The Dangerous Safe Road

June 19, 2012

There 's good deal of concern in the markets that Europe's slow collapse will turn into something a little more 2008-ish. Remember 2008? The year Lehman, along with most of the financial services industrial complex, imploded? At least until governments near and far propped up the poor pinstriped saps and halted the panic. Free markets until markets free fall.

The worry this time around centers on the governments themselves – governments that have increased spending to support weakening  economies while simultaneously moving the debts of a global real estate bubble to their own tattered balance sheet The buck has to stop somewhere. 

Just as a side note in financial history, many  factors impact the economy and your investments, but the Numero Uno, Grand Poobah – bigger than governments, debt, unions, taxes, Freddie Mac, Goldman Sachs, Congress, regulations, welfare, blah, blah, blah, all the stuff you hear that's responsible for  destroying world economies – is bubbles.

When you put debt behind the bubbles, unlike the Dot-com bubble, but just like the Great Global Real Estate Bubble, you get a problem that could take 20 years to fully flush out of the system with lingering effects for decades more. Even astute economists and investment professionals are already committing the original sin by focusing on "The Great Recession"’ like it was just a recession that started this whole mess we're in, or some government mishap.

We note this because somewhere along the way, amidst the anger at bankers, governments, deadbeats, lazy Europeans, lenders, you name it, we forget that the core issue is when lots o’people hold the collective belief that an investment has a lot more upside than downside and they can indeed get rich fast if they just get in the game. What really brought down entire countries, including Iceland, Ireland, and Greece, was rank speculation in real estate as a can’t-lose investment. And it's not the first time. Japan is still dealing with the aftereffects of a stock and real estate asset bubble 20+ years later.

At MAXfunds, we expect bubbles to eventually pop, or more commonly, for the overvaluation and excitement to go away and investing opportunities to be created in its wake. That's why we've been giving negative fund category ratings to popular and hot investing areas since 2000. Investing in out-of-favor areas during a bubble – value stocks in 2000, for example – works, but so does buying post-bubble train wrecks.  Tech funds in 2003, Priceline, or Amazon stock on a 12-year chart highlight this riskier opportunity.

The trouble with this current "debt crisis" is that debt is one of the most overvalued assets. As investors, we can’t get enough of it. There are some distressed areas – notably Greek debt yielding around 30% – but by and large, no broad areas of the debt markets are down in the dumps. Not government bonds (anywhere, pretty much), not real estate loans, not high-yield "junk" bonds, and least of all, not foreign bonds, or even emerging market bonds. 

This is the problem for the lower-risk, yield-hungry investor today. You can’t get a return that beats inflation without sharply upping your risk level. It's not the stocks we're worried about. The S&P 500 now yields about 2.3%. That will grow over the next 10 years, surely with some hiccups along the way. But the likelihood of S&P 500 companies paying less in dividends in ten years? Nearly nil. In other words, stocks won't just likely outperform government ten-year bonds now yielding well under 2% (and certainly shorter-term bonds yielding near 0%) over a ten-year holding period. They'll likely return more than even higher-yield corporate bonds, given the dividend growth – and that’s assuming no growth in stock price, just in dividends. 

But nobody wants to earn a risky total annual return in the 2-6% range with the chance of another 50% slide along the way. This fear's keeping too much money in cash and short-term bonds. But we can’t blame investors. Twice bitten, thrice shy? We’ve seen two big stock slides now in 12 years. And this Europe mess sure seems like a 50% hit maker.

While we don’t want to force anyone into a volatile portfolio, the alternative – a very low-risk portfolio – is going to require more savings and less drawdown in retirement, because the expected return over the next 5-10 years is pretty low, perhaps 2-3% before inflation.

Consider this: although stocks are risky and likely to slide again in the next 10 years, the big 50% slides don’t usually happen when there's an obvious threat brewing, like Europe. Did it seem like we were on the edge of economic collapse in 1928? What about during the Dot-com boom in 1999? How about when we were riding high on real estate wealth in 2006? Most of the time, the majority of investors don’t see a 50%+ slide coming. Right now, many fear it. But it probably won’t happen on that alone.

The other issue is the debt itself. In the 10-plus years since we created the Powerfund Portfolios, we've always owned bond funds, but you have to question the logic of loading up on debt as an investment strategy when you're most concerned about the global debt crisis. If the worst case scenario really does hit Europe (it likely won’t), lending money around the world at sub-5% (and often sub-2%) rates seems like a pretty bad idea — which is what you're doing when you buy global bond funds. 

If it really falls apart, your best-case scenario with this strategy is massive deflation like they've had in Japan, when you in effect get paid back with more valuable money. Any other scenario likely benefits stockholders more. Especially if we get a group central bank policy to inflate our way out of the deeper hole, the only real solution once they run out of options and depression looms. We still see deflation as the bigger risk, which is why we own some longer-term bond funds, though their appeal is dwindling.

The main reason to own low-return investments at this time – shorter-term bonds – is with a plan to shift to riskier assets, if and when they tank hard (they may not, which is why you should own at least some higher-risk assets now). If we get the third slide – the triple 50% dip – things will certainly appear scarier than they do today, but you'll need to face your fear or see your 1% returns quickly inflated away by panicking politicians. We're already seeing what happens globally to politicians who make the painful policy choices of higher taxes and lower spending. 

Bottom line: the likelihood of a 25-50% slide in stocks from here, although it may seem more likely, is lower than it has been over much of the last 15 years. Not nonexistent, but lower. The expected return from playing it safe has probably never been lower. Global governments and bond-hungry investors are already lowering returns on the safest bonds into negative territory,  punishing the safety seekers. This punishment may get much worse if politicians and central bankers lob a Hail Mary and make bondholders suffer in order to save their own economies and jobs.