Current Portfolio Key Issues

Your Financial Muscle

I read recently an old fighter saying that says, “The punch you don’t see is the one that gets you.”

This FinancialMuscle edition is meant to discuss some key issues that I feel should affect our judgment. It is not meant to give advice. It is only meant to inform and educate.
Over the last year it’s easy to assume that if we put everything in the stock market, we could have made great returns. That, however, is not what investors do. They look forward. They have to make smart choices about their money based on the data that they have at the time. I call this “being in it”. You make your best decisions based on the information you have. Recently, I was able to go to the 150^th anniversary of the Battle of Gettysburg and its reenactment. I remember thinking at the time that the generals running the battle were really “in it”. Soldiers had to eat and sleep, not everyone was compliant, no one knew when the next battle was or what the outcome would be, and sometimes bullets and cannonball were flying everywhere, while men were screaming and horses were wailing. Add to that the fact that you could barely see because the fog created by the gunpowder clouded the skies. It was all out of their control. In 1863, when all they had were messengers on horseback to let them know what was happening miles away, generals still had to make decisions. There were no iPhones or sophisticated communications like we have grown used to. There were no satellite pictures showing troop movements. They made their best efforts appraisal given the information at hand. It’s noteworthy how that hasn’t changed. With sophisticated communications and mountains of historical data, you still can’t predict the future. We are still in the business of making decisions with much at stake when it comes to your money.

What We Know

So, what information do we have at hand? The numbers indicate that we are in a recovery. The recovery is barely. Here’s how we know this:

·         Gross domestic product is inching up net of inflation (the little under 2% annual rate),

·         Light vehicle sales have been inching up, albeit in fits and starts for several months,

·         Housing starts have broadly inched up, although they are nowhere near the long-term average,

·         Inventories have been inching up and are roughly equivalent to their long-term average,

·         Capital goods orders have been broadly inching up since 2012 and are above their long-term average,

·         Household debt as a percentage of disposable income has dropped pretty consistently since 2007 while household net worth has been inching up through the second quarter of 2013.

All of these indicate that things are generally on the mend, albeit at a very, very slow rate. These are generally indicators of the business cycle, but the credit cycle is a different story.

Yes, we have a credit cycle, too. Interest rates go up and credit becomes more expensive, interest rates go down and borrowing becomes cheaper. That’s a credit cycle. Credit has been easy for several years and pretty much all of the bullets have been shot from the Federal Reserve gun. Yet, the economy can barely get off the runway. We have a mismatch between the normal credit cycle and the normal business cycle. Usually they move in unison. As business heats up interest rates go up to slow business down, and as business decreases interest rates go down to speed it up. That is not exactly what’s happening now and that creates uncertainty.

More of What We Know

Asset Prices: Having important issues is nothing new. These are different, though. They are big:

1) Increasing government regulation over private industry which has in some cases come close to paralyzing free market business operations.
2) Moving private debt to the public balance sheet through treasury, fed, and fiscal operations.

The casualty of these behaviors is lowered asset prices. Starting in 2008 prices of assets corrected. They had been propped up by government and private easy money programs. Think: low-doc and no-doc mortgages at low interest rates. We found out the hard way that cash flow does not lie. When people could no longer pay their mortgages on time investors dumped the underlying securities and lowered asset values…as they should have…to be in line with the real abilities of debtors to pay back. Housing prices, business prices, most asset valuations in society crashed. The recovery has gone slowly since.

Since 2008 free and easy cash from the Fed has eased the pain. Unfortunately, easing the pain is essentially a valuation lie. The full measure of pain eventually happens no matter what. Investors ultimately vote based on real value as opposed to fictitious value. All easing does is prolong pain while increasing debt, hence making more pain along the way. Since government creates little value, the money it uses to ease pain is of lesser and lesser value because it is backed up by decreasing ability to pay. The hope from the Fed is while easing the pain the economy can gain momentum and pick up where the Fed leaves off. It could work. It has worked in the past, but not on this scale. This is new scale. The jury is out.

Looking Forward

Operating intelligently means evaluating where our system is against where each of us are personally. For those who have plenty of financial cushion in their lives taking large scale stock market risk could pay off. For those for whom a mistake is more meaningful, remaining conservative can be a very smart option. Even if the market goes up another 20% or even 30%, the risk of loss - which is just as large - can be devastating. This plays out in a retiree’s life in a way that is generally undesirable. Perhaps he has to lower his lifestyle or go back to work. Most people do not like being forced to be in this position. This is where having a realistic, workable strategy pays off. Living well can result from designing a strategy that realistically considers goals, resources, and risk.

Please feel free to contact me if you have any questions or would like to talk at 952-230-1340.

Warm Regards,

Christopher Gerber, CFA

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

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