The conclusion of any year is a time for reflection and looking back, but also for looking forward and planning to meet what lies ahead. 2009 was a tumultuous, schizophrenic year, when stock markets surged while unemployment climbed and formerly runaway consumer spending was replaced by virtually unfathomable government largesse. The start of 2010 also ended a decade marred by shocks (September 11th, WorldCom, Lehman Brothers), bubbles (dot.coms, housing), stagnation (jobs, wages), and global recession. Yet Americans remain resiliently optimistic. Following steep declines in 2008, consumer confidence has been climbing and recently reached a two-year high this past January.
Within BSW, the New Year brought a new name, an updated building, a few new faces, and the transition of Chief Investment Officer from Debi Baydush to David Wolf. In light of these changes, and to chart the route ahead, we at BSW reflected back on our collective experiences to reaffirm our core investment philosophy and guiding principles. As detailed below, these guiding principles inform our asset allocation decisions, investment choices, and broader economic outlook, while also continually focusing us on our most important objective: meeting the needs of our clients.
Guiding Principle #1: BSW’s clients have already done the hard part by creating and accumulating substantial assets. As such, within a portion of the portfolio, return of capital is often more important than return on capital.
In the investment world, bonds are generally considered the boring wallflower, an afterthought, really. But despite the headlines and hand-wringing over corporate bailouts, bank rescues, TARP, TALF, General Motors, Merrill Lynch, AIG, etc., the financial meltdown of 2008 was largely a story about bonds – or at least financial instruments that were ostensibly labeled “bonds.” And the story of these bonds is illustrative of BSW’s Guiding Principle #1, the importance of capital preservation.
Following the collapse of the dot.com bubble in 2000, the US Federal Reserve opted to hold interest rates artificially low for an extended period of time. This ignited a new bubble, in real estate, as mortgage rates are generally tied to 10-year US Treasury Bonds. Recognizing an opportunity, Wall Street stepped in to package all of these newly minted mortgages into pools, which could then be “securitized” as mortgage-backed securities. Add a pinch of insurance and, voila, the mortgage-backed security was now AAA-rated and could be sold off to unsuspecting investors, like Iceland. Not to miss out on the financing frenzy and lured by lucrative origination fees, banks began pushing more and more exotic mortgages that required no money down or no interest payments. From the bank’s perspective, who cared if borrowers were qualified? The mortgages were just going to be pooled, securitized, and sold off, right? And these were safe, right? They were rated AAA and historic mortgage default rates were incredibly low, right?
In fact, Wall Street was so effective at creating the illusion of safety, that they even deluded themselves. Firms such as Merrill Lynch and Bear Stearns held these securities both in their trading inventories and also as collateral for their own loans or investments. As it turned out, though, historic default rates from owner-occupied, 20% money down mortgagors had very little predictive capability when applied to their speculative, no-money-down cousins. As borrowers began defaulting, both the perceived safety and the actual value of these bonds quickly evaporated, creating a financial crisis that left many banks insolvent or bankrupt and the US economy in shambles.
What are the morals of this story, from BSW’s perspective?
First, if something seems too good to be true, it usually is. 2009 was awash with Ponzi schemes, frauds, and collapses. It was a rude reminder that investing is very challenging and involves significant risks. As such, BSW approaches all investments with vigilant skepticism and rigorously evaluates opportunities against a very high standard.
Second, capital preservation is of utmost importance. To this end, BSW recommends that all clients invest a meaningful portion of their assets in safe, high-quality bonds, such as those backed by the unlimited taxing authority of a state or a city, the revenues of essential municipal services like water or sewer systems, certificates of deposit insured by FDIC, etc. These bond allocations form the stable, secure foundation of our clients’ portfolios, helping them weather the inevitable turbulence caused by market gyrations and fickle public perceptions.
Finally, within our growth portfolios, BSW aims to capture most of the markets’ gains while protecting against significant losses. Institutional investor Charlie Ellis, author of the 1975 investment classic, “Winning the Loser’s Game,” summed up this strategy when he famously observed that investing, like amateur tennis, was a “loser’s game,” in which the victor often prevails because he makes fewer mistakes than does his rival. Continuing this analogy, BSW recognizes that our clients are already well ahead in the match and that continued success comes from the discipline of consistency and playing high-percentage shots, not going for the big ace or the “sure-fire” big winner.
Guiding Principle #2: BSW is a long-term investor. Our investment outlook is shaped by enduring themes which enable us, and our clients, to avoid both the destructive paralysis and hyperactivity caused by market noise.
Of the many enduring themes that guide BSW’s investment outlook, two have been featured prominently in recent news and deserve discussion: a) the emerging markets, and b) unemployment.
Investment Theme: The Emerging Markets:
In BSW’s estimation, global demographics, and the concomitant themes of urbanization and an expanding Asian middle-class, will be the most powerful and robust driver of economic growth in the years ahead. As the world steadily grows from six to more than nine billion people over the next 40 years, investment opportunities will abound. Population growth in the developing world, the rise in megacities, and Asian middle-class spending will create unprecedented opportunities in resources, infrastructure, consumer goods, and particularly the intersection of these areas within “green” industries, such as renewable-energy generation, energy efficiency technologies, mass transit, water treatment and waste management.
As the populations of the developed world (Europe, Japan, and the United States) continue to age, the vast majority of people in the developing world will be of working-age (15-64). Working-age people are both the global economy’s primary producers and its primary consumers, as they start families, buy houses, and strive to improve their standard of living. In China, for example, more than two-thirds of the population is under the age of 35. That’s roughly 750 million people – nearly two and a half times the total population of the US!
Recognizing the importance and magnitude of these trends, BSW looks for asset classes, industries, and sectors that will benefit from these historic demographic shifts. It’s an enduring investment theme that cuts through the daily babble of market pundits and talking heads on CNBC, and one that is already manifesting itself in real investment outcomes. Consider that from 2000 to 2010 the annualized performance of the emerging markets stock index was +16.2%, meaningfully outpacing more developed economies.
Investment Theme: Unemployment, Inflation & the New Abnormal
Unemployment is all over the news and for good reason. Jobs and, more specifically, job creation, is certainly the key to a lasting and sustainable economic recovery in the US. Unfortunately, the data is grim. According to recent estimates, roughly 15.5 million people are out of work, about 10% of the US workforce. More than 7 million jobs have vanished and 5.9 million workers have been without a job for more than six months, the highest on record. Obscuring the issue are the various ways that the Federal government determines the unemployment rate. Discouraged job-seekers who have temporarily given up and are “not actively seeking employment” are not included in the “official” unemployment rate of 9.7%. Another unemployment measure, which includes these discouraged job-seekers, as well as part-time workers who want full-time jobs, puts the unemployment rate at a sobering 17.3%, or roughly one in six workers. And the problem is not confined to the US, either. Official unemployment in the 16-nation Euro-zone also reached ~10% in late 2009, the highest level in 11 years.
Looking back, it’s been a decade to forget. Adjusted for inflation, wages grew a meager 13 percent over the past 10 years, the slowest pace in the past 50 years, with only 464,000 net new jobs created, compared to the nearly 22 million jobs created between 1989 and 1999. And living standards, the general metric of the American dream, have actually been falling. According to the 2008 US Census, inflation-adjusted median household income (which includes wages, salaries, investment income, and government benefits) dropped to $50,503, down 4 percent from a peak of $52,587 in 1999.
Chipping away at the unemployment burden will likely be a long, arduous process. The last time official unemployment reached double-digits (in 1982) it took six years to bring it down to normal levels of about five percent. Assuming the up-beat GDP growth forecasts of the White House Council of Economic Advisers are correct, unemployment is projected to remain at ~10% through 2010, falling to 9.2% in 2011, and 8.2% in 2012. This suggests it could take until 2015 for unemployment to return to historically normal levels – and in the meantime creating a “new abnormal” state of persistent unemployment. The longer joblessness persists, the more its grinding, erosive effects are felt in housing, consumer spending, credit markets – and the more pressure builds to extend jobless insurance.
What is BSW’s take on the situation? First, it is suggestive that we may be closer to adding jobs than might be expected. Looking back on 2009, corporate profits rebounded strongly from 2008, largely due to cost cutting, as companies shed workers and disgorged bloated inventories. As earnings improved, investors gained confidence and markets surged, with the S&P 500 up more than 26% for the year. These equity market gains have lent credence to the belief that the economy is recovering, improving business and consumer confidence. In essence, 2009’s impressive investment returns were largely driven by the expansion of unemployment rolls early in the year, along with massive stimulus spending by the Federal government.
Remember, though, that unemployment is a lagging indicator. Consequently, it will peak when the economic rebound is already well underway and secure. So as the media and the public gain more faith in the recovery, the ranks of discouraged job-seekers who had given up on looking for work will once again resume their active search and headline unemployment will spike. The media and partisan politicians will turn pessimistic and claim that the sky truly is falling, again. But in reality, the temporary spike in headline unemployment will likely signal that job growth is just ahead.
So, again, even as job creation begins, it will be a long, arduous process. But that will likely be good for stocks and very good for inflation. With so many workers unemployed, employers have little incentive to raise wages, even as job growth gains momentum. Likewise, more than 30 percent of US industrial capacity still remains idle – dampening the potential for inflation due to rising costs. Consequently, inflation will remain muted, at least in the short term, despite massive government intervention and monetary expansion. With inflation constrained, Washington will be able maintain its “easy money” policy, holding interest rates low throughout 2010. Low borrowing costs, improving economic conditions, wage constraints, and lean workforces should all create a positive environment for stocks, as the S&P 500 has regained less than half of its bear market losses — even after 2009’s sizable gains.
Guiding Principle #3: Asset allocation is the primary driver of portfolio performance, while diversification, both at the macro/portfolio level and the micro/investment level is critical to reducing risk.
The financial crisis of 2008-2009 conveyed myriad lessons, but perhaps none are as practical and actionable as the need for portfolio diversification and ongoing rebalancing. Global financial markets are increasingly erratic and investor sentiment is hopelessly mercurial. The best strategy, again, is to avoid the “loser’s game” and instead cultivate a rational, disciplined approach. As Warren Buffet quipped in 1999, prior to the dot.com crash, “Success in investing doesn’t correlate with I.Q. What you need is the temperament to control the urges that get other people into trouble.”
In an effort to re-evaluate this principle, BSW has looked at investment returns over the past ten years, comparing stocks (the S&P 500, the Russell 2000, and the MSCI Europe-Australia-Far East Index), to bonds, and, finally, to a balanced portfolio of stocks (large and small, domestic, foreign, and emerging), bonds, REITs, commodities, and alternative investments. As you see from the chart below, bond returns are fairly consistent, while growth assets wax and wane, with gains often presaging losses, and vice-versa.
When these yearly returns are blended together, bonds are the clear winner over the past decade, which is not surprising considering the market corrections of 2001-2002 and 2008-2009. Over longer periods of time, of course, bonds lag considerably. The next best performer? The balanced portfolio, with an average annual return of 6.1% – far from blistering, but still respectable – and far better positioned for future growth.
Looking Ahead . . .
The consensus view for 2009 was decidedly negative. As usual, though, the consensus was wrong. The consensus view for 2010 calls for subdued growth, “muddling through,” and a BBB recovery (boring, bumpy, and below-par). It will most likely be wrong this time, too. Although there are certainly challenges on many fronts, there are many reasons for cautious optimism. First, the credit crisis has eased dramatically, although it may not be immediately evident in bank lending. Second, the simple need to re-stock inventories will spur some measure of economic growth, further boosting consumer confidence. Finally, it is now politically imperative for the Obama administration to record some job growth prior to the 2010 mid-term elections. As a result, we’re anticipating a new round of government stimulus targeting “green collar jobs” in clean energy. On balance, following a healthy, pessimism-driven consolidation, we expect above average growth, mainly during the second half of the year as economic fundamentals continue strengthening and the recovery gains further traction.
We wish you, our clients, good health, happiness and success in the coming year. As our motto states, “No one can predict the future – we’ll make sure you’re prepared.” So please feel free to contact us with any questions or comments you may have. We are happy to help.
–David Wolf, Chief Investment Officer