Newsletter Edition - April 2011

Is Slower Growth Ahead?

 The events of the last month should remind us how fortunate we really are. It is hard to comprehend the human suffering and physical damage in Japan. Nor can we really understand the uprising in the Middle East. However, we can feel the fragility of safety -- physical, political and economic.  
 
As investors, we see the disaster in Japan disrupting production, both internal to Japan and across borders. Consumption is also declining in Japan, the world’s third largest economy.   Turmoil in the Middle East is causing higher oil prices, leaving less money for consumers to spend on other goods and services.
 
The U.S. stock market has shown resilience in shrugging off these events, moving upward again during the 1st Quarter. Retail investors are finally moving cash into mutual funds after sitting on the sidelines for two years. The Federal Reserve continues with its intention to help the economy through June by buying Treasury bonds. These two factors, combined with stronger corporate balance sheets, generally explain why stock prices continue to climb.
 
We were recently listening to a lecture with David Booth, after whom the University of Chicago business school is now named, and one the founders of Dimensional Fund Advisors (DFA). In his talk, he noted that since World War II, periods of low stock returns are usually followed by periods of high returns. From 1945 to 1964, we experienced the “go-go years,” when the S&P 500 returned 591% (see graph below – all returns adjusted for inflation). From 1965 to 1981, the S&P 500 lost 6% for the period.   From 1982 to 1999, the “anyone can do it” years, the market returned 1000%! From 2000 to 2010, the market returned an ugly -20%. The decade from 2000-2009 was the worst in history. 

 
 
At the end of his talk, Booth offered the possibility that today feels like 1981, and a new period of strong returns is possible. David Booth is an investing icon. Reading the opinions of investment icons today is like playing red/black at roulette. Half of the iconic minds are black and half are red. Usually the different super-smart minds just give us slightly different odds of good returns. Not today.   It’s either red or black. They either think things are fine, or like Bill Gross at Pimco, they think that we should really prepare for lower returns.
 
So, with all due respect to the icons, we’ll offer our opinion that stock returns will not be “go-go” or “anyone can do it” in the coming years.  It is also unlikely that the bond market repeats its returns from the last three years.   Here are just three of many reasons to expect market returns to slow down:
 
Slower Growth Reason No. 1 -- We have too much debt in the U.S. and other developed countries. When excessive debt is the cause of a recession, recoveries are slower and weaker. As we talked about in previous letters, the cost of the interest payments is like a tax on our economic growth. We have yet to successfully have the economy stand on its own since the crash. To keep the economy going, the U.S. Government issues bonds at very low rates, and then the Federal Reserve buys them back. If that sounds like moving money from one pocket to another or printing money, it is. 
 
Slower Growth Reason No. 2 -- A weak job market. While official unemployment numbers have dropped below 9%, the number can be misleading. People who have stopped looking for work are not counted, and others are permanently under-employed at lower paying jobs.   Also, job creation in this economic recovery is lagging compared to other recoveries. At optimistic levels, it will take years to return to full employment at 5%.
 
Slower Growth Reason No. 3 -- The housing market. As of September 2010, 25% of homeowners with mortgages owed more on their mortgages than their homes were worth. Foreclosures and inventories are likely to remain high in many cities, and it will take a while for home prices to fully recover.   Home prices matter because they strongly influence people’s sense of wealth, which in turn impacts what they spend. 
 
Although the government stimulus may drive the stock market higher in the short term, we believe these challenges will result in a slow growth economy.   (And this forecast does not account for any real global crises like an oil supply disruption, a credit or real estate bubble in China, further defaults of European countries, etc.) 
 
Don’t get us wrong, we absolutely believe that our portfolios can deliver reasonable returns. However, we are not as committed to the stock market rally as others. Given the risks we face, it makes sense to cast a wide net around opportunities to earn a good return. We don’t want to be constrained to a volatile stock market as our only tool to obtain returns. Similarly, we don’t want to be constrained to a low yielding bond market or cash as our only tool to manage risk. We have added some new innovative funds in the energy, hedged strategies, and fixed income areas, and we will continue to innovate to attempt to meet our client’s goals with low volatility.  
 
 

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