David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
“It Was Only a Paper Moon”
January 7, 2010
The rarity of a New Years Eve blue moon has now morphed to a waning gibbous form as the moon leads reveling partygoers back to an early January reality. We will summarize some of the investment strategy themes for the start of this century’s second decade. The bullets follow.
1. 2010 will be the year of very large sovereign debt issuance. Governments in mature economies in Europe (including the UK), Asia (Japan), and North America (the US) will be borrowing huge amounts, while private-sector borrowings remain low and still shrinking in some areas. Government debt is substituting for private debt. The market will confront continuing credit-watch notices and credit downgrades for sovereign states. This will be disconcerting, since the downgrades will occur on the 50 US states and the 27 EU states. In our view this creates terrific opportunity for bond investors who are able to sort through the credits and who understand the nature of debt. Taxable (Build America) and tax-free municipal bonds in the US are an example of an area where investors can act opportunistically. This is less true for most corporate debt and federal agency debt, where spreads have narrowed. The debt of financial enterprises is an exception. Cumberland’s managed bond accounts have favored this strategy for over a year and have extremely underweighted Treasury debt in 2009. We expect that strategy to continue as spreads in Muni land sequentially narrow in 2010. For some details see Peter Demirali and John Mousseau commentaries on our website, www.cumber.com.
2. Stocks still have room to go higher before this bull market is over. This may be in spite of a corrective selloff during 2010. Various estimates of S&P 500 earnings for 2010 range from about $70 to $80. At a 15 multiple that would put a fair-value range on the S&P Index of 1050 to 1200. A 15 multiple against a 10-year Treasury bond yield of 3.8% suggests an equity risk premium of about 3 points, which is in line with fair valuation. The surprise in 2010 may come on the upside, since labor costs are held down by the high rate of unemployment. That means productivity and profits will be unusually high coming out of this post-crisis recession. We expect the US stock market to close the “Lehman gap.” That could bring stocks to the pre-Lehman-failure level of over 1250 on the S&P 500 Index. Cumberland’s ETF accounts have been nearly fully invested throughout most of 2009 and continue that way as we enter 2010.
3. The Fed is likely to keep the short-term interest rate very low for an “extended period” while it gradually withdraws the special facilities put in effect under “emergent and exigent” circumstances. These two terms are important for investors to understand. “Exigent and emergent” mean the Fed has to officially find that the emergency conditions exist in order to maintain these special facilities. This is a black and white test for the Board of Governors. They have to vote that the conditions either do or don’t exist. If it isn’t clear, then the likely answer is that they still do exist. We believe “extended period” means about 3 or 4 FOMC meetings before a change in rates will be initiated. That is about a half a year and enough time for the Fed to determine that the emergency is over. The clues for this change are likely to be revealed in speeches by FOMC members, in the quarterly economic forecasts of the FOMC members and in the statements that the FOMC makes and releases after each of its meetings. Bob Eisenbeis has comments about using the forecasts as clues; find it on our website at www.cumber.com. Markets will react to any change that suggests the “extended period” is approaching an end. The FOMC does not know the extent of that forthcoming market reaction. It can only guess at it which is why it will do as much as possible to prepare the markets for this change. The FOMC also knows that the greatest risk to the fragile and nascent economic recovery comes from the FOMC moving too soon. Double-dip recessions and “W” economic outcomes have occurred in the past only when the Fed moved too soon and triggered the second down leg. 1937-38 and 1980-81 are two examples of this type of policy error. Bernanke has said he will not repeat this mistake. We take him at his word.
4. Inflation will not be a threat in 2010. Much of the market player’s hand wringing about a big inflation coming is misplaced. Velocity measures are at their lowest in the last decade in the US, euro –zone, and Japan. As an outcome of monetary policy, inflation needs to have two operative elements: an expanding private sector credit multiplier and a rising labor cost. In most mature OECD country economies, both credit and labor are pressured as we enter 2010. That is certainly true in the United States. If anything, we see inflation flat-to-declining in 2010 and into 2011. That means upward pressure on bond yields that arises from inflation risk premia is likely to be muted. Markets seem to expect otherwise, which is why they may be pleasantly surprised. If bond yields rise, it will be due to credit concerns or a fall in the global supply of savings. Note that foreign official holdings of US government securities approach $3 trillion as we enter 2010; this number was well under $1 trillion at the millennium anniversary. We expect it to rise over the next decade as the US continues to run large current account deficits.
5. Worries about an end to emerging market growth are premature. We expect the emerging market growth story to continue for a long time. Corrections in these markets are buying opportunities. Investors should not confuse high volatility in both directions with an end to the long-term growth story. High “Vol” in emerging markets will continue, as it should, since these economies have more cyclical risk attached to them than the mature ones. The mature ones are more predictable, although they are experiencing much slower growth rates and rapidly rising debt ratios. We continue to overweight emerging markets in our Global Multi Asset Class approach to ETF investing. Bill Witherell has a piece on Global asset allocation posted on our website, for those who are interested in this detail. See www.cumber.com.
We look forward to a fascinating year as markets continue to heal from the policy-failure-induced vicious destruction of 2008 and early 2009. That traumatic period has given way to the stimulative-policy-induced recoveries of 2009 and 2010. We view these recoveries of the world’s economies as tentative and fraught with higher than normal risk. Policy making is extraordinarily unusual in this cycle. The Fed is in unchartered waters with its new tools. The federal deficit is enormous. America’s tax policy is very uncertain and likely to lead to much higher rates of taxation in the United States once the economic recovery gets into a more sustainable mode.
We believe the US should be viewed as a new entrant into the group of social-democratic states that pursue “industrial polices” where government is a large intervener into private affairs and private enterprise. That means comparisons need to be thought about differently. Government debt-to-GDP will be over 100% in the US, UK and euro–zone by the end of this new decade. It is approaching 200% in Japan. Social burdens and aging populations will play enormous roles in their respective economics. 90% of the world’s debt is denominated in these four currencies: yen, pound, dollar, and euro. We discuss these issues in some detail in our forthcoming book “Invest in Europe Now!” The book is an effort I co-authored with Italian financial journalist Vincenzo Sciarretta. Wiley will release it in April.
Regrettably, we will not leave on Friday for the GIC meetings in Shanghai and Hong Kong; meeting details are found at www.interdependence.org. A wrenched back, some meds and doctors keep us from catching up with Asian, African and North American friends who are planning to attend. For those nearby and capable of last minute travel, the event that we helped organize and now must experience vicariously features conversations with policy makers, investors, bankers, and economists; all are scheduled during the week.
By the time the GIC delegation returns in mid-January the blue moon of New Years Eve will have waned through gibbous and crescent to the first new moon of the new decade. Is this a paper moon? A prescient moon? Will we need moonshine to tolerate the craters ahead? Or will moonbeams illuminate a path for investors in the coming decade?
David R. Kotok, Chairman and Chief Investment Officer, email: firstname.lastname@example.org