07/07: Reversal of Fortune
Financial markets bounced back in the second quarter of 2005 with most asset classes posting modestly positive returns. Reversing the negative returns of a dismal first quarter, bonds rebounded to positive returns for the year to date. Equities also posted positive returns in the period but still remained slightly under water for the year through June 30, 2005. Cash (money market funds) improved to a current yield of almost three percent and remains one of the better returning asset classes thus far in 2005.
What can we expect looking ahead?
That Picture Is Upside Down!!!
Elliott Farr, a former colleague of mine, was a leader in the Philadelphia investment community for many years. He spent most of his career at Girard Trust and at WH Newbold’s where he distinguished himself as a value investor.
Farr’s special genius was the ability to see what most others could not. Like a good puzzle master he could see and understand relationships that eluded others. My favorite description of his talent was as the man who could look at a painting that others had been admiring (perhaps for a long while) and suggest that it was upside down! Oh, suddenly everyone could see much better. Now they understood!
I wonder what Elliott would see today?
Prosperity Built On A Mountain of Debt
Perhaps the most important trend in our economy in recent years has been the shift in the sources of economic growth. Historically growth in the US has been fueled by hard work, increasing savings and investment, innovation, improving productivity, and the rising wages and profits flowing from all of these.
Times have changed. While we are working longer hours, and productivity has increased at a better than average rate, US incomes are not keeping up with inflation in these last years (see Bureau of Labor Statistics). This has not deterred us from spending more however and corporate profits are high and rising. How can that be? Surely Elliott Farr might suspect something was amiss?
The primary source of our growth has come from spending borrowed money! As the 90’s stock market boom gave way to the real estate boom we (individuals, families and government) have been borrowing and spending more to finance our continued and growing consumption. The mechanism for families has been home equity loans and cash-out refinanced mortgages. Government has simply issued more bonds as we have moved from budget surplus to seemingly endless deficits.
Interestingly, the corporate world is an exception to this trend. Many companies (and in aggregate) are paying down debt and hoarding cash rather than increasing their investment in productive capacity (new plant and equipment). The reason seems to be that available returns (projected) do not justify added investment.
Historically, 2/3rds of our GDP has come from consumer spending. Today consumers are over 70% of our economy! Our current prosperity is being fueled by consumer spending that is funded by debt that in turn is supported by the growth in asset values (real estate). We are spending our wealth!
Truly this is an upside-down situation worthy of the analytic skill of Mr. Farr.
Mean Reversion
The primary source of this borrow and spend cycle has been the Federal Reserve Bank and its easy money policies – discouraging saving while promoting borrowing. The Fed adopted these policies in response to the collapse in equity prices that began in 2000 in order to cushion the economy. The result was a very shallow recession followed by an anemic rebound (in jobs and wages). The continuation of this easy money policy (featuring real interest rates below zero) has led to the current speculative bubble in real estate. Long term relationships have been upset. Will they be restored?
In short yes. Over time financial markets trade around fair value often spending years above fair value (mean) and years below fair value. In the past equity markets and real estate have always returned to the long term mean value. Always! The relationship of home values and rents are a primary measure of valuation in real estate. We are currently well above the long term mean. We should expect real estate to return to its long term trend. Knowing when (and what will precipitate it) is the big question. Federal Reserve Policy will perhaps be the determining factor.
Whither The Fed?
Alan Greenspan and the Fed have difficult choices in front of them. Because they have chosen to let real interest rates stay low (negative) for so many years they have painted themselves into a corner. If they take away the punch bowl (by raising short rates to “normal” or about 5%) just as the party is getting good, it might trip up the real estate boom and lead to a long and painful recession featuring deflation (falling prices). If however, they keep real short term interest rates near zero (they have just raised the short term rate to 3.25% - just slightly above the annual inflation rate) the real estate bubble and attendant growth in consumer spending and debt might simply continue.
Greenspan’s MO has been to respond to economic crisis by flooding the financial system with liquidity (by lowering short rates and creating money by buying Treasury bonds) thereby creating a spurt in consumer spending. This happened in 1987 after the stock market crash, several times in the nineties (Mexico, Asian banking crisis, and the collapse of the hedge fund LTCM) and most recently (2000 – 2003) in response to the stock market decline. His motivation appears to have been the avoidance of the long term consequences of mean reversion (falling stock and real estate prices such as happened in Japan from 1990 until recently). Certainly an admirable goal.
So now the Fed is facing a moral dilemma. If they continue to tighten money (raise short term interest rates and slow money growth by selling Treasury bonds) they run the risk of an abrupt end to the “borrow and spend” cycle that has been propping up our economy. A deep recession with high unemployment and falling stock and home prices might reasonably be expected in this scenario. On the other, hand if the Fed stops its monetary tightening it is likely that long term interest rates and short term interest rates will converge at about 3.5%. This likely would set off another round of mortgage refinancing and further consumer spending growth fueled by borrowing against asset (home price) growth.
Whither the Fed? It is very hard to know but one can imagine that they do not wish to precipitate either a severe recession or an accelerated housing bubble. Most likely they will look for the middle way.
John Mauldin in a recent on-line newsletter (see Thoughts From the Front Line: http://www.frontlinethoughts.com/article.asp?id=mwo070105 or email John at: John@FrontlineThoughts.com ) suggests that the middle way will create a self-correcting antidote of sorts. The Fed may continue to raise rates for awhile which will dampen real estate speculation but lead to market anticipation of slower economic growth and therefore trigger investment in long term bonds. This investment flow will lead to lower long term interest rates and therefore lower mortgage rates thereby triggering another wave of mortgage refinance.
Some might see this as a virtuous circle. Alternatively these actions may simply delay the inevitable or spread it out over many years. Bill Gross of PIMCO and Stephen Roach of Morgan Stanley (two very smart observers) think that long term interest rates (10 year maturity) may fall to a range of 3% to 3.5% from their current 4%+.
Whither the Fed? I find the arguments of Gross and Roach as reflected by John Mauldin persuasive. It seems likely that the Fed will work overtime to create a soft landing from the speculative excess of the current real estate bubble. Slow growth, frequent mild recessions, falling prices and falling interest rates would be the likely outcome of this scenario.
Upside Down Asset Allocation? A New (Old) Model For Asset Allocation
Given these assumptions it is likely that stock market returns will continue to be meager and that fixed income investments (dollar denominated and foreign currency denominated) may well produce better returns.
Our work suggests that many investors might do better with asset allocations that looks upside down to them (and their advisors). Current asset allocations are typically 60% equity, 30% bonds and 10% cash. We propose a flip to these allocations with a new Upside-Down Investment Strategy! Specifically we propose that for investors dependent upon their portfolios for income, a more sustainable investment policy would produce an asset allocation with 40% bonds, 30% stocks, 25% low risk alternatives and 5% cash. The ingredients might look like this:
30% Stocks
US Stocks
International Stocks
Emerging Market Stocks
40% Bonds
US Intermediate Maturity Bonds
US Long-term Maturity Bonds
US Inflation Protected Bonds (TIPS)
International High Quality Bonds
25% Low Risk Alternatives
Absolute Return Investments (hedged fixed income)
Tactical Asset Allocation Fund
Hedged US Equity (long-short with no leverage)
5% Money Market Fund (cash)
Expected Risk and Return
The expected return of this allocation would be about 6% with an expected annual standard deviation (risk) of 5%. The typical current asset allocation (60/30/10) would generate less return (5.4%) with much greater volatility (risk). The Upside-Down Strategy would also provide significant downside protection in the event of a protracted stock-market decline.
Better return with less risk? Easy choice.
O. Sam Folin, CFA
June 30, 2005
What can we expect looking ahead?
That Picture Is Upside Down!!!
Elliott Farr, a former colleague of mine, was a leader in the Philadelphia investment community for many years. He spent most of his career at Girard Trust and at WH Newbold’s where he distinguished himself as a value investor.
Farr’s special genius was the ability to see what most others could not. Like a good puzzle master he could see and understand relationships that eluded others. My favorite description of his talent was as the man who could look at a painting that others had been admiring (perhaps for a long while) and suggest that it was upside down! Oh, suddenly everyone could see much better. Now they understood!
I wonder what Elliott would see today?
Prosperity Built On A Mountain of Debt
Perhaps the most important trend in our economy in recent years has been the shift in the sources of economic growth. Historically growth in the US has been fueled by hard work, increasing savings and investment, innovation, improving productivity, and the rising wages and profits flowing from all of these.
Times have changed. While we are working longer hours, and productivity has increased at a better than average rate, US incomes are not keeping up with inflation in these last years (see Bureau of Labor Statistics). This has not deterred us from spending more however and corporate profits are high and rising. How can that be? Surely Elliott Farr might suspect something was amiss?
The primary source of our growth has come from spending borrowed money! As the 90’s stock market boom gave way to the real estate boom we (individuals, families and government) have been borrowing and spending more to finance our continued and growing consumption. The mechanism for families has been home equity loans and cash-out refinanced mortgages. Government has simply issued more bonds as we have moved from budget surplus to seemingly endless deficits.
Interestingly, the corporate world is an exception to this trend. Many companies (and in aggregate) are paying down debt and hoarding cash rather than increasing their investment in productive capacity (new plant and equipment). The reason seems to be that available returns (projected) do not justify added investment.
Historically, 2/3rds of our GDP has come from consumer spending. Today consumers are over 70% of our economy! Our current prosperity is being fueled by consumer spending that is funded by debt that in turn is supported by the growth in asset values (real estate). We are spending our wealth!
Truly this is an upside-down situation worthy of the analytic skill of Mr. Farr.
Mean Reversion
The primary source of this borrow and spend cycle has been the Federal Reserve Bank and its easy money policies – discouraging saving while promoting borrowing. The Fed adopted these policies in response to the collapse in equity prices that began in 2000 in order to cushion the economy. The result was a very shallow recession followed by an anemic rebound (in jobs and wages). The continuation of this easy money policy (featuring real interest rates below zero) has led to the current speculative bubble in real estate. Long term relationships have been upset. Will they be restored?
In short yes. Over time financial markets trade around fair value often spending years above fair value (mean) and years below fair value. In the past equity markets and real estate have always returned to the long term mean value. Always! The relationship of home values and rents are a primary measure of valuation in real estate. We are currently well above the long term mean. We should expect real estate to return to its long term trend. Knowing when (and what will precipitate it) is the big question. Federal Reserve Policy will perhaps be the determining factor.
Whither The Fed?
Alan Greenspan and the Fed have difficult choices in front of them. Because they have chosen to let real interest rates stay low (negative) for so many years they have painted themselves into a corner. If they take away the punch bowl (by raising short rates to “normal” or about 5%) just as the party is getting good, it might trip up the real estate boom and lead to a long and painful recession featuring deflation (falling prices). If however, they keep real short term interest rates near zero (they have just raised the short term rate to 3.25% - just slightly above the annual inflation rate) the real estate bubble and attendant growth in consumer spending and debt might simply continue.
Greenspan’s MO has been to respond to economic crisis by flooding the financial system with liquidity (by lowering short rates and creating money by buying Treasury bonds) thereby creating a spurt in consumer spending. This happened in 1987 after the stock market crash, several times in the nineties (Mexico, Asian banking crisis, and the collapse of the hedge fund LTCM) and most recently (2000 – 2003) in response to the stock market decline. His motivation appears to have been the avoidance of the long term consequences of mean reversion (falling stock and real estate prices such as happened in Japan from 1990 until recently). Certainly an admirable goal.
So now the Fed is facing a moral dilemma. If they continue to tighten money (raise short term interest rates and slow money growth by selling Treasury bonds) they run the risk of an abrupt end to the “borrow and spend” cycle that has been propping up our economy. A deep recession with high unemployment and falling stock and home prices might reasonably be expected in this scenario. On the other, hand if the Fed stops its monetary tightening it is likely that long term interest rates and short term interest rates will converge at about 3.5%. This likely would set off another round of mortgage refinancing and further consumer spending growth fueled by borrowing against asset (home price) growth.
Whither the Fed? It is very hard to know but one can imagine that they do not wish to precipitate either a severe recession or an accelerated housing bubble. Most likely they will look for the middle way.
John Mauldin in a recent on-line newsletter (see Thoughts From the Front Line: http://www.frontlinethoughts.com/article.asp?id=mwo070105 or email John at: John@FrontlineThoughts.com ) suggests that the middle way will create a self-correcting antidote of sorts. The Fed may continue to raise rates for awhile which will dampen real estate speculation but lead to market anticipation of slower economic growth and therefore trigger investment in long term bonds. This investment flow will lead to lower long term interest rates and therefore lower mortgage rates thereby triggering another wave of mortgage refinance.
Some might see this as a virtuous circle. Alternatively these actions may simply delay the inevitable or spread it out over many years. Bill Gross of PIMCO and Stephen Roach of Morgan Stanley (two very smart observers) think that long term interest rates (10 year maturity) may fall to a range of 3% to 3.5% from their current 4%+.
Whither the Fed? I find the arguments of Gross and Roach as reflected by John Mauldin persuasive. It seems likely that the Fed will work overtime to create a soft landing from the speculative excess of the current real estate bubble. Slow growth, frequent mild recessions, falling prices and falling interest rates would be the likely outcome of this scenario.
Upside Down Asset Allocation? A New (Old) Model For Asset Allocation
Given these assumptions it is likely that stock market returns will continue to be meager and that fixed income investments (dollar denominated and foreign currency denominated) may well produce better returns.
Our work suggests that many investors might do better with asset allocations that looks upside down to them (and their advisors). Current asset allocations are typically 60% equity, 30% bonds and 10% cash. We propose a flip to these allocations with a new Upside-Down Investment Strategy! Specifically we propose that for investors dependent upon their portfolios for income, a more sustainable investment policy would produce an asset allocation with 40% bonds, 30% stocks, 25% low risk alternatives and 5% cash. The ingredients might look like this:
30% Stocks
US Stocks
International Stocks
Emerging Market Stocks
40% Bonds
US Intermediate Maturity Bonds
US Long-term Maturity Bonds
US Inflation Protected Bonds (TIPS)
International High Quality Bonds
25% Low Risk Alternatives
Absolute Return Investments (hedged fixed income)
Tactical Asset Allocation Fund
Hedged US Equity (long-short with no leverage)
5% Money Market Fund (cash)
Expected Risk and Return
The expected return of this allocation would be about 6% with an expected annual standard deviation (risk) of 5%. The typical current asset allocation (60/30/10) would generate less return (5.4%) with much greater volatility (risk). The Upside-Down Strategy would also provide significant downside protection in the event of a protracted stock-market decline.
Better return with less risk? Easy choice.
O. Sam Folin, CFA
June 30, 2005
