The Probable, the Possible and the Likely

August 31, 2010

By Annika Ferris, CFP®, CIMA®  Don Wilson, CFA, CFP® 

In thinking about the economic recovery and the stock market, it is important to distinguish between what could possibly go wrong versus what will probably go right¹. Most news sources tend to focus on the lower probability negative scenarios in order to keep their audience emotionally charged and coming back for more. However, based on the current economic data and previous historical outcomes, we believe these negative scenarios will most likely not come to pass. Brightworth partners Don Wilson and Annika Ferris explore this concept and how it relates to investors as they discuss their perspectives on some of today’s headlines.

Is the U.S. economy headed for a double-dip recession?
DON: While a double-dip recession is a risk, we believe the most likely scenario is for the U.S. economy to continue to grow at a moderate pace. Double-dip recessions are unusual. Once an economy begins to recover, a virtuous feedback cycle takes place resulting in continued growth over a multi-year period. That appears to be taking place this time as well, albeit at a slower than normal recovery rate.

ANNIKA: Although the pace of growth slowed in the second quarter of 2010, it did mark the fourth quarter in a row of positive GDP growth since the recovery began. The economy has grown 3.0% over the last year as companies have rebuilt inventories and increased spending in areas such as technology. Corporate revenues and earnings have improved significantly from very low levels (in many cases from cutting costs and increasing productivity). Many corporations have taken advantage of the low interest rate environment to refinance their debt at attractive rates which could add to their bottom lines for years to come. Additionally, many companies are holding significant amounts of cash which will be available in the future to finance growth initiatives, pay dividends, and buy back stock.

DON: The economic recovery has been led by businesses as high unemployment, increased household savings, and reversion to more frugal behavior have resulted in only a modest recovery in consumer spending. Cyclical big-ticket purchases such as housing and autos remain well below their long-term averages. Consumers postpone these large purchases during a recession. Eventually, however, consumers need these items and the rebound from pent-up demand helps drive the economic recovery. While the low current levels of these cyclical purchases have resulted in a more modest recovery, it is unlikely that the levels will decline further which reduces the risk of a double-dip recession.²  

Although unemployment remains high there have been some improvements in the labor market in recent months including increases in private payrolls, hourly earnings, the length of the average work week, and online job postings.  We expect continued gradual improvement in the labor market which should result in continued improvement in consumer spending, helping the economy avoid falling back into recession. In addition, the Index of Leading Economic Indicators points to a continued expansion in the near term. A double-dip seems unlikely.

ANNIKA: The media often reinforces a short-term perspective, and negative news tends to attract a bigger audience than positive news. We believe a longer-term viewpoint is more appropriate when it comes to investing.  It is impossible to consistently predict what the economy may do in the next quarter or two, but the good news is that investors don’t need to make short-term economic predictions to do well in part because asset classes like stocks and bonds have usually already priced in the current economic outlook. Also, being proactive in working on the things we can control such as spending habits and portfolio diversification contributes more to building and maintaining wealth over long periods of time.

What about deflation — do you believe the U.S. will experience Japanese-style deflation?
ANNIKA: Deflation is possible, but again we do not believe that is the most likely scenario. Absent a significant economic or market shock, we believe the risk of material deflation is currently only around 20%. Both the headline and core consumer price indices have declined recently and are below their long-term averages. However, this year the only CPI subset with falling prices is apparel. Housing, food and beverage, medical, and transportation prices have all risen.

DON: Although high unemployment, low capacity utilization, and consumer deleveraging are putting downward pressure on prices, the Federal Reserve and central banks around the world continue their very accommodative monetary policies. The Federal Reserve has taken the Fed Funds Rate essentially to zero. In addition, the Fed has engaged in quantitative easing and a number of other nontraditional monetary strategies. They have been quicker and more aggressive in dealing with the problem than Japan was. Another difference between the U.S. and Japan is that Japan’s stock and real estate bubbles were much more severe than in the U.S. resulting in steeper and more sustained declines in stock and home prices. Stock and housing prices in the U.S. are now at reasonable valuations and should not add to deflationary pressures. Should deflation become a higher probability, we expect the Fed would “pull out all the stops” to try to prevent a sustained period of deflation. Congress could also pass another round of stimulus spending in an effort to fight off deflation if it appeared. Currently the market expects inflation to be about 1.3% per year over the next five years based on the yields of TIPS and Treasury bonds.³

With all the uncertainty, should I move my portfolio out of stocks and into cash and bonds until it stabilizes?
ANNIKA: Bonds play a central role in a portfolio to protect cash flow and reduce volatility. However, since many people are living longer in retirement, having a “growth engine” with stocks to outpace taxes and inflation is important too. The incremental return gained from equity exposure adds up to a significant amount of money over long periods of time, and staying in a diversified mix of stocks with a portion of the portfolio can greatly reduce an investor’s probability of depleting their investments.

DON: It has been our experience that investors do more long-term damage than good to their financial situation by making dramatic short-term shifts between their allocations to stocks, bonds, cash, etc. Studies of mutual fund flows show that investors repeatedly sell out of an asset class that has underperformed (often at the bottom and right before that asset class is about to do well) and pile into an asset class that has been outperforming (often just before this asset class tanks). The result of this performance chasing has been that the average investor’s total return has been less than 1/3 of stocks or bonds over the last twenty years and has not even kept pace with inflation (see Chart 1).

Chart 1


After ten years of poor performance by stocks and strong performance by bonds, investors have been getting out of stocks and into bonds. From July 2008 – June 2010, investors have taken $211 billion out of stock mutual funds and put $476 billion into bond mutual funds. To put this into context, this is an even greater disparity than what took place during the Tech bubble when investors added $424 billion to stock funds versus only $20 billion to bond funds from April 1998 – March 2000. Because of the low yields on bonds now,  bond returns going forward are very likely to be significantly lower than they have been over the last twenty years when higher and declining interest rates increased total returns. 

ANNIKA: Over the long term, investors that maintain their investment discipline have almost always been better off than those that react based on their emotions. Asset pricing bubbles and corrections will continue to happen in the future because of two strong human emotions - greed and fear.  However, historically over almost all 10-year periods (with the last 10 years being one of the few exceptions), investors have made money in stocks. The stock market is more volatile than bonds and cash, but that volatility is reduced substantially as an investor’s time horizon increases. As Chart 2 shows, although the range of returns for stocks over a 1-year period is much wider than bonds or cash, over longer periods the range of returns contracts considerably.  

Chart 2


So should I just turn CNBC and Fox News off?
DON: Despite the constant focus of the media on the “current crisis,” most of the doomsday scenarios don’t come to pass.  Just a few months ago, the big concern was over the Euro. Last year it was the dollar and inflation. Now the concern is deflation and a double-dip recession. Remember Y2k? Back in the 1980s, one of the fears was that U.S. companies could no longer compete against their Japanese competitors…and the list goes on.

As it relates to investing, it has been said that the stock market climbs a “wall of worry,” and it is uncertainty that creates the opportunities for higher returns than CDs and money market funds over time.  If we look at stock market history through decades of uncertainty, the Dow Jones Industrial Average has grown from being in the 100s in 1940, to the 600-900s in the 1960s, to a level of 800-2700 in the 1980s, to over 10,000 today. 

ANNIKA: People often forget about the ingenuity and adaptability of free market-oriented economies to make changes to keep these negative scenarios from unfolding. Technological and medical breakthroughs can rapidly and fundamentally change things so that the future is not a linear projection of the past. That’s not to say bad things don’t happen. They certainly do, and unexpected events (either positive or negative) can cause volatility in the financial markets. However throughout history (and we expect this will continue to be true in the future), the economy, companies, and stocks do end up recovering and eventually start to grow in spite of the challenges of that time period.

In a New York Times article⁴, Ross Douthat wrote, “just as healthy optimism can turn into irrational exuberance, a clear-eyed realism about the challenges facing the United States can gradually inflate a pessimism bubble.” That seems to be what many are experiencing today. Focusing on the probable and the likely and less on the possible is a good path to a more peaceful and profitable financial future.

¹ Dr. David Kelly, Chief Market Strategist from JP Morgan, Conference Call, July 8, 2010.
²  Ibid.
³ As of August 27, 2010 the breakeven inflation rate was 1.27% for five year Treasuries versus TIPS.
⁴  “The Pessimism Bubble”, The New York Times, July 4, 2010.