January 2006: Cover Story for 2005: Nomination for “Force of the Year”
Our award for this coveted accolade goes to the U.S. economy which, despite an incessant media dirge and abundant self-serving political spin to the contrary, behaved admirably and turned in a vintage performance. Moving forward at a $12 trillion annual pace (contrasted, for example, with China’s recently revised estimate of $2 trillion), U.S. Gross Domestic Product (GDP) grew 4% in the year just ended and in 12 months created two million new jobs. Since 1993, the entire European Community added only 4 million jobs, at least half of which were in the government and public service sectors. U. S. exports increased during 2005 even though the dollar rose 13% relative to our trading partners’ currencies. (Yes our trade gap expanded in absolute terms, but as long as U.S. inflation is contained, this can be tolerated). Worker productivity continued to improve at nearly twice the rate of the other free world countries. Quite a remarkable result, despite U.S. central bank-administrated increases in short-term interest rates that have signaled the end of the FED’s accommodative credit environment. A stellar performance, and more so, since after a number of years of uninterrupted expansion, our residential housing market shows signs of topping. Beyond this, although energy costs continue to rise, inflation rates remain under control.
All of this, lest we forget, was accomplished in the context of a not-too-hospitable geopolitical background, and in a year which inflicted a tsunami on Southeast Asia, three Category 4-5 hurricanes on our Gulf Coast, as well as a horrific earthquake in Pakistan.
Amongst pundits continues a “pall of pessimism” which our political worthies are only too happy to demagogue for whatever spur-of-the-moment PR advantage can be gained. No question, investors are faced with a full plate, but throughout all this the U.S. “engine” of world economic growth continues to exhibit remarkable resilience. When the media and our politicians wake up to how they have missed the mark, they will be surprised to learn that the rules of the game have, and perhaps even the game itself, has changed.
Globalization, Phase II
Integration of the world’s economies continues apace. If one embraces the idea of a free-market integrated planetary economy, then globalization of trade among all nations necessarily follows. Can this inexorable movement be stopped, its course altered or guided, or politically influenced? Probably not; nor, if we wish to provide a reasonable economic backdrop for generations to come should the powers-that-be attempt to intervene.
As has been discussed by others, global economic integration within the framework of a free-market umbrella results in a certain amount of “creative destruction.” We can attempt to put a human face on this, but with a continual stream of information technology innovations allowing users to uniquely create (and produce) at the local level without restriction, controlling this output and outcome, will be impossible. Better that we recognize the implications, and in so doing attempt to invest our resources to optimize the circumstances.
The Pulitzer Prize winning author, Thomas Friedman, in his latest book, The World is Flat, provides a useful context to gain perspective. He concludes that the net effect of this next phase of globalization will be a better world-wide distribution of wealth, a more competitive pricing climate benefiting consumers, relative pricing equilibrium among producers, moderate inflationary pressures, more purchasing power and options in the hands of the public.
This suggests a frame of reference for us to think about how we can best maintain our country’s current edge in the race to remain the driving force in the economic evolution ahead. As of the moment, U.S. entrepreneurs, working in a business environment depending on the sanctity of contract and within a patent and copywrite context protecting intellectual property, provide much of the world’s innovative economic energy. If it is to remain so, then our challenge is to maintain free-thinking, collaborative, synergistic commercial surroundings in which the U.S. continues its dominant role as innovator. This may carry with it the overtones of national conceit, but the concern is one of survival and whether we thrive in a highly competitive world. It seems best to face the issue directly. Practically speaking, how can U.S. investors seeking reasonable long-term results take this understanding to the bank? To begin with, recognize that in a free-market the industrialized countries will continue to out-source their manufacturing and production to lower labor-cost countries. The U.S. will develop further its reciprocal dependence with China. France and Germany will out-source to Eastern Europe, Japan to China, China to Southeast Asia and India. India will be a major factor in this economic integration equation. Quietly implementing a program to build its own competitive model (e.g., a nation-wide circumferential interstate highway system joining all its major cities), India will, in the near future, be a force with which to reckon. Throughout all this, the U.S. needs to assure it remains the driving innovative power, the right side of the brain, in Tom Freidman’s words. Competitively, our trading partners should be relegated to perform left-side, routine, repetitive roles implementing U.S.-created products and services with content meeting market needs and profits accruing to content owners. Achievement of this, of course, will be in a relative context, implementation will take the form of an infinite number of relationships.
Profitable portfolio investing in this long-term climate will require, first, the requirement to further diversify into non-dollar equity markets. Beyond this, an obvious pressure point will be (is) the need for natural resources to fuel anticipated global growth, and even later in the future, technology to synthesize these scarce elements. Portfolios structured with this understanding in mind should prosper in the coming years. The anti-globalization factions in Cambridge, MA, The Peoples Republic of Santa Monica, France, and the Middle East remain in denial of these trends at their own economic peril.
Whither the FED? Exit Stage Right, Mr. Greenspan takes A Bow: Enter Mr. Bernanke
Alan Greenspan, whose fourth and final term as head of our central bank, The Federal Reserve System, ends his tenure this month. He has been cleaning off his desk and accepting a cascade of richly-deserved accolades! In modern times, his 18 years of service, added to those of predecessor, Paul Volker, have provided the U.S. with effective, independent banking system regulation from which the country has benefited greatly. The Greenspan years included a full menu of crises, duly dealt with by employing creative techniques only occasionally revealing the Chairman’s hand. He always explained his policies in obscure language and oracular terms, leaving the markets to draw their own conclusions. A hard act to follow, one-time Princeton academic Ben Bernanke, takes the reins on February 1st at a time of relative quiet in the world’s financial markets.
Mr. Bernanke shares much of the departing Chairman’s philosophy. His professed focus is on containing inflation, engineering real economic growth through productivity improvement and avoiding any pronouncements about the dollar’s relative value. However, as discussed earlier, his task of maintaining the country’s preeminent economic position won’t be easy.
The Chairman-elect’s first test will be determining whether the FED has raised short-term rates sufficiently (14 increases in the past 18 months to 4.25% today) to constructively slow the economy and dampen the housing boom, without killing the recovery underway these past three plus years. At this juncture, short-term interest rates are at parity with long rates (i.e., a flat to slightly inverted interest rate yield curve). This can be viewed either as a neutral credit environment created by a benign anticipatory series of creative policy steps, or a retrenchment on the part of the FED compensating for an overly stimulative monetary policy during the recent past. The U.S. economy is coming in for a ‘soft landing’, and if the FED can engineer it without raising rates too high, 2006 and probably 2007, could prove to be profitable for investors, just like the year just ended.
The result of the FED’s policy shift of the past 18 months is that today, it is no more costly to borrow short-term than long. In the past, a flat yield curve such as we have currently has often been a condition presaging recessionary conditions ahead. Although it is risky to make such an assertion, today the circumstances are different and how this resolves itself is of interest to all, particularly bond investors. For the fixed income markets, the ‘Big-Question’ these past eighteen months has been when to extend bond portfolio duration? Resolution may finally be nearing.
Human Touch vs. Construct, Active vs. Passive; How did Proprietary Stock Selection Approaches Fare Against their Asset Class Benchmarks in 2005?
Over any given ten year period in the equity markets the vast majority of active equity managers under-perform their benchmarks, usually by at least the amount of their fees (by Morningstar’s estimate today averaging 1.36%, or 136 basis points). Passively constructed funds (i.e., those which merely replicate a certain segment of the market, only attempting to generate a return equal to the segment targeted) have over time generally produced better after-tax results for individual investors. 2005 turned out to be the short-term exception to the rule, in particular for large and mid-sized company funds where over the years active managers have generally lagged. Our enclosure, “Mutual Fund Performance, 2005, Sort by Asset Class,” illustrates the point, as well as the fact that active managers in the small company and international markets continue to better their sector proxies by a fair margin.
Our strategy is to build portfolios with a mixture of active and passive approaches. We attempt to blend and weight passive strategies (internal fund expense ratios ranging from 15 to 40 basis points) with active management, aiming to achieve an overall cost-effective after-tax result. An analysis of our client portfolios reveals an aggregate dollar-weighted average internal fund management expense ratio approximating 70 basis points, roughly half the Morningstar and Lipper Universe averages; compounded over the long-term not an insignificant number. For a number ofyears our accounts have included passive funds constructed by Dimensional Fund Advisors (DFA). This week’s edition of Barron’s includes an article (see “Ditching the Monkey,” enclosed) on DFA which we thought you might find of interest.
Investment Portfolio Results for 2005; What Worked and What Did Not?
Our enclosed fund performance summaries, highlights what worked and what did not during the year just ended. The small, international and natural resources categories trumped large company strategies. Value approaches, although by a narrowing margin, bettered growth. Real estate (REIT’s for the most part), almost against all expectation, turned in another better-than-market result. Since the past three years have produced generally favorable equity fund returns, and accumulated internal fund losses have been offset by managers taking gains, capital gains distributions to fund shareholders in 2005 were generally higher than usual. This was the case even in ‘tax-managed’ funds, most of which had not declared a distribution during the past five or six years.
Looking ahead, although such an exercise is sometimes hazardous to one’s wealth, we might expect growth investing to do better than value in 2006, and many of the highly recognized larger ‘Old Growth’ names to rise to the top of the list. In the recent past, we have alluded to this possible shift in market sentiment, prompted by our assessment of relative market asset class valuation differences. Realignments in portfolio structure to tap into this potential shift are underway, but to date have yet to yield relative benefits.
Going forward, all of the above, as you no doubt have already considered, is conditioned by an almost endless list of ‘ifs.’ If oil goes to $200 per barrel, if Iraq’s petroleum production moves back to normal, if the Israeli-Palestine confrontation blows up, if Israel decides it cannot wait for the diplomatic charade with Iran to play out, if the Syrian régime falls, if, if, if… make your choice, any combination of scenarios is sobering and would impact financial market behavior negatively. By most standards of fundamental economic guideposts and investment market signals, however, the global outlook for equities remains positive.
Moving to 30 Federal Street
As mentioned in the past few months, by early March we should be installed in our new space two blocks north on Federal Street. In many ways this move reflects, we think, a number of enhancements to our firm’s client services which will become more evident as the new year unfolds. More conference rooms will be available for client meetings and parking at the Post Office Square Underground Garage (we will validate your ticket) is just across the street. We continue to test our business model and client services offering, and internally examine our business as a business. This includes understanding better our client mix, fee structure, marketing strategy and business objectives. We are focusing on the development of our organization, client financial planning approach and investment management process. A few weeks ago, Charles Hipp joined the firm from Fidelity. He will develop our fund analysis and market research activities, as well as oversee our Investment Committee sessions.
We are attempting also to implement more productive uses of information technology. The most immediate result of this is that our new website (www.tfcfinancial.com) is now live. We will be adding interactive portals in the months ahead, leading ultimately to the transmission of client information via the web, and aggregation of client data for both financial planning and combined reporting purposes. All this assumes privacy and security concerns can be allayed. Stay tuned, we will keep you informed of other improvements.
Please do not hesitate to call us if you have comments or questions.
Sincerely,
James L. Joslin
Chairman, CEO