October 2004: Cloudy With Intermittent Periods Of Sunshine
In meteorological terms, the investment climate, as is often the case, continues at best foggy. Financial market uncertainty reigns and the geopolitical landscape is strewn with obstacles which today seem insurmountable. One certainty, which a futurist can embrace, is that like predicting the weather financial markets prognostications are subject to constant revision as the dependent variables in the equation shift. However, as that well known baseball philosopher, Yogi Berra advises, “You can observe a lot by just watching.” So what can we observe by just watching the signals in today’s economic and investment environment?
A notable starting point would be the behavior of the financial markets themselves during the past 12-18 months. Since the strong rebound beginning in March-April 2003, which peaked earlier this year, equity markets worldwide have traded within a narrow channel (in the U.S. around 10,000 on the Dow 30 Index and 1,100 for the S&P 500 Index, a broader stock market benchmark). A “range-bound” market such as this often follows major stock market turnarounds. The remarkable characteristic of this market’s recent behavior has been its ability to endure a steady diet of unfavorable news from the political and diplomatic fronts. The media spin on these developments gives one hardly a chance to see the other side of the coin, and yet investment markets globally have held up surprisingly well. Why is this so?
The answer, we suspect, is to be found in the underlying economic fundamentals, which no matter how they are spun indicate an improving corporate earnings climate based on strong U.S. economic growth the remainder of this year and into 2005. Add to this as well a change in the conventional wisdom that interest rates in the near term must of necessity rise sharply due to resurgent inflation, and it leads one to consider the probability that near term (i.e., through 2005) REAL Gross Domestic Product growth may be greater than anticipated. Better-than-average U.S. GDP growth this year of 4%, plus just average improvement (3-3½%) in 2005, both achieved without near-term acceleration in the inflation rate, would provide our central bank (i.e., Mr. Greenspan and the FED) additional time and greater flexibility in its effort to move short-term interest rates up to more “normal” levels. What some have termed “Mr. Greenspan’s Kabuki dance to control inflation” might instead turn out to be a waltz.
Outside the U.S., global GDP seems on track to increase by 5% this year, which The Economist points out is the strongest rate of growth in a generation. Fired by China’s surging economy, Japan’s recovery has exceeded expectations and even the sclerotic Euro community (lead by its recently admitted Eastern European emerging market partners) shows signs of picking up the pace. Forecast economic growth for all non-dollar denominated countries in 2005 indicates a possible 4½% above-trend surge. Globally, corporate free cash flow has assumed huge proportions, providing the wherewithal to finance the next round of capital expenditures and job growth, adding further support to an improving economic picture.
Convergence of Rising Economic Tides: “Best of All Possible Worlds,” or Trap for the Unsuspecting?
Some readers may remember that roughly a year ago we suggested the prospect that the world’s economies might soon be in lock step on an upward slope, possibly all competing for the ever-scarcer natural resources needed to fuel continued expansion. Today, commodity prices are rising and a new petrol-dollar recycling is underway. Although higher gasoline prices at the pump are disconcerting, their damage to our economy may prove far less onerous than past experience might lead one to expect. Since the 1970’s, the average energy content in the cost structure of the U.S. manufacturing sector has declined from 16% to 6%; a marked improvement in energy utilization efficiency. The cost of a gallon of gas, calculated in the number of minutes required out of the average manufacturing wage earner’s hourly pay, has declined from 11 minutes in 1981 to 7 minutes today (courtesy Steven Leuthold). Although an increased burden to the average consumer, at current levels higher oil prices should not generate the economic shock endured during the 1973-74 Arab oil embargo.
However, global economic growth convergence carries with it other possible risks. In the developed countries, housing prices seem frothy, particularly in the U.S. on both our east and west coasts, as seems also the case in the UK, Spain and even now Australia. A residential real estate asset bubble deflation would be devastating to personal balance sheets throughout the world.
Today 13% of the world’s GDP (the U.S. by contrast accounts for roughly 32% to total global production), China’s economic miracle could lose its luster. A retrenchment would have a ripple effect amongst China’s trading partners, and certainly negatively impact global investment sentiment. If Chinese financial authorities should be forced to deal with more troublesome rates of inflation, a reluctance to finance our trade deficit might ensue, resulting in additional pressure on the U.S. dollar. During the next few years, as the Chinese attempt to install central banking discipline, realign the Yuan with other currencies, grapple with its massive pollution problems and prepare for the 2008 Beijing Olympics, the stress on the world’s financial institutions will be immense, but probably manageable.
Portfolio Structure In A Range Bound Equity Market
As mentioned earlier, our equity markets give every indication of being locked in a trading range as many investors continue to sort through the debris of their still fresh bear market experiences and attempt to assess whether the recent economic and financial market turnaround is sustainable. Psychologically this isn’t an easy task. Market behaviorists in the academic community suggest that the average investor during the 2000-2002 period suffered a severe loss of self-confidence, developed an aversion to stock market risk and today is immobilized by what behaviorists term the “anchoring” phenomena. By the latter is meant a fixation on previous market and/or stock price levels below which the investor won’t sell a stock presently held at a tax loss, or will not enter equity markets. With the passage of time and the advent of higher prices, many of these now-reluctant fence sitters will once again participate.
Meanwhile, U.S. equity market valuations (i.e., stock price ? earnings per share, or P/E), as corporate earnings rise inexorably, have become more reasonable. Today, the consensus P/E for the S&P 500 Index (about 75% of the stock market value of all U.S. corporations), based on estimated earnings in 2005, is roughly 16 times, reasonable by past standards. Stock market volatility has moderated considerably, trading volume has held up as hedge funds now account for nearly half of daily transactions and passive (e.g., index funds) programs are assuming greater importance. A trendless continuation of the current flat stock market pattern while earnings methodically catch up with stock prices wouldn’t be the worst of circumstances and might eventually make believers of today’s equity market skeptics.
At roughly 50% of Domestic stocks, our portfolio fund holdings today continue to be over-weighted in small companies (when compared with a broad market benchmark like the Wilshire 5000 Index). If interest rates in fact rise more slowly than predicted, smaller company stocks should continue to benefit from lower than anticipated borrowing costs. We are similarly over-weighted in the international equity markets where we feel better values are to be found and continued U.S. dollar weakness could benefit portfolios.
The gradual addition of the Natural Resource asset class to portfolio structure will have three possible benefits: (1) An inflation hedge through participation in a potentially higher priced raw materials market, (2) Further diversification into a non-correlating asset class and (3) A broadening of portfolios across our northern border into Canada and other international, non-dollar denominated securities markets.
One Year Later: The Mutual Fund Industry’s Annus Horibulus Is History.
Since Elliot Spitzer began his crusade 13 months ago, on the surface much has changed in the fund business. With the SEC joining the hunt, penalties exceeding $2.5 billion have been assessed against fund companies and brokerage firms, some of which will be paid back to investors who can prove losses were incurred. An SEC process, under the so-called Fair Funds restitution process, will hopefully channel these reimbursements directly to investors, bypassing the usual class action trial lawyer route. More than 500 funds have also indicated their intention to reduce fees by roughly $800 million over the next 5 years. As we suggested might occur when the scandal broke, other fund marketing practices such as directed brokerage (sending fund commission business to brokerage firms which sell management company fund shares) has been killed, and soft-dollar usage (paying for broker-generated services like research with fund commission business) will be curbed. Still to be dealt with are sales trailer practices such as 12 b (1) payments to brokers.
However therapeutic all this might sound, the fund business, which today managers roughly $7.5 trillion in investor assets, must still confront a nagging basic issue. That concern, which will become more of a problem for fund management companies in the future, is the need to provide investors with better absolute and relative returns at more reasonable fees. In many ways victims of their own fund management company marketing success, today fund portfolio managers find their freedom of action constrained by massive amounts of shareholder cash inflows, often forcing them to alter time-tested investment techniques. The reaction on the part of portfolio managers, often reinforced by management company compliance-motivated corporate counsel, is to build portfolios that more closely replicate the benchmark (e.g., Russell 2000 for a small company fund) by which the fund’s performance will be measured. In other words, fund managers will fashion portfolios, which will be more passive in nature, but still charge active management fees. Today, the average mutual fund active manager increasingly under-performs his/her benchmark. Our screening process still uncovers a few outstanding managers in each asset class, but the challenge then becomes tracking a fund’s cash inflow characteristics to determine if a manager’s creative instincts can be freely employed.
As a footnote to the above, clients might be interested to know that the regulatory atmosphere for Registered Investment Advisors like TFC has become far more complicated. Future SEC compliance inspections promise to be more complex and in-depth. As of October 5th, a new set of SEC-mandated compliance measures became effective and the writer has been appointed Chief Compliance Officer for the firm. We feel that we have been and are in full compliance with all of the SEC’s new standards.
On A Lighter Note
Watching the Olympics in mid-August apparently prompted George Melloan of the Wall Street Journal to sit back and think about whether things were as bad as “…the daily diet of doom and gloom dished out by the press and TV” would have us believe. As he suggests, “Trouble makes news,” and there is enough of it to fill the front page on most days, plus the “politically motivated fakery” aimed at capturing the headlines. However, consider the obverse, be a bit contrary and follow Yogi’s advice. Family values are back, seven-grain bread has forced Wonder Bread off the shelves and into bankruptcy, chicken, fish, and red meat have prompted McDonalds to change its menu. Violent crime is down, drug use is declining, and teenage pregnancy rates have dropped. Amongst the “Echo Generation” (those today in the 12-25 year age group) “…self-restraint, commitment and personal responsibility” are by its definition commendable virtues. Being a good team member is an acceptable label. Globally, food production per-capita is up, many countries are on a course toward more liberal market-oriented economic development (e.g., China), life expectancy (except in Russia) continues to lengthen. In the U.S., contrary to class warfare rhetoric “…only 12.1% of families were below the poverty line, compared with 22.2% in 1960.” Occasionally, it’s useful to count one’s blessings rather than dwelling on the dark side.
Questions, comments and general observations are all welcome.
Sincerely,
James L. Joslin
Chairman & CEO
Renée Kwok
President