Performance figures for each account are calculated using time weighted rate of returns on a daily basis. The Composite returns are calculated based on the asset-weighted monthly composite constituents based on beginning of month asset mix and include the reinvestment of all earnings as of the payment date. Composite returns are as follows:

The Rub: Where is The Economy Going and How Can We Prepare?

By John Nicola, CLU, CFP, CHFC

“Ay, there’s the rub.”

When Hamlet spoke these words more than 400 years ago, “the rub” – meaning an obstacle or difficulty – was him grappling with thoughts of committing suicide. Today one might argue that “the rub” in the financial world is how countries such as Greece, Portugal, Ireland, Spain and Italy will fund their debts and deficits.

But that might be just one rub among many:

  • Will “The Gang of Six” (three Democratic and three Republican senators in the U.S.) be able to come up with a compromise budget proposal before the August 2nd deadline when the U.S. could officially default on its own $14.2-trillion debt?
  • It is possible there will be global cuts in government spending despite high unemployment rates – will equity markets nosedive under the weight of such potential negative economic stress?
  • Is it time to liquidate assets, buy gold and head for the hills?

Liquidate and Hibernate?

Recently, a few clients have been wondering whether or not we should, in fact, liquidate our positions in equities and financially hibernate until this debt debacle is over.

What, they argue, is the point of remaining in this asset class when such ominous clouds can easily be seen on the horizon?

A fair question and one that might, in the end, prove to be right (at least temporarily).

However, there are strong reasons for sticking to a disciplined asset allocation approach and focusing on both cash flow and diversification. Before I get into our belief systems though, I think it fair to take a look at how bad things are and what might occur over both the short and long term.

Perhaps Oliver Hardy said it best to Stan Laurel back in the 1930’s (another torturous decade financially): “This is another nice mess you’ve gotten me into.”

There is no other way to describe this fiscal situation than “it’s a mess.”  Likely one that will get worse before it gets better. Here are my own observations:

  • As we wrote a year ago, Greece is bankrupt and much of this renegotiation of the terms of their debt is the financial equivalent of rearranging deck chairs on the Titanic. The markets have already determined that Greek debt is, at best, worth 50 cents on the dollar (Greek two year bonds trade at an interest rate of about 28%) and at some point the holders of that debt will lose 50%.  This in my mind is no longer a question of “what,” but of “how.” As of July 21, 2011 a new proposal to ”save” Greece has a European bailout fund lending new money at much reduced interest rates and extending repayment by many years.  Bottom line: this is a constructive default; the first in the 13-year history of the euro.
  • Portugal and Ireland will also not be able to handle the amount of their debt and the market interest rates on that debt (as it rolls over). Whatever happens to Greece by way of write downs on current debt will likely occur here as well. (As of mid-July, Irish 10-year bonds were paying 14% interest and Portuguese Bonds almost 13%, compared to just under 3% for Germany.)
  • Apparently according to some, Italy and Spain have also crossed the Rubicon. Last week, rates on their 10-year bonds rose to just over 6% or about 3% more than Germany pays. In the case of Italy, this is a considerable issue since it is the third largest economy in the Euro-zone and, perhaps more importantly, the third largest government bond market in the world (after the U.S. and Japan). Italy’s debt is now 120% of GDP (in Canada our equivalent federal and provincial debt is about 65%). Since then, markets have calmed somewhat and the spread between Italian and German bonds has dropped to 2.6% (July 21, 2011).
  • Europe is a mess, but not all of Europe. Germany is actually in very good fiscal shape and Europe as a whole has lower debt-to-GDP than the U.S. The problem is structural: Europe has a monetary union, but not fiscal union. This needs to be solved. It is unlikely that Spain and Italy will (or should) default, but if no one wants to lend to them, they may have no choice.
  • Not letting Europe have all the fun, U.S. lawmakers are playing a game of financial brinkmanship as they are determined to achieve the aims of their supporters. “Tea Party” Republicans will not allow any tax increases to balance the U.S. budget deficits (expected to be about $1.5-trillion in 2011) while at the same time denying any need to reduce benefits such as Social Security or Medicare (apparently Tea Partiers age the same as the rest of Americans). At the same time, Democrats want to solve the debt crisis with tax increases as the primary method (because they, too, are aging).
  • So far no one has blinked and officially, by August 2nd, the U.S. will potentially default on its debt.  They would probably simply stop paying their bills first (such as wages for civil servants, social security benefits, etc.) so that interest payments on debts will continue. However, the markets would not likely see it that way and no one really knows what might happen to U.S. bond rates. James Carville (advisor to Clinton) had it right when he said “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
  • The U.S. debt situation is all political and posturing for the 2012 election. If this were such a big deal, why have U.S. interest rates stayed so low? The bond market may be intimidating, but so far it hasn’t disciplined the U.S., leaving deflation as the primary source of anxiety.

All of the above are relatively short-term issues that have long-term underlying fiscal and demographic problems that have yet to be honestly addressed amongst most developed nations of the world. Perhaps we need another crisis in order to develop workable long-term solutions to questions such as:

  • How much health care can a government provide its citizens?
  • When should people be able to retire and how much of that retirement should be funded by the government?
  • Should governments have to report their unfunded liabilities in the same way they require the private sector to do?
  • Is the government’s primary job to provide a safety net or cradle-to-grave universal care?

Our bigger long-term concern is that governments will keep borrowing and de-base their currency (which is why gold is part of our strategy). Government spending doesn’t create sustainable growth in most cases. So while cutting deficits now could hurt economic growth in the short-term, it remains the best long-term solution.

I believe we are closer to dealing with these and other key issues than ever before, so in my mind we should follow Rahm Emanuel’s (Obama’s former Chief-of-Staff) advice and “never let a serious crisis go to waste.”

Allocating Assets for the Unpredictable

In the meantime, however, we need to decide on how we want to allocate our capital in this very challenging environment.

We have said in our last two Market Outlook Seminars (maybe even the last three) that the deleveraging process will take many years to play out. These peaks and valleys should be expected – remember, the market has had a very strong rally up until just a few months ago.  We have put in place an investment strategy that takes this deleveraging into consideration using diversification and cash flow among other strategies.

First a brief review of our expectations for interest rates as well as equity and real estate markets.

  • The bond markets are showing they have the power to discipline governments. The likelihood of continuing reductions in deficits and reduced government spending will be, at best, a small anchor on economic growth in the developed world. This should result in interest rates remaining relatively low for quite a while longer and for inflation to remain subdued. Outright deflation is very much possible.
  • According to the most recent Cap Gemini report on World wealth, Global savings –governments (yes, Virginia, some of them do have surpluses), corporations and individuals – is about 22% of GDP. That works out to about $12-trillion dollars per year. Those savings have to go somewhere. We fret constantly about the rising levels of debt, but one country’s debt is another investor’s asset. Is it possible that this sea of savings is one of the reasons that global interest rates are currently so low? (Absent rates for those countries or corporations at risk of default.)
  • While equity markets are not particularly cheap or expensive right now, we still feel that the secular bear market that started in January 2000 has a few years left to run. Capital gains will be hard to achieve. Therefore, income from dividends and covered option strategies will remain our primary focus in terms of equity investing.
  • Low interest rates should be good for real estate, and cap rates have certainly dropped over the last few years. Eventually, rates on mortgages and cap rates will rise. Hopefully, that would also mean that strong economic growth will have returned, which helps support increased rental income over time. For now, we remain committed to acquiring assets where we can lock-in at least a 2% spread between our borrowing rates for mortgages and the income return on the asset (specifically if we buy a building for $20-million with a $12-million mortgage at 4.5%, then the building needs a cap rate – net income on the building – of 6.5% or more).
  • Additional opportunities for income and capital appreciation exist in assets such as royalty trusts, farmland, mezzanine financing, and direct ownership of small and medium private enterprises. In each case, one has to consider risk and return, but overall we feel that a pool of such assets would provide a very attractive risk-adjusted return with good diversification.
  • Overall asset allocation will remain a very important part of portfolio design going forward and we are constantly seeking ways to broaden our diversification. Below is our current asset allocation averaged over all of our clients. Some are lower or higher based on their personal circumstances. Including alternative strategies, total equity exposure is about 32% and much of that is hedged in some way.

The Approach is The Difference

As we move through this tumultuous and uncertain period, here are a few things to keep in mind about our approach:

  • Market timing does not work with any consistency and in the end our objective is good results after expenses and taxes (there are a lot of studies on this).
  • When it comes to equities specifically, we want to own dividend paying companies that will grow their cash flow. We believe that the secular bear market we have been in for the past ten years will continue for some time, and our approach is to write calls and puts to increase cash flow and reduce volatility.
  • Our mandate for clients is to build diversified portfolios that have an increasing annual cash flow each year. We worry less about the price and more about making sure we adjust portfolios with some discipline. In other words, if the equity markets have risen considerably in the last 18 months (which they have), then rebalancing should have already taken funds off the table and put them into other asset classes. However, if markets correct by 30% then we’ll be buying – not because we are market timers, but because we can buy more cash flow (dividends) at a better price. This is our understanding of building wealth. Anything else to us is a form of gambling.
  • I fully expect to see at least one major market correction in equities in the next five years. I have no idea when that will be, but I do know I’ll be adding to my equities when it does occur. In the meantime, we’ll do what we have always tried to do: buy quality companies, hedge their price and income with options, and keep our allocation to equities to somewhere around 30%. This approach has worked quite well for almost twenty years in both good and bad markets.
  • Perhaps a final question is: should we be more aggressive with market timing when we see potential crises on the horizon. For us, the short answer is “no” and here are just some of the reasons why:
    1. One could have made a great argument that Europe had an obvious debt crisis a year ago. Our client accounts are up about 10% since that time. It would have been perhaps 1.5% had portfolios been in cash.
    2. One of the best predictors of the 2008 Banking Crisis was Peter Schiff who, at the end of 2007, told everyone to leave the U.S. dollar, buy foreign currencies, gold, commodities, etc. He was completely right about the crisis almost a year ahead of Lehman going bankrupt, but investors who followed his advice lost 63% of their capital by January of 2009. If they had stayed in stocks they would have lost 45%, if in a balanced portfolio perhaps a 20% loss, and if in a cash flow diversified portfolio such as the ones we have recommended for years, the loss would have been 6.5%.  As Yogi Berra said, “Predicting is hard – especially about the future.”
    3. Most of our clients are increasing their wealth over time. That means they are net buyers of assets. If this is true, and they are diversified, then in fact we want the price of assets to drop on a regular basis since we know at some point we are going to want to be a buyer.

When all is said and done, perhaps the real “rub” in all of this is that we simply want to see World governments in particular show proper fiscal responsibility. That said, we also seek higher interest rates on our fixed income assets.

Unfortunately, deleveraging and rapidly rising interest rates are normally mutually exclusive. John Maynard Keynes spoke of the paradox of thrift: at some level, too much saving (or deleveraging) would make the economy worse and keep interest rates low.  Ay, there’s the rub.

We live in challenging and yet interesting times, but we believe our investment philosophy and strategy will see us through this tumult. It is important for us to remain vigilant, but also humble enough to realize that accurately predicting the future is a pursuit best left to tarot card readers.

Let us know your thoughts in the comments below!