My Two Cents

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:

1. 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.
2. 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.
3. 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

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

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!

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

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

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

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

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?

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

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?

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...

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.