I Think It’s Going to Be Alright

The headwinds to the global economy are well-documented and financial markets are steeped in uncertainty.  Obviously, nobody knows what’s going to happen. Some people are apocalyptic, some are sanguine, expecting a prolonged low-growth malaise. Very few are optimistic about the future.

I think it will be better than most people predict it’s going to be partly because the feedback loop is so negative. A few years ago, economists were predicting 3% GDP growth and 3% inflation and 6% unemployment into perpetuity.  We mistakenly believed that we were in a “goldilocks” business cycle brought about by artful management of monetary policy. Everyone, including myself, bought into those assumptions because it was conventional wisdom, it resembled what we had experienced historically, and it was compelling. The deficiencies of those assumptions are glaringly obvious today but it made a ton of sense at the time.  It’s human nature to forecast our current situation (whether it is good or bad) into perpetuity. We think it will always be the same and in reality, it is always changing. We’ve always been in a cycle and we always will be. We don’t understand where we are in the cycle until we’re looking at it over our shoulder.  A decade ago we were too optimistic.  Now I think we’re too pessimistic.

Middle-class consumption drives the global economy.  The picture isn’t great for the developed countries. In the United States, we’re still recovering from the real estate crash but we’ve done a lot to heal our personal balance sheets (now it’s Congress’ turn).    Europe is going to be working through its currency woes for years.  In my opinion, the Euro as it is today will not exist in a decade.  It might be a four country currency zone.

I’m extremely optimistic about the rising middle class in the emerging market economies: Asia, India, Latin America and Africa.  I’d like to give the world a Coke… and some Kentucky Fried Chicken, and an iPhone and a Wal-Mart in every town.  Someday it will happen and our clients will benefit from it.

D – FENCE!!!

One of the problems with communicating is that words mean different things to different people. Some people say they are being defensive by selling all stocks and holding cash, or moving all they have into gold, or moving all they have into treasuries.  It’s a wholesale, all or nothing, big bet on what the economy is going to do and what they expect the markets to do.  It’s a short-term knee jerk reaction to the long-term expectations they have for this moment.  But moment by moment, long-term expectations change.  We get a glimmer of hope and some asset class surges.  A poor report and people flee to these “safe havens”.

The media is responsible for this phenomenon, retarding investors’ ability to keep a long-term perspective and muddying the waters with conflicting information.  For example, if you were to watch an hour of financial television, the standard format is to have two brilliant investment professionals with diametrically opposed worldviews arguing over the latest financial data that came across the newswires.  This dialogue is confusing and unactionable to the average viewer.  Furthermore, every piece of information relayed to the viewer is BREAKING NEWS!!!  But the reality is it’s just noise.   

The media promotes a short-term, speculative, trading-mentality.  The only people who make money this way are hedge funds and institutional traders.  Individual investors have no chance for long-term success emulating their behavior.  Timing the market is foolish.  For younger investors saving each month in their 401ks this volatility is awesome.   But Retirees have to be more defensive and that does not mean buying gold and burying cash in Folgers cans in the back yard.
 
When I hear “defensive”, the first thing I think about is asset allocation.  It must be designed to accomplish your short, intermediate and long-term goals.   Short-term goals are going to be met with the capital allocated to cash.  Intermediate-term goals will be met with the capital allocated to bonds.  Long-term goals will be funded by the capital allocated to stocks.  Occasional rebalancing is the key to managing risk and keeping the proper amount of capital allocated to these asset classes to accomplish all of these goals with differing time horizons.  At any given moment one asset classes will be tanking, one will be surging to record highs and the rest will be treading water or somewhere in the middle.   So the best defense is a prudent asset allocation that accomplishes your near-term and long-term goals.

Heck Yeah, I Know Him!

I have a great friend named Woody who was laid off from his job after 25 years with the same company.  He landed an interview and asked if I would be a character reference for him.  I assured him that I would love to. Shortly thereafter I got a call from a lady in California who was the character reference checker for a large national company.  She asked me, “Mr. Black, do you know Woody?”

“Heck yeah, I know him!”

She proceeded to ask me a bunch of questions about my friend that I answered honestly and forthrightly.  Woody is a great guy and would be an awesome asset for any company.  I would hire him if I could. 

At the end of the conversation she told me, “This is all wonderful information.  He sounds like a great guy.  Is there anything that he isn’t good at?” 

“Well, actually, yes.”

This caught her off guard.

“Last summer when Woody wasn’t working he agreed to help our friend Curly build a play house for his five-year old daughter.  Woody is pretty handy, you see.  Well anyway, he was framing up the walls for this playhouse and he was holding the wall up with his left hand while shooting it with a nail gun in his right hand.  The trigger to his nail gun is very sensitive, so while he was performing this ingenious operation, he accidentally pulled the trigger and shot a nail through his left index and middle fingers.  Can you believe that?  He nailed his fingers together!”

I could hear the interviewer take in a deep breath.

“Curly screamed like a little girl, which is ironic because he is a firefighter and he sees accidents all the time.  Curly wanted to go the emergency room and get it looked at.  Woody, calm as can be, grabbed the nail with his right hand, yanked it out of the fingers on his left hand, wrapped it up in duct tape, and continued working on the playhouse.  Fortunately, the nail penetrated the meat of his two fingers but none of the bones.”

The interviewer was speechless.

“So Woody is a hard-working, thoughtful guy.  He’d give you the shirt off his back.  He is a fantastic manager of people, but his nail gun skills suck.  So if I were you, I would hire him, but I wouldn’t let him operate a nail gun.”

Woody landed the job and is doing quite well.  I didn’t tell him about the interview until he had been with the company for almost six months.  I suppose the moral of the story is to be careful when you ask a character to give you a reference…

Is Your Investment Strategy a Recipe for Disaster?

Prudent portfolio construction begins with a strategic  asset allocation.  The asset allocation is comprised of different asset classes such as stocks (large, small and international), and  bonds (short-term, intermediate,and  long-term  maturities of varying investment grades).   We identify how much risk we are willing to bear by targeting  a certain percentage of stocks and bonds and than purchasing the best components in each asset class.  So the asset allocation is the recipe for the portfolio and the components are the ingredients.  Most investors ignore the recipe of their portfolio and  focus on the ingredients by chasing returns.  They buy the top five performing funds in their 401k plans (which are commonly in the same asset class)  or the latest outperforming star that they read about on the internet. 

Top performers last year are rarely the top performers this year.  This phenomenon is known as ”reversion to the mean”.  One year stocks will outperform, another year bonds will.  When investors are scrambling all over each other to buy or sell the asset class it is usually too late.  The good or negative event has already happened.  Each year the  asset class that investors love , or revile, is different. 

Imagine what a pot of gumbo would taste like if you grabbed the most popular  ingredients du jour and threw them in the pot.  No measurements relative to the other ingredients, just a handful of this and a handful of that because they are the current hot performers (i.e. tech stocks, real estate, gold).  Over time the concoction in the pot wouldn’t resemble what it could have been had it been constructed with a recipe, which provide structure and discipline for the ingredients.  Over time, the end result might not be palatable, merely a pot of mush.

Set reasonable goals, then design a strategic, long-term asset allocation based upon your time horizon to fund your future retirement liabilities and your risk tolerance.  Once you have determined the recipe for success, populate it with the best ingredients: low-cost indices and good mutual funds. 

Occasionally, you need to adjust the recipe.  Your appetite for risk changes over time and opportunities do as well.  Maybe the gumbo needs a little more heat, maybe it needs to be toned down.  I’m in the midst of that process right now.  I’m tasting the gumbo and I’ve already identified some new ingredients that will improve the flavor and the long-term outcome for our clients.

Growth, Inflation or Default? Oh My!

Sovereign debt is traditionally considered one of the least risky forms of debt  because governments can raise taxes (annoyingly referred to as “revenues”) through the political process.  Because of this unique benefit their borrowing costs are lower than non-sovereign (corporate) bonds.  But not all sovereigns are the same.  S&P  rates 19 out of 127 nations as AAA, which is its highest credit rating.  The United States is the only AAA rated country with a negative outlook.

The negative outlook doesn’t mean that we have lost our AAA rating yet.  In the ponderous credit analysis process, giving a negative outlook is announcing to the world that a downgrade is possible.  The wording of the S&P release was looking ahead two years to 2013 as a possible timeframe for the downgrade to occur (if it were to occur).  A lot could happen between now and then to change the outlook.  The purpose of the statement was to put the bond market and Congress on notice.  The stock market reacted with a 1% drop which is not that significant.  The bond market didn’t react at all.  Gold and silver spiked.  In essence, financial markets already know.

Where do we go from here? There are three ways to get out of sovereign debt: grow the economy, create inflation, and default.  The most desirable way to get out of debt is through economic growth which creates rising tax revenues.  This requires policies that are friendly to small businesses whose entrepreneurship creates the bulk of new jobs in an expanding economy.  Another option the United States has, that most countries do not,  is to devalue our currency.  Inflation robs all bondholders of real value because we’re paying back debt in dollars that aren’t worth what we borrowed them in. For the 23% of Americans that owe more on their houses than they are worth, this might be a small consolation. The United States is in the catbird seat because the dollar is the world’s reserve currency and we can “quantitatively ease” as much as we want, up until the point that foreign investors (especially China) stop buying U.S. Treasuries, which can happen rather abruptly.  The third way to handle debt is to default on it.  For most debt burdened countries that are not in control of their own currency, such as Greece, this is their only option.

We have known for thirty years that the federal budget is structurally flawed.  Tough choices will have to be made and it will impact the lives of all American citizens and many foreign interests as well.  More than ever, it is important that we vote intelligently and plan prudently.  It is a very good time to take a good look at our goals and to position our portfolios to maximize the likelihood of attaining them.  We’re in a different world today than we were five years ago.  Five years from now, things will be different again. I am hopeful that it will be for the better, but I am planning for less favorable outcomes as well.

Thoughts on Inflation

The Federal Reserve insists that we are in a low inflationary environment but rising energy and food costs appear to contradict that assertion.  Are the problems with rising commodity prices structural, temporary or irrelevant?  

Volatility in oil prices is structural.  The sustained economic vitality of the global economy hinges on the price of oil. The Middle East and North Africa loom large on the horizon for global financial markets. 35% of the world’s oil comes from this region (Russia is now the world’s largest supplier of crude oil at 51%).  The surge in oil prices is not due to disruption in supply. Prices are driven by future expectations and political unrest fuels higher prices.  Oil inventories swelled during the economic downturn.  These are starting to shrink with the recovery of the developed country economies and the amazing growth spurt that Asia is experiencing.  Saudi Arabia has the capacity to make up for any lost productivity in Northern Africa that occurs as Libya works through its political complications. All eyes are on the Saudis to see how they weather the political fallout sweeping the region.  Democracy is not a common form of Arab government.  Out of of 22 Arab nations, 19 are autocracies (i.e. dictatorships). 

Food prices are higher today in real terms than at any time since 1984. The main reasons for higher food costs are weather related and appear to be temporary.  Russia, Argentina and China are in a drought.  Floods have plagued Canada and Pakistan. Supply shocks have led to export bans and rising tariffs to protect existing stocks and farmers.  Biofuels initiatives have also distorted food prices.  For example, ethanol accounts for 8% of America’s fuel for vehicles (due to Federal mandates and subsidies) but consumes almost 40% of America’s corn crop.  It irritates me that I’m paying more for a bag of Doritos because of Federal ethanol mandates.

The Economist’s commodity-price index has risen 39% over the last year.  This index includes food and industrial materials (non-food agriculturals and metals).  Manufacturer’s prices have risen and they want to pass these costs on to retailers and ultimately consumers. Retailers are crafty about raising prices.  A common strategy is to reduce the size of a product while keeping prices the same (more air and less chips in my bag of Doritos for the same price!?).  

Quantitative easing (i.e. printing money) obviously factors into rising commodity prices as well.  The Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England have all been printing money and lowering interest rates for the past two years.  Investors and speculators react to these monetary policies and a common strategy is to buy commodities.  I don’t know how to differentiate or quantify the appreciation of commodities between supply and demand factors and the impact of central banks printing money.

This isn’t the end of the world, it’s just a cycle.  When we see a spike in prices like we have in energy and food, it inspires producers to increase harvests or develop new oil fields to cash in on the boom (drill, baby, drill!).  Often this results in an increase in supply and downward pressure on prices.  

Monetary policy will also change in the next few years.  At some point central banks will raise interest rates in their attempt to navigate a “soft landing” for our economy. This could presage a sharp decline in commodity prices.  Who knows, maybe in the next year or so we’ll be reading headlines about destitute farmers, oil producers and small investors that lost their shirts when the commodity bubble burst… and investors are funneling money back into real estate and condos in Florida!

Growing in Charity

I have much to be grateful for.  But so often I focus on the things that aren’t as I would have them to be rather than appreciating the countless things that are wonderful.  That is pride, which is human nature at its worst.  The way to overcome pride is to cultivate the virtues of humility and gratitude.  The way we cultivate humility and gratitude is by making sacrifices.

“Sacrifice” is a loaded word.  Often when I hear it I want to run the other way.  But we’re happiest when we are giving of ourselves and this is the essence of sacrifice.  All parents sitting around a Christmas tree sharing with their families understand this.

St. Therese of Lisieux was a Carmelite nun who is world-renowned for her charity. In her autobiography, A Story of a Soul, she shared how she grew in charity and gratitude.  She had what she called “sacrifice beads”.  Every day she wanted to make ten sacrifices for others and she used the beads to keep count.  Instead of making a negative comment or judgment about a person, she would say something nice about that person.  Then she would pray, “Lord, I make this sacrifice as an act of love for you.”

This is a habit I am cultivating.  I hope it works for you, too.

Merry Christmas and God bless you!

An American Holiday

“I would maintain that thanks are the highest form of thought; and that gratitude is happiness doubled by wonder.”  ~G.K. Chesterton

Thanksgiving is a distinctly American holiday.  It’s such a big deal I had always assumed that it was a global event, but it’s not. I made a new friend visiting from Finland this week named Jouni.  He will celebrate Thanksgiving for the first time this year with a large group of friends in Atlanta. He was telling me how excited he was to try traditional American food, watch American football, and perhaps witness a family argument.  His perception of Thanksgiving was shaped by movies and television shows.  It will be interesting to see if the reality measures up to his expectations.

I wish you all a Happy Thanksgiving and hope the “traditional” family arguments are skipped this year!

Rising Standard of Living in Emerging Markets

The global economy is growing but it doesn’t feel like it in the developed countries (the United States, Japan and the Eurozone).  Asia is booming.  India is growing at a healthy clip.  Africa and South America are exporting massive amounts of natural resources.  China has surpassed Japan to become the number two economy in the world, although they still lag the United States by far, which retains the number one position. 

There are 6.8 billion people in the world.  About 800 million of them live in the developed countries.  That leaves 6 billion people in emerging market countries who aspire to the American dream, which in essence, is a standard of living.  American exceptionalism is not elitism or nationalism.  It is the understanding that anyone can come here, work hard and provide a good life for their family.  Unfortunately it is not possible for every emerging market country to emulate the United States in our standard of living due to political instability (or corruption) and the lack of rule of law in their native countries.  As emerging market countries adopt policies that encourage the rise of a middle class, they are prospering.  When the Chinese started acting like capitalists their economy exploded.  Obviously they have a long way to go towards rule of law and an open society, but a little bit of freedom for 1.3 billion people goes a long way, and has had a profound impact on the global economy.

I believe the U.S. economy is healing but it has a long way to go.  High unemployment and the depressed real estate market will not go away without significant changes in public policy from Washington.  Hopefully the recent elections will bring us closer to the fruition of those policies.  It will not be pleasant for families that are depending on government entitlement programs or for the taxpayers that must sacrifice to pay for them.  It will take a lot of time to strike a balance between these two constituencies if our experience is anything like what we’ve seen in Greece and France.  It will require character and leadership from Washington which has not been evident thus far.

What the Heck is Quantitative Easing???

“Quantitative easing” is when the Federal Reserve purchases bonds (normally treasuries but since the credit crisis mortgage-backed securities as well) which pours liquidity into our financial system.  It it is the way the Federal Reserve prints money.  It sounds more innocuous to call it “quantitative easing” than “printing money”.  Most people grasp what happens to the value of their dollars if the Fed prints more of them.  Wall Street can make money in a rising or falling dollar environment.  They’re not particularly excited about the value of the dollar declining but they know how to profit from it.

The value of the dollar (and all currencies) are in constant flux.  A strong dollar means we can buy more stuff relative to other currencies.  It’s great for the American consumer but not so great for the American manufacturer.  A weak dollar makes American goods more affordable for foreigners to purchase.  This provides a tailwind to American manufacturing and stunts consumer spending on foreign goods.  A weaker dollar policy would, in theory, increase American manufacturing and demand among Americans for goods that are made in America.

The problem with devaluing our currency is that other countries will react in kind.  Commonly by devaluing their own currency or enacting regulations, tariffs and taxes to make American goods more expensive to foreign consumers.  It’s a vicious cycle and it has a profound impact on the structural level of unemployment in the United  States and the standard of living of billions of people around the world. 

In a falling dollar environment, investors buy “stuff” to preserve their purchasing power.  Gold is a common hedge, but I believe it’s too speculative and it’s very difficult to determine its intrinsic value.  It could be in bubble territory  based on the volume of commercials on television that exhort Grandma and Grandpa to buy it.   Stocks do relatively well because companies have balance sheets with plants, equipment and most importantly, innovative people with good ideas to bring to market.  They have revenues and earnings which can rise in an inflationary environment (so long as it’s not “excessive”).  Real estate is also a great asset to hedge against inflation.  It is also one of the most reviled asset classes at the moment, which makes it particularly appealing.  Investing in bonds is very tricky right now.  Hapless bond investors will be the biggest losers over the next three to five years, and the sad thing is they think they are being “safe”.