This Weekend's Contemplation #2 - Hope is Not a Strategy

I periodically correspond with Lon Witter in Lousiville that does investment advising for a living. I first saw an Op/Ed piece that he wrote for Barron's about 2 years ago so we have communicated off and on over that period. He recently sent me the piece below so I thought some of my readers might be interested in his comments. For completeness I have included Lon's advertising at the end. Text in bold is my emphasis. So with Lon's permission:

By now, most investors should realize that traditional, long-only investment managers, mutual funds, and buy and hold investors are in serious trouble. They "hope" that the market will soon recover and go back to new highs as it did from 1985 to 2007. That is entirely unlikely and "hoping" is not a strategy. The economic environment today is vastly different from the one that prevailed from the early 1980's to 2007.

So what makes today so different from the past 25 years? Let’s go back to 1985 to compare. In 1985, interest rates, inflation, and taxes were beginning a 23 year downtrend. Free trade was in its infancy. The greatest credit expansion in history had just begun. There was no trade deficit. The dollar was strong. Budget deficits turned to surpluses by the late 1990's. Owning a home was the American dream as the value of a home only appreciated. In 1985, we were in the beginning of a great expansionary economic period. Is it any wonder why the stock market would always recover and reach new highs in such a positive economic environment? Today, these positive economic trends have reversed. Why would an investor expect the stock market to recover like it did for the past 25 years when the economic environment is so different?

We are not in a business recession; we are in a consumer recession. All recessions since World War II have been business recessions. Business recessions occur when businesses over-expand and over-hire in good times, then have to retract until the inventory build-up dissipates. Then the business cycle begins again. Consumer recessions occur when the consumer is no longer able to spend the amount needed to maintain economic growth.

The American consumer is 67% of our economy and 20% of the world's economy. The American consumer is the engine that drives the world’s economy. If the engine breaks down, the world’s economic train grinds to a halt. The American consumer must increase his spending annually by approximately 3.3% to keep the world's economic train on track. This has not been a problem since World War II, until today. For many years, the salary of the American consumer increased 3.3%. In the years that salary did not increase by at least 3.3%, the American consumer could tap into savings, use a credit card or borrow against home equity to make up the difference. For the past 60 years, the American consumer had no problem increasing his spending by 3.3% a year.

2008 will be the first year the American consumer leads the world’s economy into a recession because spending fails to increase by 3.3%. For the past few years, the average salary increase has only been 1.7%. The consumer cannot tap into savings because the savings rate has been 0. Banks are responding to the credit crisis by restricting credit at the same time home prices are declining; therefore, increased borrowing is not a viable option for consumers. To make matters worse, the skyrocketing energy, food, and health care costs leave Americans with fewer dollars for discretionary spending.

To get out of this recession, one of the following four things must occur: 1) Salaries must go up at a rate greater than 3.3%, 2) Banks must extend credit to the average consumer and make terms easier, 3) Home prices must significantly recover lost market value or 4) The cost of energy, food, and health care must decrease significantly. Unfortunately, none of the above is likely in the near future.

It took the stock market 25 years to recover from of the excesses of the industrial revolution, 15 years to recover from the excesses of the roaring twenties, and 12 years to recover from the inflation/oil crisis of the early 70's. How long do you think it will take the stock market to digest the excesses of a housing bubble, credit expansion and rising food and oil prices, all at the same time?

Optimists will agree that the long range returns from the stock market are unlikely to be better than 5½% plus dividends. From 1985 through 2007, the S&P 500 earned 11% plus dividends. If the stock market averages 0% plus dividends for the next 23 years, it would merely bring us back to the expected long range returns. Is your portfolio prepared for the stock market to average 0% plus dividends for the next 23 years? I believe that traditional mutual fund managers and investment advisors will be the farriers of the 21st century.

Witter & Westlake Investments Programs Update
Witter & Westlake’s ProFunds Original and Gold Programs are now being monitored by Theta Investment Research. Theta Investment Research independently verifies the returns of investment managers by monitoring the daily returns of an actual traded account. I am pleased to announce that our 6-month returns for the ProFunds Original program were 10.67% after fees and that our 12-month returns were 27.38%. Our 12 month risk adjusted rate of return was in the 99th percentile. Our 6-month returns for the Gold Program were 16.14% after fees and our 12 month returns were 39.36%. Our 12-month risk adjusted rate of return was in the 96th percentile. All numbers were as of 06/30/08.

If you would like to view our record at Theta Investment Research, please contact Witter & Westlake Investments at (502) 339.8840 or by email at lon@witterwestlake.com.