A Low Return World – January 2010

January 20, 2010

Dow Jones Average: 10,725
S & P 500 Index: 1,150


A Low Return World

Even though stocks have been in recovery mode since last March, the broadly based indices such as the NASDAQ and S&P 500 Index are still far from previous highs set some ten years ago. The past decade (2000-2009) has been one of the worst periods in market history for most investors. Ten years ago the Standard and Poor’s 500 Index was at the 1500 mark, well above its current value of about 1150. It is extremely rare for markets to produce negative returns over such an extended period of time.

The problem as we see it is that the world is awash in both investment capital and debt. It seems paradoxical for there to be too much capital and too much debt at one and the same time, but that is the case in our opinion. The large pool of investment capital is an outgrowth of the huge U.S. trade deficit with emerging market economies. Modest trade deficits are a normal part of international commerce, but massive, sustained deficits represent a transfer of wealth from the citizens of one nation to another nation. As Americans go into debt partly to buy foreign made goods, bank balances in China swell. There is currently an unhealthy level of both debt and available capital in the world.

When investors are flush with capital and eager to deploy it, they often make unwise decisions. Financial bubbles form when aggressive investors try to outbid each other for various assets. There was little basis for oil shooting to 150 dollars per barrel in 2008. The move was driven by speculators looking to commit excess capital. The tech bubble of 1999-2000 and the worldwide real estate boom were the result of too much capital pouring into financial markets. Markets work on an auction principle with buyers putting in competing bids for shares of stock or property. A throng of buyers with money to burn means high starting prices. A high starting price leads to low future returns and disappointed investors.

While the large pool of available capital has fostered bubbles, the debt situation has engendered a fear of systemic financial meltdown. In the United States, from 1930 to 1980, the aggregate debt obligations of individuals, corporations and government came to 1.8 times the size of the economy. Debt levels started to expand rapidly in the 1990’s and have exploded since 2000. The aggregate debt load in the U.S. is now 3.7 times the size of the economy. The financial position of many other countries, i.e., Iceland, Greece, Spain, Dubai, and Japan is even worse than the situation in the U.S. The accumulation of debt is easy. Paying back the debt is another matter. The explosive growth in debt turned to debt implosion in 2007 and 2008, taking stocks and real estate prices down worldwide. Historically high debt levels will continue to restrict real (inflation adjusted) economic growth and asset appreciation for years to come. The combination of excess capital, unsustainable debt levels, and a flood of liquidity (printing money) from governments has created a low return world for investors.

Current Strategy

Stock markets across the globe have rebounded strongly from the nearly sixty percent decline that took place in 2008 and early 2009. Investors are wondering whether the rally will continue or fade. Market seers and pundits are decidedly split on the future direction of stock prices. Some believe that markets and the economy are headed higher, driven by trillions of dollars in government stimulus and a resurgent China. Other prognosticators think that the market rebound is almost done and will be followed by a nasty correction in prices. This group believes that the stimulus effect will be temporary and that China is a bubble about to burst.


There have been many periods in market history where catastrophic declines spawned vigorous rallies. While these rallies gave nimble investors a chance to recover, the gains were often fleeting. The Japanese market experienced four different rallies of about fifty percent, following its initial seventy percent decline. Today the Japanese market remains seventy percent lower than its 1989 high as none of the four rallies were sustained. The U.S. market in the 1930’s behaved in a similar fashion, with the Great Crash of 1929-1932 succeeded by several, powerful, short-lived rallies. Given the history of great declines and subsequent rallies we avoid becoming emotionally attached or vested in the trend of the moment.


As we listen to the pundits and ponder the future direction of prices we have to admit that the situation is less than clear. The market trend is up at the moment and trends do not reverse easily. On the other hand prices are quite extended after such a quick rally, which leaves the market vulnerable to an equally quick and painful fall. It is hard to see where future gains in the averages will come from, as the better companies have already experienced nearly full recovery in share price, and the weaker companies have disappeared or become permanently disabled.


Over the past few months we have been selling positions that have reached our price objective. We purchased many of these stocks at low prices during the panic of 2008. Taking gains at this point is very much in keeping with our pattern of the past decade. We have made a positive return for our clients over the past ten years, because we have been willing to exit stocks when prices are elevated, fully aware that the proceeds will sit for a period of time in low yielding money market funds.


The fixed income market is frustrating. Short-term interest rates remain near zero percent in the U.S. and in other nations as well. Buying longer-term bonds, such a s ten year U.S. Treasuries yielding 3.7 percent, is tempting, but could be dangerous if inflation undermines the value of the bonds. We have purchased some Canadian bonds, and may place additional funds in foreign paper. We have to consider many factors, including government policy and inflation, before making U.S. bond purchases. When buying foreign bonds we have to consider economic policy in other regions which adds further complexity to our decision making process.

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