THE INVESTOR’S DILEMMA

May 4, 2009: For the past 25 years and in cycles before that since the turn of the 20^th century, investors have been well served by a strategy of allocating a large percentage of their assets to a diversified portfolio of equity securities.  Most individuals employing assets in their retirement (401k or IRA) accounts and institutional investors responsible for allocating their employee retirement accounts, or administrators of foundations and endowment funds have experienced solid appreciation in the equity value of their stock holdings through a strategy of broad diversification.  Investments positioned by investment managers in large and small companies seeking to out perform the benchmark index of the S & P Index has broadened the number of holdings in most professionally managed portfolios so the amount of money in any one holding has become a very small percentage of the total value of the portfolio.  While the global economy expanded and markets generally appreciated, the increase in value experienced by these broadly diversified portfolios produced returns that compared favorably with alternative investments in fixed income.  This result was the consequence of reasonable selection, expanded and better quality research, and moderating interest rates thus causing rising price earnings ratios.  But most of all, the demand for equity security investments by the “Baby Boom” generation, leveraging more and more of their earnings to consumption, had an enormous impact upon prices of all assets, particularly that of housing.  The demand was so great that the U.S. Mutual Fund industry’s assets from 1990 to 2008 grew by extraordinary 60 times from $400 Billion to $26 Trillion and prompted many new management organizations to enter the field of managing and selecting securities for mutual funds and institutional investment accounts.  The World experienced a “rising tide that began to lift all ships” as investment demand, augmented by leverage or debt, and the relative increase in demand versus supply for good investments forced appraisals or “price earnings ratios” to historical highs.  As we all know, during the past 2 years the markets have adjusted that premium as the global economy has fallen into a financial black hole and deleveraging of consumer excesses have taken place.

Ok, that is what has been happening. Looked at in hind sight, few professionals are not verbally flogging themselves for failing to fully realize the existence of the house of cards that broke the back of the stock market by almost 50% since its peak in October of 2007 and the extent of the damage that would occur to investment portfolios.  What I am hearing from them now seems to be equally mistaken conclusions about the future of stock prices.  That failure, in my opinion, is promulgated by their statements that historically we have learned that recessions end and stock prices recover in eighteen months or sooner so their strategy is to stay the course and stay invested in broadly diversified portfolios of large and small companies that they have researched and believe will experience recovery and then experience higher growth of earnings.  Here is the flaw I see in that expectation- “Obamanomics”.

The political landscape has changed.  The American voter has decided that increasing the government’s role in the allocation of capital to economic opportunity is better for them than free market capitalism.  Mr. Obama’s plan is to install a “social” or a more egalitarian type government influenced economy providing the country’s citizens with services and basic needs while requiring less individual or personal responsibility to pay for them.  He says that Wall Street’s large national and multi-national corporations will be less dominant in the U. S. economy in the future. What effect will this type of government be likely to have upon security markets?  While it’s difficult to know how we get there, it most likely will be through a change in consumer behavior, lower investment, higher savings, lower risk assumption, higher taxes, and higher prices for everyday goods and services because of inflation.  The inflation risk could be significant if the government is forced to inflate its currency to deal with the huge national debt we are creating as a percentage of gross national product.  Reducing that percentage is the only way to preserve the relative value of the dollar and that is not likely, at least for several years.

So, if we can’t invest in cash, or nominal yielding government bonds, and we don’t expect the economy to grow much under the above scenario because of the reasons stated, what do we do?  This is our dilemma!  To cope with the prospective concerns, we must be invested in equity but must also realize that the “tide” is not yet rising and may in fact continue to ebb for a while.   Therefore, we need to continue to hold equity funds (or a well diversified individual stock portfolio) managed by competent, experienced portfolio managers, backed up by in house research, hoping those managers  will be more alert to those macro factors that destroyed up to half of our wealth in the last eighteen months.  I personally will hold some 60-70% of my capital in a diversified list of municipal bonds which currently are yielding 4-5% and select them based on their rating being at least double A.  I then will hope that the issuer will be able to generate enough net cash to pay both interest and principal as we go through these transition years.

One Man’s Opinion – Bud Brewer