Quarter 3, 2012 – Things to worry about

Source: The Federal Reserve, J.P. Morgan Asset Management.

Source: The Federal Reserve, J.P. Morgan Asset Management.

Ordinarily, this letter strives to convey a positive tone. Primarily, that is because the writer honestly possesses a very positive outlook on the state of our nation, the global economy, and the future in general. This outlook remains true today. However, with the current wave of election campaigning in full swing, and the constant hammering of negative perspectives on virtually every aspect by the popular media, I thought it would be a worthwhile endeavor to take an earnest look at all the things that could go wrong today. After all, for some reason that has eluded me for the past several years, the typical American investor has stayed away from risk-based assets, favoring instead the safety of bonds. Not only do investor fund flows year to date greatly favor bond funds over equities, cash on the sidelines has continued to build. Take a look at this chart:

Source: Standard & Poor’s, First Call, Compustat, FactSet, J.P. Morgan Asset

Source: Standard & Poor’s, First Call, Compustat, FactSet, J.P. Morgan Asset

Since the middle of 2009, investable cash has increased by almost $1 Trillion, and another Trillion or so has moved into bond funds, clearly anticipating the demise of the equity markets. While this has gone on, the equity markets have quietly staged a significant recovery, with the S&P 500 index having doubled since its low in early 2009. As a result of investor caution, the above mentioned $2 Trillion has not participated in this return.

We have certainly taken a more optimistic approach, continuing to believe in balanced, diversified investment strategies, even as times get challenging. As I evaluate the enormous disparity between investor actions and the outcome of the markets, however, I’m starting to wonder: Is there something I’m missing? Should I be more concerned?

Let’s take a look at some of the things weighing on investor’s minds (and the news headlines) today:

1. The economic recovery is anemic, and slowing.

As of this writing, we are in the fourth year of a slow (but definitive) economic recovery. Despite what we hear on campaign ads, GDP has increased every quarter since Q3 2009, and as of the most recent quarter, demonstrated an annual growth rate of 1.9%.1 Likewise, unemployment has decreased from over 10% at the beginning of 2010, to slightly over 8% today.2

While this rate of improvement is not anything to write home about, it is improvement, nonetheless. Despite this fact, many people are rightfully concerned about the banks’ continued unwillingness to lend, the fiscal drag from decreases in government spending, and the continued crisis in the Euro Zone and how it may affect us domestically.

All are valid concerns. However, as I look at the slow-growth recovery in progress, none of these issues piques particular worry. Indeed, a “crash” in our economy feels unlikely…crashes tend to come at times of exuberance…not plodding, barely noticeable growth. As a colleague recently put it, “You can’t hurt yourself by jumping out of a basement window.” I tend to agree. While I don’t mean to belittle the seriousness of the issues facing us globally, and concur that the combination of these factors may slow growth even more, I don’t believe the downside risk exists to cause me to change my feeling that the equity markets offer attractive opportunities in today’s environment.

2. The “Fiscal Cliff” is approaching, and the result will crush the economy.

Cascade Newsletter Q3-2012 img3We’ve all heard the term “Fiscal Cliff”, but may not know exactly what it means.
The “fiscal cliff” is what Federal Reserve Board Chairman Ben Bernanke has called the many major fiscal events that could happen simultaneously at the close of 2012 and the dawning of 2013. The events include the expiration of the Bush era tax cuts, the payroll tax cut and other important tax-relief provisions. They also include the first installment of the $1.2 trillion acrossthe-board cuts of domestic and defense programs required under last summer’s bipartisan deficit reduction agreement. At the same time, lawmakers may have to raise the debt ceiling once again, potentially triggering another standoff in Congress.3

Obviously, any issue this politically charged should be considered a major campaign opportunity, and should not be squandered by means of coming to a quick and amenable solution for the benefit of the nation. While I fully expect this to be another action-packed round of political posturing resulting in another temporary extension of current policy at the last possible second, there are actually rumors circulating around Washington that an extension deal is already in the works, in hopes of taking this item off the table for the campaign season, allowing the candidates to focus more on personal name-calling than having to work on real issues. For guidance as to what the perspective outcome of this effort might do to the world of investments, I’d suggest we look at any of the similar actions of the past 3 years, and keep in mind those took place at a time with the S&P was in the process of doubling.

3. Growth is slowing in China.

This year, Chinese growth is expected to be only half of its peak in 2007. Chinese labor rates are rising, the endless supply of labor is finally beginning to tighten, and workers are gaining the power to negotiate. Further, The European Crisis has had a meaningful impact on Chinese exports.

However, we need to keep in mind that even at roughly half of its 2007 rate, the Chinese economy is expected to grow at 7.6% in 2012…roughly four times that of the United States. Indeed, it is starting to take on the characteristics of a maturing economy, with a rise of consumerism, an improvement in standards of living, significant infrastructure spending, and challenging changes in political leadership. With over 1.3 billion people (otherwise known as “potential consumers”) it’s hard to rule out the continued impact on the global economy that a “developing economy” like China’s can bring. Slowing or no slowing, I continue to see China as a positive force in the global economy.

4. If the Democrats keep the White House (or if the Republicans win the White House), we’re screwed.

It seems like only yesterday that we were inundated enough in political advertisements that I completely turned off the television and radio. Based on the number of visits by both candidates to the great state of Colorado over the past 60 days, I assume we will have a front-row seat to all of the election shenanigans. I take comfort in the fact that no matter how worried we all are about the concerns facing our country and the globe, our leaders do not afford these matters enough significance to interfere with the importance of the campaign.

Regardless of whose ads you tend to prefer, you can rest assured that we will hear a lot about which candidate wrecks jobs, spends on cronies, will lay waste to the poor, will promote socialism, taxes kittens, eats kittens and so on. The best part is that virtually none of it will be true, it is simply designed to maximize the creators’ efforts to manipulate you into their way of thinking. One popular quote currently burning up the chain e-mail circuit references Obama’s recent “If you’ve got a business, you didn’t build that” quote. My initial reaction to hearing this was that he must have been misquoted…so I looked it up. You can find the full text of that speech here:

http://abcnews.go.com/blogs/politic

While yes, he did say exactly that, but I don’t believe he meant it in the way it is being portrayed in the media. I think he meant to say that the role of government is to build the infrastructure that has allowed America to be the land of opportunity; the land where anyone can accomplish anything. This investment in infrastructure is funded by American taxpayers, and everyone must help “feed the goose that lays the golden egg”. I do think, however, he spoke volumes in what he did not say; He did not say that the American taxpayers have made a heavy investment in our freedom and our infrastructure, and the laws of the state make sure that the benefit of these investments applies to all of us equally. Each of us has the opportunity to become whatever hard work and perseverance allows us to in this great country, and it is our responsibility to maximize the return on the taxpayer’s investment. Remember, never has it been uttered, “Oh my gosh, Guyana is the land of opportunity! If I could only get to Guyana, I could make my fortune!” Nope, America is the place for that, and part of that is due to the investment of the American taxpayer. Further, the president appears to have presented a potential solution to the budget/spending challenges of the coming decade in what else he did not say: He did not say that it is or should be the role of government to provide disproportionately government funding for citizens who fail to capitalize on the investments of the taxpayer, by providing welfare assistance, socialized medicine, or other forms of compensation for their failure. I think both candidates can look to the wisdom of what was not said for guidance as to how to best balance our budget, and to define the role of government going forward.

One thing is certain-after the election, regardless of all the election ads and of the eventual outcome, our situation will be pretty much the same. With some fine tuning, taxes will be pretty much the same, deadlock in congress will be pretty much the same, our deficits will be pretty much the same, and our lifestyles will be pretty much the same. The differences will emerge between people who look at today’s environment as a world of opportunity…and those who fear the worst and devote their resources to building fallout shelters and “Y2K” era food and weapons caches.

My suggestion is to turn off all the political ads…maybe read a book.

While I read almost constantly and there are many lofty tomes which can be suggested to help you wade through the current economic and political decisions we are now facing, I instead recently chose to read a lighter volume for guidance, that being Bill Bryson’s “The Life and Cascade Newsletter Q3-2012 img4Times of the Thunderbolt Kid”. Essentially Bryson’s satirical autobiography (of a kid growing up in middle-America in the 50’s and 60’s), the chapter entitled “What, Me Worry?” made a particular impression on me. In this chapter, (and throughout the book), Bryson chronicles some of the many crises that faced our country in those days. Nuclear war and frequent atmospheric testing of nuclear weapons (I looked it up…the Bikini Atoll is still uninhabitable…but recently re-opened for tourism if you are interested!), the polio epidemic (which kept kids out of public swimming pools…which turned out to be safe), alien attacks and the Roswell Incident (it’s real…I saw it in the movie “Independence Day”), the rise of Communism in the U.S. and Joseph McCarthy’s lists (McCarthy died in disgrace after a Senate censure following his accusing General George Marshall of treason…without any proof), Russia’s lead in the “Space Race” and their rumored development of space weapons (which they never had), the Cuban Missile Crisis (designed to prevent them from getting nuclear missiles into Cuba…which we found out almost 30 years later they already had over 100 nuclear weapons in Cuba by the time of our blockade…I looked that one up too), and that according to popular polls, over 40% of adults in 1955 fully expected that World War III would happen before 1960?

To be sure, these people had a lot to worry about.

However, Bryson’s insight as to what preparations people made for the pending end of life as we know it might serve as educational to us as we face our current menu of crises:

“Yet, the very people who claimed to expect death at any moment were at the same time busily buying new homes, digging swimming pools, investing in stocks and bonds and pension plans, and generally behaving like people who expect to live a long time. It was an impossible age to figure.”

So in our own impossible age, what is one to do? In short, do something. Current inflation is chewing up the purchasing power of cash alternatives and bonds at an alarming rate. As an illustration, take a look at this chart, showing the average income generated by a $100,000 six-month CD:

Source: Federal Reserve, St. Louis Fed, Bankrate.com, J.P. Morgan Asset Management.

Source: Federal Reserve, St. Louis Fed, Bankrate.com, J.P. Morgan Asset Management.

Indeed, fixed income investments cannot serve the role of income production and capital preservation they once did in portfolio design. To be successful in the future, portfolio design must give thought to all asset classes, including real estate, commodities, and other “nontraditional” asset classes to be successful. Most of you have seen this chart in one form or another before:

Source: Russell, MSCI, Dow Jones, Standard & Poor’s, Credit Suisse, Barclays Capital, NAREIT, FactSet, J.P. Morgan Asset Management.

Source: Russell, MSCI, Dow Jones, Standard & Poor’s, Credit Suisse, Barclays Capital, NAREIT, FactSet, J.P. Morgan Asset Management.

In summary, this chart tells you that even a “generic” asset allocation approach could have provided significant (6.4% annualized) gains during the period many analysts are referring to as the “Lost Decade”. It is Cascade’s belief that a portfolio crafted to meet your specific needs can do even more. The time to act is often when others lack the conviction to, and based on this review it is clear that many lack that conviction right now. Please contact us if we can be of assistance.

Have a great remainder of your summer!