increase was accompanied by modest spending cuts. However, even these limited cuts were delayed until 2014/2015. In other words, both political parties were happy to postpone for a few more years any real solutions to our debt crisis. In Wall Street’s parlance, Washington continued to kick the can further down the road in pursuit of a strategy of buying time. The government hopes there will be a strong recovery in economic conditions which will solve all of our problems without requiring structural change through legislation. We are strong believers in the efficacy of the free market place as a corrective mechanism, but government policies, especially deficit financing, have muted the effectiveness of the market place.

The issues which need to be addressed by Congress and the new super committee of twelve are well known and have been debated for years but now need constructive action. Briefly they are:

a. a steady reduction in the government’s annual deficit towards a balance fiscal budget
b. an overhaul of the federal income tax code
c. changes in government and military employees retirement and health care benefits
d. changes in Social Security and Medicare to make both systems solvent
e. reductions in state, municipal and local government employee pension and health care programs to make them solvent
f. changes in union labor laws to enhance U.S. competitiveness
g. a restructuring of the national real estate mortgage market.

These are the main issues as we see them. Provide immutable, concrete long-term solutions to these problems and we will become wildly bullish about the prospects for U.S. economic growth and the stock market. However, the magnitude of these problems is large. We believe they are solvable by leaders truly acting in the interests of all the people. This probably means no one gets everything they want and it also means everyone will have to make sacrifices. To illustrate the magnitude and difficulty of these problems, unfunded entitlement programs in the U.S. exceed $115 trillion as of today. These are future obligations of the government, which the government owes and has agreed to pay. This amount is at least 10 times the size of our annual Gross Domestic Product. These unfunded obligations of the government increase daily just like the deficit. Simply stated we were all promised more than any government can pay.

The combination of low economic growth and questions regarding political determination will put pressures on valuations in the capital markets. Although corporate profit growth among the nation’s 500 largest companies has been excellent in the past year, the stock market is basically unchanged despite significant volatility. The price/earnings ratio of the S&P 500 index has fallen from about 13x-14x in 2010 to about 11x to 12x now. Because a financial cure for the issues listed above will require belt tightening, we do not see real U.S. economic growth returning to a sustained level of 3 to 4 percent for many years. The country’s growth since 1990 has been steadily borrowed from the future. As once said by a very lucid 95 year old woman to her equally old husband, “the future is now.” Macroeconomics for the past year has won the battle versus seemingly low price/earnings ratios. If the stock market turns into a bear market, then price/earnings ratios on average will fall well below 10x before reaching a bottom and creating a time to buy.

We do not forecast an economic collapse, and we do not forecast market levels. We find it difficult enough to correctly allocate assets. For the past couple of years caution and conservation have been the primary pillars of our asset management. We believe high frequency trading right now is the most likely way to make money in the stock market, but we do not espouse taking the risks of this approach. Even with quantitative models and high speed computer trading risks are high. Instead we have maintained very low levels of investment in common stocks during various time periods since November 2007 and consistently below our average historical levels during the last four years. There are many good companies selling at attractive prices if Congress and the White House will initiate a long term cure to our debt and unfunded liability problems. However, until we see this occurring exposure to the general stock market is to be limited.

Although we believe economic theory is correct that increased government spending is a major tool for ending recessions and hastening economic recovery, this form of economic stimulus is no longer available to the country. It has been overused in good times and bad times and its corollary of withdrawing the temporary excess stimulus when conditions improve has always been ignored. Consequently, more federal stimulus at this juncture may produce adverse effects in the financial markets and the Federal Reserve has exhausted most of its primary stimulative tools. Government fiscal retrenchment has begun albeit slowly and it will accelerate during the next few years. This retrenchment along with corrective action in other areas of excess liability are major reasons for our expectation of slow U.S. economic growth for at least the next several years.

We also believe corporate profit margins will begin to slip in 2012 and beyond. With all the changes being advocated as necessary to bring government spending under control, the effect on corporate profits is unknown, but we do not believe it will be net positive. Major revisions to the federal income tax code will affect public companies. Again the impact is unknown, but a reduction in corporate tax breaks is to be expected. The “super committee” of twelve has been selected but it is going to be the recipient of super lobbying, especially by corporate America. The success or failure of their lobbying efforts from their narrow perspective will have an effect on their profit-margins. Typically, companies during a period of recession, such as in 2008 and 2009, reduce investment both in capital expenditure and in labor. As a result company expense structures become very lean and profits and profit margins improve. Going forward there is little room for further margin growth. Corporate profits will have to be driven by revenue growth which may be increasingly difficult in this post recession anemic recovery.

Psychology is a very important influence of stock prices. There is always mentioned the axiom that profits run the stock market. A true statement but overstated. Investor psychology dictates stock market valuation. If the investor is happy, the stock market is happy. If confidence wanes or deteriorates sharply, the stock market in time will follow the same trajectory. Often the relationship between market performance and sentiment becomes self-referencing, negative sentiment driving prices lower which reinforces negative sentiment. It is like a run on a bank. The repeated sharp decline in equity prices during the past 11 years has significantly undermined investor psychology. If you add to this questioning of confidence the daunting, long-term macroeconomic problems facing the developed nations in the world, a sustained improvement in confidence indicators heralding the advent of a new secular bull market will not be forthcoming soon. Suspicion, disapproval and fear are the paramount factors shaping investor psychology now. Worry, if not fear, is also a prevalent concern among the public regarding job creation, employment and wage growth. Huge quantities of debt at all levels, e.g. municipal, state, federal and household, were assumed under the auspices of future growth. Remove the prospect of growth, and fear becomes the major characteristic affecting decision-making, especially in the area of debt reduction. The specter of debt accompanied by psychology of fear in a no growth society will negatively impact asset valuations. If you do not believe suspicion, disapproval and fear have gained traction in our western society, look at the prices of silver, gold and short-term treasury yields.

America’s problems, in our opinion, are fixable. Clean, honest communication with its citizens is essential and political leadership needs to emerge. America’s bull market in stocks since March 2009 has lived on borrowed time and perhaps is a rally within the context of a secular bear market which began in 2000. We have no opinion on determining historical landmarks. They cloud an assessment of the present and future. The U.S. cannot grow its way out of its debt morass. Only spending cuts, revenue increases via taxes or a combination of both can achieve the return to financial strength necessary to push the country onto a new growth cycle. This cleansing process will take a decade in our judgment. During this time the stock market will be punctuated by brief rallies and declines which may offer opportunities for the quick, but in our judgment the environment for this decade will be one of high volatility and low returns on stock investments as measured by the major stock market indexes just like the first decade of this century. We have not changed our view since November 2007 that macroeconomics will continue to dictate the direction of the stock market, not Wall Street’s conventional valuation metrics, which we characterize in this environment as propagating the inevitable proposition that stocks are cheap. We will continue to structure portfolios with under representation in the stock market until the catalysts of debt reduction, employment increases, wage growth, entitlement program reductions, tax code simplification all coalesce into a mixture cementing the new foundation for future growth. Until then our asset allocation will minimize common stocks.

{ 0 comments }