Weekly Commentary December 31st, 2012

The Markets

“This too shall pass.”

--Ancient proverb

Like getting emotionally involved with your favorite sports team, it’s easy to get caught up in the drama surrounding the fiscal cliff. Combining politics, money, power, gamesmanship, and national impact makes for a compelling story line. But you know what? “This too shall pass.”

As Reuters reported, “One way or another, Washington will come to an agreement to offset some effects of the cliff. The result will not be entirely satisfying, but it will be enough to satisfy investors.”  Unfortunately, we have to go through a totally avoidable wailing and gnashing of teeth before we get the Democrats and Republicans to do what ordinary Americans do when faced with opposing issues—compromise.

Up until last week, the stock market seemed undeterred by the circus in Washington. However, as it became clear that a deal would come down to the wire, investors got nervous and stocks experienced five days of declining prices.

Unfortunately, this partisan bickering could create an unintended consequence.

Back in 2011, wrangling over the debt ceiling triggered the first-ever U.S. credit downgrade. Even though the debt ceiling was raised and the U.S. did not default, credit ratings agency Standard & Poor's nonetheless lowered the U.S. credit rating stating, “the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.” If the continued discord in Washington leads to another downgrade, it would not be good for the financial markets, according to Jonathan Golub, chief U.S. equity strategist at UBS Equity Research.

 
Outside of the fiscal cliff, one thing we know for sure will pass this week is the end of one year and the beginning of a new one. And to that we say...may the New Year bring you health, happiness, and family closeness.

 

NORTH DAKOTA IS A SHINING EXAMPLE of why things are not always what they seem.

Back in 2009, PIMCO coined the term, “New Normal” to reflect their view that the U.S. had entered a multi-year period of balance sheet de-levering and restructuring that would stunt economic growth and keep stock market returns low. So far, they’re half right. Economic growth has been moderate as predicted but the stock market has performed well since the beginning of 2009 as it bounced off the bear market lows.

Implicit in PIMCO’s view is the idea that economic growth comes from three factors.

1)      Growth in the workforce (demographics is key)

2)      Growth in productivity (helped by improvements in technology)

3)      Growth in physical capital (e.g., plant, equipment, machinery)

Source: University of Colorado

Here’s where it gets tricky—trying to predict changes in those three variables is not easy.

For example, let’s turn the clock back to July 1, 2011. On that day, if we asked you to guess which state would have the highest percentage growth in population over the next 12 months, what would you have answered? Would North Dakota have come to mind? Probably not, yet, the Census Bureau recently reported The Peace Garden State topped the list in the past year.

This achievement is even more remarkable considering North Dakota was only the 37^th fastest grower between 2000 and 2010. In other words, it essentially came out of nowhere to become a fast grower all thanks to new technology which enabled the rapid development of an oil- and gas-rich shale formation.

Today, fiscal cliff issues, massive deficits, unsustainable government spending, Eurozone problems, and the Middle East powder keg are just a few of the many reasons to be negative on the markets and the economy. Yet, we need to remember North Dakota.

Nobody knows where the next “North Dakota” will come from, but it will likely come. So, while things may be tense in the markets and the economy, chances are our American ingenuity will rise to the occasion and eventually restore us to a position of economic strength.

As that unfolds in 2013 and beyond, we’ll keep doing what we do which is manage your investments according to your goals and doing our best to achieve solid risk-adjusted returns.

Weekly Focus – Think About It…

“Year's end is neither an end nor a beginning but a going on, with all the wisdom that experience can instill in us. Cheers to a new year and another chance for us to get it right.”

 

-- Oprah Winfrey, talk show host, media mogul.

Weekly Commentary December 24th, 2012

The Markets

The situation is fluid.

As politicians scramble and we inch closer to the fiscal cliff day of reckoning, it’s important to keep one thing in mind—the big picture. While the cliff situation dominates the headlines, the underlying economy is quietly marching ahead. Consider this recent data.

·         Orders for long-lasting goods jumped in November. The data suggested a surprisingly strong and broad increase in corporate spending.

·         Sales of existing homes climbed in November to the highest rate in three years.

·         Consumer spending climbed in November “as Americans pushed aside the threat of higher taxes next year, buying gifts for the holidays and making up for shopping lost to superstorm Sandy,” according to Bloomberg.

·         Car and light truck sales rose in November to the highest annual rate since 2008.

·         Economic growth, as measured by gross domestic product, was revised up to 3.1 percent in the third quarter from the originally reported 2.7 percent, according to Reuters. That’s more than double the growth rate from the second quarter.

·         Corporate profits hit a record high in the third quarter and, “Clearly, corporate America is on a roll,” according to Forbes.

Sources: MarketWatch, Bloomberg, Reuters, Forbes

The above paints the bull case for the economy. Yet, it’s not all rosy. The U.S. still faces tough budget deficit issues, tax issues, and an overhang of malaise that could pose stiff headwinds. And overseas, Europe is still problematic. 

Returning to the big picture, let’s remember that economic cycles and political wrangling have been and always will be with us (just watch Steven Spielberg’s new movie Lincoln). The players may change and the nature of the issues may vary, but as Led Zeppelin sang, The Song Remains the Same.

The good news…we survived the end of the world last Friday as the Mayan prophecy was a non-event! And we suspect we’ll survive whatever happens in Washington, too.

 

IS BUILDING A BUY-AND-FORGET PORTFOLIO that tries to capture long-term trends a good idea? Well, FORTUNE Magazine thought it was, so back on August 14, 2000, they published a list of 10 stocks and said, “If you're a long-term investor, these 10 should put your retirement account in good stead.”

To begin, FORTUNE identified the following long-term trends that they felt had the potential to transform the economy.

1.      The lightning-fast changes in communications networking.

2.      The brave new world of entertainment.

3.      The “boomerization” of financial services.

4.      The coming of age in biotech.

From there, the magazine came up with a list of 10 stocks to capitalize on these trends.

So, let’s see how their 10 stock picks performed over the next 12 years and 4 months between August 14, 2000 and December 19, 2012 as reported by Ritholtz.com.

·         2 of the 10 stocks went bankrupt.

·         1 received a government bailout.

·         2 were bought out at prices lower than their August 14, 2000 price.

·         0 stocks rose in price by the end of the 12-year period.

·         The cumulative portfolio, excluding dividends, declined by more than 50 percent during the period. By comparison, the S&P 500 index rose more than 20 percent during the period.

Source: Rithotz.com

As you can see, the magazine’s results were not pretty. Here are four conclusions from this buy-and-forget experiment.

1)      Don’t get your stock picks from magazines! You have to do serious research.

2)      Long-term trends are powerful, but the winners at the beginning of the trend may not be the winners at the end of the trend.

3)      Since “winners rotate,” it’s important to have a “sell discipline” to help you avoid hanging on to stocks long past their prime.

4)      To paraphrase an old saying, if you follow a static crystal ball, you may end up eating a lot of broken glass.

 

While nobody can predict the future, trends can last a long time and may offer profitable investment opportunities. However, as this example shows, you still have to diligently manage your portfolio so you don’t get caught on the wrong side if a shift happens.

 

Weekly Focus – Think About It…

It came without ribbons! It came without tags!

It came without packages, boxes, or bags!

Then the Grinch thought of something he hadn't before! 

Maybe Christmas, he thought, doesn't come from a store. 

Maybe Christmas... perhaps... means a little bit more! 

--Dr. Seuss, How the Grinch Stole Christmas!

Weekly Commentary December 17th, 2012

Special Note: The horrible tragedy at Sandy Hook Elementary School tugs at the heart of all of us. In the midst of a joyous season, we have another example of the fragility of life. We pray for the innocent victims and their families and hope they may find some measure of comfort and healing in their time of great pain.

The Markets

There they go again.

Doing its part to keep the economy afloat, the Federal Reserve announced last week, “that it would enter 2013 with a plan to purchase $85 billion a month of mortgage-backed securities and Treasury securities, part of a continuing attempt to drive down long-term interest rates to encourage borrowing, spending, and investing,” according to The Wall Street Journal.

In other words, the money printing not only continues, but expands.

Prior to the financial crisis, the Federal Reserve’s balance sheet stood at about $900 billion. Now, after previous rounds of securities purchases, it weighs in at about $2.9 trillion. With last week’s announcement, it’s on track to reach about $4 trillion by December 2013. And, based on the Fed’s guidance last week, it could hit $6 trillion before the Fed rests.

There are two schools of thought on the wisdom of this balance sheet expansion policy. One school says it will lead to massive inflation and destroy the value of the dollar. The other school says it’s necessary to keep the economy stimulated while giving fiscal policymakers time to fix the structural issues with the economy.

For its part, the Fed says it can manage its balance sheet without causing unwanted inflation.

So far, inflation is calm, the financial markets have stabilized, and the unemployment rate has dropped steadily over the past two years. By those measures, the Fed’s policy has been reasonably effective. Yet, as The Wall Street Journal points out, “Many critics of the central bank believe it has already gone too far in its quest to boost economic growth, and say it might be exposing the financial system to new risks of inflation or a financial bubble by pumping so much money into banks.”

We are concerned about the potential long-term consequences of the Fed’s unprecedented money-printing actions and we’ll continue to keep a close eye for any sign of the market “rejecting” it.

THE BEST PERFORMING STOCKS BETWEEN ELECTION DAY 2008 AND ELECTION DAY 2012 in the S&P 500 index are quite a varied group. It’s interesting to see what companies performed well during this time because it encompassed a good chunk of the Great Recession and the stock market recovery that ensued. Without naming names, here are the industries represented by the top 12 performing stocks, according to a list from MarketWatch:

1)      Leisure

2)      Grocery Stores

3)      Auto Dealers

4)      Leisure

5)      Lodging

6)      Computer Systems

7)      Restaurants

8)      Auto Manufacturers

9)      Footwear and Accessories

10)  Software

11)  Residential Construction

12)  Data Storage

The cumulative return during the 4-year period for these companies ranged from 373 percent for company #12 to 1,107 percent for company #1. By contrast, the S&P 500 index rose 47 percent during the period, according to data from Yahoo! Finance.

Notice that only one industry – leisure – is represented by two different companies on the list. This suggests the top performers were indeed a diversified group.

Are you ready for a quiz? See if you can name three companies on the list given the following hints:

Company #1 on the list: Their spokesperson has gone “where no man has gone before.”

Company #2 on the list: It’s sometimes referred to as “whole paycheck.”

Company #6 on the list: Their commercial, which aired only once on TV in 1984, was rated the 12^th best ad campaign of the 20^th century by Advertising Age.

Stumped? See below for the answers. Let us know how many you got right!

Weekly Focus – Think About It…

“(Holiday) gift suggestions:

To your enemy, forgiveness.

To an opponent, tolerance.

To a friend, your heart.

To a customer, service.

To all, charity.

To every child, a good example.

To yourself, respect.”

--Oren Arnold, novelist, journalist, and humorist

 

Answers to quiz:

Company #1 is Priceline.com

Company #2 is Whole Foods Market

Company #6 is Apple

Weekly Commentary December 10th, 2012

The Markets

Another week is history and we’re another week closer to the “fiscal cliff.”

You can’t turn on the TV or surf the internet without some reference to the fiscal cliff. But, consider this. Remember all the fuss about Y2K back in 1999? Everybody was worried about planes dropping from the sky at midnight, ATMs freezing up, and the power grid shutting down on January 1. Well, the clock struck midnight and, poof, like Cinderella’s glass slippers, nothing changed.

Perhaps it was all the preparation ahead of Y2K that ensured it would be a non-event. In fact, one could argue that all the upgrading of equipment and intense preparation that went into the buildup toward Y2K helped propel the economy and fan the tech bubble that culminated at the turn of the century. Then, as you may know, it was right after Y2K that the stock market went over its own cliff and fell into a bear market.

Now, here’s where it gets interesting. While the overall stock market has been weak during the 13 years since Y2K, corporate earnings continued to rise. As a result, the Shiller PE10 ratio, a measure of valuation of the overall stock market, has dropped from 44 at the end of 1999 to 22 at the end of September of this year. In other words, the overall stock market is a lot less “expensive” than it was 13 years ago.

This could mean a couple things:

1.    If we go over the fiscal cliff, the stock market may not fall as much as it did after Y2K because the overall market valuation level is much lower now.

2.    Investor psychology and Federal Reserve policy are still wildcards. How investors and the Fed respond to whatever happens with the fiscal cliff could have a significant impact on the markets – good or bad.

No matter what happens with the cliff talks, we’re keenly focused on the situation and we’ll make adjustments to your portfolio as appropriate.

THE OLD SAYING “THERE’S SAFETY IN NUMBERS,” may work in some settings, but not necessarily in the financial markets. Doing what everybody else is doing in the markets might make you feel more comfortable, but it’s not a way to get ahead. Famed investor Howard Marks pointed this out in his recent book titled, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.

Marks said, “Unconventionality is required for superior investment results, especially in asset allocation.” Further, he said, “You can’t do the same things others do and expect to outperform. Unconventionality shouldn’t be a goal in itself, but rather a way of thinking.”

To frame this way of thinking, Marks developed the following matrix:

	Conventional Behavior	Unconventional Behavior
Favorable Outcomes	Average good results	Above-average results
Unfavorable Outcomes	Average bad results	Below-average results

Source: Howard Marks

The matrix says conventional behavior will get you average results – either good or bad. By contrast, it’s only through unconventional behavior that we can be in position to achieve above-average results. But, do you see the rub here?

At times, unconventional behavior may lead to below-average results and, since you’re not part of the “safety in numbers” crowd, you could stick out in an uncomfortable way.

As it relates to managing investments, striving for a mix between conventional and unconventional behavior seems like a good strategy. You don’t want to always go against the crowd because the crowd is often right. But, there are times when it makes sense to take a stand, perhaps a more conservative stand than the crowd, and be a little unconventional.

If our portfolio is at times a bit unconventional, it’s because we’re trying to look out for your best interests.

 

Weekly Focus – Think About It…

“If everyone is thinking alike then somebody isn’t thinking.” 

– George S. Patton, U.S. military leader

Weekly Commentary December 3rd, 2012

The Markets

After all the huffing and puffing of the election, the fiscal cliff, and the Dancing With the Stars season finale, the U.S. stock market ended the month of November within 0.3 percent of where it started, according to The Wall Street Journal.

Although the return for the month was basically flat, a chart of the daily returns looked more like a healthy man’s EKG. From the closing high of the month to the closing low, the S&P 500 dropped 5.3 percent. Then, from that closing low to the last trading day of the month, the index rose 4.6 percent, according to data from Yahoo! Finance.

Overseas, the markets jumped around, too:

·         In Europe, the Stoxx Europe 600 index rose 2.0 percent on the month – its sixth monthly gain in a row.

·         In China, the Shanghai Composite index fell 4.3 percent in November and is now down about 10 percent for the year.

·         In Japan, the Nikkei Stock Average jumped 5.8 percent on the month to close at a seven-month high.

Source: The Wall Street Journal

What’s happening in Japan is rather interesting. The country will hold an election later this month to elect a Prime Minister. The leading candidate, Shinzo Abe, recently said the Bank of Japan should pursue a policy of unlimited bond purchases and zero-to-negative interest rates in order to rev up the moribund Japanese economy (sounds like the U.S.!). Abe’s easy money policy rhetoric helped lead to a roughly 10 percent drop in the value of the Japanese yen against a basket of developed market currencies between June and November 19 of this year and helped propel last month’s 5.8 percent rise in the Japanese stock market, according to Bloomberg and The Wall Street Journal.

As last month’s results show, we live in an interconnected world with many moving parts. Even something as simple as a Japanese Prime Minister candidate promoting an easy money policy can move markets dramatically.

ARE STOCK MARKET RETURNS CLOSELY RELATED TO the overall level of growth in the economy? Logically, it makes sense to think as the economy grows, so will stock prices, and vice versa. Let’s test that hypothesis using historical data.

The following table compares the return in the stock market during three different time periods to economic growth during those periods. Two of these periods were weak times for the market and one was strong. They are compared to real growth in the economy (i.e., after removing inflation) and to nominal growth in the economy (i.e., with inflation included).

Period	S&P 500 Annualized Return	Real GDP Growth	Nominal GDP Growth	Market Cycle
1966 - 1981	1.7%	3.0%	9.6%	Weak Period
1982 - 1999	14.6%	3.3%	6.3%	Strong Period
2000 - 2008	-6.2%	2.3%	4.8%	Weak Period

Sources: Bureau of Economic Analysis, Yahoo! Finance

Note: S&P 500 returns exclude reinvested dividends

Here are some conclusions from the table:

1.      Economic growth – after removing the effect of inflation – has remained remarkably stable at 2.3 percent to 3.3 percent during extended strong and weak market periods dating back to 1966.

2.      Stock prices can rise or fall dramatically during extended periods of time regardless of what’s happening to underlying economic growth.

3.      The high inflation period from 1966 to 1981 – as shown by nominal GDP growing 9.6 percent versus real GDP growing 3.0 percent – did not help stock prices as the S&P 500 index only rose 1.7 percent on average per year excluding reinvested dividends.

4.      A combination of strong stock market returns from 1982 to 1999 (which raised market valuation to an extremely high level) and somewhat slower economic growth helped cause stock market returns from 2000 to 2008 to be quite negative.

5.      The change in the rate of inflation or disinflation can have a major impact on stock market returns.

This table is a great example of why it’s so important to do research. The logical thought that stock price movements mirror changes in economic growth is not supported by data going back to 1966.

Just like you can’t judge a book by its cover, you can’t always evaluate the stock market by taking logical ideas at face value.

 

Weekly Focus – Think About It…

“Reason itself is fallible, and this fallibility must find a place in our logic.”

--Nicola Abbagnano, Italian existential philosopher

Weekly Commentary November 26th, 2012

The Markets

What fiscal cliff? 

Stock prices rose last week to their best weekly gain in five months as investors cheered the start of the holiday shopping season, encouraging economic data from Germany and China, improved housing data, and confidence from President Obama and Congressional leaders that the fiscal cliff will be avoided.

Is this the beginning of a “Santa Claus rally?”

Jordan Kotick, global head of technical strategy at Barclays, told CNBC, “We are about to head into the best seasonal time for the equity market.” Despite this seasonal tailwind, the market’s near-term direction may still depend on how Washington handles the pending budget and tax cliff. So far, the market seems to be pricing in a compromise that will avoid the worst-case scenario.

Beyond the fiscal cliff and a potential Santa Claus rally, what’s in store for the U.S. economy? Well, here’s a not-so optimistic take from famed money manager Jeremy Grantham:

The U.S. GDP growth rate that we have become accustomed to for over a hundred years – in excess of 3% a year – is not just hiding behind temporary setbacks. It is gone forever. Yet, most business people (and the Fed) assume that economic growth will recover to its old rates.

In his view, our economy will grow at a snail’s pace of about 1 percent per year after inflation for the next several decades. Without getting bogged down in details, his gloomy case rests on population and productivity changes.

However, there are some potential bright spots on the horizon. Please read the second half of this commentary to learn about one important part of our economy that could turn Grantham’s pessimistic view upside down.

THE YEARS 2020, 2030, AND 2035 could turn out to be pivotal years for the United States and the geopolitics of global energy. Here’s why. The International Energy Agency (IEA) predicts the following will happen by those years:

·         2020 – The U.S. will overtake Saudi Arabia as the world’s largest producer of crude oil.

·         2030 – The U.S. will become a net exporter of crude oil.

·         2035 – The U.S. will become effectively self-sufficient in meeting its total energy needs through domestic sources.

Source: International Energy Agency World Energy Outlook 2012

Today, the U.S. imports about 20 percent of its total energy needs. Can you imagine a world in which the U.S. is energy self-sufficient and not beholden to foreign energy sources? This could deliver a huge boost to our economy.

Five years ago, the IEA predicted the U.S. would pump 10.1 million barrels of oil per day by 2020. In this year’s report, the IEA’s new estimate is 11.1 million barrels per day by 2020. This projected increase in production is, “driven by the faster-than-expected development of hydrocarbon resources locked in shale and other tight rock that have just started to be unlocked by a new combination of technologies called hydraulic fracturing,” according to MarketWatch.

So, we have Jeremy Grantham stating the bear case for the U.S. economy then we have the IEA publishing a report that puts the U.S. in the driver’s seat for the world energy market in the next couple decades.

Now, here’s the thing. Both Grantham and the IEA are making long-range forecasts based on data available today. Yet, we know things can change just as the IEA raised its oil production estimate from 10.1 million barrels of oil per day to 11.1 million.

Trends take time to develop and then, all of a sudden, they could change due to some new technology – as in the case of  “fracking.” We do keep an eye on these long-term trends, but we also understand that investment decisions to buy and sell have to be made based on what’s happening now. This “bi-focal” approach is one of the many tools we use to manage your assets.

 

Weekly Focus – Really?

“Whoever said money can't buy happiness simply didn't know where to go shopping.”

--Bo Derek, American actress