Quarterly Market Overview – Q3 2011

October 21, 2011

Market Overview

Equities
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


Part Three: Retirement in Times of Uncertainty – Managing Retirement Income

July 8, 2010

For years, many retirees and people near retirement could bask in the near certainty that with sound asset allocation and a long term investing perspective, they could expect a steady and possibly even a growing stream of income during retirement.  Unfortunately, the recent global credit crises and ensuing recession has forced many investors to reevaluate their retirement income strategy.  Given that we are in a period of unprecedented uncertainty and global economic turmoil, what can be done to help provide a stress free retirement?

Clearly define your current and future income needs
The amount of income you require changes over time and is different for everyone but there are generally four phases that are relevant to most individuals.

  1. The Spending Spree: During the first phase, people tend to initially spend a bit more than they did while working because of pent-up demand for activities like traveling and remodeling.This phase typically last 2 to 4 years and spending tapers off over time.
  2. Reversion to the Mean: In the second phase, expenses tend to decline back to the pre-retirement level as the activities on people’s “want-to-do” list gets completed.
  3. The Golden Years: During the third phase, overall expenses usually decline even further as people settle into their golden years and become less active. However, a notable exception is that health care expenses generally rise during this stage and should be taken into account as part of any comprehensive financial plan.
  4. Accelerating Expenses: In the fourth phase, expenses can accelerate significantly due to the increased cost of health care and senior support services. Although this phase is typically the shortest, it tends to consume a relatively large portion of total retirement assets.

An understanding of these phases provides valuable insight into your potential  income needs and enables you to proactively plan for the future. It will also be helpful to consider both essential and discretionary income needs so that you can build some flexibility into your ultimate plan in order to respond to the many unanticipated future events that may occur.

Conservatively assess where you stand now
After projecting your future income requirements, the next step is assessing the likelihood that your resources will be adequate to meet these objectives. You should work with your financial advisor to establish reasonable assumptions for income growth, investment return, tax rates, inflation, etc. so that you will have a general idea regarding how close you will be to meeting (or exceeding) your goals. When making assumptions, it is best to use conservative estimates so that you won’t be taken by surprise by any unseen bumps in the road.

Create a strategy for success
After determining where you currently stand in relation to your goals, you can make adaptive choices to ensure success or you may decide that you don’t need a second vacation home and maybe your children can take on student loans or work part time to help cover education expenses. Delaying retirement, working part time and selling a primary residence are all common tactics for getting your financial plan back on track.

It’s also important to speak with your financial advisor about tactical distribution strategies such as whether to take distributions from your Roth or regular IRA first and what allocation of income versus growth investments is optimal.

Regularly review your strategy and progress
Life is an ongoing process of adapting to change and any retirement income strategy must be regularly reviewed and revised to ensure long term success. Changes to tax law, economic conditions, your personal life and health challenges are all things that could affect your strategy. Meeting with your financial advisor at least annually will help you stay informed and on track to meet your goals. Independent studies have shown that people who meet at least once a year with their financial advisor are more likely to feel confident about their future and to successfully achieve their retirement goals.

If you have any questions or concerns about your retirement strategy and progress, we would be happy to have a conversation with you so feel free to give us a call or send us an email.

All the best,
Pacific Mountain Advisors Team


Part Two: Investing in Times of Uncertainty – Low Risk and High Yield Strategies

March 26, 2010

In our previous post we emphasized the importance of having a comprehensive financial planning review as way to manage uncertainty and the never ending process of change. An important fundamental aspect of any personal financial planning review should include an analysis of your investment portfolio strategy. An investment strategy review enables you to incorporate new research and adapt to actual and probable changes in the global macro-economic landscape as well as your personal financial situation.

Since October 2007, we have seen the S&P 500 move from 1,565 down to 666 and then back up to 1,180. During that time, economic analysts made a wide range of predictions including a “small correction in housing” to a complete collapse of the financial markets leading to a second depression. Even now, there is nothing close to consensus on where the economy and market are heading due to pervasive and unprecedented systematic uncertainty. On one end of the spectrum, we have analysts forecasting a 1937 style double dip recession arising from sovereign defaults, deterioration in the commercial real estate market and a prolonged period of above normal joblessness which will eat away at consumer spending. However, there are analysts on the other side of the spectrum predicting a very robust recovery due to pent-up consumer demand supported by the expanding middle class in emerging markets.

The uncertainty arising from these widely disparate outlooks can make investment decisions all the more challenging. Fortunately, the ability to predict the future is not a requirement for successful investment management. At Pacific Mountain Advisors, we have observed over recent years that there is a suprisingly small correlation between performance metrics such as earnings/GDP growth and the prices of stocks. For example, the S&P 500 had one of its best performing years in 2009, even though unemployment was rising and GDP was contracting. Markets initially recovered last year as investors cheered that we had avoided a total global economic collapse, however, the subsequent stages of the rally took place because investors began speculating that economic conditions would dramatically improve resulting in the much ballyhooed V-shaped recovery. Although we would like to believe that the speculators are correct, we feel that it is wise to remain cautious and flexible until economic facts support this belief.

It’s easy to get caught up in the black and white hype of boom or bust, however reality is much more colorful and digging your heels in with either camp forces you into a situation where heads, you win – tails, you lose.  By remaining flexible and diversified we are better able to better manage volatility, reduce risk and benefit from the widest possible range of outcomes. For these reasons, we continue to be rooted in the core fundamentals of our value oriented  investment methodology such as diversification, cash flow and tactical asset allocation/rebalancing.

Since the founding of Pacific Mountain Advisors, our focus on intrinsic value, demand-based fundamentals and portfolio cash flow has helped us to substantially outperform the overall stock market on a risk adjusted basis. Although some aspects of our proprietary methodology have changed, our overarching principles remain untouched. We seek out investments that  A.) Are more conservatively valued relative to the overall market, B.) Have a history of paying substantial dividends that are growing (historically, reinvested dividends have accounted for over 40% of the stock market’s total returns), and C.) Stand to benefit from secular or demand driven growth trends such as clean energy or emerging economies. This low-valuation and high dividend approach enhances long term investment returns while also providing shorter term price support.

It is generally believed that nobody can reliably predict the future, however, not only is that technically untrue (you can predict that the world will continue to change and will be much different ten years from now), it also completely fails to address the real issue that you do not need to predict the future in order to effectively manage investments. Time spent trying to see into a crystal ball will surely be less productive than working with your financial advisor to  implement a diversified investment strategy customized to your individual situation and reviewing it on a regular basis. This will help ensure better outcomes by keeping your portfolio up-to-date with the constantly evolving markets as well as changes in your investment goals and preferences.

“I don’t look to jump over seven foot bars; I look for one foot bars that I can step over”.
– Warren Buffet

All the best,
Pacific Mountain Advisors Team


Part One: Planning in Times of Uncertainty – Review, Revise, Repeat

March 11, 2010

This may sound a bit like a Zen koan but if you are certain that uncertainty will continue and even increase then at least you are certain about that. Greek philosopher, Heraclitus first expressed this concept thousands of years ago with his observation that “the only thing that is constant is change“.

It is widely understood that the pace of change on the planet is accelerating and dramatic shifts in economic, social and political realms will occur with greater frequency. Unexpected and potentially disruptive events will continue to influence and shape our world during this period of transition as we move forward into the this next millennia. I’m hopeful about the long-term prospects for the economy but pragmatic regarding the shorter term effects that this increased volatility will have on individual lives and communities. However, expecting the unexpected allows you to broaden your perspective about what is possible and to position yourself with a strategy that will provide you with greater flexibility for responding to these issues.  Risk is always present, but at least we can manage our exposure to it. This awareness informs how we approach both portfolio management and financial planning for our clients.

Having an up-to-date comprehensive financial planning strategy that reflects changes in the global  investment landscape as well as any changes or probable changes to your financial situation and goals will help you make more coherent decisions and better navigate through these uncertain times. We have recently revised our fee and service model to incorporate comprehensive planning reviews for most of our clients. Below, are some of the areas of interest our clients have expressed, which serve to underscore the need for a regular planning review.

  • Retirement Planning: Recent studies indicate that retirement planning is one of the most significant concerns of U.S. workers and also one of the most neglected issues. Many Americans do not even have a financial plan and those that do have had to revisit their assumptions due to a change in employment, household income and in the value of their real estate and/or investment portfolio. The past few years have underscored the importance and value of regularly reviewing your retirement plan, investment assumptions and implementation strategies. People should assess the changes in their lives on a regular basis and incorporate the new assumptions into their overarching financial plan to reflect current realities and achieve the best possible outcome.
  • Monthly Cash Flow Analysis: Furloughs, lay-offs and declining revenues for the self-employed have put pressure on many household budgets, emphasizing the importance of reviewing your budget regularly and making revisions to ensure your financial flexibility.
  • Education Funding: Many college funding plans have been damaged by the market over the past few years. Coupled with the continued rise in education costs, these plans need to be reviewed and revised to reflect the current reality. Some may add more funds to make up the gap, alter investment parameters for a larger return, or simply delay withdrawal until Junior or Senior year.
  • Mortgage Management Strategies: Current mortgage rates are at historically low levels and the interest income that can be made on deposits are minuscule. For people in a position to refinance, it may make sense to pay off the balance and become debt free.

The most valuable aspect of the planning review is the dialogue that takes place during the review process. The facts inform the discussion but the iterative process of sorting through various options and concerns provides the insight one needs to make intelligent, informed decisions.

“Planning is bringing the future into the present so that you can do something about it now.”
– Alan Lakein

All the best,
Pacific Mountain Advisors Team