Rick Ashburn, CFA

Blog moved....

2012-01-17T13:17:00.000-08:00

I have redesigned our company website onto the Wordpress platform, and all blogs now appear over there. Go to www.creeksidepartners.com to read our latest thoughts.

Click here if you would like to receive our occasional (~monthly) commentary and quarterly newsletter by email. The email is on the Constant Contact platform, so you can unsubscribe whenever you like.

Best regards -- Rick

On Being Ready to Act

2010-06-09T12:00:00.000-07:00

Our outlook over the next 5-7 years is for lower than average GDP growth and a slow grind back to normal employment levels. Over that same time horizon, we expect the nation to gradually come to grips with the fact that the federal government (in the form of Medicare) and state/local governments (in the form of pensions and health benefits) have promised more than they can afford to pay. Something’s gotta give and, whichever form that giving takes*, it will put downward pressure on consumption.

(*higher taxes, shrinking government, higher private savings, etc. "Austerity Measures" is the best catch-all phrase.)

Along with slow GDP growth comes slow earnings per share growth, the two being inexorably linked. During eras of slow earnings growth, stock investors must rely on dividends for much of their returns, and on P/E expansion for the rest. Unfortunately, P/Es are today rather expensive and don’t provide much room for rational investors to expect expansion. The market is today priced at a normalized P/E ratio of around 20; the historic average is around 15-16.

We like to think we are rational investors, and we too are looking to P/E expansion for decent returns. That means we are looking to buy stocks at cheaper prices than today. With the S&P500 at around 1075, we’re not quite there yet. With another 100 point drop…we’re going to buy some stocks. Another 50 more points and we’ll buy more. And so on. With one eye on the important dividend stream, we will focus our purchases on large global companies flush with cash and a demonstrated willingness to hand some of that cash over to shareholders on a regular basis.

As we are fond of saying, we’re not economic forecasters and we are certainly not currency forecasters. We don’t know what will happen among the world’s major currencies, and neither does anyone else. But we don’t have to get the timing right of all these macro events. All we have to get right is the purchase price of our investments. If we get the price right, time and macro cycles will do their thing and we will come out just fine.

We look at the California state budget crisis this way. We don’t know if the legislature will pass a good budget, a bad one or none at all. We don’t even know if the state will attempt to default on debt. We do know one thing however: If we buy the right type of bond at a fair price, we will get paid a fair return. The chance that the State of California (or any local government) defaults on voter-approved general obligation debt and stays in default is about the same as me pitching for the Giants this summer.

So, that’s where we are. We are waiting and we have trades that we are ready to make. If the next year or so is anything like the last couple of years, windows of opportunity will open and shut quickly. Stocks were overpriced for about a dozen years. They got cheap last winter for about a month and are now expensive again. Similarly, muni bonds got very cheap for about six weeks in late 2008. We bought bunches of them and are now waiting for the next panic attack.

In an environment where no conventional investment offers the prospect of satisfying returns, investors need to think ahead and have a plan of action. We have a plan in place, and we are patiently awaiting windows of opportunity.

GDP Report -- A Lesson in Messy Data

2010-05-04T08:32:00.000-07:00

On Friday 4/30 the Commerce Dept. (more specifically, the Bureau of Economic Analysis, or BEA) released its first estimates of economic activity for the first quarter. The headline number was that GDP grew in the first quarter at an annual rate of 3.2%. OK...that's a number, but what does it mean?

First, you need to ask whether that is a figure that adjusts for inflation or not. News accounts didn't make the distinction, and the first few paragraphs of the official release don't say either. I had to dig pretty far into the news release to be sure that, yes, that figure is a post-inflation number.

The BEA estimates total economic output for the quarter and then "annualizes" it...which is a fancy way of saying, "multiply by four" (or, "add one; raise to the fourth power; subtract one"). But, it does little good to know that output went up by 2% if inflation was running at 2% -- the net growth is really zero in that case. So, the BEA wisely factors in the amount of inflation that it measured. Along with the economic output data, the staff comes up with a "price deflator." In Q1 2010, the BEA figured that total output grew by 1.02%. Annualizing that figure, we get 4.1%.

Now the question is...how much of that was eaten up by inflation? The BEA figured that prices rose at an annual rate of 0.9% in the quarter, which results in the net reported figure of 3.2%. With me so far...?

But, if I wander over to the website of the Bureau of Labor Statistics (part of the Department of Labor), I find that those folks figured that prices rose by an annual rate of 3.1%. Subtracting that from the 4.1% total growth rate reported back over at the BEA, and we get a net figure of only 1.0%, not the 3.2% reported by BEA!

So what's going on here? Is this some secret government conspiracy where the Commerce Department wants to say the economy is great and the Labor Department wants to say, no, it's not...? I don't subscribe to such theories. I think simpler and more mundane explanations are at work. The fact of the matter is that nobody knows for sure just what happened in a particular quarter until a year or so later. The Commerce Department has three scheduled revisions of the GDP figures yet to come. Frankly, I trust the Labor Department's inflation figures since they have far more resources dedicated to gathering the data and emply state of the art statistical methods and concepts in deriving a useful price index.

Whichever figure you want to use -- 3.2% or 1.0% -- the fact of the matter is that this growth rate is not sufficient to soak up unemployment. Productivity grows at 1.6% to 1.8% per year; the workforce grows by 1.0% or so. These combine to "use up" all of the growth we are experiencing at the moment, and don't provide much room to put everybody back to work.

The economy is still digging out of a hole and we've got a ways to go.

Stocks Could Keep On Rollin'

2010-04-14T11:48:00.000-07:00

Regular readers (and clients) know that we are underweight to equities at the moment. Meaning that, if a family has a long-term objective of 60% stocks, we only have about half that exposure to stocks and stock-like assets. We made this tactical change in late 2009 when stocks moved into mildly over-valued territory.

Our view is that a collection of stocks (say, the S&P500) is inherently worth some multiple of the ability of those companies to produce earnings. In the short run, earnings are affected by all sorts of things and will spike up and down. In the longer run, the earnings of a large group of companies grows on a relatively stable path, as all the short-term fluctuations (charge-offs, one-time gains, etc.) are smoothed out. If we further adjust for inflation, we find that real earnings growth moves like a battleship -- nice and steady and relatively predictable.

Using data available on Standard & Poor's website, we find that the trailing one-year earnings of the S&P500 companies peaked in June 2007 at $85 per share. As I write, the current trailing one-year earnings are reported at about $60 per share. This is up from the bottoming-out figure of only $7 per share a year ago, and reflects the ongoing and robust recovery. A key question for us now is whether earnings are headed back to their earlier level of $85, or if they will instead now oscillate around a different level. If earnings are headed back to a steady $85, then the S&P500 is worth about 20% more than today's price. If earnings are instead going to settle in the $60 range, then the index is overvalued by about 20%. This is a critical question that can't be answered with certainty, but can be analyzed a bit to understand the probabilities.

In the chart below, the red line shows the short-term variability of earnings (click on it for a bigger view). The blue line is the 10-year trailing average; the dotted line is the trendline of the blue line. As you can see, short-term earnings have recovered right back above the 10-year average.

So, again, our question is whether "it's different this time" and earnings will escalate back to their earlier highs -- and stay there. Or, will they settle nearer to their long-term potential, as shown by the blue and dotted lines? We cannot know for sure, but we need to make a decision about portfolios. To make that decision, we look to the individual investment policies and mandates of our actual clients. Unlike institutional managers and hedge funds, who typically deal with a small slice of a client's overall wealth, we manage most of the life savings of our clients. Our mandate is not, "just go make money," it is a mandate to balance opportunities with the very real fact that this is all the money our clients have, and we cannot risk losing it.

With that mandate in mind, we choose not to make a big bet that "it's different this time" -- even though it might be. After all, earnings moved above trend for most of the 1990's, and stocks went to the moon. As we know, they then fell back to earth. Rather than make that painful and disruptive round trip, we are placing our bets conservatively. We will have to be patient if and when earnings accelerate past a sustainable level, which will surely pull stocks up with them.

Read our quarterly newsletter here for some further commentary on our current positioning.

Greece, Default and Insurable Interests

2010-02-25T09:10:00.000-08:00

You'll be reading more in coming weeks about credit-default swaps on Greek debt. The Fed seems to be interested (finally) and the do-nothings on Capitol Hill might decide to pretend they're doing something.

I've been raging over the danger of credit default swaps for years. A credit default swap is an insurance contract, only it doesn't have the word "insurance" in it. Therefore, it's not regulated like insurance. You might enter into a credit default swap against, say, General Motors bonds. If GM defaults on those bonds, the swap pays you the notional amount of the contract. This is a sensible tool if you own $10 million of these bonds. You worry about default, but you don't want to sell the bonds. So, you buy insurance against loss. Same as you do for your house or your car.

However, a central and bedrock principle of the insurance world is that, in order to buy insurance against some calamity, you have to be at risk of that calamity. I can buy insurance against my own house burning down, but I can't buy insurance against yours. This would create a moral hazard, in that I sit around hoping your house burns down. Who knows...if I were a nefarious type, I might even devise sinister methods to increase the odds that your house burns down. I might figure out ways to impede the fire trucks from getting to your house quickly. I cannot buy insurance unless I have an insurable interest.

The requirement of an insurable interest ensures that no more insurance is outstanding than the potential losses from the event. If a storm causes $1 million in damage, no more than $1 million will need to change hands. It would be profoundly destabilizing to have more money change hands than the losses from casualty events. We'd have the equivalent of people out in the streets stopping fire trucks from getting to fires simply so those people could realize a profit. We cannot have a system wherein certain participants hope that bad things happen to other people. Whenever a lot of (wealthy, influential) people hope that something happens, it generally tends to happen.

The existence of this moral hazard, and the need to outlaw it, was figured out hundreds of years ago. Lloyd's of London has had this policy in effect during its nearly 400 year existence. It is not a new notion that requires new concepts of regulation.

Credit default swaps are a end-run around the requirement that one have an insurable interest. Big banks, hedge funds and other speculators at one point ran the outstanding volume of credit default swaps into the trillions of dollars, against mere billions in potential losses. This is because the contracts can be bought by investors who don't even own any of the subject bonds. This no more a tenable outcome in the financial markets as it is in the casualty insurance market.

There is a very simple piece of regulation that will fix this problem: Credit default contracts need to be called what they are: insurance. And insurance can only be purchased by those at risk of the involved loss. It's really a rather simple concept that has served us well for hundreds of years. But, as usual, the lobbyists will fight back and true reform will probably remain elusive.

A Long Hot Summer for Muni Bonds

2010-02-18T10:20:00.000-08:00

It all seems too quiet right now...but it's going to heat up. The state and local government budgeting process is going to get rolling soon, and the picture is bleak. The sheer size of the budget gaps faced by cities, counties, school districts and the state itself is downright overwhelming. Articles are already appearing that hint at potential bankruptcy filings.

In the face of this, muni bonds are still trading at very high prices -- meaning very low yields. We were offered some 1-year bonds yesterday at a yield of 0.40%.

As regular readers know, we are tactical investors. That means that we spend a lot of time waiting for opportunities -- opportunities to move into cheap assets or to move out of expensive ones. Right now, muni bonds are expensive...and we are waiting. While we are quite reluctant to get into the predicting game, we do sometimes play the expecting game. And we expect that the mid-summer budget distaster will reach a crescendo at some point and investors will flee muni bonds the way they fled Fannie Mae and Greek bonds.

If that fleeing occurs, we will buy bonds by the fistfull. As we have written before, some muni bonds are genuinely at some risk of default. But, many types of bonds are "money-good" even under a bankruptcy proceeding. Municipal bankruptcies aren't like corporate proceedings...courts don't dissolve the entity, sell the pieces, and distribute the cash to bondholders. School districts, cities and the like can't "go out of business." They don't have "equity" to give to creditors upon a default.

I read a recent rating agency report that confirmed the AAA credit rating on the general obligation bonds of my favorite California small town. This high credit rating is much deserved, and the report touted at some length our town's prudent fiscal management. But, here's the catch: The credit quality of those bonds has almost nothing to do with the town's prudent fiscal management.

The City Council doesn't "appropriate" the bond payments -- fitting them into a budget of many choices. No -- the bond payments come directly off the property tax bills that are printed, mailed and collected by the county tax collector. Should, heaven forbid, our dear town find itself in bankruptcy, the bonds payments will continue to flow from property owners, right on past city hall, and straight to the county's money pool, from where it will be sent to the paying agent for the bonds.

These are the types of bonds that would get beaten down along with other, more risky, types of muni bonds. And we will be standing by in the heat of July ready to fill our portfolios with misunderstood and high-yielding bonds. We saw the same opportunity in late 2008 and we took advantage of it then.

My Two Cents

2009-12-30T14:10:00.000-08:00

I've been writing newspaper columns, blogs and essays fairly regularly for about the past 8 years. In all that time, I have stayed away from the other half of the "friendly gathering taboo" duo: politics, or at least, political policy. It's said to never discuss money or politics in polite company. I violate the former all the time, but I generally shut my trap on the latter. Why? Because people pretty much hold their opinions strongly, and are only interested in mine to the extent that they can then berate me for my foolishness. Given that I am an avowed political eccentric -- simultaneously holding both left- and right-handed views -- everybody I meet is always ready to disagree with me about something. And, since I am as stubborn as they are...I don't really want to hear it. So, we talk about sports or the appetizers instead.

But, just this once -- I've got an opinion to share and it's about taxes. First, I will establish that I'm not a harsh anti-tax table-pounder. We want stuff; we have to pay for it. Taxes pay for the stuff we like getting -- roads, schools, courts, jails, firemen, police, parks, beaches, cash-f0r-clunkers rebates, etc. Don't get me wrong -- I don't favor tax increases. We pay plenty here in Cali, and the state is going to have to figure out how to cut expenses. Ditto the feds.

My problem with the tax code is its bass-ackwards investment incentive structure. As currently written, the capital gains tax rate only makes one distinction: how long did you hold the investment asset? If you held it a year or longer before sale, you profits are taxed at a 15% rate. The intent here is to move away from short-sighted trading strategies into more stable long-term outlooks.

Let's take a sidetrack for moment so that I can make a distinction between investments that add to economic productivity and those that are merely transfers of money from one pocket to another. If a plumber spends $25k to expand his business (buying tools or training apprentices), that investment of $25k was productive. If instead he buys $25k worth of Google stock, that investment was not productive and will have zero effect on job creation or GDP growth. Remember, when we buy stock, we buy it from someone else. Google doesn't actually get any of that money.

In the tallying up of the National Income and Product Accounts, stock purchases are not "investments." Purchases of commercial equipment are "investments." Productive investments are those that put money directly to work in profit-making enterprises. If you buy a condo that already exists simply to flip it to the next sucker, you are making a non-productive investment. If you build or significantly remodel a condo, and then manage it over time for income, you are making a productive investment. You have to understand that the VAST majority of money that flows into and around Wall Street has nothing to do with actual productive investment. Most money spent on productive investments in the U.S. comes from retained earnings. The plumber, and Google for that matter, expand their businesses by deploying money they earned in the past. Wall Street provides only a tiny fraction of actual productive investment capital. Our national obsession with "saving Wall Street" is based on the myth that, without Wall Street, businesses will have no access to investment capital. The reality is far different.

Yet, the tax code provides an equal treatment of productive and non-productive investment profits. The long-term capital gains tax rate of 15% applies equally to hedge funds trading currency swaps and to the plumber who one day sells his business to retire. This is, in my view, absurd and destructive. Your Congress has swallowed this story whole-hog from hedge fund managers:

"If you are going to ask me to be in the same tax bracket as a plumber, I cannot be bothered to get out of bed in the morning. I will be forced to close my business. I can get by on $10 million a year. If you tax me to the point where I can only make $9 million a year, then I will have no choice but to stop working and go on welfare. Tax the plumber and leave me alone."

I am paraphrasing here an actual bit of testimony before Congress the last time it considered requiring that hedge fund managers pay income taxes instead of capital gains taxes.

Our business tax policy should create incentives to make actual, productive investments instead of encouraging the non-productive and speculative practices of simply moving money and assets from one account to another, while skimming off the crumbs as they go by. These trading practices should be taxed at ordinary income rates, since they are returns not based on real additions to GDP, but are instead returns to the labor and skill of the traders. In all other professions, income earned for labor and skill is taxed at ordinary rates. Only on Wall Street are such skills taxed at artificially low rates under the lie that the income is based on "investment returns."

So, here's my rough proposal as we move into what should prove to be an interesting year as Congress is forced to re-consider the Bush tax structure:

Capital gains realized from the sale of productive investments will be taxed at 15%. This will include pretty much all small businesses since their cost basis is entirely productive investments. Buying a condo and flipping it a year later is not productive -- it's trading income and should be taxed at ordinary rates. If you construct a building, rent it out and sell it later, you can have the 15% rate.
Corporations should get a full expense deduction for dividends paid out to shareholders, to the extent they are less than or equal to taxable earnings. Corporations should not pay a punitive double-tax for returning cash to shareholders.
Capital gains taxes on ordinary stocks, bonds and mutual funds should depend on who you are. If you're a household taxpayer (or a trust benefitting a household), you qualify for the current long-term capital gains rate of 15%. If you're a hedge fund, investment bank or other entity that is in the business of making such profits, your profits are taxed at ordinary income tax rates.

My frustration with the tax code is that it rewards non-productive "investment" behavior the same way as it rewards productive investments. Our long-term economic growth depends entirely on productivity growth. Productivity growth arises from productive investments in equipment, research and education. It does not arise from condo-flipping, day trading and CDO-packaging.

Tactical Changes - Tale of Two Outcomes

2009-11-19T10:38:00.000-08:00

In our quarterly commentary, we carried the theme that we are at a crossroads. While we still feel that's true, we feel that both roads lead to disappointment for holders of long-dated risk assets.

I don't mean to make this overly simplistic, but I'm going to try anyway. Here is the investment decision of our time, and investors (and their, ahem, advisors) need to take sides:

Either inflation will rise in the near term or it will not.

As we have written, the Fed is desperately trying to get prices moving up again. Part of its mandate is price stability. What that really means in a paper-money world is a controlled and predictable slow rise of prices. Say, 2.5% to 3.5% per year. The Fed is deathly afraid of deflation. Money supply has grown barely 5.5% in the past year and the Fed would probably prefer to see it grow twice that fast. What little money growth we're getting seems to be pouring into financial assets (and gold) rather than into business expansions and paychecks.

The argument for high inflation takes the position that the Fed will get what it wants, and probably overshoot the mark. Couple that overshooting with rising borrowing demands and you've got yourself an inflation/interest rate/falling dollar scenario that scares the bejeezus out of the doom-and-gloom crowd. Global collapse and all that.

On the other hand...

The Fed could fail. Compelling arguments can be made that without a surge in consumer demand, you just can't get a wage-price spiral rolling. The Fed reports that we're running our economy on 70% of its productive capacity. The official unemployment number is above 10% and the real, actual unemployment number is probably north of 15%. At no time in our history have low capacity utilization and high unemployment numbers paired up and produced spikes of inflation. For reference, capacity utilization was above 83% when inflation spiked in 1978-1980. It takes more than money expansion to produce inflation in the near-term -- it also requires that more money is chasing less output capacity.

There are smart, experienced and successful investment celebrities both sides of this bet-of-a-lifetime. We're not here to make big bets. The difference between most of those pundits, bloggers and analysts is that they either (1) don't invest other people's money for a living; or (2) only invest a small subset of other people's money. If the latter, their job is to be aggressive and be right. If they are neither, they get fired and the client has only lost a few dollars.

Our job, on the other hand, is to preserve the entirety of our clients' life savings. In over 90% of our client relationships, we oversee the entire investment portfolio. We therefore make more measured bets and always err on the conservative side of split decisions. We are tactical allocation investors. The classic model of tactical investing means that, absent a compelling reason to move into or out of an asset class, we stay neutrally invested in a vanilla mix of stocks and bonds. Say, 60% stocks and 40% bonds, with a little foreign thrown in there for flavor.

We are instead going to move away from the classic model. Rather than stay in a vanilla portfolio while waiting for clear signals and opportunities, we are going to move more strongly into a defensive stance. We are in the process of reducing holdings of equities and high-yield bonds and will move those funds into short-term bonds and TIPs, both domestic and foreign. These assets have moved up significantly over the past 9 months. We have profited nicely and it's time to take some of those profits.

Then, we will wait. When there are cracks in the prices of assets that we like for the long-term, we will buy a little and then wait some more. When we look at the choice between "inflation soon" and "inflation later" we see little upside for stocks over the next few years. This is particularly true since we believe that stocks are already trading above their long-term fair value.

So, while the debate rages between a "V" (straight up), a "W" (double-dip) or an "L" (extended doldrums), we will sit quietly by and wait for opportunities.

Thinking About Gold

2009-10-28T12:19:00.000-07:00

We've been thinking a lot about inflation risk lately. As was discussed in our recent quarterly commentary, we grind our teeth at night worrying about the potential for an uncontrollable rise in the money supply, interest rates or both. In the past year or so, the Fed has added more money to the reserve accounts of its member banks than was the entire global supply of currency before August 2008. We took 100+ years to put $900 billion into circulation. We took merely a few months to add an equal amount to banks' reserve accounts. The banks are now free to withdraw that money and start lending it out; the usual multipliers will kick in and and what starts out as, "Good news! Banks are lending again!" turns into, "Yikes! A gallon of gas costs six bucks!" That worries us, and we think it should worry you. (As soon as you start reading stories about how banks are lending madly again, go fill up your tank.)

Our job at Creekside isn't to fix such problems. Those who recently rifled through Timothy Geithner's phone records learned that he hasn't been calling me for advice. Our job is to accept the world as it is and make investment decisions for our clients that, we hope, keeps them moving forward toward their financial goals.

That leads us to consider all the available asset classes and ask what might be the effect on that asset class if high inflation does, in fact, come to pass. While some assets, such as stocks and real estate, keep up with inflation in the fullness of time, that time horizon can be unacceptably long. We think about asset classes that can offer the possibility of keeping up with inflation in real-time. As you might imagine, we field a lot of questions about gold as.

It is true that gold will generally rise in periods of accelerating inflation. The problem is that its rise and fall is far out of scale to the nature of the problem -- and the reversal of the problem. The price index grew by 36% between fall 1976 and spring 1980. Gold rose by 740%. While you might think that proves that gold covers inflation, it should in fact give you pause. Gold prices wildly overshot inflation. When a price overshoots its proper place, it inevitably falls back to earth. Sure enough, gold had lost more than 60% of its value by summer 1982. Between spring 1980 and summer 1982, the price index rose by 22% and gold fell by 63%. Some inflation hedge!

If you were fortunate enough to have gotten in early -- say by early 1978, then you ended up with decent inflation protection by the summer of '82. Gold did cover inflation over that period, from where it started to where it bottomed out.

In our view, the extreme volatility of gold is in large part due to the fact that so little of the world's gold is available for investment applications. Jewelry, dental and industrial uses consume some 90 percent of the world's annual gold production of about 2,200 tons. The total annual production of gold would make a pile that would fit in your living room -- and only a small fraction of it ends up in coins or bullion. The world's entire historical accumulation of gold in all forms would make a cube that would fit on the infield of a Little League baseball diamond.

Given the somewhat small market for actual gold, it is surprising (to me, anyway) that the annual futures market trading activity in just the Chicago exchange exceeds $3.4 trillion dollars! That trading volume is about 40 times the world's actual yearly production of gold -- and Chicago is just one of many worldwide exchanges. (Coincidentally, that figure equals the approximate market value of all gold that exists in the entire world.)

The result of this very large amount of money chasing around this very tiny amount of gold is that a surge in demand for gold can easily send its price soaring past all measures of reasonableness. We expect that will happen if inflation accelerates. We also expect that the price will collapse once the inflationary fears abate -- as happened in the early 1980's. We are quite reluctant to buy into an asset class whose profit potential is utterly dependent on getting the starting and ending dates right.

We can grant for the moment the goldbug's assertion that, volatility aside, gold will keep up with inflation. True enough, perhaps. But -- how much of your portfolio are you going to invest in gold? Some gold proponents say 2-3%; others 5%. The more aggressive folks say 10%. Now, let's imagine that the consumer price index rises twofold over the next five years -- bordering on hyperinflation. If gold matches inflation (and it has never done more than that over a full economic cycle), a 5% position in gold will have added 5% to your portfolio value (since the gold doubled in price). That's about 1% a year contributed toward your inflation protection, during a time when inflation was raging at nearly 20% per year.

Not such a great hedge, eh? The only way gold is going to cover your loss of purchasing power over an entire bust-boom cycle is if you put everything into gold. And then you hope and pray you bought early enough, and will sell out at the right moment.

We agree with the premise that, in the face of runaway inflation, we are well-advised to own "real" assets instead of paper ones. However, we think that gold is not that asset. While gold is a physical commodity, its market price is as often as not fueled by the same irrational human emotions and "animal spirits" as are the prices of paper assets (eg, stocks or currency). We prefer physical assets that have a role in the production chain instead -- industrial metals, oil, gas and other natural resources. With a far larger base of annual production and consumption, we are more confident that the prices of these assets will stay more closely linked to the real world than will the highly emotional price of gold.
While we worry about a spike of inflation over the next couple of years, we think there are better ways to position our portfolios than making a meaningful commitment to gold. We have our bonds concentrated in short maturities (less than three years); we have our stock positions tilted toward energy and natural resources companies; we have overweight positions in foreign-denominated stocks and bonds. We are in the midst of a closer look at inflation-indexed bonds, or "TIPS," and will publish our conclusions soon.

We have taken a serious and sober look at gold, and we can only conclude that the risks far outweigh the potential benefits. We believe there are less volatile and equally effective ways of mitigating the effects of inflation on our clients' portfolios.

Whoa...Slow Down There, Cowboy!

2009-08-07T09:40:00.000-07:00

I'm about to head off on a nice week to the beaches of San Diego with my family. But before I go, I thought it important to remind our clients and readers of our outlook and tactics for portfolios.

At the top of most folks' minds at the moment is the historic rally in the stock market since its bottom in early March. A 50%+ rise in so short a period has only been matched one previous time in the last century. I'm getting calls even from conservative investors imploring me to get heavily back into stocks. Momentum is a very real effect on near-term stock prices and it's not to be ignored. Stocks surely could continue to rally strongly as the year rolls on.

But we don't think it is worth the risk. First, and most importantly, we now believe that stocks have pushed past fair value. As Jeremy Grantham recently lamented, stocks spent about 15 years being overvalued. They went below fair value for all of a couple of months and are now look modestly expensive again. Life's not fair.

In our opinion, fair value for the S&P500 is around 925 (it's at 1000 today). Important to note is that our view of fair value already assumes a full earnings recovery. It's not like we think the market is worth 925 based on today's temporary depressed earnings -- we think that is the right price after earnings recover from the recession. The recent good earnings reports are merely the path back to normal earnings. These earnings reports do not warrant pushing the S&P500 back over 1000.

The second point I'd like to make is that, while stocks have had a huge rally from the March bottom, they are only up about 11% year to date*. We ask the question: Since we have been underweighted in stocks, how have the assets performed that we bought instead of stocks. Quite nicely, thank you.

What we bought with money that would otherwise be in stocks:
Foreign Bonds = up 15% year to date
High-Yield Bonds = 32%
Energy Stock Fund = 26%
Natural Resource Fund = 37%
Muni Bonds = 10.2%

(*Vanguard S&P500 Index Fund returned 11.03% through 7/31/09)

So, while the stock market has had a sharp V-shaped year, our average client has had a far smoother ride and has ended up at a slightly higher point.

The standard disclaimer applies: Past results are not necessarily indicative of future performance. All investments bear risks. For a complete description of Creekside's performance composites, you can email me at rick@creeksidepartners.com.

Again -- and this is very important -- we believe that the S&P500 at a price of about 925 is the fair value of the market after a full recovery from the recession. That's why we're willing to pay that price today. But we are not terribly willing to make full allocations back to stocks at a price closer to 1000.

Cheers,
Rick

Over-Expectations

2009-06-22T14:58:00.000-07:00

It's been a while since my last blog. Spring, little league baseball and too many hours spent pondering the state of the world have distracted me from my scheduled semi-occasional written musings. Not that I haven't been thinkin' -- I just haven't been writin'.

I've spent many of my waking hours trying to figure out what to make of all this. The economy doesn't seem to be in free-fall any longer. It is, as best I can tell, far from a recovery. But still, we have reached somewhat of a steady-state. Consumption, income and employment are all below previous highs. I expect they might stay that way for a while. Stocks have recovered strongly from the lows reached in early March.

As money managers, we have gone from a six-month state of constantly reacting to rapid changes (I made more trades from Sept 08 to April 09 than in the previous six years combined) to now having a little breathing room to make some forward-looking decisions.

Most of my head-scratching the past six weeks havs been about stocks. What should we expect from stocks? After staring at data series to the point of blindness, I have some thoughts about expectations. Namely -- people expect too much from stocks. We are prone to anchoring our expectations in the good years (double-digit returns) and forget to factor in the so-so years (losses). I still come across articles by various financial planning pundits such as Suze Orman that counsel us to expect high returns over any given reasonably long holding period. Such advice is usually accompanied by a cherry-picked starting and ending point for the analysis. The starting point is invariably a period of low stock valuation, and the ending point is one of normal or high valuation. Of course returns were high with such assumptions. But, if you bought stocks in 1966, you have had a lousy 43 years. Bonds would have done better.

But really -- what can we expect with some degree of certainty, or at least rationality? Your stock portfolio grows faster than inflation due to three and only three sources:

- Growth in Real* Earnings per Share
- Dividends
- P/E* Expansion

(*"Real" means after-inflation; "P/E" means Price divided by Earnings, using our method of adjusting for inflation, and averaging Earnings over 10 years to smooth out accounting shenanigans.)

The earnings per share of a large basket of public companies grows at a real rate about 1-2% less than the growth rate of GDP. You would think that these companies would grow their collective earnings at about the same rate that the whole economy grows. They do actually come close, but that's on an aggregate basis. Your portfolio of stocks only goes up if the earnings rise per share -- and big companies relentlessly dilute their shareholders with new share creation. Since 1945, real EPS grew at 1.7%; real GDP grew at 3.3%. Over longer periods, the gap is worse.

So, let's assume that real EPS grows at an optimistic 1% slower than GDP. In a near-perfect world, GDP grows at about 3 to 3.5%. Alas, the world is not perfect in the U.S. Working age population growth is slowing -- and that growth rate is an arithmetic addition to GDP growth. If you drop 1% off the population growth rate, you eventually reduce GDP growth by the same 1%. GDP's other arithmetic input is productivity growth (yes, those are the only two long-run inputs to GDP growth), and productivity growth is likely to be dampened as we work off our debt. So, we've got a double-layer wet blanket thrown over the economy.

I would be surprised to see real GDP grow by more than about 2.5% per annum over the next decade. That would mean real EPS growth in the 1-1.5% range. (And I don't mean growth from the temporary lows of today -- I mean growth from the line we were on before the boom and bust. Growth back up to that line is merely a recovery -- it's not really moving us forward.)

Add the current 2% dividend rate to that EPS growth figure and you get an expected return on stocks of 3 to 3.5% after inflation. And, in fact, that's the return we've achieved since the last time the market was priced like it is today. (See the blog below for our discussion of the price of the market.) This is the "baked in" return on stocks -- it will grind away in our favor regardless of what the market does year to year.

Now -- what about P/E expansion? Yes, every rise in the P/E ratio is additional returns to stock owners. If the P/E rises from 17 to 22 over a three year period, that's a bonus of 8.8% per year added to our 3-3.5% expectation. Good times indeed!

But, should you expect the P/E to expand from its historic levels in the mid-to-high teens? If it is low to start with, sure. But, if it is at or above reasonable long-term levels, no. Realize what you are expecting to happen if you expect to sell your stocks to somebody else at a higher P/E in the future. You bought stocks expecting a return of 3-3.5%, and you are hoping someone else will come along expecting something lower and buy your stocks from you. Remember, the 3-3.5% expected return is baked in and doesn't change with the market. The more someone pays for stocks, the more they are eroding their ability to actually capture that 3-3.5%.

P/E expansions above trend are only sustained by the speculative hope that someone will come along and pay more. They are not sustained by fundamentals.

We expect stocks to pay 3-3.5% real return over the coming 7-10 years -- we are not going to hang our retirement hopes on P/E expansion. That is not a terrible return, but it does give us pause in going back to full stock allocations. It's because stocks are not a take-it-or-leave-it choice. They are an either-or choice, and we have other assets to choose from that offer similar or higher expected returns.

More on those choices in the next installment...

Buy & Hope

2009-05-04T10:18:00.000-07:00

After what we've experienced these past 18 months in the investment markets, it is tempting to throw out the age-old wisdom that we should buy and hold our investments. We might begin to question Warren Buffet's adage that the ideal holding period for a stock is "forever."

However, I would implore readers not to react hastily and toss out this investment rule simply because of recent events. I instead implore readers to toss it out without regard to recent events! I tossed it out years ago, even while it was working.

The notion behind "Buy and Hold" -- or what I prefer to call "Buy and Hope" -- is that stocks are always and everywhere priced fairly. That is, they are never too cheap or too expensive, and you are foolish to try to divine anything different. Why? Because economic theory says so.

(Or, rather economic conjecture says so. In the real sciences, ideas supported only by argument or math are mere conjectures -- educated guesses. They only rise to the level of theory upon proof by repeatable out-of-sample experiment. Economics is alone among the "sciences" in that it awards prizes and honors solely based upon the elegance of the argument, not based on whether the argument is actually true or not. So anyway...)

The Buy and Hold devotees will suggest that, in the long run, everything works out fine and that average returns will accrue to you if only you are patient. And this is nonsense. Average returns assume that you bought at the average price. As I wrote in my most recent quarterly letter, the actual price of stocks, when measured in appropriate units, varies all over the place. History (and common sense) tell us that the higher the price you pay, the lower will be your returns.

Ah, perhaps true, say the Buy and Hold folks. But the long run will bail you out. And I say -- no, it won't. If you pay too much for stocks, you are screwed. For the long run. If you bought at the PE peak of 1966, you have done worse over that whole time by owning stocks than if you merely rolled over 3-year Treasury notes. 43 years and you're still worse off than a bond investor. Sure, I like the idea of "the long run" -- but, really, just how long am I supposed to wait?

If you bought at the peak of March 2000, you will probably be sitting there 40 years from now wishing you hadn't.

Back to "Buy and Hold" -- Buffet is right, but only if, like he, you buy on the cheap. The idea of hanging on through thick and thin must still begin with the initial wise investment decision. If you buy an asset cheaply, it will almost certainly pay off for you if you are patient. If you pay too much, it will almost certainly disappoint you, no matter how long you hold onto it.

In our view, Buying and Holding is a subset of our overarching theme of tactical allocation. Buy cheap and hold the asset; sell expensive assets and look for something better. There is never a place for a pollyannish view that one can blindly buy broad asset classes and then strap in and hope for the best.

In the usual bass-ackwards way they serve their customers, big advisory firms are now suggesting that perhaps clients shouldn't expect to buy and hold all the time. The paradox here is that the current market has moved into the price conditions that will probably make Buy and Hold a wise strategy for a number of asset classes for a while. Many advisors and investors will switch back to the Buy and Hold mantra as these assets begin to get expensive again; we hope to be moving out at that time. And the cycle will go on.

Saying All the Right Things

2009-03-16T14:43:00.000-07:00

I've only been writing this blog for a few months, but I've been setting my investment opinions down on paper for about six years now. If you read what's on here, you might come to the conclusion that I'm saying a lot of the same things most advisors are saying. Just about everyone is saying the right things now: Things will turn out OK; stocks are cheap; be patient.

The problem is this: Most of *them* were saying the same things two and three years ago. I wasn't.

In this "I told you so..." installment of the blog, I offer some examples of past writings.

Going back to my April 2005 client letter...

"Most every major asset class is overvalued. The world trade system is precariously unbalanced and at some risk of painful correction...The savings rate in the U.S. is now teetering on the negative. Our irrationally exuberant habit of tapping our home equity to buy SUVs and big-screen TVs continues to prop up the economy in the face of dismal real personal income growth...It has been more than a year since we unwound fat-pitch positions in REITs and High-Yield bonds...Sure, we own some stocks and some bonds, but our core models (and the vast majority of actual client portfolios) have about half of the normal allocation of stocks and medium-term bonds..."

"My major investment theme these days is “keep your head down.” This is not the time to acquire volatile assets. The return expectations are too low to compensate us for the risks. I have some clients encouraging me to take more risk — saying that they can accept the risks. Sorry, but I can’t advise the traditional risks right now."

"I am quick to remind clients that stocks decline by an average of over 40% in a recession. I have no reason to believe the next recession will be any different. That means that, sometime between today and whenever the next recession starts, stocks need to rise by 75% if we hope to just break even after that recession is over! ... When is the next recession? I don’t know, but I am going to be utterly shocked if it takes longer than 3 years to begin. That would mean stocks must rise more than 20% in each of the next three years in order to ensure that our portfolios can survive a 43% decline during that recession."

Flash forward to October 2007, as the market was peaking and all the bad financial system news was supposedly behind us:

"By now, you have read the explanations for these gyrations: The drop in the housing market has led to a high rate of defaults in the sub-prime mortgage markets. Simple enough, and we would agree that mechanism is the likely top-line trigger of much of the turmoil. However, we suggest that the sub-prime meltdown is a mere special case of a larger and more general problem. The larger problem is, well, larger – and is far from resolved."

"Wall Street does not stand idly by and let market conditions get in the way of profits. The simple answer to the lack of satisfying risk premiums: leverage. Take more risk than your capital would normally justify. Borrow as much money as you can, and buy any asset that offers the tiniest bit higher yield. There are only two catches – you have to believe that (1) the assets you buy will hold a steady value; and (2) the money you borrow will always be available."

"Trying to make money by borrowing at 4% and investing at 5% is like trying to squeeze blood from a stone. You can squeeze and squeeze, but you eventually realize that the blood you see on the ground is your own."

"Still, we believe that the worst is not over. The crisis in the credit markets is deeper and is festering. Too much money was lent too readily, for questionable purposes, for too long. Already, we see the cancellation of large private equity deals and leveraged buyouts. The commercial paper market remains tenuous. Mortgage approval standards have risen dramatically (as they should). The housing market is in an apparent free fall. Price drops haven’t hit every town and every price range – yet."

And, finally, in January 2008 we were saying:

"Our outlook for 2008 is significantly more cautious than in recent years. While in past years we have been worried about the high value of stocks, we have not been terribly worried about the economy in general. We are not in the business of forecasting recessions. However, if we were...we might forecast a recession for 2008."

"The intent of the Fed’s lower rates is to stimulate borrowing, which in turn could stimulate general economic activity. We’ve been around the debt markets long enough to know that if people can’t even afford the principal payments, they sure can’t afford the interest payments, no matter how low the rate might be. If a mortgage on an office building exceeds its market value, a lower rate will not cure the situation. The building owner will be likely to just walk away and let the bank foreclose."

"Domestic Stocks. Value range: 4.5 [out of 5.0]. In our valuation methodology, stock valuations are in the highest 10% of periods over the past 100 years. Returns over 5-year periods following valuations like we see right now have been near zero over inflation. We are underweight domestic stocks by 15-50%, depending on client objective."

Those who've been following us for several years probably began to think we were perma-bears. The flip side now is that I worry that new readers will think we're like everyone else -- perma-bulls. We're neither -- we are rationalists who take current prices and conditions for what they are and make decisions accordingly.

What can I expect

2009-03-02T14:40:00.000-08:00

We calculate the P/E ratio on stocks using Robert Shiller's method: Take the last 10 years of reported earnings on the S&P500; adjust for inflation; average those numbers. That produces a quite reliable figure for future earnings expectations -- the peaks and valleys of the business cycle (and accounting manipulation) get smoothed out and we have a sensible picture of the capability of this group of 500 companies to make money.

The "Shiller P/E" closed at 12.3 today. So, I ask a simple question:

In past eras, what have stock returns looked like in the five years following a P/E like this? In other words, if I bought stocks when the Shiller P/E dropped under, say 13, how did I do over the next five years?

Answer below.

The image is a little fuzzy (click on it for a clear enlargement), but that "Worst 20%" bar says 4.7% per year; the "Best 20%" bar says 20.1% per year. How many periods only returned 1% or less? Four out of 417.

Our message: This is not the time to panic or bail out.

How Low Can it Go?

2009-02-18T13:55:00.000-08:00

I figure there's a ten-to-one rule that applies to questions. For every client that takes the trouble to call or email me with a question, there have to be ten others who were thinking the same thing, but didn't ask me outright. I got three calls the past two days with the same question, so about thirty others are out there thinking about the same thing.

How low can stocks go from here? We're down 12% from the start of the year already, and we're testing the low set back in November. Do we stay the course? Do we bail out?

Giving the honest answer first: Yes, stocks can go quite a bit lower from here. We have no way of knowing and no way of making a forecast. All we can do is look to the current situation and consult some history.

By our estimation, the S&P 500 at 788 (today's close) represents an under-valuation of about 17%. In the great majority of past eras when stocks could be purchased at this valuation level, investors have been amply rewarded with annualized returns over the ensuing five years of 5% or more above inflation. On that basis, we are quite confident that our investments in stocks will turn out nicely if we are patient.

But, that avoids the question: How low can it go? In the previous two major bottoms (and major recessions), stocks fell to much lower levels. Adjusting everything in terms of today's prices, the S&P500 would have to fall to about 400 in order to match the low of 1982 and 475 to match the low of 1974. Those are staggering numbers, to be sure. When stocks bottomed in 1974, they did so from a valuation peak reached in 1965; fair value was reached in 1970.

The low reached in 1982 wasn't really off of any highs or even fair-value -- stocks bottomed in 1974 and stayed below fair value all the way out to 1990. Sixteen years! That long period of below-trend valuation is what set up the 19 year bull market that ended in 2000.

We are today below fair value off of a valuation peak reached at the end of 1999. We only touched fair value (for the first time since 1990!) in October 2008. We have had an 18-year round trip from fair value to fair value. As a side note: Annualized return over that time? 3.3% after inflation. So much for stocks paying a long-term return of 5-7% above inflation, as some pundits claim. When stocks are bought for fair value, and then sold for fair value, the returns aren't all that stunning. Why? Because corporate earnings growth per share isn't all that stunning.

Now for the important part -- the, "Yeah, but..."

At both of the major market bottoms in 1974 and 1982, inflation was very high. Annual inflation touched 12.3% in late 1974 and hit 14.7% in mid-1980. Inflation had already started to moderate by the market bottom of 1982, but interest rates were still high and corporate earnings were still declining.

At each of the past two major market bottoms, the country was experiencing not only a sharp recession, but strong inflation to go with it. In any economic recovery, we will expect inflation to move higher. What we do not expect is for inflation to run into double-digits and to precede the economic recovery.

So, that is what we are paying most attention to: Will inflation spike above the long-term "tolerance" level of 3-4%, or will it spike sharply higher? Will that inflationary spike occur in conjunction with an earnings recovery, or will the inflation arise before a recovery? If inflation arises too soon, and rises too high -- stocks are in for a hard time. As I wrote in the piece below, we worry about inflation moving above-trend over the medium-range cycle as the economy recovers.

Our outlook, then: We expect any sharp spike of inflation to be short-lived. Unless employment is in a full-bore recovery, we expect the Fed to move quickly to quash any inflation above its policy range. Likewise, we expect any sharp selloffs of stocks driven by inflation worries to also be short-lived.

We do, however, expect a genuine economic recovery to be accompanied by an orderly movement of inflation to somewhat above trend. In the fullness of time, this movement is the one we want to anticipate and protect against, as it will grind down the value of our investments.

As I have written before, an investor can implement strategies to protect against short-term inflation or long-term inflation. But you have to choose which is the bigger concern. You can't really have it both ways. We choose to place modest protections against short-term spikes of inflation (natural resources, energy) and stronger protections against persistent inflation (short bond durations, stocks, real estate).

In sum, stocks can certainly go lower from here. However, we believe any such move will be short-lived and will offer us the opportunity to rebalance portfolios to take advantage of low valuations.

Tactical Change to Portfolios

2009-02-11T08:53:00.000-08:00

In the post immediately below this one, I offered some thoughts about a potential dollar decline. In the interim, I've done some more thinkin' and analyzin' about our current state of affairs, including the imminent stimulus package. As has often been the case over the past several years, I found in the writings of Jeremy Grantham the crystalized message that had been foggily drifting around in my head. I couldn't quite get my hands on that fog, but Grantham managed to present me with a "That's it!" moment.

We are in the midst of a great write-down of asset values -- real estate and equity in businesses for the most part. Prior to this value destruction, total private debt was about half of the asset values. As the values come down, so too must the debt. We are headed for a debt reduction in the $10 to $12 trillion range. That reduction needs to occur before we can return to our long-term GDP trend line.

There are three ways to reduce debt.

One: The old fashioned way -- pay it down. Stop consuming and investing and instead use cash wages and earnings to pay down debt. This translates into a drawn-out period of suppressed economic activity. And it takes a long time.

Two: Default. If you don't pay it back, and the lender can't collect, the debt kinda disappears. This is problematic for you, to be sure, but it's happening right now on a grand scale.

Three: Inflation. If you can pay back a dollar of debt incurred in 2005 with a dollar-fifty of money earned (for the same work) in 2012, your debt has effectively been reduced by a third.

The first of these is modestly underway at present. Consumer saving rates rose sharply in late 2008, and much of that saving is going to pay down debt. But, this is a slow, slow process. For historic precedent, you can look to Japan's economy post-1989. It took the better part of 15 years, but this is how Japan largely managed its debt reduction. We have bet on this trend by continuing our underweighting of stocks and real estate.

The second of these is emphatically underway and we're not the only ones to realize it. Default rates are exploding upwards. In fact, we expect to profit from a probable over-reaction in some sectors. We've purchased debt at discounts of 20%-30% on which we expect to incur loss rates of only 0%-15%.

The last debt-reduction method (inflation) is not yet in full swing. However, it's coming and we want to be ahead of the curve. The stimulus package, together with the Fed's continuing commitment to create (ie, "print") money with a vengeance, all but ensures an above-trend period of inflation sometime over the next X years. How long is X? We cannot know for sure, but we think the cost of being early is low.

Our principal current investment positions that provide insulation from a weakening dollar and rising inflation are energy and natural resource stocks. We have also kept our bond maturities short, but that's more of a defensive posture than a profit-seeking one.

This week, we have added positions in developed-market foreign bonds. We owned such positions for several years and gradually eliminated them throughout 2008. We are buying those same positions back now, but at about ~20% lower prices. The exposure to foreign bonds is a hedge against a weakening dollar -- if the dollar weakens, the bonds rise in value. If we are right, we profit nicely. If we are wrong, we earn about the same interest rate we could earn on domestic bonds. We think the odds of the dollar strongly strengthening from here are low.

This is my favorite type of investment scenario -- one where the payoff probabilities are asymmetrical. The downside is low or improbable; the upside is high or probable.

We will continue to watch carefully for opportunities to shift gradually toward an inflation-defensive posture.

What if the Dollar Collapses?

2009-02-02T10:25:00.000-08:00

We get this question with some regularity, so I figured I'd write up our thinking. The dollar has been gaining strength against foreign currencies since last July, when the bottom started falling out of the US economy. By "gaining strength" we mean that a dollar buys more units of a foreign currency than before. If one dollar bought 50 units of currency X, it now buys 60 units. If a cup of coffee in country X cost 50 units in July, and 50 units today, we come out for the better since we now have both the cup of coffee and 10 extra foreign currency units to spend. That's why we use the word "strengthen" -- our currency buys more foreign stuff, all else equal. The word "strengthen" sounds positive, and the word "weaken" sounds negative. As you might expect, people tend to panic at the thought of our dollar weakening or even plummeting. If it sounds bad, and if it uses scary words to describe, it must be bad...yes?

Before we get to worrying about that, I pose the somewhat glib and off-hand question, "Why do you care if the dollar falls?" What really happens when the dollar falls? What direct effect does it have on your life? The answer -- like everything in economics -- is, "It depends." In ECON 101, we learn that when the price of something changes, there are two opposite effects going on at the same time. On the one hand, the seller gets more money per unit sold and that puts upward pressure on his total revenues (the "Income Effect"). On the other hand, people will reduce the number of those things they buy by shifting their purchasing to substitute products (the "Substitution Effect"). That puts downward pressure on the seller's revenues. Which effect wins out? No way to know -- it depends on the specifics of the situation. And so it is with the selling of the dollar (we being the seller).

So again, why should I care if the dollar falls? First, a cup of coffee when I travel overseas will cost more. If you travel a lot, that might matter to you. Generally, there will be upward pressure on the price of foreign-made goods. An LCD TV might cost a little more. A Toyota might or might not -- many are made here in the US of A. In the full picture of our spending habits, these price movements are not all that powerful -- we can substitute our buying among various goods, made in various countries and manage our standard of living accordingly.

There is one import whose price can rise with a falling dollar and harm us more quickly: capital. A major portion of our global balance of payments is the purchase by foreigners of our debt -- we import dollars by exporting debt. If the dollar begins to slide, foreigners might wish to own fewer of our bonds since the value of those bonds will be falling when measured in their own local currency. Selling pressure in the bond markets will drive domestic interest rates upwards.

And finally, there is one import product which we cannot easily live without or substitute away from: Oil and other natural resources. A slide in the dollar can cause our cost per-barrel of oil to rise. If the dollar is buying fewer and fewer units of other currencies and of foreign-produced goods, the oil exporting countries will take that into account and demand additional dollars to make up the gap. It is this effect that most concerns us.

A long-term slide in the dollar on the world exchange markets will most likely lead to persistently high real interest rates (the amount by which rates exceed inflation), and to higher oil prices. This does not necessarily lead directly to inflation. As we saw in 2007, a spike in oil prices can put the brakes on our economy faster than Merrill Lynch can write bonus checks. Inflation plummeted from 5% to zero in six months.

Which asset classes offer protection? Energy and natural resources stocks (we favor a T. Rowe Price mutual fund); and discounted short-to-medium term bonds in the corporate and municipal sectors. Folks ask us about TIPs, or inflation-protected bonds. These don't provide protection against rising real interest rates. If inflation stays tamed, and interest rates rise, TIPs will not perform well at all. The other asset we are staying away from at the moment is US Treasuries. While they are safe if held to maturity, the yields are absurdly low and do not compensate us for the risk of rising rates as the recession bottoms out.

In sum, we care about a falling dollar primarily in terms of the effect on (1) the globally-set price of oil and other natural resources, and (2) domestic interest rates in excess of the rate of inflation. Remember -- rising commodity and oil prices do not necessarily lead to long-term persistent inflation. The Income and Substitution Effects will pull in opposite directions. In the short-term, the Income Effect usually dominates. In the fullness of time, the Substitution Effect will steer our consumption to other energy and resource supplies. As we have written before, you can either worry about short-term inflation or long-term inflation, but you can't have it both ways. We worry more about the long term and will take positions in our portfolios accordingly.

Who Has Your Money? A Madoff Lesson...

2009-01-09T10:49:00.000-08:00

While certainly the whole world was shocked by the revelations of Bernie Madoff's misadventures, those of us in the world of independent registered investment advisors were particularly stunned. Stunned that people would allow the party making the investment decisions, and providing reports to clients, to also hold custody of the investment assets themselves.

When folks come in to talk to us about opening an account, they sometimes (but not always) ask a key question: "Why would I hand my money over to a small firm like yours?" Our answer is simple:

"You shouldn't!"

Safe and prudent money husbandry requires a division of duties. The party making the decisions is different from the party tallying and accounting for those decisions. A CPA cannot both compile a company's financial statements and have signing authority on their checking account. Who's going to know if the CPA is doing someting nefarious?

Likewise, the investment advisor can never have the ability to be the sole source of information about a client's assets. Our clients' investment assets are held at Schwab and Fidelity. That way, those companies will send monthly statements directly to the client. Firms like ours are then prevented from being in a position to falsify statements about what a client actually owns.

We also advise two private partnerships in which our clients invest. The assets of those partnerships are held and controlled by an independent manager; the financials are compiled by independent accountants. We do not have signing authority on the checking accounts and cannot otherwise obtain and transfer any assets.

Bernie Madoff's clients made the fatal error of trusting both custody and reporting to the same party. Whether our clients realize it or not, we have set up our business so that a client cannot make that same error.

This is almost getting silly: Muni Bond Yields

2008-12-15T12:20:00.000-08:00

In a normal world, muni bonds yield slightly less than taxable bonds, such as treasuries. If a 10-year treasury bond was yielding 2.6% (like it is right now), we would expect a muni bond to yield somewhere between 2% and maybe 3%. The low end would be for ultra-safe state general obligation (ie, "unlimited taxing authority") bonds and the higher end might be a lower-rated local government entity.

We bought some 11-year muni bonds this morning yielding 7.625%. That is not a typo. An after-tax yield that is about three times what we can earn on a treasury bond -- and over 4x if we consider taxes. You might wisely ask -- what's the catch? Surely this must be some kind of junk bond...? Nope -- I'd put my grandmother's life savings in this bond.

The muni bond world breaks down into three big buckets. The first bucket (that I put no money into) is bonds sold for private non-profit things like hospitals, universities and other charitable enterprises. We also include here such things as pollution control bonds and airport terminals. These are essentially corporate credits, and I don't invest in them.

The rest of the muni world is bonds sold to fund what we think of as essential public facilities: Roads, schools, libraries, water systems, etc. There are two types of these bonds: Those supported by a direct revenue stream and those supported by the "general fund" of the agency or city. If you've been reading the paper, you know that local and state agencies are under extreme financial stress right now. Elected officials will have to make the tough decisions about how to allocate a fixed revenue stream. There is risk in this process for bondholders -- if the agency's fixed obligations (pensions, public safety, basic teacher head-count, etc.) exceed its revenues, there is some risk for interest payments. That type of bond does, perhaps, deserve to sell at higher yields.

The other type of local government bond is not affected by these other demands. Some muni bonds are paid from property taxes or other revenues that do not first pass through the general operating fund of the agency. Those revenues are captured, sequestered and used to pay the bondholders. Property owner pays taxes; county captures taxes; taxes go to bank to pay our bonds. I like that arrangement. The Governator can't get his hands on my money!

That is the type of bond we've been buying. For technical reasons, bond mutual funds are being forced to dump bonds on the market -- bonds with a very high degree of security that in many cases were not rated by S&P or Moody's when the bonds were issued. The bond we bought today is secured by special property taxes on over 4,500 housing units in Irvine, CA. I have worked on projects like this as an investment banker, tax administrator and disclosure consultant for over 20 years. Getting paid 4x over treasury yields to take this little risk is as good an investment as I have ever seen.

To the point that it's almost silly. I keep pinching myself.

Meeting with your advisor soon? What to ask.

2008-12-13T13:06:00.000-08:00

A friend asked me a perfectly reasonable question last night: I'm going to meet with my advisor soon. What should I ask about?

Here's the single most important thing to ask your advisor: If I had all of my portfolio 100% in cash right now, what would you do with it? That is the place from which we should always start when reviewing our portfolios. If we, even for one moment, consider our portfolio from the perspective of what we already own, we are engaging in the well-documented behavioral biases of commitment and loss-avoidance. Rather than view the investment landscape by considering today's conditions and tomorrow's potential -- we try to drive forward by looking backwards.

I will guarantee you that 90% of advisors are giving all-cash clients different advice than they are clients with various mixes of stocks and bonds. And this is completely and utterly irrational. Let's imagine that an advisor is telling new, all-cash clients to allocate only about 20% into stocks right now and to maybe do some dollar-cost averaging back into the market. Be cautious; take our time and see how the recession plays out. Perfectly reasonable advice, in my view.

Now, let's think about what the advisor is telling a longtime client with identical goals and life position; a client who's had 70% of her money in stocks for several years. I'll bet you a box of donuts that the advisor is telling the longtime client a different story. The advisor is talking to that client about "holding on" and waiting for a recovery. After all, the poor client's stock portfolio is down by almost half and the only way the advisor is going to recover the client's confidence is if most of that is won back, and quickly.

So that client is told to hang on. See the irrationality of it all? Under identical market conditions, what is good for one investor is 20% stocks and what is good for his twin is 70% stocks. This type of advice borders on malpractice, but it will happen in tens of thousands of year-end meetings over the next month or so.

Ask your advisor what he'd do with all cash. If that differs significantly from how you are invested, either ask the advisor to explain himself, or find a new advisor. If your advisor really thinks that you should be invested differently than a "twin you" who's starting with cash, then you have some hard decisions to make.

Acting Quickly in Troubled Times

2008-12-08T11:15:00.000-08:00

All investment decisions have to be made after a sober and diligent consideration of all relevent information. We study, we ponder, we stare at the ceiling. Eventually, it all comes down to a judgment call and we decide -- buy or not buy.

We think the bond market offers the best investment opportunities right now, when considering both the return and the risk. The fracturing of the credit markets has caused large numbers of investors to flat-out dump perfectly good bonds onto a market wholly unable to digest them all. Those that can pick the wheat from the chaff will profit from this forced selling.

Last Thursday, I received an email from a bond broker that we like (and that I used to work for) with a few bonds out on offer. I scanned the list and immediately replied that I'd take a block of one particular bond.

Let's see -- how long did I spend researching that bond? It didn't have an underlying credit rating, and the AMBAC insurance is nearly worthless. I spent about 5 seconds considering the bond. Did I do my homework?

You bet. I had worked with this particular school district in my past life as a municipal bond investment banker. I knew the deal; I knew the community. The bond is secured by over 9,000 single-family homes. The assessed valuation of the property is nearly 80 times the amount of the debt. I know that the tax collector in that county has a policy of advancing delinquent tax payments from bond districts of this type. Standard & Poors and Moody's might have their points of view, but mine was simple: This is a money-good bond. As secure as any muni bond we can get, including those issued by the state of California.

Alas -- I wasn't the only one who jumped quickly. This bond maturing in 6 years, yielding 6.25% tax free, traded before I could even get back to the broker.

We will see more opportunities like this, and we will jump quickly on the ones I can understand at a glance. The muni bond market is as cheap, relative to other alternatives, as I have ever seen it in my career. But, we have to seize opportunities when they arise.

Why are banks cancelling the good loans?

2008-12-02T09:09:00.000-08:00

I've heard a few personal tales of perfectly good borrowers with perfectly good leased-up commercial properties finding that their formerly perfectly cooperative bank is declining to renew a mortgage. It seems strange that banks would decline to make safe and profitable loans during a time when they must be desperate for safe and profitable loans. But, we need to imagine ourselves in the mind of that banker...

>>>>>>>>
Sure, my bank has fifty billion of assets that we have no clue how to value, or how secure they are. They're just sitting there and we're going to have to figure that one out with Paulson and Bernanke. But, I do have this other twenty billion over here and I most definitely understand the quality of this batch. These are good loans to good borrowers, but the accounting rules require me to carry them at 70 cents on the dollar, since that's what they're trading for on the open market. Heck, I'll make at least a 40 percent return on these assets if I simply hold them to maturity.

But -- the regulators are going to make me sell them if I can't raise some capital or reduce my total loan portfolio! What am I going to do? My kids need new shoes and I need new golf clubs. Hmmm...the capital we raised came from the Feds and is tied up supporting that fifty billion in assets that we (and they) don't understand. I'll need to reduce my total assets in some way...hey, here's a loan that's coming due for one of my longtime clients. I can only get away with charging this guy 7 or 8 percent, but he's a good borrower with a great property.

What to do? I can make 40 percent by keeping these oddball assets that the regulators don't like, or I can make 7 percent by renewing that commercial loan to my longtime client and golfing buddy.
>>>>>>>>

We see where this is going, don't we? Banks are being perfectly rational by calling in low-risk loans because they are also low-yielding loans. There is more money to be made investing in oddball assets that are also low-risk.

This is pretty much the same thing we're doing by not buying Treasury bonds or California GO bonds -- they're safe, but they don't yield diddly. We can make more money by buying very high-quality bonds that the market simply happens to hate at the moment -- GNMAs and local goverment revenue bonds among them. Capitalism is not a perfect system -- its flaws run deep and are well understood. But in this instance, the market forces that push us toward the best combinations of risk and return will serve their purpose in the fullness of time.

The Wisdom of "Why?"

2008-12-01T14:29:00.001-08:00

I am an unrepentant skeptic. If you want to get my attention, make a claim about a factual matter without providing any proof or data to back up your claim. Even worse, provide bad or incomplete data. The practice of skepticism has a long and shining history, starting with the Greek philosophers and running through such modern luminaries as Albert Einstein and Michael Shermer.

At its core, skepticism is the art of asking, “Why?” Someone makes a claim or observation. You ask, “Why?” They give a first answer, to which you again ask, “Why?” The process of drilling down into the issue – of peeling back the layers of the onion – can eventually lead to truth. Or, equally often, it will uncover the lack of truth.

I’d like to illustrate the concept with reference to a magazine article I read a couple of years ago. A national news weekly gave the advice that, in order to beat inflation, you should buy stocks. They used three periods of time to illustrate their point: 1926 to 2004; 1987 to 1990; and 1979 to 1981. During those selected periods, stocks paid significantly more than the rate of inflation. The investment skeptic will ask, “Why,” and look more deeply at the question.

First, we should notice the odd selection of time periods. A 78-year period, a 3-year period and a 2-year period. Hmm. What about 5, 10, or 20 year periods? I don’t have 78 years to wait, and 2-3 year periods are too short a horizon for stocks. On a hunch, I looked through the data myself. It wasn’t hard to find a few periods where stocks did not keep up with inflation. In fact, they all but leap out of the database.

For the 5 years from January 1973 to January 1978, stocks paid a total annual return of minus 4.5%, while the annual inflation rate averaged 8.0%. Stocks trailed inflation by a compounded 46%, over only 5 years! The spending power of stock portfolios was cut almost in half.
What about periods in which stocks made good money, but inflation was high enough to wipe out returns? Since you asked, the 5 years following January 1945 saw annualized stock returns of 5.2%, with annual inflation of 7.4%. I could go on and on.

The point here is that, with a sloppy or careless examination of the data, one can find select periods of time that support almost any conclusion. The question, “Why?” doesn’t lead to an answer about why stocks beat inflation, but rather to the question about why the magazine chose these time periods.

As we continue to ask, “Why,” we begin to find that stocks tend to do well not merely when inflation is high or low, but rather when inflation is moving from high to low. Paul McCulley of PIMCO has written about the difference between the journey and the destination. It is the journey of inflation from one level to another higher or lower level that triggers stock movements. Stocks move higher more often when inflation has drifted lower than when inflation is stable.

Since 1900, whenever inflation in one 5-year period changes a small amount from the previous 5-year period – what I call stable inflation – stocks beat inflation two-thirds of the time. This is true whether inflation is high or low. In times when the rate of inflation declines significantly across those sequential 5-year periods, stocks beat inflation an astounding 98% of the time.
Finally, if the rate of inflation increases significantly, stocks fail to keep up with inflation 55% of the time. In 5-year periods during which inflation rose, stocks trailed inflation by an average of 1.5% per year.

These figures provide some evidence that it is the change in the rate of inflation that matters most to stock investors, not so much the actual rate of inflation itself. The national magazine article looked only at the average rate of inflation, not the change in direction of inflation. This article also highlights the fact that even well-meaning, independent investment advice can lead us astray.

While the magazine implored investors to move into stocks as inflation moves higher, the evidence from the 20th century provides advice to the contrary. If you believe that inflation is moving higher, you need to make a decision about stocks.

Investors must be skeptical, and continually ask, “Why?” If someone advises you to buy an investment, you must ask, “Why?” If the answer is, “Well, it has paid 11% annually for the last 25 years,” you need to ask, “Why did it pay 11%?” What were the facts and circumstances that led to that 11%? Are those circumstances likely to repeat themselves? What about other time periods?

This last example should be asked of index fund promoters, who are fond of merely citing the historic average return, while giving no thought whatsoever to whether those historic returns have any hope of being repeated. Investment returns don’t just happen. They happen for reasons. An argument over index funds versus active funds misses the point. What are the reasons and conditions that led to past investment returns? Are those conditions present today? Should we rationally expect the past to repeat, or should we actually pick up our heads and look around at the real world?

The skeptic has a reputation for being a curmudgeonly naysayer that questions everything and everyone. While this behavior might not be the best way to approach all areas of your life, it is the best way to approach your investing.

Up and Down and Up and...

2008-11-21T11:28:00.000-08:00

The Roller Coaster Continues...

I sit to write this missive and start typing the same thing I typed last time. What more is there to say? The economy is most clearly going backwards; the bond market is behaving entirely irrationally; stocks keep getting cheaper. What's an investment manager to do? I'll take the easy route and just answer the two questions that we get from clients, friends and the Friday morning Rotary meeting...

1. Where is the bottom? You already know my answer: I don't know. But what I do know is to look at past cycles and examine what was going on and how the market bottomed. In my analytical world, the "price" of stocks isn't the number you see on the front page of Yahoo -- it's an inflation-adjusted price-earnings ratio that looks at the last 10 years of earnings. My PE ratio tells me how much I am paying -- the price -- for the expected earnings of stocks over some reasonably long future period. That, and that alone, is the price that we care about when parsing historic tables and making judgments about stocks.

Using our methodology, stocks have bottomed with a PE of 7-8 several times in the past 75 years. They closed today at a PE of about 13. That means that the S&P 500 *could* fall another 45%. Yikes. That would be a 70% decline from its peak in summer 2007. A huge fall, to be sure, but not unprecedented.

However, as my friend and friendly competitor Eric Hull pointed out to me recently, those single-digit PE bottoms have generally occurred in a period of accelerating, double-digit inflation. The market bottoms in periods of declining and low inflation have been in the 11 to 13 range. When we came to work this morning, the PE was at 12.5 and we bought some stocks. Not a lot -- just 2-5% in most accounts.

I will not make any prediction about a possible market bottom, but I can tell you this with all candor: History shows that investors who buy stocks at prices like we see today are amply rewarded over 5-7 year periods. Patience is the key -- if you have the stomach for some volatility, the odds are very high that the total return on stocks over the next 5-7 years will be higher than the returns to bonds or cash, especially after adjusting for inflation.

2. What Kind of Stocks Should I Buy? For the first time in 50 years, the dividend yield on a basket of blue-chip stocks is significantly higher than the yield on long-term treasurys. The 10-year treasury closed today yielding 3.17%, and the yield on our favorite bundle of dividend stocks is over 5.5%. Even better, yields on stocks rise with inflation over time, while yields on bonds are fixed.

This situation might not strike you as all that earth-shattering, but I assure you it is. This is a major milestone that I never thought I would see in my lifetime. For my entire career, the choice about stocks came down to something like this: I can buy stocks and earn a nothing yield of 2% and hope stocks go up. Or, I can put money in cash and bonds and earn 5-6%. But I will miss out on any stock upside.

Today, we can own stocks and earn much higher income than on cash and bonds, and we still have all the upside of stocks. Keep in mind that, if we buy $100k of stocks and receive a $5k annual dividend, we keep getting that $5k even if the stocks go down. That $5k is higher than the $1k to $3k we would have gotten from cash or bonds. From an income perspective, we are no worse off by owning stocks -- even if they go down in the near term. If you have the willpower to stay with that decision for 5-7 years, I am highly confident you will be happy you did.

Our recommendation, should you choose to buy stocks right now, is to look at dividend-oriented stock mutual funds and ETFs. The usual search tools at Morningstar and Schwab can point you in the right direction.

Have a wonderful Thanksgiving week!

Cheers,
Rick Ashburn

2008-11-07T14:18:00.000-08:00

Back to Business...

With the election behind us, we should now consider what the near-term holds for our portfolios. To tackle the first question on everyone's mind: Is Barack Obama going to be good for our portfolios? My view has long been that the President has far less effect on economic outcomes than folks would like to believe. Mostly, people believe that if something good happened on "their guy's" watch, then he deserves credit for it. If something bad happens, it's not his fault. Conversely, if something bad happens on the "other guy's" watch, it's clearly that guy's fault. Phooey. Mostly, stuff just happens. I don't need to be shy about the fact that I'm no fan of G. W. Bush, but I'm not about to lay this financial crisis and economic downturn at his feet alone. Lay it at Greenspan's feet? You bet, but that's a blog for another day...

President-Elect Obama has shown all the signs of preparing to deal with our economic problem in a thoughtful and rational way without resorting to populist salves. He has, to date, surrounded himself with experienced and thoughtful advisors with a decidedly centrist economic bent. We remain optimistic that, to the degree an Administration can do much at all, the pending Obama administration will do a good job. The real cures for our economic turmoil are out here on main street and time needs to pass for things to turn right again.

I like to think about our current predicament as a family that has built a third story on its house, and then moved everything up to the third floor. The view from the third floor is grand and we have all the worldly comforts we can imagine. But then one day we realize that we can't afford the third floor that we built and begin to move back down to the second floor.

Once we are back on the second floor and a little time passes, we will realize that the view from here is darn near the same. We have pretty much the same stuff, even if it's not as new as we would like. Frankly, life is hardly distinguishable from that third floor we used to think was so essential.

The US Consumer is in the process of moving down to the second floor. The painful disruption is not in the eventual destination -- it is in the moving down process itself. The longer it takes to get the move over with and to board up and forget about the third floor, the longer the recession will last and the longer the bear market will last. As I write this, the move down seems to be picking up speed. While I do not gloss over the pain of that move down -- job losses, bankruptcies, depleted portfolios -- it's better to get the move over with sooner rather than later.

Our investment themes for the time that the movers are still carrying boxes:

- Remain underweight to stocks. Look for opportunties to buy small amounts when the S&P500 index is below about 925. Accelerate a move back to full allocations if the S&P500 moves sharply down into the <800 range.
- Stay short on the bond maturity spectrum. 3-5 years at the longest.
- Stay in high-quality bonds. Treasuries, mortgages and high-grade corporates.
- Buy muni bonds. Again, stay short (3-5 years). Munis are a screaming good deal right now. Stick with high-quality GO (ie, voter-approved) and utility revenue bonds and you won't need to worry about looming budget problems in the municipal sector.

Congrats to those whose candidates/initiatives won and condolences to the not so fortunate. We're all still one big happy family and we now look to the road ahead.