Less than Zero

February 17, 2012

The biggest long-term problem facing investors right now isn't U.S. debt, or even European debt. It’s the likely near-indefinite future of very low returns on the lowest risk investments: CDs, money market funds, Treasury bills and notes, savings bonds, and even shorter-term corporate and municipal bonds. Any assets with a maximum downside of 5% or less probably have a likely upside of less than 2% per year for the foreseeable future. 

This future seems longer in duration – excuse the pun – at each turn, especially now that the Federal Reserve chairman says he expects to keep rates as low as they can go for the next several years (a rare prognostication). 

This current dilemma fits neatly into what could be called our grand unification theory: we believe most of what went wrong in investing over the last 20 years in particular (and to a lesser extent, throughout most of recorded time) is simple — too much money.

An excess of money available for investment is what keeps U.S. government ten-year bonds yielding less than two percent. Certainly, lack of supply isn’t the problem. An excess of cash is also ultimately what caused the real estate bubble. Buyers wanted to get in on great returns, but usually by financing with low money down and at low interest rates – a double whammy that almost certainly spelled trouble for the lenders. 

People keep asking who's to blame for the real estate crash. Investors are. Investors with more collective investing power than even the global real estate market could safely swallow. Everything else was just a detail or a feature.

Our current state of excessive safe asset demand is a direct result of investors' disenchantment with high-risk, low returns, both in stocks, and even more recently, real estate. Lower-risk investments also have demographics on their side, because everyone knows you have to shift to bonds and cash as you enter retirement. Too bad so many are entering retirement now.

Recently, stocks have been picking up steam, flying in the face of the continued risk abroad of a slow global economy turning even slower. Sure, the U.S. is sitting pretty, but we’re not exactly in the catbird seat. At some point in the future, hard choices about spending cuts and tax increases are going to have to be made, either by choice, or as Greece is learning, by market forces. No major government today could survive the high borrowing costs in Greece. 

The main selling argument  for stocks is that they're likely still good for a slightly higher return due to slowly growing dividends alone than most fixed-rate bonds will pay over the next five-thirty years. Companies are very profitable now, but a good chunk of that is the dual benefit of ultra-low borrowing costs as investors snap up bonds, and low labor costs caused by relatively high unemployment and businesses squeezing more productivity out of fewer workers. But unlike real long-term sales growth, these benefits are semi-finite. 

For most companies, investors will be best served if we get the 2% inflation the Federal Reserve wants. That is, if they really want it. Perhaps they know the money games they need to play in order to fight a deflating asset bubble of epic proportions will cause inflation of 2%, so they might as well just claim that’s what they are shooting for. We’ll derail that train of thought, though, because conspiracy theories and investing just don’t mix.

Such a mild steady increase in prices will lift stock prices, and lead to perhaps a 6% annualized return into the future: 2% from dividends and 4% from stock price appreciation, half of which is mere inflation. This math – far from the "stocks for the long run" model of 10%+ — is still better than a 2% TAXABLE bond yielding less than zero after taxes and inflation.

The market may just be onto this possible future. All the trillions in safe investments will have to face a reality with no immediate downside risk except the Chinese water torture of slowly eroding value. Some of this money mountain will surely head back to stocks and just lump the periodic 25-50% drops in order to achieve that 6% long-term return. The rest will stay in safe investments.

What we fear is this: a few years from now, if enough money piles back into stocks, we could be faced with a trifecta of bad options: stocks back up to 25+ p/e ratios and 1% dividend yields, similar to what we saw in  the late 1990's, only without the fast-growing earnings, 5% money market, and 6% bonds to round out the portfolio.

For investors heavy in safer, fixed income investments today, there is still hope. We may yet slide into a Japanese economy – government-debt-laden with an underlying slow economy and flat-to-falling inflation. To the bond investor locking in 2-5% in longer-term government and corporate bonds today, negative 1% inflation is gold: your money becomes more valuable by 3-6% a year. That beats a 7% bond with 4% inflation after-tax. Of course, the other scenario,  a return to 4% inflation and 7% yields, would be a disaster to today's longer-term bond investor.

We'd prefer to see things play out like this: we get one more good slide in risky assets in the next few years, which scares even more money into safer investments and sends the yields down to Japan levels for good, leaving stocks even cheaper than they are today. Follow this up not with deflation, but some economic growth, in spite of government cutbacks and taxes, because quite frankly, we tend to have the world’s best companies and ideas right here at home, and with the proper exit from safer investments, we'd like to sit back and collect 8%+ returns for a good, long run. 

Few hold this forecast, which is, of course, at least one indication that it just might happen.