Quarterly Market Overview – Q3 2011

October 21, 2011

Market Overview

We began our last quarterly narrative by expressing concern that the exceptional performance of the S&P 500 and global markets so far in 2011 had left them overstretched and susceptible to a pullback. That being said, we were not expecting to see the worst quarterly performance since the end of 2008 when we were still in the throes of The Great Recession.

During the third quarter of 2011, the S&P 500 lost 13.86% of its value, bringing its year-to-date return to a negative 8.67%. The MSCI EAFE (Europe, Australasia and Far East) fared significantly worse with a third quarter loss of 18.95% which dragged it’s year-to-date performance down to -14.62%.

Domestic equities outperformed foreign equities for the second quarter in a row as developed nations in Europe continued to struggle with their sovereign debt crisis and emerging economies dealt with rising inflation and slowing demand from China. Emerging markets took the worst hit in the third quarter due in part to the more cyclical nature of many of their key industries such as energy and mining. Additionally, the Chinese government had their banks give out $586B in loans during the financial crisis to spur growth, an amount equivalent to about 13% of their economy (the $787B stimulus in the U.S. only accounted for about 5% of our GDP for contrast). Many of these loans were invested unproductively and not all of them will be able to be repaid as they come due over the next several years. It is very possible that the central government could step in to help the problem but there is a severe lack of transparency on these issues so it is nearly impossible to evaluate the extent of the losses. We will continue to follow China closely in the coming months because they are one of the last significant drivers of global growth with the developed economies still stuck in a state of low growth and outright contraction in some parts of Europe.

The U.S. economy continued to expand with GDP growing by 1.3% in the second quarter but you wouldn’t know it by looking at the unemployment rate, which is remains above 9%, home prices which are still bouncing around near the their lows, or food stamp usage, which continues to set new records every time the data is released. Among the unemployed, almost 45 % have been unemployed for more than half a year and there are now a decent amount of unemployed who are no longer being counted in the numbers because they have fallen off of the list of people eligible to receive benefits. These persistent issues appear to be creating a significant change in investor sentiment toward domestic equities. Over the last several months, many of the  sectors that had been driving the earlier rally such as financials, energy, industrials and materials have now become the worst performers as the market declined during the quarter. During this same period the best performing sectors have been defensive areas such as consumer staples and utilities (both of which are well represented in client portfolio’s).

Fixed Income
The picture in fixed income markets was very mixed in the third quarter. In general, foreign bonds sold off during the quarter because of continuing sovereign debt concerns in Europe and rising inflation in emerging markets. Domestic bonds fared better with the Barclays Capital Aggregate Bond Index turning in a gain of almost 4%. That return should be taking with a grain of salt though because the vast majority of the gain was fueled by the biggest rally in U.S. Treasuries since 2008 and was for the most part not representative of the domestic fixed income market, which turned in relatively meager results. Inflation protected treasuries slightly underperformed the index as deflationary pressures re-entered the market and commodities sold off along with crude oil. The third quarter also marked a possible shift in investor sentiment as high-yield bonds experienced a substantial selloff as investment grade corporate bonds continued to generate positive returns. High-yield bonds had been outperforming investment grade bonds almost the entire time since stocks bottomed in 2009 and the recent divergence could suggest that investors are becoming more concerned with the return of their capital rather than the return on their capital.

Foreign Exchange
In our last portfolio update, we mentioned that the U.S. Dollar (referred to as the Dollar from here forward) was consolidating in a range after having spent most of the previous year declining against the currencies of most of our trading partners. This consolidation phase ended during the third quarter as investors fearful of the debt crisis in Europe piled into Dollars and other safe haven assets such as treasuries. The Swiss Franc had been performing the best out of all safe haven currencies during the quarter but then the Swiss Central Bank announced that they would be intervening in the currency markets to prevent their currency from appreciating too much which was negatively impacting their domestic companies. This intervention caused even more upward pressure on the Dollar since it’s safe haven competition took itself out of the race.

Sharp runs up or down happen when everybody is rushing to one side of a trade. When this happens, asset prices usually overshoot to the upside or downside as momentum builds, but eventually, the underlying fundamentals come back to being the key driver of returns. Right now, the dollar is correcting from being temporarily oversold (and may overshoot to the upside) but we remain confident that the long term trend of the Dollar against its major trading partners is downward. In the end, the value of a country’s currency is derived from the demand for the goods/services produced in the country. It is also influenced by the supply of the currency in question.

In the case of the U.S., there is not tremendous demand for products made in the USA (relative to how much we import from abroad) and our Federal Reserve system has enormously more flexibility in terms of increasing/decreasing the supply of money because the European Central Bank has a great deal of restrictions that limit their monetary policy options. It is also very important to note that although three Federal Reserve presidents in the U.S. have been dissenting over what they feel is overly loose monetary policy, they will be almost entirely replaced by more accommodative presidents over the next few years as the board membership rotates.

Commodities & Precious Metals
All commodities that trade on the major exchanges are priced in Dollars so it should not be surprising that most of the commodity complex had a rough third quarter (although they outperformed equities by a nice margin both year-to-date and for the quarter). In addition to the strengthening Dollar, softening demand from China and other emerging markets continued to weigh on agricultural and industrial commodities. A major standout in the third quarter was gold which managed to rally 8.26% even as the dollar strengthened. Live cattle futures also bucked the trend and staged a 9.75% rally due to the extreme droughts in Texas which have prevented farmers from being able to provide the needed food and water to keep their herds alive. This is a disturbing development that will continue to affect cattle prices in the years ahead because many livestock breeders were forced out of the industry and will not be returning because it takes years if not decades to build up a good herd and many are semi-retired or close to retirement.

While further weakness is likely if demand from emerging markets continues to wane, we believe that it would only be transitory because the key drivers of higher commodity prices are still in place. Emerging market growth may slow, but “slow” growth over there tends to be faster than “strong” growth in developed economies. This will continue to result in an expanding middle class in emerging markets, which will increase their demand for protein which will in turn magnify demand in other soft commodities. Scientific progress is also finding new uses for commodities which is increasing demand such as the use of corn in making ethanol fuel (the USDA predicts that 2011 will be the first year in history that more corn goes towards fuel than feeding livestock). Climate change has also be negatively impacting the amount of arable land available in the world as well as water supplies (the Ogallala aquifer, which provides water and irrigation to one of the most fertile areas of the U.S. is predicted by some scientists to run dry in as little as 20 years). Increasing rates of drought and flooding is also hurting crop yields across the world.

As always, please do not hesitate to give us a call should you have any questions whatsoever.

– The Pacific Mountain Advisors Team


Quarterly Investment Newsletter – Q1 2011

April 21, 2011

Market Summary

The strong rally in equities and commodities continued unabated into the beginning of the first quarter of 2011. The tragedy in Japan and the uprisings in the Middle East and North Africa region (MENA) all caused selloffs in equities but they have so far proven short-lived. As of March 31st, the S&P 500 has regained almost all the ground it lost in the selloffs and increased 5.92% for the quarter to bring its one year trailing return to 15.65%. Although the market’s rally continued in the first quarter of 2011, it was not as broad based as in past quarters. Energy, health care and industrials were the only sectors that outperformed the index (usually around five outperform, and around five underperform), which could foreshadow future weakness in equities. Emerging markets and developed European markets continued to underperform the US due to persistent inflation and sovereign debt worries in the respective regions. Additionally, we are pleased to announce that our  aggregate client portfolio composite has reach an all time high and now stands 1.63% above where the market previously peaked at the end of 2007. Despite one of the most unprecedented rallies in history, the S&P 500 remains 6.15% below its previous peak, which emphasizes the important of maintaining a long term view of the markets.

Fixed income markets in the US improved in Q1 but you wouldn’t  know it by looking at the Barclays Aggregate Bond Index, which only managed to return 0.42% in the first three months of the year.  The aggregate index’s returns were lower than what our portfolios achieved because we are overweight inflation protected securities, which performed well, and because we had very little exposure to US Treasuries (which declined in value) during the quarter. Our holdings of foreign sovereign debt also performed very well during Q1 with a gain of over two percent.

The first quarter was also quite eventful for the currency markets with fears about inflation and quantitative easing causing the US Dollar to decline towards multi-year lows against most major currencies.  Fiscally sound currencies such as the Swiss Franc and resource based currencies such as the Australian and Canadian Dollars have broken out to decade long highs against the US Dollar. Monetary metals such as gold and silver continued to appreciate in this weak dollar backdrop.

Positive Developments

Gross Domestic Product (GDP) grew at an annualized rate of 3.1% during the first quarter of 2011, marking the sixth consecutive quarter of positive growth. Austerity measures taken in Europe to combat the sovereign debt issues in the PIIGS countries (Portugal, Ireland, Greece and Spain) began to show up in the data, resulting in a tepid 0.3% GDP growth rate for the Euro zone. China and India continue to grow their GDP at a 9.7% and 8.2% annual rate respectively but their official inflation rates have grown as well to 5.4% in China (a 32 month high and also very likely to be under reported based on on-the-ground surveys) and 8.82% in India. Although these developing markets are growing fast, the equally aggressive pace of inflation is putting pressure on many consumers and businesses.

U.S. Industrial production has been booming except for the construction market, which continues to lag significantly because of the excess capacity of commercial and residential property. While this is not good news for construction workers, it is a positive sign for the rest of the economy. We also set a new record in March for exports when adjusted for inflation (tip of the hat to Chairman Bernanke and his printing press which has made our exports more competitive with other countries).

The economy generated about 331,000 jobs in the first quarter of 2011, making for the sixth month of consecutive gains. We are hopeful that this trend will continue to accelerate because the job market is not yet growing at a rate that can absorb the growth of our population, not to mention the more than 7 million jobs lost during the Great Recession (more on this later).

Headwinds for 2011 & 2012

Popular media has swung from pessimistically bearish at the bottom of the market to enthusiastically bullish now that the S&P 500 has almost doubled off the March 2009 lows. Despite the ongoing trickling of positive economic data and the media exuberance over the rising stock market, it is more important than ever for us to maintain a watchful eye on the several key issues that still have the potential to derail the fragile recovery just as the fundamentals are beginning to improve.

Jobs & Housing

In the early stages of The Great Recession, it was often referred to as the subprime mortgage crisis or the housing crisis, but both of those terms belied the root causes behind the collapse: a multi-decade long decline of the real purchasing power of most Americans in the face of rising prices and credit expansion. Since the 1970’s, the average American has seen their income stagnate when adjust for inflation. Meanwhile, goods and services like homes, health care, education and energy have all outpaced inflation.

To fill the vacuum in real disposable income, American households had been saving less and turning to credit and debt in greater and greater numbers. Then, in the early 2000’s, the value of homes started to increase more rapidly, further fueling the debt driven consumer spending based economy. Banks began loosening credit standards to satiate the demand of both homebuyers and investors creating the real estate fueled bubble. Homeowners then used equity from their homes to fund discretionary spending based on the popular assumption that housing prices would rise indefinitely. In essence, Americans did not feel like they were becoming poorer even though their income was declining once inflation was taken into account.

In 2008, the debt-driven household wealth machine broke (see chart above) and a vicious cycle kicked in: 1.) home prices stopped going up, 2.) which led banks to pull back on lending, 3.) which lowered demand for real estate, 4.) which caused prices to fall, 5.) which took away the piggy bank of millions of Americans and caused the balance sheets of major financial institutions to deteriorate because of their heavy exposure to mortgage derivatives, 6.) which caused overall consumer spending in the economy to fall, 7.) which led to massive layoffs and further pullbacks in credit.

Throughout the recessions over the last half-century our economy always pulled through because American households kept spending (even when we did so by saving less and using more debt). However, as you can see from the graph below, all good things must come to an end.

The steady decline in savings that began with the credit bubble in the 1970’s has sharply reversed course. From here on out, further demand growth in our economy will need to come from more jobs, higher disposable income or lower inflation because the banks can no longer provide credit the way they did when home prices were perpetually rising. Currently, inflation is ticking up and real weekly earnings have been declining since June, which leaves the onus for further growth on increased jobs.

The unemployment rate declined to 8.8% in March from 9.4% at the end of 2010 but a closer look at the raw data reveals that had workers not given up looking and dropped out of the labor force, the unemployment would have actually risen to a bit more than 10%. This also does not take into account that we have population growth of about 1% per year and that we still need to make up for the more than 7 million jobs lost in the recession. Additionally, non-Government polls including the Gallup Poll and IBD/TIPP Survey as well as several prominent economists, all have estimates of the current unemployment situation that are north of 19% and rising (they also include part time workers who would like a full time job).

The continued slack in the job market has resulted in corresponding slack in the demand for existing homes. After rebounding slightly from the earlier plunge in prices, the 10 and 20-City Composite indexes have spent the last six consecutive months declining and are now only 2.8% and 1.1% above their respective bottoms from 2009. Over the last two years, we have at best seen the housing market bounce along at lows, and at worst, the much-feared double dip in housing may be happening (as we have been predicting for quite some time now). Some measures of the housing market such as new home sales and residential construction have already reached new multi-decade lows and are yet to show any signs of improvement. On the positive side, the commercial real estate prices have continued to rise and have regained approximately 85% of their value since the 2007 peak according to data compiled by Green Street Advisors. Reasons for the turnaround include the lack of new construction and improving occupancy rates across most commercial real estate sectors (especially hotels and apartments).

European Sovereign Debt Crisis

The sovereign debt crisis facing Europe has intensified since our last report. Elections in Ireland resulted in the populist Fine Gael party coming to power with the goal of re-negotiating Ireland’s bailout from the year earlier in order to pay lower interest and reduce principal. Portugal also finally requested a bailout from the European Union and the International Monetary Fund (IMF) after seeing their cost of borrowing more than double since the beginning of 2010. This move has once again called into question the solvency of the other PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries as shown by the recent spikes in their respective 10-Year treasury yields. Austerity measures implemented in Greece have weighed heavily on their GDP, which has fallen in each of the past six quarters. The big elephant in the room however is Spain. Spain currently has a higher budget deficit ratio that Portugal but is a much bigger economy. If Spain were to fail, there is simply not enough money in the Euro zone to fund an adequate bailout and the entire European banking system would once again come under scrutiny. GDP growth in much of Europe has barely managed to stay positive and if the bailout of Portugal is not successful, the peripheral country sovereign debt crisis could quickly escalate into one of continental proportions.

Domestic Budget Deficit

Over the past decade, a combination of the Bush tax cuts, lower income tax receipts because of lost jobs, multiple ongoing wars and recession-induced stimulus programs have left our country with an absolutely astounding debt burden when you account for off balance sheet liabilities such as the wars, Medicare, Medicaid and Social Security.

The normal way that countries reduce their deficits is a combination of lower spending and higher taxes applied to where they will have the greatest net economic impact (taxing the poor destroys aggregate demand because almost 100% of the poor’s disposable income is deployed right back into the economy. Wealthy individuals have a much higher propensity to save their income, which does not directly benefit the economy but may increase investment). Unfortunately, Democrats will not allow sufficient budget cuts and Republicans are unwilling to raise taxes (even though they are currently the lowest they have been since WWII) so the deficit reduction efforts we have seen so far have been mostly token political gestures.

In the absence of political will and an almost insurmountable level of debt, the Federal Reserve has embarked on its own plan to reduce the deficit through monetary policy that destroys the value of the US Dollar by maintaining artificially low interest rates which, when combined with rising inflation, are producing negative real rates of return on Treasuries. While these actions may not technically count as defaulting on our debt, they have the same result for our creditors who end up being paid less than they were supposed to in real inflation adjusted terms.

However, after more than two years, popular anger (both domestically and from abroad) over our debt and the opaque actions of the Federal Reserve have put pressure on them to scale back their monetary operations, and they have now stated that a third round of quantitative easing is unlikely to be initiated after the current QE2 ends in June. This is a concern for equities because since the Fed began QE two years ago, there has been an approximate 86% correlation between the Fed’s balance sheet and the price of the S&P 500 according to data compiled by Haver Analytics and Gluskin Sheff. The heavy selloff in the middle of 2010 was largely due to uncertainty surrounding what would happen when the Fed was no longer supporting the market.

In the beginning of 2011, we now face the same looming end of QE as well as the new reality that Federal Government spending (which has been helping to fill a huge gap in private demand) will begin to be rolled back in 2011 and 2012 due to vocal opposition to government spending by Republicans, incoming Tea Party members in the House of Representatives and even Democrats who are beginning to realize that opposing spending cuts is turning into more and more of a dangerous political game to play.

While we welcome this new attitude toward fiscal responsibility, we believe the timing is a bit questionable. By pulling back fiscal support for the economy before we have reached a level of self-sustaining growth, we risk making the same mistake that we did in the early 1980’s when we pulled back support too soon and sent ourselves into a double dip recession. In a more recent example, the United Kingdom posted negative GDP growth for the fourth quarter of 2010 after taking measures to reduce their deficit.

Valuation of Market

All of these issues bring us back to the issue of market valuation, in other words, are investors paying too much for the underlying earnings of the businesses they own? This is where things get interesting. Commentators who are bullish on the stock market cite the fact that the current P/E ratio of around 16 on the S&P 500 is well below its average of 30.6 over the past ten years and they therefore conclude that the market is a bargain and has plenty of room to run.

However, the decade that they are citing included two of the biggest stock market bubbles to take place over the last 100 years. When instead we look at the widely respected Shiller 10-year inflation adjusted P/E ratio (which incorporates multiple business cycles to smooth out distortions), we arrive at a P/E ratio in excess of 23 times earnings, which puts today’s current market valuation in the same territory as the bubble years from 2005-2008 and the post World War II boom that peaked in the mid-1960’s and preceded the economic malaise and stagflation from the 1970’s. The technology bubble’s peak in 1999 and the two years proceeding Black Tuesday in 1929 are the only periods in the 20th century that were equivalently as overvalued as the market is today when using the Shiller 10-year P/E.

While it’s true that earnings for the S&P 500 are expected to grow a great deal over the next year or two, which would justify a premium for the P/E, we believe that earnings expectations may have gotten slightly ahead of themselves. According to data compiled by Bloomberg, the expected earnings for 2011 are currently 59% higher than the average actual yearly earnings over the last ten years (which includes multiple business cycles).

So when else have earnings been expected to grow by such a large amount? August 2000 and December 2006 which, in retrospect, ended up being within months of when profits were peaking and economic expansions were ending. In other words, analysts get the most exuberantly bullish towards the end of bull markets because they see a trend and then extrapolate to the sky. Given the current “optimism” in the analyst community, we feel it would be wise to give more heed to the trends of the past century than those of the past decade.

The dividend yield on the S&P 500 currently sits at 1.77%, which is slightly lower than the average over the past twenty years (implying that the market is very slightly overvalued). However, when you look at the last 100 years, we see a similar trend as with the P/E. From 1900 to 1990, the yield on the S&P 500 ranged from about 3%-7% and averaged 3.38 in the post war period after 1950. From where we stand today, dividends would need to grow by 100% next year (dividends have grown by approximately 1.01% per year over the past twenty years), or the S&P 500 would need to fall by 46.4% to bring the dividend yield back to average.

The market looks cheap when compared to the yield of the 10-Year treasury but this is more a matter of quantitative easing which has maintained rates at artificially low levels than anything else. If Treasury yields rise as they did during the inflationary scare in the late 1970’s and early 1980’s, (or even to a historically normal level of 3-5%) the percent of GSP that goes toward paying the interest on our debt would soar (we are currently paying very little interest because rates are so low) and a drop in the S&P 500 would be expected.

Global Macroeconomic Risks

Although the previously discussed issues are very important to the global economy, it was the devastating events in Japan and the continued unrest in the Middle East North Africa (MENA) region and that grabbed most of the headlines in Q1.

The loss of life that took place in Japan as a result of the 8.9 magnitude earthquake and subsequent tsunami was truly shocking and saddening. The potential for a serious nuclear situation is still present as radiation continues to seep from the damaged Fukushima Daiichi nuclear power plant. Beyond these immediate humanitarian disasters, companies all around the world are being affected due to the important role that Japan plays in the global supply chain (especially for high-tech and automotive companies). It also remains to be seen how fast production will be able to return to normal because of rolling brownouts and restrictions on power usage as a result of the lost capacity from nuclear sources.

Over in the Middle East and Africa, attention has shifted from Egypt, which appears for the moment at least to be moving towards a new democratic government and towards the conflicts in Libya and the Ivory Coast, as well as the protests in Syria and Yemen. The conflict in the Ivory Coast has strained global supplies of cocoa and the loss of supplies from Libya has put pressure on the price of crude oil. Additionally, concerns have arisen that the protests in Syria (where a Sunni minority also rules a Shia majority) may spread to Saudi Arabia, the world’s biggest exporter of petroleum, but so far the monarchy has managed to avoid major demonstrations by announcing reforms and paying out large sums of cash to its citizens.

Since the protests began in Egypt on January 25th, Brent Crude oil rose 20.9% to $116.94 and Light Sweet Crude rose 13.5% to $106.79 as of March 31st. This rise has been closely watched by investors because rising oil prices will ultimately squeeze corporate margins, lower household disposable income and slow economic growth. The rise in oil prices has already canceled out all of the simulative effects of the payroll tax decrease that was enacted last quarter and is threatening to overheat many emerging market countries that are currently serving as the main driver of the global economy.

Aside from the rise in oil, prices of many food commodities have continued to rise, putting an estimated 44 million people into poverty since June on 2010 according to the World Bank, with poverty being defined as living on $2.00 or less per day. This is arguably a larger threat to emerging markets than the rise in oil because food accounts for such a great proportion of their incomes. In the U.S., rising commodity prices are showing up in higher input costs for companies, which will have to either suffer lower margins (substantially in some cases) or pass the prices on to the consumers for many daily staples, further pressuring GDP growth.

Poor crop yields in many countries have been attributed to “extraordinary” events such as fires in Russia and floods in Pakistan, but the likely reality is that these events will become much more ordinary moving forward into the future as global climate change continues to make the weather patterns more and more volatile. In addition, growing middle classes in developing markets like China, India and Latin America are creating increased demand for proteins, and it takes about 16 pounds of grain on average to produce one pound of meat because you need to feed the livestock.

In Summary

While the economy certainly is expanding, it is doing so at an unacceptably slow pace despite the presence of more direct and indirect fiscal and monetary support than at  any other time in history. These actions have resulted in substantial distortions to economic indicators such as GDP and more importantly, the interest rate on Treasuries (the “risk free” rate of return). The “risk free” rate is used in discounted cash flow calculations, which are used to make investment decisions regarding asset pricing, corporate spending and M&A activity. So long as the rate is being held artificially low, it increases the incentives for companies and individuals to borrow and spend while penalizing savers with a negative real rate of return after inflation. Therefore, we will need to wait until these distortions have been removed before we can assess whether or not the recovery we are currently undergoing is self-sustaining and whether the current pricing and valuations of equities will hold up under normal conditions.

Although we do not feel that the market is overvalued, it is by no means a bargain. This has been the case for the last three or four quarters where earnings have grown to meet the higher expectations. Margins, which were previously increasing to cycle highs, will now be coming under pressure due to rising input costs and lower consumer demand arising from higher energy costs. Potential supply chain-related aftershocks from the catastrophe in Japan, the end of QE2, and the pending withdrawal of fiscal stimulus as the Federal Government moves to cut the deficit are all issues of concern in the short to intermediate term. However, we would welcome the re-pricing of markets as an opportunity to add selectively to positions at lower prices. In the meantime we will continue to be patient and focus our buying on relatively lower-risk equities and on holdings with low correlations to equity markets such as currencies.

As always, please do not hesitate to give us a call should you have any questions.

– The Pacific Mountain Advisors Team

Words of Wisdom for Q2

“If you are of the view that a new secular bull market began in March 2009, then please follow your beliefs. Secular bull markets tend to last between 16-18 years. It will be the first time a secular bull was born from printing money and the onset of state capitalism.

 But if you are of the opinion that what we just witnessed since March 2009 was a typical cyclical rebound within the confines of a secular downtrend, well, these tend to last two years (Ned Davis found 34 of these since 1900) and see average gains of 86%. This time around, it was just a month under in duration and 13 percentage points over in magnitude.”

 – David Rosenberg, Chief Economist & Strategist at Gluskin Sheff (from February 24th)

Quarterly Investment Newsletter – Q3 2010

October 29, 2010

Overview & Outlook

Toward the end of the second quarter, it appeared as though the stock market was finally beginning to price in the faltering recovery and likelihood of a double dip as the S&P 500 fell more than 11%. However, the third quarter reversed almost all of this decline in one of the best performing Septembers in over 50 years. Our analysis of U.S. economic and recent market performance indicates that fundamentals have been temporarily thrown out the window in favor of speculating around the actions of the Federal Reserve and other central banks, the third quarter rally took place in a backdrop of worse than expected economic data, some of which came in at or below lows not seen since the collapse of Lehman Brothers in 2008.

Although it seems contradictory, the rally was due in large part to the bad news that came out over the quarter. Ben Bernanke, Chairman of the Federal Reserve, gave a speech during the third quarter while the market was under heavy selling, in which he basically said that the Fed would do everything in its power to support the weakening economy and signaled that the Fed would engage in a second round of Quantitative Easing (QE2). On the day immediately following Bernanke’s speech, the S&P 500 began a significant rally.

You may be wondering what QE is exactly, it is a euphemism that economists and Central Bankers use to say “printing money and debasing the currency”; or as Brian Sack from the New York Fed would say, QE “adds to household wealth by keeping asset prices higher than they otherwise would be…

Isn’t artificially elevating asset prices normally considered “fraud” or “manipulation”? Apparently, the jargon of Central Bankers is a little different than that of most people. It would seem that the government has given up on trying to improve the real fundamentals of our economy – by investing in infrastructure, education, productivity, innovation and entrepreneurship – and is now deciding to play make-believe instead.

Since Bernanke’s speech on August 27th to the end of September, the market rose more than 10% but was paced by an almost equal rise in the price of gold and other commodities, reflecting investor beliefs that the result of QE2 would be inflation rather than actual economic growth. To illustrate the difference between nominal growth and real growth (nominal growth minus inflation) we have included the following chart below which shows the value of the S&P 500 when priced in gold. It’s important to note that since QE1 was first announced, the S&P 500 has rallied 33.05% in nominal terms but it has actually lost 11.86% when priced in gold.

S&P 500 Priced in Gold (1/1/2007 – 9/30/2010)

The secular trends that have caused this divergence remain in place and show no signs of dissipating, which is why we have increased client holdings of commodities and have begun to build a position in gold. We would of course reconsider this strategy if the Fed ever begins to tighten its monetary policy but we see this as a remote possibility for the foreseeable future.

In summary, QE is a monetary tool that is not well equipped to handle the structural issues facing America such as our weak housing and job markets, overleveraged private and public balance sheets, a bloated public sector that will be forced to downsize for years to come and shifting global trade dynamics that are increasingly centered around emerging economies. QE2 may succeed in raising asset values above their true level in the short term but in order to drive real economic growth, companies need to have sufficient visibility and confidence in the future in order to plan, hire and grow. Government interventions such as QE only serve to muddle normal market signals, slowing the process of a real recovery and continues our dependence on credit driven boom and bust cycles like we have been stuck in throughout the past decade which have never ended well.

U.S. Gross Domestic Product (GDP) Data
The rebound in corporate earnings persisted in the third quarter but top-line revenue growth continued to be sluggish. The disappointing GDP growth of 2.7% from the second quarter was revised downward to an annualized rate of 1.7% because of worse than expected net exports.

As we mentioned in our last quarterly newsletter, inventories continued to build up in the third quarter and slower order growth has not been able to keep pace, signaling the possibility of future markdowns. The ratio of new orders to inventories fell below 1, less than 18 months after our recovery began. Historically, our economy has slipped into recession 75% of the time shortly after the new order to inventory ratio went below 1.

This declining trend in GDP is especially concerning because we are usually growing at more than double our current rate by this stage of the recovery. Our unemployment situation is also so severe that according to most economists, it would take several years of 5%+ GDP growth just to bring the unemployment rate down to 8% but many investors don’t seem to care as they continue to disregard fundamentals in favor of chasing performance. A great example is how the S&P 500 rallied on the day that Q2 GDP was revised down to 1.7% because investors speculated that the GDP number was so bad that the Federal Reserve would be forced to step in with QE2 to support the market.

The market is no longer cheap, margins are at the peaks of their cycles, unemployment remains at decade-long highs so why is the market rallying? It feels like this Cinderella rally is getting close to midnight because the carriage is starting to smell like a rotten pumpkin. Considering the bleak state of the economy, the September 20th announcement by the National Bureau of Economic Research that the recession ended in June of 2009 feels like a “Mission Accomplished” moment. As Mohamed El-Erian from PIMCO recently said in a speech at the IMF, “We have won the war, but we have not secured the peace.”

Foreign Developments
A major positive during the third quarter was the resumption of strong growth in China following the cooling off period from the second quarter. The growth in China helped pull along other emerging economies with high exposure to mining, industrial materials and precious metals. We are however somewhat skeptical of the clockwork-like GDP numbers published by the Chinese Government because of the lack of transparency around their real estate and credit markets. There are entire cities in China that were built during the boom years and now remain largely vacant. There are also documented cases of partially constructed office buildings being demolished, only to have another building erected in its place. These actions create GDP growth on the accounting books, but destroy value in real terms. China may have enough foreign currency reserves to manage this situation but it is something we plan to monitor.

Another matter that we have been keeping track of is the ongoing financial troubles in the Euro zone. Protests of discontent have continued in Greece and have also taken place in Spain, Italy, Latvia, Poland, Portugal, Serbia and France. Most of the outrage is arising from large scale public sector job cuts and reduced pensions for Government workers in order to help close ballooning deficits. These protests could derail efforts to stabilize their debt and currency markets.

The stress tests of European banks conducted by the European Central Bank (ECB) helped to calm investor nerves about the precarious state of sovereign finances within the Euro zone following an announcement that only seven banks needed additional capital out of the 91 that were examined. The tests received widespread criticism for not being tough enough (they did not even include the possibility of a default on sovereign debt, which was the precise reason that investors felt the tests were needed in the first place) but investors shrugged it off.

A large reason for the calm in European financial markets came from the fact that Ireland (perceived to be one of the financially weakest countries) was able to raise cash by selling debt on the open markets instead of needing to crawl to the ECB or IMF for funds. Unfortunately, recently released data showed an almost dollar for dollar match in the amount of money that was raised by Ireland, and the amount of debt that was bought by the ECB and major commercial banks that act as intermediaries for the ECB. It seems that the Europeans have learned a great deal from the U.S. in terms of financial smoke and mirrors. For anyone familiar with the classic “shell game” where someone puts a marble under one of three cups and then moves them all around to confuse the onlookers as to where the marble is; the recent financial gimmickry out of Europe may seem familiar.

An additional piece of disturbing information came out on the very last day of the third quarter when Ireland announced that Anglo Irish Bank, which had previously been nationalized, would require an additional €34B in bailout funds due to continuing losses. Then ten days later, Ireland announced that it would also effectively be nationalizing Allied Irish Banks, bringing the total of nationalized major Irish banks to four since the beginning of the financial crises and bringing Irelands debt to GDP ratio to almost 100%.

Why are bail outs of major Irish banks due to insolvency needed less than two months after the ECB conducted stress tests and gave the all clear signal? If a huge multi-billion dollar bank managed to slip through the cracks, we wonder what else did. These concerns were exacerbated when a recent financial audit of Greece, conducted by EuroStat, the European Unions’ statistical office,  revealed that Greece had once again been misleading the public regarding the true scale of its debts. European credit markets do not seem very credible at the moment.

Labor Market
The official unemployment rate ticked back up to 9.6% from 9.5% during the third quarter. Unfortunately, this move was outpaced by U-6 unemployment (a more comprehensive measurement) which rose to 17.1% from 16.5% and is now just 0.3% shy of its all time high. Temporary hires have been gradually picking up which, in the past has been a leading indicator of future full time hires. However, in this instance, we believe that it is likely a result of employers using part time workers to accommodate busy periods while keeping overall payroll low. Small businesses remain slow to expand and hire new employees due to difficulties obtaining loans and a persistent lack of clarity regarding future taxes and the implementation of healthcare regulation.

The unprecedentedly high medium duration of unemployment in the U.S. is becoming more concerning as each day passes. The current level is already almost twice as high as any other time since World War II and gives further credence to the notion that many of the jobs that have been lost over the past few years have permanently disappeared or moved to other areas such as Asia, India and Latin America.

The notion that we can have a sustainable real economic recovery with U-6 Unemployment above 10% and a housing market that continues to muddle around at decade lows is simply not something we can put faith in. Some of the more optimistic analysts on Wall Street say that it is normal to have a jobless recovery based on strong corporate earnings growth but there are two main problems with this thesis.

1.) Where is future earnings growth going to come from? Companies have already laid of more workers in a one-year period than during any other time in recorded history so additional cost cutting is likely to cut into muscle rather than fat. Also, profit margins are currently rolling over from business cycle highs rather than turning up from the lows as they were at the beginning of the rally.

2.) This recession and recovery are not normal by any measure. Below is a list of serious conditions that are not in any way normal and need to be addressed as soon as possible.

a. The percentage of the long-term unemployed (over six months) has been above 40% for months. The highest this percentage has ever risen in the past ten recessions was 30%.

b. One in six American adults is either unemployed or underemployed. You could only call this normal if your baseline for normality is the Great Depression.

c. A record 20% of American disposable income is now coming from Uncle Sam in the form of Federal and State salaries, food stamps, unemployment benefits, social security, etc. Historically, economies that are highly concentrated in the public sector do poorly because it crowds out investment by small businesses and results in poorly allocated resources. This trend has been gaining momentum since the 1980’s (see chart below).

d. We are more than a year into the “recovery”, yet household income is still contracting instead of rising.

e. We experienced 26 consecutive months of job losses totaling 6.2 million during the Great Recession, followed by just three months of gains in which we only gained 883,000. Since then, we’ve had four more months of declines in which another 405,000 jobs were lost.

We are especially concerned about these pieces of data because of the extraordinarily stimulative backdrop that these problems are occurring under. The Federal Reserve is holding interest rates at zero while tripling the size of its balance sheet, bringing our annual deficit to GDP ratio to just over 10% (about three times higher than in 2008). The last and only other time that our annual deficit to GDP ratio reached double digits was in 1945 when we were ending the war with Germany and Japan.  In addition, we had the $787 billion stimulus package that was supposed to cap the unemployment rate at 8%. Under such conditions, the fact that the job market and overall economy are not vigorously roaring back to life is very troubling.

Housing Market
Although home prices continued to slowly grind higher during the third quarter, sales fell dramatically, bringing new sales to their lowest point since the Census Bureau began keeping records back in the 1960’s. Of the sales that took place, an average of approximately 25% of them were foreclosure/distressed sales, much higher than usual.

Despite the small gains in price over the past year, the 20-City S&P/Case-Shiller Composite remains almost 30% below its peak in mid 2006. The housing market continues to suffer from oversupply and low demand because of persistently high unemployment. Homes are more affordable in terms of price and mortgage rates than any other time in the last century, yet people are still not buying because of an unwillingness to take on new debts, economic uncertainty and the continually growing shadow inventory of houses which could cause further declines in price when they come on the market. Most economists believe it could take another 2-5 years until the housing market is able to reach a level of equilibrium.

When you take a look at the kind of gains some housing markets experienced during the boom years, it would be entirely reasonable to expect further declines in home prices (see graph below).

Market Summary

The S&P 500 recouped most of its losses from the second quarter by gaining 11.30% as speculation began to build around the prospects of a second round of quantitative easing by the Federal Reserve and other central banks around the world. Our defensive posturing, which benefited clients greatly in the second quarter, was a drag on performance during the third with our composite client account gaining a still respectable 5.75%. Our composite is now neck and neck with the S&P 500 year to date with a gain of almost 4%.

The MSCI EAFE (European, Australasian & Far East) index roared back to life in the third quarter with a gain of 16.53% as investor enthusiasm regarding emerging markets overshadowed concerns over worsening conditions in European financial markets. The EAFE is now up 1.45% year to date compared to 3.89% for the S&P 500. Despite the financial troubles in the Euro zone, we remain confident in our positions in the emerging economies in Asia, Latin America, and India as well as select developed overseas markets with little financial and currency exposure.

The Barclays Capital U.S. Aggregate Bond Index also benefited from quantitative easing fervor and continued to chug along with a gain of 2.49%, setting yet another multi-year record on August 25th. The index is now up 7.95% year to date, making it the best performing asset class for 2010. Bonds have had a great run but we will be watching for signs of weakness in the further out parts of the yield curve for signs that the credit markets are no longer responding to efforts by the Federal Reserve to support the market.

We are quite pleased with the performance of our composite of client accounts so far in 2010, having mostly matched the returns of the S&P 500 but with substantially less volatility. Although there is no crystal ball with which we can predict the future path of the markets, we believe that our client portfolios are well positioned going into the final quarter of 2010 for whatever uncertainties lay ahead.

Words of Wisdom for 2010

“If you lead the horse to water and it won’t drink, just keep adding water and maybe even spike it …”

Former Dallas Fed President, Mike McTeer, commenting on the wisdom (or lack thereof) of undergoing a second round of quantitative easing by the Federal Reserve

Quarterly Investment Newsletter – Q1 2010

April 21, 2010

Overview & Outlook
The first quarter of 2010 was one of extremes and started things out with a bang. The S&P 500 began the year at 1116 and quickly rose to 1150 before undergoing a 9.2% selloff (the steepest since the recovery began in March of 2009) down to 1044. Investors (such as ourselves) took advantage of the “sale” on stocks during the selloff and used it as an opportunity to add to positions. The ensuing buying pressure caused a 12% rally and the S&P 500 ended the quarter up at 1169.

Optimism abounded during the first quarter as corporate earnings continued to meet or beat expectations; auto sales maintained their upward trend and 4th quarter U.S. Gross Domestic Product (GDP) registered growth at an annual rate of 5.6% (the strongest growth since 2004). The jobs picture also improved in the first quarter with a drop in the unemployment rate down to 9.7% from 10% in December.  March was especially strong as the economy added 162,000 jobs, the biggest monthly gain in over three years. Unfortunately, over 40,000 of those jobs were temporary Government hires for the Census and, after dropping to 9.7% in January, the unemployment rate has not fallen any further.

The signing of the health care reform bill by President Obama eliminated some uncertainty in the markets; influencing performance positively. Although the long term effects of this legislation are not yet clear, companies can now move forward with a solid understanding of what the rules of the game will be. Economists had been arguing that until the bill was either signed (or killed) it would be very difficult for companies to hire new employees because they wouldn’t know the true cost of employment.

Credit markets also continued to improve with the spread between corporate and government bond yields falling back to historically normal levels. Inflation was beginning to be a concern for investors towards the end of 2009 but the Consumer Price Index (CPI) data from the first quarter of 2010 allayed those fears by showing very muted gains. This maintains the foundation that the Federal Reserve needs to maintain its “exceptionally low levels of the federal funds rate for an extended period” while also providing financially strapped consumers with lower prices for their everyday items.

Despite the good news, there continue to be significant caveats and reasons for caution:

  • Unsustainable GDP Growth
    The blistering 5.6% GDP growth rate from the fourth quarter is not likely to be repeated because it was primarily driven by companies stocking up their inventories for the holiday season. Inventory stocking is typical in the fourth quarter but its effects were magnified in this case because companies were being cautious last year and maintained especially low inventories during 2009. To provide some context, we would need three more quarters of 5%+ GDP growth to drive unemployment down just 1%.
  • Weak Jobs Market
    Although the unemployment rate has fallen from its peak, it is still at historically elevated levels. U-6 Unemployment (a broader and more complete picture of unemployment) had been slowly declining but has now been ticking upward since February and registered at 16.9% in March. The picture gets even worse when you look at the details. Out of all the unemployed Americans, 44.1% have been unemployed for more than six months (almost double the worst level seen in our last recession). Also, many people who have been unemployed for more than a year are no longer being counted in the official statistics. This trend has only been getting worse and could mean that a lot of the jobs that have been lost are not coming back (particularly in construction, manufacturing and financial services). Unemployment rose in 24 states, while California, Florida, Nevada and Georgia all set new records for joblessness in March.
  • Rising Oil and Commodities Prices
    Over the past couple of years, oil companies have drastically cut their capital expenditure budgets for building new capacity because global demand had significantly slowed. Following strong stimulus programs from around the world – most notably China’s – demand for commodities and oil has been rising and global demand for oil is expected to set all time records in 2011. This strong demand combined with a diminished supply of oil could cause another sustained run-up in oil prices, which would severely dampen the economic recovery taking place.
  • Interest Rate Policy and Bank Lending
    A key driver of this recovery has been the strength of banks and their ability to keep credit flowing throughout the economy so that consumers can spend (even when they shouldn’t) and companies can expand. The more money banks make, the more credit they can provide. With the Federal Reserve holding their overnight lending rate at effectively zero, it has been extremely easy for banks to make money by borrowing from the Fed (AKA U.S. taxpayers) at a rate of 0% and then lending it out to companies at a rate of 5% or more; essentially providing the banks with windfall profits. Eventually the Fed will need to raise rates to stave off inflation, which will severely crimp the margins of banks, limiting their ability to continue contributing to growth.
  • Continued Uncertainty Around Financial Regulation
    Now that health care legislation has been passed, the administration and congress can turn their attention toward regulating of the financial services industry There is strong political and popular will to ensure that a financial crises of the magnitude that we saw in 2008 does not repeat but it is still unclear whether it will be done in a way that would impair the ability of banks to provide credit. Major banks made themselves easy targets by taking taxpayer money (whether they claimed to need it or not) and then spent lavishly on employee compensation stoking outrage that continues to smolder.
  • The U.S. Budget Deficit and Tax Increases
    In combating the recession and reforming the healthcare industry, the U.S. budget deficit has grown to unprecedented levels. This has been exacerbated by falling tax revenues due to lower corporate profits and consumer income. President Obama has already said that taxes will need to be raised for upper class Americans but it is not unreasonable to assume that lower income levels could also see higher taxes. Of particular concern for the stock market is that taxes on capital gains and dividends may also be raised, which would most likely be perceived negatively by the market.The elephant in the room however is looming social security and Medicare expenses that will continue to balloon as the baby boomers retire. Any reform will most likely require a mixture or higher taxes, reduced benefits and tougher eligibility requirements. Faced with the prospect of higher tax rates and decreased social benefits, investor sentiment is likely to wane.

Despite our caution we are hopeful and optimistic that economic data will continue to improve. We would like to believe the market cheerleaders on CNBC who say that we are in a new long-term bull market but unfortunately, the facts of the situation do not yet support that assertion. Although we have increased our exposure to certain areas of the market recently, we have done so with a defensive posturing.

During times like this when hope and optimism outweigh the raw data, it’s important to maintain perspective and discipline. Warren Buffett said it best in a letter he wrote to his investors during the stock market frenzy of 1969:

It is possible for and old, overweight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.

Market Summary
Although very volatile, the S&P 500 continued its upward march, gaining 5.39% in the first quarter of 2010 and bringing its return for the trailing twelve months to 49.76%. However, it is still down more almost 19% from the October 2007 market highs. Meanwhile, our average composite client portfolio is less than 4% away from the 2007 highs after rising 1.62% in the fourth quarter and 7.84% over the past year.

The MSCI EAFE (European, Asian & Far East) index continued to underperform U.S. equity markets with a gain of only 0.94% in the first quarter, bringing its’ total return for the past year to 55.19%, slightly above the S&P 500. We feel that the MSCI EAFE is still being held back by a strengthening U.S. Dollar as well as concerns over sovereign debt in countries such as Greece, Ireland and Portugal. Despite these concerns, we maintain a favorable view on foreign/emerging markets as a whole because of their stronger fundamental growth prospects and lower consumer debt to income ratios.

The Barclays Capital U.S. Aggregate Bond Index underperformed equities during the first quarter of 2010 with a gain of 1.78%. The index is now up 7.70% over the past year and yields approximately 3.8% as of the close on March 31. The recent underperformance of bonds is likely due to investors shifting money from bonds (which are relatively safe) into riskier assets such as stocks (which offer greater returns). Another downward force on the price of bonds is speculation regarding when the Federal Reserve will begin to raise interest rates (higher rates tend to depress the price of bonds) and by how much.

Final Thoughts
We are proud of our long-term market beating track record and believe that it is a testament to the effectiveness of our investment approach and methodology. Over the previous five years, our composite portfolio performance tallied an increase of almost 28% net of fees compared to a gain of just 9.94% for the S&P 500, and we did it with less than half of the volatility.

Although we have underperformed the market in some years of exuberant rallies, we have consistently outperformed by a wide margin during years in which the market declined (the times that truly matter). As Warren Buffett would say “our defense has been better than our offense, and that’s likely to continue.”

For detailed information on our historical investment performance, please email us at info@PacificMountainAdvisors.com.

Investing Words of Wisdom for Q2 2010

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

– Paul Samuelson

Wishing you all the best,
The Pacific Mountain Advisors Team

“We’re Here, to Take You There

Annual Investment Newsletter – Q4 2009

January 1, 2010

Overview & Outlook
There has been much to celebrate during 2009 as the stock market ended its’ free-fall and set off on one of the biggest single year gains since the Great Depression. We have also seen continued improvements in many economic indicators such as temporary hires, corporate earnings and initial unemployment claims. Credit markets are no longer frozen and many companies from around the world have been able to successfully issue debt and equity to strengthen their balance sheets. Due to the global nature of today’s economy, negative elements fed on themselves on the way down, but thanks to the swift action of governments and central banks from around the world, we were able to prevent further disaster. Globalization may now help us during the recovery and the stimulus programs enacted in 2009 come in to full effect during 2010 which could possibly lay the foundation for a self-sustaining recovery going forward.

Despite the steadily improving flow of news, we remain cautious because of many structural issues carried over from the last few years that remain to be dealt with and because of the significant caveats that apply to much of the good news. For example, the big recent fall in initial unemployment is to be expected at the end of the year because companies usually try to avoid the bad PR of laying off employees going into the holidays.

At this time last year, investors were excessively bearish on the economy and were pricing in a large probability of a complete collapse of the financial markets. Over the course of 2009, the market became decidedly less pessimistic and began pricing in a strong recovery. The S&P 500’s projected 2010 price/earnings ratio of 19.9 is  above the historical average of approximately 16, but is still within  normal ranges experienced during the early stages of a recovery. Although we do not feel that the market is significantly over-valued at current levels, looking ahead we see few catalysts for significant sudden additional gains and after pouring over historical data, we believe there is a relatively high likelihood that the market will correct moderately to the downside as previously mentioned issues play out and the following headwinds begin to manifest:

  • Tepid Employment Outlook
    Although the initial unemployment claims numbers have been declining recently, a disturbing trend in the data has been emerging in which continued unemployment has been rising almost proportionally. This indicates that a growing number of people have been and are being disconnected from the labor market for almost a year. These people will lose their unemployment benefits soon, depressing their ability to contribute to the economy while also subtracting from the spending power of those who remain employed because many people are now using discretionary income to support family members and friends who have fallen on hard times. U.S. holiday consumer spending was up slightly in 2009 from 2008 but remains a long way off from 2007 numbers.To make matters worse, many of the jobs that have not yet come back (such as manufacturing, financial services, automotive, etc.) are not likely to return to pre-crash levels of employment and sectors that are growing such as health care are not hiring as much as they normally would be because of persisting uncertainty regarding regulation in the sector.
  • Withdrawal of Monetary and Fiscal Support
    A large part of the recent global rally has been due to strong fiscal and monetary policies enacted around the world during the crisis but these will be fading out and expiring over the next couple of years as central banks and governments withdraw liquidity to keep inflationary pressures from building into additional asset bubbles. The U.S. Government is by far the biggest borrower in the world and it hasn’t even come close to issuing all of the debt that is required to fund its’ growing deficits. Now that a complete global financial meltdown is off the table, investors are already demanding higher yields to make purchasing sovereign debt worthwhile considering the balance sheet problems facing the issuers. The U.S. is in one of the worst fiscal positions of all developed nations because of our ballooning spending and declining revenue base. If this can’t be brought under control, Yields on treasuries will eventually put serious pressure on an already fragile credit market and economy.
  • Hobbled Banks and Declining Credit
    Commercial banks are the backbone of the worlds’ credit markets and they have been badly injured over the past few years and are still being held together by unprecedented levels of legislative (termination of mark-to-market), monetary (lowering of central bank discount rates around the world) and fiscal (TARP, etc.) support. The banks are still being hobbled by a multi-year build up of toxic “assets” and exceptionally high default rates on a wide range of consumer and commercial loans. The situation is most acute in areas such as Greece, Ireland and Dubai where lending practices were utterly absurd but is also impacting nations with highly developed financial systems like the U.S. and the U.K.

    This has significantly curtailed the ability of banks to loan out new funds in the market, which would in turn spur economic growth. These toxic assets are also likely to have a very slow and rocky path to recovery because commercial real estate has longer rental lockup periods than the residential market so much of the damage may not have even occurred yet. Meanwhile, the “green shoots” of a recovery in the residential market could easily be trampled from the large shadow-inventory that banks are holding and as more and more people remain unemployed for so long that they can no longer make payments.In recent prior U.S. recoveries, we have always been assisted by expanding credit and declining savings rates which spur demand, however, the most recent recession seems to have fundamentally changed things and our economy is no longer being boosted by leverage. The weakened banks can no longer increase the credit they give out (in fact, credit has been contracting) and Americans have begun rejecting their debt-loving nature, sending the national average savings rate above 4.5% in 2009 for the first time since 1998.

    The markets rejoiced and rallied on the news that many of our nations’ major banking institutions had returned to profitability. Unfortunately, the opposite reaction could take place when/if investors realize that the return to profitability was heavily aided by taxpayer support and that normalized bank earnings will be lower going forward because of weakened balance sheets and lower levels of lending.

  • Persistent Structural Uncertainty
    In the past, the U.S. has often been the leader in many monetary, structural and regulatory matters but we seem to be in a state of ‘paralysis by analysis’ this time. Very intelligent individuals are looking at the same data but drawing very different conclusions on what it means and what should be done about it. There continues to be a great deal of uncertainty concerning the Federal Funds Rate over the next several years and government intervention in the markets as we mentioned in our newsletter from the Third Quarter.There are also other issues that have been temporarily swept under the rug which could come back to haunt during 2010 such as health care reform, regulation of the financial industry, changes to the tax code and taxes on greenhouse emissions. We feel that these are important issues that must be tackled comprehensively and in a timely manner. Unfortunately, this will likely continue to be a challenge for the current Congress and could become even worse following the 2010 midterm elections. Every day that goes by while these issues are in play is another day that executives will delay decisions on hiring and expenditures because of uncertainty about the impact of their decisions.

Despite the challenges still facing the U.S. and global economy as well as the many caveats for good news, we remain focused on the long term and strongly believe that stocks and bonds around the globe will be higher in five years than they are now. The U.S. has especially difficult challenges ahead of it but we have faced challenges in the past and emerged stronger than before. This may mark the end of America as the world’s sole superpower but we feel that the rise of other competing nations also means an expanding middle class abroad creating a larger market for us to sell our goods. We see this as a great opportunity for America over the long term because it could help to resurrect key sectors of our productive manufacturing capacity, lower our trade deficit and provide a source of strength for our middle class.

We will continue to regularly revisit our investment thesis and will incorporate new information throughout 2010 with an emphasis on protecting recent gains and preservation of the capital that you have entrusted to us. Given the uncertainty surrounding our domestic and global outlook, we feel it prudent to position client portfolios so that they may benefit from the widest range of outcomes while keeping risk low by not making outsized bets on any single country, industry or asset class.

Our prudent and defensive posturing over the past two years helped our clients lock in gains before the 2008 crash and emerge relatively unscathed from the worst financial crises since the Great Depression. We use this comparison because of the great similarities between then and now. The Great Depression began in 1929 when the market fell steeply following years of greed and financial excess (sound familiar?). Market sentiment quickly recovered and stocks experienced one of their greatest runs in history over the next several months as investors covered short positions (bets that the market will fall). The rally took the market all the way to the half-way back point (almost exactly where we are right now) but investors began taking profits as they waited for the projected fundamental economic improvements that did not materialize and the market proceeded to dive and didn’t fully bottom until almost four years later in 1933.

Mark Twain once said “History doesn’t repeat itself, but it does rhyme” and with this perspective in mind we approach the uncertainty that lies ahead with caution and an emphasis on flexibility and capital preservation.

Market Summary
The S&P 500 composite slowed its’ growth gaining only 6.04% during the fourth quarter to rack up a total gain of approximately 26% during 2009. However, it is still down almost 23% from the July 2007 market highs. Meanwhile, our average composite client portfolio is less than 6% away from the 2007 highs after rising 1.42% in the fourth quarter and 6.64% in 2009.

The MSCI EAFE (European, Asian & Far East) index underperformed U.S. equity markets with a gain of only 1.1% in the fourth quarter, bringing its’ 2009 gain to 23.23% which approximately matches the S&P 500. The index now sits only 35.8% below its’ 2007 highs. We feel that recent underperformance was partly due to the strengthening U.S. Dollar and disparities in when different global markets bottomed.

The Barclays Capital U.S. Aggregate Bond Index underperformed equities, shedding 1.65% of its’ value during the fourth quarter after reaching a multi-year peak on November 30th. The index is now down 0.97% over the past year as investors have moved money into equities although it is still up 16.73% since the lows in 2008. The recent fall in price has mostly been caused by bond investors moving into riskier stocks, as well as fears regarding rising inflation which are reflected in the significant relative outperformance of our inflation protected treasuries.

Investing Words of Wisdom for 2010

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

– Warren E. Buffett