The Guest Blog

Farr: What's Really Driving Your Investment Strategy?

Stock Chart and Dice

How is everyone out there feeling these days about the economy?

Judging by the 45% rise in the S&P 500 off the March 9th low, it would seem that investors feel pretty good. But while the "green shoot" mentality has certainly taken root in the stock market, the consumer remains in precarious condition. The unemployment rate is now 9.5% and is expected to reach over 10% by year end; housing price declines continue in much of the nation as banks resume foreclosures; and banks are restricting access to credit for all but the most qualified applicants.

Why is this important? Because consumer spending still accounts for over 70% of domestic GDP. Inventory replenishments and short-term booms in government spending and/or exports can certainly have a dramatically positive impact on GDP growth in any given quarter, but sustained domestic economic growth can only be achieved through a healthy consumer who is willing and able to spend. It seems that neither the willingness nor the ability are forthcoming.

After a long period of relying on housing appreciation as a nest egg, consumers have finally been spooked into saving nearly 7% of disposable income (for the month of May, 2009) from close to zero percent over the past few years. The increase in saving is the result of the loss of $15 trillion in net worth through a combination of housing and stock market declines. While it is tempting to say that the increase in savings is a temporary phenomenon, we believe it represents a much more permanent shift in consumer behavior. Baby boomers are ill-prepared for retirement, and the loss in wealth sustained over the past couple of years is unlikely to return any time soon. Therefore, a permanent shift in consumer savings rates is likely to be a major drag on the economy for a prolonged period of time. However, it should be noted that although a higher savings rate would undoubtedly subtract from economic growth over the next few years, we view this shift towards higher savings as absolutely imperative for longer term economic growth and stability, and it should ultimately lay the foundation for the next bull market.

Notwithstanding the negative economic effects of a higher savings rate, the recent rise in stocks helped spark a rebound in consumer confidence off the February low of 25.3 to a yearly high of 54.8 in May. Over the past two months, however, the index has pulled back to 46.6 in July. Digging into the numbers, there were sharp drops in both the "present situation" and "expectations" components of the index over the past two months. These declines undoubtedly reflect the employment situation. The percentage of people surveyed in July describing employment as "hard to get" increased to 48.1% from 43.9% in May. Given the anxiety level over job prospects and a shortage of retirement savings, it does not appear as though the consumer's willingness to spend will rebound any time soon.

As for the ability to spend, the banks hold the key.

An article in the Wall Street Journal on Monday described a disturbing trend amont the big banks. According to the article, "The total amount of loans held by 15 large U.S. banks shrank by 2.8% in the second quarter, and more than half of the loan volume in April and May came from refinancing mortgages and renewing credit to businesses, not new loans." The actual decline in credit extension is likely much greater as the securitization market remains essentially closed. The article goes on to say, "The numbers underscore two related trends weighing on the economy. Financial institutions are clamping down on lending to conserve capital as a cushion against mounting loan losses. And loan demand is falling as companies shelve expansion plans and consumers trim spending to ride out the recession." The bottom line is that banks are lending to only the most credit-worthy borrowers, which is likely to continue to constain consumer spending for many quarters to come.

So this might be a good time to ask yourself a few questions. The answers to these questions may provide useful insight that can be applied to your investment decisions:

  • Would you describe your spending habits as more or less cautious than a year ago?
  • Are you saving an amount you believe will be required to maintain your lifestyle at retirement?
  • Is any shift you have made in your savings a permanent shift or are you likely to save less in the event of an economic recovery?
  • Do you feel you have access to the credit you will need over the next 2-3 years?
  • Do you feel like your job is secure even in the event of a protracted recession?
  • How have your job-related compensation expectations changed over the past year?
  • How do you feel about upgrading to a larger house and taking on a bigger mortgage? Are you planning any other major purchases like a new car?
  • Have your expectations regarding investment returns changed in the wake of the market decline?
  • How do you feel about committing new dollars to stocks now?

Now that you have contemplated these questions for yourself, put yourself in the shoes of Joe and Jane Sixpack. Do you feel like your situation is reflective of the challenges facing Middle America? If not, do you feel your investment decisions are being driven by a perspective that goes beyond your own personal circumstances?

We suggest you use these queries as food for thought. Emotion is the foe of the long-term investor. Patience, clear perspective, and listening to your own truth are vital to your success no matter if you are out of step with the herd.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C.  Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.