Many investment professionals have been reading the New York Times bestseller This Time Is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff. It is a powerful rendering of how often financial crises have occurred since the dawn of finance, and how often sovereign countries have defaulted on their debt through the centuries. Most important, the two authors, one residing at the Peterson Institute for International Economics, the other at Harvard, illustrate how one could predict such crises, and most important for us, outline what one could expect in their aftermath.

In the first part of this report, we will offer some salient points made by Rogoff and Reinhart which certainly apply to this moment in financial history. The second half will offer some historical context to likely asset class returns based on where we are today.

The first point to be made is that there are three kinds of financial crises, including the type we recently endured, which are financial bank crises. Reinhart and Rogoff report that “The aftermath of systemic bank crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources”. In fact, they point out that while too much debt leverage among consumers, and commercial and financial enterprises are typically the cause of adverse financial events, the recovery is held back primarily by fiscal drag caused by a dramatic expansion in sovereign debt that must be paid down over time. On average, government debt rises 86%(!) during the three years following a bank crisis. Real housing prices drop an average 35% over six years; equity prices drop 56% over a 3 ½ year span; the unemployment rate rises seven points during the downward phase lasting over four years; and output drops 9% lasting two years.

Does all this sound familiar? Bear in mind that this book was published in 2009. Clearly, this time is not different.

Certainly salient to our current situation, financial crises, particularly those that are long and difficult to resolve, can have profound effects. After financial crises, asset market collapses are deep and prolonged, there is a sizable decline in output and employment, and the value of public debt explodes. A general deleveraging is required, which has largely been accomplished, except for the large amount of sovereign debt still accumulating. Certainly, this sovereign debt overleverage could sow the seeds for the next financial crisis. It is the recognition of this risk which is holding back the stock market.

It is clear that our recovery from The Great Recession will be long and slow. Where are we on the path to recovery? Real housing prices peaked in late 2005. Add six and half years and that would put the bottom at mid-2012. That sounds about right. Equity prices peaked in the third quarter of 2007. Three and a half years would be early 2011. The stock market recovery actually began two years earlier than that. The unemployment rate did rise about seven points from the bottom. Four years from the low point in unemployment in 2007 would be 2011.

All of this suggests that based on history, the worst is behind us and the stock and bond markets will continue to heal.

Is Europe about to experience a financial crisis due to its overleveraged junior sovereign partners within the Eurozone? Reinhart and Rogoff point out that there are usually four conditions that trigger financial crises: massive global current account imbalances, asset price inflation, rising household leverage and slowing output. All four conditions were met just prior to the 2008 bank crisis. In Europe today, only two conditions are being met: current account imbalances and slowing output.

Sovereign defaults have been with us for centuries. It is no surprise that Greece is on the brink of default. In fact, Reinhart and Rogoff point out that since 1800, Greek debt has spent more time in default than being current with their debts. It is a classic serial defaulter. What is happening in Europe has played out on numerous occasions throughout the centuries, except the solution must be countenanced by many countries as long as Greece remains part of the Euro zone. In other words, this time is no different from myriad previous sovereign default events.

Are we about to have yet another crisis in the United States caused by the large federal deficit? The U.S. also is satisfying two of the four conditions: current account imbalances, and slowing output. Will this trigger a “run on the bank” scenario like the one playing out in Greece? Not yet and maybe not for a while. The U.S. possesses a unique advantage in that the dollar is the primary exchange currency and is still perceived as the least risky currency to possess in times of trouble. It is still true today. This factor will likely forestall a currency crisis much longer than would normally be the case for a small country’s currency. We probably have a few years to solve our sovereign debt issues, but it is not forever, and the moment of judgment is never predictable.

Alright, let us assume for the moment that one way or the other, a solution to our debt issues will occur after the 2012 elections, probably in 2013. What returns could one expect from various asset classes after a financial crisis like the one we have experienced, one which has quite lingering aftereffects?

The financial bible for U.S. asset returns is Ibbotson’s Stocks, Bonds, Bills and Inflation Classic Yearbook, which is now published by Morningstar. It provides compound annual returns for various asset classes going back to 1926. It is in that year when the predecessor to the S&P 500 was created.

First, let us level set returns by asset class. It is important that investors understand what various asset classes have done through thick and thin periods of modern financial history.

The following table shows the compound annual returns for various major asset classes, plus the compound annual inflation rate, since December 1925, and what a dollar’s investment in each asset class would have returned:

Compound Annual Return

Wow! Just an extra 220 basis points in return from small stocks large stocks over 85 years gave you that difference in returns? The answer is unequivocally yes. That is the power of compounding over long periods of time. For that substantially greater return one must accept high annual variations in those returns, but clearly it is worth it over the long run. Also look at the difference in returns between large stocks, long term government bonds and T-Bills. Over the long run, less risk means substantially less returns. Even if one assumes two hundred basis points lower returns for stocks and long term bonds over the long run because of a more mature domestic economy, as we do, absolute returns will be less but the difference in relative returns will remain about the same.

But are not bonds safer than stocks? Yes they are. The variation in their returns are less than for equities, but less risk does not mean no risk, and the risk of owning fixed income investments may be greater than you think. The following table shows the number of times out of 85 years each asset class had a positive return, the percentage of times they were positive and the number and percentage of times each asset class had the highest returns among all asset classes:

Fixed Income – Number of times positive (Past 85 years)

It is not all that surprising that either small or large stocks had the highest annual returns 64% of the time between 1925 and 2010, or that T-bills had positive returns 99% of the time. But one would have thought long term bonds would have had positive returns more often than stocks. They do but not by much, really not much at all. Given the much higher returns stocks get, that is not an argument for overweighting bonds. Also, bonds are not immune from providing negative returns, and that usually occurs after returns have been higher than usual, like now.

Okay, but stocks drop more than bonds during financial crisis. That means it would take longer for returns to recover, right? What if we looked at how often there are positive returns over rolling five year and ten year periods for each asset class and the number and percentage of times an asset class had the highest five and ten year compound annual return? There are 81 rolling five year periods and 76 rolling ten year periods to consider.

Positive Returns over 5 & 10 year periods

How often there are positive returns over rolling five year and ten year periods for each asset class and the number and percentage of times an asset class had the highest five and ten year compound annual return.

Well, doing worse in a financial crisis certainly does not harm the comparative returns of stocks versus bonds over five and 10 year periods. Over rolling five year periods, stocks had a positive return 86% of the time and had the highest five year returns 88% of the time. It is important to note that even though long term bonds provide the highest returns 11% of the time, they are still not immune to negative returns. The ten year comparative returns are similar

Well that is fine, but what are the returns for these asset classes after their worst periods? The next table shows the worst five year and 10 year periods for each asset class and their five year and 10 year returns after that. Please note that the best returns were provided by stocks, and certainly not T-Bills. In fact, adjusted for inflation T-Bills provided negative real returns in both periods.

Worst 5-10 Year periods

After the worst five year period for each asset class, stocks, as usual, provided the best returns. This time the returns over bonds were way over historical averages, both on an absolute as well as relative basis. The 10 year return after the worst 10 year periods were closer, but large stocks still won. We do not know what the 10 year returns after the worst 10 year period for small stocks are because it is a relatively recent event.

One might reasonably ask, what were the comparative returns of stocks compared with bonds after the best period for bonds, which would be similar to recent events? We think you are on the verge of becoming tabled out so we will just tell you that the best five year and 10 year return periods for long term corporates and long term governments were 1982-1986 and 1982-1991, respectively. Long term corporates returned a sterling 22.5% a year for the five year period and 16.3% a year for 10 years. For the succeeding five year and 10 year period, the returns for corporates were 10.4% and 8.1%, respectively. For governments, the best performing annual returns over five years and 10 years were similar to corporates, 21.6% and 15.6% respectively, and for the succeeding five and 10 years, they returned 9.8% and 6.7%. Those are great numbers, but stocks during the five years ended in 1996 and 10 years to 2001 did way better than that: 17.3% a year for small stocks over five years, and 15.4% for large stocks, and for the 10 years, a 15.6% annual return for small stocks and 12.9% for large stocks. In other words, stocks did better than bonds after each asset class’ worst period, as well as after the best period for bonds.

Where are we now? For the five years through 2008, small stocks had a -7.7% compound annual return. That is pretty terrible but by no means the worst period suffered by that asset class. Large stocks had a 2.2% negative return. On the other hand, long term corporate bonds had a 5.8% annual return, long term governments a fabulous 10.4% CAGR, Treasuries 3.0% and inflation 2.7%. None of these returns represent the worst periods for any of these asset classes, nor their best. Nonetheless, given the comparative returns of stocks and bonds over the five years to the end of 2008, close to the end of the last major bear market, one would expect stocks to perform comparatively better, and by a large margin.

They have. For the two years ended in 2010, the annual return for small stocks was 29.7%, large stocks 20.6%, long term corporate bonds 7.6%, long term treasuries -3.2%, and T-bills 0.1%, against inflation at 2.1% a year. Wow! Well some of those gains have been given back so far this year, but stocks have still provided great returns since the end of the bear market, and significantly better than long term bonds, let alone treasuries.

Stocks are clearly performing just as you would have expected them to perform based on modern financial history. As for fixed income investments, it is corporate America that has by far the best income statements and balance sheets. Investment grade corporate bonds are well supported by record profit margins and record highs in net cash. Compare that with the U.S. government’s income statement and balance sheet.

It is our view that investors with time horizons beyond the next six months should overweight three types of investments: long term corporate bonds, dividend paying stocks and stocks for capital gains. Long term corporate bonds provide better returns than treasuries and offer far better balance sheet support, the dividend rate of the S&P 500 is above that of 10 year governments. That is an extremely rare event and a very bullish signal. Lastly, small stocks are apt to continue providing above average returns following the worst 10 years going back to 1925.

What are the takeaways here? Financial crises test the stamina of citizens because of the adverse impacts on their quality of life, not just immediately after the debacle, but many years afterward. It does not matter who is in the White House or controls congress, economic growth will be below normal for many years, but that does not mean stocks will provide poor returns. In fact, they are likely to provide above average returns over five years and 10 years. It is true that the best returns in a bull market are in the first two years, but based on history, equity returns over the next few years are likely to be positive and above that of long term bonds.

History does not exactly repeat itself, but it rhymes. We firmly agree with Reinhart and Rogoff: the worst is over. This time is not different.

YPNewsletter_printversion_0911

Inside you’ll find:

• A market perspective, comparing the present situation to Sept 2008
• Economic outlook on three key indicators: Oil Prices, the Housing Industry and Vehicle Sales
• An article on the variations within the unemployment rate
• A column on “The Mania of Pessimism” by Chris Jacobs

Comparing Deficit Reduction Plans – New York Times

Where we accumulated the debt (and who holds it) – New York Times

An Investor’s Perspective

It turns out this is generally the case every evening all over America.  But is this truly a reflection of what is going on in the United States?  I don’t think so.  It is too one-sided.  I think like an investor.  Investors are likely to be much more analytical in their assessment of America’s present and future.  They play it by the numbers.  But to be an investor one must always be considering what the future will look like.  Even though most investors commit funds to maximize returns based on their own individual risk profile and time horizon, since stock prices tend to rise over the long run, most of us will focus on those sectors and companies that will at least grow with the economy over time.  If stocks rise roughly 10% a year as they have over the last 84 years, a little more than a typical lifespan, emphasizing the negative is a surefire way to under perform over time.  Oddly enough, although most pundits view equity investors as conservative folks, investors, nonetheless, are typically betting that something will go right.

When looking at a company, an analyst typically starts with the macro view.  What are the company’s competitive advantages?  Let’s look at the United States in the same light.  What are the country’s long term capabilities which are unlikely to go away any time soon and which can keep the country in a leadership position for decades to come?   And let’s look at all this in relation to China, what is likely to be our main economic and political rival throughout the twenty first century.

Political Stability

The first sustainable advantage we have is political stability, which is why the Chinese yuan is very unlikely to displace the dollar any time soon.  The orderly transition of power is fundamental to investing for the long run.  What is likely to be more stable, with a more predictable regulatory environment over the ensuing 25 to 50 years, China or the U.S.?

Ingenuity

Next on the list is the ability of a country to sustain innovation in order to take advantage of global demand.  Capital has to be allocated efficiently.  An environment has to be engineered and sustained to attract people willing and able to discover and exploit new innovations and manage their development and profitably deploy them..  How is America doing?  We have the most distinguished universities.  We have the finest business schools.  And we spend more on R&D, both as a per cent of revenues as well as on an absolute basis, than companies and governments located in any other part of the world, including China.  Until recently, Americans invested more in venture capital sponsored firms than the rest of the world combined.

38 million people in the U.S. were foreign born. This is the country people still emigrate to when seeking social acceptance and wealth.

More important, we welcome intellectual capital to a greater degree than any other major nation.  At recent count, and as noted in Eric Catts’ recent book, Up on America, 38 million people in the U.S. were foreign born, 12 million in Russia, 10 million in Germany, 4 million in China (!), and 2 million in Japan.  This is the country people still emigrate to when seeking social acceptance and wealth.  It is true, Europeans typically get 400 more hours of vacation time than in the U.S.  But our society is designed for the ambitious.  Half of the people earning in the bottom quintile in this country, climb to a higher rung within 10 years.  There are few countries that can match that.  Plus, as opposed to most developed countries, and China, our population is scheduled to rise through 2050, which will also foster economic growth and expand our human capital.  By 2050, thanks to immigration, the population of the U.S. will increase by almost a third to about 400 million people.  The population of Japan will decline by over 25 million individuals.  Working age people are expected to fall by 30% over the next 20 years in Italy, Spain, Germany and Greece.  By 2050, based on current trends, China’s population will fall by an estimated 100 million people, which will put the labor pool at a competitive disadvantage versus other emerging countries with growing populations, like India, Vietnam, Pakistan and Nigeria.  As Casey Stengel the old perfessor, used to say: “You could look it up”.

Lastly, and probably most important, this country, along with Europe, unlike what is still the case in most emerging countries, provides women, half of the world’s population, much more of an opportunity to fully participate in the affairs of state, commerce and academia.  And because so much of the world has already been exposed to our language, English is likely to remain not only the lingua franca of commerce throughout the twentieth first century but the common language for scientific and general academic conversation.

One only has to look at the list of transforming technologies to see that the U.S. still leads in their development, application and deployment.  We lead in chip development, computer software, broadband and wireless technology, Internet software and information and data gathering tools, entertainment dissemination, health care robotics and other surgical devices, drug discovery and genomics, nanotechnology, specialty alloys, metals processing technology and tools for energy exploration and development.  Semiconductors, mobile infrastructure, information storage, routers, switches, smart phones, cable boxes, bio-tech, the Internet, and fracking tools were all developed and exploited by American firms.

Global Reach

Another sustainable competitive advantage we have is the global reach of our largest companies.  China may export more than the U.S., but it is American companies that have mastered the deployment of capital on foreign soil for the benefit of domestic owners.  About 40% of sales generated by companies in the S&P 500 are in foreign countries.  America, more than any other nation, has perfected the ability of a corporate enterprise to market products beyond its borders for profit.  This capability also means that our profit pool from foreign activities is greater than anyone else’s, and can be put to use for sustained growth.

This is the country that perfected capitalism.  There is still no other form of economic enterprise that can direct the desire for personal betterment to maximize a greater common good for the majority of a population.  China has unleashed tremendous economic forces via the profit motive.  However, it remains to be seen whether a command economy can enhance economic development versus our brand of more market driven capitalism.  It also remains to be seen whether the implementation of most basic civil rights is enough to sustain its brand of capitalism without political freedom.

The U.S. versus China?  Right now, the expectation is for the U.S to generate GDP growth in the 2%-3% range. That is more than any other developed nation. If China grows at its current rate, it will overtake the U.S. by 2050.  But given its aging population because of the old “one child rule” and the inevitable decline in growth which will occur once it completes its transition from an agrarian to an urban economy, the current rate of GDP growth is much less likely to continue over the entire period than what is projected for us.  China’s growth rate will revert to the mean just like any growth economy, growth industry or growth stock, pushing out the day when China will have greater productive capacity than the U.S. well past mid-century.

What could undermine our advantages?

What could permanently undermine our competitive advantages?  At the top of the list is regulation.  Our government has implemented a contract to provide an environment to encourage individual achievement and consequent economic rewards.  That cannot change.  Regulation cannot be unilateral.  It must be globally implemented and the U.S. must encourage that.  Next on the list is our current debt level.  We are living beyond our means.  That is the one thing we have in common that has undermined great nations throughout the centuries.  Another is crime.  We have 5% of the world’s population and 25% of the prisoners, and it is not only because we are better at catching or punishing criminals.  But there is nothing we face that could undermine our way of life than what we have already surmounted: slavery, segregation, political and corporate corruption during our period of fastest growth, the disenfranchisement of women in the workplace, the Great Depression, Nazism and communism.

This country has just come through a period of great economic stress that has shaken our confidence, but consider how much more successful our navigation of this great storm was, thanks to Mr. Bernanke and others, than this country fared during the 1930s.

This country has just come through a period of great economic stress that has shaken our confidence, but consider how much more successful our navigation of this great storm was, thanks to Mr. Bernanke and others, than this country fared during the 1930s.  Financiers rarely make the same mistake twice.  It’s like raising children.  Most of us don’t make the same mistakes our parents did.  We make different ones.  Fortunately, our economists continue to develop a collective consciousness to help us to better deal with the inevitable adverse consequences of a less managed economy structured for ambition and economic success.

During the over 30 years that I have been a securities analyst, research director and portfolio manager at Standard & Poor’s, Bear Stearns and now at Yellowstone, I have searched for companies with sustainable competitive advantages and underlying equities at attractive relative values.  As I look at the valuations that exist today and the still very attractive overall equity risk premium for U.S.-based stocks, betting on America now is a relatively easy call.

2011 June Newsletter (2nd Quarter)

• A market perspective, evaluating the relative value of the overall market indices at the moment.
• Economic outlook on three key indicators: Nonfarm Payrolls, ISM Manufacturing, and US Exports
• An article on the implications of recent social media company IPOs
• Details regarding our recent agreement with Rainbow Capital, LLC
• An update on the fixed income market by Rick Baird, CFA

New York Times: Happiness graphic

This year’s award is already well underway with nomination ballots having been distributed to several schools in the Idaho Falls District 91 area. We’re looking forward to reading and hearing the stories from students about the wonderful teachers we have in the area.

This is still very new, and as it grows so too will the areas of eligibility. More information can be found on the award’s website.

Update:

We have announced and awarded the winners. Here is a little video of the ceremony that we put onto Youtube.

Congratulations teachers!

Watch the interview below or view it on The Street’s website.

Robert Natale joined Yellowstone Partners on April 1st, 2010 as the Senior Portfolio Manager for both the Small and Large Cap growth portfolios. Read his full bio.

Google recently put together an interesting visualization of this year’s census data which helped to put California’s woes into perspective.

Read the full article on the Wall Street Journal.