"Income Consuming Assets - Is it Time for a Change?"
Sydney M. Williams
Today’s world-wide market weakness reflects the decision by S&P to reduce Italy’s outlook to negative and a reaction to the Spanish elections, in which the ruling Socialist Party suffered their worst defeat in thirty years. However, looking at markets through a wider scope, commodities and Treasuries have done well over the past decade with the yield on the 10-Year falling from 6.6% at the start of the decade to 3.15% today. So, is it time to switch the emphasis from income consuming assets (commodities, antiques, art, and collectibles) to stocks, an income producing asset? The question is perhaps too simplistic, as there are enormous differences, not just between but within asset classes. Nevertheless, it is worth considering.
The point about income consuming assets, as Warren Buffett has noted, is that the only way an owner makes money is when somebody proves willing to pay more than you paid – a dependency on what is sometimes called the “Greater Fool.” A painting hanging on the wall takes up space. A diamond bracelet or a gold coin spends most of its life in a safe. A rare book is squeezed between two others. Oil, like a good meal, is consumed and then is gone forever. In contrast, an income producing asset provides dividends or interest and the prospect of growing earnings and expanding its book value. With that opportunity comes risk. Management may commit fraud or, through incompetence, shrink the company’s earnings. There is also the risk that one pays too much for the business, and there are exogenous risks over which one has no control. Commodities are also subject to exogenic factors and the risk of price. Have you, the buyer, become the greater fool? It is difficult to determine how much of the price of a commodity reflects underlying demand and how much represents speculation.
Two factors fueled the boom in commodities over the past ten years. One was the growth of the emerging world, a development that should persist, albeit with periodic and temporary setbacks. The second was a function of the Federal Reserve. In the wake of the stock market collapse in 2000-2001, the Fed began reducing the Fed Funds rate from 6.5% at the end of 2000 to 3.5% by the end of August 2001. In the wake of 9/11 and the mild, stock market-slump induced recession in 2001, the Fed overreacted and continued lowering Fed Funds until they reached one percent in June 2003. They remained at that level until the following June, in spite of the fact the recession had ended three years earlier, and the stock market bottomed in October 2002. By June of 2006, rates were back to 5.25%, but the damage (in terms of housing) had been done. The low cost of money encouraged households to take on enormous amounts of leverage. Wall Street and mortgage brokers were willing to oblige.
The Fed was slow to dampen the speculative fervor that coursed through the economy in the mid 2000s and they were slow in responding to the credit crisis in mid 2007. While the Discount rate was lowered in a special meeting in August of that year, it was September before the Fed lowered the Funds rate twenty-five basis points to 4.75%. And it wasn’t until December 2008 (after the worst of the credit crisis was behind us) that the rate was lowered to today’s level of 0.25%. The minutes from the most recent meeting suggest that they are conscious of the possibility of rising inflation, but those minutes also imply they are in no rush to change direction. To assume the Fed will get it right this time is to bet against history.
In the late 1990s, as the last century was coming to a close, the price of oil was $17.00 per barrel, gold was selling at $279.00 an ounce and the S&P 500 closed the year 1999 at 1469.25. Now, more than eleven years later, gold has risen 5.4 times, oil 5.7 times and the S&P 500 is 10.9% lower. The decade of the 2000s was the mirror image of the 1990s.
The end of the 1990s culminated with a spectacular, speculative demand for internet-tech stocks. The NASDAQ 100 had risen more than sixteen fold in the previous ten years to 4816.35; its high-water mark, reached in March 2000, was 10.5% above where it is today! During the 1990s, the S&P 500 rose from 366 to 1525, an increase of more than fourfold. By the time the party came to an end, the multiple on the S&P 500 was thirty-five times peak earnings. During that decade (the 1990s), gold fell from $391.00 to $279.00, while oil fell from $27.00 to $17.00. Both commodities had fallen in price during the 1980s – gold from $800.00 to $379.00 and oil from $35.00 to $27.00.
The rate of inflation has been moderating for forty years and bonds, for three decades, have risen in consequence. During the 1970s, the CPI rose 112%; its rate of increase declined to 59% in the 1980s, then 32% in the 1990s and 27% in the 2000s. One of the many conundrums facing investors is: will this trend continue, or have we reached an inflection point? The fact that leverage has swung from corporations and consumers to government suggests that the risk of a depreciating dollar (and a concomitant rise in inflation) has increased. We should never forget that government controls the printing presses. Why would government pay the Chinese (or the Federal Reserve, for that matter) expensive dollars when it can repay in depreciated dollars?
The last four decades have been extraordinary. The next one will have its own characteristics. Commodities dominated the 1970s; bonds and stocks the ‘80s and ‘90s. Commodities roared back in the 2000s. Is it time for stocks again? No one knows for sure. The great bull market that began in 1982 and ended in 2000 was driven by a combination of factors, none of which exist today: single digit multiples of earnings at the start of the rally; declining interest rates and inflation; long years of tax reductions, and a business-friendly regulatory environment. Today, earnings multiples are double what they were in 1982, interest rates and inflation are more likely to rise than not, the regulatory environment is getting tougher, not easier, and taxes are certain to be raised should Mr. Obama win re-election, which, given Republican disarray, seems probable.
However, money must flow somewhere. Decisions, unfortunately, must be made without the benefit of hindsight. Nevertheless, expectations, in my opinion, should be for modest returns. Cash, even with no return, is a valid option, as it provides the chance to take advantage of inevitable and unpredictable opportunities.
The forty-year compounded return price return to the S&P 500 has been 6.8%, roughly the very long term average. Gold, from its frozen position of $35 an ounce prior to the summer of 1972, has risen at a compounded annual rate of 10% and as we know, it cannot be drunk or eaten and does not generate income. The prospect that a 3.2% return on a Ten-Year Treasury will offset inflation seems dubious. So, if asked today to make the choice between owning $1 million worth of gold, $1 million worth of Treasury Bonds, or $1 million of a portfolio of stocks selling less than ten times earnings, with a history of improved earnings and with nominal yields, I would answer, stocks. Keep in mind, though, the environment is very different than it was in 1982.
Thought of the Day
“Income Consuming Assets – Is it Time for a Change?”
May 23, 2011Today’s world-wide market weakness reflects the decision by S&P to reduce Italy’s outlook to negative and a reaction to the Spanish elections, in which the ruling Socialist Party suffered their worst defeat in thirty years. However, looking at markets through a wider scope, commodities and Treasuries have done well over the past decade with the yield on the 10-Year falling from 6.6% at the start of the decade to 3.15% today. So, is it time to switch the emphasis from income consuming assets (commodities, antiques, art, and collectibles) to stocks, an income producing asset? The question is perhaps too simplistic, as there are enormous differences, not just between but within asset classes. Nevertheless, it is worth considering.
The point about income consuming assets, as Warren Buffett has noted, is that the only way an owner makes money is when somebody proves willing to pay more than you paid – a dependency on what is sometimes called the “Greater Fool.” A painting hanging on the wall takes up space. A diamond bracelet or a gold coin spends most of its life in a safe. A rare book is squeezed between two others. Oil, like a good meal, is consumed and then is gone forever. In contrast, an income producing asset provides dividends or interest and the prospect of growing earnings and expanding its book value. With that opportunity comes risk. Management may commit fraud or, through incompetence, shrink the company’s earnings. There is also the risk that one pays too much for the business, and there are exogenous risks over which one has no control. Commodities are also subject to exogenic factors and the risk of price. Have you, the buyer, become the greater fool? It is difficult to determine how much of the price of a commodity reflects underlying demand and how much represents speculation.
Two factors fueled the boom in commodities over the past ten years. One was the growth of the emerging world, a development that should persist, albeit with periodic and temporary setbacks. The second was a function of the Federal Reserve. In the wake of the stock market collapse in 2000-2001, the Fed began reducing the Fed Funds rate from 6.5% at the end of 2000 to 3.5% by the end of August 2001. In the wake of 9/11 and the mild, stock market-slump induced recession in 2001, the Fed overreacted and continued lowering Fed Funds until they reached one percent in June 2003. They remained at that level until the following June, in spite of the fact the recession had ended three years earlier, and the stock market bottomed in October 2002. By June of 2006, rates were back to 5.25%, but the damage (in terms of housing) had been done. The low cost of money encouraged households to take on enormous amounts of leverage. Wall Street and mortgage brokers were willing to oblige.
The Fed was slow to dampen the speculative fervor that coursed through the economy in the mid 2000s and they were slow in responding to the credit crisis in mid 2007. While the Discount rate was lowered in a special meeting in August of that year, it was September before the Fed lowered the Funds rate twenty-five basis points to 4.75%. And it wasn’t until December 2008 (after the worst of the credit crisis was behind us) that the rate was lowered to today’s level of 0.25%. The minutes from the most recent meeting suggest that they are conscious of the possibility of rising inflation, but those minutes also imply they are in no rush to change direction. To assume the Fed will get it right this time is to bet against history.
In the late 1990s, as the last century was coming to a close, the price of oil was $17.00 per barrel, gold was selling at $279.00 an ounce and the S&P 500 closed the year 1999 at 1469.25. Now, more than eleven years later, gold has risen 5.4 times, oil 5.7 times and the S&P 500 is 10.9% lower. The decade of the 2000s was the mirror image of the 1990s.
The end of the 1990s culminated with a spectacular, speculative demand for internet-tech stocks. The NASDAQ 100 had risen more than sixteen fold in the previous ten years to 4816.35; its high-water mark, reached in March 2000, was 10.5% above where it is today! During the 1990s, the S&P 500 rose from 366 to 1525, an increase of more than fourfold. By the time the party came to an end, the multiple on the S&P 500 was thirty-five times peak earnings. During that decade (the 1990s), gold fell from $391.00 to $279.00, while oil fell from $27.00 to $17.00. Both commodities had fallen in price during the 1980s – gold from $800.00 to $379.00 and oil from $35.00 to $27.00.
The rate of inflation has been moderating for forty years and bonds, for three decades, have risen in consequence. During the 1970s, the CPI rose 112%; its rate of increase declined to 59% in the 1980s, then 32% in the 1990s and 27% in the 2000s. One of the many conundrums facing investors is: will this trend continue, or have we reached an inflection point? The fact that leverage has swung from corporations and consumers to government suggests that the risk of a depreciating dollar (and a concomitant rise in inflation) has increased. We should never forget that government controls the printing presses. Why would government pay the Chinese (or the Federal Reserve, for that matter) expensive dollars when it can repay in depreciated dollars?
The last four decades have been extraordinary. The next one will have its own characteristics. Commodities dominated the 1970s; bonds and stocks the ‘80s and ‘90s. Commodities roared back in the 2000s. Is it time for stocks again? No one knows for sure. The great bull market that began in 1982 and ended in 2000 was driven by a combination of factors, none of which exist today: single digit multiples of earnings at the start of the rally; declining interest rates and inflation; long years of tax reductions, and a business-friendly regulatory environment. Today, earnings multiples are double what they were in 1982, interest rates and inflation are more likely to rise than not, the regulatory environment is getting tougher, not easier, and taxes are certain to be raised should Mr. Obama win re-election, which, given Republican disarray, seems probable.
However, money must flow somewhere. Decisions, unfortunately, must be made without the benefit of hindsight. Nevertheless, expectations, in my opinion, should be for modest returns. Cash, even with no return, is a valid option, as it provides the chance to take advantage of inevitable and unpredictable opportunities.
The forty-year compounded return price return to the S&P 500 has been 6.8%, roughly the very long term average. Gold, from its frozen position of $35 an ounce prior to the summer of 1972, has risen at a compounded annual rate of 10% and as we know, it cannot be drunk or eaten and does not generate income. The prospect that a 3.2% return on a Ten-Year Treasury will offset inflation seems dubious. So, if asked today to make the choice between owning $1 million worth of gold, $1 million worth of Treasury Bonds, or $1 million of a portfolio of stocks selling less than ten times earnings, with a history of improved earnings and with nominal yields, I would answer, stocks. Keep in mind, though, the environment is very different than it was in 1982.
Labels: TOTD
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