US politics are still a significant risk, as some politicians may recreate the debt default threat like in 2011, or allow very contractionary tax hikes and spending cuts to take effect at the start of 2013. Both parties have good reasons to compromise, but that doesn’t mean they are certain to.

Neither of these wildcards changes our longer term outlook for the US economy, which we believe will improve once residential construction is again building at a sufficient pace to keep up with population growth as we discussed in last year’s post here .  We are in fact seeing what could be the beginning of a return to those levels as discussed here.

Car sales and production continue to do well as we expected from last year’s post here.  US auto makers are running their plants at a very high level as discussed in this story.

We should also be approaching the point at which local and state governments’ tax revenues are stabilizing and starting to improve, which should lead to the end of large scale government layoffs which have added quite a bit to the unemployment rolls over the last couple of years.  If they merely stop cutting jobs, it will actually be a boost to GDP growth.

These themes are why we remain optimistic about the five year outlook for the US economy.  The wildcards may create a recession and stock market sell off in the short term, so we have gotten a little more defensive, but we are also mindful that the longer term outlook is good so if we do get a sell off, we will use that opportunity to buy stocks with funds from sales we made earlier this year.

Keep an eye out, as we’ll be posting more detailed analysis soon on the two wildcard themes, Europe and US Politics.

Of course not everything that is sold as exclusive is lacking in value.  Viewing the Super Bowl from the first row on the fifty yard line is undoubtedly a fantastic experience, at least for most football fans.  And a long stretch of beach with few others in sight is more enjoyable to some than being one of thousands at Myrtle Beach on July 4th.

The most extreme recent example of exclusivity psychology being used in an abusive way is Bernie Madoff.  His fraud will likely go down in history as the largest fraud that preyed mainly on the wealthy.

He and his accomplices (both the ones in the know as well as the naïve), cultivated a brand that was built on exclusivity.  Potential investors who dared to ask questions about how he was generating high risk-free returns, were told to take their money elsewhere.

Of course the tragedy is that he was not generating high risk free returns. He was merely a thief and a cheat.

Hedge funds are marketed as investments available to the wealthy.  They develop messages that seem to tell wealthy investors that unlike common investors, they can achieve superior investment returns with little or no risk.

The track record however is certainly less than convincing.  In 2011, the HFRX Global Hedge Fund Index* which is “…designed to be representative of the overall composition of the hedge fund universe.…”, lost 8.87%.  And this was after less than stellar returns of 5.19% in 2010, and 13.40% in 2009.  The annualized three year return was only 2.8%.

At Financial Symmetry, we have always balked at the very high fees that hedge funds charge.  And we also do not believe that you can achieve good long term returns without experiencing some periods with losses.

By implementing a well designed investment strategy, there are opportunities presented during a period of falling stock prices that will enhance returns over a full market cycle.

Our composite return**, which includes all of our clients, also had a loss in 2011. However it was only 2.32%.  And that followed a return of 11.05% in 2010, and 23.79% in 2009.  Our three year annualized return was 10.32%, or 7.5% per year more than the average hedge fund investor.

When it comes to investing, there are times when being part of an exclusive group can provide superior results.  One example is when a quality small cap fund closes to new investors before the fund becomes too large to successfully maneuver.

Then there are circumstances where fundamental design, combined with high costs, add up to an almost insurmountable hurdle.  Hedge funds, in their present form, seem to have this problem.

* Source www.hedgefundresearch.com
** Please contact us if you’d like more details on Financial Symmetry’s composite performance results.

One of the ways you can check to see how a charity is spending their money is to look them up online using Charity Navigator.  While the caller was on the line I went to Charity Navigator to look them up.

I could not find them and was told by the caller that they don’t submit information for rating since it costs money and since Woman 2 Woman is a non-profit they try to save money where they can.

I then went to the Woman 2 Woman website and found their audited financial statement for 2009-2010.  Turns out that in 2010 they had revenue of nearly $6.5 million, and that they spent $6.2 million on fundraising!  After an additional $60,000 in Management and General expenses, they spent only $201,000 for their stated mission.

That means if I had donated $100 to them in 2010, they would have only used three dollars to help breast cancer patients.  Needless to say they will not be receiving any donations from me.

If you get a call from a charity, do some homework and you can make sure that your money will get used for the purpose you care about.

Changing Health Care Costs?

As we pointed out in out our post on the cost of health care, getting healthcare costs under control is by far the number one thing we need to do for the long term fiscal health of our nation.

The Cleveland Clinic is bucking the ever increasing cost trend with some inspired strategies.  As their director of wellness put it “We want to make it easy for you to do healthy things and hard for you to do unhealthy things”.

Read about what they’re doing here.

Click to see data charts

When it comes to investment markets, determining “The Fairest of them All” depends not just on where you are investing, but also on the initial conditions.

We’re going to look at two different time periods to get a sense of the attractiveness of three primary investment areas – Cash, Bonds and Stocks.

For cash we use the three month treasury bill yield.  For bonds we use the ten year treasury bond yield.  And for stocks we use the earnings yield on the S&P 500.  The earnings yield is the reported earnings per share as a percent of the price per share.

The 2000s

First is the beginning of 2000, and the starting yields.

• Cash     5.5%
• Bonds    6.5%
• Stocks   3.5%

Over the next ten years, the annualized returns were

• Cash      2.71%
• Bonds     6.38%
• Stocks  -0.95%

Notice that for bonds, the return for the ten year period was just about the same as the starting yield.  This makes sense since we measured the return of ten year bonds over ten years.

For cash, the return being lower than the starting yield was a reflection of falling interest rates over the ten years.

For stocks, despite the fact that reported earnings are now about 70% higher, the return was negative.  This is because the very low earnings yield was indicating that stock prices were significantly overpriced.

The 1990s

The second time period we’ll look at is the ten year period starting in 1990.  The starting yields were:

• Cash     7.8%
• Bonds    7.9%
• Stocks   6.5%

Over the next ten years, the annualized returns were

• Cash       4.85%
• Bonds     7.70%
• Stocks   18.21%

Once again, the return on ten year bonds was almost identical to the starting yield, while cash earned less than the starting yield due to falling interest rates.

Now let’s take a look at current starting yields (see graph below).

• Cash      0.0%
• Bonds    2.0%
• Stocks   6.7%

What does it all mean?

So the current valuations are the mirror image of what we saw at the beginning of 2000.  And while we don’t know exactly what returns will look like over the next ten years, the initial conditions mean the odds are that stocks will provide the highest return of the three.

We do not think stocks are likely to earn over 18% a year like the 1990’s as we are not expecting stocks to reach a point as overvalued as they were in 1999.

Our guess is that bonds will have the worst returns given that we wouldn’t expect returns to be higher than the starting yield of 2%.  We do however expect cash to average more than the current 0% as we expect interest rates will rise at some point this coming decade.

We also need to understand how much stronger housing may get.  The graph below shows the number of housing permits issued each year since 1959.  The Linear trendline shows the gradual rise over time, which is reflective of the growth in the number of households in the country.  Since our population continues to grow, we can say with a high degree of certainty that the future trendline is likely to be close to its current level, which is about 1.4 million new units per year.

While we clearly overbuilt from 1996 to 2007, we have also been significantly underbuilding since 2008. At our current pace of only about 600 thousand new units, we can then feel quite confident that the longer we continue to underbuild, the more we will have to build in the future.

This second graph represents housing permits in red (left scale), overlaid with the unemployment rate in blue (right scale inverted).  As one would expect, residential construction has a significant relationship to employment.

Based on this relationship, we believe that when residential construction gets back to the level needed to keep up with our growing population, we will have unemployment under 6%.  We cannot say with certainty when we will see this construction recovery, but it is very unlikely to be more than four years from now and will probably be more like two years from now.

And this coming resurgence in construction is not just about houses for purchase, as the data above includes apartments.

This is a good look at some major components of the US economy over the last 16 years.  There are a few insights that are particularly meaningful in understanding why overall job growth has continued to be disappointing.

Two of the areas show strength since the bottom of the recession in 2009: Exports and Business Equipment Investment.

We often hear the belief that the US doesn’t make anything, much less make things that the rest of the world wants. But we can see from the black exports line that exports have grown over the last 15 years.  We can also see that since the bottom of the recession in 2009, exports have recovered.  So this is an area of the economy which is doing surprisingly well.

The blue line shows that companies have been investing as business equipment investment has recovered well from the low point in 2009. However businesses won’t invest significantly more until the overall economy is stronger since businesses invest and hire when they have more customers.

Two of the areas are not helping with the recovery: Government Purchases and Residential Construction.

The green line for government purchases relative to the economy shows that such purchases have been declining for the last 15 years.  While this was not a negative when the other areas were strong- like from 2003 to 2005, and from 1995 to 2000, this was because the other three areas were strong.  With the most recent decline, it occurred while only two of the other areas were increasing.

The biggest reason we have high unemployment is clear from the red line- Residential Construction.  If this area had started recovering as government purchases started falling this year, then we likely would not be in our current slowdown.

Fortunately, there are good reasons to be optimistic about construction getting back on track. We believe this will be what ultimately brings unemployment down to reasonable levels.  Basically we are currently under-building residential units.  We explore the reality in this post.

Below is a chart showing a composite of all of our clients’ returns starting in March of 2002 (Point A).  Six months later (Point B), account values were an average of almost 13% lower.  Jumping ahead to Point C we can see that despite the short term loss from A to B, returns averaged a 6.6% annualized return. This was good compared to the more conservative alternatives of cash which only earned 2% (three month Treasury bills), and bonds which only earned 5.8% (Barclays US Aggregate Bond Index).

Returns from Point B were better, averaging 8.8% to the end of 2010.  Of course if we had a perfect crystal ball, we would have sold all stock holdings earlier in 2002 and bought back at the very bottom in late 2002 (and sold everything at the peak in 2007 and bought back at the bottom in 2009, and then sold everything in early 2010, and so forth…however no one knows everything, especially about the future).

There are a couple of important lessons from this example.

First, you should have enough funds in cash and bonds to cover withdrawals you’ll need to make in the next few years, so that you will not be forced to sell stock positions if prices are low.  We use our risk capacity measurement to set appropriate allocations for cash and bonds based on expected withdrawals.

Second, returns from lower prices are higher, so use lower prices as opportunities to buy.

In operation, the higher your capacity for risk, the more of your portfolio can be allocated to stocks which offer higher long term return potential but have greater short term volatility than cash and bonds.

The chart to the left demonstrates the historic ranges of returns for US Stocks going back to 1928.

As you can see the average one year return is 11.3%, but has been as high as 52.5% and as low as -43.8%.

Then as you look at longer time periods, losses become less likely, and over periods of at least fifteen years there has been only one loss of 0.2%.

Notice that while the difference between the best and worst returns gets narrower as you look at longer time periods, the average returns are close over all time periods.

Bond and Cash returns follow a similar pattern, with the difference between high, low and average returns being lower for bonds, and lowest for cash.

So a sound investment strategy should take into account when you are likely to need money from your portfolio, and allocate the money you won’t need for many years to stocks, while money you will need in the next few years should be in bonds and cash.

Below are some examples of how our Risk Capacity formula puts this into practice.

The more money you will need each year, the more you should allocate to bonds and cash and this results in a lower stock allocation.

If you are saving money for the next several years, you can allocate more to stocks and less to bonds and cash.

Risk capacity is also dependent on the amount of savings or withdrawals relative to the size of your portfolio as can be seen by the difference in stock allocation for examples C and F.

Example F shows that a maximum of $200,000 of the portfolio would be in stocks, thus allocating $300,000 to bonds and cash which would allow for six years of withdrawals at a $50,000 annual pace.

Example C would allocate $650,000 to stocks and $350,000 to bonds and cash, which would be seven years of withdrawals in bonds and cash.

Don't push the panic button

Probably not, even though it may feel like it.

What’s Going On

The financial markets have been hit with a steady barrage of negatives.

Europe is still struggling to address the problems inherent in the Euro — namely that they have a currency union but not a political union.

Here in the US the short term budget deficit caused by the Great Recession is being confused with the long term budget problems.

These long term problems are primarily about rising healthcare costs, tax revenues that are too low by historical standards, and to a lesser extent Social Security.

This confusion, combined with a toxic mix of politicians in this year’s Congress, caused a dysfunctional budget process. And this dysfunctional process caused Standard & Poors (S&P) to downgrade US Treasury debt (though that company’s past performance on debt ratings leaves substantial doubt about whether they should be listened to).

On top of all of this, we were already in a slowing industrial cycle directly related to China tightening their monetary policy to bring their inflation rate down.

Reactions

Fear that these issues could push the US and the world into another recession is causing falling stock prices.

Most tellingly, these issues have actually reaffirmed investors’ faith in US Treasury debt as Treasury prices have steadily risen as the negatives have piled up.

Clearly investors do not believe that S&P was correct with their downgrade, or US Treasury prices would be falling, which causes rates to rise.

In fact, since the beginning of the year, the yield on the ten year Treasury bond has fallen from 3.4% to 2.4% as fearful investors sought a safe haven. And most of this decline in rates occurred in the last two months as the debt crisis manufactured in Congress ramped up.

This Day in History

Our research tells us that it is not uncommon at this point in a recovery to have a slowdown, so the current economic slowing may not lead to a recession.

Furthermore, the current recovery is only a little over two years old, and in the last 80 years there have only been two recoveries that lasted less than 3 years. In both of those previous cases, the stock market did correct, but the decline was less than 20%.

Double Dip?

There are good reasons that this current crisis is not likely to be a repeat of 2008.

Households and corporations alike have spent the past few years rebuilding their balance sheets. Corporations have become leaner and added significantly to their cash positions.

This should enable them to weather an economic downturn without needing to make layoffs on a scale like we saw 2-3 years ago.

More Good News

We are also encouraged by attractive stock market valuations.

The current stock market’s earnings yield is around 7%, which provides a much higher return potential than high quality bonds which are only yielding about 2% to 4%.

We also believe that companies will see rising earnings over the next 5 to 10 years. Even though the decade of the 2000s was a poor one for the US economy, earnings of our big corporations still rose by about 60%.

For the decade of the 1990s, earnings rose by over 100%. So it is plausible to believe earnings will rise over the coming decade at least as much as in the 2000s.

What We’re Doing

As has been our experience with large market drops like this one (and large market rises as well), we have learned not to make investment strategy decisions based solely on short term market gyrations, though they can present opportunity.

Our research lead us to reduce stock allocations at higher stock prices in late 2007 and earlier this year. Conversely we will be increasing stock allocations at these now lower prices.

We are paying close attention to valuations as some sectors are not as reasonably priced as others.

We are continuing to emphasize large-cap, high-quality companies as they are more attractive than smaller stocks at current prices and better equipped to endure difficult conditions.

Our focus on international equities is in developed economies as they too, have better valuations when compared to emerging markets, though we are maintaining a position in emerging markets as we anticipate those countries to be the drivers of growth during economic expansions.

Many high-quality US companies are also uniquely positioned to take advantage of the emergence of a middle class in China and developing economies as they expand their operations into these markets.

Given that emerging market stocks have also declined, we may be bringing up emerging market allocations for the first time in several years.

The Bottom Line

When fear is high and confidence is low, people have a difficult time seeing how things will get better.

But they always do.

* Photo credit: jma.work