Surf's Up ... Someplace

There is always opportunity, even in overheated markets.

The movie theater near you probably didn't even exist in 1967 when the film "Endless Summer" was making the rounds of American neighborhoods. As I was thinking about the topic for this month's column, images from that movie flickered in my imagination; scenes of lithe and beautiful young people astride their surf boards, chatting idly as they paddled about in calm ocean waters, straining their eyes toward the horizon in earnest anticipation of the perfect wave.

I was musing on waves and surfing on a recent Friday afternoon at the office as I watched the slow trading activity on the NYSE wind down to a quiet close of what had been a hectic week. I was all alone; our staff had been dismissed a little early as a thank-you for managing an extraordinary volume of new client activity during the past few days. Suddenly, my reverie was shattered by a vigorous "Hello, anybody here?" from the reception area.

The voice was vaguely familiar. Sitting upright, I put my feet back on the floor. Leaning toward my office door so I could see into the lobby, I was thrilled to behold, replete with an unfamiliar shock of silver hair, a friend and fellow analyst from my Wall Street days whom I hadn't actually seen in 20 years. "Bob, you old rascal, I can't believe it! What in the world are you doing in Maryland? It's so great to see you!" "Nancy and I are in town for a family wedding and I couldn't resist the chance to look you up. Got time for a glass of wine with an old buddy?" "Your timing couldn't be better; Mary Liz is having dinner with her sister tonight. I've got just the place for us to have a long visit."

Amid a flurry of catching-up chatter, I shut down the computers, threw some weekend reading into my Land's End tote, locked the front door and guided Bob across the mall to the Iron Bridge Wine Bar and Restaurant, where I knew we would enjoy some memories and swap investment ideas for a couple of hours.

Facing Our Elephant

We arrived in time to get the last table. In no time we were pouring from a chilled bottle of Kanu Chenin Blanc (South Africa) and sampling the restaurant's signature brochetta. "Mike," Bob began, "I've been reading your column in Financial Advisor, and I must say you are starting to get to me with the concerns you have been writing about; especially the acceleration of credit and the high valuation levels of both stocks and bonds."

"That's a pretty succinct summary of the key issues, Bob. Loose money, a bunch of exciting new technologies and a classic dose of speculative fever spawned a spectacular stock market boom; and the cheap equity capital funded enormous malinvestment at the turn of the millennium. On top of that, reduced credit standards and falling interest rates ushered in a housing price boom that fostered a credit-based consumption boom. When the stock bubble finally burst in 2000, and jobs started disappearing, the Fed and Congress poured on the monetary and fiscal fuel to "save us" from a natural correction. Corporate debt, consumer debt and government debt all rose at the same time.

"I have a chart in the office that I call 'the elephant in the living room.' It shows total debt in the U.S., as a percentage of GDP, zooming in 15 years from a normal 125% to an unprecedented 310%."

"Yeah, I think I saw the chart in Barron's. But what do you mean by 'elephant in the living room?'" "It's an expression from AA, referring to a family member's drinking problem. Everyone in the family knows it's a problem except the person, but nobody wants to talk about it. It's like having an elephant in your living room, and everyone is trying to ignore it. It's not going to go away, and if you don't do something there's going to be some damage. As professionals responsible for clients' nest eggs, I don't think we can safely ignore the potential consequences of huge debt."

"Yeah," my friend agreed again, "the mediocre growth we have been able to generate has come at a high price. At some point the cost of carrying all this debt has to start pulling down consumption, doesn't it?"

"Well, I suppose rising carrying costs will slow consumer spending, especially if rates rise, and possibly precipitate more defaults, which would cause credit to tighten up and rates to rise more. Not pretty," I added unnecessarily. The waitress was just placing the broiled crab cake special in front of us. "Not pretty? What are you thinking, hon? That's a bea-utiful crab cake." I tried to explain that I didn't mean the crab cake, and I poured two more glasses of Kanu and asked if they still served that delicious raspberry iced tea; I had to drive home later.

Those Were The Days

"Bob, do you remember seeing 'Endless Summer'?" "Sure. Bunch of young surfers circling the globe in search of the perfect wave or something like that?" "Yeah, that's the one," I said. "I've been thinking about it, and I believe there's an investment lesson in it."

"Something in your iced tea?" Bob wisecracked.

"No, really. It's made me think that there are always waves; the trick is to wait for them, stand up and ride them while they last, then get off and watch for the next one. Like the oceans, markets are always moving; there are always waves you can ride. Or you can sit on your board and let them pass you by because they're not good enough, and wait for that elusive perfect wave, the next 20-year bull market."

"Mike," Bob licked the last crumb of backfin from the corner of his mouth and drained his glass, "You and I are old enough to know that 1982-2000 was the perfect wave, probably a once-in-a-generation thing of beauty. Ignore the dips, hang on and never look back! We may not see that again in our careers, even if we work as long as John Templeton and Roy Neuberger."

"I'm sure you're right, Bob. It was the longest, most powerful wave in modern financial history. Almost 20 years of rising P/Es and falling interest rates. Do you remember when the Dow sold at less than seven times earnings in 1979?" "Sure I do. And those were peak earnings, too; corporate profits didn't get that high again for about ten years!"

"And a couple years later, long Treasuries sold at a 15% yield and nobody wanted them, remember?" "Sure I remember. But now look what we've got, 30 times earnings and 4% on the ten-year bond. Is this a wave we can ride?"

Everything's Expensive

"Well, I don't know. Maybe it is," I suggested to Bob's amazement. "Yeah," he rolled his eyes, "P/Es will go to 60? Or maybe we'll squeeze 15% earnings growth out of a 3% GDP trend? Or maybe the 2013s will trade at 2%? Where's the wave?"

"Well, I agree with you that everything is expensive; stocks, Treasuries and even junk. But remember, there are two sides to every trade.

"In the days of the great bull market, if you thought prices were getting ahead of themselves you might take a breather, take some profits and wait for a dip to get back in, like 1984 and 1987. But you were always long. Today, on the other hand, when everything is so expensive, it could take years to get back down to normal valuations ... Or, you gotta agree it's possible, a correction could happen suddenly. I don't know about your clients, but half of mine are retired and making withdrawals from their portfolios. If I try to hide from the overvaluation of stocks and bonds, what am I going to earn hunkered down in cash and short-term bonds? 1%? 3%? That's not enough; I have to shoot for 7% average returns. If I don't believe that being long in the market can provide that, I have to think, 'How can I make money even if the market is choppy, flat or falling?'"

"Whoa, brother!" a frightening realization had apparently fallen upon Bob. "Are you talking about selling short? Naw, you're not; right? Tell me you're not."

"The idea is as foreign to me as it is to you, Bob. I'm just thinking out loud about ways we make might make money for our clients in the capital markets when we don't have the wind to our backs like we did when P/Es were rising and interest rates were falling.

"The most fundamental rule of portfolio management keeps coming back to me: DIVERSIFY. We all agree you never bet the farm on any one concept, right?" Bob nodded but his arms were folded across his chest and his face was a mask of skepticism. "That used to mean you put 60% or 70% in a basket of small-cap, large-cap and foreign stocks, something like that, and you mixed in 30% or 40% of short-to-medium-term bonds to dampen volatility, right? That was diversified.

"But we both know that stock returns in the U.S. and Euroland are no longer uncorrelated. In both places we're looking at historically high valuations, sluggish demographics and high debt loads that strongly imply slow growth and at least the risk of a financial disaster of some kind. And the gap between value and growth stocks has largely closed; ditto for small- and large-caps. So if we have 70% of our money in developed market stocks, are we diversified or have we bet the farm on a single delusion?

"I have to wonder, just wonder mind you, if perhaps I should consider making an investment in the possibility that valuations will come down to match the slower-growth realities of the mature economies. It would certainly provide some diversification, right? And it would give me a vehicle for rebalancing. In the last ten years, I used long-term Treasuries for this purpose, but that game seems largely played out."

The Next Wave

"Would you short stocks, or what?" "No, not individual stocks; but I could go long the Rydex Ursa fund, or maybe buy index put options. I haven't gotten that far yet. But a long market slide would not be a surprise, so that's one possible wave I'd like to be prepared to ride." "What are some other waves?" Bob asked.

"Well, the Fed and most other central banks seem increasingly locked into what looks to me like a currency war. Every host country wants its currency to be cheaper than the other guy's to help their trade balance. But obviously this is a zero-sum game. If the game goes on, it seems pretty obvious that the price of globally traded raw materials like energy, metals and maybe food will rise in currency terms. There's a wave we could ride. It would help offset damage to the principal value of our fixed-income portfolios. It would be like overweighting energy and mining equipment in the 1970s."

Bob was really getting uncomfortable, "Next thing you know you'll be long gold!" "Well, actually..." "No, I don't want to hear about it," Bob insisted. "OK," I said, "We'll skip gold for now."

"But speaking of gold, I've been reading a very interesting and provocative book by Marc Faber called Tomorrow's Gold; Asia's Age of Discovery. He's recorded tons of financial history from the early 19th century through the 1990s New Era. Reviewing all those cycles helps you realize that human nature doesn't change. Our cycles of greed and fear, optimism and pessimism, always exaggerate quantifiable business realities like profit and loss. Global capital keeps sloshing away from overpriced assets toward overlooked ones. If we think of the securities markets as rational, we'll never master them. The average modern portfolio manager accepts current pricing as "efficient" and spends his time trying to be sure he is diversified across all asset classes. In the 1990s this manager looked good whether he owned U.S. stocks or long-term bonds, because whether he knew it or not he was riding a wave of enthusiasm manifest in ever-rising P/Es and ever-falling interest rates.

"Today those waves are washing up on the shore. Capital is starting to flow away. We can keep standing on our surfboards wondering why we're not going anywhere, or we can paddle out into the deep in search of, if not the perfect wave, at least some very good rides."

Bob and I tussled playfully over the check, vowed to meet soon in New York, and I drove my friend back to his hotel to rest up for tomorrow's wedding ... and the next wave!

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.