Weekly Commentary August 29nd, 2011

The Markets

Like wanderers in the desert, investors breathed a sigh of relief when an oasis appeared last week. After Federal Reserve Chairman Ben Bernanke’s speech, the Dow Jones Industrial Index posted its first weekly gain in more than a month, finishing at 11,284, an increase of more than 4 percent for the week. The Standard & Poor’s Index and Dow Jones Global ex US Indices also were up for the week. In addition, the Chicago Board of Exchange Volatility Index (VIX), which is known as the ‘fear index’ because it reflects the amount of volatility investors anticipate in the next 30 days, fell by more than 10 percent. According to The Wall Street Journal, the head of U.S. equities index trading at Barclays Capital said that after Mr. Bernanke's speech, some investors set up options positions that are designed to profit from improving stock market stability in the future.

While stock markets reflected optimism, economic indicators provided a mixed picture. According to Barron’s:

• The Commerce Department revised second quarter’s Gross Domestic Product growth number down slightly to 1.0 percent annualized from 1.3 percent.
• Inflation estimates remained relatively stable.
• The manufacturing sector showed strength as new orders for durable goods increased 4 percent during July.
• Sales of new and existing homes fell, and the Federal Housing Finance Agency’s purchase-only house price index showed that housing prices fell quarter-to-quarter.
• Despite debt-ceiling woes, a downgrade of U.S. credit, concerns about European debt, and a wildly volatile stock market, the Reuters/University of Michigan survey consumer showed that consumer sentiment improved slightly.
• Despite improved sentiment, the survey also found that consumers don’t expect things to get better any time soon.

While a week with positive market performance was welcome, the question remains: Has stability returned or is this just a shimmering illusion? Only time will tell.

America has had four national banks since the American Revolution. There has been a lot of talk recently about the roles of central banks in countries around the world, including the Federal Reserve (the Fed) in the United States. While the Fed may be the most frequently well-known, it is actually the fourth national bank in the U.S. The first was the Bank of the United States, which was created in 1791 to help consolidate debt from the Revolutionary War. Once the bank had successfully paid down the debt, Congress did not see any further need for a national bank, and voted not to renew the bank’s charter in 1811.

In the early 1800s, state banks were issuing their own currencies. As debts from the War of 1812 mounted, many suspended payments on their currencies. By 1816, public sentiment favored a national bank that would make state banks pay, and the second Bank of the United States was set up. President Jackson objected to the bank because he believed that powerful private institutions were susceptible to corruption and hard to control. The bank’s charter was allowed to expire in 1836.

In 1863, the need to finance the Civil War led to the creation of a national banking system. Banks with national charters issued currency that was printed by the government and backed by federal bonds. By 1865, state currencies disappeared and the United States had its first uniform national currency. The banking system was plagued by panics, however, experiencing at least one per decade after the Civil War. This caused Congress to reconsider the structure of the system and the Federal Reserve Act, which created the Federal Reserve, became law in 1913. Today, the national banking system includes:

• A Board of Governors, which sets reserve requirements for member banks and discount rates for district banks. It also reviews the budgets of district banks.
• 12 Federal Reserve district banks, which are private institutions established to serve the public interest. Originally, they issued money that could be redeemed in gold.
• The Federal Open Market Committee was established in 1933, when the gold standard ended, to ensure responsible monetary policy.
• The Federal Advisory Council includes a bank executive from each district. It advises the Board about the state of the industry and money supply.
• The Consumer Advisory Council looks out for the interests of consumers, communities, and the finance services industry. Members are appointed by the Board.
• Several thousand member banks, which may include your bank.

Weekly Focus – Think About It

A rising nation, spread over a wide and fruitful land, traversing all the seas with the rich productions of their industry, engaged in commerce with nations who feel power and forget right, advancing rapidly to destinies beyond the reach of mortal eye; when I contemplate these transcendent objects, and see the honor, the happiness, and the hopes of this beloved country committed to the issue and the auspices of this day, I shrink from the contemplation and humble myself before the magnitude of the undertaking. --Thomas Jefferson, First Inaugural Address

Weekly Commentary August 22nd, 2011

The Markets

The financial markets are currently filled with contradictions and that’s contributing to head-scratching and risk-aversion on the part of investors.

Consider these head-scratchers:

• Mortgage rates are at a 50-year low, yet the housing market is still severely depressed.
• Ten-year Treasury yields hit a record low last week even though the government just experienced a downgrade in its credit rating and it is running trillion-dollar annual deficits.
• Gold prices hit a record high last week even though gold pays no interest and the core inflation rate is running below 2 percent.
• The value of the dollar fell to a record low against the Japanese yen last week even though Japan has been mired in a slump for 20 years and “Japanese government debt is more than double the Euro Area average and more than double the US,” according to Jim O’Neill at Goldman Sachs.
Sources: Bloomberg, MarketWatch

The situations described above suggest there are “distortions” affecting the markets that may not be explained by traditional portfolio theory.

One distortion that has clearly impacted the markets is government policy and intervention. In just the past three years, we’ve seen the $700 billion Troubled Asset Relief Program (TARP), the $787 billion American Recovery and Reinvestment Act, the Federal Reserve’s zero interest rate policy, and the Fed’s QE1 and QE2 bond purchases. All these have generated numerous market side effects.

In addition, a major argument is unfolding between politicians who believe government intervention is necessary to prevent an even worse downturn and those who believe the free market should be left to fend for itself. Some politicians are even calling for the abolishment of the Federal Reserve.

A similar situation is playing out in Europe. For more than a year, European governments have scurried from one bailout strategy to the next in order to prevent a sovereign default.

All these distortions and philosophical debates are, not surprisingly, causing confusion in the financial markets. The result -- a stagnant economy and falling stock prices.

The denouement of these interventions and political squabbles is unknown. What we do know is we continue to do all we can to help ensure your goals and objectives are met.

DOES RISK GO UP OR DOWN as stock prices decline? The answer may surprise you.

Let’s start with a definition. For our purpose, we’ll define risk as the probability of losing money. With that shared definition, let’s look at the S&P 500 index. On October 9, 2007, it closed at an all-time record high of 1,565. On March 9, 2009, it closed at 676, which was a 12-year low, according to CNNMoney.

Now, was it riskier to own stocks when the S&P 500 was at its all-time high in 2007 or its 12-year low in 2009?

Hindsight tells you owning stocks at the all-time high was much riskier. Why? Because stock prices proceeded to fall by 57 percent over the next 17 months, while prices rose about 100 percent over the next two years from the 2009 low.

Money manager John Hussman framed it this way in a May 23 commentary, “As valuations become rich, risk increases, and as valuations become depressed, risk declines. At the same time, rich valuations imply weak long-term prospective returns, while depressed valuations imply strong long-term prospective returns.” In plain English, he’s essentially saying as stock prices go up, risk goes up, and as stock prices go down, risk goes down.

Warren Buffett was even more succinct. In an August 11 Fortune Magazine interview, he said, “The lower things go, the more I buy.”

It may go against human nature, but the lower prices go, the less risky they become and the more likely you are to experience strong long-term prospective returns, according to Hussman and Buffett.

For investors who are saving for retirement or simply trying to preserve their wealth, seeing lower stock prices is no fun. However, assuming you don’t need to sell today, what matters is what prices will be in the future when you do sell. And, with prices dropping now, it may be setting the market up for better returns down the road.

Weekly Focus – Think About It

“Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong.” --Ayn Rand

Weekly Commentary August 15th, 2011

The Markets

If there was ever a week for investors to be on vacation and “off the grid,” last week was it. By being unplugged, you would have missed the following wild ride:

·         Monday: The S&P 500 index plunges 6.7 percent partially in reaction to the U.S. losing its triple-A credit rating. By the end of the day, about 99 stocks out of every 100 close lower -- the biggest rout since May 13, 1940 when Germany was beginning its invasion of France, according to CNBC.

·         Tuesday: The index soars 4.7 percent as the Federal Reserve announces it will leave its benchmark interest rate at a record low for at least two more years.

·         Wednesday: The index tumbles 4.4 percent as concern about the health of the European banking sector and France’s triple-A credit rating sends investors to the exits.

·         Thursday: The index skyrockets 4.6 percent as calmer heads prevail and investors swoop in to buy perceived bargains.

·         Friday: The index closes higher in a relatively uneventful day.

·         For the week, the Dow Jones Industrial Average rose or fell at least 400 points on four consecutive days -- the first time that’s ever happened.

Sources: The Wall Street Journal, Bloomberg, CNBC

Yet, remarkably, after all the volatility, the S&P 500 index lost only 1.7 percent for the week.

As mentioned above, the U.S. lost its coveted triple-A credit rating from Standard & Poor’s on August 5. However, in the irony of all ironies, rather than seeing U.S. interest rates rise on this bad news, rates actually dropped dramatically. The interest rate on the benchmark 10-year Treasury dropped from 2.56 percent on August 5 to 2.24 percent last Friday, according to data from Yahoo! Finance. It turns out that the stock market volatility had some investors fleeing to the perceived “safety” of U.S. Treasuries.

But wait, there’s more. In another irony, the value of the much maligned U.S. dollar was virtually unchanged last week, according to MarketWatch. Despite the downgrade of our credit rating, people still felt our currency was worth holding relative to other currencies such as the euro.

While the major headlines were scary, some good news occurred last week, too. The Commerce Department said retail sales rose a solid 0.5 percent in July and first-time unemployment claims dropped below 400,000 in the week ended August 6. That was the lowest level for unemployment claims since early April, according to MarketWatch.

With markets dropping and volatility rising, some pundits are now comparing the current market environment to the 2008-2009 financial crisis period. And, while there are some similarities, The Wall Street Journal pointed out a glaring difference in its August 13 edition.

The panic in 2008 represented a crisis in markets. What's happening now seems to be a crisis in government. In 2008, the world's richest countries embarked on a series of unprecedented interventions to stop financial markets from seizing. Today, the tables are reversed: Financial markets have lost confidence in politicians' ability to master their problems. In 2008, countries united in response. This year has been marked by tensions and misunderstanding, including those between the U.S. and Europe over the continent's response to its debt crisis.

This “crisis in government” has led to a “crisis in confidence” in consumers. According to the Thomson Reuters/University of Michigan preliminary index of consumer sentiment, U.S. consumer confidence dropped in early August to the lowest level since Jimmy Carter was president in May 1980. This extremely low confidence level may be a headwind for the economy.  

At times like this, it is very important to maintain perspective. While the markets are swinging wildly, the S&P 500 index still closed last week more than 9 percent higher than a year earlier, as shown in the box below.

As investment managers and investors, we can’t let short-term gyrations derail us from our long-term objectives. 

Weekly Focus – Think About It

“Courage is fear holding on a minute longer.” --George S. Patton, U.S. Army General

Weekly Commentary August 8th, 2011

Brief Summary of This Week’s Extended Comments

• A last minute deal staves off a U.S. default.
• Standard & Poor’s downgrades U.S. credit rating from its long-held ‘AAA.’
• Dow Jones Industrial Average now in correction territory with a 10 percent decline from its April 29 high, however, declines in the Dow of 10 percent are normal and have happened, on average, about once per year between 1900 and 2010, according to American Funds.
• Contagion fears spread in Europe as Italy and Spain are drawn into the debt battle.
• Investors are nervous that the risk of another recession is rising; however, Warren Buffett said on August 6, “Financial markets create their own dynamics, but I don’t think we’re facing a double dip recession.”
• Took the developed world decades to build a mountain of debt, will take more than a couple years of deleveraging to get out of it.
• We remain focused on providing you with the stability and return you need to meet your long-term planning needs.

The Markets

The good news about last week is… it’s over.

We started the week with a highly partisan, last minute deal to stave off the U.S. defaulting on its debt obligations and we ended the week with the U.S. losing its long cherished ‘AAA’ credit rating from Standard & Poor’s. In between, the U.S. stock market, as measured by the Standard & Poor’s 500 index, tumbled 7.2 percent -- its largest one week decline since November 2008.

In light of these major events, we’d like to take a step back and review what happened last week and then do a deeper dive into how we got into this situation and what the possible end game may be.

Last Week

To knock the market down seven percent in one week, you need a series of catalysts and we had a few that came to a head last week including the following:

• Worries about a U.S. default that culminated in a bitter compromise.
• Continued and expanding sovereign debt problems in Europe that now include Italy and Spain -- the third and fourth largest euro-zone economies, coupled with ineffective policy responses from European leaders.
• Concerns about the heavy exposure of European banks to the sovereign debt of overleveraged countries.
• A series of weak economic reports that have investors concerned about a new global recession.
• Concern that the U.S. government, particularly the Federal Reserve, is about out of bullets when it comes to using monetary policy to jumpstart the economy.
• Growing public anger with a dysfunctional Washington that may prevent both parties from reaching consensus on decisions that could help the economy.

Sources: The Wall Street Journal, Barron’s, BusinessWeek

When you combine the above with human emotions that are still smarting from the 2008-2009 financial crisis, you create the potential for a bad week like we just had. Now, let’s take a deeper look at how we arrived at this point in our economy.

How Did We Get Into This Situation?

For decades to come, historians will debate the exact causes of the financial crisis that we experienced in 2008-2009 and the aftershocks we are feeling today. But, as Leonardo da Vinci said, “Simplicity is the ultimate sophistication.” Taking da Vinci at his word, we think you can boil the financial crisis down to one word -- debt.

Individuals and governments have been piling debt upon debt for years and the burden has finally become unbearable.

One could argue that the debt deluge began in 1966. That year, the first Baby Boomers turned 20 and Bank of America started to license its BankAmericard credit card (now known as VISA). It was a match made in heaven as Boomers loved to spend money and plastic made it easy.

In the mid-1980s, central banks got into the act as they began to pursue monetary policy which sought to, “avoid recessions at all costs,” according to The Economist. Their weapons of choice were low interest rates and a flood of cheap money.

Now, when you combine human’s desire to spend money with banks who are willing to lend and top it off with central banks eager to keep the economy greased, you have a recipe for a massive mountain of debt. And, that’s exactly what happened.

Here are a few of the mind-boggling debt figures that hang like a ball and chain around the U.S.:

• $  14,564,970,167,709 (Total public debt of the United States as of August 4, 2011)
• $  2,446,100,000,000 (Total U.S. consumer debt outstanding as of June, 2011)
• $  1,300,000,000,000 (2010 Federal Budget Deficit)

Sources: U.S. Treasury Department, Federal Reserve, BusinessWeek

Like politicians, Americans like to spend money. Between 1985 and 2007, American’s disposable income grew 5.9 percent per year, but household indebtedness grew 8.7 percent per year, according to The Wall Street Journal. In other words, we were spending money much faster than we could earn it for more than 20 years. During that time, periods of cheap money and rising consumer debt levels helped fuel the 1982-2000 bull market, the 2002-2007 bull market, the tech stock boom of the late 1990s, and the housing boom of the early to mid-2000s.

Mirroring the U.S., a similar debt binge was happening with some foreign consumers and governments, too.

Why Come to a Head Now?

The world’s accumulation of debt was unsustainable. The only question was, “When would it end?” Well, few people would have guessed that sub-prime mortgages in the U.S. would be the tipping point.

By the mid-2000s, cheap money, low credit standards, and the Wall Street money machine helped fuel an unprecedented housing boom in the U.S. This boom turned to bust in 2006/2007 when interest rates began to tick up and people started defaulting on their loans. Soon, a cascading domino effect ultimately pummeled the world banking system, greatly increased government debt levels, and led to steep stock market declines and a deep U.S. recession.

Dramatic levels of government stimulus helped fuel the stock market recovery in 2009 through mid-2011, but now that stimulus is wearing off and, today, we’re left with the hangover.

What’s Next?

As of last Friday, the Dow Jones Industrial Average had declined just over 10 percent since April 29, according to The Wall Street Journal. To put that in perspective, the Journal said, “Since 1962, the Standard & Poor's 500-stock index has seen 25 corrections of 10 percent during a bull market -- but in only nine of them did the losses grow to 20 percent or more, according to Birinyi Associates Inc. That means there is only slightly more than a 1-in-3 chance that the market is going to keep cratering.”

Based on history, 10 percent corrections are normal and to be expected. Only time will tell if this one morphs into something more.

What happens to the economy, though, is another issue.

If what we experienced in 2007-2009 was a “normal” recession, we should have bounced back strongly by now. But, it was not a normal business-cycle type recession. Instead, some people are calling it a “balance sheet” recession, in which over-indebted consumers (and governments) try to reduce their debt and spending, according to economist Richard Koo. This reduction in demand has helped keep a lid on economic growth.

One key to reigniting the economy is to find a way to lift growth while concurrently reducing public and private debt. That’s no easy task as it’s like trying to be tall and short at the same time.

Closing Comments

Realistically, it took the developed world decades to get into this debt situation and it will take more than a couple years of deleveraging to get out of it. There is no magic bullet that will quickly turn the economy into a growth machine.

As your advisor, we strive to develop a plan that, over time, has the possibility of providing you with the stability and return you need to meet your long-term planning needs. While we can’t make any guarantees about performance or control what the market does, we have searched high and low for a plan and strategy that we believe is appropriate for you.

America is a great country. We’ve been through difficult times before and we always find a way to overcome the obstacles. This time should be no different.

If you have any questions about your individual situation, please contact our office. As always, we greatly appreciate the confidence and trust you place in us. We work hard every day to earn it.

Weekly Focus – Think About It

“Most of the important things in the world have been accomplished by people who have kept on trying when there seemed to be no hope at all.” --Dale Carnegie, American Writer, Lecturer

Weekly Commentary August 1st, 2011

The Markets

“Uncertainty” is an overused, but appropriate word to describe the situation our country finds itself in.

·       We have uncertainty in Washington about how our budget issue will get resolved.

·       We have uncertainty about the economy as it hasn’t fully recovered from the Great Recession.

·       We have uncertainty about the value of the dollar as gold prices hit record highs and the dollar remains depressed.

·       We have uncertainty about how the war on terrorism will progress.

·       We have uncertainty about when the housing market will recover.

Yet, when you think about it, uncertainty is actually the norm. For example, in the past 100 years, we’ve had two World Wars, several regional wars, a Cold War, a Great Depression, a presidential assassination, a bitter battle over Civil Rights, rampant inflation, and other scary events.

History shows that uncertainty is a fact of life. History also shows that Americans find a way to deal with it and overcome it.

As financial advisors, we can’t “control” or “fix” uncertainty. We can, however, account for it. We realize that every investing decision carries with it a certain degree of risk or uncertainty. Knowing that, we do the best job we can to “account” for what could go wrong.

We try to make decisions that consider the best case and worst case scenario. We try to find investments that help balance each other so a possible decline in one investment might be offset by a possible rise in another. We try to look at the big picture and make investments that are commensurate with the risks our clients are willing to incur.

 
Because of uncertainty, we won’t always be right. However, because of our awareness of uncertainty, we’re always looking for ways to help protect the downside while leaving room for potential upside profit.

THERE IS A DISCONNECT BETWEEN MIDDLE AMERICA AND CORPORATE AMERICA and that’s one reason why the economy remains stuck in neutral.

Unfortunately, Middle America is stagnating. The economic recovery that started in June 2009 has been the second weakest recovery since World War II, according to The Wall Street Journal. Underscoring that weakness, the government reported last week that the economy grew at a feeble 1.3 percent pace in the second quarter -- essentially stall speed and not enough to reduce the unemployment rate.

The average American is also feeling glum. Thomson Reuters/University of Michigan reported last week that their index of consumer sentiment for July fell to its lowest level since March 2009. You may recall that March 2009 marked the bottom of the recent bear market.

Simply put, Middle America is getting squeezed with high unemployment and slow economic growth.

On the other hand, Corporate America is thriving.

Despite weak economic growth, profits of U.S. corporations are at record levels, according to government data as reported by MarketWatch. Relatively stronger growth in emerging markets coupled with belt tightening, productivity gains, and slimmer payrolls have helped U.S. companies generate these record profits.

Longer term, for our economy to rise above the malaise and corporate profits to remain strong, Middle America needs more jobs which will help boost spending and jumpstart economic growth. Consumer spending is critical because it accounts for about 70 percent of economic activity in the U.S. and until spending starts to accelerate -- it rose only 0.1 percent in the second quarter -- we may find ourselves continuing to “muddle through.”

Weekly Focus – Think About It

“Do not let what you cannot do interfere with what you can do.”

--John Wooden, Ten-time NCAA National Championship Basketball Coach