Government Rescues Are Digging A Deeper Hole

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Domestic and global economic data worsened again this week.  Central banks around the world eased further, and today’s weak domestic employment report rekindled speculation that the Federal Reserve would unveil QE3.

Arguments rage long and loud about the wisdom of government stimulus.  The question of what government action or inaction is best for the economy typically concentrates on what would be best over a relatively short time period – from a few quarters to a few years ahead.

Of course, the time frame of most politicians and their appointees is short because of the looming pressure of the next election.  That pressure explains the political compulsion to take any action necessary to avoid recessions, which inevitably unfold in the relevant short time frame.  If we had real statesmen, not political opportunists (in both parties), they would examine a longer time frame.

When observers focus on the shorter time frame, the best government action almost always appears to be more stimulus.  Who doesn’t want additional jobs to pull more people off unemployment rolls?  Who doesn’t want to cut taxes to leave more money in the hands of consumers and investors?  How many would refuse apparently free goodies from the government?  The consequences of the resulting debt typically unfold only over a longer time frame.

If we imagine future generations of Americans without the malevolence of the legendary Sisyphus, but similarly condemned to roll the boulder of debt up a great hill, we must view our generation as the torturer.  Each time we alleviate some of our short-term economic pain, we add to the size and weight of the debt boulder to be pushed uphill.

Very few would consciously place such a burden on their grandchildren and their grandchildren’s grandchildren.  Decisions to alleviate today’s pain may not be consciously selfish.  In fact, they may even be motivated by positive social concerns.  Of course, we want more people to hold jobs and be better able to care for their families.

But are today’s financial woes more important than those that could be our grandchildren’s decades from now?  Do we even have the right to make that decision?  Our fixation with alleviating our generation’s pain, which we and our immediate ancestors caused, is creating what will almost certainly be an unsustainable financial burden on generations to come.

A stark case in point is staring at us from across the ocean.  We are witnessing the collapse of much of the European welfare system, no doubt created with the best of social intent, but without full appreciation that neither individuals nor countries can indefinitely spend more than they earn.

As any number of people who do the math have pointed out, the United States is already well past the point of no return.  We will never be able to fulfill all our financial promises in anything similar to dollars of current value.

Recognizing that recession now might logically precipitate a debt collapse spiral, politicians and central bankers appear willing to increase today’s debt indefinitely and pass the burden on to our heirs.  Of course, we can’t know whether or not markets will remain patient enough to allow us to defer the pain much longer.

We will never solve our debt problems without severe pain.  The primary question is who will bear it.  We have no right to saddle future generations with the task of pushing our massive debt boulder uphill.

I strongly opposed the multiplication of our national debt for the purpose of bailing out insolvent financial institutions four years ago.  Had we not gone through that bailout exercise, the world would undoubtedly have suffered its most catastrophic financial collapse ever.  Bankruptcies and unemployment might well have resembled the 1930s in scope, but we would likely be well on the way to recovery today, admittedly from a far lower economic level.  Overextended debtors would be wiped out.  Creditors who failed to appreciate the need for due diligence would be severely hurt.  Our financial foundation, however, would have been reset and solidified in a far less leveraged condition.  Moral hazard would have been banished for generations.  And future generations would rightly be spared the burdens of Sisyphus.  As it stands, a 1930s style depression could still lie ahead if a debt collapse unfolds with the even greater levels of leverage that have been added through the rescue programs of the past few years.

All current indicators point to more government stimulus and debt creation immediately ahead.  To prompt a change of direction, we ought to fight vigorously for term limits. Only then might politicians think in a longer time frame if they’re freed from the constraint of a constant quest for reelection.


Tribute To A Beautiful Lady

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My mother, Evelyn Feeney, died a month short of her 95th birthday.  Her obituary follows.

Evelyn Pease Feeney, 94, died Saturday, June 16, 2012. She was preceded in death by her loving husband, Thomas J. Feeney, Sr. She is survived by her sons, Thomas Feeney, Jr. (Carmen), James Feeney (Linda) and Dennis Feeney (Katie); daughter, Kathleen (Richard); sisters, Priscilla and Dorothea; brother, William, along with nine grandchildren and seven great-grandchildren. Mom’s sunny, loving presence will be sorely missed by her children and grandchildren alike, who will tell stories of her wonderful life to the growing ranks of her great-grandchildren. Evelyn graduated from Northfield Seminary in Northfield, MA and the Columbia University School of Dental Hygiene. Before her marriage in 1941 she worked in New York City as a dental hygienist and part-time model. She was photographed for ginger ale and Duco paint ads in Life magazine, and artist sketches of her illustrated stories in Liberty and the Saturday Evening Post. She was a member of the Mayflower Society, descended through her father, Howard Milton Pease, in two direct lines from Governor William Bradford and John and Priscilla Alden of the Plymouth Colony, passengers on the Mayflower when it landed at Plymouth Rock in 1620. She and her husband had lived in New York, Virginia, Connecticut and Florida before moving to Tucson in 1994. After retirement, Evelyn and Tom Sr. enjoyed many cruises and trips, including visits to Denmark, Italy, Greece, Costa Rica and Alaska. Burial will be private. A Memorial Mass will be celebrated at St. Thomas the Apostle Church at 10:00 a.m. on Thursday, June 28, 2012. In lieu of flowers please make a gift in memory of her to your local Food Bank.

Her funeral and related family activities filled much of last week.  My sister, Kathy Feeney, delivered the primary eulogy.  By way of closure and commentary to clients and friends who have inquired about Mom, I include brief comments I made at her funeral.

Sad as losing any loved one is, I felt real joy in reflecting back on Mom’s life.  In preparing a few words for today, I found myself doing a mental inventory of Mom’s personality characteristics and actions.  What struck me most was the flood of positive adjectives that came quickly to mind.  Someone who didn’t know her would think: “That’s just a son seeing what he wants to see.”  So I tried to think of any negative characteristics.  Virtually all of us have psychological warts or annoying characteristics.  The worst I could come up with about Mom was that she was hard of hearing.

She lived a long, beautiful life.  She was unfailingly kind, unassuming, considerate, giving – a truly gentle soul.  I wish I had inherited more of those genes, but she gave all of us a target to strive for.

She was simple in the very best sense of that word:  not complex; not hard to understand.

She never sought the spotlight.  It was never “about me.”  Rather, she reveled in the experiences and successes of others.

She bore the hardships of old age with grace and patience.  Any distress she suffered silently.  She lived with a level of equanimity unmatched by anyone else I’ve known.

She retained a bit of “girlishness” into her last days.  In Mom’s last two weeks of life, Carmen bought her a stylish jacket.  She loved it and insisted on getting out of bed to try it on over her hospital gown.

Mom radiated love.  She loved her family dearly, and we knew it.  In return, she was dearly loved.

The four of her children and our spouses were blessed to have her for a mother.

All in all, she had to be one of God’s favorite humans.


Market Votes “No” – Not Enough Government Rescue

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Stocks were mostly lower this week, although the more speculative indexes like NASDAQ and small caps advanced slightly. The lack of a significant cumulative move, however, masked considerable volatility intra-week. Coming off Sunday’s election which rejected the anti-bailout party in Greece, stocks bounced Monday and Tuesday, as investors regained confidence that Greek bailouts would continue–at least for a while longer. On Wednesday, attention turned to the Federal Reserve’s announcement after its two-day meeting. The Fed promised no QE3, which Wall Street had hoped for, offering only a token extension of Operation Twist. The market’s initial reaction was negative. But as stocks fell, German Chancellor Angela Merkel stepped into the breach indicating that European rescue agencies “might” buy sovereign bonds of faltering Eurozone members. And to help keep confidence afloat, Ben Bernanke assured investors that, if necessary, the Fed stood ready to do more. While those actions halted Wednesday’s decline, confidence was fleeting with stocks falling aggressively on Thursday. The week closed on a low volume upmove as many traders squared positions going into the weekend, with another European mini-summit scheduled. Rumors circulated about a possible grand bailout announcement. Most fundamental data releases made unpleasant reading throughout the world. Governments and central bankers have learned, however, that they can keep investors from turning more aggressively bearish through a constant drumbeat of possible future rescue actions and a schedule of high level meetings. Never before in my 44-year investment career have I seen such an orchestrated attempt to keep investors from focusing on underlying fundamentals.

In his press conference following the Wednesday Fed announcement, Chairman Bernanke reiterated the purpose of lowering interest rates by buying up the majority of long term treasuries – to force investors to buy riskier securities. Should there be huge losses if interest rates eventually rise aggressively and/or if stock markets fall, who will then bail out the retirees who reach for those riskier securities to maintain yield? One wonders whether Ben would urge his elderly retired relatives to invest in such riskier assets, knowing what he knows about the U.S. and world economies and about overindebtedness around the world. It’s much easier to prescribe such actions if you don’t have to deal with the repercussions on a personal level.

Central bankers seem to accept that there is little reason not to keep stimulating if inflation is not currently dangerous. Very few are commenting on the growing danger every time central bank balance sheets are increased. Each increase in debt is a bet that puts future generations in greater peril. It’s instructive to remember that the problems governments are wrestling with today are the product of excessive debt. Instead of solving those problems, debt-producing central banks are exacerbating them. Trying to solve them with austerity has been talked about in this country and implemented in such countries as Greece, Spain and Italy. Not surprisingly, austerity has been extremely unpopular. Politicians seeking reelection and central bankers wanting reappointment have quickly perceived that advocating austerity fails to garner wide support. As a result, most opt for continued bailouts, which offer hope for at least temporary relief from financial pain. Unfortunately, such actions are increasing the potential for worldwide financial upheaval.

Counterintuitive as it is to try to solve a problem of excessive debt with more debt, is there any reason to believe that these wise men and women see a solution not apparent to us mere mortals? It should not instill great confidence when one recalls that these central bankers failed to see or appreciate the excesses that have been building up and now undermine the very existence of the banks they were regulating. Why should we believe that their insights today are any more perceptive?

Ultimately, I choose free markets with intermittent pain over central planners and their flawed promise of perpetual prosperity.


Market Roots For Another Government Rescue

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This week provided a clear picture of what is moving the U.S. equity market. Economic news was almost universally bad. Most distressing to many analysts was the worsening unemployment claims reading. Improvement in the employment picture has been the touchstone of the economic recovery argument. Greece might leave or be forced out of the Eurozone. Europe is sinking further into recession. And China is clearly slowing.

Notwithstanding the growing list of negatives, the S&P 500 improved by 1.3% for the week, with a 3.2% advance coming in the week’s second half. All it took was an unconfirmed rumor that the world’s central banks were planning coordinated action to provide further liquidity following this Sunday’s Greek election. Never before has the fate of stocks so depended upon government support.

While liquidity certainly is a problem with some major banks and countries, the bigger question is whether the issue is really solvency. Central bank action might help current liquidity shortfalls, but it is of dubious value if the issue is insolvency.

The stock market has bounced after each major central bank stimulus action, yet the world economy continues to slow. The law of diminishing returns presents itself as logical. And great danger exist that investor confidence in the effectiveness of central bank rescue actions could wane quickly. If that occurs, investors beware!


Technical Conditions Lean Bearish

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From last Monday’s mid-day low, the equity markets marched upward through most of the remainder of the week, closing with gains of almost 4%.This rise constituted the biggest bounce in the second quarter, following a double-digit decline from the April 2 high.

Without doubt, the primary determinant of the market’s near-term progress will be investors’ perceptions of the unfolding Eurozone drama. Since the short-term twists and turns of that story are hardly subject to traditional investment analysis, I’ll take this opportunity to examine the technical condition of the market.

As usual, there are crosscurrents, especially if we look at the market in different time frames. Over the very long term, stocks began a long weak cycle (a secular bear market) in 2000. We believe that the secular bear market continues. So far, within the secular bear, stocks have experienced two shorter cyclical bear markets and two cyclical bull markets. The question facing investors today is whether or not the cyclical bull market that began in March 2009 ended on April 2 at 1422 on the S & P 500.

The Dow Jones Transportation Average failed to confirm the 2012 high in the Industrials. Stocks’ sharp decline in May broke important support levels and led Richard Russell, the nation’s foremost interpreter of Dow Theory, to declare a new bear market in force. Other data support that position.

The weekly graph of the S & P 500 comes from the excellent DecisionPoint site. Prices in the top portion of the graph reached successively higher peaks in 2010, 2011 and 2012. The momentum measures in the bottom section reached similar levels at the 2010 and 2011 highs, but have shown less strength at the 2012 peak. Such diminished momentum frequently characterizes a weakening advance, a long-term consideration. Similarly, the number of stocks hitting 52-week highs has diminished over the successive market price highs in 2010, 2011 and 2012.

It is also noteworthy that at the April high, the cyclical bull market had just exceeded 36 months, the approximate long-term average length for cyclical bulls. Stock market volume has been declining since the 2007 peak and throughout the rally over the past three years, typically a long-term negative.

While major U. S. stock market averages climbed to new four-year highs in April, most major world markets have been far weaker. In fact, almost all are below their levels of twelve months ago and of 2007. Ironically, China, the engine of emerging market growth, sees its stock market down for the past one, two, three, four and five years. Something is apparently very wrong that is not yet evident in China’s economic statistics.

A great many market technicians rely heavily on investor sentiment as a powerful contra-indicator, particularly at sentiment extremes. The price decline from the April peak turned sentiment quite negative (which is bullish), although the level is well above the negative extremes reached during the price declines in 2009, 2010 and 2011. Longer-term sentiment, however, as measured by equity valuation levels, remains near historic highs, except for the bubble period beginning in the late 1990s. According to Investors Intelligence, there are currently very few bearish investment advisors. Longer-term sentiment measures as well as the scarcity of bearish advisors point to lower stock prices ahead.

Analysts who look at cycles may find hope in a study done by Ned Davis Research. Placing equal weight on the one-year seasonal cycle, the four-year presidential cycle and the ten-year decennial cycle leads to a forecast for the current calendar year’s low falling near the end of June, followed by a rally over the year’s final six months. While it helps to know what historical records indicate, no forecast is foolproof. The presidential cycle prediction was dramatically wrong in 2008, the last presidential election year, when a positive forecast was followed by a 37% loss in the S & P 500.

While stocks became significantly oversold through the decline into Monday morning, June 4, the rally since then has moved most short-term indicators into somewhat overbought territory. Intermediate-term indicators, however, still remain somewhat oversold, which may reduce any potential decline from the short-term overbought condition.

Also still in the somewhat bullish camp is the moving average picture. Most major equity indexes traded below their 200-day moving averages early last week but bounced back above those moving averages as stocks rallied late in the week. Those indexes, however, remain below descending 50-day moving averages, which are threatening to break below the 200-day averages should the current rally fail. For the moment, moving average studies remain in the bullish category, but a 50-day break below the 200-day would prompt a bearish forecast.

Notwithstanding short and intermediate conditions, our major concern is the longer-term picture. On that basis, we believe the technical picture points to the probability that another cyclical bear market began at the April highs. At the April price peak, advance/decline statistics failed to confirm the new highs in prices. Over the past 80 years, such a condition has always been present before major market tops.

Major market tops are also characterized by expanding supply figures. The market has experienced such expansion over most of the past seven months, despite the price advance into April. Lowry Research Corporation has studied buying power and selling pressure since the 1930s. They note that the increase in selling pressure over most of the past year is typical of patterns exhibited prior to major markets tops. Lowry’s also highlights the rising number of new 52-week lows in recent market declines. In fact, they note that a large number of stocks are down by 20%, even 30% or more, indicating a diminishing number of companies holding up the major indexes.

As anyone who has studied technical analysis knows, there is no foolproof indicator. At best, technical analysis points to tendencies and probabilities. As I write this on Sunday, Europe is circling the wagons and pledging a bailout of insolvent Spanish banks. If past patterns endure, more rescue money will likely produce an immediate and potentially powerful short-term rally. If world central banks have decided to provide a coordinated “big bazooka” type response, our Federal Reserve could also add some additional version of QE3. Such a move would probably add power to the rally, but we’ve seen this act several times already. Before long it’s likely that investors will focus more on the deteriorating fundamentals than on historic central bank rescue efforts.

Whatever governments and central banks decide to do, we believe it probable that April’s highs will mark the top of the cyclical bull market that began in 2009. Since we believe the secular bear market still to be in force since 2000, another cyclical bear market poses a major threat. With banks and entire countries in danger of insolvency, technical conditions may be issuing a helpful warning.


Are We Losing Confidence In Government Rescues?

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As clients and regular readers know, we believe that the stock market has been in the grips of a long-term secular bear market since 2000.  In that context, stock prices have suffered two devastating declines and enjoyed two powerful rallies.  Despite the wild gyrations, most major equity indexes rest at 1999 levels.  U.S Treasury bills have outperformed the average common stock over more than a dozen years.  Feckless monetary policy has reduced the value of the U.S. dollar by about 20% over that extended period of time.

At the end of the 1990s, we warned in conferences and publications of the coming long weak cycle.  We pointed to absurdly high equity valuations and forecast that they would inevitably revert to or below their historic means.  We argued that analysts failed to appreciate the danger to equity valuations resulting from the markedly improved productivity introduced by the IT revolution.  If young companies could rapidly get up to relevant mass and importance, established companies’ competitive advantage could quickly be competed away.  In an environment of a less durable competitive advantage, companies should logically sport lower rather than higher price-to-earnings and other valuation multiples.  Since 2000 those valuation metrics have been noticeably reduced, but in the aggregate they remain near their historic highs but for the bubble period that began in the second half of the 1990s.

The second great excess leading to the still unfolding long weak cycle was debt.  Unlike valuations, which have improved somewhat, debt conditions have worsened.  In 2008, debt conditions nearly brought the world financial system to its knees.  Only through a flood of money creation were many of the world’s largest financial institutions kept alive.  Since then the world’s major central banks have continued to supply unprecedented amounts of monetary stimulus in a so far unsuccessful attempt to reinvigorate economic conditions.

Virtually every news release out of Europe highlights the growing debt crisis that has spread from the financial system to sovereign nations themselves.  The very existence of the entire Eurozone financial structure now depends upon the continued willingness of the German electorate to support the debt of the Eurozone’s most beleaguered nations.  As Europe’s fundamental conditions deteriorate, that willingness will increasingly be called into question.

Friday’s economic news was bleak in Europe, Asia and the United States, and the world’s stock markets reflected growing concern that repeated government attempts to prevent another recession may be failing in much of the world.  Even the hope that poor economic news will prompt another Federal Reserve rescue action in this country failed to stem the worst price decline so far in 2012.  We have contended for many months that investors are potentially reaching the point at which they will doubt the effectiveness of any additional rescue efforts.  After all, following QE1, QE2 and Operation Twist, our economy is still struggling, and the rest of the world is clearly deteriorating.  Should the Fed introduce QE3 and the markets fail to demonstrate the vigor that followed the first three stimulus efforts, market psychology could turn aggressively gloomy very rapidly.

As we have stated since the end of the 1990s, we are not in a “business as usual” environment.  The world financial structure is held together by a thin thread of confidence in governments and central banks.  If that confidence is lost, risk asset prices could sink precipitously and could remain submerged for a very long time.  Each investor must evaluate carefully how much capital should remain at risk in an environment in which governments may or may not succeed in sustaining the current global financial system.


Facebook Strikes A Discordant Note

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The big news today was Facebook’s tremendously hyped initial public offering.  It did not turn out as the underwriters had hoped.  First, NASDAQ could not open the stock at its scheduled 11AM first trade, which finally came about a half-hour later.  Large numbers of investors then could not get trade confirmations and did not know throughout the day whether they had purchased the stock or at what price.  While Facebook’s 573 million share trading volume was extremely active, the exchanges have dealt with greater volume than that in the past.

The stock came to market at $38 per share.  The first reported trade was at 42.05, about a 10% premium.  Twenty minutes later the stock had given up that gain and for another seven minutes it traded at or just above the 38 offering price.  The underwriters were forced to commit large amounts of capital to keep the stock from breaking below 38.  A second wave of buying pushed the price back to 42 in the early afternoon.  When it became apparent that the stock could not break through the morning highs, holders who were simply in it for the hoped-for initial pop began to bail out.  The price again fell back to 38 and traded there or a penny or two higher throughout the day’s last half-hour until a twenty-cent bounce in the final few minutes.  By the end of the day it appears that the underwriters had committed well over $1 billion to prevent Facebook from suffering an embarrassing drop below its offering price on its initial day as a public company.

In an environment in which stock market trading volume has fallen badly, Wall Street has been counting on an increase in investment banking to provide profits.  Today’s experience was an unexpected black eye, since most believed that at least Facebook would meet a friendly reception, even with a dearth of additional high quality product waiting to come to market.  Today’s reception will certainly give pause to others considering initial public offerings.

The weak general market action of the past three weeks also dampened the mood before the expected Facebook party.  Major indexes have dropped from 7% to 10% from their recent highs, and this week saw unrelenting pressure pushing prices down all five days.  Considerable technical damage was done, as expected support levels were broken.  Markets have continued their descent despite being considerably oversold on a short-term basis.

International news remains dreadful, and major international stock markets are universally down over the past twelve months, including our own.  Most distressing is that China, the supposed growth engine of the world, has seen its stock market decline to a point below where it was one, two, three, four and five years ago.  Something is clearly wrong.

Hope endures that central banks will again come to the rescue of the world’s equity markets.  Obviously, recent central bank largesse has had a limited effective life in the Eurozone.  Our Federal Reserve has very successfully kick-started stumbling equity prices over the past three years, but the law of diminishing returns appears to have set in.  The Fed’s recently expressed willingness to again provide rescue money has met with a noticeable lack of enthusiasm.  Should they continue Operation Twist or initiate QE3 and the markets not respond, what might governments do next?

At the very least, today’s market response to Facebook’s IPO should suggest that the public’s willingness to believe that government support will trump crumbling fundamentals may be waning.


JP Morgan Chase: Too Big To Exist

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The news of the day was that JP Morgan Chase, held in esteem by many as the pre-eminent mega-bank, had sorely miscalculated and lost a couple of billion dollars or so on what was characterized as a “hedge.”  These guys were reputed to be the best and the brightest.  If this was a hedge, where are the offsetting profits?

This debacle was not the work of a single rogue trader.  Allegedly, the decisions were made in the Chief Investment Office.

Late in the day, Fitch downgraded its ratings on the bank’s long-term debt and indicated that all the bank’s debt was on credit watch negative.  The ratings agency indicated that the magnitude of the loss implies a lack of liquidity.  Fitch also stated that the complexity of the bank’s operations makes it difficult to assess risk exposure.

Onerous as a multi-billion dollar loss might be to the House of Morgan, by itself it won’t threaten the bank or the banking system.  Two important questions present themselves, however.  1) Is this a stand-alone sour derivative trade or–according to the cockroach theory–having seen one, can we assume that there are many still to appear? And 2) Could this be a common trade in the banking industry, which might fall apart at other giant banks as well, cummulatively causing risk to the system?

Common sense dictates we should not have to worry about such questions.  No bank should be so large that it could threaten the financial system and, therefore, be too big to fail.

My March 30th entry on this site recounted several quoted sections from the Dallas Fed’s annual letter in which Dallas regional President Richard Fisher argued powerfully and convincingly against allowing any bank to be too big to fail.  In light of this most recent example of giant errors from giant banks, more taxpayers must demand that we not be held liable ever again for bailing out mega-banks that are allowed to speculate to the degree that they obviously continue to do.  I urge you to read my March 30th entry, “A Powerful Ally Against Too Big To Fail.”

One quote from that Dallas Fed report underlines the scope of the danger that we narrowly escaped just a few years ago.  “The term ‘too big to fail’ disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.”

That government assistance either comes out of your pockets and mine or those of our grandchildren or their grandchildren.  Notwithstanding how much of that assistance has been recovered this time through the continuing largesse of essentially free money from the Fed, it must never occur again.


Reprise Of A Golden Oldie

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Much of this week has been spent in preparation for our client seminar next week, leaving me no time to write a new entry for the blog.  Instead, I am reprising the first major piece I wrote warning about a coming top to the stock market rally of the 1980s and 1990s.  We sent it to clients as our year end letter in January 1999, almost exactly one year before the stock market peaked and prices plummeted by almost 50% on the S&P 500 and almost 80% on the NASDAQ Composite.  Prices today are still more than 10% and 40% respectively below the 2000 peaks in those two indexes.

We titled the report The Fiduciary’s Dilemma.  We had alluded to the growing debt crisis in prior reports, and it became a more frequent topic as the debt mountain continued to grow.  In this particular report, however, we focused on evidence that extreme valuations had created a condition of extreme long-term risk for all equity holders.  While today’s conditions are different in many respects from those of thirteen years ago, there are many lessons to take from the experiences of that earlier era.  Had investors properly heeded them, their portfolios would almost invariably be healthier today.

While this piece is long, I hope you’ll find it an interesting and educational trip back in time.


Quarterly Report
January 1999

The Fiduciary’s Dilemma

The fiduciary with responsibility over any institutional investment portfolio is confronted with the most perplexing conundrum of his/her career.  Interest rates on long term bonds, at just a bit over 5%, are near their low yields of the past 30 years.  Rates on shorter, less volatile fixed income securities are even lower.  In an era in which double-digit returns from common stocks have become commonplace, there is little attraction to the fixed income sector.  Because historically outsized returns have accrued to common stocks almost every year for more than a decade and a half, most fiduciaries have known no other environment during their periods of responsibility over these institutional assets.  On the surface, the investment answer is obvious.  Buy stocks and enjoy the ride to ever-higher portfolio values.  After all, the long-term statistics all verify the wisdom of that course of action, and the analysts and strategists profiled on TV’s business and general news shows urge you toward that path every day.  The conundrum arises, however, for fiduciaries that know more than just the financial headlines.  To participate in stocks at these market levels requires fiduciaries to pay far more for ownership than at any prior time in U.S. history.  And unbroken precedent teaches the fiduciary that even when fervor for overpriced stocks has been far less euphoric than it is today, major losses of portfolio value have preceded any long term increase.  What’s a fiduciary to do?

A great many factors shape the environment in which common stocks rise or fall: interest rates in this country and around the world, current business conditions domestically and internationally and investors’ outlooks for such conditions in the quarters and years ahead, current corporate profits and their prospects for growth or decline, the current and potential returns on competing non-stock investments, the supply of money being pumped into the system, and the level of investor confidence in the prospects for future stock profits.  Some of these factors are currently positive, some negative.  Let me summarize the condition of each of these variables.

Interest rates both in the United States and in most of the major industrial countries around the world are very low by the standards of recent decades.  Some of the former Asian tiger countries and a number in Latin America which are struggling to defend their currencies are in stark contrast with rates well up into double digits.  Slowing business conditions in the U.S. will continue to put downward pressure on domestic interest rates as we head into 1999.  A possible wildcard in the U.S. interest rate picture, however, would be the repatriation of capital by Japanese or European investors.  Both are holders of very large quantities of U.S. debt in the form of bonds.  Should either contingent, either because of the need to shore up Japanese yen-denominated investments or because of a desire to diversify into new Euro-denominated securities, pull substantial funds from U.S. investments, our interest rates could spike upward, driving bond prices down.

U.S. business conditions remain relatively healthy. Fed Chairman Alan Greenspan has warned, however, that it is unlikely that the United States will remain an island of prosperity in an unhealthy international environment.  A serious recession still claims most of Asia with only a few glimmers of hope in selected Asian economies.  The 500-pound gorilla remains Japan.  There are faint signs of a few economic upticks there, but some analysts attribute those to the recent outburst of government spending which cannot be sustained.  Japanese banks remain in serious condition with the amount of acknowledged bad loans growing by the week.  The Japanese economy has been weak for nearly a decade, and most analysts expect that it is at least a few years away from a significant recovery.  In Latin America, Brazil has recently devalued its currency, and there is no certainty that it will not be repeated.  Despite the $41 billion rescue effort being undertaken by the International Monetary Fund, questions still exist about whether Brazil will be able to repay its debts in 1999.  As the economic engine of Latin America, continuing economic travail in Brazil would inevitably infect the rest of the region with serious consequences to companies that export there.  The Canadian economy remains less than vibrant, and Europe is slowing.  In the eighth year of the current business advance, it is questionable whether the U.S. can grow much longer with overall world business slowing.  When looking several years down the line it is important to realize that even the most optimistic economists see the U.S. Gross Domestic Product growing significantly less than it did in the earlier decades of this century.  That is typical of mature economies.  They tend to grow less rapidly than young, emerging economies.  This should be a sobering realization to all who ignore history in the belief that the Internet and high speed computing make this an investment environment in the United States unlike all earlier ones.  No matter how much innovation occurs in the United States, there is a wide world of eager, sophisticated business people ready and willing to compete away any excess profit advantage that exists here.  The U.S. cannot protect such an advantage for long.  That is the flip side of instantaneous data transfer and globalization of business.  These factors considered, it becomes clear why Chairman Greenspan cautions that we will not long remain an island of prosperity.

U.S. corporate profits have stagnated in 1997 and 1998.  After very strong corporate earnings growth from 1992 through 1996, earnings have barely budged since then.  Standard and Poor’s reported that the growth in earnings in the S&P 500 companies was 2.6% in 1997.  They estimate that 1998’s final figures will show a decline of 1.5% in S&P 500 earnings.  In each of the past two years investment analysts, an inherently optimistic crowd, forecast earnings growth near 20%.  That group remains optimistic for 1999 as well, although their enthusiasm has been slightly muted because of the experience of the past two years.  In fact, in a recent study Value Line reported that its analysts have made upward revisions of their earnings estimates on 89 of the stocks that they follow and downward revisions on 394.  That is the largest disparity since early 1991 when the United States was in recession.  In Value Line’s 30 years of experience, they have found that revisions in either direction tend to be followed by future adjustments in the same direction.  In other words, initial revisions tend to be understated.  This bodes ill for the earnings forecasts for 1999.  For the time being at least investors are paying scant attention to corporate earnings.

The dividend yield on the stocks in the S&P 500 is 1.3%.  If a broader base of stocks were considered, the yield would be even lower.  Obviously today’s stock investors are not buying primarily to get the dividend.  They are counting on substantial capital appreciation to justify their purchases.  That expectation has been rewarded like never before over the past decade and a half.  Will it continue in the years ahead?  Throughout most of this century the average total return on common stock has been about 10% per year.  That return has come on average from approximately a 4% dividend and a 6% capital appreciation.  The yield on high-grade bonds has generally been in the neighborhood of 150% of common stock dividends, or about 6%.  Today, stock dividend yields are so low that high-grade bonds yield over four times the amount of the common stock dividend.  In past decades even approaching that disparity between stock and bond yields has led to significant declines in stock prices.  Over time investors also compare stock yields with the yields on non-security investments.  Real estate has traditionally been a competing asset class to common stocks.  Commercial real estate, residential real estate and raw land have all proved more or less attractive in different time periods.  With dividend yields so low, virtually any income producing real estate is today offering a greater return than common stocks.  The only advantage to stocks in the years immediately ahead would come if their capital gains outstripped the increases in real estate prices.  Real estate in most parts of the country is far less overvalued than are common stocks.

The rapid increase in the supply of money is one of the primary causes of the continuation of this great bull market.  Perhaps afraid of the disinflationary and deflationary forces apparent around the globe, the Federal Reserve has been pumping money into the system very aggressively over the past year with the rate increasing in the most recent quarter.  When such money cannot find a good business purpose, and many companies have pulled back on their capital spending, it often finds its way into stocks and bonds.  Because the U.S. has not been experiencing any significant inflation, the Fed has been able to lower interest rates and pump plenty of money into the system.  Chairman Greenspan and other members of the Fed’s Board of Governors continue, however, to issue warnings about the potential for an increase in inflation.  They know that these loose money practices have traditionally led to inflation.  Should inflationary trends surface, the Fed would almost certainly tighten the money supply and raise short-term rates.  That would be a very difficult environment for common stocks, even if they were not more overvalued than ever before.

The single most important reason for the continuation of this greatest of all U.S. bull markets is the massive levels of confidence that investors have that stock buying presents no long term risk.  On the contrary, today’s stock buyers, according to recent surveys, believe that they will reap rewards near 20% per year for the next decade or longer.  Such levels of confidence are rare in U.S. history and have only occurred after many years of almost uninterrupted stock market gains.  In the past, such levels of enthusiasm for stocks, never as great as today’s, have marked market peaks, not periods preceding continuing market advances.  Such periods have also been characterized by dramatic excesses and the belief that such behavior was not really excessive.  Today we have the example of the Internet stocks, which have clearly become a bubble sector.  Prices have been pushed way beyond the realm of reality.  For example, America Online has a market capitalization of about $80 billion with 1998 earnings of $230 million., the online bookseller, which may or may not ever make any money, reached a market capitalization just a few weeks ago of over $30 billion. That’s worth more than the country of Norway.  Yahoo, with a market capitalization a few weeks ago of $44 billion and 1998 earnings of about $45 million, is worth more than all the stocks on the Singapore stock exchange.  These companies and others in the same industry have all been founded in the past several years.  The industry’s technology is evolving, and no one knows what the industry will look like five years from now, much less over the long term.  Very likely the leaders of this industry ten years from now are not even on our radar screens yet.  Many of today’s hottest companies will likely never make a profit and will fade from the scene in the years ahead.  That notwithstanding, nearly $250 billion of investor money is in these stocks today.  It is pure speculation that many professionals are masquerading as investment.

Some argue that while they don’t know which Internet companies will be the long-term leaders, it is prudent to participate in the group even at these extreme prices because it is the wave if the future. That echoes the claims of decades past about stocks in a variety of emerging industries. In the late 19th century, investors thought they had a sure thing with the advent of electricity. We hear talk about the Internet as a reason for looking at this as a new era justifying new investment principles and standards. Imagine how much more dramatically people’s lives were changed by the widespread introduction of electricity. Most of the advances of the twentieth century were made possible through the use of electricity. At different times the spread of rail transportation and the advent of automobile and air transportation shrunk the size of our country and our globe, facilitating the movement of people and goods. The development of telephone technology and the spread of its use fostered instant communication across the globe. The developments in medicine and biotechnology lengthened lifetimes and the quality of life. The invention of the computer and the development of its technology have changed the face of business, the pace of knowledge development, and in many respects our ways of life. Each in its own time was a reason offered by optimistic investors as justification for looking upon that period as a new era making outmoded past market and economic principles. Amazingly, the time-tested measures of value have survived these and all other societal changes of lesser magnitude over the past century. That unwavering consistency should lead any good student of market history to look askance at the new era claim that “It’s different this time.” That becomes an even more obvious conclusion when we realize that the screaming overvaluations in the U.S. stock market in January 1999 are not mirrored very widely. Severe overvaluation is, for the most part, limited to a relatively small number of western stock markets. Formerly dramatically overvalued Asian and Latin stock markets have been smashed to fractions of their former highs. Real estate in the United States and elsewhere around the world, which exhibited extreme valuations in some areas, was severely cut in price from the extremes. At different times and in different sectors various types of art and other collectibles have seen the bottom fall out of their markets. A few western stock markets are among the relatively few areas that have so far resisted revaluations to more historically normal levels. Despite the near reverence in which are held Alan Greenspan and his fellow Federal Reserve governors, U.S. investors have disregarded their repeated warnings of “irrational exuberance” and insufficient earnings to justify today’s stock prices. Investors are basically disregarding anything that could disrupt the party.

It is important to recognize what stock buyers are paying today. The S&P 500 is selling at about 33 times its 1998 earnings. Since its beginning, that index has sold on average at just over 14 times its earnings. The S&P 500 is selling at more than 75 times the dividends being paid out by those 500 companies. Historically the stocks in the index have sold at about 26 times what they have paid out. The industrial stocks in the S&P are now selling at over 5 ½ times their book values. Over the past 71 years those stocks have sold on average at 1.9 times their book values. Throughout this century stocks have routinely sold above and below their long-term average valuations, although never more above than they are today. Invariably they have reverted to their long-term mean levels of valuation. Almost certainly they will again, whether quickly or in the years ahead. If the Dow Jones Industrial Average instantly reverted to its normal valuation levels, it would have to fall into a range between about 3100 to 4100. From 9200, where it rests today, a decline to that range would necessitate losses ranging from 55% to 66%. Many today see such a decline as inconceivable. In the United States we have only three instances in this century in which investor sentiment has even approached today’s unprecedented euphoria for stocks: in the late 1920’s, the late 1930’s and the late 1960’s. The ultimate price declines from the market highs that accompanied these peaks of investor sentiment were 89%, 52% and 45% respectively. More recently the runaway Japanese stock market that peaked in the late 1980’s reached a low last year 67% below its high of nearly a decade earlier. We have not one precedent in any major industrial country’s 20th century stock market history of a severely overvalued market avoiding a major loss (usually over a period of several years) before ultimately advancing on a more sustainable basis. Perhaps even more disheartening, the recovery periods to the former high prices have been discouragingly long, 25, 12 and 16 years respectively in the United States. It has been over nine years since the most recent peak in the Japanese market, and Japanese stock prices are still 63% below those former highs.

Many of today’s investors anticipate that they would simply ride out any decline. They profess a long-term orientation, and many see any decline as an opportunity to buy more stocks. If markets continue up in future decades as they have in the past that is a sound plan. Unfortunately, even the soundest plans can be confounded by highly fallible human beings. By way of most recent example, fiduciaries should review the responses of their board members after the brief but sharp market crash in 1987. Many fiduciaries were very reluctant to recommit money to stocks after stock prices fell 36% in less than two months in late 1987. That is consistent with what fiduciaries have done after every sharp market decline, especially when the price decline has taken over a year or more. The tendency to avoid stocks becomes stronger the longer a decline lasts. From personal experience I can vouch for the difficulty of convincing fiduciaries to commit significant portions of portfolios to common stocks after the markets have been non-productive for years. For the entire decade from the mid 1970’s to the mid 1980’s, the price to earnings ratio on the S&P 500 ranged from about seven to thirteen times earnings compared to today’s 33 ratio. Despite stocks selling at extremely cheap prices for an entire decade, almost nobody wanted to own them. Of course, investors who accumulated large amounts of cheap stock while it was on the bargain table ultimately reaped high rewards when those stocks eventually reverted to and beyond historically normal higher valuations. Unlike the behavior of potential investors in that decade of ultra cheap stock prices, today’s investors can’t get enough stock despite the fact that it is more expensive than at any prior time in U.S. history. Before the decade of the 1990’s, investors who purchased stock at below normal valuation levels have always had significant profits five and ten years later. Conversely, investors who have purchased stock near overvaluation extremes have always shown net losses five and ten years later.

For all their long-term predictive properties, valuation measures are not precise short-term forecasters. Investor sentiment can carry a market from one extreme to an even greater one, especially if augmented by infusions of additionally liquidity. The markets behavior in the past quarter is an excellent example of that. When cumulative world problems led the market to its early October lows, the Federal Reserve came to the rescue with three cuts in short-term interest rates, and they revved up the money supply. That rekindled investor enthusiasm to recent unprecedented heights. The world’s financial problems have not disappeared, however, and corporate earnings are now slowing or declining in most of the world. While the Federal Reserve could still reduce rates again, pressures could arise in 1999 that might lead to a Fed tightening.

A very important short-term consideration is the technical condition of the market. While the major stock averages are currently at or near their all time highs, they have been led there by a disproportionately small number of companies. Because the S&P 500 and the NASDAQ are capitalization-weighted indexes, the price performance of the largest companies is far more important than the price performance of average sized companies. In 1998 the S&P 500 was up 28.6%, despite the fact that roughly two-thirds of the stocks showed a loss for the year and the average stock declined by 4% in 1998. The index showed such dramatic gains while most stocks were down because of the spectacular performance of large stocks such as Dell Computer (+248%), EMC Corp (+210%), Lucent Technologies (+175%), Ascend Communications (+168%), and Cisco Systems (+150%). With Price/Earnings ratios of 97,78,60,75 and 80 respectively, these stocks were obviously the provinces of traders and longer-term buyers willing to suspend belief in the need for visible earnings. No value stock buyers true to a value orientation (like Marathon) could touch stocks at valuations like that. In such an environment growth stock managers will certainly outperform value managers who stay true to their time tested disciplines. It is instructive to note that growth stock managers always outperform value managers in the periods just before major market tops. It is also important to recognize that the vast bulk of the pioneer leaders in the industries discussed earlier as society changers in the past century (electricity, railroads, automobiles, air transport, telephones, biotechnology and computer technology) either went out of business or suffered major stock price collapses after the period of initial euphoria. That fate may befall most or all of today’s Internet leaders. Apropos of 1998’s market leaders, which are all in the high tech sector, it is important to know what has happened to the high tech market leaders of the past. Twice before, from the late 1960’s to the early 1970’s then again in the early to mid 1980’s, computer technology grabbed the investing public’s attention, and the prices of these stocks skyrocketed. In a fascinating study of the leading two to three dozen firms from those eras, Marc Faber published results in Barron’s that showed the average loss of the leading tech stocks to be about 85% from their highs to their lows in each era. While the growth stock tech jockeys are riding high right now, they will almost certainly experience the down side of the roller coaster in the quarters somewhere ahead.  Such declines have been gut wrenching in past bear markets.

While trying to make short-term market calls is a perilous business, there are ominous signs today. It is rare that major investment indexes rise very long once the majority of stocks start to decline. While the market averages are currently near their highs, more stocks have declined than have risen since April 1998. That is a pattern that has preceded most stock market peaks throughout history. The analogy Wall Street has used for decades for this condition is that of the generals leading and the troops not following. It is considered an ominous condition usually masked by the highly favorable publicity accorded the market leaders. That is exactly what the market is experiencing today.

This brings us back to the fiduciary’s dilemma.  Should (s)he either stay committed or become more committed to common stocks which have been an unrelenting engine of asset growth virtually without interruption for more than a decade and a half?  Or, conversely, should the fiduciary keep minimal exposure to common stocks in recognition that in no major stock market in this century have common stocks reached levels even close to current valuations without suffering serious losses, some of which have lasted for a decade or more?  If the latter choice is made and the markets continue to climb in the year ahead, there will be inevitable regret that opportunity for profit will have been foregone.  If fiduciaries choose the former course, which is the advice of the majority of today’s market analysts, and the markets ultimately do what they have always done, the portfolio will experience significant losses that may not be recovered for years.  An even bigger danger would be that current or successor fiduciaries might lessen the exposure to common stocks after major losses, which is what fiduciaries have done after every major market decline in this century, thereby fully realizing the losses and lessening the potential for future recovery.  The lesson of history is clear, but throughout history the majority of fiduciaries have consistently chosen to follow more popular current sentiment, rejecting historic precedent.  At every major market top and bottom throughout the century, however, following the popular belief proved wrong and historical precedent reasserted itself.  It does create quite a conundrum.


Beware Of Chasing Yield

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Many themes for these blog posts come from friends’ and clients’ questions.  This week two friends asked about prospects for generating more income.  We’ve written on this topic before, but in an extremely low interest rate environment, further analysis seems appropriate.

A starting point in any discussion should be recognition that you can almost always find greater yield.  Most recently, you could have bought a one-year government bond with the promise of more than 100% return on your money. Unfortunately, the government was Greece just prior to its recent default. That example is extreme, obviously, but the underlying principle is important to recognize.  At least with respect to publicly traded securities, there’s no such thing as a free lunch.  No issuer of securities will gratuitously offer more yield than necessary to find buyers.  If any security provides a better than market average yield, you can count on the fact that a buyer will be assuming greater than market average risk.  Don’t for a minute believe that your research has uncovered an underappreciated opportunity.  Recognize that you are competing for yield against the wealthiest, most powerful financial entities in the world.  Not that such entities don’t make occasional giant mistakes, but it’s rarely because they didn’t know about an opportunity that you found.

If that principle is true, what accounts for worldwide financial giants pouring unprecedented amounts of money into securities yielding effectively zero and losing money after inflation?  A prime example this week came from Germany, where the two-year government note was sold at a majestic yield of 0.089%.  In other words, investors were willing to loan money to Germany for two years for a mere $890 per million per year, the lowest return in the euro-era.  These investors didn’t overlook the alternatives.  Their behavior is simply a quintessential example of investors concentrating on the return of their money rather than the return on their money.

While some do, most investors don’t look first to equities when looking to boost yield. In fact, high dividend-paying stocks have become a popular theme in recent quarters.  But such stocks are far from risk-free.  While a meaningful dividend can provide a helpful buffer when markets are not advancing, we urge investors not to ignore price fluctuations.  Utilities, typically payers of substantial dividends, provide a clear example of how a quest for yield can be penalized in weak market environments.  From its peak in 2000, the Dow Jones Utility Index fell over 60% in less than two years.  No amount of income can compensate for such a precipitous decline.  While that index’s nearly 50% decline in 2008 was a bit less severe, it certainly defeated the purpose for those who bought supposedly conservative income producers when the broader stock market looked toppy.  More than four years later, the index is still far below its 2008 peak.

Far more typical for investors looking to boost yield is a turn to bonds.  Bonds have, in fact, been a sound–if only moderately profitable–investment over most of the past decade.  Unfortunately, most bond yields are at or near hundred year lows, which makes future profit potential problematic at best.  Any rise in interest rates will take away the yield and very possibly turn total return negative.

The Federal Reserve’s reduction of short-term yields to virtually zero was designed to force yield seekers out into riskier investments.  Many have ventured into municipal bonds, high yield (junk) bonds and emerging market debt.  So far, those approaches have justified the risks assumed.  Future profits become increasingly improbable, however, with rates as compressed as they have become.  The erudite James Grant, publisher of Grant’s Interest Rate Observer, has spoken and written eloquently and often against the Fed’s financial repression.  He argues that Fed actions have created mispricing across a broad array of assets.  When investors are desperate for yield, they have a strong tendency to accept the most attractive alternative, even if it falls far short of its historic value.

It is important to recognize that total return is as critical for bonds as it is with utilities.  Simply holding bonds to maturity can be destructive to wealth if inflation rises appreciably in the interim.  Emerging market bonds have always been volatile, and each carries its own country-specific risks.  High yield (junk) bonds currently appear particularly attractive relative to government and agency bonds with minimal yields.  Newcomers to the high yield arena should recognize that investor fear can be destructive to junk bond prices.  From late-2007 to early-2009 the IShares High Yield Corporate Bond Index fell by more than 40% and today sits about 15% below its earlier peak.  It’s also worth recognizing that when economic times get tough, junk bonds default at uncomfortably high rates.  Even municipal bonds, looked upon by many as extremely safe, have experienced substantial volatility in recent years.  In 2008, when there was fear that many municipalities would be unable to meet all their obligations, the average municipal bond dropped in price by 17%.  Just over a year ago, muni bonds suffered another double-digit price decline.  At such price troughs, the news is invariably bleak, and many sell with losses.  Furthermore, if prospects for other assets look more attractive, sales at losses might be necessary to raise capital.

As was the case after equity investors had experienced the 50% decline from the turn of the century into early-2003, people are turning again to real estate.  The rationale for most is different today, however, from that of eight to ten years ago.  In the earlier instance, real estate, fueled by cheap and easily available money, was soaring.  Heavy leverage was multiplying profits.  People were leaving their jobs to become condo-flippers, reminiscent of the earlier era of day traders who similarly sought the path to easy riches during the bubble.  Once chastened, real estate investors are today a more sober group, seeking yield through more conservative investments.  Others are buying up foreclosures or otherwise available properties at prices far below their peaks of a few years ago.  These investments may prove profitable, but they are probably not as low risk as they appear on the surface.

The common assumption among those turning again to real estate is that the crisis has ended and that, even if progress remains slow, we have lived through the worst.  For the good of the United States, we have to hope that to be the case.  Stock market behavior over the past decade, however, should give pause to those with a high degree of confidence that risks to newly deployed real estate capital are minimal.

Following the nearly 50% stock market decline from 2000 to 2002-03 (nearly 80% for the Nasdaq), investors began to pour money again into stocks as prices began to rise, the Fed remained accommodative and the worst seemed to be in the rear view mirror.  Traumatic as the market collapse had been, investors reflected back on the prior two decades in which buying every major market decline proved profitable.  They resolved not to lose sight of the rewards that accrued to those who were willing to buy into the early stage of each new bull market.  For some reason, however, this time was different.  Those who got back into equities after the 2003 bottom saw all of those profits and more taken away in the second market collapse from 2007 to 2009.  What they did not recognize was that we had entered a long weak cycle in 2000 similar to three predecessors in the twentieth century, the last of which was from 1966 to 1982.  In each of those instances, it had taken three or more major stock market declines to wipe away the excesses of the prior long strong cycle.  Premature buyers had profits unceremoniously taken away.  Investors couldn’t buy profitably for the long term until those excesses were expunged.

The very real danger for today’s real estate investors is that they could experience a similar fate.  The debt excesses of the prior long strong cycle have not only not been eliminated, they have been exacerbated in many major sectors.  It is likely that real estate investors are subject today to the same macro concerns and considerations that affect stock market investors.  While it is true that all real estate is local, the past decade has demonstrated conclusively that macro factors affecting the broad U.S. or world economies can put extreme pressure on local real estate.  With several major countries throughout the world (including the U.S.) in severe debt distress, a disorderly unraveling of that debt could quickly envelop most of the world in another significant recession.  As fragile as our domestic recovery has been, such an event could again wreak havoc on both residential and commercial real estate.  As illiquid as most real estate is, it would be difficult to adjust quickly to such a changed economic environment.

Some advisors have recently recommended annuities as an approach to raising client income. That approach could make sense if interest rates stay low for many years.  Buyers should recognize, however, that annuity rates reflect current interest rates and are near historic lows.  Should severe inflation result over the next several years in response to the flood of new money flowing out of the world’s central banks, returns on current annuities may fail dismally to keep pace with the cost of living.  And if punishing economic outcomes occur because the debt crisis unravels, some of the most impacted firms will be those financial organizations that offer annuities.  It is imprudent to put more money in an annuity than you would be willing to invest in a bond issued by the same company.  Financial firms have been known to fail.

It is possible, though not likely, that governments and central banks may succeed in solving the world’s debt crisis by issuing far more debt.  If they fail, however, the penalties on those who stretch for yield could be severe.

Unpalatable as patience is, it is likely to be the most profitable prescription in the long run.  In an unstable economic situation, it is unlikely that interest rates will stay low for long.  Rather than putting money in potentially mispriced assets, you will almost certainly be better served in the years ahead by preserving capital, accepting low-risk returns in the near term and keeping assets liquid to take advantage of prices that could be extremely volatile for many years.