Sunday, June 30, 2013

5 Years After Great Recession, What's Next?

As I have mentioned in other recent posts, this summer season feels like the calm before the coming storm.

I am not predicting a September/October market crash, nor am I saying the market will shoot higher while we climb a wall or worry. I cannot predict Mr. Market. But this season is a milestone because five years ago this time we were getting close to the start of the Great Recession. The last five years covered the full force of the Great Recession as well as a seemingly miraculous recovery.

It is often said the true measure of an investor or money manager is how he does through at least one full boom and bust economic cycle. No great investor has been called great without showing that he has weathered several such cycles. Think of the likes of Benjemin Graham, Warren Buffett, Walter Schloss, Seth Kalman, John Neff, John Templeton, and on and on.

Furthermore, many investing sources will give you the past 1, 5, 10 year period performance of any mutual fund or hedge fund. So I have collected the a list of some prominent equity funds, as shown below:

Fund Manager(s) Last 5 YR Annualized Return
Bruce Fund Bruces8.6%
Yacktman Fund Yacktmans 14.0%
Davis New York Venture A Davis/Feinberg 2.7%
Fairholme Berkowitz 5.2%
Pabrai Investment Fund 2 Pabrai 3.0%
FPA Crescent Romick/Rodriguez 6.5%
Legg Mason Cap Mgmt Value C Miller/Peters 1.0%
Hussman Strategic Growth Hussman -4.0%
T2/Kase QualifiedTilson/Tongue -2.9%
S&P 500 Total Return (Jan 2013) 3.1%
Returns include fees. Period is Jan 2008 to Jan 2013, or if not possible then a close period to it.

The list includes hedge funds, mutual funds, US equity funds and international equity funds. So, the list isn't meant to be a direct comparison but as a gauge of how various funds and their manager's strategies have fared.

The fund managers in the table are some of the most prominent fund managers in the US. They are all probably in their 40s and 50s. These are going to be our thought leaders in the coming five years. It will be very interesting to see five years from now how these funds and their managers fare!

In the last fives years we have learned a lot about ourselves and our world. One of the biggest is that our world is not going to grow as much as we would like. In the past the typical investor like myself were too optimistic about the long term stock market growth. We thought 10% to 12% is achievable. That I feel is one of the biggest reasons for two horrific market corrections in the last 15 years. Investors were sold on the idea that we can achieve high growth, if we just knew where to go. So first it was high-tech in late 1990's and when that failed, well, we'll just go to housing.

Now I, and a lot of other retail investors, are much more jaded and are much more wary of equities. I am more resigned to the overall market achieving 7% long term, rather than the 10% to 12% I expected before. This, coupled with the fact that we had a run up in stocks in the last 4 years, leads me to think we should expect much lower than 7% in the coming 5 years.

The rise of formerly developing countries like China is creating ever greater demand for commodities. I am talking about better foods, like meat, oil, water, etc. This fact by itself isn't really surprising, but its consequences can be surprising. For example, higher oil prices and innovations have caused the US to produce more oil than any other time in recent memory. And as the US produces ever more oil, the US will be able to reduce its trade deficit and the dollar will get stronger.

Next Five Years

The US Fed actions of the last five years have shown that the US dollar is a debased currency. But the Euro isn't much better with all the problems in the EU countries. Meanwhile, developing countries like China also have fundamental problems. I feel the conventional thinking is that China is a country with a tremendous amount of "animal spirits". And the country has a command economy that can direct whatever necessary for the greater good. However, I feel the conventional thinking doesn't give enough weigh to the roadblocks to China's success. China does not have long history of rule of law, nor does it have a long history with a large vibrant middle class. These and various other negatives, which developed countries do not have, can lead to corruption, discontent and distrust of the local financial system. This can have a dramatic effect on Chinese household asset allocation.

The average Chinese cannot cannot rely on the equity markets for returns because the Chinese equity markets have not proven themselves to be good allocators of capital. China's GDP grew at around 9% annually in the period from 2000 to 2013. Yet the Shanghai Composite Index has only returned about 2.1% annually over that time! Yes there are many elite and powerful people in china who have become extremely wealthy through equities, but these are mostly through connections which are closed to the average household.

In addition, the Chinese get low rates on deposits. So recent articles have pointed to a "shadow banking" sector whereby the average person can deposit money for loans to corporations through less regulated banks or institutions. The Chinese are starved for yield to combat their inflation.

It is quite interesting that the last few years of easy money all over the world has not resulted in excessive inflation. Wages are kept low and companies are achieving record margins. Money is growing faster for shareholders than wage earners. Maybe that's why inflation for everyday items are low. But we may soon see inflation of financial assets, such as bonds and equities. But it has to be quality financial assets.

According to this report, the world owns $198 trillion USD in financial assets in 2010. One third of this amount ($67 trillion) is equities. The report expects the world's financial assets to reach $371 trillion in 2020. That is a reasonable 6.5% annual increase. But the report stresses that developing countries do not invest in equities nearly as much as developed countries. This is a case of distrust of the equity markets and less sophisticated equity markets in those developing countries. But I think good equity markets are necessary for an advanced economy.

Now is only 7 years to 2020 and how is it playing out for China? Well, either the article is off the mark, or the China market is going to explode, or the Chinese will have to invest in bonds or other alternatives, or they will have to move money overseas. I feel the latter will be a big factor; that is, they will invest more and more in real estate overseas, as well as equities and bonds overseas. If they are restricted from moving money overseas, they will face lower returns. You can see this in the low returns of the stock market, bank deposits and the high price of real estate in China. And when they move money overseas, they want more to preserve capital rather than generate cash flow.

And China isn't the only developing country with growth and reform issues, as we have seen from protests in Turkey and Brazil.

So my conclusion here is that the coming five to ten years will see a resurgence of asset values in developed areas of the world; i.e., North America, Japan and Europe. And based on this I think the CAPE (10 year PE) of the US markets can remain above average for the next five years. But considering the fundamentals of the US, I don't see the market going 20% higher in the next year or two. But, I also don't see a prolonged correction in the near future.

No comments:

Post a Comment