Counterpoint Commentary

Vital Signs

A number of vital signs of the U.S. economy appear to be improving at the margin.

In some cases, this improvement merely marks a slowing in the rate of deterioration. In other cases, the improvements constitute positive signs of life. In any case, they represent a change for the better relative to how things looked in February when the world economy seemed to be in freefall.


And one would hope that at some point, some of the unprecedented medicine that has been thrown at the patient and the problem would start to have some positive effect.

Investors have greeted these signs of improvements with impressive enthusiasm. The U.S. stock market, as measured by the S&P 500 has rallied 25% from its lows in early March.

We are encouraged but remain defensively allocated in client portfolios.

The improvements are real and meaningful, and they sure beat the alternative. But the patient is on artificial life support and we should have no illusions about the disease, which may not be fatal but is likely to be chronic and debilitating.

The medicine will have major side effects and the costs are staggering. For now, we can put it all on our AMERICAN DISTRESS card, with no preset spending limit and low-cost financing, but this won’t last. We can’t borrow our way out of debt, although that is exactly what we are trying to do.

We do believe that a bottom has been made in the stock market, at least for the near-term. The bond market has also shown improvement, as have global equity markets.

What is most important is that it appears the economy and markets are healing. Confidence is improving, capital is beginning to flow again. Higher quality companies have been able to issue new debt and equity on favorable terms and the volume of mergers and acquisitions has picked up. Good assets are being sorted from bad.

But we also think that investors have moved from being overly fearful to overly hopeful.

There is a big difference between “less worse” and “all better.” Uncle Sam is not about to jump out of the hospital bed and launch into a big song and dance number. And then there’s the matter of the hospital bill.

Although we increased our exposure to stocks in early March after keeping client portfolios very defensive in January and February, we would expect a pullback as expectations have moved ahead of reality.

You Are Here: A Tale of Two Eras.

In order to understand where we are headed, it is important to remember where we have been and how we ended up in the emergency room in the first place. Specifically, we need to look at the role that debt, savings, interest rates and other factors have played in driving consumption, growth, market returns and in shaping future expectations.

To put it bluntly, we as a nation have been living and consuming beyond our means for a long time. Not just for a few years, but for several decades.


Consider Chart I. It shows the growth of total outstanding debt in the U.S. economy – consumer, corporate and public – relative to GDP between 1954 and 2007. It tells a tale of two eras.

Between 1954 and 1981, the debt line is relatively flat, indicating that debt was growing in line with the economy. In 1981, the line takes on a sharply positive slope, as outstanding debt - primarily consumer and housing driven - grows at an average of 3% to 4% per year in excess of the growth rate of the economy.

Against this backdrop of outstanding debt relative to GDP, it is also instructive to look at savings, interest rates and inflation, as well as stock market performance.


Chart II shows that between 1954 and 1981, the personal savings rate (savings as a percentage of disposable income) rose gradually and averaged 8.8%. This trend reversed in 1981 and savings plunged to below zero in 2005, coinciding with the peak in housing stocks.


Chart III shows inflation and interest rates. The first era was marked by rising interest and inflation rates. Inflation peaked in 1980 and interest rates peaked in 1981. We have since enjoyed a quarter century of declining interest rates and relatively benign inflation rates.

The combination of expanding credit, declining savings, and declining interest and inflation rates acted as major tailwinds for economic growth and rocket fuel for the stock market.


Chart IV tells the story. Between 1954 and 1981, stocks - as measured by the Dow Jones Industrial Average - rose respectably for the first 10 years before trading sideways for the next 15. Over the entire period, the average annual return was just under 3%. Then, after reaching a low point in the summer of 1982, the Dow blasted off and began a 25 year meteoric ascent to its peak in October, 2007. Despite a few notable downturns, the Dow averaged an impressive 19.2% annual return for the period. Since it’s peak, the Dow has lost 45% of its value, bringing the average annual return since 1982 down to 8.6%.

Looking back, it is clear that these tailwinds created a false sense of prosperity and well-being, fueling consumption and boosting economic growth, corporate profits, asset valuations and tax receipts beyond a sustainable level.

Looking forward, it is clear that these tailwinds have now become headwinds and are not likely to dissipate any time soon.

As we have written in the past, this is not a typical correction, but the culmination and unwinding of years of unhealthy behavior.

Our national recovery will likely be arduous and also transformative. We are not returning to the way we were, and the future will most likely look very different than what we have known in recent years. How we deal with the challenges, in combination with how other nations deal with them, will define how well or poorly things play out.

Goldilocks is Dead.

Throughout each era, certain belief systems about the way things are and will likely be become entrenched.

In 1981, most financial professionals believed in a world of persistently high inflation and interest rates. Stocks were treated with some caution, dividends and fixed income were an important source of total return, and active asset allocation was an important means of adjusting to changing market conditions.

Fast forward twenty five years and until quite recently, most financial professionals, and the products and advice they sold their clients, reflect a very different world view: one of low interest and inflation rates, steady 3% GDP growth, double digit returns on stocks, and a faith that these conditions represented a status quo that could be counted upon to endure well into the future.

The postergirl for this belief system was Goldilocks and the concept of the Goldilocks Economy; one that, guided by skilled monetary policy, could continue to grow and prosper and be “just right” without ever getting too hot or too cold.

Goldilocks is likely dead, or at the very least, has proven herself to be a fairy tale from once-upon-a-time. Meanwhile the three bears of debt, deleveraging, and deflation, along with the prospect of inflation down the road remain and are very real.

The world has changed and we are entering a new era, one much more likely to resemble the period between 1954 and 1981 than the one that just ended. Financial advice needs to change to reflect this new, post Goldilocks, era.

Our Investment Strategy:

We increased our equity exposure in March, after becoming very defensively positioned in January and February. Valuation levels fell to a point where things just looked too cheap not to buy.

But that is no longer the case. The U.S. and global stock markets have had a very strong rally off the bottom in March.

Things do really seem to be less worse, but that is not good enough to justify ever increasing valuation levels. For the market to go significantly higher, more economic indicators need to get materially better. We expect the indicators to spit out mixed signals from here, although with a generally improving trend line.

Longer term, we expect the massive debt load of the U.S. economy to become a major concern. The cure for overconsumption and overborrowing cannot be more of the same.

For now, we continue to invest according to a number of the strategic guidelines we outlined last fall. These include the following interrelated ideas:

1) The strong get much stronger. The gulf between winners and losers will be huge. While their competitors are bending over to tie their shoelaces, the strong and swift move forward, entering new markets, launching new products and making acquisitions. We are therefore focused on owning “best of the best” businesses that we believe are not just going to be survivors, but long-term winners. Examples would include companies like Cisco, Goldman Sachs, Berkshire Hathway and Qualcomm.

2) Headwinds and Tailwinds. Those forces that were tailwinds driving growth and profits and a lack of government regulation are now headwinds. This suggests an era of slower growth, leaner profit margins, and lower valuation multiples. Companies that can deliver real growth and maintain pricing power in this environment should do well. We like technology in particular for this reason.

3) Focus on innovation and growth. Focus on companies whose products will be in demand around the world. We feel technology, media, industrial companies, biotech, power generation, and food represent the areas of greatest potential for our nation as an innovator and exporter.

4) Get in the way of government spending and out of the way of excessive government regulation.

Congress will be directing hundreds of billions of dollars in fiscal stimulus back into the economy.

In addition, the government is taking on a much more active role in the private sector, especially in the financial services industry. Healthcare is also likely to fall under increasing regulation.

The regulatory pendulum will almost surely swing too far in the other direction, and to us the thought of Congress running anything is frightening to us.

We feel a risk is that the government may create and empower a number of enterprises that may have the potential to destroy the economics for everyone else. Focus on companies that can control their own destiny. Avoid those that can’t.

5) Follow the brains and the bucks. We are investing in companies that we believe have the financial and human capital to be strategic and opportunitistic buyers of high quality assets - equities, debt, real estate - at bargain prices. Examples of companies that fit this bill include Goldman Sachs, Berkshire Hathaway and the Blackstone Group.

6) Developing economies continue to develop.

Economies like China and India are strong and getting stronger. We expect them to represent a growing share of world GDP growth in the coming decades. We have been increasing our exposure to select developing markets in client portfolios.

7) Bonds are still attractive.

We are maintaining a relatively high exposure to bonds, especially corporate bonds - high yield, bank loans, and investment grade - which offer attractive yields and potential for appreciation. Treasury bonds seem overvalued to us.

8) Prepare for inflation. The cure for deflation is reflation or inflation. Given the amount of fiscal and monetary stimulus being put to work here and around the world, the massive deficits being created in this country, and the use of quantitative easing (printing money) to keep long-term bond yields down, the deflationary spiral should ultimately reverse and give rise to reflation or inflation. This reversal has the potential to be violent and long-lasting. We have started to build some exposure to basic materials and gold in client portfolios.

Concluding Thoughts:

Vital signs are improving, but the risks still warrant caution.

The patient is healing, but is heavily medicated and has a long way to go. Confidence is returning to our national psyche and the financial markets.
The fog of uncertainty is clearing. It is becoming easier to analyze and value investments based upon their fundamental virtues and a reasonable set of assumptions about the future.

This should help to create a solid foundation upon which sensible investment and risk-taking can be rebuilt.

Longer-term, we will face the reality of slow economic growth as our national hangover endures, and we figure out how to pay the hospital bill.

In the mean time, the stock market has come too far, too fast and is due for a pullback as the reality that things are less worse - but not good enough to justify the current prices - sinks in.

As always, we welcome your questions, referrals and the ability to be of service.

Jurika Mills & Keifer.
April, 2009

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. The net performance represents performance figures net of all fees including management, performance fees, transaction costs and commissions. Past performance is no guarantee of future returns, which may vary. Please note that one cannot invest directly in an index.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.