Economic & Market Update, December 2010
by Richard Morey

The U.S. Economic Dilemma, European Sovereign Defaults & Asian Investing
Richard Morey

The world economy remains troubled. At one point in November we had nearly every asset class in the world going down at the same time. Asian stocks and bonds were declining due to increasing inflation in China, European markets were dropping due to continuing concerns about the debt problems in Ireland (and numerous other countries), and both the U.S. stock and bond markets fell as investors worried about potential problems with the Federal Reserve Board’s decision to resume printing hundreds of billions of dollars. At the same time, there are signs of sustainable economic growth. One week the financial news is focused on the positive and the stock market goes up, then the next week negative news dominates and it goes down. This may continue for some time, with no clear direction.

The United States

At this point there appear to be two possible outcomes for the U.S. economy over the next few years:

1) Slow, “bumpy” growth. This is the most likely scenario. Without fresh credit (banking) concerns, we would expect overall economic growth of 2.5%-3.5% a year over the next 3 years. While below the normal rate of expansion after a recession, this would typically be considered respectable. Unfortunately, we need economic growth of approximately 3% just to keep employment steady, as more people enter the workforce than retire each month. As a result, if the economy performs on the high end of our estimate and grows at 3.5% a year, we will still have nearly 10% of our workers unemployed – 17% if you include the underemployed – for the foreseeable future. This is a serious economic and social problem.

While I still see large hurdles facing our economy, I continue to hear many stock market analysts declaring that strong growth is right around the corner. On one hand it makes sense to expect strong economic growth at this stage. After almost every recession in U.S. history the economy grows much faster than it normally does. This growth leads businesses to hire the workers who lost their jobs during the recession, and on we go. Unfortunately, the exceptions to the “high growth after recessions” rule involve times of financial crisis. This time it really is different, but not in a good way. After a financial crisis an economy takes much longer to recover – typically many years instead of quarters. And while we will eventually recover and get beyond these difficult times, we’re not there yet.

Current stock prices are still predicated on a rapidly growing economy, i.e. they are overpriced if the economy doesn’t start growing quickly fairly soon. And while the Federal Reserve Board's massive money printing could indeed get the stock market to go up in the next year, the best minds I can find on the topic aren’t expecting much from U.S. stocks over the next few years. Warren Buffett of Berkshire Hathaway and Bill Gross of PIMCO say stock investors should expect annual returns of approximately 7% in the coming years, while the more conservative John Hussman of the Hussman Funds and Jeremy Grantham of GMO expect the stock market to make 4-5% a year over the next 3, 5, & 10 years. That’s not very good news for retired investors. To make things worse, the road is
unlikely to be smooth. At some point people may end up wondering why they are investing in an asset class – U.S. stocks – that is making them so little with so much risk.

I would wonder myself if we did not have some managers who have shown they can give us excellent returns during times like these. While the stock market is likely to have single-digit returns on average for the foreseeable future, the best stock funds such as the Fairholme Fund are likely to continue to make 10-15% a year. However, funds like this are very, very rare. I do plan to remain overweight in the Fairholme Fund, putting 25% of our stock money into this one fund. But that is about the most we can put in one fund without sacrificing prudent diversification, and the rest of the money has to go into investments that will not only keep up with inflation but give all our clients real profits.

Berkshire Hathaway stock and the Yacktman Fund are two other great U.S. stock investments that can give us good returns even if the broad stock market does poorly. We recently purchased the Yachtman Fund in most accounts, as it is the perfect type of U.S. stock investment going forward. This is because it owns the large U.S. multinational corporations that receive much of their income from the rest of the world, including Asia. And while we continue to have complete faith in Berkshire Hathaway and Warren Buffett, I did put in a sell order for some of this stock if it should go down to $77.5 a share. Over the last few years we have become overweight in Berkshire Hathaway, so if it goes down I want to lock in the 17% gains we would still have this year if sold at $77.5. If this sale occurs, it would give us approximately 15% of the total amount allocated to stocks in Berkshire Hathaway.

We used to own as much of Berkshire Hathaway as we do the Fairholme Fund, and Berkshire’s 24% gain this year has certainly been welcome. But going forward I believe a more modest allocation is warranted. This is due to the fact that Mr. Buffett is having a difficult time finding replacements for himself when he passes away. For example, he hoped to have a remarkably successful Chinese- American investor succeed him, but that individual makes so much money running his hedge fund that he declined. Two of his other top choices to replace him also make so much at hedge funds that they declined Mr. Buffett’s offer. And while Todd Combs, the person Mr. Buffett ended up choosing to manage at least some of Berkshire’s money, does have an excellent track record, Mr. Combs appears to be fairly defensive versus growth-oriented. This definitely does not mean I don’t believe in Berkshire Hathaway long-term, as I am quite sure it will remain a great company long after Mr. Buffett is gone. It does mean that I believe Bruce Berkowitz’s Fairholme Fund is the better investment choice to overweight going forward.

Summary: We believe there is a 65% chance the economy will grow at a rate of 2.5% - 3.5% a year over the next 3 years. However, this is not sufficient to reduce unemployment substantially. Based on current prices, the stock market is likely to remain quite volatile, delivering on average only single-digit returns for the foreseeable future.

2) Another round of debt crisis, leading us back into recession. I remain unconvinced that our banks are actually "cured" at this point. Unfortunately, it is impossible to really know, as the accounting changes made last spring that allow banks to unilaterally decide how much their mortgages are worth are still in place.

We do, however, know that the housing and mortgage markets remain troubled – to say the least. And we know that this can and will lead to new, very large losses for some entities. Thus far that entity has primarily been the U.S. taxpayer, as the Fed and Treasury have continued their creative ways to transfer losses from the banks to the taxpayers. But given the many hundreds of billions of dollars of potential mortgage and real estate losses, another round of financial crisis is certainly possible. At the same time, European sovereign debt crises could also derail U.S. economic growth.

We would give the probability of another round of serious financial upheaval and recession to be around 35%. Obviously, this would lead world stock markets much lower. Everything would go down again except U.S. and Japanese Government bonds. However, if the U.S. Fed responds by printing even more money and our Government responds by creating more debt, at some point world markets will no longer consider U.S. Government bonds to be a safe haven. I actually consider this to be nearly inevitable. As a result, in early January we will be restructuring the bond portion of our portfolios to protect against this very serious risk.

Summary: While modest U.S. economic growth is the most likely scenario, we are certainly not out of the woods yet in terms of this financial crisis. Further mortgage and housing market losses could derail our economy’s tentative growth, as could additional strains on European sovereign debt.

Europe

I can make this analysis very short. Many economists thought the European sovereign debt problems (i.e. the solvency of numerous entire European nations including Greece, Portugal, Iceland, Ireland, Italy and Spain) were solved when the European Union created a massive bailout fund earlier this year. However, several of the very best economic minds in Europe stated that it was literally impossible to save counties such as Greece from defaulting on their bonds, essentially going bankrupt. Not much has changed in the interim, and in November these problems resurfaced when Ireland needed a massive bailout.

In this report I’m not going to attempt to sort out the European financial problems and how their leaders are responding. Instead, I will simply state that I will not purchase one European stock or bond until their sovereign debt problems are fully resolved. This will not happen next week or next month.

Finally, please note that one word highlights the serious dangers Europe poses to world markets, and that word is ‘Spain.’ The Spanish economy is over twice as large as Greece, Portugal and Ireland combined. If it looks like Spain may default on their debts, the entire world economy and markets will plummet once again.

Asia

While pretty much all of Asia (except North Korea) appears to have a bright future, China may stand out as the brightest (with India close behind). While the middle class in the U.S. is shrinking, China has hundreds of millions of people moving very quickly from poverty into the middle class.

In the past, we always invested the bulk of retirement money in U.S. stocks and bonds, as our bonds were clearly the safest in the world, and we also had the least volatile stock market that had earned as much or more than any others over extended time periods. Unfortunately, those days may be gone, at least for some time.

As a result, over time we plan to invest up to one quarter of our money allocated to stocks into Asian stock funds (and one quarter of our fixed income money into funds that invest in developing economies in Asia, Central and South America). If Mr. Buffett was in my shoes, the fact that he wanted to put a Chinese investor in charge of Berkshire Hathaway’s money is one indication that he would do the same thing. He has also been making investments in Chinese companies for the last few years. Plus, when he talks about future economic growth, he regularly says Asia is going to lead the way.

I expect this quarter of our stock money to make over 15% a year, and probably more than 20%. That being said, Asian stock investing is neither smooth nor easy. Our recent experience highlights this fact. In November we purchased a modest amount of a Chinese stock fund in many accounts called “Guggenheim China Small Cap.” This fund owns 155 of the best small companies in China. The reason we plan to focus on smaller companies first is that they will benefit most from internal Chinese economic growth. While China has risen as an economic power due to its export business, over time this sector of their economy will be growing more slowly – in fact its export growth rate is already slowing down. But the hundreds of millions of Chinese consumers in the process of entering the middle class will be increasing their spending by a huge amount over the next few years, and the best smaller companies poised to sell to them will generate enormous profits.

From an overall portfolio perspective, it makes the most sense to focus on large U.S. company stocks and smaller Asian company stocks. People invest in smaller companies, whose stocks are inherently more volatile, in order to get the biggest growth. So with Asia leading the way in terms of growth, it makes sense to invest the most growth-oriented portion of our portfolios in smaller Asian companies.
Over the long-term, small-cap Asian stocks should deliver higher returns than any other asset class in the world. But on a short-term basis, all Asian stocks are very volatile. In other words, there is a price we pay for having the opportunity to get big gains from Asian stocks, and that price is the possibility of short-term losses. When I recently purchased the Guggenheim China Small Cap fund in many accounts, my reasoning was threefold: 1) If the U.S. Fed’s “quantitative easing” program of printing hundreds of billions of dollars to buy more bonds succeeds in inflating stock prices in the U.S., Chinese stocks will go up even more, 2) The Shanghai stock index was still down 50% from its 2007 high, and 3) The Chinese economy has been growing at a very high rate of 9-10% in the last year.

Unfortunately, a week after I made this purchase inflation concerns hit the headlines, and Chinese stocks started to retreat. Inflation in China has been increasing all year, though it “only” increased from 4% to 4.4% last month. However, the Chinese leadership knows how dangerous inflation is to an economy. Plus, like every government I have ever seen, they are definitely understating the real inflation rate. As a result, the Chinese central government announced plans to slow down the economy, which promptly led Chinese stocks down.

We purchased the Guggenheim fund at approximately $33.3 a share, and on December 2 it closed at $32.3 a share. This modest decline isn’t a serious concern, as from a longer-term perspective we do expect this fund to make more than anything else we will own. That being said, I know how dangerous inflation is. If the central government doesn’t get it under control, we could see Chinese stocks drop another 50%, which would put them over 75% off their highs. While I would actually like to see this happen, as it would give us a rare chance to purchase the stock of the fastest growing companies in the world at truly bargain prices, I would not like to see our first modest purchase go from $33 to $16 a share. Therefore, if this fund goes under $30 a share I plan to sell it. And if their market does go down enough thereafter I will make all three of our planned purchases, including the Guggenheim fund as well as the Matthews Pacific Tiger Investor and Matthews China Investor mutual funds. We will then keep all three of these superb funds for an extended time period. (If we haven’t yet purchased the Guggenheim fund in your account, we will as soon as we see the Chinese Government’s attempt to slow inflation getting traction.)

We also purchased the PIMCO Emerging Local Bond fund in many accounts in November. Like the Guggenheim fund, my timing on this purchase was also suspect. But also like the Guggenheim purchase, the underlying premise is solid and I would say undeniable. This fund invests in bonds from “developing economies,” including those in Asia, Central and South America. It can also purchase bonds in Eastern European countries when attractive. This fund is basically guaranteed to go up when the U.S. dollar goes down. It unfortunately went down in November, but over time we are certain it will do well. As our country continues to print trillions of new dollars and deal with huge deficits, the U.S. dollar will go down and this fund will go up in price. Plus, it pays a nice 4.78% in interest. In terms of credit risk, I would say this fund is safer than domestic bond funds – even those that own primarily U.S. Government bonds. While our country faces huge and increasing deficits, many developing countries have little or even no debt. And this particular fund focuses on the bonds of countries with unusually good, prudent central banks that are protecting their currencies and do not have debt problems.

We will also be purchasing a second, similar fund called Doubleline Emerging Markets Income. This superb fund is run by managers who made approximately 14% a year over the last decade at TCW Emerging Markets Income before switching to Doubleline. These managers are also safety-oriented. Making 14% a year while focusing on safety is an excellent track record.

While we may sell the Guggenheim fund if it drops further (to repurchase it later at a lower price), I’m not concerned about any possible short-term losses in either the PIMCO Emerging Local Bond or Doubline Emerging Markets Income funds. It is extremely difficult – most would say impossible – to predict global currency changes on a short-term basis. However, as described above, over the next few years I am certain the U.S. dollar will go down relative to the currencies of the developing countries with no debt problems. When that occurs, these funds will go up in price.

Summary

For now, and for the foreseeable future, our accounts will remain overweight in conservative, fixed- income funds. While they did not have a great month in November, for the year we still have good gains, and our targeted 10% return for the year is still within reach. Plus, our core stock investments have soundly defeated the stock market this year.

In January we will be restructuring the fixed-income portion of our portfolios to protect against possible inflation in the United States and weakness in the U.S. dollar. This process is already beginning, as we are taking money from some of our broad U.S. bond funds to begin investing in the new PIMCO Emerging Local Bond and Doubleline Emerging Markets Income funds. By the end of January we will have no money invested in any of our broad U.S. bond funds, including PIMCO Total Return, PIMCO Fundamental Advantage, and the Metropolitan West funds. We will then begin focusing very, very seriously on protecting against the coming inflation we see for the U.S. economy.

While the world economy is clearly still filled with potential land mines, the new funds we are purchasing now and will purchase in January have excellent prospects. As a result, even if the stock market does deliver only low single-digit returns, and even if the broad U.S. bond market makes very little over the next few years, I remain confident our goal of safely making our clients 10% a year or more is achievable. And someday we’ll have an economic world that isn’t beset by huge macroeconomic problems, in which case we should have the opportunity to generate higher returns to get “ahead of the curve.” Throughout it all, as always, first and foremost we will continue to focus on protecting our clients’ retirement money.