Are Happy Days Here Again?

The stock market is a leading indicator.  It gives the collective opinion of future economic growth on a global scale.  Now that it’s revisiting past highs, it’s presumably predicting a sound global economy with solid growth prospects, or is it?

The best reason for the stock market to rise is in anticipation of growing GDP:  For example, Apple is selling more gizmos and its revenues and profits are growing, or Exxon is producing more fuel for emerging market countries that have an expanding middle class.  Two factors that influence GDP growth are fiscal policy (Congress) and monetary policy (the Federal Reserve and global central banks). Washington is dysfunctional and it will be forever.  That doesn’t mean that we’re doomed to the economic doldrums from now on.  Dysfunction is a relative term.  If Congress were slightly less dysfunctional, it could get out of its own way, which would benefit the economy.  For example, small businesses are the primary driver of job creation in the United States.  Both companies noted above began in a garage with two people that had good ideas and hired people (creating jobs) to implement them.  Now they’re the biggest companies by market capitalization in the world, employing hundreds of thousands of people. Small business owners and the jobs they create are the main casualties of rising tax rates, which presently appears to be the primary goal of Congress in the name of “income equality”.

The Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England are all printing money.  That money is sitting on their balance sheets.  It’s not being lent out.  If it were being circulated through the economy via lending we would see inflation.  When banks are eager to lend we will see a lot of inflation.

Investors make decisions to allocate their life savings based on what they expect Congress and the Central Banks are going to do.  They have a bad taste in their mouth from the credit crisis in 2008.  Many are not aware of how much risk they are really taking in their portfolio.  Some are chasing stock market returns hoping to recoup what they lost in the Great Recession while others are piled into bonds thinking that they are being safe.

Cash has a negative real return due to inflation but it has to be a part of a portfolio to meet short-term goals and needs.  When interest rates go up cash will benefit but it will still be a drag on performance.

Bond prices go down when interest rates go up.  With interest rates at 0% it is safe to predict which direction they will eventually go. We are in the foothills of a rising interest rate environment.  Interest rates aren’t going up until the economy is really growing and banks are lending money.  Inflation also negatively impacts bond returns.  Nonetheless, they are a key component of managing risk.  We’re using solid bond managers with a global perspective.  In the immortal words of Johnny Cash, our bonds “are everywhere, man”.

Stocks are going to do better than bonds and cash, especially if the trend of an expanding middle class in emerging market countries continues.  The stock market has done well the past few years but investors don’t really see it that way, especially if they sold stocks in 2008 and 2009.   If Congress exhibits a lower level of dysfunction going forward stocks would do very well in the next decade.

Real estate is one of the more reviled asset classes the past few years but I think it’s headed in the right direction.  It should do relatively well in the coming decade especially if inflation kicks up.  Mortgagees will benefit from higher inflation as well.  Consumer confidence has taken a huge hit with the bursting of the real estate bubble. I don’t think there are many “deals” left in real estate other than getting lucky and picking up a short sale, which is still a tedious process.

The stock market is at five year highs.  The GDP growth rate for the United States in 2013 is questionable.  In the fourth quarter we contracted unexpectedly by a fraction.  I’m not optimistic about the growth of the economy in the first or second quarter of 2013 based on Congress’ ability to lead and get out of its own way (and ours).  I think the main reason the stock market is doing so well right now is that there is nowhere else to allocate capital.  Stocks are more fundamentally sound than cash and bonds, and they are liquid, unlike real estate.  But stocks are also more volatile than cash or bonds and we could see a big sell-off when we get unfavorable news.  Investors are quicker to pull the trigger on stocks than they used to be and that short-term mentality is detrimental to their long-term goals.

The key to protecting our life savings is fostering a long-term perspective and proper asset allocation.  We need a certain percentage of cash, bonds and stocks to reach our long-term goals.  That percentage varies from family to family.  Investing is not the same as trading or speculating.  No one knows the future, especially me.  We design our clients’ asset allocation to manage their risk and maximize the likelihood of success measured in decades, not days.  Populating that allocation with the best components is critical.  The equity index funds and actively managed bond funds we employ are among the best building blocks of wealth available. Happy days might be here again, or they might not, but our clients are positioned to weather either eventuality to the best extent possible.  That is the basis for private wealth management with charity, prudence and fortitude.

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Filed under + Economics, Politics and Financial Planning

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