Thankfully 2012 is an election year, which allows the American economy to move forward with virtually no concern that any type of legislation will be discussed. In fact, a full-year extension of the payroll tax cut is “essentially the last must-do item of business on the President’ s congressional agenda” in 2012, White House spokesman Josh Earnest said in a Dec. 31 briefing. 1
Maybe this is good, because in doing nothing there is less chance of making a bigger mess. Speaking of messes, our friends in Europe appear to be taking pages from our own playbook by continuing to muddle through their situation rather than taking decisive action.
On the surface, these continuing political machinations seem as though they might be crushing the spirit of our economy, when in reality the opposite appears to be true. Recall the chart on consumer confidence from last quarter, and our discussion on the move from “very gloomy” to “very gloomier”? In fact, consumer sentiment reached a 30+ year low in August, only to rebound sharply in the fourth quarter.
As the chart demonstrates, this is potentially significant, as this move appears to mark a near-term trough. The orange numbers listed at the previous trough points indicate the 12-month S&P return following each trough…and those numbers are pretty attractive. Combining this with the strong 4th quarter performance of domestic stocks and a very strong start to the month of January, our confidence in our thinking of “turning up the dimmer switch” from last quarter continues to grow.
Despite strong equity market performance, money continues to pour into fixed income investments. This, unfortunately, is not as unusual as it might seem. This chart shows that for most of the so-called “lost decade”, investors shunned equities in favor of bonds, while the S&P posted impressive gains. Many times, the decision to invest is made solely on the past performance of an asset class, a particular manager, or the track record of a given mutual fund. From where we sit today, I think there is a significant inherent danger in market history that may lead investors into destructive behavior, based on the 30-year bull market in bonds and interest rates. We’ve looked at this chart before:
See the peak in interest rates on 10-year treasury bonds in 1981? Essentially, interest rates have declined consistently from then through today. It is important to note that when interest rates go down, bond prices go up (and vice versa). Thus, the 30-year decline in interest rates has fueled above-average returns for bonds and bond funds over that time. See at the right, where “real” interest rates (the interest rates you earn after adjusting for inflation) have turned negative? This means that investors in the 10-year treasury bond are agreeing to lose money on a 10-year treasury investment. While it’s impossible to predict when interest rates might turn higher, it is a safe bet that when that happens, investors who bought bonds with a negative real return by looking only at historical performance might end up being disappointed with that choice.
The surprising thing about this is that I do still believe that bonds serve an important function in portfolio construction. Properly utilized, bonds can add a degree of stability, confidence, and predictable cash flow, allowing your equity investments to work over the longer time periods needed to benefit from their higher volatility. My point would be that bond investing is about to become very complicated, and the best-performing funds of the past may be the most inappropriate selections going forward. This is an excellent time to be discussing your bond strategy with your advisor, and verifying that you agree on a strategy that is relevant to today’s interest rate environment.
GOOD NEWS ON JOBS?
There is no arguing that GDP growth and the economic recovery looked better, as a whole, a year ago than they do today. That being said, there are signs that growth is continuing, which is good. The headline number we constantly hear about is job growth, and there is some progress being made in that arena. As this chart represents, while still high at 8.6%, this is an improvement, reflecting a gain of 2.9 million jobs, or approximately a third of the jobs lost in the last recession.
The news might actually be better than that for most of the readers of this newsletter. Recently released data from the Bureau of Labor Statistics show that education may be one of the paths to a reduction in unemployment. This table indicates that while workers who lack a high school diploma are struggling with unemployment percentages in the mid teens, those with a bachelor’s degree or higher are in a more normal range, of approximately 4.1%. If I were a politician, I might be tempted to explore the link between education, employment rates, and economic growth…
BUT WHAT ABOUT HOUSING?
Strange as it may seem, housing numbers appear to be coming into line as well. Clearly, home foreclosures are up, and mass liquidations by Fannie Mae and Freddie Mac are pushing significant holdings out into the market, where a fair price for the assets can be determined. While the “shadow inventory” of not-yet-foreclosed homes remains significant, recent progress has brought home inventories roughly in line with historical numbers and current demand. Perhaps more importantly, home affordability, the measure of mortgage payments as a percentage of household income, is now at its most affordable level since the measure has been tracked, starting in 1975!
Whether or not we agree with current interest rate policies, we do have to recognize the impact current rates have on the housing markets—which appear to be fueling the recovery.
WHAT DO HOUSES AND STOCKS HAVE IN COMMON?
In two words: relative affordability. Take a look at the lagging P/E (price to earnings) ratio of all US companies as depicted below. P/E ratios are a measure of affordability (much like the mortgage affordability of homes), and a lower number indicates a less expensive stock. As you can see, by this measure of valuation, US equities are not only cheap, but actually have a P/E ratio below their average valuation in a recession.
So what does this mean to investors? Let’s examine what we’ve got:
a. Inexpensive stocks
b. Expensive bonds
c. A teetering economic recovery
d. Economic worries in Europe
e. Political worries at home
What’s an investor to do? If you’re confused, you’re not alone. What investors want in this environment is lower volatility and a clear path to investor success. To be succinct, dream on. We aren’t going to get that. Instead, we must take the information at hand and build a clear plan that allows us to participate in what appears to be a significant investment opportunity combined with the stability and liquidity needed to ride out the inherent volatility of “going against the herd.” If you feel your plan needs a review–give us a call.
We employ a proven consulting process designed specifically to fully inform us of your values, goals, and objectives, so that we may provide you with a financial roadmap to help guide you on your way. This balanced, five-step consultative process ensures that recommendations we offer are in line with your objectives, and our ongoing review process helps you track your progress through these increasingly complex economic times.
If you have questions about your current strategy, want to review your current planning to ensure that your investments are appropriate for your goals and objectives, or if you would simply appreciate a second set of eyes looking over your plans, please consider our “second opinion” service. By taking you through our consultative process, we will provide:
An evaluation of your current circumstances and needs. To craft the best possible recommendations, our discovery process focuses on fully understanding your particular situation and goals. What are your personal and professional goals? What values guide your decision making? How do you view your obligations to your family and the world at large? Who are your other advisors, what role does each play, and how do you prefer to work with them? How are your investments currently structured?
A Complete Diagnostic. Working from our knowledge of your situation and needs, our team performs a complete diagnostic, evaluating your current position and generating a range of alternatives. From these possible outcomes, the most viable, cost-effective and tax-efficient scenarios are outlined in the areas of your investment planning, retirement planning, estate considerations, risk management, and charitable giving.
Presentation of Recommendations. We next meet with you (and your other advisors, if applicable) to present our recommendations. Realizing that different people work with information in different ways, we take great care to present our recommendations in ways that meet your preferences exactly, so that you receive the type of information that is most useful to you. With this information in hand, you are ready to consider options for moving forward.
Delivery of Results. If, as a result of our review, you elect to pursue an advisory relationship with us, we take on the role of investment fiduciary on your behalf, and begin coordinating the various facets of your wealth management plan in an agreed-upon timeline and framework that is consistent with your preferences.
Ongoing Regular Progress Meetings. Depending on the scope of work to be undertaken, we hold regular meetings, typically quarterly at first, to keep you updated on the status of your planning, the performance and positioning of your assets, and other steps in the implementation of your road map. Our continuing objective is to maximize the probability of achieving your goals and objectives. These regular progress reports help keep everything on track, and serve as a quarterly “report card” on the progress toward your goals.
If this “second opinion” service sounds like it may be useful to you and your family, please contact your Cascade advisor or firstname.lastname@example.org to arrange a review.