Market Musings Blog

This year about $85 billion of cuts to the discretionary portion of the US budget will be implemented, at least under current law which, as we know, could change. Dire consequences have been forecast. Could these forecasts come true?

First of all, we’ve spent a couple hours with the Congressional Budget Office papers on this topic, as well as other writings, trying to understand one thing: are these really cuts or do they merely slow the rate of growth of spending? As best as we can tell, these will be real cuts, such that the federal government will spend less on many things in 2013 versus what was spent in 2012. However, Social Security, Medicaid, federal interest payments, and several other programs are exempt from the cuts. There will be only a modest cut to Medicare reimbursement rates. So while a part of the budget will be reduced, another large part will keep growing. 

The amount of the cuts in 2013 – at $85 billion – is around 0.5% of the overall US economy, and that’s overstated, because it is based on the US GDP in 2011, and the economy grew in 2012. 

Will this mean a hit to the economy – a recession, job losses, an uptick in the unemployment rate? Not likely. The size of the cuts is minuscule relative to our economy and the cuts are lagged, with the full effect unfolding over months rather than immediately. For evidence that informs our opinion, we looked to state budget cuts from 2009 through fiscal year 2013. In fiscal 2009, states had to cover budget gaps of $110 billion – that’s for one single year. In 2010, it was a huge $191 billion gap; the following years the gaps were $130 billion, $107 billion and for this year, $55 billion. Yet despite this drag, the economy began growing in 2010, posting 3% for the year. An $85 billion cut from the federal government will be less than any of those single years, except 2013, and our economy is healthier now. In out years, as the sequestration continues, we expect state and local hiring to pick up, taking up some or all of the slack from the federal level austerity. In fact, we are particularly lucky in that the synchrony of these events is allowing for slower deficit spending – something that is crucial to the future health of America’s economy.

As we expected, the Dow finally broke through the upper end of a long term trading range and is making new highs. Now that we’re here, worry abounds. Even analysts who expected new highs in 2013 are calling for a pullback. We take this as a good sign, meaning the rally can continue for a while. Day after day of a rising market is an unreasonable expectation, but certainly a market that works higher without drama is possible given the cautious sentiment. Except for Tuesday last week, daily moves in the Dow have been less than 100 points as opposed to the huge unsustainable leaps that are associated with extreme volatility. We also like the market’s breadth: every type of company is having its day in the sun. All told, the Dow is up over 9% so far this year. No doubt there will be bumps along the road – we’re not going to have a +60% year.

Meanwhile, bond interest rates are rising, but for the best possible reason: the economy looks better, inch by inch. Notably, history shows that stock market returns are excellent during times of slow, steady economic growth because that kind of environment is less prone to bubbles and distortions. 

All in all, we like it!

The stock market has been flirting with five year highs – but not breaking through to all time highs – for a  week now. We are at an inflection point in the markets, for both stocks and bonds, and the coming days should tell us whether we will finally reach escape velocity and surge to all time highs on the Dow and the S&P, or whether it’s back down to the trenches for who-knows-how-long. 

The strongest argument for new highs and a new bull market is valuation. The PE on stocks is low. Depending on how you measure it, it’s around 13 give or take. The last two times we’ve been near these levels on the S&P, the PE was 26 and 15 (2000 and 2007, respectively). Twenty six was ridiculously high and 15 was not enough to produce escape velocity, apparently – because we didn’t. Implied returns from a PE of 13 are around 13% per year over the next five years – certainly better than most bonds. The average PE after a recession-recovery cycle is 13.9 – higher than where we are now. So from a valuation perspective, it should happen. We should reach new highs and head to orbit.

But assets can stay cheap for what seems like forever. The intrusion of government into the private economy, troubles overseas, and countless other “products of the milieu” are very worrisome and have convinced many investors to sit on the sidelines. 

Hold your breath, because this battle between the bulls and the bears is about to be decided. A win by bulls will have us off to the races, and stock investors will be very happy indeed. A win by the bears consigns us to another long hibernation.

Occasionally, and always when things are going well, a client will ask us for a riskier portfolio, which usually means we are supposed to sell those good-for-nothing bonds and add more stocks. In other words, “risk up.”

Our industry has done a disservice to investors by oft-repeating this phrase: “The more risk you take, the more return you’ll earn.” Sometimes this is flipped, as in: “To obtain a high return, you must take more risk.” After years of this mantra, we can’t blame investors for reacting to good returns by wanting more “risk”. And note that these sentences are constructed to appeal to every human’s inclination towards greed: who wouldn’t want more return?

The problem is, these shorthand phrases are akin to incomplete sentences. Technically they qualify as complete sentences, but in fact they leave off the most important concept around risk, the thing about risk that will make you cry, feel despair, and swear off stocks forever and this time I mean it: risk means big losses as well as big returns.

On your way to earning 90%, your risky portfolio will hand you months, even years, of misery. That’s “will”, not “may” or “might”. You will have losses. If you put $100,000 into an S&P index fund on 1/1/08, it was worth $63,000 by the end of that year. It took until sometime last year to get back to even – nearly four years underwater. Furthermore, if you react by selling because you just can’t stand it any longer, you will effectively decimate your returns for years to come. The lack of money in your portfolio will only reinforce your misery.

On the other hand, if you truly have the temperament for it, a risky portfolio will eventually hand you more return than non risky portfolio. Eventually.

Here is how to know if you are a candidate for a riskier portfolio than you have now, assuming you’re not already way out in the risk stratosphere:

• When stocks go down a lot, you get excited. You can prove this because in 2008/9, you added to your stock portfolio and/or you did not stop your 401(k) contributions to stock funds.
• On the other hand, when stocks go up a lot, you worry.
• You think about your portfolio as a whole, and losses on this or that individual holding do not bother you. You do not obsess about making back losses.
• You are willing to increase your investment time horizon. In other words, if you were investing for the next ten years, you can take on more risk if you recognize that you must think now in terms of investing for the next fifteen years. You may need those extra years to recover from losses.
• You inherited a bunch of money/invented something really cool/found oil in your back yard and do not need to live off your portfolio any longer.
• When the news about the economy/politics/environment is bad, you understand that this, too, shall pass. You can insulate your investment decisions from how you feel about the news.

If the majority of these things are not true of you and your investment behavior, better think long and hard about “risking up”. Even if you can identify with most of these descriptions, be careful: timing counts. With stocks bumping up near highs, now may not be the best time to increase portfolio risk.

In one corner, we have a company that owns commercial real estate. It owns properties located all over the country, mostly stand-alone buildings with one or two tenants, many of them leased to banks. This company was thoroughly sideswiped in the recession. It was forced to pay its dividend in stock rather than cash for a while. Revenues have slipped nearly every year since the recession of ’08. Cash flows have not yet recovered, but have at least stabilized. On the other hand, things are improving. Revenues aren’t falling as fast; occupancy is ticking up. The dividend yield is 5.6% and it’s now paid in cash. The stock sells at a measly $10.75.

In the other corner, we have Apple, a corporate powerhouse. Rich in cash, with huge and consistent sales and earnings growth, and a brand new shiny dividend, instituted in mid 2012 (Apple did pay a dividend back in the ’90s, but it was eliminated when the company nearly went under.) With the right mix of hardware and software, Apple has captured hearts all over America, resulting in long lines outside its retail stores when new products are launched, and a stock price in the stratosphere, at over $500 per share.

Which stock has done best over the last year?

The first stock, Lexington Realty, has outperformed Apple’s stock by about eighteen percentage points. LXP is up 32% over the last year, while Apple is up 14%. That doesn’t include the hefty dividend on LXP.

But that’s a cheat, you say. It’s easy to find a low-dollar stock that’s done well in this market. Ok, what about a mundane industrial stock, like Illinois Tool Works? ITW makes everything from fasteners and solder to putty. It has been around since 1912 and has never been thought of as glamorous. It has edged Apple out of the ring by rising just shy of 20% over the last year. It sells at $61.87 today.

The more interesting fact is that if we run longer historical numbers, Lexington outperformed Apple from about 1994 through early 2005 when finally Apple pulled ahead. ITW bested Apple from about mid 1987 through early 2008; then Apple surged. Fact is, the wondrous performance by Apple has been recent, boisterous, and incomparable to any other time in the company’s history.

We’re not here to bash Apple. Our point is only that performance need not come from the most popular companies on the planet. It can come from overlooked stocks that make necessary items (no, the iPod is not a “necessary item”) or own useful assets. And sometimes, the performance from these boring stocks comes with much less drama to boot.