Five Years Later: “Advantage America” by Dr. Gary Shilling

Lehman collapseLehman Brothers collapsed September 15, 2008. Five years later, the world is still struggling to recover from the most serious crisis since the Great Depression. Our government seems to be in perpetual dysfunction. The media seems intent on focusing on real and potential problems. It is easy for Americans to feel pessimistic about the future.

There is another side to the story. It is presented by Dr. Gary Shilling who has become quite bullish about the future prospects of the U.S. This is particularly interesting, since Dr. Shilling has been a “confirmed bear” and may be best known as the author of The Age of Deleveraging- Investment Strategies for a Decade of Slow Growth and Deflation, originally published in late 2010.

Dr. Shilling, in his July 2013 issue of Insight, wrote that prospects are bright for a return to rapid U.S. economic growth and a resulting decline in the federal debt-to-GDP. He outlined six key areas where the U.S. is better positioned for the future than any other country- developed or developing. These include:

1.  Demographics. The U.S. fertility rate is currently 2.06 to 1. That is close to the 2.1 rate needed to sustain the population in the long run. All of Europe, and even Canada and Australia, are below the reproduction level. Japan is at 1.30 and China at 1.55. In the long run, this means our population should stay roughly constant and there should continue to be a large percentage of younger workers. This is critical for future economic growth. No other developed country has these characteristics.

2.  Entrepreneurial Spirit. “Despite perceptions of an erosion of U.S. economic vigor, America still seems way ahead of whoever is in second place,” wrote Dr. Shilling. Our educational systems encourage free inquiry and challenging the accepted doctrine. Japan and China discourage individuality and education typically is based on rote memorization and lack of inquiry. In addition, U.S. manufacturing has regained its spot as the most favorable spot for foreign direct investment, pushing China into second place.

3.  Labor Flexibility. In the last 40 years, union membership in the private sector has been reduced from 40% to 6% of the workforce. In the last five years, Americans that are out of work have accepted new jobs, many at lower pay. In the auto industry, for example, the average pay of autoworkers is now less in the U.S. than in Germany or Japan. As a result, American made vehicles are beginning to be shipped abroad in significant numbers.

4.  Declining Need for Foreign Financing. Americans are saving more. Most recognize that you cannot count on double-digit returns every year from your investment portfolio. In addition, you cannot plan on your home equity providing the funds you need for retirement. Therefore, Americans need to save more and they are doing that.

More savings means consumption will grow more slowly. In addition, when spending growth is retarded, this means buying fewer imports. The result will be, in Dr. Shilling’s estimate, a reduction in the U.S. trade and account deficits. This will put fewer U.S. dollars in foreign hands. And, it would mean that America could meet more of its financing needs internally.

5.  Strong Dollar. Despite all of the issues here in America, the U.S. dollar is not even close to being unseated as the world’s primary reserve and trading currency. We have the largest economy, deep and broad financial markets, free and open financial markets and economy, lack of substitutes and credibility in the value of the currency. No other country can boast these attributes. Hence, the U.S. dollar is the only safe haven of any size in a persistently uncertain world.

6.  Energy Independence. America is on the way to self-sufficiency in energy. There are predictions that the U.S. could be relatively free from foreign oil dependency as early as 2020.

Certainly, no one can predict the future. However, Dr. Shilling’s remarks do unmistakably outline the reasons why America is better positioned for the future than any other country in the world. With all the negative media we see, hear, and read daily, it is nice to be reminded and encouraged by positive facts foretelling a brighter future.

Bond Bull Market May be Over- Time for Revised Strategies

Source: James O’Shaughnessy / WSJ
Graph Source: James O’Shaughnessy / WSJ

What were you doing in 1981? A mere twinkle in someone’s eye? Attending school? Working? Married? Elise and I were buying our fifth house and taking on a 15% mortgage. The rate seemed pretty decent to us. 20-year Treasury bonds were yielding 15%, businesses were paying 21% for a “prime” lending rate, and inflation was in double digits. Many people thought we were living in Jimmy Buffet’s “Banana Republic;” where inflation and interest rates would continue at record highs for decades to come.

This was not to be. We had reached a turning point in 1981, where apparent trends started to reverse. In fact, inflation and interest rates decreased steadily for the next thirty-one years. Inflation has averaged less than 1.5% over the last five years and 20-year Treasury bonds yields reached a low of 2.11% last year. Now, it appears that we have a new, permanent change of direction-rates are beginning to rise. The thirty year bond bull market seems to have ended.

Until this year, bonds have provided a great place for investors to put a good share of their money. Performance has been very good and the risk has been low. Total return, as Brett pointed out a few blogs ago, is equal to the yield (interest paid on the bond) plus the change in value of the investment. Because bond prices increase when interest rates decline, bond investors have been rewarded with both their interest income plus an increase in market value for last thirty years.

From 1/1/2000 to 12/31/12, 20-year treasury bonds produced a total return of 7.6% per year. The S&P 500 had a total return of 2.4% over the same period. It’s no surprise that investors fell in love with bonds, not only for the excellent return but also for the lower risk and volatility. However, the experience of the last three decades in bonds is unlikely to continue.

It’s a shame, particularly for older investors.

Here’s a simple example. Let’s say that you own a bond paying 4% interest that matures in 5 years. If the interest rates for similar bonds decline by 0.50%,then the value of your bond is reduced by roughly 2.5% (0.50% decline x 5 years to maturity). Hence, your total return that year would be 4% interest income less 2.5% of price reduction. Hence, a net total return of 1.5%.

So, why would someone even own fixed income investments? The simple answer is that they still serve an important role in your portfolio. Fixed income has traditionally provided diversification and low volatility and should continue to do so. When equities rise, bonds won’t keep pace. But, when equities decline, fixed income historically advances. In addition, fixed income provides superior capital preservation qualities over other asset classes, including equities.

We believe in long-term investing and are known for not making “knee jerk” reactions. However, when there are major investment turning points, as we are seeing now, it is time to review portfolios with new proactive strategies in mind. This may include reduction of the allocation to fixed income, modifications within the fixed income asset class, and other techniques. Our DWM clients have seen a number of rebalancings focused on these matters in the last few months.

If you want to hear more, mark your calendars. DWM’s annual client educational update this year will focus on proactive strategies in a rising Interest rate environment. Our Charleston/Mt Pleasant event will take place October 23rd in the afternoon and our Palatine event will take place the afternoon of October 30th. We do recognize that the topic may, for some, be important but unexciting. That said, we can promise all attendees some pleasantries at the receptions that will follow. Be sure to watch for more details soon.

Liquid Alternative Monthly Spotlight

saupload_MLP-ETFsThis month: Master Limited Partnerships (MLPs)

For the next few months, I will spotlight a strategy utilized within our Liquid Alternatives model to give the reader a better idea of what “alternative” means and how it adds value. To start our series off, we will talk about MLPs.

Master Limited Partnerships, or MLPs for short, are limited partnerships that are publicly traded. The majority of MLPs currently operate in the energy infrastructure industry, owning assets such as pipelines that transport crude oil, natural gas and other refined petroleum products. MLPs typically generate fee-based revenues, which tend not to be directly tied to changes in commodity prices. In other words, these companies are like toll-keepers, picking up a fee every time someone has to transport a product. We like this because it is not about the commodity that they’re transporting – those tend to be quite volatile – it is really just about the steady, consistent “toll” they bring in.

In our Liquid Alternative model, DWM uses the JPMorgan Alerian MLP Index ETN (symbol: AMJ) for this MLP exposure. AMJ tracks a variety of different types of MLPs: petroleum transportation, natural gas pipelines, propane, exploration/production, and gathering and processing. These firms operate at various stages of the transportation of energy. The largest MLPs own several businesses to capitalize on their scale and offer start-to-finish services. Kinder Morgan is an example of an MLP like this and a company you may have heard of before. Federal regulations require new energy projects to undergo a rigorous vetting process, so economically unviable pipelines are rarely built. As a result, most pipelines and processing facilities run by MLPS are local monopolies and are quite lucrative.

We like MLPs for a number of reasons. First, they provide relatively low correlation to the traditional asset classes of equities and bonds. Second, they have produced attractive yields – current yield of AMJ is around 4.68%. Third, in the past few years besides the nice coupon, there’s also been price appreciation. In fact, AMJ’s 3 yr annualized total return as of 6/12/13 was 20.91%.

Some people knock MLPs because typically the burdensome K-1 forms are associated with them. But because we use AMJ, which is an exchange traded note from JPMorgan, investors get the friendlier 1099 tax form. Another advantage of AMJ is the diversification it provides: the Alerian MLP Index is a market-cap weighted, float-adjusted index that covers the major players (Enterprise Products, Kinder Morgan, Plains All American Pipeline, Magellan, etc) within the MLP space.

As you can see, MLPs are a different breed and we think make for a compelling investment opportunity. As such, AMJ is a star player on our Liquid Alternative team. Next month we will introduce you to some other stars also on that team!