Risk and Return

Bond investors will face some difficult choices in the months ahead.  Our base case for 2012 includes a modest acceleration of GDP growth accompanied by an improvement in employment and personal income.  US housing prices will finally stabilize and inflation, as measured by the Consumer Price Index less food and energy costs, will continue to rise.  (This inflation measure bottomed at 0.6% year over year in October and now stands at 2.2%.)  The Federal Reserve, however, is likely to keep short term interest rates at virtually zero.  All this points to a significant rise in government bond yields.

The current yield curve for government bonds looks strikingly similar to that which prevailed at the close of 2008.  Based on the improving domestic economy and our assumption that the European debt problems will be contained (admittedly, not a universally held point of view), we think the changes in bond market yields will be very similar to those which occurred in 2009.  If so, it implies interest rate increases in excess of 150 basis points for US Treasury securities with maturities of five years or more.  That translates into a near 12% price decline for ten year government securities.  To avoid these possible losses, investors would need to shrink the average maturity of their portfolios to two years or less and accept current returns of 0.25% versus the 2%-plus yields now available on longer dated investments.

Mortgages, normally a refuge for investors in a rising rate environment, pprobably won’t be a good port of call in 2012.  The market prices of high coupon mortgage securities are astronomical–GNMA pass-thru mortgages with coupons between 5% and 7% are being valued at 110% to 115% of par value.  These premiums are much higher than during previous low yield episodes; for example, GNMA 7% coupons never traded above 106 until mid 2010.  The current mortgage market bubble has occurred because mortgage refinance activity in these premium coupon mortgages has been exceptionally low, limiting prepayment losses for investors.  Borrowers have been unable to refinance because they are underwater on their existing mortgages and lack the equity to meet requirements on new mortgages.  That could all change with the stroke of a pen.

It is rumored that President Obama wants to replace the acting Federal Housing Finance Agency head with a more activist chairman and push for a multi-trillion dollar refinancing plan.  It would permit current borrowers in the government agency guaranteed programs to refinance into lower coupon mortgages with no requirements other than being current on the existing mortgage.  No appraisals, no income verification, no upfront payments.  This is actually a great idea.  It would save consumers tens of billions of dollars a year, increase housing demand and lift home prices, and boost economic growth–in an election year no less.  The losers under the plan would be holders of high coupon mortgage securities who would probably see the market value of their investments drop at least 5%.

While a change in the rules could hurt high coupon mortgages, their lower coupon cousins–the mortgage pass through securities with 3.5% to 4.5% coupons–would be crushed if interest rates rise.  Given the already inflated prices of even these securities, their upside appreciation potential, even in a declining interest rate environment is very limited.  (And we could see that further reduced if government actions unleash a flood of new low coupon securities.)  Meanwhile, they would suffer sizeable price declines and negative total returns if interest rates rise.

Making choices

As we begin 2012, most of our accounts are 20% to 30% below their benchmark maturity targets.  This is at the outer end of our usual duration bands and represents a significant call on the direction of interest rates.  During the fourth quarter of 2011, we added to our holdings of short term US Treasury notes.  We are generally overweight US Treasury securities compared with mortgages.  Nonetheless, a large rise in market yields would result in losses for most of our portfolios.  Accordingly, it is possible in the months ahead we may adopt an even more defensive maturity stance if the economic and political scenario we envision begins to materialize.

In closing, we thank you, our clients, for your support during 2011 and we will continue to work to merit your loyalty in the year ahead.  We wish you a healthy and prosperous New Year.

Note:  The Market Environment reflects the vies of the Investment Advisor only through the date of this report.  The Investment Advisor’s views are subject to change at any time based on market and other conditions.  December 31, 2011.

Thanks again to Strategy Asset Managers for allowing PSI to publish “Bond Market Environment, Fourth Quarter 2011.”

Follow the money

The Federal Reserve recently released its quarterly flow of funds study for the period ending September 30th.  Despite a brisk pace of federal government borrowing, aggregate credit demands remained weak.  Total non-financial debt grew at about a 4% pace as households shrank their borrowings.  This provided plenty of space for federal government debt to expand.  Meanwhile, the Federal Reserve was dumping huge amounts of money into the economy.  A broad measure of money supply–so-called M2–increased 9.8% over the last year.  Lots of money and little credit demand resulted in very low interest rates.  This could change quickly, however.

The US consumer has been tightening his/her belt since 2007.  The bursting of the housing bubble resulted in lower home prices, lower turnover and a decline in mortgage debt outstanding–from $14.8 trillion in June 2008 to $13.6 trillion in September 2011.  Faced with a troubling job market, consumers reduced non-mortgage debt as well.  This peaked at $2.6 trillion in 2008 and now stands at $2.47 trillion.  This borrowing metric seems to have stabilized recently as consumer confidence in future economic prospects has improved.

While the household sector of the economy has been paring back debt, the financial sector–commercial banks and savings & loans–has been reducing debt and balance sheet leverage.  This explains why few are worried about the leakage of European banking problems into our financial system.  So, once folks are ready to buy a new car or upgrade to a bigger house, banks will be able to provide them credit.  Despite the massive (+300%)  growth in federal government borrowings over the last decade, households remain the largest sector of the credit market with $13.2 trillion of debt outstanding versus $10.1 trillion of federal government debt.  If household borrowings increase by just 5%–less than half the rate experienced in the first half of the last decade–aggregate credit demand could rise by 7%.  This rate of expansion is not compatible with the current low level of interest rates.

That’s it for today.  SAM, LLC’s conclusions tomorrow.

Here’s yesterday’s initial post in this series.

The analysis is very worthwhile reading.  It’s long enough, however, that I’m going to publish it in three posts, all sans charts.  Here’s the first, an outline of the current bond situation:

Is it time to get off the bus?

2011 was a remarkable year.  The bond market encored its 2008 performance as investors flocked to the safety and liquidity of US Treasury securities.  We brought back the same actors–inept central bankers, anxious politicians, sketchy borrowers and frightened investors.  The accents were a little different–more European–but the plot was the same–a financial system supposedly on the verge of collapse.  And the ending for investors was also the same–the frugal, risk averse bond buyer won the prize in the final scene.  The prize in this case was a whopping 30% return from investing in long term US Treasury bonds.  And this came on top of a good showing in 2010–a 9.4% return for US Treasury bonds.  But as all moviegoers know–the third installment in a series is usually a dud.

We don’t think the numbers add up for another bond market rally in 2012.  Last year’s increase in bond prices lowered yields sharply.  For example, the Barclay’s Long-Term US Treasury Index closed the year with an effective yield to maturity of just 2.7%.  This compares with 4.1% a year ago.  The smaller yield means a smaller cushion against any price decline.  Meanwhile, the mathematics of bonds is such that lower yields equal greater price risk for any given change in interest rates.  The measure of risk is called duration and the duration of the Barclay’s Long-Term US Treasury Bond Index on December 31st was 16.2 compared with 13.9 for a similar basket of bonds a year earlier.  Now, investors should expect that a one percentage point change in interest rates would cause a 16.2% change in the price of the bonds, a very nice gain if interest rates for twenty year government bonds fall to 1.7%.  If, however, the yield of such securities rises to just 3.7%–a level 50 basis points below the average of the last five years–get ready to book a 13.5% negative total return (yield plus price change).  Of course, the returns from bonds with shorter maturities would be less damaged.  Nonetheless, there would be plenty of red ink for all.

If you think current bond market returns aren’t very generous, you’re right.  The sub-2% ten year government bond yields produced during the final quarter of 2011 were the lowest on record.  In fact, they were lower than the rate of inflation.  This has rarely occurred.   This occurred during the inflation tsunami of the Seventies, and again, briefly, in 2005 and early 2008 when oil prices spiked.

The bond market has reached these low levels because of:

(1)  fears of a European banking crisis,

(2) the free money policies of the Federal Reserve, and

(3) modest non-government domestic credit demands.

The impact of these factors is being amplified by hedge fund “risk-on, risk-off” trading that pushes short term money between various capital markets.  If any of the three legs supporting the bond market cracks in the months ahead, a substantial interest rate increase is in the cards.

That’s it for today.  More analysis tomorrow and Wednesday.

two caveats:  

–I’m looking at equities as a US-oriented individual investor with a global outlook.  My portfolio will be keyed off the S&P 500.

–I think there’s a chance that the EU is the new Japan.

Two decades ago, faced with a choice of preserving a traditional way of life or beginning a painful reorienting of priorities that would stimulate economic growth, the forces of the status quo in Japan overwhelmed those of progress.  Japan’s economy has since stagnated.  Its stock market, once the largest in the world, is now a backwater.  Its leading companies, other than auto firms, have been surpassed by foreign rivals.  Global investors don’t bother with Tokyo stocks.

Something similar could easily happen with the EU.  Bad for people who live there; not such a big deal for everyone else.  For investors, the EU would become a special situations market.  Portfolio managers would be on the lookout for unique, counter-culture firms, or for international giants who would be European only by accident of listing.   There’d still be the possibility, however, that such stocks would be held back by the general economic malaise andnot perform as well as they would if listed elsewhere.

That’s a worry for the future. My main concern for the present is the transition from superstar securities market to irrelevance.

That process didn’t go smoothly inside Japan, but it had relatively few negative effects on the rest of the world.  Japan was a single country, relatively isolated, and whose banks and government were funded by Japanese citizens.

In contrast, there’s some possibility that if the EU–a bunch of different countries, all dependent on outsiders to keep their financial systems afloat– chooses the Japanese route, the bumps in the road will have considerable negative effects for the rest of us.

How to protect yourself against these possible bumps?

I think this is an asset allocation issue–you protect yourself by having a smaller allocation to equities and a larger one to other asset classes, especially cash.

My equity strategy doesn’t consider that European financial woes might send temporary shockwaves across the rest of the globe.

(Two other points on Europe:  although investors outside the US seem to me to continue to be especially fearful, securities markets have been discounting Eurozone problems for over a year, and increasingly so over the past six months.  Also, I think the worst nightmare of the markets–another “Lehman moment”–is an unlikely outcome.  Even if the failure of a key financial player in Europe were to happen, the world already has a blueprint for action to prevent global trade from grinding to a halt.

up 10%?

I’d characterize good performance for 2012 as being up 10%.  In looking at individual stocks, my first question is how it will deliver at least that return.  For what it’s worth, I expect stock markets will be volatile throughout the year and that the bulk of the year’s return will come in the second half.

what I’m doing

1.  Three years ago, with the US as ground zero of the financial crisis, it was clear that the US would be growing more slowly than the rest of the world.  So the right thing to do was to avoid stocks that were focus on the domestic economy and heavily overweight those that, while US-based, have the bulk of their profits elsewhere.

That worked exceptionally well until several months ago.   But it’s no longer the right thing to do, in my opinion.  Why not?

–Nothing works forever.  Stocks get expensive, and relative growth rates in the world change.

–Today, economic recovery in the US is broadening and many Americans have gotten excessive debt under control.  The housing market appears to be bottoming after almost five years.  Yes, recovery is slow and unemployment is high.  But changes on the margin are positive and that’s what counts.

–In contrast, Europe is in the midst of a crisis where the outcome is certain only to be one of various shades of ugly.  Emerging markets, while still generally growing more quickly than the developed world, are struggling with overheating.

It seems to me that consumer businesses that address a broad base of American customers and industrial makers of durables and of manufacturing equipment are the place to be.

2.  Market attention is also shifting again–correctly, I think–to larger, more mature companies.

Part of this is that American income-oriented investors are continuing to buy dividend-paying stocks.  Yes, this process isn’t new.  It’s been going on for two years.   And, yes, it’s scary that the trend has hit the newspapers.  But these slow growers are also reasonable ways to play the gradual bounceback of the fortunes of the average American.  And the Fed is likely to keep interest rates artificially low on fixed income for at least the next year.

Not exciting stuff, but investing is about making money–not about glitz.

3.  Not every consumer stock will be a winner.  Over the past couple of years, the clear winners were the luxury retailers and the dollar stores–the consumer bookends of the very affluent and the very not-affluent.  We’re now in a period, I think, of average Americans beginning to spend more freely. So the bookends are not the place to be.  I find it hard to figure out the net result of trading up and having too much bricks-and-mortar retail capacity, however.

4.  I still find IT attractive–e-commerce, social networking, cloud computing, mobile…are all important growth areas in all economies.  A big issue with the sector has been that the index is heavily tilted toward very mature companies.  In the current environment that may be a good thing.  I own a bunch of smaller companies.  INTC is my largest position.

5.  Europe is a place to avoid for now.  Yes, you can pick and choose among European-listed companies that have large exposure to the US or to emerging markets (I’ll confess to owning IHG).  But risks of a particularly unattractive outcome to the Greece-Italy situation are still higher than zero.  So why expose yourself to that possible downside if you can find comparable stocks at reasonable prices in the US?  If you’re going to buy Europe anyway, find something listed in the UK, Sweden or Switzerland rather than in the Eurozone.

6.  I think direct emerging market exposure of some type should be a continuing part of any equity portfolio.  Nevertheless, actively buying individual stocks in any of these countries (with the possible exception of Hong Kong) is financial suicide for just about everyone.  You might just as well burn the money in the street–at least you might get some entertainment value while your money goes up in smoke.

For what it’s worth, I own the Vanguard emerging markets index fund and a couple of the Matthews China-related mutual funds.

4Q11 earnings report season begins with AA after the close this afternoon.  According to theFinancial Times, Wall Street analysts are predicting that the companies in the S&P 500 will report another in a long line of quarters of year on year profit expansion, but at a rate under +10% for the first time since 2009.

There are four reasons for the weakening of the earnings comparisons:

–the € has weakened recently as the financial crisis in the Eurozone deepens.  That means a fall in the dollar value of profits earned by S&P 500 members in the EU.

–in response to Euro worries, wholesalers and retailers globally decided to reduce the amount of inventory they have on hand.  So they cancelled orders for merchandise that they would normally have bought from producers in 4Q.

–widespread flooding in Thailand led to hard disk drive and auto component shortages, meaning some products couldn’t be built and shipped

–economic growth in the emerging world continued to decelerate.

The component shortages and inventory shrinkage are temporary.  € weakness may be as well, depending on how the Eurozone crisis plays out.  If so, their main impact will be to transfer, say, 1% of yearly corporate earnings growth from 4Q11 into 2012.  As far as 4Q11 is concerned, however, the four together have probably been enough to offset all the positive effect on S&P earnings of a strengthening US economy.

According to the FT, S&P 500 earnings per share for full year 2011 will amount to $96.38, surpassing the previous for the index of $87, in 2007.  Given the sharp decline in reported earnings from financial companies since then, the 2011 figures document a huge rebound in performance by non-financials.

What about 2012?

The FT says the current consensus calls for eps of $106+ for the S&P this year, a gain of almost 11%.

My take is that that figure is really optimistic.  I also think that the analysts whose earnings estimates underlie this figure are assuming no negative impact on results from the financial crisis in Europe.  While that’s possible, I don’t should be one’s base case.

My assumptions are as follows:

base case

US (50% of S&P 500 earnings)       10% growth          = mild acceleration

Europe (25% of S&P 500 earnings)      5% decline          = significant deceleration

Emerging markets (25% of S&P 500 earnings)  15% growth          =significant deceleration

total          7.5% eps growth

optimistic case

US          +10%

Europe          +5%

Emerging markets          +15%

total          +10%

pessimistic case

US          +10%

Europe          -15%

Emerging markets          +10%

total          +4%.

Two observations:

–if I’m correct that some of the factors depressing 4Q11 eps are temporary, their reversal in 2012 should add a bit to 2012 S&P eps.

–in order for the pessimistic case to produce negative year on year eps for the S&P, European profits would have to fall by 30%.   While this is also possible, I don’t think it’s likely.

what about the multiple?

My pessimistic case yields eps for the S&P 500 of around 100.  The optimistic case generates eps of about $107 (i.e., the consensus).

If we apply the current market multiple of 13.5x to these numbers, we get an expected index level by mid-year of 1350 on my pessimistic view, 1450 or so if we’re optimistic.

In other words, it’s reasonable to expect single digit gains for the S&P from today’s level based on 2012 earnings.  Add the current 2% dividend yield on the market to this and expected total return from owning US stocks appears more worthwhile, if not up to the standards of 2009-2010.  It’s certainly better than bonds.

What could move results outside this range of possible outcomes?

–good/bad sector and stock selection

–rise/fall in the multiple applied to the earnings (decreased uncertainty could move the multiple in a positive direction)

–severe economic problems in China (unlikely, in my view) or implosion in the Eurozone (a year ago, I would have said this was impossible.  I still rate an extremely unfavorable outcome as unlikely, but it’s no longer inconceivable).

That’s it for today.

Tomorrow:  putting the pieces of I though V together.

It’s increasingly important in looking at the current US stock market, as it typically has been with almost every other national bourse, to distinguish between the health of the domestic economy and the prospects for the stocks listed there.

How so?

According to the best information from Standard & Poors (not every member of the S&P 500 chooses to break out revenues geographically), only 50% of the revenue generated by the 500 come from the US.  About 25% are sourced from Europe and the rest from emerging markets.

In today’s US, as has been the case for the last generation elsewhere, one of the first questions an investor should ask is whether economic growth inside the country will be better or worse than growth abroad.

So let’s look at the US economy.

the economy

the Great Recession

The domestic housing bubble began to collapse of its own weight in mid-2007.  The economy reached its nadir in mid-2009 and has been recovering since.

recovery

Three bumps in the road:

–the boost from spending deferred by companies and individuals during the down turn was exhausted in mid-2010 and the economy slowed somewhat.

–the Fukushima nuclear disaster disrupted industrial supply chains in March 2011.  That’s basically over.

–worries about a financial implosion of the EU that could send negative ripples globally caused companies worldwide to shrink inventories, starting in the summer.  That downward adjustment appears to have just ended.

Looking into 2012,

the economic situation in the US seems comparatively good:

–the housing market may finally be bottoming, in all but the areas worst affected by speculation, after almost five years of decline

–much of the excessive debt taken on by consumers during the bubble has been worked off during three years of restrained consumption

–employment is improving at a slow, but gradually increasing, rate

–real growth in the US will likely be around +3% for this year, which would make the country the best performer among the major developed economies.

Yes, the US faces longer-term problems:  substantial government debt, continuing government budget deficits, increasing competition from China and other emerging countries, the decades-long failure of either major political party to develop a policy agenda relevant for contemporary America.  There’s also the near-term question of fallout from potential economic/financial problems in Europe.

Still, relative to both its own experience over the past several years and prospects for the reset of the developed world. the US is looking pretty good.

the stock market

From a simple top-down perspective, I think market strategy is clear:

–there’s a clear case for overweighting the US vs. Europe or Japan.

One might also argue for overweighting the US vs the emerging world as well, since domestic earnings will likely be expanding at an accelerating rate while emerging markets’ profits, although growing faster,  will be doing so at a decelerating rate–but I’m less confident that this is the right thing to do.

–one should emphasize domestic-oriented firms vs. international companies, especially those with exposure to the Eurozone

–manufacturers of industrial equipment and consumer durables should do relatively well

–expect consumers to continue the process, already begun, of trading back up to the higher-end brands they abandoned during the recession

–given that growth stock beneficiaries of structural change have been the biggest winners until the past few months, it’s possible that traditional business cycle-sensitive value stocks will have their day in the sun.

Nothing’s ever that easy, though. 

The internet, as wielder of the sword of creative destruction, continues to wreak havoc among bricks-and-mortar retailers and the strip malls they inhabit.

The question of whether the current high unemployment rate is cyclical or structural (I’m in the structural camp) is also relevant.  If you think high unemployment is cyclical–and that continuing economic growth mostly means the long-term unemployed gradually get their jobs back–buy WMT or DG.  If you think it’s structural–and that growth mostly means the currently employed get raises–buy TIF or JWN.  (Note: for the past six months, DG has been the clear winner, with WMT in second place.  Is this a counter-trend rally or the start of a new trend?  If the former, is it already mostly played out?)

Luckily, there’s no need for any investor to have a strong opinion about everything–or to act on everything he has an opinion about.  Instead, the secret to success is to understand what the issues are, but to locate a small number of things that you have the highest degree of confidence in to invest in.

I’ve been watching European stock markets for over 25 years, but I don’t consider myself an expert on Europe.  There are too many social and political quirks for me to get motivated to master its intricacies, given the relatively small size of each country, and of continental Europe in the aggregate, in stock market terms.  So I’ve taken an “American” approach and tried to just pick stocks.

…but everyone has to have a plan

On the other hand,  most stock market investors have to have a plan for dealing with Europe, since it’s a big trading partner with China and maybe a quarter of the revenues of the S&P 500 come from Europe.

Even a simple plan is almost infinitely better than nothing.  It gives you a baseline to monitor for signs that the reasoning behind your stock selection is wrong.  Rather than simply watch your stocks go down in flames, you can try to fix the budding problem.

Here’s my take on Europe:

There are a number of political groupings in Europe.  The widest is the EU itself.  Then there’s the Eurozone (all the countries which have adopted the common currency, the €) as a subset of the EU.  And there are other things like the Schengen free travel area.

For investors, the Eurozone is the most important of these.

To my mind, the defining characteristic of the Eurozone is that it has a common monetary policy, but fiscal policy that’s determined by each country.  This is what has the EZ in trouble today.

The ECB sets interest rates at a level that’s appropriate for the EZ as a whole.  For traditionally slower growing countries at the core, like France and Germany, that has arguably been too restrictive.  For faster growing, smaller economies on the periphery of the EZ, the rate has been extremely stimulative.

Easy money sloshing around the periphery found its way into massive numbers of speculative real estate deals.  Of course, each country should have recognized this and restrained speculation through cautious fiscal policy.  But what politician is going to take the punch bowl away from the party?  After all, there’s always an election around the corner.

To some degree, real estate speculation also infected the periphery with the “Dutch disease,” meaning that demand for construction workers drove up wages elsewhere–making other, export-oriented manufacturing industries less competitive.  For Americans, it’s like Detroit and the car industry.

If that weren’t bad enough, two countries, Greece and Italy, decided to game the system.

In my experience, Italy has always been the least economically responsible large country in Europe.  Yes, it took heroic measures to restructure itself to qualify to enter the EZ as a charter member.  But then it fell back into its old slovenly ways.

I’ll confess that I know next to nothing about Greece.  My impression is that it thinks membership in the EZ was a fabulous chance to scam the rest of Europe.  My impression is that it will happily default on its sovereign debt and leave the EU as soon as it gets a chance–sort of like skipping out on a restaurant check.  Luckily, its small size makes it a rounding error for Europe as a whole.

That’s the problem.  But where are we now?

I think we’re past the worst and on the way to fixing the current EZ problems.  I don’t mean the structural flaws in the EZ, but just today’s crisis.

We’re already seeing serious reform out of Ireland and Spain.  Greece and Portugal (another country where I have no clue) are too small to matter.   The real EZ economic uncertainty comes down to what happens in Italy.

Italy went through another painful wholesale economic reform process to enter the EZ and it has appointed economist Mario Monti as premier with a mandate for reform.  I think these are good signs that Italy is wiling to make the necessary changes to its economy once again.

One other point to mention:  a much simpler fix to problems in Italy and Greece would be to have the ECB loosen money policy by, for example, buying up Italian government bonds.  Doing so removes any incentive for Italy to reform, however–so it just kicks the can down the road.  More than that, money policy that’s inappropriately loose for Germany creates the need to use restrictive fiscal policy to offset it.  Angela Merkel certainly doesn’t want to have to do that.

my bottom line

economics

Politicians in any area of the world only seem to me to act when the situation has deteriorated so far that the painful measures they need to implement are greeted with relief by the electorate as a “rescue” from a worse fate.

I think we’re at, or past, that point in the EZ and that the essential measures are already agreed to, through changes in government, that will end the current EZ crisis.

The main means of change will be austerity.  Once the ECB is convinced that Italy is sincere in its reform efforts it may provide some monetary assistance.  But cutting government spending and enforcing tax laws will be the order of the day.

For the European periphery, this spells recession today and low growth for a while after.

stock markets

The bigger question for equity investors is often not so much what the economic reality is likely to be as, rather, what economic scenario is currently being discounted in today’s stock prices.

I have four conclusions:

1.  I think today’s European stock prices discount a more pessimistic outcome than I see as probable.

2. I don’t think that attitude will change, however, until we see changes in EZ laws that are slated for March plus further concrete developments from Rome.

3.  I don’t want to bet the farm on my analysis.

4.  No matter what the precise outcome, Europe is likely to be the slowest growing area of the world in 2012.

Therefore,

I’m substantially underweight Europe.   I hold small positions in a couple of equity mutual funds, and one stock, through its ADR, IHG.  I would prefer Europe-listed companies that have most of their business in other parts of the world over primarily domestic-oriented firms.  I’d also prefer to reach into Europe through multi-nationals listed elsewhere that have some European exposure.

Before I’ve written everything out (I usually think things through by writing), I suspect my bottom line will be that we’ll remain in a trading range for now, with short periods of investor enthusiasm alternating with periods of real fear.  I also expect the crucial issue will not be the way economic events will play out, but rather when investors will shift from discounting the same old (and bad) news again and again (typical down market behavior) to anticipating the possibility of good news in the future.  I think that the next major move is up.

globalization

Today I want to mention one dynamic–globalization–that I think will be an enduring issue over the next several years.  A week or so ago, I saw a commentary that’s part of the Financial Times’ A-List series (which is, as far as I can see, a hodge-podge of writers ranging from the exceptionally talented to the functional equivalent of Paris Hilton or Donald Trump).  It’s titled “The downward slide continues–the great revolt will come later,” and was written by Mark Malloch-Brown, a former UN official.   It’s short and well worth reading.  The part I found interesting was paragraphs 2 and 3.

It’s not that I think that Mr. Malloch-Brown has hit the nail on the head.  I don’t.   The situation is much more complex than his simplistic portrayal would have you believe.   I don’t think the world is going to hell in a handbasket from here, either.  And the emerging world vs. developed isn’t exactly new news. After all, the first Toyotas reached US shores almost 40 years ago.  It is true, though, that pace of change accelerated once mainland China decided the capitalist road was worth walking along (around 1980) and SAP et al developed supply chain software capable of monitoring global businesses (mid-1990s).

What I like about Mr. Malloch-Borwn is that he doesn’t mince words.  There’s something important to the idea that governments like Greece, Italy, or to some extent the rest of the developed world, wittingly or not (I’m in the not camp), have maxed out their credit cards spending borrowed money to protect the local economic status quo, and to dampen the negative effects of pretending increasing competition from emerging economies doesn’t exist. The bill for that has come due.

It’s tempting to riff on the intellectual poverty of politics in the US.  I won’t–other than to say that there’s some small chance of a positive surprise if enough citizens demand change.

Whether that happens or not, I think that dedication to trying to preserve the status quo, which is what led Japan to into its two “lost decades” (so far) can be a useful litmus test for investors to separate countries into winners and losers and control their portfolio exposure accordingly.

There’s another important consequence of the idea that governments in the developed world no longer have the money to try to roll back the tides of change.  It’s that economic change may well happen at an accelerating rate over the next several years.

For investors, I think this means we should own agents or beneficiaries of change.  That’s already been the ticket to success since the turn of the century.  It may be even more so in the coming decade.

A quiz:  Rank the following stocks in order of their performance (on a capital changes basis–I’m lazy) over the past ten years:

Amazon

Apple

Berkshire Hathaway

Cisco

Kellogg

Intel

Microsoft

Oracle

Procter & Gamble

Wal-Mart.

Answer below↓

Apple     +3378%

Amazon     +1348%

Kellogg          +72%

P & G          +70%

Oracle          +67%

Berkshire          +56%

S&P 500     +8%

Wal-Mart          +4%

Cisco          -10%

Microsoft          -21%

Intel          -31%.

Huge gains for innovators, losses for companies that have gone ex-growth, struggles for firms that don’t globalize.  I think the next decade will bring more of the same.