The Long Run Quarterly Letter: July 2009
"When the wind changes direction, there are those who build walls and those who build windmills.”"
--Chinese Proverb
Leave it to us to argue with ancient Chinese wisdom, but we like to think that our philosophy mandates both options for changing weather patterns. While we believe our prime directive is to build a solid foundation in each account that can protect against the erosion of its value, it is also important to be positioned to move ahead when the wind is at our back.
We relay these thoughts because the economic winds have been fierce this past year, but have shown signs of changing. The S&P 500 Index, which had declined in value for each of the previous six quarters, reversed direction and increased by 15.9% in the most recent three months (and 41% since the March 9th low). The Nor’easter buffeting the markets was replaced by a fairly powerful trade wind.
Unfortunately, many investors had built no wall to protect against the financial crisis of the previous three years and had no stomach to fund the construction of windmills, the growth to the future. Due to fear of further market declines, cash sitting in low-yielding bank accounts rose from an amount equal to 60% of the value of all stocks in the S&P 500 at the beginning of 2008 to 140% back in March at the start of this rally.
While we have spent several years discussing the impending financial crisis and the resulting economic decline, we would be remiss not to also spend time discussing changes in this environment. The current recession has been going on for 17 months, which would make it the longest post-Depression downturn since the double recession of 1980-82. This compares with an average length of 10 months for the typical recession.
Whether it is a result of tremendous amount of money that the government is putting into the economy, or a product of our bail out of the failed financial system, or simply due to the passage of time, we are seeing – for the first time in years – early indications that the economy seems to be bottoming out. While we could point to several different economic weather vanes that are beginning to show this shift, one of our favorites is the Leading Economic Indicators (LEI). A fairly reliable rule of thumb is that when the LEI rises three months in a row, the economy will likely return to growth over the next three-to-six months. This index did, in fact, increase in June for the third consecutive month – the first time this has happened since 2004.
As a result, we are becoming more comfortable with the outlook that the U.S. economy will likely return to a modest level of growth soon. This view is supported by the recent results from some of the “windmills” we have placed in portfolios. Companies as diverse as Apple, Deere, Intel, Novartis, Sims, Vestas, and Canadian National Rail have all reported surprisingly good earnings this quarter.
Before you think we have taken this “winds of change” theme too far, we still want to emphasize that this recovery will likely be modest and very uneven because some sectors of our economy will continue to face a very stiff headwind. While we have never used charts before in The Long Run, we have included one this time because we really think that this picture does replace one thousand words. The chart on the next page shows what we believe is one of the most important long-term trends to be facing our economy for the next decade. That is, consumers will be deleveraging (i.e., paying off their debts) and this will restrict economic growth.
Paul Volker said last week, “The crisis is an opportunity. It’s an opportunity to do some things that in ordinary circumstances would not begin to be possible.”
While Baby Boomers may have been about peace and love in the 1970s, they certainly opened their wallets to consumerism in the 1980s and 1990s. As a result, consumers became an ever larger portion of our country’s economy. This trend is now decidedly over as Baby Boomers are being forced to accept the reality of their pending retirements and insufficient savings. The trend towards saving and away from consuming is just getting started and will impact our economy (in good ways and bad) for years to come.
What will replace the contracting U.S. consumer? To some extent, it will be consumers from emerging economies. Additionally, it is likely that the long-term trend to outsource jobs from the U.S. will begin to reverse and more manufacturing jobs will come home. Most of the world economy has been built on the availability of cheap energy, a trend that is likely over. Locating closer to less expensive sources of energy rather than to cheap labor will be a more important theme of the future. The U.S. has been a leader in investing in energy efficiency (in areas outside of autos) and seems to be heading down a somewhat winding road towards greater usage of renewable energy.
While we have focused on the “winds of change” for the economy in this letter, it is always also of interest to observe these changes for individual corporations. For example, Wal-Mart has long been the most demonized company in the world, yet we note that they recently broke ranks with their peers and came out in support of all companies providing health care for employees, as well as beginning a program of providing environmental ratings for all the products it sells. Similarly, Exxon, the second most despised company, which under previous management has gone out of its way to deny the existence of global warming and the need to develop renewable sources of energy, made a large investment in an algae-based bio-fuel company.
In Reynders, McVeigh news . . .
During the quarter, we added Anne Wisotzkey to our staff as an Administrative Assistant. We welcome her to our team and believe she will help us continue to improve our services for you.
We had the good fortune to be profiled in an article in the June 22, 2009 issue of Forbes entitled “Betting on Green,” as well as being featured in the Wall Street Journal and Business Week. Topping off an eventful quarter, we were selected as the 17th highest-ranked investment management firm in the country by Wealth Manager. While we don’t fully agree with their methodology, we were pleased to be included.
In closing, we remain dedicated to steering our clients’ portfolios through these difficult times – balancing current economic challenges with attractive asset valuations and developing growth opportunities.
