LeverageSubmitted by Antaeus Wealth Advisors on August 29th, 2011
With fears of another global recession gripping the world, the 10 year Treasury yield fell below 2% for the first time in history on 08/19/11, and the S&P 500 had fallen -6.4% in 2011 as of August 26th. The volatility in the capital markets over the last 4 years comes down to one word: leverage. Antaeus has discussed these unsustainable debt levels for quite some time – including personal debt, debt in the banking system, municipal debt, and now federal and sovereign debt – as well as the unpleasant process of unwinding this debt. When homeowner’s utilize their home equity like an ATM machine, when municipalities provide free health insurance and generous pensions regardless of cost, and when federal governments ignore swelling entitlement expenses, debts spiral. Today America has $53 trillion of credit market debt compared to $15 trillion of Gross Domestic Product (GDP), a ratio triple that of 1974.1
The leverage in the global economic sector started in the 1970s, and it will not disappear overnight. I tend to agree with the economist A. Gary Shilling, who wrote in May 2010 that “this de-leveraging probably will take a decade or more.”2 While we have begun to de-lever, as indicated by a slashing of consumer debt, we have a long way to go. Over the past 50 years federal revenues have averaged 18.0% of Gross Domestic Product (GDP) while federal spending has averaged 20.5% of GDP; but estimates for 2011 are just 14.8% on the revenue side and 24.3% on the spending side.3 The cold reality is that the federal budget will not be balanced without both increasing taxes (rates are at their lowest levels since 1950) and cutting spending on Medicare, Medicaid, Social Security and defense.
Most Americans feel fragile today. National unemployment remains above 9% (12%+ in Nevada and California) and roughly 60% of home equity has vanished in just 4 years (real estate prices in Las Vegas, Atlanta, Cleveland and Detroit are below their 2000 prices). Further, and just as alarming, the great recession was both the largest decline in GDP and the smallest recovery of any business cycle since World War II. As a response, consumers have reduced their expenditures, which brings major challenges to an economy derived 71% from consumer spending.4 The good news is that corporate profits are strong, U.S. banks have stronger capital ratios than 3 years ago, and crude oil has fallen from $145 per barrel in July 2008 to $85 per barrel on 08/26/11.
Across the pond, conditions are even worse. Portugal, Spain and Ireland simply have too much debt, and a Greek default appears to be more or less inevitable. In short, with a slowing global economy and elections that may be particularly bitter in 2012, Antaeus anticipates high levels of volatility during the foreseeable future. There is a real possibility of fear pushing down valuations in risk assets even further, as well as another credit crunch. We simply do not know how Europe is going to play out.
So what are some strategies for navigating these times of uncertainty?
- Remember to keep time horizon and asset allocation above market timing and security selection in the hierarchy of your portfolio. For example, if you plan to make 10%+ withdrawals within the next five years,
- minimize your allocation to risk assets, such as stocks. This strategy helps prevent selling risk assets during weak markets.
- Understand that de-leveraging will take time. Today’s volatility is driven by lack of demand, not lack of liquidity. Even if the Federal Reserve continues to flood the financial system with cash, until consumer confidence and demand recovers, we expect ongoing sell-offs and alarming media headlines.
- Invest in risk assets when they are trading at low levels. With the exception of March 2009, stocks have not been this cheap (11x earnings on the S&P 500) since the early 1990s. Over time, the probability is that inexpensive assets (like equities) will appreciate, and that expensive assets (like gold) will depreciate.
- Have realistic expectations for bonds, and allocate appropriately. In 1981 a 10 year treasury bond paid 15.8% per year, and today it pays just 2.2%. Add these low coupon payments to rising interest rates, when bonds tend to fall in price, and the result is low total returns. Today Antaeus recommends a combination of high quality corporate bonds with short maturities (defense), municipal bonds in credit worthy states, and unconstrained fixed-income strategies that may act on tactical opportunities (offense).
- Overweight established companies and underweight small/aggressive companies. The balance sheets of most blue chips currently are flush with cash, which encourages stock buybacks (i.e. increasing the earnings per share for outstanding shares) and rising dividends. Dividends are especially valuable to investors when stock prices bounce around, and they historically have provided a significant component of total return.5 Further, it probably will be difficult for companies dependent on U.S. sales to see large growth; whereas the opportunities for global franchises selling to the growing middle class in countries like China, Brazil and India are tremendous.
- Start hedging the dollar. With high levels of debt, persistent trade deficits, and an aging population, there is a real risk that eventually the U.S. dollar will be replaced as the global reserve currency. One strategy for hedging a declining dollar, while also collecting interest income, involves converting a portion of your cash to foreign currencies, and then buying foreign sovereign and foreign corporate bonds.
- Re-visit real estate. With exceptionally low interest rates and an implosion in values, the next few years may prove to be the opportunity of a lifetime to buy quality investment properties in certain markets.
In addition to the above strategies, over the remainder of 2011, Antaeus will begin increasing client cash positions by about 2%, while moving a portion of their stock allocations to market neutral, absolute return and satellite strategies. In other words, if a European credit crisis brings a large loss scenario to the capital markets, we want your portfolios to be ready. With more and more conviction, in the current environment, we believe that a long only (i.e. dependent on rising markets) buy and hold strategy is a precarious strategy – especially for those of you taking income from your portfolio. As your investment fiduciaries, we believe that having a contingency plan in place is the prudent course.
Finally, despite the kicking of the can in Washington, we recommend that clients prepare for these eventualities: higher taxes on upper income individuals and on capital gains, rising oil prices, higher interest rates, and cuts in Medicare benefits and Social Security eligibility.
Evan P. Welch, CFP®, AIF®
Chief Investment Officer
Disclosure: Indices mentioned are unmanaged and it is not possible to invest directly in an index. No single strategy can assure profit or guarantee against loss. Past performance does not indicate future returns. The opinions expressed in this commentary are those of Antaeus Wealth Advisors, LLC and are based on information believed to be reliable; however, these views may change as information changes or becomes out of date.
The opinions expressed in this article are those of Antaeus Wealth Advisors, LLC. Securities offered through Cambridge Investment Research, Inc., a Broker-Dealer, and member FINRA/SIPC. Investment advisory services and financial planning offered through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Antaeus and Cambridge are not affiliated companies.
1 Source: U.S. Treasury, 06/09/11.
2 Source:The Age of Deleveraging, page xv of the Introduction, by A. Gary Shilling, May 2010.
3 Source: J.P. Morgan, 06/03/11.
4 While Americans are saving more than a few years ago at approximately 5% of income, this rate is far below the 20%+ rate that Antaeus typically recommends to clients.
5 As of 07/31/11, since 1936 approximately 40% of the total return of the Dow Jones Industrial Average was from dividends (Thomson Reuters).