January 21, 2010

Lessons Learned From the Past Decade

As 2009 ended, the media bombarded us with the best and worst of everything of the decade, down to the worst dressed celebrities. At Wagner Wealth Management, we invested in expanding our service capabilities through expanding our staff and improving our client relations technology. In addition, there were several important financial lessons that were learned from the past decade.

Lesson 1 – Too much debt can mask the truth. The first decade of the new century was an experiment in what happens when an economy relies heavily on borrowed money. People, governments, banks, and corporations borrowed extensively to finance growth and lifestyle. After the recession of 2001-2002, the economy bounced back nicely, but the debt continued to grow faster than the economy. For the entire decade, we were using debt to create bigger homes, unprecedented consumer spending, massive banking profits, and increased government spending. (the government spending was inspired in part by the 9/11 tragedy).

Increasing debt masked some very important facts, which have now been revealed. There has been zero net job creation since December 1999. Not since the 1940s has our country experienced a decade of job growth of less than 20 percent. Economic output rose at its slowest rate of any decade since the 1930s. Middle-income households earned less income in 2008, when adjusted for inflation, than they did in 1999 -- and that number is sure to have declined further during a difficult 2009. The net worth of American households -- the value of their houses, retirement funds, and other assets minus their debts -- has also declined when adjusted for inflation, compared with sharp gains in every previous decade since data was initially collected in the 1950s. In other words, the millionaire next door may not be a millionaire at all; they may just have a lot of debt.

Lesson 2 – Think globally –not everyone had a bad decade. The decade brought some good news to emerging markets. China, India, Brazil, Russia and Indonesia experienced unprecedented economic growth. The growth was accompanied by the spread of capitalism, maturity of legal systems, stability of currencies, a reduction in corruption, and willingness by the developed world to embrace these economies.
Most economists agree that the fundamental source of economic growth is new ideas, which enables everyone to generate more profits from a given set of resources. U.S. companies and investors can gain from the wealth and creativity of people in other countries, even if we can’t always feel like the top dog country.

Lessen 3 – The only true insurance against loss is high quality U.S. Treasury Bonds. In 2008, when Lehman Brothers went bankrupt, every single asset class other than U.S. Treasury bonds and cash declined heavily.   Despite the talk of the dollar losing status, people ran to the dollar and U.S. Treasury bonds in a crisis. During the decade, U.S. stocks returned a negative 10-24%, depending on which measure is used. In contrast, U.S. Treasuries returned a positive 85% (all returns cumulative, not annualized). It was a unique decade; we don’t expect these returns from bonds to continue.

Lesson 4 – Hedge funds can be bad, but they can also be good. The Madoff and other hedge fund collapses are cause for great concern.   However, there are true hedging strategies that take advantage of changing opportunities, reduce the risk of loss relative to stocks, and still earn reasonable returns over time. During the decade, as U.S. stocks returned a negative 10-24%, the Hedge Fund Research Institute Index earned a positive 58%.

Another data point from the decade is that hedge funds outperformed bonds when interest rates were rising.   In 2004 and 2005, when interest rates rose, government bonds earned 2-3% per year, while hedge funds earned 7-7.5% per year.   Interest rates are effectively at zero today and are likely to rise. If history repeats itself, hedge funds will outperform bonds in the coming years. To make hedging strategies more attractive, we can now access them through mutual funds instead of private hedge funds, offering the transparency needed to prevent another Madoff.

Lesson 5 – Asset allocation works, even if it didn’t in 2008. Why do we need foreign bonds, emerging market stocks, commodities, hedging strategies, and real estate in our portfolio? After all, none of that stuff helped us in 2008. Read this next sentence twice. For the decade, while U.S. stocks lost 10-24%, emerging market stocks, commodities, real estate stocks, and international bonds all earned well over 100%. These are all volatile asset classes so, in our portfolio allocation strategy, we keep the portfolio percentages reasonable. Nevertheless, the pronounced death of asset allocation in 2008 was a little premature.

The Lesson for Every Decade – Financial success depends more on planning than investing. Prudent investing is a required element of a successful financial plan. In all our experience, however, the most important predictor of a successful financial plan is the client’s ability to spend reasonably relative to their wealth, creating cushion in their financial plan.   At no time was this principle more relevant than in the last decade. With returns failing to meet expectations during the decade, families learned the value of additional savings or controlled spending to replace subpar investment returns.

Looking to the Future. It is very difficult to predict how the economy will behave in the future without government stimulus dollars. We believe the economic recovery will be slow and choppy, and we have positioned our portfolios to protect against a number of potential risks. We will have exposure to U.S. stocks to protect against underestimating economic growth and the risk that the investing herd inflates stock prices. We will own hedging strategies in an attempt to both scratch out return in a potentially stagnant environment and to outperform bonds and cash. We don’t expect significant further appreciation of bond values, but we own bonds as insurance against another recession and market decline.   We own commodities and TIPS to protect against the risk of inflation. We own international stocks and bonds to protect against the risk that U.S. economic growth trails other countries and the risk that the dollar declines.   Finally, we will remain diligent to re-balance portfolios to protect against the risk that any asset class appreciates beyond reasonable levels.

We wish you a healthy and prosperous 2010.
The Wagner Wealth Team