Seek not comfort, but opportunity
March 31, 2010
Market Summary – 1st Quarter, 2010
Despite these encouraging facts, the media continues to focus on the negative. That noise created an uncomfortable environment for investors throughout the market’s dramatic 73% rally (from March 9, 2009 through March 31, 2010).
Economists Brian Wesbury and Robert Stein of First Trust recently produced a list of key negative signals that have been relentlessly played up in the media since early 2009. They include all of the following:
• Rising credit card delinquencies
• Declining values of Credit Default Swaps
• The collapse of commercial real estate
• The “real” unemployment rate (in the 17% range, counting underemployed)
• Rising home foreclosures
• Adjustable-rate mortgage resets
• Uncertainty regarding government policy due to Washington gridlock
• A lack of bank lending
• Universal healthcare
• Cap-and-trade legislation
• Looming tax hikes
• China supplanting the U.S. as the next economic power
• Greece and the rest of the “PIIGS” (Portugal, Italy, Ireland, Spain as well) defaulting on their debts
• The unwinding of the Federal Reserve’s and Treasury’s efforts to add liquidity to the markets.
Most of those problems either resolved themselves, did not turn out to be at all onerous, or never really existed. They clearly added to the discomfort of investors. The “flight to comfort” is best exemplified by the direction of flows into mutual funds. In January and February, bond mutual funds had net inflows of $62 billion, while equity funds captured just $17 billion. Over the 12-month period ending in February, bond fund net flows dwarfed those of equity funds – $464 billion to $78 billion.
During the same period, the stock market enjoyed its most dramatic end-of-recession rally in the past 60 years. The lesson is an important one – investing is not meant to be comfortable. The greatest opportunities for investors are often created at the times of severe distress.
Historically, markets performed surprisingly well when favorable sentiment was lacking. Whether investors today are skeptical or nervous given the market’s rapid and significant rebound, there remains an uneasy feeling among the investing public. A contrarian may take this as a sign that equities remain reasonably priced. History indicates that the proverbial “wall of worry” may be working to an equity investors’ advantage.
Government mismanagement and the investor’s dilemma
We don’t mean to dismiss legitimate fears about the future. Let us focus on issues we believe really impact long-term wealth accumulation.
The biggest concern, from our perspective, is exploding government debt. The problem isn’t new, but the lack of recognition and deadly silence by both political parties is troublesome. USA Today recently pointed out that 2009 was the first year in our nation’s history when every single dollar of revenue was already spent by previous houses of Congress before current members could even vote on a single expenditure. Every dollar of revenue has already been spoken for by “mandatory programs” and to pay interest on the debt. Spending on the vast majority of the government’s agenda – education, defense, the environment – adds to the deficit, as committed entitlement spending is completely inundating the budget. Put succinctly, the U.S. government is spending $1.49 for every $1.00 our country collects.
In a painful coincidence, 2009 also turned out to be the first year where the Social Security system paid out more in benefits than it took in from payroll tax receipts – seven years earlier than initially projected.
Also, the U.S. government has unfunded commitments for Medicare, Medicaid, Social Security and Federal pensions estimated at $109 trillion (according to data provided by the 2009 Social Security and Medicare Trustees Report).
It makes one pine for the days when Senator Everett Dirksen, mocking profligate spending a half-century ago, was credited with muttering “a billion here, a billion there, and pretty soon you’re talking about real money.”
The problem has been kicked down the road for so long that we’ve now reached a point that even the best solutions may result in:
• a weakening of the dollar;
• a significant upturn in the inflation rate; or
None of the above are appealing.
Behavior has consequences
History suggests that governments tend to seek the least painful cures to debt crises – monetizing debt and printing money. This has happened in many nations in the past and results in the loss of currency value and significant increases in inflation.
The concern outside of the Beltway seems to be growing. A commentary by left-of-center columnist Michael Kinsley (The Atlantic, April 2010) suggests that a renewal of rampant inflation is his nightmare scenario. Kinsley admits his concern may be partly out of a puritanical instinct. He believes the recession must have occurred for a reason – not just the financial misbehavior that triggered the crisis, but underlying factors as well. Kinsley says the cure for the troubled economy so far has been “one ice cream sundae after another. It can’t be that easy, can it?” What Kinsley is waiting for is corrective pain, not the kind caused by the recession, but from the cure to our increasing debt problems.
The increased money supply that created significant inflation during the 1960s and 1970s was initiated by government policy to pay for the escalating Vietnam war and “Great Society” programs. This was seen as an easy solution to the government’s expanding debt problem – but it left significant economic scars.
Today, government may be in the same position. It too recognizes that a fiscally painless way to deal with the debt is to “outgrow” it. Kinsley says with inflation of 10% per year over five years, the value of the nation’s debt would be greatly eroded, allowing the powers in Washington to avoid difficult choices. That’s because commitments not indexed to inflation, like pensions, would be worth less. And the Federal Reserve, through the power of the printing press, can flood the market with currency. This typically leads to higher inflation. It also devalues the currency dramatically.
This reality demonstrates that inflation is not a virus. It occurs not by accident or bad luck. It is a pre-meditated government policy designed to solve financial problems by choosing to print money rather than find real solutions.
Iceland is going through this in a serious way. The nation found itself greatly indebted as a result of mismanagement and questionable business practices that came to a head with the financial crisis. As a consequence, Iceland’s currency declined in value – dramatically – and the cost of goods soared. This is hard on everyone, even a behemoth like McDonald’s. The company discovered that the cost of goods needed to make its products became prohibitively expensive. Facing the reality that selling Big Macs for more than $6 was not a sustainable business model, the company closed its doors in Iceland.
The risk created by excessive debt is real. The consequences are potentially painful. What is an investor to do?
Do we just sit there – or do we buy something?
This comment from Buffet, which we’ve published before, came during the depths of the financial crisis. Within five months, markets turned around and rebounded sharply. Buffet’s point – the comfort of cash was no comfort at all – even in the worst of times – for those serious about building wealth.
If our concerns about the consequences of government debt are real, with the dollar losing value and inflation eroding our purchasing power, that leaves investors a choice:
• Stick with comfort and wait for evidence of economic certitude, but risk having to pay up for assets that are likely to rise in value during that time; or
• Take action and begin the process of building your portfolio of attractively priced assets today regardless of one’s own feelings of comfort.
If asset prices are going to rise, it makes sense to own those resources now, whether it be quality stocks at a good price, depressed real estate or hard assets like gold.
This could be one of those uncomfortable times when markets create opportunity. When markets peak, it is difficult to find assets that are appropriately priced. But in challenging times, when investor skepticism is high, bargains tend to be more numerous. In today’s markets, investor comfort levels remain relatively low, as evidenced by the $5 trillion being held in cash today, mostly by those waiting for stocks to endure another drastic decline. Market history and life experience tells us that most or all of that $5 trillion will never get a second chance to buy at the previous bargain price levels that we saw in 2009.
If the risk of higher inflation is real, fixed income investments won’t keep pace. Conventional wisdom claims that equities also struggle in times of high inflation. But the record shows mixed results. If you follow stock market performance in comparison to inflation trends, it becomes clear that while inflation is a factor, it does not drive equity market performance. In the last 50 years, the annual inflation rate has topped 5% in 11 different years. Stocks managed gains in five of those years, even earning more than 30% on two different occasions.
Here is more evidence that inflation does not drive stock market performance. The worst decade for inflation in our times was the 1970s. The annual inflation rate averaged 7.4%, and stocks returned just under 6% on average. Between 2000 and 2009, inflation averaged 2.5% per year. But the S&P 500 lost, on average, about 1% per year. So low inflation did not automatically trigger better returns.
Modest inflation rates are preferred for many reasons, but opportunities can still be discovered in times of serious inflation.
Looking through the haze
Equity investing is a long-term proposition. Ownership of assets is the best way to capitalize on future growth. So are there reasons to feel optimistic that growth opportunities will continue to be uncovered in the future? Or, as many skeptics have pronounced, are America’s best days behind it?
A big factor that many are overlooking is the likely direction of world demographics. Populations in Europe and Japan are stagnating, and aging even more dramatically than our own. Joel Kotkin, urban expert and author of
“The Next Hundred Million – America in 2050,” says in comparison to the U.S. “most developed countries in both Europe and Asia will become veritable old-age homes,” due to stagnant population growth. Their vast welfare-state apparatus will burden them, he claims.
In contrast, Kotkin predicts that population in the U.S. will rise by 100 million in the next 40 years, driven by slightly higher birth rates and continued immigration. Because of this, the labor force in the U.S. will grow by 42% over that time. Is that good news? Kotkin says in advanced countries, “a rapidly aging or decreasing population does not bode well for societal or economic health, whereas a growing one offers the hope of expanding markets, new workers and entrepreneurial innovation.” That’s the future he sees for an increasingly diverse and vibrant America.
This is likely to play a big role in keeping the U.S. on the march economically, despite all of the apparent headwinds we face in the near term. Growth potential is not a thing of the past. New York Times columnist David Brooks (Relax, We’ll Be Fine, April 6, 2010) points out that the U.S. remains at or near the top of almost every global measure of economic competitiveness. While there has clearly been economic upheaval, Brooks sees the stage being set for revival.
Throughout our nation’s history, incompetence in Washington couldn’t by itself stop economic progress. As Brooks writes, “The U.S. has always been good at disruptive change. It’s always excelled at decentralized community-building. It’s always had that moral materialism that creates meaning-rich products. Surely a country with this much going for it is not going to wait around passively and let a rotten political culture drag it down.”
Nor a media culture that continually promotes a sense of discomfort. Wealth accumulation is about investing for the future. There is no time like the present to position yourself for it. In our opinion, now is the time to be an owner, ready to profit from whatever the future holds.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.