Is the Economic Cup Half Empty or Half Full?
Part 1: Perception = Reality
PERCEPTION IS REALITY
Albert Einstein once famously said, “Reality is merely an illusion, albeit a very persistent one.”
Wikipedia, on the other hand, defines reality to the contrary: “Reality is the state of things as they actually exist, rather than as they may appear or may be thought to be.”
As we monitor the domestic economic data and stock market activity, we find ourselves appreciating the concept that perception is reality. Depending on your perspective, we are either in very good shape and getting better or on the verge of having the other shoe drop.
If you are unemployed, your perception of reality is quite bleak. If your house was foreclosed upon, or even if it merely dropped significantly in value, your perception of this economic recovery probably is severely jaded. If you were about to retire and your portfolio dropped in 2008 by 40-50%, you had better love what you do because you will be doing it for a lot longer.
When we look at the stock prices of various companies selling luxury goods, it looks and feels like a bull market. However companies selling their products to people who are struggling economically are looking less robust.
Let’s consider the chart of two companies to help paint a picture.
The first company is Coach Incorporated (COH). Coach sells high-end luxury leather products and has stores in the toniest of malls. For our foil, we will choose Walmart (WMT). They are not in luxury malls. Once famous for creating a profitable brand known for cutting prices to the bone, their growth has faltered and their customers do not appear to be spending. Here is the two-year (2009-2010) chart, with the dark line representing Coach and the yellow line showing the stock price of Walmart.
We wonder if the reported “increase in consumer spending” (and sentiment) isn’t mostly weighted on the side of the higher-end consumers who a relatively small percentage of the consumer base which has been the engine of our past economic growth.
ECONOMIC PROGRESS, NOT PERFECTION
We believe there is sufficient economic data to justify cautious optimism. As a nation, we clearly avoided falling into the precipice of a second, perhaps Greater, Depression. The feared double-dip recession has not materialized. The dreaded deflation that Japan experienced, causing what is referred to as the Lost Decade, has not materialized here, either.
Much of the credit goes to Federal Reserve Chairman Bernanke who both created and steered monetary policy. While still a politically sensitive subject, we think some of the credit also has to go to government policies that, among other outcomes, created a powerful perception of a country on the road to recovery. Perception can be reality.
Our economy has gone through a three year regimen of extreme physical therapy, but is still not yet ready to run a marathon. Many unanswerable questions remain. Some believe that a jobless recovery is not a recovery at all. Others are convinced that the recent QE2 government stimulus and an ever-increasing burden of debt are leading us into another crisis. As the economy finally shows signs of standing on its own two feet, there is a fear that the Federal Reserve will withdraw the stimuli and interest rates will rise. After all, there is no more room for rates to fall further.
Imagine refinancing your home at an interest rate 2-3% higher than it is now. Rising rates will mean that the government will pay out a significantly higher portion of our economic output just to pay the interest on our national debt. Corporations, currently enjoying cheap borrowing rates to spark their growth, will find higher interest rates to be an impediment. They could perhaps delay even further the hiring back of the currently unemployed or recent college graduates, and creating worse structural unemployment in the process.
We have clearly made some progress. However, there continues to be major global and domestic challenges to sustaining this recovery and moving to expansion.
Part 2: Our 2010 Year in Review
SILVER OAK’S 2010 YEAR IN REVIEW
Beginning with our successful avoidance of the extreme declines of 2008, Silver Oak’s investment approach has been twofold. First, we want to create solid, sustainable portfolio growth based on each client’s required rate of return. Secondly, yet certainly as important, we want to achieve that rate of return at the lowest possible level of risk.
We define the required rate of return as the combination of income and appreciation that is shown to make each client’s financial plan successful. It is a growth rate that we believe is realistic based on reasonable expected returns of the various investment vehicles from which we can choose.
Thanks to a spectacular 4th quarter, which was largely attributable to Ben Bernanke announcing a new round of “quantitative easing” and to the renewed Bush tax cuts, the stock market as measured by the S&P 500 rose about 15%. Yet for those who do not recall, the picture for the full year looked like a roller coaster ride. Through August, the S&P 500 had experienced a loss of 5% year-to-date. Meanwhile, Silver Oak’s typical portfolio advanced in a very different pattern.
The following graph reflects the volatility of the stock market during 2010 as measured by both the S&P 500 and Dow Jones Industrial Average. The yellow line is a bond index and includes components that formed part of Silver Oak portfolios. The lighter blue line is representative of many of our portfolios which contained a high allocation to fixed income as well as a lesser allocation to our “higher risk bucket.”
2010 Index Returns: Barclays Capital U.S. Aggregate Index: 6.55%; DJIA: 14.06%; S&P 500: 15.07%
It is clear that while the stock market (dark blue and red lines) ended higher than the light blue line (Silver Oak portfolio), it did so with terrific volatility, which we have observed is quite unsettling for most clients. It is our belief that building portfolios intentionally with a steady and gently upward sloping growth line (our light blue line) is preferable for most investors.
Part 3: The Year Ahead
SILVER OAK’S INVESTMENT PHILOSOPHY & OUTLOOK FOR 2011
We’ll now take this opportunity to review our investment approach and outlook at Silver Oak Wealth Advisors for 2011.
In these challenging economic times, we feel that the ability to make tactical changes to our portfolios is an invaluable component of delivering returns with less volatility. We always utilize the most advanced scientific, analytical tools and research available. We do not try to predict the stock market, and we do not consider our approach to be market timing; no one has shown that they can do that successfully.
What we can do to a significant extent is to estimate the risk that our clients are assuming and provide our guidance as to whether they are being fairly compensated for taking that amount of risk. By noting the relative likelihood of both positive and negative impactful macro-economic events, tactical portfolio decisions provide us with a tool to recalibrate the portfolio risk levels while identifying asset classes that are likely to help reach each client’s targeted or required rate of return.
As we contemplate 2011 and scrutinize the data, we see a different picture than we saw a year ago. The implications and potential effects on our existing client portfolios have caused us to make some modifications as we have entered this new year.
First, fixed income is unlikely to produce the substantial gains we experienced over the past two years. Various bond holdings and bond funds experienced double-digit returns annually over that period. This was possible due to a combination of factors including declining interest rates and a reduction in the perceived riskiness of the market in many individual bond categories; plus the perceived riskiness of the stock market.
Rates are now more likely to rise than decline, although we believe the government will continue to push for low short-term rates for an extended period of time. Longer-term rates are a function of various market forces that are out of the government’s control, including inflation. Therefore, we have sold a number of appreciated bonds and bond funds and have repositioned that money.
Due to our concern about the relative weakness of the U.S. dollar, we are continuing to hold and add new investments that will help maintain purchasing power.
The investment outlook for equities is obscured by continuing mixed messages. Because the economy has shown signs of improving, there is certainly cause for optimism that corporate earnings can continue to improve. As earnings improve, and as investors feel more optimistic, there is room for stock prices to also rise. However, we are aware that by some stock market measures the U.S. stock market is overvalued and vulnerable to a correction. This is NOT the time for a “Mission Accomplished” banner to be displayed over the U.S. economy.
There are any number of known risk factors around the country and globe that might derail this recovery and precipitate a market correction. Housing, unemployment, rising commodity prices, rising interest rates, an emerging market hiccup that may be caused by China slowing its economy, and sovereign debt issues in Europe, to name just a few, are all risks that would negatively impact stock markets globally. Again, these are known risks. In this unstable world, we continue to also be concerned about unknown risks.
We are currently witnessing both known and unknown risks case leading to an Egyptian regime change. The Dow Jones Industrial Index tumbled 166 points on the news in one day. As the regime change did occur peacefully, the market has resumed its steady climb. However, Egypt is not ready to raise its own version of George W. Bush’s “Mission Accomplished” banner quite yet, as more uncertainties and internal conflicts emerge. And the many other Arab countries caught in this contagion are raising new concerns. While it is impossible to ponder all the potential risks, we believe it is prudent to incorporate a certain level of sensitivity to presently unknown possibilities into our portfolio design.
When we look at various indicia of equity valuations we again see that some indicators suggest valuations are high and others suggest valuations are reasonable. After factoring in these conflicting views, we do believe that the level of risk in the U.S. equity markets is lower than in the past two years due to the present growth in our economy. Since we had previously minimized equity exposure, we are now recommending a slight increase in higher risk assets for most clients. We think that selectively adding about 10% more to our higher risk bucket will provide the potential for additional portfolio returns this year.
We are adding equity exposure in a couple of areas that will provide a good dividend or income component to our portfolios. Our objective is to augment the cash flow previously generated by our fixed income investments, which requires taking on greater risk to duplicate. To enhance our diversification, for example, we recently added an international energy-related holding with an almost 9% dividend. We expect that this addition will contribute both cash flow and a potential for good appreciation.
In many respects, 2011 represents to us the Chinese character for “dangerous opportunity.” We will not be taking these “better times” at face value or for granted, but, as always, remaining ever-vigilant over the safekeeping of our clients’ financial well being.
As always, we welcome your questions and comments.
Sincerely,
Joel H. Framson, CPA/PFS, CFP® Eric Bruck, CFP®
President Principal
TEETER-TOTTER TIME
