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Rise of a New Asset Class, Part 2


What works in investments about to change forever.

Editor's Note: This is the second of a 2-part series. Part 1 can be found here.

Last week, I pointed out that we're in a "muddle-through economy" -- a recession fueled by the bursting of the housing bubble and the onset of the credit crisis -- and that we'll be in it for at least another 18 months. Neither credit nor housing will really respond to a lower federal funds rate, but simply have to be worked through.

This situation will lead to reduced growth (or even contraction) in consumer spending, which we're seeing now, from lower mortgage equity withdrawals, higher energy costs, rising unemployment, inflation in an environment of lower real income growth, and less availability of cheap and easy credit.

I offered a detailed analysis of earnings, showing that corporate earnings are likely to continue to drop precipitously, which will eventually weigh upon the stock market. Price-to-earnings ratios are mean-reverting over long cycles, and there's no reason to expect that to change in the future. This will be a drag on long-term growth in US stock portfolios.

Let me offer one chart from last week on this topic, which illustrates the problem.

Click to enlarge

The current situation is worse than the chart depicts, because on Wednesday of this week the as-reported 12-month P/E ratio for the S&P 500 was 22.87 through the end of the second quarter. We have a long way to go to revert to the mean. The only way for that to happen is for earnings to rise or for stock prices to fall, or some combination of both. Otherwise, you have to suggest we are in an era of permanently and significantly higher stock valuations. (Remember, these cycles last an average of 17 years. We're only 8 years into this one.)

Unrealistic Expectations

Valuations are important. They're the key to long-term returns. Your expected returns in any one 10-year period highly correlate with where you start investing. If you start when stocks are cheapest, you're going to compound at about 11%. But if you start when they're the most expensive, at an average PE of 22, you're going to compound at about 3.2% over the next 10 years. For the people and pension funds that are expecting to get the 8 or 9% that they've got written into their returns in their equity portfolios, that isn't good news.

The following chart from my friends at Plexus illustrates the point. I should note that this calculation works not just on US stocks but in every market that I have seen studied. This is a fundamental principle of investing.

So, what we have is a situation where many aging Baby Boomers and the pension funds and insurance companies which are investing on their behalf are not likely to be able to get the returns they need in order to meet their obligations from traditional US equity holdings, as this chart shows.

The Boomers Break the Deal

On another subject: Boomers (and that would be me and most of the people in this room) are going to break the deal our fathers and grandfathers made with our kids: That we'd die in an actuarially and statistically definable timeframe. Without being able to know how large populations will "shuffle off this mortal coil," things like planning for Social Security and Medicare, insurance, and pension plans become a very dicey business.

And the news we Boomers have for our kids and the actuaries who actually care about these things? We're not going to die on time. We're going to live longer, and this is going to have consequences for everyone's investment portfolios. We're not going to get into why we're going to live longer; the simple answer is that medicine is advancing. The boomers are going to live, on average, about 10 years longer than they statistically should; my kids and those under 40 are going to live, on average, a lot longer. But that's a topic for another time.

Simple fact: The majority of Boomers don't have enough savings. Numerous studies show they haven't saved enough to be able to retire. They certainly haven't saved enough if they're going to want to live longer and take advantage of medicine to do that.

If we start living longer, there are going to be massive problems with pensions and annuities, because there are actuarial tables that say people are going to die along this timeline. If people suddenly start living longer (and a 10- or 15-year period would be "suddenly" from an actuarial or pension-fund point of view), it's going to mean that those who pay will run out of money sooner rather than later. Since they'll notice the problem long before they get to the end of the money, they'll have to make adjustments. That means they're either going to have to lower pension payments, or they're going to have to get more money from somewhere (either increased contributions or increased returns).

Now, if they're in a period where they're projecting 8-percent returns from their equity funds, and they're not getting 8% -- if they're only getting a long-term 4 to 6% from here over the next ten or fifteen years -- that's a big funding problem. Public pension funds have the same problem, but it's much worse. They're a couple of trillion dollars underfunded.

This is why you're seeing California cities beginning to declare bankruptcy, because they're having to tell their firemen and policemen, "We can't pay you what we agreed to pay you; let's renegotiate something." It's going to get ugly in a lot of cities.

For those of you who live here in San Diego, it's a huge problem. Politicians promised the police and fire and the city people all sorts of wonderful things, they got their votes, and they're not going to have to be there to deal with the problem when it becomes a crisis in a few years. Isn't politics wonderful? Promise anything for votes today - and let our kids pay for it tomorrow.

The problems that we're now projecting for Social Security and underfunding are massively understated. We're going to have to pay a lot more for Social Security than we expected, because we're going to live longer. And the younger generation isn't going to be real happy about having to pay a lot more money to older people who are living longer and don't want to (or can't) go back to work.

When they started Social Security, retirement was at 65 and the average person died at 66. There wasn't a lot of expected payout. Now people who make it to 65 will on average live well into their 80s and are soon going to live well into their 90s. This is going to create generational issues.

It will also demand an increase in taxes. It's coming guys, and you are the target. You've got a big target right on your wallet. Like in California: "If you're making over a million, we want to take an extra one%" – that's going to happen in so many states.

A Nation of Wal-Mart Greeters

Now, let's look at it from another angle. Let's say you're getting ready to retire, you're 65, and you put your money into the most aggressive portfolio you can that historically has given the best returns -- that's the stock market -- and you're going to take out 5% a year. That seems a reasonable number.

A lot of people say, "We can take 5% of our money out every year." What would happen? Well, remember that graph I just showed you? Depending on the P/E ratio when you retired, if you started out when stocks were the 25% most expensive, over 50% of the time you'd run out of money in an average of about 21 years. Look at this table from my good friend Ed Easterling of Crestmont Research.

Even if you started when stocks were 25% less expensive, you would run out of money before the end of your remaining 30 years about 1 out of 20 times. If I came to you and said, "You know, you got a medical problem and we're going to have to have an operation tomorrow. And oh, by the way, you've got a 5% chance of dying," you would probably be quite nervous. What I'm telling you now is, if you get too aggressive with your retirement and investment assumptions in a muddle-through world, especially at the beginning, you're going to end up with problems. We could end up with a nation of Wal-Mart (WMT) greeters. (Not that there's anything wrong with those happy people who greet me! It's just not the retirement many people plan for.)

But many in the Boomer generation who are getting ready to retire haven't made adequate plans and are assuming very optimistic future returns. So are their pension plans. You're going to be living with neighbors and friends who have this problem. And not just neighbors and friends, but voters looking for someone to solve their financial problems with your tax dollars.

The Wealth of Nations

Now, let's look at the next topic: the wealth of nations. From 1981 to 2006, our national wealth in terms of the houses we own, stocks we own, real estate, bonds, businesses -- everything -- our national wealth (or maybe it's better to say, "the prices we put on our assets") grew from $10 trillion to $57 trillion.

Over very long periods of time. national wealth is by definition a mean-reversion machine. Over 40 or 50 years national wealth has to revert to the growth in nominal GDP. That's just the way the economics and the math work out.

Basically, the principle is that trees cannot grow to the sky. Just as total corporate profits cannot grow faster than the overall economy over long periods of time, neither can national wealth. Think of Japan. At one point in 1989, relatively small areas of Tokyo were worth more than the total real estate of California. And then the bubble burst and Japanese national wealth decreased and grew much less than GDP and is now in line with the long-term nominal growth of GDP.

In the US, long-term growth of nominal GDP is about 5.5%. We've actually grown by 7.2% for the last 25 years. To revert to the mean means that over the next 15 years (maybe more if we're lucky), we're going to see nominal wealth grow between 2.5 and 3%. That's a major headwind and a major dislocation from the experience that we've had. Investors have been expecting to get the past 25 years to repeat themselves. The laws of economics suggest that can't be the case.

We've seen monster growth in equities in terms of total market cap, even given the flat growth of the last ten years. We all know about the housing market.

Remember the part above where we talked about stock market valuations being mean reverting? We are watching housing values come down. What we are going to see is a very difficult period for asset growth in precisely the two areas where investors tend to concentrate their portfolios: US stocks and housing. Using history as our guide, that period could last for another 5-7 years.

Let me hasten to add: I'm not suggesting that the stock market won't go up over the next 7 years. What I am suggesting is that we could be in a period like 1974 through 1982 where the stock market did indeed go up over those eight years (in fits and starts), but profits went up even faster. Thus P/E ratios were in single digits by 1982.

Let's begin to put all this together. What are the requirements of retirement, whether for individuals or pension funds? I think I made the case that traditional investments are going to underperform – that's the stock markets of all the developed countries and to some degree the emerging markets.

But, you've got to have income and savings if you want to retire. You can't throw caution to the winds and invest in the most risky and volatile assets in hopes of getting the returns you need. Hope is not a strategy. You do not want to take much risk with retirement assets, which will be hard to replace.

You've got to figure out, "How do I get income in an era of low interest and low CD rates?" And "How do I convert my savings, and what do I put them in that will give me that income?"

If you're a pension fund, if you're expecting 8% from your equity portfolios and you're only getting 2 to 3, you're going to get nervous. You're going to realize you've got to do something else. Same thing with insurance companies and annuities. That means there's going to be a drive for more absolute-return-type funds.

The problem is, the place to go for reliable absolute returns is smaller funds. But most large pension funds are trying to put 1 or 5 or 10 billion to work, not a few million. And if everybody tries to get in the water at the same time, the pond could get very crowded.

Now, full circle. This is where I think the credit crisis is going to come to the rescue. I think we're having a reverse-Minsky moment. Hyman Minksy said that stability breeds instability. The longer something is stable, the more instability there is when that moment of instability happens. The crisis period of instability is called a Minsky moment.

So we had a long period of time of remarkable stability in the credit markets, then there were a few cracks here and there, and now we're having the crisis which started in July of 2007. The losses in both housing values and bonds will be in the trillions of dollars. Why? Because stability creates an environment for people to feel safer taking on more risk and leverage. It's just part of human nature.

Note: This is not just an American disease. It has happened since the Medes were trading with the Persians and in every corner of the earth.

But now I think we will get kind of a reverse of this pattern, a reverse-Minsky moment, where instability will breed stability, because we as investors, we as human beings, don't like instability; and we'll do whatever it takes and whatever we need to do to demand a return to a stable investment environment.

So, 2 forces that I've touched on are going to come together. First, we have destroyed -- we've vaporized -- 60% of the buyers for the structured credit market and badly wounded the survivors. We've got to create something to substitute for that, as we need a smoothly functioning debt market to allow for growth and a healthy business environment. It's absolutely necessary for individuals to have access to credit for purchases. If we all had to go to cash, it would be a disaster of biblical proportions.

Second, there's a need for equity-like returns on the part of investors of all sizes, from the smallest to the largest pension funds. If you can't get 8 to 10% from equities over the next ten years, where do you turn?

I think what we're going to end up creating, and what we're already beginning to see happen, is going to grow into a huge wave: we're going to see the creation of a series of absolute-return funds that I think of as private credit funds. I don't really want to call them hedge funds, because they're not really hedging anything.

For all intents and purposes, they're going to look like banks. They're going to put their green eyeshades on, and when they loan you money, they're actually going to expect it to come back. And they're going to expect it to come back with a level of risk return commensurate with the level of risk they're taking.

Instead of going through the messy business of getting depositors to put money into accounts, depositors who can come in and out, and having to service them and let them write checks and all of that stuff, they're going to go to investors and say, "Give me $100 million or $200 million or $500 million, and I can attack this market and give out loans in this manner, and I can generate these returns - 8%, 9%, 12%."

Maybe we can lever some of these markets up 2 or 3 times. 2 or 3 times leverage sometimes sounds like a lot. But our average commercial bank is leveraged 10 times. Our investment banks are leveraged 25 times or more. Two to three times in a properly structured debt portfolio isn't a lot of leverage, but it can give you high single-digit or low double-digit, relatively stable returns.

These private credit funds will look like private equity, in that they will have long lock-up periods, so that the duration of the investment somewhat matches the duration of the loans made. It is the mismatch of duration that has created much of the problem in the current market. All sorts of investment vehicles like SIVs, CDOs, etc. borrowed short-term money and made long-term investments.

So, we've got demand from two sources. We've got a demand from a retiring generation, from a pension generation, demanding equity-like return, when they can't get equity-like returns from the equity market. We've got a demand for credit funds -- we've got to replace the people we've vaporized.

We're going to see the creation, I think, of a multi-trillion-dollar marketplace of people, pensions, and investors looking to be able to attack those credit markets. Initially it will be for large funds and investors, but it will eventually filter down to structures that the average person can get into.

For a lot of us, we're going to see the ability to find stable returns, equity-like returns, show up at our door. And one way to attack this initially may be funds-of-funds, where you can spread your risk over a number of these types of funds and managers. It's going to require somebody to go in and actually analyze the banker who's making the loans to see if he's, you know, a real banker. Because we know we don't want the guys from Wall Street who made the last set of loans running our funds, at least not until they've gone back to school to learn what a loan is.

While a broad asset class that I call private credit funds will share some characteristics, the individual funds themselves will be quite different as to what type of credit they provide (housing, commercial real estate, auto, corporate, credit card, student, and a score of other areas), what types of returns they target, who their customers are, and who their investors are.

Furthermore, while private credit will initially compete with banks, I think that at some point banks will see this as an opportunity to return to their recent and very profitable model, which is to originate loans and then sell them off. Properly run, private credit will be good for the managers as well as the investors. And there is no reason that the management cannot be the banks. In some ways, they have an obvious advantage in this market, as it will be easier for them to attract large investors like pension funds and sovereign wealth funds.

This is a new era. We're going to have to shift from thinking that broad-based stock funds are for the long run. Over the last ten years, if you invested in the S&P 500, your net asset value is flat and dividends have badly underperformed inflation. With today's high inflation and lower earnings, that underperformance could last another lengthy period. If your time horizon is 30 years, then maybe you can talk about the long run. But if your time horizon is 5-10 years before retirement, you need to think about your definition of long run.

Now, you can buy individual stocks if you're a great stock picker or find a manager who is rather good at picking stocks. Donald Coxe was talking to us about agriculture, which I agree is in a bull market. There are other types of technologies - I think the biotech world, for example, is going to be huge, starting in the next decade. There are going to be places where we can go into specific target areas and make equity-like returns from equities.

But I don't think we are going to be able to do it in a cavalier, "I'm going to put my 401(k) into the Vanguard 500" manner and walk away. It's going to be a challenge for your retirement portfolio if you do.

Retirement in today's world is going to take considerably more thought (and funds!) than was traditionally believed. I encourage you to look at your own situation and carefully analyze the assumptions you've made.

Weddings and 08-08-08

The wedding's in a few hours, and friends from far and near have gathered, including George and Meredith Friedman and Paul McCulley, who got to town in time to have a long leisurely lunch with us. Dr. Mike Roizen just called to say he's off the plane. My friend from first grade, Randy Scroggins, and my first business partner, Don Moore, have come in. It now seems there will be 150 people at the wedding. We first thought 75 would be there. Oh well - so much for my forecasting ability. It's great to have so many friends from both sides of the aisle here.

It is not just the Olympics that begin on 08-08-08. In about two hours, Tiffani will be saying her wedding vows to Ryan. They picked a most auspicious date, and I trust it will bode well for them.

It is an interesting set of emotions I am dealing with. I am happy for her and Ryan. It's the start of a new chapter in their lives, and in mine. They are talking about kids, and are committed to making me a grandfather, if Henry and Angel don't beat them to it. (With 7 kids, I will ultimately have more than my share.) They all grow up so fast. Where did the time go?

My 91-year-old mother is in the hospital and can't come to the wedding. We almost lost her last week, from an infection she apparently caught in the hospital while there for minor surgery. She is fine now, but can't make the wedding. The contrast of old and new, looking back and looking forward, is food for some serious meditation.

The wedding is going to be something special. As anyone who knows Tiffani will attest, she can't do anything without a serious dash of her own unique flair. Several national TV series have asked about getting options on the video.

I think I mentioned a few weeks ago that there are going to be some serious fireworks at the wedding when we do the formal toasts. Tiffani was most insistent about having fireworks, and they will be choreographed to music. And while we were going over the plans, I met with the man who is directing the fireworks. For a little extra on the side, he threw in some special effects. What Tiffani and Ryan do not know is that when the minister says, "I now pronounce you man and wife," there will be a round of fireworks going off, and when they kiss an even larger display will erupt over their heads. Every woman says they want to see fireworks when they kiss their new husband. Tiffani will. And Dad's eyes may just get a little moist.

It is time to hit the send button and put on my tux. I'm not supposed to be late for this one.

Your getting a tad sentimental analyst,
John Mauldin
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