Financial Insight For Changing Investment Seasons | Godsell & Hughes

Uploaded by GodsellHughes on 05.01.2012

The financial collapse of 2008 ushered in a new season for investors. The high spend
/ high growth days of 1982 to 2007 are gone and investors must now think differently.
So let me put it this way: Let's say you were planning a trip to Chicago in January and
you knew that the average annual temperature was 50 degrees.
Would you pack for 50 degree weather in January? No, of course you wouldn't, because you would
know that's very unlikely. You would pack for a typical, cold, windy Chicago winter
day. Yet, most investors have prepared their portfolio
for the average market temperature, without regard to season. And many are risking financial
frostbite as a result. Many investor, and I include professional
advisors in this category, continue to invest as if 1982 through 2007 was typical market
behavior and that the last three years were just a bump in the road back to normal.
This is understandable because it's easy to be deceived into believing a market pattern
is normal if it lasts long enough. But the only thing normal about markets is that seasons
change with time. And changing seasons significantly impact
investors because strategies that work well in one season may not work at all in another.
But this doesn't mean that investors are doomed to fail, it simply means they must think differently.
Well, the answer is easy: we spent more than we could afford for 27 years, and that ended
in 2008. And now it's payback time. And when you are forced to pay back debt it means you
have less money to spend and invest. Now I want you to stay with me here, because
I need to just quickly review a couple economic concepts that are going to be critical to
understand what I'm going to talk about here when I refer to the big picture.
1) Now the first of those concepts is every dollar we spend becomes income to another.
So for example, if you buy a McDonalds hamburger for a dollar, part of that dollar goes to
the farmer who raised the cow, part of that dollar goes to the employee who grilled the
burger, and part of that dollar goes to the McDonalds shareholder as corporate profit.
So since corporate profits are a form of income, they cannot sustainably grow unless spending
is growing. And remember it is ultimately growing corporate profits that make stocks
more valuable.
2) The second concept I want to review is GDP, it stands for Gross Domestic Product
and is something I think we've all at least heard of at some point in our lives. Gross
Domestic Product is simply the most popular measure of total spending in the economy.
It's calculated by adding together all the spending by the private sector, which is businesses
and individuals, all the spending by the government, and net exports, which is just the amount
of stuff we've sold to other countries, minus the amount of stuff we've bought from them.
GDP = Private Sector Spending + Government Spending + Net Exports
Now I want to talk about each of these three components, so you can see where future spending
growth, and therefore economic growth, might come from. And I'm going to start with the
first component: the private sector. Prior to 2008, we massively increased our
borrowing and spending. And towards the end of his period you had millions of people more
or less using their homes as piggybanks. The more we borrowed and spent, the more the economy
grew. To put this in perspective, let's say you
earned $100,000 and you decided that wasn't enough, you wanted to live the high life,
so you ran up credit card bills of $20,000 a year. For a glorious period of time, you
could live as if you made $120,000. However, when the bill came due, not only
can't you spend the extra $20,000, you may only be able to spend $80,000 of your original
income because part of that will be going to reduce debt. So we can't live beyond our
means forever. Now in 2008, this is really what happened
to the private sector. The bill collector came knocking at the door and living beyond
our means was no longer an option. It is now time to reduce our debts.
Now the good news here is the private sector has since made some progress toward reducing
debt, but the bad news is we still have a long ways to go. So this means that it's going
to be very difficult for the private sector to meaningfully contribute to economic growth.
If the private sector can't do it, could it be Uncle Sam that steps in and picks up the
tab? Well this is really what's happened here since 2008. Governments have run massive deficits
in order to compensate for reduced private sector spending, but this too is unsustainable.
You are seeing it now . . . lenders are drawing the line and governments are approaching their
borrowing limits. So with constituents up in arms, it's going to be very difficult for
governments to continue spending and they must too tighten their belts in the years
ahead. So this leaves the third component of GDP,
which is Net Exports. If the governments can't do it, and the private sector can't do it,
could it be exports to rapidly growing countries like China, and India and Brazil that save
the day? It certainly offers a ray of hope. But the
problem is that many other countries have the same game plan – and that is to export
their way to prosperity. But someone must import more than they export in order for
the math to work. So while net exports may generate some growth in the years ahead, they
will be hard-pressed to carry the burden on their own.
Now I focused mostly on debt and deficits so far, but there are many other hurdles that
need to be jumped in order to achieve sustainable economic growth.
Just to name a few others: Demographic trends have turned from favorable
to unfavorable as baby boomers reach retirement age.
The bill for unfunded Medicare and Medicaid promises has now come due.
Savings rates are low and future income is more likely to be saved than spent in the
years ahead. Interest rates are near all-time lows and
stimulating spending with lower interest rates is no longer an option.
Taxes, they were lowered in the mid-80s, they were lowered again in the early 2000s. Given
all these debt and deficit issues I've been talking about, the next direction or taxes
is most likely to be up. Now I could go on here, but I think you're
getting the idea. Duplicating past growth rates is going to be very difficult in the
years ahead. So it's important to understand the reasons
growth might be challenged, what investors really want to know is how is it going to
affect the markets. In simple terms, there are really three possible outcomes: Goldilocks,
Muddle Through, and Three Bears. So let me just comment briefly on each of these.
1) Goldilocks would be a scenario where all these obstacles in the path of growth that
we discussed are overcome, and market returns are more in line with those experienced in
recent decades. Goldilocks is certainly a possible outcome and shouldn't be dismissed
by investors, however, with all the challenges we've talked about, it does not appear to
be the most likely outcome. 2) The second scenario, Muddle Through, is
where spending doesn't drop off a cliff, but just grows very slowly and gradually over
time. Positive and negative economic forces might clash, and just leave behind a stock
market that is very volatile, but makes little progress over time. Now with all the challenges,
it appears that a Muddle Through scenario is a much more likely outcome than Goldilocks.
3) Now Three Bears would be a scenario where spending just entirely falls off a cliff and
we enter another bear market along the lines that we experienced in 2000 or 2008.
While a Three Bears scenario is always hard to predict, significant economic imbalances
have at least elevated the risk that we could experience another. And in economics, imbalances
must be corrected. The question here is whether they are going
to be corrected by strong growth, which would be consistent with the Goldilock scenario,
whether they'll be corrected very slowly over time, which would be the muddle through scenario,
or whether they're going to be corrected through abrupt market adjustments, which would be
the Three Bears. Often when I suggest to investors that Goldilocks
should not be entirely dismissed, they'll laugh. Yet their portfolios remain invested
as if it is the most likely outcome. They are doing the same things they always have
because they, or their advisor, don't know what else to do.
This disturbs me to see people really rolling the dice with their future without really
understanding the risks that they're taking. But there is a right way to react to changing
seasons. Up to this point I've focused primarily on
the big picture, but what is it that investors should do with this information? Well adjustments
to your investment approach can help you to combat the challenges I've discussed. So let
me offer a little perspective on investment strategy.
Now investing can get pretty complicated in today's world with all the vehicles and strategies
that are available, but when you strip away the fluff there's really two primary investment
options available. You can invest as an owner, which is what you're doing when you invest
in stocks, or you can invest as a lender, which is what a bond investor is doing.
Now most people don't think of it this way, but investors taken together are the market,
and therefore must earn the returns of the market.
For example, if the stock market returns 10%, some investors will earn more than 10% and
some less, but on average they must earn 10%.
In a rising market all investors can be winners. In my previous example, where I talked about
the market going up 10%, even investors who don't earn 10% can still be profitable. However,
what if the market returned 0% instead of 10%? Well in that case, the only way an investor
can make money is at the expense of another investor who loses.
So unless you believe that a Goldilocks scenario is in the cards, the only way to succeed is
to be different than the market.
So this means, for example, you should consider strategies that:
1) Emphasize certain stocks or sectors over others
2) Seek opportunities that don't entirely depend on rising stock and bond markets in
order to succeed, and ; 3) Take profits more quickly and wait for
new opportunities to arise, which will almost certainly be the case on volatile markets.
Now I want to be clear that I am not suggesting that you abandon traditional stock and bond
investments. I am only suggesting you reconsider the way you invest in them.
Now if you're using an advisor, don't assume they understand the things I just explained
to you. Advisors may have different opinions or different approaches to investing, but
the opinions of advisors who have failed to do their homework should be dismissed.
I suggest you put your advisor to the test. And ask them things like "How are corporate
profits and GDP related?" Or "How will net exports impact economic growth?" I can assure
you that most of you will be shocked by how little your advisor actually knows.
Unfortunately, the advisory industry has been raised in a sales culture, and too many advisors
don't have the knowledge or haven't taken the time to make these very important connections
that we discussed. Like them or not, do you want to put your financial future in the hands
of an uninformed advisor? I think the answer is no.
Now if you'd like to learn more about season changes and how they might affect you, I urge
you to go to to sign up for our free educational monthly newsletter.
Just to give you a little background on who we are, Godsell & Hughes is an independent,
fee-only investment advisor. Investors have been taken advantage of for too long, and
it's our mission to provide investors with a better option at more reasonable fees.