Poignancy will not be lost in this edition of the strategist.  I write to you this week from Bretton Woods in New Hampshire as I prepare to embark on a 200-mile relay race with 12 friends from all over the country.  We will begin at Mount Washington, and we will finish on the coast.  For 30 hours or so we will all be locked in vans, cheering on our teammates, reminiscing and debating the pressing issues of the day.  Inevitably the conversation will turn to the topic du jour, politics.  The tempers around the political issues of the day will manifest and ultimately lead to concession or divided silence.  Sound familiar?  I am devoting this week’s email to address a dangerous investment trend brewing:  The emotional degree of today’s political debate undermining the rational investment decision-making process.  Many who feel under-represented or un-represented by the ruling administration of the day have used their portfolios to express votes of "no confidence."  Selling stocks, buying bonds and raising cash most often represent the "no confidence" ballot, and yet, as I will argue, this strategy actually expresses the utmost confidence in today’s political characters.  While the financial panic of last year led to a series of emotional responses, I am finding the political panic of this year contains even more hyperbole.  I will do my best to examine the root causes of this hysteria, peer forward to prognosticate most likely outcomes, and detail how we will position our portfolios accordingly.

Twitter Me This

In graduate school, one of my finance professors gave me a "C" on a research report I had written on a telecommunications company.  My spreadsheets were flawless, my investment thesis was sound and my target price for the security ended up being right on the money.  The flaw? My headline was boring.  She told me that ultimately my reports would compete against an infinite number of Wall Street research reports and that the differentiator would not be the quality of my analysis but the seductivity of my title.  How prescient.  Today’s technological prom queen, Twitter, requires users to limit entries to headlines only (140 characters max).  With newspapers terminal, content has become so passé.    Journalism has become editorialism and incendiary emails spread like viruses.  (I recognize that by default my observations and opinions populate your inbox weekly, making me party to the mania, but my highest objective would be to be your chosen filter).

Want to be recognized?  Say the most combustible thing you can think of.  How much type became devoted to the MTV Video Awards spat between Kanye West and Taylor Swift this past week?  Enough so that the President of the United States tied off the event by labeling Kanye West a "jackass" (full accord with the Pres on that call).  What bothers me most is that I know about this tiff, the President knows about this tiff, and it’s because technology attacks us through various channels, piercing our intelligence, violating our intellectual domains and injecting us with toxins.  Technology has become obnoxious.  The stimulative properties of today’s technology mixed with the limited time in our schedules for further inquiry leave us more susceptible to emotional baiting than ever before.  So at a point in time when the nation has chosen to debate and re-evaluate major social institutions, ubiquitous technology and editorialists have sensationalized even the most benign variables.  Investors must protect themselves from the resultant emotional acceleration.  Decisions made at the height of emotional energy are seldom the correct ones.  So we must recognize that political anxiety transitions poorly into investment strategy.  However, policy decisions do influence investment returns.  The key is to sift through the rhetoric and identify the macro-policies within.  Once these macro-policies have been distilled, the strategies become clear.  In many cases I may not personally like what the government is doing, but I know precisely how to make money on it.

The Government Playbook

1.  
   1. Grow the Economy – In the 1930’s the monetary and fiscal stimulus measures deployed by the US government amounted to 8.3% of GDP.  To combat the most recent recession, the government has allocated nearly 30% of GDP.  Recovery has begun and corporate earnings growth will follow.  This is a certainty.
   2. Swap Private Debts for Public Debts – To mitigate the trauma of a marketplace resolution to the unsustainable debt levels in the private sector, the government has chosen to simply absorb the excess debt levels on to its balance sheet.  Debt levels have not been reduced by these actions; they have merely been shifted from individual institutions to the collective taxpayer.  This has bloated the deficit to a projected $9 trillion over the next decade.
   3. Entitlement Reform - Over the next 10 years the government projects spending of $43 trillion.  Of this amount, social security, defense and net interest payments account for 48% of the outlays.  Non-defense discretionary spending accounts for 15%, and 13% of remainder spending services diminishing programs like TARP.  Medicare and Medicaid not only make up the largest component (24%) but also the fastest growing at 7% annually.  Clearly the most meaningful reductions in government spending come through health care reform, hence the current debate.  Whether appeasing all of the constituents necessary to acquire the votes for passage leads to cost savings is another matter.  The truth remains, either systematic cost has to be reduced, or benefits must be reduced.
   4. Restructure GDP - The US and China have engaged in a codependent economic relationship for years.  By pegging the Chinese yuan to the US dollar at a low level, China boosted its manufacturing and export sector while the US boosted its consumer sector.  The excess cash China accumulated simply became re-invested in US debt, keeping interest rates low.  The combination of low interest rates and cheap imports…you know the rest.  The new reality is that the US needs to reduce the consumption portion of GDP while China increases the consumption portion of their GDP.  The US needs to increase its manufacturing and export components while China reduces their reliance on manufacturing and exporting.  The easiest way to look more like China is to act more like China.  If the undervalued yuan stimulated exports and manufacturing while suppressing consumer spending, why wouldn’t an undervalued US dollar do the same?  A weak dollar is the economic agent to restructure our economy.  Furthermore, the only way to get China to appreciate the yuan is to force inflation upon them.  By pegging to our currency, they adopt our loose monetary policy, which simply adds accelerant to an already speedy economy.
   5. Social Re-organization - Points 1-4 translate directly into portfolio strategy, as I will exhibit in the next section.  Debates around the restructuring of the healthcare, financial services and energy industries are nothing more than that at the moment.  Furthermore, any re-organization of these enormous sectors of our economy will take years to accomplish. And, as Americans, if we are not happy with our chosen path, we simply vote in new pathfinders.  To me, these incendiary topics have "potential" labels on them while 1-4 have "essential" labels on them.  The investment implications of these re-organizations shift hourly as the debates migrate.  Trying to align your portfolio with the legislative process is like sailing a rudderless boat.  Who knows where you will end up, and you will likely get seasick.    

W&A’s Playbook

1.  
   1. Capture Market Upside - The amount of fiscal and monetary stimulus administered globally ensures economic recovery.  Our outlook for stocks and corporate bonds has been and remains positive.  Furthermore, as risk appetites improve, riskier market segments tend to outperform.  Our exposure to small cap stocks and emerging markets demonstrates this thesis. 
   2. Avoid Government Debt - To finance the government’s strategy of absorbing private sector debt balances, the Treasury must issue substantial quantities of bonds.  While the global appetite for US debt remains robust, a successful restructuring of the global economy will potentially diminish demand.  Greater supply and lower demand leads to lower prices and higher yields for government paper.  Municipal paper adds significant tax advantages to Treasuries but yields tend to correlate.  Any municipal or federal paper should be held in short maturity.  The government has four methods to reduce debt balances over time.  First, they can increase taxes.  Second, they can reduce expenditures.  Third, they can rely on robust economic growth to increase tax receipts.  Fourth, they can simply inflate the obligations away.  Obviously, inflating away our debt would irritate our creditors and would be the worst singular solution.  However, blaming inflation on "necessary" stimulus measures might offer some political cover, and the threat of inflation needs to be accounted for in portfolios.  Inflation is cancerous to bond portfolios and therefore necessitates cautious construction of any fixed income allocation.  Managing bonds during rising rate regimes requires vigilance.
   3. Align Portfolios with Global Restructuring - Although the US represents 20% of global GDP, it will account for only 5% of its growth rate in 2010.  Brazil, Russia, India and China will account for 70% of global growth.  The development and strength of these economies will dictate industry growth patterns.  For example, the highly successful Chinese stimulus package led to sizable commodity purchases, increasing values across fuels and metals, benefiting US materials and energy names and jumpstarting the US stock market.  Our portfolio benefited from having direct exposure to the buyers and to the sellers.  Moving forward, the increase in emerging market consumption could be substantial, by some estimates perhaps even greater than US consumption by 2011.  This means terrific opportunities for US exporters and emerging market retailers and financial services firms.  The weaker US dollar will also contribute to these developments, and provide greater dollar adjusted returns for our international holdings!
   4. Respect the US - While we have steadily been reducing our exposure to the US over the last year, the flexibility of the US should not be underestimated.  If the government’s initiatives on entitlement reform reduced our long-term obligations, the US dollar would soar; further attracting global investors (see 1995-2000).   While the US may produce relative underperformance in global advances, it produces relative out-performance in global retractions.  Remember that in 2008, the US dollar advanced, and the stock markets held up much better than those of our more fleet-footed friends.  US policy debate may be heated, but that process defines democracy, the most proven economic governance system ever.  While W&A’s long-term investment strategy revolves around the developing world, so do the strategies of many US CEOs.  Recall that through the first eight months of 2009, General Motors has increased car sales in China by 50% over last year.  US headquartered corporations will provide their investors with global earnings power, and our portfolios will benefit.

Back to the Poignancy

As I stated, the race from Bretton Woods that will be underway as you read this proves poetic.  In 1944, representatives from 44 allied nations gathered at the Mount Washington Hotel in Bretton Woods to establish the US dollar as the world’s reserve currency.  Now, 65 years later, in the aftermath of 2008’s financial crisis, confidence in US fiscal sovereignty has eroded significantly.  With the dollar’s relative valuation extending its declines to ever lower levels, it may seem that the world is running away from Bretton Woods.  Add to this ego blow the cacophony of political discourse and the inflammation of today’s invasive technologies, and this can be a very unsettling time for Americans.  It seems as though our governing principles, values and institutions are all being interrogated at the same time. 

Many I talk to simply cannot bear the confusion and have chosen to increase levels of cash and bonds.  Ironically, if the US truly is in a state of decline, the worst place to hide is in cash and bonds, which will suffer significantly with a weakened currency and higher inflation.  If you find yourself troubled by the path being drawn by the leaders of the US, consider the path being drawn by the leaders of the planet.  At no other point in history have so many global inhabitants been exposed to the benefits of democracy and capitalism.  Truth be told, "Americanism" is not in decline, it’s spreading like wildfire.  Our share of the global economic pie may shrink, but the overall growth of the pie benefits us much more than a larger chunk of a smaller pie.  The S&P 500 hasn’t climbed back above 1050 because US policies have ignited growth, but through the collaborative policy efforts of our global partners.  While this shift in leadership may feel awkward to us, distributed responsibility makes for a more balanced and resilient global economic regime. 

As I leave Bretton Woods, I can’t help but admire the remarkable work that was done here to construct a post WWII global economic order and the position of US economic strength at its center.  Alas, 65 years have passed and the economic prosperity of the globe has improved immensely, poverty has declined and peaceful interrelationships abound.  Mission accomplished!  It is also not lost on me that finishing the 200 mile race we are embarking on requires the effort of twelve of us and could not be accomplished by any one of us alone.  The current G20 will meet next week in Pittsburgh to discuss various measures, but it is clear that ex-US contributions and global coordination continue to increase.  While many may claim that these are the worst of times, I assure you they are not.  Do not confuse the sensationalized relative decline of America with the very real global rise of Americanism.  We have not ended an age of prosperity, we have simply entered a new one…and there is money to be made in this age too! 

Remember:  Performance is not an outcome, it's a discipline.