A few weeks ago I was attending a Weight Watchers® meeting in my never-ending battle to lose weight. The subject was, Where We Eat our Meals and the Environment in which We Eat Them. The answer was simple for me. I eat at home in the kitchen or dining room. I eat lunch in the office kitchen with the staff most days, and I also eat out at restaurants. I was surprised by the number of people who eat their meals in various non-traditional venues.
One young lady said she eats breakfast, lunch and sometimes dinner in her car. She is in sales and on the road all day and cannot eat her meals at restaurants or at home.
She said her car, littered with used food wrappers and containers, was disgusting. Her comments got me thinking about how important my environment is to me. This is something I have become keenly aware of over the past decade. When my office is piled up with newspapers, magazines, research materials and annual reports, I can’t focus. Then I feel the need to devote a day to cleaning the place up. It’s amazing how focused I can be when I work in a clean, uncluttered office.
I asked her if I could make a suggestion regarding how important my environment is to me. She agreed. I explained it to her and suggested she take her car to a car wash, clean it out and have it washed and detailed. I said, “You’ll feel better in the clean and uncluttered car, and you’ll probably feel more confident.” I also said that I would be willing to bet that her sales numbers would increase if she does this. She looked at me with her eyes wide open, and said, “You must be an oracle! My car was in the repair shop all last week, and I rented a brand new car for the week. I just had the best week ever in sales.”
I’ve also noticed in the last decade that the quality of my decisions improves when the environment is right. As a matter of fact, because I am a heavy duty fact finder, it used to take me forever to make a decision because I wanted all the facts. In the right environment, I require fewer facts, because I’m clear on what’s important and what’s not important, and make much better decisions much faster.
Lately, I’ve noticed that people are distracted by the recessionary environment in which we find ourselves and by the poor stock market performance that is a byproduct of that environment. At times like these, the market is undiscriminating and erratic with the trend being down. It seems that people don’t want to make decisions or commitments because they are not clear about the future. There is an old saying on Wall Street: “When the tide goes out, all ships sink to the new level.” It’s clear that the sub-prime mortgage meltdown, the ensuing credit crisis, lack of liquidity and a slowing economy constitute a tidal event. Those of us with experience in the market have seen this movie before. We know how it’s going to end, but we still seem to cry in the middle of the movie.
So let’s be clear on what’s been happening and put it in a more useful perspective.
1. We are most likely in a recession. We have had four recessions since 1980 and they have lasted an average of 9.5 months.
2. We have had eight recessions in the last 50 years, six of which have been accompanied by bear markets. This includes the last three recessions.
3. A bear market occurs when multiple market indexes decline 15% to 20%. The S&P 500 index is down almost 20% from its mid-October 2007 high to the end of the first quarter in 2008.
4. What you read and hear in the media is mostly generalization and does not necessarily reflect how your portfolio is performing. There are different asset classes in your portfolio: stocks, bonds and cash.
a. The Lehman Brothers Aggregate Bond Index is up about 3.36% since the October 2007 high of the stock market to the end of the first quarter..
b. Cash or money funds have returned about 3% during this period of time.
5. Therefore, if you owned a moderate-risk portfolio with an allocation of 60% stock, 35% bond and 5% cash allocation, it would be down about 10.85% during the same period of time, about half of what the S&P 500 is down.
6. The lesson here is that asset allocation is important. It lets one ride out market declines without losing as much as the market itself. As uncomfortable as this is, it has always been the right thing to do. Since we are starting with more money when the market turns around, we don’t have as far to go to get back to breakeven and begin to make money on the upside.
7. Diversification within asset classes is also important. For example, having both domestic and foreign exposure helps, since other markets around the world are growing faster than the U.S. market. In addition, diversifying among industries and among companies within the same industry also helps protect the value of your portfolio. For example, precious metals, commodities and agriculture are sectors that have been positive over this period of time.
The Federal Reserve has taken actions recently to defuse the credit crisis. Most of these moves have further weakened the U.S. dollar (which is inflationary for you and me). In addition, most economists agree that these actions have the potential to increase inflation in 2009 and beyond. This year is an election year, so the Fed’s willingness to act is good for the politicians and is improving short-term liquidity, but it’s probably not good for the economy longer-term.
Our focus is on the longer-term economy and there is good news amidst the constant media drumbeat of economic and financial woe, as we outlined in our March 2007 e-newsletter titled “Uncertainty.” Here is an update on those comments:
The Good News
Looking at the bright side, we are now part of a rapidly integrating global economy. While a slowdown in the U.S. will obviously have some global impact, it will not push rapidly growing countries like China and India into recession. They will continue to grow, albeit at a slower pace that will actually be beneficial to those economies longer term by easing inflationary pressures. The most recent indication of this trend is the World Bank, which lowered its estimate of China’s economic growth for 2008 (from 10.8% to a still blistering 9.6%) (1) due to cooling global export demand, particularly from the U.S.
The Prescription
So, what’s the prescription? Well, it looks like the government is doing everything possible to bail out the housing and credit industries in an effort to stop home prices from declining further. These actions are weakening the U.S. balance sheet and are inflationary longer term. To combat the future threat of inflation, our government now needs to produce a serious policy of energy independence with an emphasis on efficiency and cleaner (and renewable) energy sources. The goal of such a policy will be to ease our over-reliance on increasingly expensive oil. You may even begin to hear the “n” word again (that is, nuclear) as the higher cost of energy and food becomes too painful for the consumer to cope with.
I know this has been a taboo topic domestically since the Three Mile Island incident in 1979. But let’s at least start a dialogue on the subject again. Let’s start with some facts. Did you know that there are currently 65 nuclear energy plants operating in the United States, accounting for about 20% of the country’s electricity output? France has 58 nuclear power plants that supply 76% of that country’s energy. Currently, nuclear reactors account for approximately 17% of global power generation.
Could a nuclear energy policy free us from our dependence on foreign oil? Could nuclear energy be a means to cleaner air? Nuclear energy has zero carbon emissions. Wouldn’t it be ironic if nuclear energy became the answer to Al Gore’s An Inconvenient Truth movie? While I’m not an expert on this subject, I have to assume that we have the technology to operate these plants safely. I don’t recall another Three Mile Island incident in the U.S. in the last 39 years. Can you also imagine how much less money would be in the hands of oil producing countries, which are now buying up U.S. companies and land using their sovereign wealth funds?
I think it would be beneficial to initiate a dialogue again. Given the attention nuclear power received in the 2005 Energy Policy Act – which included incentives for nuclear plants and plans for two dozen new reactors – it appears attitudes may be shifting.
Increasing inflation, higher interest rates and tighter credit will eventually help this economy emerge from the recession by imposing some badly needed fiscal discipline, but it will extract a price in doing so. Lower housing values, less consumer spending and higher food and energy costs will be the norm for a few years.
In another scenario, the government might attempt to stimulate the economy by using the savings gained from winding down operations in Iraq (the outlay for which is estimated to be $12 billion a month) on badly needed infrastructure maintenance and expansion instead of paying down the deficit.
The Strategy
I think a good assumption, at this juncture, would be that the dollar will remain weak and perhaps fall even further. U.S. stocks will remain weak in a slowing economy and bond spreads will continue to widen (short rates go down while long rates increase) generating a more conventional yield curve as we emerge from the recession.
This means adopting a more defensive asset allocation strategy by:
1. Creating the proper risk-controlled asset allocation (stocks, bonds and cash) that meets your tolerance for risk (volatility).
2. Placing an emphasis on high quality domestic stocks and bonds.
3. Large-cap multi-national stocks (dividend paying) are at good valuations at these levels.
4. Municipal bonds are very attractive right now for tax-conscious investors, as are high-quality foreign bonds. (As it seems likely taxes on the wealthy will rise, it will stimulate demand for municipal bonds creating a profit opportunity).
5. Increasing holdings of foreign equities (less exposure to the dollar).
a. An allocation of 20% to 50% in foreign equities.
b. Both high-quality and emerging market equities.
6. Employ limited portfolio-hedging tactics to reduce some of the downside risk for the near term until we see some evidence that the economy is beginning to recover.
7. Focus the portfolio’s securities by overweighting promising areas that will have pricing flexibility in an inflationary environment and will maintain the purchasing power of your portfolio. Those areas would include agriculture, energy, natural resources, precious metals and health care.
8. Look for an infrastructure opportunity, should we get a government that will try to stimulate the economy through public works projects (deficit gets bigger and dollar stays very weak or declines further).
So, the lesson here is to be in a nice, quiet and uncluttered environment when making important decisions related to strategies like those outlined above. It allows a clear focus on what’s important while maintaining the patience of Jobe to ride out the recession. While there are no easy answers, employing a sound and prudent approach to portfolio management will help to smooth out the ride as the markets recover. Remember that recessions are a normal part of the business cycle, and adapting allocation strategy to recessionary conditions is a normal part of the investment process. Also, bear in mind that periods of market decline offer opportunities for discerning value investors who can more easily buy up high-quality companies at a discount.
Speaking of making better decisions, Roe and I were in a luncheonette having breakfast last week when the couple sitting next to us had their food delivered to the table. The middle-aged woman had ordered “The Hungry Woman’s Special.” You name it and it was on two plates. There was so much food. The woman smiled at us and said she was starting Weight Watchers® on Monday. Her husband turned to us and said his wife had joined Weight Watchers® once before and lost $300. I suddenly realized why Weight Watchers® is so focused on making better choices. If you don’t exercise discipline, you won’t reach your goal. It’s the same for portfolio management, as it is for most things in life.
Weight Watchers® is a registered trademark of Weight Watchers International, Inc.
Footnote: (1) According to the Financial Times, March 24, 2008
