Debt Levels

U.S. government debt currently hovers around $13 trillion. Debt levels have experienced rapid increases since the onset of the global financial crisis.

Most countries have seen significant increases in government debt levels due to higher stimulus-related spending combined with falling tax receipts. While U.S. debt is quite high relative to many emerging economies, it’s actually inline with the larger developed markets. In fact, only Canada has a lower net-debt-to-GDP ratio than the U.S. within the G7 nations. But elevated debt levels require close scrutiny by all levels of government. On the bright side, viable options are available to improve the current situation. Through a combination of spending cuts and increased revenues, the U.S. can outline a plan to reduce deficits and rein in government debt.

The good thing about reining in costs in the world’s largest economy is there’s lots of fat available to trim. While there are many places to cut costs, key areas of focus will include reforming entitlement programs, such as Medicare and Social Security, and reversing recent increases in military spending. While the recent passage of healthcare reform came with a slew of reimbursement cuts for industry participants, many politicians argue more can be done to control the rising costs. It’s very likely the highly debated, nationalized, single-payer system will be revisited in the years to come, along with many other options for dealing with escalating healthcare costs. Military spending, meanwhile, is already in the crosshairs, according to Defense Secretary Robert Gates. In a recent speech, he said the Pentagon must hold down its spending and make choices that will anger powerful people in an era of economic strain.

With a $535 billion budget expected for 2010, the Department of Defense base budget equals the entire national debt of Canada. Items contributing to a swelling military budget include a top-heavy uniformed and civilian management force, big-ticket weapons systems and increasing healthcare costs — not to mention the wars in Iraq and Afghanistan. As polls show rising public opposition to both wars and as President Obama strives to fulfill campaign pledges, we should see a continued decline in military spending. Aside from spending cuts, the other side of solving the debt problem will come from higher revenues. Among the debated items are higher estate taxes, higher marginal income-tax rates and even the possibility of a value-added tax.

Many options are available for tackling the U.S. debt; they just require the political will to proceed. With this in mind, President Obama created the bipartisan National Commission on Fiscal Responsibility and Reform earlier this year. Its main objective: reining in soaring federal debt. The panel’s recommendations, due out later this year,should provide more clarity towards solving the problem.

Weak Consumer

Another commonly used argument against U.S. equities follows quite logically. The consumer is 70% of the U.S. economy and the consumer is weak; therefore, avoid U.S. equities. But this argument is deceptively simple and breaks down under closer scrutiny. The problem is, most people associate consumer spending with iPods, Ugg boots and fancy dinners. While personal consumption does make up 70% of U.S. GDP, 75% of that household spending is non-discretionary in nature. That would include items such as housing, healthcare, energy, groceries and other household staples.

Only 25% of personal consumption is discretionary spending, which equates to less than 20% of U.S. GDP. While discretionary spending is still important to the U.S. economy, it’s not nearly as relevant as the scary headlines might suggest.

Lower Expected Growth

Why invest in the U.S. and other developed markets when China, India and other emerging markets are expected to grow faster? If only it was that simple. The expectation of slower economic growth from the U.S. and Europe versus the emerging nations is not a new phenomenon. Developed markets have typically exhibited lower growth than emerging markets – it’s probably why they’re called developed markets to begin with.

More importantly, despite a long history of higher economic growth, emerging markets have underperformed developed markets over the long term. In fact, between 1975 and 2009, emerging markets provided an annualized return of 9.5% while developed markets provided an annualized return of 10.6%. That equates to more than 1% underperformance annually over 35 years.

The significance of this performance differential is even more surprising when we consider the major economic and financial events that transpired in these developed markets: Two lost decades of economic performance from Japan, a decade of flat equity market returns in the U.S. and most recently, a financial crisis across Europe.

Meanwhile, we saw China enter the World Trade Organization and quickly become an economic superpower, while India experienced robust growth in its middle class of 300 million citizens. Yet despite all this, emerging markets underperformed developed markets.

Research from three authors at London Business School sheds some light on these surprising performance figures. Looking at 83 countries over 110 years, Dimson et al found no evidence that investing in growth economies produced superior returns. Instead, they found stock markets incorporate predictions of future economic growth into current valuations, often leading to disappointments relative to expectations.

“Historically, the total return from buying stocks in the low-growth countries has equalled or exceeded the return from buying stocks in the high-growth economies,” the authors concluded. More important than long-term growth prospects, which are difficult to accurately predict and subject to a barrage of unexpected events, is valuation. On this measure, U.S. equities appear very attractive, trading at 12 times expected earnings.

Poor historical performance

U.S. equity performance has been awful for the last ten years, with the S&P 500 providing negative returns of 1.8% annually. While the average investor would likely shun U.S. equities based on this track record, a contrarian investor would view this favourably for the return prospects over the next decade. After all, the decade of poor performance is largely due to a starting date that begins in the year 2000, at the most lofty index levels of the technology bubble. In fact, for the ten-year period ending August 31, 2000, the S&P 500 returned a staggering 19.5% annually. We should have known – performance like this simply isn’t sustainable over the long term. What we’ve experienced in U.S. equities since then is a period of dramatically reduced earnings expectations, significant compression in valuation multiples and a normalization of returns.

Academics refer to this phenomenon as mean reversion – the tendency of a variable to converge towards its long-run average value over time. So, what goes up tends to come down, and vice versa.

Mean reversion occurs in nature and many economic indicators, including GDP growth, exchange rates, interest rates and not surprisingly, stock prices.

Let’s look at another example of mean reversion. Think back to the year 2000, when you were debating which investment funds to contribute to in your retirement account. Perhaps you glanced at the best and worst performers over the prior decade. Remember all the science & technology funds making the top performers list? It wasn’t too hard with the S&P 500 Information Technology Index annualizing 31.5% for the ten-year period ending August 31, 2000.

And certainly you noticed the awful performance of all those precious metals funds. It was tough to deliver positive returns with the S&P/TSX Gold Index down 4.2% annually over the same time period.

Fast-forward to the present day and have a look at this month’s best and worst performers over the most recent decade. The tables have certainly turned. If you’re looking for those high-flying technology funds, you’ll need to glance over to the worst-performers list. It’s very hard to deliver positive performance when the S&P 500 Information Technology Index declined 8.8% annually over the latest ten-year period ending August 31, 2010.

Meanwhile, many of the gold bugs who bailed out in 2000 aren’t pleased with their market timing. Over the same time period, the S&P/TSX Gold Index returned an average of 13.5% annually. Can you count how many times you see precious metals in the names of the top-performing funds?

The bottom line is, pay attention to the fine print in your investment prospectus. Past performance may not be indicative of future results and returns. As legendary investor Jeremy Siegel showed in his book Stocks for the Long Run, strong future returns have often followed poor historical results.

In reality, when forecasting returns, valuations matter much more than historical performance. And today, U.S. equities aren’t sitting at astronomical valuation multiples based on ridiculously optimistic forecasts. They trade at some of the lowest valuation multiples of the past 50 years.

Weak Currency

With the Canadian/U.S. dollar exchange rate of 1.066 at August 31, the greenback has declined 34% against the loonie since peaking at 1.614 in early 2002. The large decline of the U.S. dollar, combined with bouts of high volatility, added to the sense of frustration for any Canadian holding an unhedged U.S. equity position by further hampering investment returns.

The consensus view is the Canadian dollar will continue to appreciate versus the U.S. dollar, supported by a stronger Canadian economy, higher commodity prices and our nation’s fiscal prudence relative to the U.S.

While it’s tough to make a bull case for the U.S. dollar, it’s important to remember a big reason for its devaluation has been the weaker relative performance of its economy and stock markets over the last few years. Currencies, like economies and stock markets, move in cycles and experience periods of mean reversion. And this tendency over the long term is one of the reasons many institutional investors prefer not to hedge their currency exposure.

If you prefer not to be subjected to the day-to-day currency fluctuations, there are a wide variety of hedged investment options available. These strategies employ futures or another hedging vehicle to substantially reduce the currency volatility. Of course, the hedging doesn’t come free. Dan Hallett, an independent mutual fund analyst, estimates hedging costs can add up to 0.4 to 0.5 of a point to the cost of owning a mutual fund.

On the Brighter Side

While investing always entails some caution, it’s important to put your concerns in perspective and assess the significance of those risks. High U.S. debt levels are a relevant risk but solutions are available to address this concern. A weak consumer is also an issue but the risk is often overstated in the headlines. Lower economic growth would seem to imply lower equity market returns, but the historical research would argue otherwise.

A poor historical track record may actually be viewed as a positive for future prospects. And if you can’t handle those currency swings, there is a large and growing universe of hedged investment options available to you. And of course, let’s balance the risks with the positives and examine everything in the context of current valuations. U.S. equities offer the largest potential universe of investment options with over 5,000 stocks to choose from in just about any market niche you can imagine.

For Canadians, they provide prudent diversification away from banks and resources into sectors not well represented north of the border, such as health care, consumer discretionary and information technology. They offer access to the brightest entrepreneurs in the world who practice in one of the most supportive political and regulatory landscapes. The U.S. economy offers a pure-play on free market capitalism – “the best path to prosperity” as Larry Kudlow reminds us each evening on CNBC.

With equity valuations closer to 50-year lows, I’d say the risks are well discounted in current prices, while the many positives offer significant upside for the contrarian investor.