Kreitler Associates LLC
Administrative Support Services
Sea Change
195 Church Street, 11th Floor, New Haven, CT 06510 Phone (203) 867-4396 Fax (203) 867-4398
January 2009
Financial and economic changes have occurred dizzyingly fast over the last eighteen months. Not only is the rate of change unsettling, but not understanding what is causing the change is creating great angst. The purpose of this paper is to address these in two ways: First, to put in perspective what is happening and to project where we are going. Second is to provide the foundations for financial strategies for the new world. This is important for all investors but it is particularly critical for those close to retirement or already in retirement as they have the least flexibility to recover from any mistakes.
Part I: How did we get here?
We have talked for several years about what we call “Super Trends”. This dealt with the expansion of free markets around the world as the Iron Curtain fell and the rise in productivity from computerization. These forces caused explosive growth around the world, not only raising the living standards of Americans, but more importantly, lifting hundreds of millions out of poverty. “Super Trends” has been our term for the financial implications of the forces Thomas Friedman described in his book, “The World is Flat”.
What has changed to plunge the world into the most severe recession since the 1930s? We believe the economy shifted from one driven by credit expansion to an economy where credit is shrinking and the credit shortfall is dragging the economy down. Simply put, the economy is de-leveraging. To grow an economy needs increasing credit. When credit is reduced, not only does this stop economic expansion, but the credit shortfall throws the economy into a gut wrenching retrenchment, which we are now in.
How did we get there? US consumers spent, spent, spent. They reduced their savings, maxed out their credit cards and borrowed against their houses. China gladly provided consumer products to America, saved a lot and then loaned the US the funds to finance the consumer purchases. The Federal Reserve accommodated all this by keeping interest rates low and money available. As the housing bubble (driven by easy credit and pro housing government policies) burst, consumers reduced their spending and increased their savings as they strove to rebuild their damaged balance sheets. I suspect the process of rebuilding balance sheets will go on for quite a few years; after all, it took many years to get where we are. The collapse of the housing bubble exposed huge problems in the banking system and on Wall Street creating the credit crisis where financial institutions did not trust each other and refused to do business with each other. One brand name financial institution after another failed, rocking the foundations of our capitalistic system. This has put the world economy in a spin.
Two things must happen to correct the downward spiral. First, the financial markets, primarily the credit markets, must regain order and function somewhat normally. Individuals and institutions doing business must trust each other so they can deal with each other. Without trust business can not function. Second, the economy must fall until it finds a new equilibrium, one that is not driven by excess credit. The US and world economies are very complex with many interdependent moving components and it may take a while for this to happen. Because of the speed of the fall we are going through the economy could overshoot on the downside before regaining its footing.
There are two implications from the above. First, it is critical that order be restored to the credit markets. It took a while but the government is now pulling out all the stops to normalize the credit markets. The Federal Reserve and the US Treasury are both taking unprecedented steps to restore the flow of money and we are seeing significant improvement. Second, even without broader government intervention in the economy the downward spiral in the economy will end and the economy will reach a new equilibrium. Hopefully with the speed the economy is changing it won’t take too long before the descent ends.
The view that the economy will right itself on its own without government fiscal stimulus is held by few. The prevalent view is that it is the government’s responsibility to solve the mess we are in through fiscal stimulus and government intervention is needed to stop the drop. We think much of the reason determining the future direction of the financial markets is so challenging is the uncertainty over what the government will do and then more importantly what impact it will have on the economy. In our view, the government will have to adopt some very inept policies to negate the normal forces that help the economy stabilize at a new equilibrium which presumable will be far above depression levels. We are optimistic this won’t happen as our economic system is very resilient. Regardless, government fiscal stimulus is assured. The Obama Administration is asking Congress to quickly pass a large stimulus bill. If consumers won’t spend, the government will, with the hope of accelerating the recovery.
There is a growing feeling that free markets of the past and the financial regulations that supported them are responsible for the problems we face. This is driving the move to increase the government role in the private sector. Examples are the partial federalization of the banks and the bailout of the US auto industry. The change started under Republican George Bush and is accelerating under Obama’s Democratic Administration, which will tighten regulations in many areas. The goal is to achieve a tamer, gentler and more equitable world. According to our logic, such a world cannot be as profitable, GNP growth rate will be less, stock prices will have less upside potential, and in aggregate people’s standard of living will improve more slowly. Others will say this is a fair trade off for a tamer, gentler, and more equitable world.
The proposed government solutions are different from what was done in the 1930s and Japan in the 1990s when it tried to do to pull itself out of its deep and long recession. We are in unchartered waters. There is the possibility (hopefully small) that government actions will fail and lead to something worse- a depression or hyper inflation. Somewhat troubling, the problem we are in was caused by borrowing and excess spending. Yet, the solution is to use massive government borrowing (or printing money) and government spending to replace lost consumer spending.
Part II: How can Investors survive and profit in this new world?
The economies around the world have changed. We have moved from a high-growth economy to, at best, a recession to be followed by resumed but slower growth. We have moved from an inflationary environment to a deflationary one. We are moving toward a more regulated economy with more government involvement. Stock and bond investments have collapsed and are pricing in a major recession. Only government securities have done well and the gap between returns on government securities and other investment vehicles are at record spreads because investors have run to safety.
Investors face multiple different economic scenarios, all of which are reasonably possible. The challenge is that their portfolios must be able to handle any of these. Picking one scenario and betting the entire portfolio on it could be dangerous to one’s financial health.
For ease of discussion we describe here a base case scenario which we think has a reasonable chance of occurring. Under this scenario there will be a relatively steep recession, the government provides a very large fiscal stimulus, the economy recovers, but the recovery is subdued as people spend less, save more and rebuild their balance sheets. The government also increases its involvement in business and our personal lives. The base case scenario also assumes that as the economy improves the government successfully reduces its stimulus efforts, inflation is not a problem, and the dollar remains sound.
Under this scenario stocks and bonds do not significantly drop below their lows of October and November of last year, go through a relatively lengthy bottoming process, and for a number of years move within a range bound by the 2008 lows and the highs of the previous bull market. The base case assumes it will be a number of years before the US economy and the financial markets go on to new highs.
Values of many asset classes including stocks and many bonds have been driven to very depressed levels giving many markets the potential for a near term rally. The government efforts to push down interest rates should help the bond market because when interest rates go down bond prices go up. However, after the economy bottoms and begins to recover, consumer efforts to deleverage and the heavier government involvement in the economy will likely hold economic growth to lower levels than we have been accustomed. Low economic growth is likely to restrain long term gains by stocks. This could continue for quite a long time. We are witnessing huge changes. Investment strategies must adjust to reflect them. Stocks could lose their appeal as the primary vehicle for growth, and bonds could become more attractive. Global diversification continues to be important. Emerging markets, if they continue to provide the economic growth engine for the world, could have additional attraction, but will likely to continue to be very volatile. Portfolio design needs to take into account that scenarios other than the base case are possible. If things turn out better, stocks could break into new highs, providing excellent returns, making investors wish they had higher exposures to them. The base case could also turn out to be too optimistic and the possibility of this should be factored into portfolios. Government actions could backfire leading to the loss in value of the US dollar, hyper inflation or in the extreme case, a mini depression. Under these scenarios asset values would continue to drop and investors’ emphasis will be on protecting what they have accumulated.
Diversification remains the backbone of our investment strategies, but we are making a subtle change in the role it plays in portfolio management. In the past, we sought out investments that have low correlations with each other; in other words, investments that move differently than each other. In our modified approach we are using asset classes to specifically address the possibility that a certain economic event might occur that is different than forecast. For example, loss of faith in our governments is not likely, but if it happens and leads to hyper¬inflation or a devalued dollar, it would be devastating to portfolios. Addition of gold mining companies, gold bullion, and foreign currency exposure are ways to, hopefully, partially hedge against this risk. Gold, gold companies and holding securities in foreign currencies each by themselves are considered risky, but used in this way may help a portfolio during volatile markets.
Below is a chart that shows which asset classes are likely to do well under a particular scenario. Investors must decide how much of each of these assets should be included in a portfolio to protect against the possibility that the scenario may occur and, in doing so, create a diversified portfolio. As we design portfolios around the concepts we must consider individual’s investment objectives. Everybody’s objectives are unique but they can be grouped into three basic categories. The first is preservation of capital; the second is income; and the third is growth of principal. Most investors will have a mix of the three. Portfolios should be managed differently depending on an individual's objectives.
Preservation of capital strives to assure one’s capital is protected and available on a moment’s notice. Many investors have given this the highest priority in the last several months as they have seen values of most asset classes plunge. Investors have run to safety, meaning US government protected short term debt (Treasury bills, CD, money market accounts, etc), with the net impact of driving down their yields to close to zero. Historically, investors needing short term access to their money receive significantly lower returns than those with longer investment horizons, but the penalty in lost income investors must pay today for this safety and liquidity is currently high.
Income is another objective. Assurance that the portfolio has the same value from day to day is of secondary importance, as is growth. We typically think of retirees having this objective but others also may place a primary emphasis on income. Like everything in investing and finance, achieving this is more complicated than it seems. Dividends and interest could become the primary determinant on how much can safely be with-drawn from a portfolio. This is what our parents and grandparents depended on. Planning to consume a portion of expected growth may play a smaller role than it has in the past 30 years and we may need to question the old rule of thumb that a new retiree can safely take 4 to 5 percent from a portfolio each year. Additionally, immediate fixed annuities may become more important as a source of reliable income.
There are many tradeoffs an investor needs to consider. Interest rates change rapidly so timing on when an investor locks in a commitment is important. Security of getting one’s money back when you purchase a bond is also important. Are you confident the other party who has promised to pay will be capable of doing this in 10 to 20 years? Dealing with future inflation is also a factor. Most people should be interested in protecting their buying power, not just receiving a constant dollar return. Future inflation can erode purchasing power and destroy plans. Taxes are a major factor and most people should be looking at returns on an after tax basis and design their portfolios accordingly. The portfolio for someone wanting income must be designed to balance these many factors so as to deliver the needed outcome. Unfortunately, there are few guarantees for the investor.
Growth: How does somebody looking for growth position a portfolio? A growth investor typically can tolerate fluctuations in the daily valuation and income is only important if it increases the value of the portfolio. The investor seeking growth has virtually all investment strategies available. Protecting buying power of the portfolio against inflation or deflation remains important as is the sensitivity to the impact of taxes. Traditionally, the long term growth investor was thought of as somebody who would own a portfolio predominantly made of stocks because over long periods of time stocks have provided higher rates of returns than most other asset classes. However, there have been three 10 to 15 year periods since 1900 when this was not the case and today’s economic climate may place us in another such period. The broader stock market indices have not gained in 10 years and our base case projects this continuing. Therefore a growth investor is likely to have a smaller proportion in stocks and more in bonds and other assets than traditionally was common.
Conclusion, the world has changed over the last eighteen months and investing has become a lot more challenging. The economy has gone from expanding based on increasing credit to contracting with millions of people and companies de-leveraging. We face a large recession and deflation. Virtually all financial markets have gone through huge losses in the past year and by many standards assets are underpriced. The government is playing a large role in attempting to restore functioning of the credit markets. Once accomplished we believe the economy will reach a equilibrium on its own. However, the government will likely provide large fiscal stimulus to accelerate economic improvement. After we come out of the current recession, economic growth is likely to be less than we have been accustomed to. The growing role of the government in managing the economy adds additional unknowns and risks for investors. The chance of a mini depression or hyper-inflation can not be disregarded. Investment strategies must be changed not only to benefit from the new world we expect but also to help protect us from the risk that it will not turn out this way.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.
Any opinions are those of Robert Kreitler and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice.
Investments mentioned may not be suitable for all investors.
Past performance may not be indicative of future results.
You should discuss any tax or legal matters with the appropriate professional.
Diversification does not assure a profit or protect against loss in declining markets.
Any withdrawals from fixed annuities may be subject to income taxes and, prior to age 59 1/2, a 10% federal penalty tax may apply.
Please note that international investing involves special risks, including currency fluctuation, differing financial accounting standards, and possible political and economic volatility.
Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.
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Phone: 203-867-4396
Fax: 203-867-4398
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