As I noted in the January Communiqué earlier this week, there is plenty to write about heading into the New Year. The corollary to that observation is that there is plenty for you to read. Well here goes.
I would like to reiterate that the economic outlook as confirmed by the ECRI has improved. Of course, the general outlook ‘improved’ for the residents of Hiroshima and Nagasaki improved when the bombing was over but there was a long road to full recovery. While the devastation of the US and global economies was not as severe, there is still a long way up to get back to the old normal created by 25 years of continued economic expansion - expansion created by consumption that was 20% above the norm. That level of consumption may not exist for another decade. What will take its place? Can the central banks bridge the gap with borrowed money? Will the central banks agree on that strategy? What will be the long term effect of that level of borrowing with money created out of thin air?
So the theme of this newsletter will be to list seven areas of concern that may make owning stocks and bonds a very risky investment right now. Where possible I will use other authors’ erudite explanation of a key area of risk. These are not new observations. However, I believe it is very timely now that a return to modest economic growth has caused a rally in stock prices since November 2009. In fact, this surge gyrated from gains to losses through September 2010 and is up 20% in just the last four months. Remember the old saying; what goes up must come down? Well as you consider the strength of this rally, please consider the foundation for economic growth upon which it rests.
Here is the partial list of potential risks that I believe we should take into account as we attempt to invest to create the income and growth needed to fund a safe and secure retirement income:
- Falling home prices and rising foreclosures.
- Rapidly falling commercial real estate prices.
- Persistently high federal government deficits.
- Growing state and municipal budget crises.
- Continue sovereign debt crises in Europe.
- Inflation in emerging countries.
- Inevitable bursting of the Chinese, government-driven infrastructure investment bubble.
The first risk, falling home prices and foreclosures, was addressed in the prior newsletter. Louis Stanislovich did an admirable job of outlining the pieces of that puzzle. That risk alone is enough to derail an economic recovery here and in other foreign economies. The US is not the only country that had a Baby Boom-driven residential housing bubble.
Commercial real estate may eventually experience the same fate especially since this type of owner is quicker to hand the keys back to the bank. Consider - If you own office space in addition to your primary residence, which are you most likely to hold on to until the bitter end? Let’s just say the people willing to pitch a tent in their conference rooms are in the clear minority.
The discussion of persistently high federal annual deficits and the existing debt over hanging the future of US as well as other developed nations is an old topic. In fact, I fear that we have become numb to the discussion and it has become difficult to understand the difference of scale between a billion and a trillion. The only good thing about this phenomenon is that there it presents us with a clear investment strategy that may protect your portfolio and potentially even make a profit. I will discuss this in a separate newsletter.
The same goes for the state and municipal budget crises. Buying the bonds of stable states and cities when the market panics can be a very profitable investment. Timing and investment selection is the key. Panic may create low prices even for fiscally-stable governments. These low prices equate to high, tax-free yields. We must be patient and have cash to be able to take advantage of these opportunities. For instance, in Virginia alone there are 8 counties with AAA ratings from Standard & Poors. This is all the more impressive when you consider that there are only 67 AAA counties nationwide. There are over 3,000 counties in the United States. (Source – S&P Global Credit)
The house of cards that has been created by intergovernmental lending between the members of the European Union is a huge risk to global economic stability. The opportunity here is the same as buying any bond at panic-driven prices and high yields. One must have dry powder or cash to take advantage of these opportunities. In addition, it may cause an increase in demand for US dollar-denominated bonds. Our diversification into bullish dollar mutual funds may profit from that increased demand.
Inflation in emerging countries is a fact. It may have a ripple effect in many ways. For example, there may be an increase in the costs of the goods they sell to us. This wave of inflation may hit the US and derail our economic recovery. At a minimum, interest rates may go up causing bonds to be a better investment than stocks. This may derail the stock market rally. Do you see how the risks lurking below the surface can so easily take a four month, 20% run up in the stock market to a loss very quickly?
Now we come to China and its amazing growth story. The easiest point to make is that the recent growth is the product of building things like airports, roads, office and apartment buildings and factories that are not being used. Of course, they can eventually be used since there are so many people living n China. Yes, the rest of the world will eventually begin to grow and need the production capacity of those steel mills. Right now, however China has approximately 2 ½ times the steel production capacity currently needed by the developed world. Therefore, the problem is the time lag that may last for decades. The investment markets expect steady growth every year if not every quarter. Imagine the effect of a slowing in growth or even a recession finally acknowledged by the investment community. Recall also that this past summer China’s government ordered a series of stress tests on the banks that factored in a 60% default rate on mortgage loans. This action, while prudent, acknowledges how sensitive their own economy may be to bad loans collapsing under lagging demand.
We intend to follow up this newsletter with research and commentary from various other sources. There is much to cover.
We will continue to cautiously deploy your capital in this environment of tenuous economic recovery. We value your feedback and welcome your questions.
Until Next Month,
Your Advisors at Dominion Wealth