January 2011 Investment Commentary

The Real Economy

In the fall of 2010, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) declared that the recession had ended.  This group is the “official” arbitrator of the economic business cycle.  They were convinced that the trough, or bottom, of the business cycle had been reached in June. The trough marks the end of the recession that officially began December 2007.  This is the longest recession since World War II. Previously, the longest postwar recessions were those of 1973-75 and 1981-82, both of which lasted 16 months.

Unlike other sever recessions; the post trough period has not been robust. This probably reflects the unique causes of this recession; but anemic growth and high unemployment rates keep everyone on edge and continue to spark concerns of a second r recession starting before the economy has fully recovered.

Data from a 5,000 household survey conducted a week or prior to the NBER announcement suggests that consumers are not all-that optimistic about the future of the economy. The Conference Board’s Consumer Confidence Index®, which had reflected a glimmer of optimism among those responding in August, had fallen a bit in September. The percentage of consumers expecting business conditions to worsen over the next six months rose to 16.4 percent from 13.4 percent, while those anticipating business conditions will improve declined to 14.9 percent from 16.9 percent.  Of course, consumer expectations – particularly from a survey of this nature – does not make the future true, but this is clearly a dominate sentiment in the media and blogs and as such this type of sentiment can affect the overall well being of the economy.

The employment picture remains dreary, with virtually little improvement in June, July or August.  However, starting in September there has been some improvement.  Average job growth has edged up slightly every month reaching 103,000 for the month of December.  The unemployment rate eased down slightly to 9.4 percent.  Despite these signs of growth for those out of work, this recession is still a depression and for those still working, the difficulty in finding work is probably adversely affecting labor force decisions.

However, the economy is growing. Average hourly earnings for the year increased 1.8 percent, effectively keeping up with inflation and third -quarter estimates of national income even after adjusting for inflation had increased on an annual rate of 3.2 percent in the fourth quarter.  This follows a third quarter rate of increase of 2.6 percent.   Real economic growth in excess of 3 percent will eventually result in a decline in the unemployment rate.

Financial Markets

For most of the year, the financial markets mirrored the real markets.  After strong gains in July, stocks reversed sharply in August, continuing a tug-of-war pattern that has characterized equity returns through most of the year.   However, a strong fourth quarter rally, punctuated by a December sprint, turned an okay year into a good year for stocks.

The large-cap Vanguard 500 Index gained nearly 11% for the quarter, and ended 2010 up nearly 15%. The small-cap iShares Russell 2000 and iShares Russell Midcap both returned in the mid teens in the fourth quarter, and gained 27% and 25% for the year, respectively. Looking abroad, the story was similarly positive for emerging markets, with the Vanguard Emerging Stock Index climbing 7.5% in the quarter and 19% for the year. Developed-market foreign stocks also had a good year, but returns for the benchmark Vanguard Total International Stock Index were restrained by concerns over Greece’s fiscal problems earlier in the year and Ireland’s later in the year, which drove the euro (and therefore returns to U.S. investors) lower. The Vanguard Total International Stock Index nevertheless gained a healthy 7% in the fourth quarter and 11% for the year.

As appropriate, for purposes of diversification, the story about fixed income differed.  The Vanguard Total Bond Market Index Fund, for example, a proxy for high-quality intermediate-term bonds, saw most of its 1.4% fourth-quarter loss come in December. Still, its strong performance earlier in the year left it with a full-year gain of just over 6%. Foreign bonds also struggled through the fourth quarter, with the Citigroup World Government Bond Index falling 1.8% and the emerging-markets JPMorgan GBI-EM Global Diversified Index down 0.4%. Each index was in the black for the year, with emerging market debt returning a notable 16%.

Connecting the Dots

The recent strength in the stock market along with a gradual improvement in the economy should not lull us into a state of complacency. Though the economy is improving at the margin and could exhibit stronger growth in 2011, structural risks remain.   Here is a list of our concerns that connect the real with the financial markets.

Household Debt Levels

1.    Debt-level trends: Household measured from the perspective of the economy has declined dramatically.  However, much of the decline was due to defaults.

2.    The cost to service debt and other financial obligations: The cost of servicing debt has declined, despite the decline in income, in part because the cost of borrowing money has fallen or loans that might have been made in the past were not being made.  Stricter access to credit and low interest rates are not likely to last  and hence this ratio is likely to increase.

3.    The overall level of debt: Unfortunately despite a meaningful reduction, the overall level of household debt remains very high relative to disposable income.  See the figure to your right.

The Weak Labor Market

Jobless claims for unemployment insurance are declining, which suggests that layoffs may have peaked.  But job growth is anemic.  Since December 2009 about 86,500 jobs have been created on average per month. Over the last three months (through November) the average has been even lower at just over 60,000. This compares to about 100,000 jobs needed per month just to keep pace with growth in the labor force.   Although this may end up being temporary, job growth for the first time since the recession started exceeded 100,000 this past December.  Other measures of employment are improving but remain dismal. There are about 4.2 job seekers per available job opening.

Even more disconcerting has been the duration of unemployment for most workers.  Of the total unemployed, 42% have been out of work for at least 27 weeks.

The Housing Market

In recent months home prices have slid backwards in many markets.  If house prices decline too much, banks might have to raise additional capital which would negatively impact the availability of credit.  There are a number of signs that suggest housing prices in many areas will fall more before they rise.  This is because a significant number of homes are “worth” less than their mortgage, jobs are still precarious, and the number of homes for sale on the market has increased dramatically relative to the number of home buyers on the market.  While housing prices are very local; credit markets are not.

U.S. Government Debt

While deficit spending is necessary to spur economic growth, gross federal debt is pushing 100% of GDP and state and local debt is another 20%.  At some point the cost of servicing this debt begins to eliminate the economic advantages of adding more debt.  We are not at that point yet, but in many countries this level of debt would be too much.  This is clearly playing out on the political stage and while reducing the debt in the long run will be good, moving too quickly or in the wrong way can undermine the advantages of the countercyclical spending that does occur.  Very often, politics does not make for good policy and we worry a lot about the tone of this discussion (even if the tragic shootings in Arizonia do change the nature of the words, this political inflection in inherent in the reality of a split Congress and a forthcoming Presidential Election).

State and Municipal Government Debt

While state tax collections have risen, State and local governments are often fiscally strapped.   Since property taxes are explicitly tied to property values, this source of revenue is down, as is taxes from income and sales.  Overall, state and local governments are not expected to contribute to any improvement in the labor markets in 2011 and will continue to face long-term structural problems from past spending decisions. It seems probable that there could be an increase in local government debt defaults though it does not appear likely that these will be widespread. They will generate headlines though, and that may trigger temporary sell-offs in the municipal bond market.  Recent talk among members of Congress of allowing state and local governments to declare “bankruptcy,” however has increased the cost to state and local governments of borrowing.  While the rising cost of borrowing is good for lenders (i.e., investors) it is not good for the state and local governments and in fact could help to bring about a default that might not otherwise had occurred!

Debt Concerns Abroad

The weakness in Europe’s periphery continues to create enormous uncertainty. Most of the southern European economies are uncompetitive and either have too much debt, high deficits, or both, amounting to a longer-term solvency issue for some.   Many of these countries can’t devalue their currencies to increase their global competitiveness.   Moreover, many have begun to institute fiscal austerity programs that will be a drag on their economic growth.

As a byproduct, the European banking sector remains stressed with lots of short-term debt that must be rolled over, fewer lending sources, rising rates, and more loan losses to come. At present, they don’t have enough capital to handle a sovereign default. Fortunately a default in the near term seems unlikely given European and IMF efforts, though eventually defaults by Greece, Portugal, and Ireland would not be at all shocking. Spain is particularly important in assessing the risks to Europe, given the size of its economy. A key concern is whether Europe will have to bail out the Spanish banking sector.

While our bet is that Europe will muddle through, it is the region of the world that seems most at risk for falling back into recession.   While a recession in Europe will not necessarily trigger a recession here, in the extreme it could and in the best of all situations it could further stifle our anemic growth.

Emerging Markets

A new worry is the economic strength in many emerging markets. The problem is not that the economies are strong, but rather that in a number of cases, policies to prevent their currencies from appreciating (and hurting their export competitiveness) necessitate low interest rates that can ignite inflation and asset bubbles.  Inflation in China is the most visible problem and it is already driving a tightening of monetary policy and fears that this will cause growth to slow too much.


While we often have to view the world from macroeconomic prism (because of the way in which national data is collected and reported) this prism is biased in a negative way.  When we take off these glasses we can see that overall, the global economy did generate a reasonably healthy level of growth in 2010—with most coming in the developing world. Things are slowly getting better on many fronts.   Emerging markets are exporting and growing.  In the United States, the corporate sector has record cash levels (though debt levels are also high) so it is in a good position to hire and invest more when confidence improves. Capital investment is already beginning to strengthen. Profits have been better than expected as companies have aggressively cut costs and benefited from lower interest rates and low wage growth. Trade flows have been strong and the United States has benefited. The recent tax bill maintains some of the fiscal stimulus including extended unemployment insurance and reduced payroll taxes. Though this adds to the deficit these polices could buy more time for the economy to gain momentum.

Finally, given the excess capacity and timid demand, interest rates and inflation are likely to remain low for the next year or so.  This may continue to lure investors back into a risk-taking mode.  While the risk of entrepreneurs is likely to be a positive, the risk taken by investors in the secondary markets (you and me) could cause speculative bubbles.

How to invest in this market

We talk to lots of folks who just do not know what to do.  For those still in the accumulation phases of their careers, our advice is to keep on saving and to save regularly.  Given the ups and downs it would make sense to save smaller amounts on a weekly basis rather than larger amounts on a monthly basis.

How to minimize Bad Decisions

Asset allocation, diversification, inflation rates, and “luck” are all critical aspects of how well your portfolio will do in the longer run.  There is a lot you can do about the first two factors and of course there are some things you can do in response to changing price levels, but luck is just that, luck.  The critical aspect of luck is the timing and sequencing of selling when you are using your savings to finance retirement.  But often, as research on investment decision making has demonstrated, the timing and sequencing of investment decisions while you are saving can also affect your returns.  Regardless of your investment strategy, consistency of implementation is critical.  Otherwise we become prone to biased decision making.  When either fear of loss or greed of gain dominate your decision making than you are no longer being systematic and this is when most investors end up confounding their luck by buying after prices have increased and selling after prices have fallen.

The single largest controllable factor in investment returns is your asset allocation.  History teaches us that there is an optimal asset allocation for both different time horizons and tolerances for risk.  Although there are different approaches to estimating these portfolios, they are, of course, based on what we have observed in the past about the correlation of different asset classes.  In the absence of an alternative strategy, recommend that most investors try and maintain their optimal asset allocation.

However, over the course of the business cycle, which may be 2-3 years, relative asset prices shift.  After all, the fact that there is a cycle, reflects different degrees and types of economic activities – in a relative sense, and what happens in the real economy does affect the financial markets.  Hence, for those with relatively long time horizons and the interest and tolerance for it, one could be tactical about asset allocations over the course of the business cycle by directing a small portion of your long-term portfolio into asset classes that appear, from a historical perspective, to be underpriced and avoiding asset classes that appear to be overpriced.

Such a tactical asset allocation is easier to achieve when you are regularly investing new funds.  By adding relatively more to an asset class that is underpriced and reducing your regular savings into an asset class that is over priced, you can increase your expected rate of return without dramatically increasing the likely risk.

Asset Class Return Estimates

The following table summarizes our current estimates of the annualized returns over the next four to five years, by financial asset class using extremely different assumptions about economic growth and inflation.

Of these four scenarios, we are the most comfortable at this time with the Anemic Growth assumptions.  The overwhelming macroeconomic signs are more in favor of recovery than recession and with so much excess capacity, it is hard to imagine any significant inflation.

This rules out the first two scenarios.  Recent estimates of national income, corporate profits, productivity, and employment are not consistent with a strong recovery making the fourth scenario too optimistic.

Our best guess is that we will realize a scenario slightly better than the Anemic Growth outlined above.

About Friedland Financial Planning

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Investment advice is based on research done in conjunction with our research partner Litman/Gregory Analytics.  Certain material used is proprietary to and copyrighted by Litman/Gregory Analytics but is used by Friedland Financial Planning, Inc. with permission.  Reproduction or distribution of any portion of this Commentary is prohibited and all rights are reserved.

©Friedland Financial Planning, Inc.  January 25, 2011

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