Inflection Points

As the events of the past quarter unfolded and we absorbed and processed the vast amount of information coming our way (someone likened it to trying to drink from a fire hose), it occurred to me that we are at an inflection point – several in fact – that will determine what the future holds. Let me review.

Deflation vs. Inflation

The economy is in a state of deflation – the sustained decrease of general prices. It is happening all around us. Housing prices are falling. Stock prices are falling. Commodity prices are falling. Suddenly, everything is worth less than it used to be.

Deflation is a very disruptive economic situation. It destroys the balance sheets of banks, companies, and families. It makes it difficult to repay debt and accelerates default. It can lead to a vicious cycle of economic contraction. Spiraling deflation, unchecked, was the dominant theme of the Great Depression.

The flip side of deflation is inflation – the sustained increase in prices. Inflation is the antidote for deflation. They are mutually exclusive – only one can exist at a time. All of the Government’s actions – federal spending, zero interest rates, and increased money supply – are designed to defeat deflation and replace it with inflation. Who do you think will win?

The answer to me is clear. The federal government is committed to winning. They want inflation over deflation – not the runaway inflation of the ‘70s, but the mild, predictable inflation of the ‘80s and ‘90s. They have deep pockets. They have learned from the mistakes of the past. They are willing to throw gasoline on a dying ember to keep the fire from going out. If we can agree that someday all this government action will cause an inflation problem, then we can agree that someday, this recession will be behind us.

Will they overshoot their mark causing dramatic inflation? Maybe, but the good news is that the Federal Reserve is better equipped to fight inflation than deflation. Given the choice, I’d pick inflation and so would they.

Fear vs. Hope

Given what we’ve been through – the stock market decline, the implosion of the banking system, rising unemployment – and the speed with which these issues unfolded, let me pose a question. Are you more fearful today than you were one year ago?

I know my initial answer is “Yes.” There are days when the bad news is overwhelming. We all know people who’ve lost jobs, or can’t sell a house. We’re all worried for the future.

But let’s consider the question from a different perspective, and let’s use the tragedy of 9/11, as an example. Was our country safer on 9/10/2001 or 9/12/2001? Clearly, we were much safer after that terrible day than before – planes were grounded, military was on alert, the attack had already happened. But how did you feel? I know I was terrified and felt less safe, but it was really an issue of being aware of risks that were formerly unrecognized.

Fast-forward to our current economic reality. All the risks which we are experiencing today existed one year ago. We just collectively ignored them.

Our banks were not safer one year ago. They are safer now. The weak ones have failed and the survivors have the implicit backing of the Government.

The stock market was not safer one year ago. It is safer now. One year ago the Dow Jones Industrials was close to 13,000. Today it’s at 8,000 – down 5,000 points. It is cheaper today and cheaper valuations limit the downside. Can it fall 5,000 more? Sure, but a 5000 point decline was far more likely to happen beginning last year than it is today (more on the future direction of the markets later).

Our economy was not safer one year ago. It is safer now. Most of the problems we are currently wrestling with were being ignored one year ago. Now they are being addressed. Yes, we’ll get some things wrong, but action is better than inaction.

So should we embrace fear or hope? I choose hope. I am hopeful that this recession is almost over. I am hopeful that as a country we will return to values of thrift and industry that gave us the highest standard of living in the world. I am hopeful that we will learn from our mistakes and never let our financial institutions become so large and complex that the failure of any one company threatens our entire system.

Risk vs. Reward

We are currently in the middle of the second deepest bear market in modern history. Everyone lost money last year, and everyone is probably asking, “Why do we own securities that can decline this far in price, this fast?”

The answer is all rational investing is exposure to risk, and all potential returns are compensation for taking those risks. Sometimes risks are realized and sometimes they are not. Sometimes they can be managed or reduced and sometimes they can’t.

Investing at its core is relatively simple. There are only a few things you can do with your money. Everything else is just variations on a theme.

Cash and Savings

You can loan it to the government or a bank (with or without a government guarantee) for a very short period of time. This is the safest thing you can do with cash. You are virtually certain to get your money back in full whenever you ask for it, which is great if you value liquidity and principal protection, but don’t expect to earn more than inflation over time. No risk – No reward.

Fixed Income

You can loan it to other types of borrowers - companies, individuals, state, local, or foreign governments. You can also loan it out for longer periods of time. This is fixed income investing – buying bonds. The interest rate you require (and therefore your investment return) depends in part on the credit worthiness of the borrower and the term of the loan. You can loan your money to (buy the bonds of) Johnson and Johnson, Inc. or you can loan it to Donald Trump. A loan to “The Donald” obviously carries much greater risk. You would expect to be compensated for this additional risk by charging a higher interest rate accordingly. More risk – More reward.

Equity

You can also buy assets – real estate, factories, mines, farms, railroads – that if employed properly will produce profit. You can buy these assets in the public markets or privately. As the owner, all the income flows to you, but in bad times you absorb all the losses. It’s feast or famine. Maximum risk – Maximum reward.

As with fixed income, your expected return should be commensurate with the risk you’re taking. If a company with a 100 year track record, in a non-cyclical industry, has low debt, pays a high dividend, and is publically traded, it may be deemed relatively low risk. Conversely, if a company is a private start up, with a lot of debt and suspect business opportunities……you get the picture.

Speculation

Lastly, you can buy something today – gold, oil, options, land, etc. – hoping that you'll be able to sell it to someone for a higher-price tomorrow. This is speculation. This is a risk for which there is no expected compensation, and therefore not what we consider an investment.

Each of these four choices involves varying degrees of risk and varying degrees of potential returns. One certainty in investing is that you can't earn a higher return without taking more risk. There is no free lunch. Although your risks can be managed through asset allocation, diversification and time in the market, they can’t be eliminated. So rational investors expose themselves to risks they can tolerate (if I’m retiring in 10 years, I can live with market fluctuations today), in return for an expected return above and beyond less risky alternatives.

That all sounds good, but is it true? We’ve taken all the risk and have received no return. Will portfolios ever recover?

We believe the answer is yes. We believe that the next 10 years will look remarkably better than the past decade, and there is lots of data to support this conclusion. As an example, I point to the chart below.

[caption id="attachment_70" align="aligncenter" width="473" caption="10yr period comparison"]10yr period comparison[/caption]

The left columns display the worst 10 year periods in the US stock market history. The right columns display the returns for the subsequent 10 year recovery period. The returns in the recovery decades ranged from 100% cumulative return (7.2% per year) on the low side to 325% cumulative (15.6% per year) on the high side. These returns are not guaranteed, of course, but they are based on fundamental economic principals of GDP growth, corporate profitability and reversion to the mean – all of which remain intact today.

Yes, there are lots of problems that need addressing, but this is almost always the case. Despite every episode of “this time it’s different” and “our best days are behind us” our system manages to move us forward. And if we move forward, companies will make money, they will use that money to pay interest on their debt, and the rest will flow through to their shareholders. Knowing how to participate in that process effectively, efficiently and consistently is the foundation of a successful investment experience, which we hope to deliver to you.

This period has been neither easy, nor fun, but we believe that the stage is set for significantly better times ahead. We still may muddle through for a while but someday when we look back on this period, the world will be divided into two groups – those who stuck around and got paid for taking risk and those that didn’t.

Posted by Jay Healy at 7:19 AM
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