Will Debt Doom Us?

By on June 16, 2007

Originally published on February 27, 2004:

Indexes on February 27, 2004

DJIA……… 10,583.92

S&P 500…… 1,144.94

NASDAQ….. 2,029.82

This issue will cover lots of ground and meander between various ideas. The market made an incredible comeback during the past year. In 2003 the Dow gained 25%, the S&P 500 28% and the NASDAQ clocked a 3rd best ever 50% return. The aggressive and conservative portfolios at this site returned 72% and 28%, respectively. Of course, the big question is….what‘s in store for this year? Unfortunately, I don’t know, but I’ll tell you how I’m allocating my assets.

The asset allocation decision is, in the end, the most important decision investors have to deal with. It probably accounts for 90% of the success of a diversified portfolio. Market timing is endorsed at this site as something that can be performed successfully when using a strict, disciplined model. However, successful timing requires an investor to endure significant emotional distress. This is due to the paradox that a successful market timer is under-invested near market tops when everyone is giddy about the prospects for stocks and over-invested when it looks like the world is coming to an end. The commitment to equities is opposite of what feels right at the time and is cause for great uneasiness in an investor’s gut.

The biggest factor in the coming years on how well one’s asset allocation works out will likely be the performance of the dollar. Unless you’ve been living in a cave, you’re probably aware the U. S. dollar has been in a steady slide versus the other major currencies over the better part of 2003. This unrelenting depreciation has boosted the return of international stocks and bonds, an area that many investors shun out of xenophobia or simple-minded fear of the unknown. This has been a mistake and will likely continue to be one over the coming years. The dollar will trend down because of the huge trade imbalance and debts that are piling up at all levels in the U.S. economy. At some point the falling dollar will put a dent in the trade problem because it is a self-correcting mechanism. However, that day could be far off. John Templeton recently said he expected the dollar to fall another 30% in value. This could take several years to play out since there will be periodic rallies along the way.

Foreign stocks should outperform in an environment where the dollar is weakening. Over the past couple of years, positions were initiated in the emerging markets in both the aggressive and conservative portfolios. The closed-end Morgan Stanley Emerging Markets Fund (NYSE: MSF) and Templeton Emerging Markets Fund (NYSE: EMF) were purchased and the performance of these funds have been among the bright spots in the portfolios. Both of the funds were trading at significant discounts to Net Asset Value (NAV), the value of the stocks held in the funds, when positions were initiated. This isn’t the case currently, so an attractive option is the iShares MSCI Emerging Markets Index (AMEX: EEM), a recently formed Exchange Traded Fund (ETF). The expenses on EEM are lower than the closed-end funds possibly leading to better performance over the long run.

The long-term future of the average American worker is bleak. The jobless recovery is portending times to come when there will be very few jobs created due to a number of factors. Technological progress is at the root of most of it. Cheap overseas labor has been a threat for several years now. New developments are leveraging this competition. The ability of corporations to outsource labor overseas through the use of cheap and effective advances in telecommunications is great for the company, great for the foreign worker, but really ominous for future employment prospects in this country. It’s difficult to compete when the average U.S. software engineer is paid over $110,000 a year while an Indian is paid less than $30,000 for the same work. Average Chinese workers make less than $3,000 a year.

Another element that will eventually decimate jobs in the U.S. is the increasing capabilities of automation and robots. This has been well documented at Marshall Brain’s Robotic Nation website http://marshallbrain.com/robotic-nation.htm. Corporations will do very well in the early years of this environment until massive cuts in the workforce result in a collapse in consumer demand. Workers that have not saved and invested a significant portion of their earnings are doomed in this future world. Unfortunately, the average U.S. consumer has been effectively brainwashed into living paycheck to paycheck and an incredible disparity between executive and average worker pay has developed over the last 2 decades. However, there are people whose views I respect that claim that the recent numbers coming out of Washington are an aberration and that job growth is going to skyrocket in the near future. I hope they are right.

Another revealing study documenting the futility of the masses and their quest to close the gap between the have and have-nots was recently released. During the year the results of an analysis by Dalbar, http://www.dalbarinc.com/, were released showing how dismal the average mutual fund investor’s results are. The study, which originated in 1994, disclosed the returns of the average investor of mutual funds. An update to the original study showed that during the one of the greatest bull markets in recorded history from 1984 through 2002, individual mutual fund investors achieved an annualized return of 2.6% versus 12.2% for the S&P 500 index. The study indicates that individual investors shoot themselves in the foot on a regular basis by letting emotions rule their investment decisions.

Investors, by and large, would do best dollar cost averaging into a balanced mix of index funds and forget about making any attempt to time the market. This may sound contradictory since market timing is used here, but I’m referring to the average investor who doesn’t have the knowledge or discipline to pursue a successful strategy such as the one used at this site. Given the scandals in the actively managed fund universe, investors would also do fine to ignore this area altogether. The expenses paid for “expert” active management are a significant drag and since most investors (including professionals) act like sheep anyway, adding expense ratio friction to a mismanaged portfolio is just another serious anchor to performance in a world over the next decade where returns from risky assets will probably be, at best, in the range of 6 to 8 percent.

Sorry for all the gloom and doom, but investors need to be realists if they are going to survive, much less prosper, in the future. Fortunately, fundamental changes unfold at an almost glacial pace allowing time to act when shifting tides are detected in their early stages. Focusing on a 3 to 5 year time horizon with worldwide demographics in mind will keep investors in good stead. I mentioned in the beginning of this issue I’d reveal my asset allocation.

Outside of the portfolios featured here, my allocation is as follows:

Bonds…………………………………………….. 20%

Cash………………………………………………. 20%

U.S. large-cap stocks………………………. 13%

U.S. mid-cap and small-cap stocks ….13%

Developed market foreign stocks…… 11%

Emerging markets stocks…………………15%

Timber REITS…………………………………..4%

Property REITS…………………………………1%

Gold mining stocks…………………………..2%

LEAP Puts (housing stocks & QQQs)..1%

This allocation is not for everyone. A fee-only financial planner may help an investor decide how to allocate their assets based on age and personal circumstances. If I were to make any changes, I’d increase the allocation to both foreign and U.S. small cap stocks and add a silver component to compliment the gold stock allocation.

The current environment is difficult to invest in since holding cash pays very little and most asset classes have experienced very strong rallies. I find nothing that is absolutely cheap relative to other investment classes or on a historical basis. Much has been written about the desirability of Treasury Inflation Protected Securities (TIPS). TIPS are treasury bonds which include an inflation component and supposedly provide protection against spiraling inflation. The concept is good, however, as with many things in the investment world they aren’t the panacea they are claimed to be. The government is the entity gauging the rate of inflation, so you when investing in TIPS you are placing a lot of trust in the Bureau of Labor Statistics (BLS) to come up with an accurate inflation number. It’s hard to place faith in a government agency facing political pressures to fudge the numbers. Nevertheless, TIPS provide an imperfect hedge against inflation that other bonds and perhaps, stocks, do not, and should be included in most asset allocation models.

There has been a lot written in the doomsday press about how the U.S. is now the biggest debtor nation in the history of the world. This is true in an absolute dollar sense, but completely misleading when you make a comparison that matters. The popular press is good at spouting off facts that are meaningless without drawing pertinent historical and peer relationships. In relation to Gross Domestic Product (GDP) the debt isn’t quite so ominous as it appears when comparing the U.S. versus other nations over recent history.

Total U.S. public debt:

1980 $1 trillion, 1986 $2 trillion, 1998 $5.5 trillion

Some Perspective:

In the mid 1990’s the U.S. annual deficit was approximately 2% of GDP, same as Japan, but the United Kingdoms was 7% and for Italy, a truly scary 10%.

In 1998 the U.S. total public debt was 57% of GDP.

For comparison (in 1998):

Italy 120%, Belgium 116%, Greece 106%, Japan 100%, Canada 90%, France 67%, Germany 63%, Denmark 59%, UK 59%, Switzerland 48%, Taiwan 0%.

Currently U.S. total public debt stands at about 60% of GDP. A good historical graph with projections several years into the future is available at http://www.aaas.org/spp/rd/debt04b.pdf.

The average of 17 major world economies over the past century has been approximately 60% of GDP. Public debt has been creeping up on a worldwide basis over the last decade, but appears to be manageable, especially if global economic growth expands at a healthy pace over the next few years.

Consumer debt has been climbing at an alarming pace, but since interest rates are so low the burden of this indebtedness has not exceeded the average range experienced in recent history. Outstanding consumer credit has risen 27% over the last 3 years to $9.3 trillion. Again the doomsayers have had a field day with the absolute data claiming that when interest rates rise the economy will collapse. This argument does appear on its surface to have a lot of credence. However, the self-correcting nature of these markets has not been given enough consideration. If rates rise, consumers will be pinched and the economy will slow. The economic slowing, in turn, will cause interest rates to fall again and so the cycle begins again. Predicting the timing of these ebbs and flows is impossible. Markets are more efficient than ever at anticipating these changes and adjustments are swift. A financial collapse is certainly possible given the serious lack of financial flexibility in the economy, but the odds favor that at worst we’ll muddle through this. Personally, I think the current recovery is on shaky ground and the economy will probably begin deteriorating again this fall around election time. Since the market anticipates about 6 months ahead, stocks could begin weakening around April or May. My biggest worry is the developing housing bubble because if it bursts the negative effects will be much more far-reaching than the busting of the NASDAQ bubble in 2000. It is a time for investors to be more conservative than they normally are, especially when investing in real estate.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>