Successful Investing in a Low Growth Economy: A Historical Perspective

SUCCESSFUL INVESTING IN A LOW GROWTH ECONOMY:

A HISTORICAL PERSPECTIVE

Aaron Careaga Research Analyst

http://www.wealthmarkllc.com/research

WEALTHMARK LLC. 1329 North State Street, Suite 206

Bellingham, WA 98225 February 2013

2

ABSTRACT

The U.S. economy has grown about 3.5% annually from the 17th century until the late 20th century. Most of American industry and wealth can be attributed to significant technological advancements starting in the Industrial Revolution. Over recent decades, productivity has significantly dropped off with some estimates of the economy growing at 1.8% annually.

Returns from innovation appear to be entering a period of stagnation. Although the causes and implications of such events remain in question, it has become increasingly vital for investors to analyze performance across similar environments in history to successfully navigate uncertain markets.

Aaron Careaga WealthMark LLC. 1329 North State Street, Suite 206 Bellingham, WA 98225 [email protected]

3

1. Introduction Most academic and professional theories on productivity are based on the Solow Growth Model, which is predicated off the fact that economic growth is continuous along an infinite horizon. There has recently been significant discussion of economic papers forecasting dismal growth with the possibility of little-‐to-‐no return on investment. Economist Robert Gordon argues that prior to 1750, the growth that we’ve become accustomed to today was nonexistent and recent productivity is likely an outlier in the larger economic history of the world.

Source: Gordon 2012

Technological advancements from the Industrial Revolution significantly progressed economies, but innovation’s ability to further growth appears to becoming less effective. Basic inventions, such as indoor plumbing and controlled energy (light bulb), heightened the standard of living far more than social networks. Society might not be as well connected without recent innovations, but at least the standard of living would remain higher than that of agrarian ancestors.

Gordon explains that:

Attention in the past decade has focused not on laborsaving innovation, but rather on a succession of entertainment and communication devices that do the same things as we could do before, but now in smaller and more convenient packages. The iPod replaced the CD Walkman; the smartphone replaced the garden-‐variety “dumb” cellphone with functions that in part replaced desktop and laptop computers; and the iPad provided further competition with traditional personal computers. These innovations were enthusiastically adopted, but they provided new opportunities for consumption on the job and in leisure hours rather than a continuation of the historical tradition of replacing human labor with machines (Gordon 2012).

Jeremy Grantham, cofounder and chief investment strategist at GMO, recently wrote an influential newsletter on the subject called On the Road to Zero Growth. The paper examines Gordon’s research and the fact that U.S. GDP growth has remained above 3 percent in recent history.

4

Grantham contends that growth rates near 3 percent are unsustainable and exhibit only a small blip in history, fueled by population growth and industrialization. As resources dwindle and populations peak, he forecasts U.S. real growth of 0.9 percent through 2030 and dropping to 0.4 percent from 2030 to 2050. Most valuation models use annual growth rates around 5 percent. How do you value investments necessary for retirement in a 0.9 percent real-‐growth economy?

Pricewaterhouse Coopers also updated its long-‐term economic outlook in January 2013, titled The World in 2050. The report includes an analysis of key growth drivers and implications of global shifts with a forecast of total GDP, average real GDP growth, and income per capita for developed and emerging countries.

PwC projects China to overtake the U.S. in terms of total GDP between 2017 (PPP estimate) and 2027 (MER estimate) depending upon underlying assumptions. The U.S. is expected to be the second largest economy behind China by 2050 with annual growth slowing relative to younger economies. China is forecasted to produce 3-‐4% real growth with the U.S. and E.U. countries growing at a significantly lower pace. As the following chart displays, Nigeria, Vietnam, and India exhibit the greatest potential for real annual growth through this period.

Source: Hawksworth and Chan 2013

PwC states that recent claims on a slowing technological frontier and real U.S. growth projections around 1% seem “rather at odds with the accelerating pace of change in ICT and the potential for further rapid progress in areas like nanotechnology and biotechnology over the coming decades” but they believe that, “it is possible that measured GDP growth could slow down due to difficulties in measuring technology-‐related improvements in the quality of some services” (Hawksworth and Chan 2013). Multiplier effects of technological innovation are rarely obvious, especially in traditional measures of productivity, and often lag business sentiment for such advancements relative to classic examples of innovation in living standards.

As an alternative perspective on the above pessimistic outlook of technological innovation, the Economist argues that, “the main risk to advanced economies may not be that the pace of innovation is too slow, but that institutions have become too rigid to accommodate truly revolutionary changes” (Economist 1, 2013). This is probably another major factor contributing to

5

slowing economy productivity, but data backing these claims will likely not be apparent for many years to come.

Projecting recent behavior onto future expectations is extremely capricious. Forecasts can give investors comfort in seeing the future, but events almost never unfold as initially expected. James Montier, a member of GMO’s Asset Allocation team, believes that, “attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future… They have missed every recession in the last four decades! And it isn’t just growth that economists can’t forecast: it’s also inflation, bond yields, and pretty much everything else” (Montier 2011).

With these thoughts in mind, it has never been as imperative to learn from past experiences given recent levels of volatility and potential conjunction of multiple forces. Technological pessimism is not a new phenomenon and historic performance is never a definitive indicator of future returns, but, regardless of the outcome, it is necessary to analyze market trends and investor reactions throughout similar periods in attempt to better prepare for an uncertain future.

6

2. Deciphering the Past

Prior to the 1800s, societies across the globe were primarily agrarian driven. Wealth was mostly derived from farming and the exploitation of labor, resulting in mild income inequality and distinct levels of society. Four features characterized pre-‐industrial societies across history: high fertility rates, little education, the dominance of physical over human capital, and low rates of productivity growth (Clark 2004). Technological innovation led to a major change in economic structures, resulting in significant supply and demand shifts across labor and resource markets.

On financial evolution, it is important to recognize that bankers and other facilitators of trade have existed since Roman time and ultimately laid groundwork for the current financial structure. European banking institutions started to facilitate trade and the transfer of funds in the 1600s. The New York Stock Exchange was created in 1792 and most of the bellwether U.S. financial institutions were founded around the mid 1800s. The Civil War was a catalyst for debt securities around this same time as bonds were issued to finance wartime expenditures. But, nothing on today’s scale of financial markets ever existed prior to industrialization and advancements in communication.

Investing before the industrial revolution was drastically different from today and somewhat limited from the common man. Markets were inefficient, assets hard to transfer, time was a luxury, and most did not have discretionary capital to invest. The transition in standards of living and societal structure can be seen in the significant real wage growth spurred from industrialization.

Source: Clark 2004

History has been plagued with slow economic productivity until the 19th century. Common investment vehicles utilized pre-‐industrialization were in hard assets (land, gold, silver) constrained by supply, leading to a more dependable store of value.

Capital became increasingly necessary to build the factories and railroads, leading to the issuance of corporate bonds and stocks. One of the leading academics on financial history is Niall Ferguson, who authored the book “The Ascent of Money”. In summary of financial evolution, Ferguson explains that:

7

From the thirteenth century onwards, government bonds introduced the securitization of streams of interest payments; while bond markets revealed the benefits of regulated public markets for trading and pricing securities.

From the seventeenth century, equity in corporations could be bought and sold in similar ways. From the eighteenth century, insurance funds and then pension funds exploited economies of scale and the laws of averages to provide financial protection against calculable risk. From the nineteenth, futures and options offered more specialized and sophisticated instruments: the first derivatives. And, from the twentieth, households were encouraged, for political reasons, to increase leverage and skew their portfolios in favour of real estate. (Ferguson 2008, 341)

Reiterated in the chart below, the Economist mapped significant innovations across the timelines originally constructed in Gordon’s research. Major improvements in transportation lagged GDP growth, but it seems that advancement in communications were adopted at a quicker pace and jumpstarted the largest period of economic growth (GDP terms) in history.

Source: Economist 1, 2013

Technological innovation has also greatly impacted employment demand over the past couple of centuries. Manufacturing advancements streamlined production and allowed workers who were previously employed in labor-‐intensive roles to reevaluate career opportunities and, in some cases, to seek higher education. The reallocation of labor from agriculture, low skill jobs towards white collar and high skill occupations becomes evident in a decade-‐by-‐decade analysis of U.S. civilian employment distributions.

8

Source: Katz and Margo 2013

As GDP is derived from the productivity of a nations workforce, effects from technological innovation on employment demand shifts are indicative of long-‐term economic trends. From the 1980s through 2010, research has displayed a hollowing of middle skill occupations likely due to the computerization of related duties (Katz and Margo 2013). The polarization of workers is also likely to impact economic growth as many significant drivers, from consumer spending to income taxes, are derived from this middle class.

To further understand financial market relationships through more recent periods and to help investors prepare for future volatility, an analysis of four cases of economic uncertainty are presented below. Germany’s Weimar Republic has become a prime example of monetary policy and it’s affects on investors through currency debasement and uncontrolled hyperinflation. The Great Depression gives insight into the political monetary relationship, investing through high unemployment, economic stagnation and unstable price environments.

Analysis of the U.S. economy through the 1970s provides investors with possibly the best indicator of future environments, if long-‐term forecasts discussed above play out, because it was the birth of Staglfation – little to no economic growth and high levels of inflation. Finally, a look at the top performing investments through Japan’s lost decade and beyond, allows insight into market reactions to economic stagnation, an aging workforce, high debt levels, and long-‐term price instability.

9

GERMANY’S WEIMAR REPUBLIC

Days of mass stimulus have been tried before and held devastating consequences. The current economic and monetary environment displays traits similar to that of past crisis. Learning from historic market events and how to manage risks associated with similar policies, mitigating volatility with the goal of earning return is critical to today’s investor success.

The Weimar Republic is a classic period of hyperinflation, where unemployment ran wild, economic growth stalled, and the value of the Reichsmark dropped like a hot rock until it ultimately collapsed. Germans struggled to survive during this period due to the devaluation of currency resulting in the erosion of most life savings. Citizens were forced into a pure survival mindset that challenged many societal values.

Wartime activities, supply shocks, and the removal from the gold standard allowed the German government to exploit its currency until the point of failure, as shown in the chart below. Those who benefited during this time were debtors as the value at which agreements were entered vaguely represented the present value of underlying currency. Loans were written off at relative cents on the dollar.

Source: Gresham’s Law 2011

Ronald H. Marcks, who wrote Dying of Money under the pen name Jens Parsson, described equity performance throughout this period as:

“At the height of the boom, stock prices had been bid up to astronomical price-‐earnings ratios while dividends went out of style. Stock prices increased more than fourfold during the great boom from February 1920 to November 1921. Then, however, shortly after the first upturn of price inflation and long before the inflationary engine faltered and business began to weaken, a stock market crash occurred. This was the Black Thursday of December

10

21, 1921. Stock prices fell by about 25 percent in a short time and hovered for six months while all other prices were soaring.

Stocks in general were no very effective hedge against inflation at any given moment while inflation continued; but when it was all over, stocks of sound businesses turned out to have kept all but their peak boom values notably well. Stocks of inflation-‐born businesses, of course, were as worthless as bonds were.” (Parsson 1974)

Investing through this period of hyperinflation was obviously more volatile than anything experienced in recent years, but profitable traits still remain true to today’s environment and managing such risk. The last place you want to be invested in times of extreme inflation is cash or other forms of debt denominated in the underlying currency. A leading journalist and author on Germany’s Weimar Republic experience explains that, “Speculators, wealthy industrialists who can borrow cheap, debtors like the government, farmers, and those with mortgages have benefitted the most from hyperinflations” (Fergusson 1974). Investors turn to hard assets (precious metals, real estate) and commodities as a store of value, where supply is constrained by relative availability or production. As demand for necessities increases so does the possible return from transferring such assets.

A necessary consideration of investing in real estate is the opportunity cost of renting versus owning a home. As inflation rises, the purchasing power of an individual’s income shrinks relative to an increasing rental price. Much like the Weimer Republic days of hyperinflation, investors who came out better were those who held debt financing. Vehicles such as TIPs and other inflation-‐indexed hedges are now available to protect portfolios should a similar scenario arise today.

Stocks generally do not perform great during periods of high inflation, but past experience has shown they are on average better investments compared to holding cash or government bonds. Equity focus should be constrained to inflationary protected businesses that operate with, or own, a decent amount of hard assets. Consumer retail and financial related stocks will be hit the hardest when individuals lose purchasing power, demand plummets and creditors are left holding the bag.

Takeaways:

• Debtors benefit during periods of hyperinflation • Avoid cash and similarly sensitive investments affected by the debased currency • Hard assets and commodities typically offer protection from inflation’s effects and

offer a decent return opportunity • Inflation indexed investments can by utilized to hedge volatility • Seek equity investments in inflation protected businesses, avoid consumer cyclical and

finance sectors

11

THE GREAT DEPRESSION

The fall of the Weimer Republic to Hitler’s Germany gave way to the Great Depression in 1930 and eventually WWII. This period was seen with high unemployment levels, currency swings between deflation and inflation, and stagnant economic growth across the globe.

In periods of deflation, cash, bonds, and other debts denominated in the underlying currency increase in value. Cash becomes a scarce resource, increasing its relative value, as the real value of hard assets drop. It pays to maintain a high level of liquidity as financing terms tighten and debt payments become costlier. Fixed income assets become more attractive than most non-‐dividend paying equities to preserve capital. As the real value of hard assets drop, the purchasing power reserved in deflated currencies increases, allowing investments at more equitable entry points.

Financially stimulating policies implemented through the middle of the Great Depression swung deflationary pressures to inflationary and resulted in spurring growth. Equities became attractive as inflation eroded the value of holding cash and similarly denominated assets.

Top performing industries through the Great Depression include aerospace, defense, energy, technology, and materials. The best returning stocks if purchased during the depression were:

Source: Moscovitz 2009

Defense spending and aviation innovation fueled the growth of companies like Electric Boat and Honeywell due to the unique demands of the era. If the U.S. and other major countries were to enter another globally conflicted phase, either fueled by government or business demand, similar companies are expected to return a comparable market performance. The key is trying to forecast which companies will be driven by long-‐term demand and not affected by intermediate fluctuations.

Another consideration is that deflation increases an individual’s purchasing power and, in times of stagnant economies and low wage growth, people are more willing to spend their discretionary

12

income on cheap fixes that provide temporary happiness or escape. Sin stocks in tobacco, alcohol, and candy companies saw more growth than say luxury auto manufacturers through the Great Depression. When compared to the Great Recession, fast food, alcohol, and electronic producers have seen increased sales over private jet or high-‐end jewelry firms in recent periods of stagnation.

Source: Zweig 1, 2009

WWII boosted the global economy, giving people a source of jobs and stimulus through government wartime spending. The period following this era also exhibited the highest real incomes in U.S. economic history. From 1963 to 2010, the top performing sectors of U.S. equities during the recessionary phase of market cycles were less economically sensitive and included

13

consumer staples (100%), health care (71%), utilities (71%), and telecom (57%) (Fidelity Management and Research 2010).

Takeaways:

• Deflation typically increases the value of cash, fixed income assets, and other debts sensitive to the underlying currency

• Inflation erodes the value of holding cash and similarly sensitive assets, equities offer greater return opportunity

• Sin stocks and cheap luxuries (ex. personal electronics) typically outperform consumer cyclical and luxury sectors through periods of stagnation

• Consumer staples, health care, utilities, and telecom sectors of U.S. equities have performed the best through recessionary phases of market cycles

14

DANCING WITH ANIMAL SPIRITS

The seventies were an astronomical decade in U.S. monetary policy, a turning point that forever changed the economic political relationship. The Federal Reserve vigorously grasped its newly acquired tools unshackled from the gold standard, attempting to satisfy mandates by directing markets through fluctuating interest rates and the money supply while using inflation and employment as indicators.

As a brief history of central bank policy modifications and market reaction through this period, Steven Cunningham and Polino Vlasenko explain:

On August 15, 1971, the U.S. abandoned the gold exchange standard by jettisoning the Bretton Woods Agreement. The dollar depreciated, and oil was priced internationally in dollars. The result was that the real incomes of oil producing nations crashed. In 1973, the Shah of Iran claimed that Middle-‐Eastern oil producers were paying 300 percent more for U.S. wheat, but had not adjusted oil prices accordingly. On October 16 of that year, OPEC raised the price of oil by 70 percent to $5.11 a barrel. By 1981, it was nearly $40 a barrel.

With billions of dollars redirected to oil-‐related purchases in the U.S. economy, the prices of other goods in the economy would have fallen as demand for them decreased. According to the Phillips curve, the lower prices would have meant higher unemployment. The logic left the Fed with little choice. If the Fed did not increase the money supply to stabilize the prices of non-‐oil products, the U.S. would have faced economy-‐wide deflation. Unemployment would soar as profit margins collapsed. Trying desperately to manage the situation, the Fed pumped money into the economy.

Once the oil prices stabilized, the Fed could not remove the additional money from the economy fast enough. The result was higher overall inflation. With the expectations of high inflation built into the economy, this higher inflation no longer produced lower unemployment. Instead, the economy stagnated. Stagflation was born. (Cunningham and Vlasenko 2012)

Stagflation is characterized as an economic cycle that displays slow business growth, high unemployment, and rising inflation. Graphed below is the annual change of the consumer price index in the United States through the 1970s. With normal CPI growth in the range of 2-‐3%, the worst years of this decade reached 12-‐15% annual growth. Upward price pressure and downward business and wage growth created a difficult environment for consumers and investors alike.

Source: Trading Economics, Bureau of Labor Statistics 2013

15

Analyzed on a longer time frame, it becomes apparent that consumer prices remained consistently stable from 1775 until 1970. Since the removal from the gold standard, prices have jumped ten times relative to purchasing power in the early twentieth century. Although major economic advancements have come through a looser monetary policy, the frequency of market volatility and downside risk associated with rebalances has increased.

Source: Liberty Blitzkrieg 2013

U.S. Consumers will likely be hit the hardest due to their inability to evade inflated prices of necessary goods and erosion of cash sensitive accounts. The yield on most money market or savings type accounts will net a negative return with high inflation, increasing the need to venture into higher risk assets. Investors looking for a diversified portfolio including fixed income should seek short duration terms and inflation protected vehicles to minimize negative effects.

So, what asset classes performed the best through recent periods of inflation?

It all depends on the relative economic stage. Equities outperform all other classes as inflation rises from a low below 3.3 percent, as displayed in the chart below. After this median is reached and inflation continues rising, commodities become the top performing sector and equities returns significantly fall. Rebalancing a portfolio to adapt to these changes is increasingly difficult due to the lag in data available relative to real time market decisions.

16

Source: JP Morgan Asset Management 2012

Investing in businesses that hold competitive advantages and are focused on commodities or other hard assets, operating in international and emerging markets, can insulate portfolios from rising domestic inflation risk. Certain producers are also positioned better to maintain profit margins as demand of necessary goods (food, clothing, shelter, transportation) varies less then discretionary sectors through high inflation and slow growth.

The rapidly evolving U.S. energy market will become even more important to investors as energy and the development of domestic natural resources increases as an economic growth driver. Balancing responsible economic and environmental policies to control resource extraction and development will increase sector volatility in the short-‐term, but investing in well diversified and alternative energy companies to return alpha is a necessary consideration for today’s investors.

The 1970’s in the United States were a period of high unemployment, rising prices (inflation), and stagnant business growth spurred from policy changes and supply spikes. Based on research referenced throughout this report, it’s plausible the U.S. economy is reentering a similar phase, which some predict to last much longer then what was experienced in the seventies.

Takeaways:

• Equities outperform all other classes as inflation rises from a low below 3.3 percent, above this median commodities become the top performers

• Businesses that hold competitive advantages and focused around commodities, operating in international and emerging markets, can insulate portfolios from domestic inflation risk

• Necessary goods producers remain more consistent than discretionary sectors through high inflation and stagnant growth

• Diversified energy companies and related alternative tech innovators, aimed at improving energy productivity, hold significant growth opportunity

17

THE LOST DECADE

During the 1980s, Japan was a model economy that most developed country’s strived to emulate. After twenty plus years of stagnation, Japan has become the prime case in analyzing how to profit through similar environments.

The collapse of a housing and stock market bubble has left Japan’s economy in a rut that government policy makers cannot seem to resolve. The chart below is of the NIKKEI 225, an average price-‐weighted stock index that tracks the top 225 companies on the Tokyo Stock Exchange. Japan’s market peaked in December 1989 at 38,916 and has fallen 81.9 percent to its lowest level of 7,054 in March 2009. The NIKKEI has slightly recovered from its low and currently trades around 11,000; about 70 percent below it’s 1989 peak.

Source: Yahoo Finance 2013

The Japanese people have dealt with a great deal of economic volatility since the bubble collapsed, mainly high unemployment with swings of deflationary pressure. The country’s central banking authority, the Bank of Japan (BoJ), recently adapted its monetary strategy to follow similar expansionary policies as the Federal Reserve in hope of stimulating economic growth. BoJ plans to inject 13 trillion yen ($145B) per month in an attempt to achieve 2% inflation target, possibly starting in January 2014. This could initiate a similar environment in Japanese equities that the U.S. markets experienced in mid 2009, rallying from historic lows.

Stephen King of HSBC recently told Reuters that:

Japan has failed to deliver lasting recovery for two decades now so the political case for doing something more radical is now quite high and I think the BoJ understands that, but if this is pushed too far, the BoJ simply becomes an agent of MoF and then the risk is that either foreign investors or domestic residents lose their faith in money, raising the risk of inflation overshoot and yen collapse… Weak financial systems can be more easily managed when structural growth, led by productivity gains, is so high. Japan's problem was that it reached the global technology frontier in the late 1980s, exposing its banking weakness. (Reuters GMF, pers. comm.)

Capital injections will translate into a cheaper Yen relative to international currencies, where the BoJ hopes to inflate away some government debt and stimulate increased exports as prices of

18

goods manufactured domestically become relatively cheaper. Neighboring Asian manufacturers, such as South Korea, will likely feel negative economic impacts from Japan’s accommodative monetary policies as their pricing becomes less competitive. Markets are already pricing in stimulus expectations as exhibited through the recent rally in Japanese equities.

But until the effects from stimulus take hold it remains necessary to avoid currency denominated or driven investments in a deflationary environment. Financial companies lose on liabilities as consumers profit from holding currency in periods of deflation. The top performing stocks through Japan’s 20 year stagnation have been focused in stable operating environments fueled by strong consumer demand, usually diversified amongst export markets (Weeratunga 2010).

The composition of sectors included in major Japanese indices changed significantly over this period, but all major indicators of the local equity market display similar trends. The best sectors in the TOPIX, which tracks the first section of Tokyo Stock Exchange, from 1990 to 2010, were health care, utilities, consumer discretionary, and information technology.

Source: Weeratunga 2010

Bellwether firms that hold proprietary research, brand name, or any other form of competitive advantage differentiate true winners amongst the crowd. These companies exhibit long-‐term growth prospects not likely to be undercut through competition or damaged by intermediate economic fluctuations. When analyzing not only long-‐term sector trends, but also individual company returns, it becomes apparent that successful firms globally diversify revenue streams (Weeratunga 2010). The following table displays top-‐performing companies in the TOPIX from 1993 to 2010.

19

Source: Weeratunga 2010

In times of uncertainty non-‐cyclical economically defensive stocks offer refuge from volatility through consistent revenue and common dividend payments, resulting in performance comparable to the Great Depression period in the U.S. The portion of internationally diversified earnings relative to long-‐term market performance is also clearly visible. This trait will likely become harder to achieve in U.S. equities due to significant increases in market correlations. Japan also holds a significant aging population that drives profitability of health care related companies, another trend likely to develop further in U.S. markets as similar demographic shifts unfold.

Takeaways:

• Financial companies lose on liabilities as consumers profit from holding currency and debt in periods of deflation

• Best performing Japanese equities have been focused in stable operating environments fueled by strong consumer demand with internationally diversified earnings. Top sectors include health care, utilities, consumer discretionary, and information technology

• Seek bellwether firms that hold proprietary research, brand name, or other forms of competitive advantage to protect against volatility

• Non-cyclical economically defensive stocks offer refuge from volatility through consistent revenue streams, and many offer dividend payments

20

3. Adding it Up

Market performance across history has taught invaluable lessons that must not be ignored given the similarity in recent developments. With that in mind, developed economies seem to be entering a period unique to only future environments that are certain to differ from past market reactions. The globalization of economies and significant improvements in financial efficiency has led to highly interconnected markets that shift on a multitude of factors.

Germany’s Weimar Republic displayed the damaging effects of uncontrolled currency debasement, supply shocks, and resulting hyperinflation. Relative to today, investors must take away the importance of avoiding cash and equally affected investments and seek diversification amongst equities more protected from inflation’s eroding power.

The Great Depression, 1970s U.S. experience, and Japan’s Lost Decade exhibit many differences unique to each period, but also similarly profitable investing traits. In times of high unemployment, stagnant economic growth, and price instability, investors are best served by seeking refuge in economically defensive assets that hold competitive advantages unlikely to be stolen. Examples of these include vehicles driven by necessity, like healthcare and sin stocks. The value of short duration debt holds when interest rates rise and chance of default increases, commonly seen in periods of inflation. U.S. real asset returns across investment classes throughout recent history exhibit the importance of such considerations.

Source: Barro and Misra 2013

The most recent decade of monetary intervention is unprecedented as the majority of central banking authorities the world over hold to seemingly unending quantitative easing and zero interest rate policies. The infusion of cheap credit is not driven by actual demand, rather asset purchase programs attempting to stimulate real economic growth. As an investor, it’s necessary to question if recent market gains are inorganic and try to anticipate what will happen when the music stops. Hopefully these monetary authorities can successfully balance policy objectives while smoothly deleveraging without collapse.

Central banks are left with little room for downward rate movements given the zero bound. Because of this, it is likely the yield on cash and rate sensitive investments have only one direction to move. This is bad for fixed income assets because relative values are inversely related to interest rates, meaning as rates adjust upward the prices at which bonds trade will fall.

21

Given the current environment, the Economist recently projected future returns over the next decade and found that, “Government bonds look like the least attractive asset to hold”, and achieving superior equity returns will be difficult because, “the cyclically adjusted price-‐earnings ratio is well above the historical average” (Economist 2, 2013). They believe the highest opportunity for return will be found in U.S., European, and British equity and housing markets.

Source: Economist 2, 2013

When looking at the relative equity market value as a whole, in price to earnings terms, over the long run it becomes apparent it’s currently slightly overvalued but nowhere near the heights of the dot com bubble. If investors lose hope on U.S. stock returns, the retreat to safer assets and more auspicious markets will lower domestic valuations and create opportunity for higher returns. This concept was exhibited through the market rally from U.S. equity lows of 2009.

Investors holding U.S. stocks over the long run will likely outperform those flipping between investments in more short-‐term rosy markets. A country’s economic growth relationship with stock market returns can be deceptive. For example, “the Chinese economy has expanded far faster than those of Latin America. Meanwhile, Latin stocks earned an average of 8.2 percent annually, while Chinese stocks averaged less than a 1 percent annual return” (Zweig 2, 2012). As demonstrated in the chart below, the most consistent highest returning investments include emerging and international equity market indexes. Analyzing total returns across asset classes over the past decade reaffirms the importance of diversification and rebalancing to minimize volatility. This concept will be discussed in greater detail in the following portfolio strategy section.

22


As mentioned above, the relationship between economic growth and stock market returns can be deceptive. GMO research displayed in Jeremy Grantham’s latest newsletter proves a negative correlation between the two factors over the past thirty years. Even though this concept seems counterintuitive, historical data on developed economies supports the claim. If innovation stalls, and U.S. productivity continues to decline, the stock market might actually perform better. Even though this might be true over historic periods, because of monetary intervention and a multitude of macroeconomic factors unique to the current environment investors must proceed with caution.

Source: Grantham 2, 2013

If volatility increases and earnings growth stagnates consumers will be forced to adapt, shifting purchasing behavior accordingly. Expenditures are likely to trend towards maximizing well-‐being

23

and minimizing excess. Necessities such as food and water, shelter, clothes, alternative transportation, energy, and defense become vitally important as capital available for service and luxury related purchases shrink. Debt and equity markets rebalance to the new economic conditions, valuing low cost manufacturers of necessities higher than more economically sensitive luxury manufacturers or service providers.

Resource supply will greatly influence the pricing of necessities due to significant population growth across the globe. Securing rights to critical inputs will become a major challenge for developed governments and leading manufacturers. Companies and governments with the capital and network resources to secure such reserves will greatly determine the long-‐term growth ability of underlying markets. A cannibalization of wasteful processes and technologies is probable, increasing the likelihood of achieving higher investment returns from firms that hold secure competitive advantages. Necessity demand and resource supply are factors that must be considered when constructing a selectively diversified portfolio in attempt to increase alpha while minimizing beta.

24

4. Creating a Selectively Diversified Strategy

For the average investor, holding a portfolio of individual companies is extremely risky and will most likely underperform market benchmarks. It has never been more important to focus on each underlying asset’s resilience when constructing a strategy. By utilizing the many financial tools and vehicles that are widely available, a selectively diversified portfolio that arbitrages economic trends has the greatest opportunity for success through market cycles over the long run.

Simple strategies that are robust in nature prove more reliable for investors to maintain. A portfolio retains significant capital appreciation through compounding value gained over many years by minimizing transaction costs and maintaining low turnover. Proper diversification and rebalancing guided by individual tolerances is also necessary to achieve these standards. Return opportunities diminish as more capital flows into passive vehicles, like ETFs and index funds. To optimize this risk and return relationship, the following strategy suggestions are given as possible opportunities.

EQUITIES

Investing in companies who hold competitive advantages like R&D, proprietary technology, or brand image will prove more resilient than younger firms without such resources. The few that hold multiple competitive advantages, proven management, and consistent financial resource create a defensive moat further protecting against volatility and increasing the probability of long-‐term growth. Targeting sectors that include major holdings of companies that exhibit these traits should be given major consideration when constructing a balanced portfolio. History has shown that consumer defensive, health care, technology, and related industries that hold similar traits perform the greatest through moderate growth, high unemployment, and politically unstable environments.

As global population growth continues and major demographic shifts evolve in emerging markets, investments in energy productivity and disruptive innovators will follow. Capturing sectors that profit from such demand, securing resources, or investing in renewable energy technology in portfolio strategy is increasingly critical. Firms that position themselves to harness the changes already occurring, by improving or transforming consumption efficiency, should greatly aid in supporting a nation’s long-‐term growth.

Possible catalysts to innovation include employment supply and demand relationships, which have significantly changed over the past thirty years. Immigration and the proportion of females in the work force have greatly influenced real wage growth and competition across almost every sector of the American economy. Companies have a larger base of candidates to choose from, increasing competition and restraining growth in real wages. This is a positive force for the country’s overall productivity as more workers are generating value, but could also be attributed to the polarization of income equality.

With relatively cheaper labor, firms become more selective when hiring and have incentive to reinvest capital in improving operating efficiencies. This drives down the demand for low skill workers and rewards innovation in improving processes. Optimization is a supporting factor to improving short-‐term efficiencies, and ultimately profitability, but can significantly inhibit the long-‐term disruptive growth opportunities of an industry. Research on the various types of business innovation and resulting effects have been greatly explored by Harvard Business Professor Clayton Christensen.

25

As an investor, the highest prospect for future growth lies with companies that balance capital reinvestments not only in improving efficiencies but also in disruptive innovation. Characteristics of this trend are commonly exhibited through private equity investment risks and returns. This is not practical for the average person due to the capital requirement necessary to analyze and track every aspect of multiple companies while looking for profitable innovators, but the main idea can be attributed to larger industries in general.

It is highly unlikely that technological evolution will continue along a linear path. Yet, over the long run the greatest opportunity for return has been created by firms willing to invest in disruptive innovation. Individual investors, unable to meet secondary market requirements, should invest in technology as a whole. The reason being that the cream (disruptive innovators) is likely to rise to the top and support widespread growth. Whether through proprietary research and development or acquisitions and mergers, companies able to disrupt such spaces are often the proven leaders that hold management and financial capabilities. Granted, financing such ventures in an early stage creates higher opportunity for return, but also significantly increases the risk of losing capital. This is often not feasible to the average investor with a long-‐term strategy. Investing in technology as a whole also provides some diversification against tech value traps.

If a moderate economic growth climate persists, the compounding effects earned from investing in equities that pay dividends becomes even more important. Stocks that pay dividends offer a consistent level of income, above earnings growth, that significantly increases return. In fact, research has proven that dividend payers outperform non-‐dividend payers through bull and bear markets (BlackRock 2013).

Earning a consistent cash flow over long periods of time supports investors through slowing growth and economic volatility. For a historical perspective of such differences, the chart below exhibits the S&P 500 average annualized returns broken into capital appreciation and dividends from 1926 through 2012.


Takeaways:

• Seek robust and economically defensive equities that hold multiple competitive advantages

• Companies focused on advancing the energy productivity and resource acquisition and processing space offer significant return potential

• Disruptive innovators will drive economic and portfolio growth • Dividends provide consistent return, protect against swings in capital appreciation

26

FIXED INCOME

Major emphasis is given to equity investments because they conceivably provide superior protection against inflationary pressures that are likely to fluctuate in coming years. The results of such an outcome could be devastating to those holding currency denominated or fixed income vehicles tied to the effects of monetary intervention.

Given the time horizon of many investors, diversification amongst fixed income vehicles is necessary to preserve capital. Because the current environment for such investments is likely to increase in volatility, portfolio allocations should incorporate today’s unprecedented risks before trends reverse. Hedging positions with short-‐term government securities or TIPs might offer a decent refuge from such uncertainty.

Utilizing a globally diversified bond index or other form of high-‐grade credit offers the greatest opportunity for return in this space. Individual fixed income investments should remain short in duration until the economic outcome, as affected by central banks, stabilizes.

Fixed income assets could preserve value and possibly offer decent return, dependent upon global economic volatility, if interest rates maintain at a permanent low level. If risks driven by growing populations and aging demographics seriously conflict the global economy it’s likely that fixed income vehicles would outperform other investment classes. But, such a case is doubtful unless developed economies crumble or some catastrophic event occurs.

Takeaways:

• Limit exposure to interest rate sensitive vehicles • Seek short duration fixed income assets • Indexed fixed income assets (ex. TIPs) provide hedge against inflation, but also hold

interest rate risk • Globally diversified indexes that hold high grade credit offer some protection against

default and rate fluctuations

ALTERNATIVE

Real estate investments look appealing given current valuations relative to pre-‐crisis heights and low financing rates, but when cap rates adjust after monetary easing ceases, property values will fluctuate wildly. Overly optimistic valuations and projections of this industry’s recovery paired with reversing rates could form another bubble. Given these circumstances, it is advisable for the average investor to limit allocations in this space to relative need based on immediate utility received.

One of the most plausible methods of government shedding debt is by deflating its currency and is witnessed throughout many recent crises. Alternative investments, driven by supply and demand characteristics or other unique traits, should rise in value over the long run. This is a broad statement that carries macroeconomic risks unique to each underlying assets.

The market has already priced in current volatility and as interest rates normalize, it is very likely to see a reversion in gold prices maintained at a higher support level. Also, it is important to note that today’s financial markets offer vehicles that more effectively hedge various risks without removing as much alpha.

27

Source: Kendall and Deverell 2013

Investors are likely to see increased inflation throughout international markets as monetary authorities continue their attempts to stimulate growth, most recent driver being Japan’s expected 2% inflation target. But these forecasts shouldn’t drive gold price expectations. Research shows little correlation exists between changes in one-‐year inflation expectations and gold price adjustments over the past twenty-‐five years (Kendall and Deverell 2013). In terms of general commodity prices, inflation has shown to be more closely related.


With resource scarcity in certain precious metals, shifting weather patterns affecting commodity pricing, and exponentially growing population demands, commodities and related investments are likely to increase in value as these trends evolve. Portfolio strategy should include exposure to natural resource assets, with the most advisable vehicle being an ETF or similar fund that contains globally diversified holdings.

Capturing such growth will become increasingly important to insure significant return opportunity and to hedge against the risk of rising manufacturer input prices. With economic growth in emerging markets projected to continue at a decent rate over the near future, commodity demand growth should remain fairly consistent. Further price support will be gained if developed economies recover better than expected.

28

Takeaways:

• Property valuations are sensitive to changes in interest rates, control real estate exposure and expect volatility

• Gold is likely to revert to a new average price as volatility decreases, remains the only true store of value across history

• Inflation expectations do not reflect gold price expectations, more correlated with commodity price expectations

• Natural resources will grow in value as demographic trends develop, offer possible hedge against rising input prices

FINAL NOTE

Market history has consistently proven more variable in nature than economist forecast. Predicting the future today is just as uncertain as predicting returns at the start of the Industrial Revolution. Many factors influence the outcome of investment performance, and due to the high degree of globalization and financial interconnectivity that has occurred throughout the past couple of decades, forecasting opportunities of such growth and innovation will never be uniform.

Significant advancements over the past three centuries have propelled many industries into a new space, reallocating capital towards furthering different degrees of innovation. The current technological plateau, as it may seem to some, doesn’t have to be the final landing of U.S. productivity growth demise. Government subsidized innovation hubs and other forms of business guidance should help refocus efforts along a more meaningful growth path.

The brief historic analysis, portfolio strategy implications, and research referenced throughout this report, should act as guidance to investors preparing for market transformations. Many of the ideas discussed above are unorthodox and are likely to conflict with some traditional portfolio strategies or investing beliefs. Further research on the opportunities considered above is welcomed to better aid investors in profiting through volatile market evolutions.

29

References

Barro, Robert and Sanjay Misra. 2013. “Gold Returns.” National Bureau of Economic Research. Accessed February 2013.

http://papers.nber.org/tmp/8795-‐w18759.pdf. BlackRock. 2013. “The Proof is in the Performance.” Accessed January 2013. https://www2.blackrock.com/us/financial-‐professionals/market-‐insight/chart-‐of-‐the week/the-‐proof-‐is-‐in-‐the-‐performance. Bureau of Labor Statistics. 2013. “United States Inflation Rate.” Trading Economics. Accessed January 2013.

http://www.tradingeconomics.com/united-‐states/inflation-‐cpi. Clark, Gregory. 2004. “Human Capital, Fertility and the Industrial Revolution”. Accessed January 2013.

http://www.econ.ucdavis.edu/faculty/gclark/papers/Clark%20-‐%20JEEA.pdf. Cunningham, Steven and Polina Vlasenko. 2012. “A World of Persistent Inflation.” American Institute for Economic Research. Accessed January 2013. https://www.aier.org/article/7897-‐world-‐persistent-‐inflation. Economist 1. 2013. “Innovation Pessimism: Has the idea machine broken down?” Accessed January 2013.

http://www.economist.com/news/briefing/21569381-‐idea-‐innovation-‐and-‐new-‐technology-‐have-‐stopped-‐driving-‐growth-‐getting-‐increasing.

Economist 2. 2013. “Home on the range: A useful stab at projecting investment returns over the next decade.” Accessed January 2013.

http://www.economist.com/news/finance-‐and-‐economics/21570702-‐useful-‐stab-‐projecting-‐investment-‐returns-‐over-‐next-‐decade-‐home.

Fergusson, Adam. 1974. “When Money Dies: The Nightmare of the Weimar Collapse.” Ludwig von Mises Institute. Accessed January 2013.

http://thirdparadigm.org/doc/45060880-‐When-‐Money-‐Dies.pdf. Ferguson, Niall. 2008. “The Ascent of Money: A Financial History of the World.” Cato Institute: 341. Accessed January 2013.

http://www.cato.org/sites/cato.org/files/serials/files/cato-‐journal/2009/5/cj29n2-‐9.pdf Fidelity Management & Research. 2010. “A Tactical Handbook of Sector Rotations: U.S. equity sector leadership has tended to shift near turning points in the economic cycle.” Accessed January 2013.

http://personal.fidelity.com/products/pdf/a-‐tactical-‐handbook-‐of-‐sector-‐rotations.pdf. Gordon, Robert. 2012. “Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds.” National Bureau of Economic Research. Accessed January 2013.

http://www.nber.org/papers/w18315.

30

Grantham, Jeremy 1. 2012. “On the Road to Zero Growth.” Accessed December 2012. http://www.gmo.com/websitecontent/JG_LetterALL_11-‐12.pdf.

Grantham, Jeremy 2. 2013. “Investing in a Low-‐Growth World.” Accessed February 2013. http://www.gmo.com/websitecontent/GMO_QtlyLetter_4Q2012.pdf.

Gresham’s Law. 2011. “Is Gold in a Bubble? Well… was the Rise in the Paper Mark Price of Gold a Bubble?” Accessed January 2013.

http://greshams-‐law.com/2011/04/21/is-‐gold-‐a-‐bubble-‐well-‐was-‐the-‐rise-‐in-‐the-‐paper-‐mark-‐price-‐of-‐gold-‐a-‐bubble/.

Hawksworth, John and Danny Chan. 2013. “World in 2050, The BRICs and beyond: prospects, challenges and opportunities.” PricewaterhouseCoopers. Accessed January 2013. http://www.pwc.com/en_GX/gx/world-‐2050/assets/pwc-‐world-‐in-‐2050-‐report-‐january 2013.pdf. JP Morgan Asset Management. 2012. “Guide to the Markets: 1Q 2013.” Accessed January 2013.

https://www.jpmorganfunds.com/cm/Satellite?UserFriendlyURL=diguidetomarkets&pagename=jpmfVanityWrapper.

Katz, Lawrence and Robert Margo. 2013. “Technical Change and the Relative Demand for Skilled Labor: The United States in Historical Perspective.” National Bureau of Economic Research. Accessed January 2013.

http://papers.nber.org/tmp/5673-‐w18752.pdf. Kendall, Tom and Ric Deverell. 2013. “Gold: The Beginning Of The End Of An Era.” Credit Suisse via Business Insider. Accessed January 2013.

http://www.businessinsider.com/credit-‐suisse-‐the-‐beginning-‐of-‐the-‐end-‐of-‐the-‐gold-‐era-‐2013-‐2?op=1

Liberty Blitzkrieg. 2013. “Inflation Since the American Revolution.” Accessed January 2013.

http://libertyblitzkrieg.com/2013/01/07/chart-‐of-‐the-‐day-‐inflation-‐since-‐the-‐american-‐revolution/.

Montier, James. 2011. “In Defense of the Old Waves.” Accessed January 2013. http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2011/ 1/04/in-‐defense-‐of-‐the-‐old-‐always.aspx. Moscovitz, Ilan. 2009. “The Top 10 Depression Stocks”. Accessed January 2013.

http://www.fool.com/investing/value/2009/09/05/the-‐top-‐10-‐depression-‐stocks.aspx. Parsson, Jens. 1974. “Dying of Money: Lessons of the Great German and American Inflations.” Accessed January 2013.

http://esocap.com/uploads/files/Dying%20of%20Money.pdf.

31

Vedder, Richard. 2013. “The Wages of Unemployment.” The Wall Street Journal. Accessed January 2013.

http://online.wsj.com/article/SB10001424127887324461604578193141690993174.html?mod=hp_opinion.

Weeratunga, Muditha. 2010. “An Investing Strategy for a Lost Decade in the U.S.” Seeking Alpha. Accessed January 2013.

http://seekingalpha.com/article/230103-‐an-‐investing-‐strategy-‐for-‐a-‐lost-‐decade-‐in-‐the-‐u-‐s.

Yahoo Finance. 2013. NIKKEI Market Data. Accessed February 2013.

http://finance.yahoo.com/echarts?s=%5EN225+Interactive#symbol=%5En225;range=19891228,20130104;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined.

Zweig, Jason 1. 2009. “1930s Lessons: Brother, Can You Spare a Stock?” The Wall Street Journal. Accessed January 2013.

http://online.wsj.com/article/SB123456259622485781.html. Zweig, Jason 2. 2012. “U.S. Stocks: Look Out Below?” The Wall Street Journal. Accessed January 2013.

http://online.wsj.com/article/SB10001424127887324296604578179470910812286.html?KEYWORDS=slow+economic+growth++US+equity+returns.

Successful Investing in a Low Growth Economy: A Historical Perspective

Economy & Finance

Transcript of Successful Investing in a Low Growth Economy: A Historical Perspective