This past week, my fifteen month-old, Finley, started taking her first steps. She’s been a solid climber for months (we frequently find her on top of the dining room table or in the dishwasher) but she’s been a bit more hesitant to walk. So, in an effort to be pushy parents, our new favorite after-dinner activity is for all four of us (Millie, three year-old Grayson, Finley and me) to sit on our kitchen floor and unashamedly make Finley walk from person to person.
And she really loves it…at first. We stand her up and she’ll stumble her way to the next person six feet away, ultimately landing in their lap with a squeal and a giggle. Of course, walking in our house isn’t easy. For starters, Finley has a big sister with the wingspan of a basketball player and the excitement of a cheerleader. Grayson frequently gets technical fouls for “excessive celebration” involving neck hugs that are a little too tight. Then there’s the 8 year-old lab mutt with a licking tongue and wagging tail who is all too excited that we’re all on her level. Worst of all, Millie and I are those parents that scoot back as the toddler nears us; hoping to get a couple extra steps out of her.
I’m astounded at how much of a pounding little Finley can take. She keeps toddling and falling, toddling and falling. Invariably though, all our “training sessions” seem to end with Finley crying, pouting and/or just flat-out refusing to put her feet on the floor when one of us tries, one last time, to stand her up. She’s a resilient kid, but she can only take so much before she is “open tears” as Grayson says.
The Obstacles We’re Toddling Through
Over the last quarter, we’ve seen the same sort of “resiliency” in the economy and in the investment markets. The economic and political environments look a lot like our toddling baby: taking a step, falling, taking a step, falling. Some of our data points suggest that investors are predicting the toddler actually won’t fall again, but rather she’ll break into a full sprint any minute now. We have been more skeptical (see our last few market commentaries) and while we believe that she will indeed learn to walk, she’s likely to have more falls, more bruises, and “Ms. Market” is likely to “pitch a fit” or two before running at full speed again.
- Middle East/ Northern Africa: It’s hard to recall a quarter that has seen so much widespread, diverse geopolitical turmoil. Starting in January, riots and uprising in Tunisia migrated to Egypt and ultimately Libya culminating in a UN sanctioned attack on the reigning regime. Even Syria, which looked to be “civil unrest-proof” is in its third week of protests and uprising.
- Japan Earthquake: In March, Japan experienced a massive earthquake. Though we’re still assessing the damage of the earthquake, the longer lasting variable is the lingering radiation from the Fukushima Daiichi Powerplant. Japan is an integral link in the supply chain for so many goods; this will only drive prices upward. I think it’s easy to say that a nuclear accident wasn’t high on many investors lists of potential risks.
- Employment: We’ve seen some surprisingly good employment data recently, although as we like to say, the news is rarely as good or as bad as it seems. The unemployment rate has dropped below 9% – the effect chiefly of two factors: 1) large numbers of people giving up on finding a job (thus not being counted) and 2) rising government hiring (which some argue shouldn’t even be counted since we have to borrow to pay these wages). Fed Chairman Ben Bernanke observed that “this gain was barely sufficient to accommodate…recent graduates and other new entrants…and therefore, not enough to significantly erode the wide margin of slack that remains in our labor market.”
- Federal Debt: The Federal Debt held by the public is around $9 trillion today. This is the amount our government is paying interest payments on (and in a historically rock-bottom rate environment, those payments are artificially low). Note that this doesn’t include the present value (money needed in the bank today) to pay for projected future demographic needs. That staggering sum is over $65 trillion and consists of $7.9 trillion for Social Security, $22.8 trillion for Medicare, and $35.3 trillion for Medicaid. Unfunded liabilities are not in themselves a problem, rather the problem lies in how likely someone will be able to fund them in the future. For example, I have an unfunded retirement liability; meaning I still need to make contributions to my IRA to be able to retire decades down the road. If I continually ran a deficit, I would never be able to close in on my unfunded retirement liability. I need to live within my means today while setting aside money for tomorrow. If the US is running a yearly deficit on top of a large debt load, how will they contribute to their “IRA”?
- Inflation: The Core Consumer Price Index (Core CPI) measures inflation without Energy and Food taken into account. This is the inflation rate that the Fed keeps an eye on and it hasn’t been wildly out of control. The problem is that most of us need to drive….to the grocery store…often. This trip costs about 15-30% more than it did a year ago. Additionally, the Producer Price Index (PPI), a measure of the cost to make things, was up 1.6% just for the month of February! This would translate into nearly a 21% increase annually in the cost to make goods, after an increase of nearly 6% in 2010! We’re kidding ourselves if we think that won’t show up on our Target receipts in the near future.
- Interest Rates: With Quantitative Easing 2 (QE2) the Fed agreed six months ago to buy $600 billion in treasuries through June of 2011. This provided the economy will loads of liquidity; but what happens when it runs out in two months? The Fed has a job to provide both stable employment and stable prices – but given a choice, they’ll likely choose employment. This could very well mean the Fed implements QE3. And with the inflation effects of QE2 not even showing up yet in the inflation numbers (it usually take 9-15 months), the implications of QE3 along with a possibly slowing economy will be even harder to stomach.
At any point in history we’ve always had some or all of these “obstacles” in the world economy and have “toddled” through one way or another. The point to realize is that some of the old tools we had at our disposal are no longer available. Most of the young parents that Millie and I know have an ample supply of foam pads to cover the corners of coffee tables, hearths, and anything else pointy and at toddler head level. Those foam pads are, in a sense, “tools” that lessen the risk of injury in the toddler stage. With our deficit sky high, home equity severely reduced, interest rates historically minimal, and more liquidity already in the system than ever in history, we are running dangerously low on fiscal and monetary versions of those foam pads to cushion the fall.
Pumpkins and Mice
Yet in all this, the S&P 500 was up more than 5% this quarter (all of it coming in the final two weeks). The largest contributors to this quarterly gain were areas we thought were the most overvalued at the beginning of the quarter (Small/Mid Caps, Low Quality Large Caps, and Real Estate). Their record performances were the results of one part speculation and one part unsustainably high profit margins – both part being fueled by this soon-to-dry-up excess liquidity. To us, these don’t look (and didn’t look) like areas with great prospects for future returns. Rather, they look like Cinderellas still dancing too close to midnight. While it’s never fun to stand on the outskirts, watching someone else dance the night away (and, for the interim, earn a higher return) it’s better than looking down and suddenly realizing you’re waltzing in dirty rags. As investors, we’d prefer to sit nearer the door rather than try to catch that last dance with the “handsome prince” (forgive my references; my 3 year-old is apparently sponsored by Disney®).
Interestingly enough, we still see some bright spots and we’ve tilted our portfolios to reflect where we see appealing risk/reward opportunities. These are mostly in the unloved or lesser-loved areas like: High Quality Equities (across all market caps but mostly in the Large Cap space), Emerging Markets, and Higher Risk Bonds (such as Corporate and Municipals). We’ve also been seeing good returns and further potential values in certain Commodities, driven by the demands both for their use (oil and food) and demand as a storehouse for wealth (silver and gold). Lastly, we’ve seen value in holding Cash. The latter idea sure won’t sell ads on CNBC, but it will certainly buy another dance or two when other investments turn to pumpkins and mice.
Justin W. Smith CFA®, CFP®
April 15, 2011