Posted by David Tillson 2012 Fourth Quarter
Despite the fiscal cliff drama in December, 2012 was a good year for investors. Stock markets around the world rose strongly and interest rates fell even further from their very low 2011 levels. Economies were still perceived to be fragile and central banks did what was necessary to shore up investor confidence and foster economic activity. The Fed’s Quantitative Easing efforts appear to be having the desired effect of pushing investors into stocks and other risk assets. The Fed believes that as this happens, stock prices will rise which will then create economic growth from the wealth effect of people feeling richer. This has probably been partially responsible for the stock market’s strong performance but it is certainly not the only reason. Housing has found a floor and rebounded, jobless claims are falling, corporate and consumer balance sheets are in much better shape, energy prices are reasonable, Euro fears have abated, and economic activity in the U.S., while slow, has been steadily increasing. People are also getting used to these difficult and often fearful times. Time is a great healer and balancer, and it is important to use time as a tool to gauge the impact of decisions made today. Peoples’ current decisions are based in part on what they think will happen in the future, but are every bit as heavily influenced by what they remember has happened to them in the recent past.
Consider the following scenario: The year is 2024, the troubles of the lost decade of the 2000’s are now remembered most clearly only in history books, and the youngest of the baby boomer generation is 60 years old and the oldest is 78. The prior ten years have been difficult as our economy rebuilt itself after the bursting of the debt bubble 15 years ago, but people finally settled into a normal routine with realistic expectations. Without trying to forecast too much of what the world will look like in 2024, there are some certainties. The first of these certainties is that things will have changed from today! Will central banks still be pouring liquidity into their financial systems? Will interest rates still be at historic lows? Will the Eurozone have collapsed? Will the U.S. still be arguing over the size of the federal budget deficit? We believe that “NO” answers the first three questions, but probably “YES” answers the last. Throughout history societies have risen and fallen and mankind has not always been very capable of controlling events. But mankind is also resourceful and highly focused on success. 2024 will bring new problems but many of today’s will have faded and some will have been forgotten. The second certainty is that we will all be 11 years older.
Demographic trends are very powerful forces and the reason that we mentioned the boomer generation above is that they will continue to heavily influence our society. According to Wikipedia, baby boomers control over 80% of personal financial assets and more than half of all consumer spending. They buy 77% of all prescription drugs, 61% of over-the-counter drugs, and 80% of all leisure travel. Another interesting aside: a survey found that about half of baby boomers polled in the United States have stated that they would rather pass on their inheritance as charity than pass it down to their children. The fact that their average age in 2024 will be 69 means that most will be retired and drawing down their assets. Further, they will very likely be more risk averse than they are even now. We believe that the majority will do as generations before them did which is to hold more of their investable assets in bonds as they age, both for safety and for the assured income stream. However, if interest rates are not meaningfully higher than they are today, a retirement that depends on bond coupons will be difficult to say the least. Many boomers have already significantly increased their fixed income holdings because of what happened in 2008-09, and have probably made this a permanent transition despite the low bond returns. Retirement plans that relied on rising prices of homes or stocks, or being able to earn a reasonable interest rate on a bond, have been thrown into disarray. Many boomers now want safety – at almost any price. But, will these same people believe that today’s decision will have been the correct one when they look back from a 2024 vantage point?
The purpose of saving is to provide for the future. Outliving one’s assets is probably the biggest worry that retirees have. As people age, the inability to replace wealth that has been lost in bad investments drives the desire to keep assets safe regardless of how much return can be earned. We are now witnessing this confluence of age/mortality, extremely low bond yields and perceived risk of equity investments. For the last 32 years, bonds have provided investors equity-like returns without the risk of sharp declines (volatility risk). Over the long term risk of actual loss in a diversified stock portfolio is actually quite low. However, as we age, sometimes the long term appears too long. Looking at the chart of 10 year rolling returns of stocks since 1950 shows that while investors may have experienced some nerve wracking shorter term periods, only in the recent November 2008 to September 2010 period did investors actually lose wealth over a 10 year period, and even then, if they stayed invested, they now are experiencing 8% annualized returns for the January 2003 to January 2013 period.
As we mentioned earlier, we will not attempt to forecast the next ten years, but we are very certain that for many, time will seem to have passed quickly as they look back. Our crystal ball suggests that the economy will have grown at least at the roughly 2% subpar rate of the past four years and probably it will have grown substantially faster. Interest rates will be higher in 2024, probably rising to the 4-5% level on the 10-year US Treasury Note, and the stock market will have produced at least an 8% annual return. Some may expect interest rates to be much higher than our projection by the middle of the next decade, but history suggests otherwise. For whatever reason, interest rates have moved up and down by only about 2 percentage points every 10 years except for the six high inflation years between 1979 and 1985. Despite the Fed’s Quantitative Easing actions, we believe that this two-percentage-point-per-decade move will hold in our current environment. Unless there is some event such as the oil embargo of the 1970’s, it is unlikely that the pattern seen in the chart will change. If true, it will be easier for the Fed to eventually remove its loose money policies without creating an even greater problem of spiking interest rates.
If we are correct in our longer term interest rate forecast, the stock market’s valuation should rise further from its current level to the 15x–17x range which would drive equity returns closer to 10-11% annually rather than our minimum projection of 8%. Many people believe that any upward move in rates would negatively impact the stock market. Stocks’ valuations and interest rates are linked and while this is true normally, today’s conditions are anything but normal. A chart that we have included in the past clearly shows how abnormal this relationship is today. The Earnings Yield is simply the reciprocal of the Price/Earnings Ratio and history shows that 10 Year US Treasury Yields and the S&P 500 Earnings Yield are highly correlated. Based on the current level of interest rates, the P/E of the market could theoretically approximate 50x, which is clearly unrealistic. More to the point, interest rates can rise to 6% and the stock market still should be able to sustain a P/E ratio of 16x, just as it did throughout the 1950’s and 1960’s.
Today, federal and state debt dominates the national conversation. Yet, the former Merrill Lynch chief investment strategist Richard Bernstein pointed out that total debt, including household, corporate and other private debt, is falling at the fastest rate in history. Total U.S. debt has fallen from 350% to 320% of GDP in the last few years and Bernstein surmises that it is one reason the dollar has remained strong. Government debt may be crowding out private debt, but this statistic is still solid evidence that the U.S. is deleveraging. One of the jobs of government is to step in when the private sector needs help. Central bank monetary easing policies enacted around the world have clearly been necessary to prevent a 1930’s type scenario of worldwide depression. But what are the unintended consequences of 14 countries now having zero interest rates out to their 2-year bonds? The relentless search for yield is probably laying the groundwork for future volatility and losses. One of the best performing asset classes has been Emerging Market distressed debt. An example is a recent Lagos, Nigeria municipal bond issuance which raised $2 billion with a 14.5% coupon. Assets flowing into almost anything that produces yield have grown sharply, a behavior which usually precedes loss. We believe that the road to 2024 is clearly marked, but it will still have many potholes and some delays and detours along the way.
Our job in managing clients’ assets is not to agree or disagree with macro-economic policy, but it is to understand the implications and consequences, intended or unintended, of such actions. We may not like or agree with certain policies, but we understand that these are simply the cards that we are dealt. Our belief system is that of basic fundamentals coupled with an appreciation of human behavior. As such, thinking ahead to the year 2024 and imagining what the then prior 10 years were like should give us a window into how the coming decade may turn out. In coming years stocks will continue to be volatile, but we certainly do not expect declines anywhere near what occurred in the 2000’s. We are very confident that stocks are finally at a point where they will grow investors’ wealth. On the other hand, it is very hard to conceive that the greatest bull market in bonds of all time will end quietly, with consequences for volatility across all asset classes. But if you consider that Procter & Gamble which has been around for more than a hundred years, can sell a 10 year bond at a 2.1% yield when its stock yields 3.1%, something is out of alignment. When it matures in 2024, investors will have gotten their principal back and they will have earned 2.1% each year. But will those investors be happy with their decision to buy that bond today when they realize that if they had just bought the stock, their dividend yield would have started at 3.1%, their dividend payments would have grown for 10 years and the value of their shares would have been substantially higher than what they paid?