The second quarter saw a continuation of the late March recovery of the equity indexes. Equities had reached irrational lows in early March, and have recovered back to fair value. Continued economic worries have kept equities from trading up much beyond fair value, which is what we would expect in a normal world.

Our overweight positions in high-yield corporate and municipal bonds resulted in solid gains in the quarter. We entered those positions in Q4 2008 and Q1 2009 under the premise that the sectors we being over-sold due to overblown default risks. We continue to believe that defaults will not run nearly as high as the asset class price would indicate. Despite their very real troubles, municipal and state governments will eventually get their houses in order, like they always have.

The interest rate environment continues to experience overall downward pressure. We are not making bets on rates going lower. If they do, fine, we’ll profit from it. We are more concerned with a steepening of rates, and we are keeping bond maturities short.

Property markets continue to experience pressure, with commercial troubles appearing to accelerate. Inflationary pressures appear to continue to be tame, and the rise in the unemployment rate to 9.5% indicates that an economic recovery is not currently underway. If one examines the employment data carefully enough, it can be argued that the true unemployment rate is closer to 15% than 9.5%. About 1 in 6 Americans is out of work or is working part-time when full-time is desired. Those are big, serious numbers that will take time to reverse.

We continue with our cautious outlook for the broader economy.

Derailing the GDP Train

The gross domestic product of the American economy is defined as the sum total of the market value of all final goods and services produced by domestic workers and entities, within our borders. If the prices of the goods and services are going up simply due to inflation, GDP hasn’t really grown. For most purposes, we care about the amount by which GDP is growing faster than inflation. We will call the after-inflation GDP the “real” GDP, or rGDP. rGDP is the top-line measure of how the economy is doing. If it’s going up, we’re doing well. If it’s not, we’re not doing so well. In the fullness of time, we actually need rGDP to go up at least as fast as the population is rising. If population and rGDP both go up by 1%, we are not, on average, any better off since the we haven’t produced more per capita.

In order to have a rising tide of rGDP that lifts all boats – raising standards of living – we need rGDP to grow faster than the population. Note here that rGDP is not a direct measure of standard of living or even of per-capita income. From 1990 to 2006, real earnings of individual workers rose at less than 0.5% per year, while rGDP rose at a 3.6% clip.

While rising rGDP doesn’t guarantee a rising standard of living, a declining rGDP almost surely indicates a falling one. Now that we’re comfortably into a recession (that we anticipated, I might add), we at Creekside are again turning our eyes to the future. I’ve written in recent months about the extreme long-term stability of rGDP. Even the Great Depression did not
derail rGDP from its relentless return to thestraight line of upward growth – never too fast, never too slow. I’ve intentionally left the dates off the above chart. While you can pick out the Great Depression (and the recovery therefrom), you really can’t pick out with any ease other events that we consider monumental economic events. The first oil embargo? The high post-Korean War inflation? The 21% prime rate of 1981? 80% top marginal tax rates? Tax cuts?

Events that, at the time, were met with hand-wringing and end-of-the-world-as-we-know-it speeches are eventually swamped over and blotted out and disappear from the charts. I must admit that I’m fairly sanguine about whether or not this or that government policy is going to be good or bad for the economy.

This rGDP chart reminds me that, in due time, the river of economic productivity will smooth out the sandy interventions of hapless picnickers on the shoreline.

You can’t slow that river down, and you can’t speed it up. With that relentless current in mind, we have been confident that investments in stocks will reward us with the modest real returns to which we have become accustomed. Absent irrational rises and falls in the price-to-earnings ratio (average = about 16-17; March 2000 peak = 40+), diversified portfolios of stocks produce the sum of two numbers:

• Dividends of around 2%, plus
• Real (inflation-adjusted) earnings per-share growth of about 1.5%

That’s about 3.5%, and that’s what a stock portfolio has historically returned if you buy it at an average P/E ratio and sell it at the same ratio sometime later. Again, you can hope that the P/E rises, but you should not expect it to. Imagine you are playing a game of 100 coin flips with your buddy. A dollar goes to you if it’s heads; a dollar to him if it’s tails. While you might hope to flip 60 heads to his 40 tails (gaining $20), you really can only rationally expect a 50/50 spit. Expecting to flip 60 heads is directly akin to expecting the P/E of the stock market to expand indefinitely. Welcome it if it happens, but don’t count on it since there is no inherent reason for it to rise from normal levels.

However, that 3.5% expectation is grounded in the confidence that corporate earnings will grow at a rate similar to the entire economy – the rGDP. What might derail rGDP? I’ve already noted that I really don’t think temporal matters such as interest rates, tax policies or even inflation levels can derail rGDP growth. To get at this question, we need to break rGDP growth down into its two ultimate pieces: population and productivity growth.

rGDP growth is composed of the growth in the workforce, and growth in the output per worker, or productivity. With workforce growth pretty much ordained by birthrates that took place 20-odd years ago (and by immigration rates), we focus our analysis onproductivity trends.

Ultimately, rGDP per-capita can only grow if each worker uses and deploys the collective capital stock and accumulated know-how to produce more goods and services each year. Productivity growth is the singular engine for rising standards of living and job creation. What, then, might derail productivity growth?

Productivity growth, and standards of living, can be plotted alongside a chart showing energy use per-capita throughout history. It’s a near-perfect fit. The story of the rise in human standards of living – productivity growth – is the harnessing of ever-larger amounts of energy of all sorts.

Everything around you is the product of only three things: Basic raw material, to which is applied human ingenuity and energy. Energy is measured in the scientific unit joules. Importantly, work is also measured in joules, highlighting a point relevant to economics – energy is work. GDP is the sum total of goods and services produced – by workers doing work. The notion that we will evolve to a “knowledge-based” economy where we all sit around and think, rather than do work, is nonsense. Thinking and inventing is only of economic value if it can increase the amount of work that each human can perform, direct or manage. Does the new invention or process increase the energy leverage of a worker? If not, it will not add to increased productivity.

We have at once two outlooks for the economy: On one side, we have Bill Gross of PIMCO representing the bearish outlook, with his “Seven Lean Years” outlook. On the other we have the perhaps more popular view that a recovery will begin in earnest over the next year or two. We don’t take sides in this debate – we are always hesitant to get into forecasting. So, we peer down both forks in the road.

If Gross is right, and we are in for a rather drawn-out period of slow growth, then stocks don’t do so well. We might rather be in bonds and other income instruments. If others are right, and the recovery gets rolling sooner rather than later, then profits and employment and all sorts of economic activity will pick up. That is good for stocks at the beginning of such a cycle, but we worry about whether those good times can or will sustain for very long. The recent explosive expansion of the money supply could result in the wage-price pressures that typically accompany expansions. Interest rates would almost certainly rise and the economy remains exquisitely sensitive to interest rates.

More worrisome is the price of energy – namely, oil. If oil has only fallen to $50-$60 in the face of the sharpest downturn since 1931, what is its price likely to look like in the face of a global recovery – particularly when considered against chronically shrinking supplies? Just as $150 oil helped the economy come screeching to a halt in 2007-2008, I would expect a rapid return to those prices to do the same. A sharp increase in the cost of energy is likely to impose disruptions to our finely tuned three-ingredient recipe for production. We will need new recipes. Adaptations do not happen overnight, and productivity growth in the near-term could end up a casualty of a renewed global economic expansion.

We expect that the eventual recovery will not happen smoothly and relentlessly, but will rather lurch us forward and back like a teenager learning to drive a stick shift. Buckle up and don’t let the dashboard whack you in the head!

Rather than try to time each lurch forward and back as the world heads into its inevitable realization that the supply curve for oil is far more steeply sloped that people think, we will position our portfolios for a smoother ride. We will continue to underweight equities. We will be raising our commitments to oil and energy stocks by 10-15%, and we will keep our bond maturities short and the credit quality high.  Eventually, we will return to the income property asset class – just not quite yet.

Our key theme for recovery is not terribly different from our key theme heading into the recession. Risk assets are risky. Under either of the forks in the road described above, we anticipate that rGDP growth will average below trend for some time. Accordingly, we will continue to manage risk and seek safe returns where we see them.

Rick Ashburn