The Next 2 to 4 Years

September 2, 2005

Investing options abound. Forget all the hundreds of thousands of individual stocks, mutual funds, bonds, hedge funds, CDs, and annuities, there are also non-publicly traded ownership interests in businesses, and hundreds if not thousands of specific industries, regions, and sectors from which to choose. 

There are countless ways to try to profit around the world, but how much you can expect to earn investing does have limits, at least in the long haul.

At the very heart of this body of investments is the economic growth rate. Since the U.S. has the world's largest economy, which drives the returns of so many other economies, it can be realistically claimed that the U.S. economic growth rate is the most important single factor in investing returns in the world.

Moreover, most people's investments tend to be tied to U.S. stock, bond, and real estate markets because we work here, live here, keep our cash here... No matter what percentage or our model portfolios ends up abroad, you can't completely avoid the influence of the U.S. economy, even if you sell your home and move to Italy.

The U.S. economy is measured by GDP, or gross domestic product (the value of goods and services we produce), which is closely related to national income (the amount of money we earn). Investors can think of it as the gravity that pulls at all investment returns. This concept is noted by famed bond fund manager Bill Gross in his <a href="http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2005/IO+August+2005.htm">most recent commentary</a>.

When you own something other people want, be it ocean front real estate or shares of Microsoft stock, its value is worth what people can pay for it - and what they can pay is directly correlated to how rich the country is. The richer the American, the more valuable your home and stock.

This is why the success of our future economy is closely tied to your own future investment wealth. Unfortunately GDP is as hard to predict as stock prices or interest rates (the ten year bond yield is still near 4% - it's been on the edge of taking off for years now).

The U.S. economy is no slouch, and earning its growth rate is a great investment. In fact, if there was an index fund that matched the nominal growth in the economy, you'd buy it. The rate has been around 7% over the last fifty or so years (this includes inflation so don't get so excited) with hardly any volatility (unlike stocks, the GDP doesn't fall 20% - everybody freaks out if it stops going up for a few quarters). Consider U.S. stocks to be a leveraged way to invest in the U.S. GDP. 

In fact, if the U.S. economy stopped growing and just parked at around $11 trillion for the next 25 years, you should expect to make nothing, and possibly lose money, in stocks. Don't worry, this isn't happening. But boundless growth, at least over the next 2-5 years, may be equally unlikely.

What does this mean for our model portfolios? Regardless of our outlook for the U.S. economy, we think investors should mainly own asset classes that are out of favor with investors as a group, as they tend to outperform asset classes that are in favor. While this is no guarantee against losses if the whole kit and caboodle (economy) slips into a deep recession, our contrarian strategy will work over time.

As for how aggressive we are in allocating to these asset classes, and our overall allocation to stocks and bonds for different risk levels, the more confident we are that the economy is going to grow at a fairly strong rate the more likely we are to increase exposure to stocks, and to some extent, higher risk bonds. Stocks tend to do better the faster the economy grows, and can slip precipitously before or during periods of economic stagnation or flat out decline - especially if they were priced for perfection going into the mess.

While forecasting economic growth is difficult, our range of outcomes for the next 2 to 4 years (about how long we intend to own a fund when we buy it) is weak at worst to average at best. Our main reason for these tepid estimates is a nagging sensation that we borrowed some future growth to juice the current economy - in consumer borrowing, government deficit spending and temporary tax cuts, and historically low interest rates.

While the nation's economy is not quite a zero sum gain (where everything won is a loss somewhere else), it's likely that 1-3% per year of recent GDP growth came from growth we would have had a few years down the road. 

For now (and into the foreseeable future) our portfolios remain a bit more conservative than they were a few years ago when our outlook was more optimistic than that of most investors. This means we will make smaller allocations to funds targeting high risk asset classes, and that we will make some sales if the market takes off significantly. We're confident our portfolios will take acceptable losses for the return potential in a down market, and yet perform quite well if the economy really does start another 90s style boom.