The photo below shows the risks in inflation. Recently when mom decided to sell the old family house I took over the stack of old family albums and while pouring through them stumbled across this hospital receipt for my birth at Portland Sanitarium Hospital.
I wonder what you can get in the hospital today for 79 bucks?
We have to make our money increase its purchasing power if we want to keep up. Where in the world should we invest to do this?
Is the stock market the best place to go? Tom Ruggie of RuggieWealth Management threw out some thoughts in his latest Weekly Commentary.
Ruggie wrote: Is the “cult of equity” dying?
Since 1912, stocks have returned on average 6.6 percent per year after inflation, according to Bill Gross, the legendary bond manager from PIMCO. Recently, Gross ruffled some feathers when he wrote that the historic 6.6 percent return “is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned.” Histrionics aside, Gross makes a point that deserves elaboration.
Gross believes that, in the future, less of the country’s wealth will be captured by capital (the financial markets) and more will flow to labor (as higher wages) and government (in the form of higher taxes). For the past 30 years, he said, capital markets were the big winner, as real labor wages and corporate taxes declined as a percentage of GDP. By his analysis, that will start to reverse with the capital markets being on the losing end.
Is Gross right?
Well, his chief critic, Wharton professor Jeremy Siegel, emphatically says no. In an August 2 Bloomberg interview, Siegel made the following three rebuttals to Gross:
1. The 6.6 percent real return was similar in the 19th century in the U.S., too, so it’s not just a 20th century anomaly or “historical freak.”
2. Other researchers have discovered non-U.S. equity markets with similar 6 to 7 percent real return averages over the past century, further supporting the idea that the U.S. is not an anomaly.
3. Often, when the media declares “equities are dead,” that’s a sign a bull market is just around the corner – remember the infamous August 1979 BusinessWeek “The Death of Equities” cover story? Three years later, stocks took off on one of the century’s greatest secular bull markets.
So, who’s right, Gross or Siegel?
It turns out they both could be right. The key is your timeframe. Since markets fluctuate, we’ll likely see periods when the market delivers more than a 6.6 percent real return and other times when it’s less. However, simply buying and holding on for dear life hoping Gross is wrong probably isn’t the best strategy. Rather, rigorous analysis of all the investment opportunities and careful portfolio tweaking could be the solution.
Notes: S&P 500, DJ Global ex US, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends and the three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.
Sources: Yahoo! Finance, Barron’s, djindexes.com, London Bullion Market Association.
Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. N/A means not applicable.
COULD THE THREE WORDS “PRIME CHILDBEARING AGE” FORESHADOW the next big up move in the stock market? We’re all familiar with the “Baby Boom” generation and the massive impact they’ve had on society. But, less noticed is their offspring, dubbed the “Echo Boom.” Nearly 80 million strong, “they will be become the next dominant generation of Americans,” according to CBS News.
Today, the number of women in “prime childbearing age” is surging and is at an all-time high. While the recent recession and lingering weak economic environment caused many Echo Boomers to postpone childbirth, this could change quickly if the economy picks up speed.
If this potential pent-up demand for babies actually materializes, we could see a spike in births that helps drive consumer spending, corporate profits, and the stock market higher. This potential demographic trend is one reason to be optimistic about America’s economic future.
Ruggie recently bought into his RWM Dynamic All Asset Strategy Portfolio:
iShares Biotechnology and iShares REIT REZ
I could not agree more. We have a larger… more integrated…global economy with more wealth and productivity than ever before. These shares make sense to me because there will be increasing demand for real estate and food.
You can learn more about Ruggie and these shares from Morgan Hatfield at Ruggie Wealth. firstname.lastname@example.org
Warren Buffet falls on the side of equities.
Buffet’s thinking would seem to fit with Ruggie’s.
Buffet said earlier this year (bolds are mine): “Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as ‘safe.’ In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.
Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as ‘income’.”
Currency investments are for money which has a reason to fail the risk test. The owner agrees to give up purchasing power in the long run to have more stability and certainty in the short run.
“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.”
My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO), IBM (IBM), and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.
Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.
“Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”
Ruggie and Buffet’s thinking agree with what I wrote earlier this year: Here are three simple facts about investing and the global economy that also support the long term potential of equity markets and that can help you spot distortions in equity markets.
The first fact: Overall we should expect the global economy to grow at about 3% per annum.
This first fact was confirmed by Alan Greenspan in his excellent book, “Age of Turbulence”. He wrote:
“A major aspect of human nature-the level of human intelligence-has a great deal to do with how successful we are in gaining the sustenance for survival. As I point out at the end of this book, in economies with cutting-edge technologies, people, on average, seem unable to increase their output per hour at better than 3% percent a year over a protracted period. That is apparently the maximum rate at which human innovation can move standards of living forward. We are apparently not smarter to do better.”
This gives us a baseline for how much an investment should grow.
If an economy rises faster than 3%, it is distorted. During early stages of excessive growth, investors will be attracted. Shares will rise faster.
If the economy remains robust, shares become overbought. Then watch out! A correction will come.
This leads us to the second fact which is “All investments have risk”.
Rather than wasting time trying to avoid risk… which cannot be done, investors should look at three risk elements instead.
#1: How much risk is there in any particular investment?
#2: What perceptions do the markets have of the risk?
#3: What risk premium is due?
Bank accounts and government bonds, for example, are perceived as the safest investments (especially if government guaranteed). A look at their long term history shows that they pay about 3%. If a bank account or government bond pays less…in the long term it’s bad. If it pays more…that’s better. The idea is that bank accounts will not really make money. They will just keep up with growth…at 3%.
To get real growth requires taking risk. If an investment appears to be less safe, it will pay more than 3%. This is called a risk premium. Bonds pay more than bank accounts because they are perceived to be less safe. Stocks pay more than bonds because they are perceived even riskier. Emerging market stocks pay more than major market stocks. Emerging market bonds pay more than major markets bonds.
Over the long run, bonds issued in countries and currencies perceived to be stable pay 5% to 7%.
Stocks in major countries should pay 7% to 10% annual return in the stock market as a function of global growth, long term earnings growth plus risk premium (above bank accounts and bonds).
To attain higher growth than 7% to 10% investors must either increase risk, trust luck or spot distortions.
This is good because the market is almost always wrong. Most investors always try to avoid risk. Most investors dump their wealth into investments that are perceived to be safe. This creates excessive demand and lowers value and actually makes the original perception wrong.
Knowing this helps wise investors spot deceits in the dimension of time.
Take, for example, the emerging market trend that has been created by an imbalance in labor costs around the world.
There are 6.6 billion people on this earth (give or take a few hundred million). 1 billion of these people live on a dollar a day. 2.5 billion live on two dollars a day. This means that there is a vast pool of cheap labor that can create goods at bargain prices. Mature economies are buying these goods at such an increased rate that 20% of all goods produced now cross a border, mostly from poor countries to the rich.
This means that emerging economies are growing much faster than 3%. They are catching up and this has caused major markets to slow down.
Yet emerging economies are perceived to have greater risk.
Smart investors have seen the value create by this distortion and have been cleaning up. They have been paid a huge risk premium when the risk has not been real!
The risk has been eliminated by low labor costs in poor countries and improvements in communications and transportation.
From 200o to 2010, the average annual return on emerging markets was 19.81% compared to 10% for major markets.
The Emerging Markets longest down turn was six months and the biggest drop 55%. For major markets, the longest down turn was also six months and biggest drop 53%.
We can see that there has been no more risk in emerging markets than major markets... plus the upside has been much better. This has now changed and you’ll see why below after looking at the third fact.
The third fact: Periods of high performance are followed by times of poor performance.
Emerging stock markets have outgrown major markets by about 7.5 times in the last seven years. Yet their economies are only growing about twice as fast.
Major markets have grown on average about 6.5% per annum for the past seven years….a little below what they should.
This has led to the point where emerging equity markets around the world correct down and major markets up a bit.
Yet in times of global panic as we have seen, all markets tend to drop. This means that at this time, major markets which may have been somewhat undervalued and should be rising are being pushed down by the drop of emerging markets (which should correct themselves).
Understanding these three facts leads us to know that a portfolio of European shares is a great bargain at this time…. but there is a special time risk.
Micheal Keppler stated in his recent major market valuation:
In my more than 30 years’ experience, I have never seen such a bad sentiment towards continental Europe. After a strong start in 2012, chances are good for a continuation of rising stock prices in general for the coming years.
If history is any guide, chances are better still for the Major Markets Top Value Model Portfolio.
This view is supported by our implicit three-to-five-year projection for the compound annual total return of the Equally-Weighted World Index, which now stands at 15.3 %, down from 17.6 % last quarter.
The upper-band estimate of 13,835 by March 31, 2016 implies a compound annual total return of 20.7 %; the lower-band value of 9,223 corresponds to a compound total return of 9.0 % p.a. Even our worst case makes equities look attractive — please see chart below, which shows the entire real-time forecasting history of Keppler Asset Management Inc. for the Equally Weighted World Index.
These numbers are based on relationships between price and value over the previous fifteen years. Given the current low levels of interest rates – real rates are negative in most places – I would like to point out that we do not have to be right with regard to the magnitude of our projections, but only directionally for investors to make money.
This is why we have been recommending High Yield shares. Most are major market equities that provide income and growth potential… plus make it easy to diversify.
This is why we are weighted into Northern European and Italian banking shares shares that we feel offer extra special value and extra risk premium.
There you have it. Understanding the 3% solution and what markets have done show a distortion. Blue chips may be oversold more than emerging shares now.
In the long term, emerging shares will rise. Poor people remain and are willing and able to make goods that others will buy. This will push their economies higher faster than in major economies. Yet for now the three percent solution shows that major markets and high quality shares especially European are more likely to recover from the current doldrums first.
Buffet Seems to Have Similar Philosophies
Berkshire Hathaway recently added energy shares, National Oilwell Varco and Phillips 66 to their portfolio.
Buffett’s firm also tripled its stake in Bank of New York Mellon, from 5.6 million shares to 18.7 million (banking). It also raised its stake in DirecTV from 23 million shares to 28 million.
Berkshire doubled its position in the newspaper publisher Lee Enterprises Inc., to 3.2 million shares. The company maintained its stakes in other publishing companies, Gannett Inc. and The Washington Post Co. (Publishing).
Four of my major equity holdings are in the same sectors:
Brookfield Renewable Power (Energy)
Unicredit & Jyske Bank (Banking)
Axel Springer AG (Publishing)
Sky Deutschland AG (TV)
Buffet and I may agree on the sectors that may be undervalued, but the difference is I am speculating on shares in Northern Europe that earn mostly in Northern Europe. This is based on my belief that markets have oversold the Euro weakness and that even shares which do not earn much outside Germany and strong Northern European economies are oversold. If the Euro fails, these Northern European companies are likely to do especially well in a currency reform.
This is more speculative than Buffet or Jyske’s JGAM who are totally out of the Euro at this time. Fund managers have to be more sensitive to short term movements. Because I manage only my own funds and have a longer time frame I can wait for this Euro weakening to unravel.
Whatever your time frame…. whatever your beliefs, you do need your money to increase its purchasing power and equities are one of the best ways to do this. I feel it is important to look for Where in the World it is best to invest in equities now.
Join Merri and me with Thomas Fischer of Jyske Global Asset Management and Larry Grossman of Sovereign International Pension Services to see where in the world to invest in 2013.