Sixty years of endless summer are winding down. Investors have happily surfed atop a long, beautiful but increasingly dangerous wave of credit. The past two years have been like the last days of August. We realized it was ending, but we were intent on enjoying every last drop of its pleasures because we knew we wouldn't see it again.

But the endless summer is finally over. Our wonderful credit wave is crashing on reality beach and it's time to go back to school.
When it comes to the credit crisis that kicked the Fed and Treasury into high bailout gear, John Mauldin maintains that the time for prudence was ten years ago. There are now no good choices. He argues that leverage in the developed countries has reached a climax from which we must retreat, either slowly or quickly, the latter being the most painful option. Last month, Ben Bernanke seemed to concur when he said the recovery is still shaky and the Fed will probably keep interest rates low for an extended period of time.

This article has two simple purposes: 1) to observe that our personal and governmental responses to an unmanageable debt burden will produce a future very unlike our easy-credit endless summer; and 2) to propose an investment strategy appropriate to the unfolding reality.

The World As It Was: The Great Moderation Of 1979-1999
Harvard economist James Stock coined the term "The Great Moderation" to describe the marvelous final two decades of the 20th century, when it appeared that modern central bank policies had succeeded in domesticating the business cycle. Energized by the consistency and predictability of economic growth during these 20 years, both stocks and bonds were very well bid. Investor optimism kept gaining altitude as each year of delightful returns begat expectations of the next.

As seen in Figure 1, returns to equity investors during this "Goldilocks" era were truly unprecedented in magnitude, duration and consistency. In 21 years, there were 19 "up" years for large-cap stocks and only two small annual declines (of -5% and -3%). The average return for the entire period was a positive 18% per year.

It is easy to identify the unique set of salutary economic characteristics that supported the Goldilocks investment experience:
Steady consumer spending growth (increased borrowing and decreased savings);
Short, shallow inventory recessions artfully managed by the Fed;
Declining inflation (from productivity gains and rising imports from low-wage areas);
Declining interest rates (a result of falling inflation and an optimistic view of credit risk because of steady growth); and
Soaring business profits (a result of strong consumer demand, high capacity utilization, the low costs of debt and oil and productivity gains).

Price/earnings ratios are the emotional barometer of the stock market. The steady decline of interest rates during the Great Moderation, plus the deepening confidence in America's perpetual growth machine, drove the market's P/E from devoid-of-hope single digits to the giddy 30s. This P/E escalation accounted for more than half of the storied return on stocks.

And that was the world as we knew it for a whole generation. All in all, it was a beautiful thing; beautiful, but far from permanent.

The Great Fluctuation: 2000-2009
From 2000 until the present, our stock market experience has been anything but smooth; in the following chart, you'll see why I call it the Great Fluctuation (Figure 2).

As every reader knows, U.S. stock valuations soared on the wings of Internet euphoria toward the end of the Great Moderation period, but collapsed rather abruptly amid a shallow recession and the terrorist attacks of September 2001. Most of the cash-burning dot-com IPOs evaporated during that two-year "correction," and even large-cap stocks lost almost half their value. But any expectation that the investor class had suddenly embraced sobriety was soon discredited by a credit expansion, one like the world has never seen and one that (here is the point of the memo) the world may not see again for a long, long time.

Figure 3 shows how the dependence on credit almost doubled during the Great Moderation and then absolutely exploded during the Great Fluctuation. In the last ten years alone, the U.S. economy has taken on a phenomenal $6 in additional debt to produce each $1 increase in annual GDP. As though delighting in our credit-based consumption boom, all indexes, save  the still-bruised Nasdaq, were fully resuscitated by 2007. But all was not well.

From the summer of '07 to the summer of '08, dark clouds gathered over home building, mortgage-backed securities, banks and the shadow banking system. Credit hell broke loose by September 2008. Mounting mortgage defaults finally grabbed investors' attention, and policy-makers pounced on an irresistible crisis. Since then, the government has been frantically pressing every conceivable stimulus, bailout and guarantee button in its effort to forestall a reversal of the credit cycle, which would have dire implications for employment and economic activity.

The S&P 500 cratered in early March '09, falling by a stark 55% from its October '07 top. It seemed the world was accepting the inevitability of a bleak deleveraging cycle in the Western world. But like the hero in an old-time cowboy movie, spontaneously or perhaps instinctively some version of a new bull market began to climb the wall of worry. Feeding off bailout optimism, trading momentum, a string of "less bad" economic news and a positive 3Q read on GDP, the index recouped half its decline in eight months. As I write, the index has stalled at 1100, still 29% below the '07 high. Inquiring minds want to know, "Where do we go from here?"

The New Reality: 2010-2020
I don't know whether it is the consensus view that we have weathered the storm and can now expect a V-shaped recovery and a new high in corporate earnings within a year or two. But a 60% gain in stock prices in eight months sure looks like somebody thinks we're out of the woods. As we contemplate the future, I would point to two glaring realities that shift the burden of proof to those betting on a return to some version of the Great Moderation.

One is the extraordinary debt burden that took our credit system to the brink has not been lightened; if anything, it is worse. Shifting worthless private loans onto the backs of taxpayers, especially the owners of job-creating small businesses, does not brighten the outlook for economic growth. Debt must be serviced, and a growing debt service burden increases the cost of production and dampens consumption. Also, history suggests that the true cost of borrowing is closer to 5% than 0% (the going rate on short-term government debt), so an increase in debt service cost undoubtedly lies ahead.

The second reality is that the explosion of government spending as a percentage of GDP is not bullish for private sector growth. Governments do not create net new jobs. The rising standard of living we have taken for granted is the fruit of the increasing productivity of labor, which in turn is a function of capital (aka savings) put to use by hard working, creative risk takers. That's Economics 101, or at least it used to be before General Motors had to seek the permission of Congress to close unnecessary dealerships-permission that was denied.

Here is our new reality: an unprecedented and still-growing debt-service burden, a banking sector still saddled with uncollectible loans and government spending at 45% of GDP-not even counting its unfunded social commitments at 4 times GDP (Figure 4). These circumstances don't portend the kind of economic growth we once enjoyed. Don't just take my word for it. Read Gross and El-Erian, Mauldin, Rosenberg, Hussman, Grantham and other luminaries. Then ask yourself if an economy struggling under debts at 375% of GDP could possibly have the same growth prospects as one with less than half that burden. Ask whether a government with operating deficits at 10% of GDP can possibly preside over future inflation that was lower than we had in the past. And ask Asian and Middle Eastern sovereign funds whether 0.3% is a fair return on a one-year loan to the U.S. Treasury Department, in a currency that has lost 19% this year.

Doesn't it seem that hoping for a "normal recovery" and a return to the growth and high returns of the Reagan/Clinton eras ignores the realities inherent in our runaway debt and our extraordinary government expansion? Doesn't it make more sense to expect that growth will be constrained and that capital will demand a higher return (higher interest rates and lower P/E ratios) until the risks come down and the growth potential improves?

I should add that expecting the necessary deleveraging to take place over ten years is the optimistic view; it would give us time to grow into the obligations we already have. If our debt load is either paid down or written down in a shorter time, we would experience something worse than stagnation. In a couple of years, depending on the policies we get, and depending on the behavior of our trading partners and our enemies, we could find ourselves actually longing for the sideways volatility of Great Fluctuation.

Investment Strategies For A Deleveraging World
If reality for the next decade or so seems likely to include deleveraging and/or rising interest rates, if consumer spending likely yields at least a little ground to a revived savings instinct and if the government holds to its current expansionary, populist track, then surely it makes sense that a portfolio structure suited to the unique circumstances of the '80s and '90s needs to be altered to adapt to these changes. What follows is the outline of our new reality portfolio approach at Financial Advantage.

Underweight equities relative to what used to be normal. It is still true that the private sector is in the best position to cope with big changes to the economic landscape because businesses are in direct touch with "the marketplace" where decisions are made by real people with skin in the game. So we want to be stockholders. But the business climate is going to be intensely competitive, and valuation pressures will affect even the best stocks.

Focus on competitive advantages. Don't buy indexes. There is no more tide of credit and consumer demand to lift all the barges. This time around there will be losers as well as winners. Invest in businesses that can grow by gaining market share against weaker competitors (or own mutual funds that can do that for you).

Dividends matter. Historically, dividends have accounted for about half of the total return on stocks. With less top-line growth, that will be true again. Invest in companies with the balance sheet and cash-flow potential to grow their payouts.
Consider avoiding Europe and Japan. Their demographics are worse than ours, their societies less adaptable to changing circumstances and their public balance sheets probably worse as well.

Overweight emerging markets, perhaps even dramatically. But be selective and average in over time since this is a volatile asset class. Not all "emerging" economies are created equal. Transparency is always a concern, and whether citizens are increasingly free is probably the most critical variable to evaluate and monitor. The less developed world is early in the industrialization cycle.
With emerging economies' access to modern technology and capital from the West, their productivity gains could eclipse even the West's wonderful economic history.

Fixed income: high quality, short term and more corporate than government. Lending money is more dangerous than we have experienced until recently. Keep your eye on the inflation/deflation issues.

The world economy is at an inflection point that will bring exciting opportunities and frightening risks. A thoughtful advisor with a sensible strategy will be worth his or her weight in gold.