August was another whipsaw month for financial markets as equity markets fell sharply and bonds, particularly government issues, rose precipitously. The indecision displayed by markets continues to be driven by the potential for the U.S. and other developed markets to dip back into recession (or deeper into recession if you do not believe that we have exited the downturn that began in December 2007). Economic data has been anemic at best with nearly every major indicator either flat to slightly down over the last three months. August saw multi-decade low figures in car and housing sales. Government stimulus programs over the last year, such as "cash for clunkers" and the "new homebuyers credit" were specifically targeted to jumpstart sales in those industries. It is now apparent that the end result was to pull forward sales which has resulted in a hangover after the programs ended. In a larger scale this has been the market's reaction to the Obama administration's economic plan. The push provided by the stimulus package and easy monetary policy of the Federal Reserve convinced the markets that a relatively rapid recovery was possible as evidenced by the near 80% rise in the S&P 500 from March 2009 to March 2010. As 2010 wore on and the end of both the stimulus and Fed easing were coming into sight the evidence shows these programs did not result in sustained growth in the economy and the market has vacillated as sentiment moves between continued but slower growth or another decline in GDP.. 

 

In our opinion, it is the deleveraging of the U.S. consumer that is the ultimate cause of the slow growth in the economy in general and consumer driven industries (such as housing and autos) in particular. The chart below shows the growth, in billions of dollars, of total consumer debt in the U.S. since 1980.

 

 

 

 

The 8% reduction in total debt from its peak in 2008 is easily the largest decline in the history of the series. Even more remarkable is the 16% drop in revolving debt (credit cards and the like) that constitutes a portion of that total debt number. As we have noted before this is a necessary development and in the longer term better for the country as it results in households with stronger balance sheets. In the short term however it limits growth to the extent that the increased savings of one family is the reduced income of another, the "paradox of thrift" as espoused by John Maynard Keynes. We believe that U.S. consumer will continue to reduce debt whether through repayment, refinancing or default for a period of time and this will put a cap on the potential growth rate of the domestic economy. On balance we are still optimistic over a longer term basis on both economic growth and equity markets. The overwhelming pessimism around stocks has led to a massive reallocation of total investment dollars into bonds. This has resulted in 10 year government bonds yielding 2.58% at the end of August. In contrast, the S&P Dividend ETF (SDY) yields 3.44%.

 

*Our thought for the weekend- If SDY was to continue paying its current dividend amount over the next 10 years, the price of the ETF would have to decline 10% over that period to provide the same return as the government bond. While we have more than enough experience to know it is possible, and perhaps even likely, that the price will be down that much or more at some point in the next ten years, we think that at todays valuation it is much more likely that the fund will appreciate in value over a 10 year time frame.

 

The rapid fluctuations in the market this year have been difficult for investors to handle. From 2001 to 2007 the market averaged five reversals per year of  5% or more from its most recent high or low. So far in 2010 we have had ten and there is still four months to go. Key stat here: Despite all this movement the S&P 500 is nearly unchanged for the year and actually at no point has it closed either 10% above or below its finishing price of 2009. While an efficient allocation of assets is the primary driver of our investment models, part of our allocation practices controls risk by moving into the stock market when we want more risk exposure and to bonds when we want less. The volatility in the markets over the last four months means that we have reversed this risk control allocation more often than normal and we moved back into bonds toward the end of August. If the S&P 500 makes a sustained move above 1120 we will reallocate to equities again. We do not like to make allocation shifts this often but we believe it is important to maintain a disciplined investment approach even when it is difficult to do so.

 

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