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)

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Quarterly Investment Newsletter – Q4 2010

January 31, 2011

Market Overview

After spending the first three quarters of 2010 bouncing up and down in a wide trading range, the stock market broke out to the upside during the fourth quarter without looking back. The S&P 500 ended the year up 15.07%, with about 75% of the gains taking place during the final quarter. This compares to a yearly gain of 8.2% for the MSCI EAFE Index (returning 6.65% in Q4) and 6.55% for the Barclays Capital Aggregate Bond Index (which lost 1.3% in Q4). Global stocks have now rallied over 20% (even more for riskier small and mid-cap stocks) since Ben Bernanke, Chairman of the Federal Reserve, first started talking about a second round of quantitative easing (QE2) to support asset prices (which include stocks), however, this is not the only factor contributing to higher prices.

In addition to the massive monetary stimulus coming from the Federal Reserve, stocks have also benefitted from an even larger $858B fiscal stimulus in the form of the extended Bush tax cuts and temporary payroll tax reductions. Regulatory uncertainty has subsided with a deadlocked Congress and investors have cheered the more business-friendly attitude coming out of Washington as shown by appointing William Daley (former Vice Chairman of J.P. Morgan Chase) to Chief of Staff and replacing Paul Volcker with Jeffrey Immelt (CEO of General Electric) as the new head of his economic advisor panel.

On the non-political side of things, the U.S. economy experienced improvements in capacity utilization rates (although still not anywhere near levels that would pressure companies to hire and expand), part-time hiring and the lowest unemployment claims in two years going into the holidays. GDP growth also ticked up to 1.7% in the fourth quarter, which is not very impressive because  if you subtract the effect of government stimulus programs and QE2, our GDP would still be in contraction. Inventory buildup (not consumer demand) has continued to be a large contributor to growth.

Many emerging market economies are showing signs of overheating with inflation rising into the double digits in some areas, however, their Central Banks have been quick to raise rates but it is still uncertain if these strategies will continue to be effective. Debt fears in Europe have calmed down for the moment due in large part to China and the European Central Bank (ECB) stepping in to purchase euro zone government bonds, especially in peripheral areas such as Portugal, Ireland, Greece and Spain. We view these actions as a temporary band aid and will be watching their respective government bond yields (see below) going forward for signs that their structural solvency issues are being resolved. In the meantime, we are maintaining relatively low exposures to these areas.

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Bullishness Abounds

Despite the improving economic data and news, the extreme level of euphoria in the stock market at the moment is worrisome.

Bullish sentiment has been at very elevated levels over the past couple of months, similar to how it was in 2007 before things started to crumble. Back then, people knew that there were serious risks to the market but they were comforted by the Fed’s reassuring words that they had everything under control. This is also similar to today where market commentators are making statements that there is no way equities and risk assets won’t go up because if the economy doesn’t improve on its own, the Fed will print money to continue supporting prices. The 2010 Barron’s Roundtable for 2011 concluded that:

“America’s structural problems, including a gargantuan deficit, and the policies that perpetuate them, just might bring the country to ruin – but not before the stock market rallies another 5%, or 10% or 20%…”

Do investors really believe they are getting good long-term VALUE for their investments with a macro outlook like that?

Another measure of market exuberance is also flashing warning signs, the Shiller 10 year P/E ratio. This measure takes the average inflation adjusted price/earnings ratio for the S&P 500 over a 10 year period so that it can accurately measure the growth of earnings over multiple business cycles. A high P/E ratio means that investors are willing to pay a high price for each dollar of earnings and vice versa. Many stock market bulls tout the one year forward P/E ratio for the S&P 500 at under 14 and say that it is below average and therefore, the market is cheap. However, if you look at the cyclically adjusted P/E ratio, we are near the high end of a 100+ year range which does not bode well for future longer term returns from this level (see chart below).

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Along with the P/E ratio, corporate profit margins are also near all time highs. This is also concerning because high profit margins attract competition which lowers prices and margins back to a more normal level. P/E ratio’s should therefore be highest when profit margins are low, and vice versa. It seems hard to imagine how investors are going to achieve above average long term returns when they are paying an above average price for above average profit margins that are likely to revert back to the mean.

Aside from market sentiment, there continue to be three major headwinds to the global recovery:

Housing Market

Although sales of new and previously owned homes has been on the rise of late, the more important metric of home prices has continued to flounder. Price is a much more important variable to watch than the number of sales because price is what drives the “wealth effect”, lets homeowners tap into their equity, and spurs new construction (see chart below to see how dead the construction market remains), which in terms drives employment.

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History is riddled with economic bubbles from Tulip Mania in the 1630’s, to the South Sea Bubble in the early 1700’s, to the British railroads in the middle 1800’s, to the Internet Bubble in 2000 and now the housing bubble. The only similarity between them all is that they involved large amounts of price speculation and that they all saw price declines of over 75% from their peaks after adjusting for inflation to their bottoms. Although we doubt that home prices will tumble that far – at some point, inflation, population demographics as well as principals of supply and demand will start to play a large role in supporting prices – we are skeptical that the current decline of approximately 16% is all that will happen (see chart below of the multi-decade home price bubble).

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The details of the past year are even more concerning, especially considering that television and the newspapers are all talking about how much housing is improving. Average home prices for the S&P/Case-Shiller 20 City Composite have fallen 3.38%  over the last 4 months (about 10% annualized contraction) and 14 of the 20 regions are setting new lows or are on their way back down and within a couple percent of new lows. Only one region reported price gains in November but it was 0.1% and is within the range of statistical error and over the past twelve months, the 10 and 20-City Composites has declined 0.4% and 1.6% respectively.

Job Market

Whether we like it or not, the future of both the housing and job markets are dependent on each other. Construction (especially residential) is one of the biggest sources of jobs in the U.S. and the amount of jobs lost during the recession in that sector alone is staggering. This leaves us with the paradox that improving home prices will spur new construction and jobs, however, prices will face downward pressure so long as the unemployment rate is at elevated levels.

While it is good news that part-time hirings have picked up lately, we do not necessarily view it as a precursor to increased full time hires and instead believe that it is representative of a broad shift in America’s labor market in which a greater share of the workforce will be composed of part-time employees. We view this as a negative development because part-time workers make less total income on average, do not get medical benefits and are not eligible for sick days or maternity leave. The issue of lower income is especially important because it means that a higher percentage of take home pay will need to be used for essential expenses, and the remainder is more likely to be saved than spent on luxuries since their job is not stable.

In terms of full time jobs, the market is still not looking very encouraging. Although normally we would cheer a 0.4% one month drop in the unemployment rate such as we had in December, it was a hollow victory for the job market because about half of the drop was the result of 260,000 more workers dropping out of the labor force (after 99 weeks, people without jobs but want one are no longer counted as unemployed) and joining the ever growing army of discouraged workers (see below).

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The labor force is now smaller than it was before we entered the recession, even though it would have needed to grow by more than four million just to keep up with population growth and our civilian labor force participation rate is now down at a 26 year low of 64.3%. Lastly, the graph below compares growth in the job market during The Great Recession to other post-war American recessions and it is chilling reminder that although we’re not seeing mass layoffs, contracting GDP and falling stock prices anymore thanks to unprecedented support from the Federal Reserve and Government, we still are nowhere close to seeing the kind of improvements needed to promote a self-sustaining recovery that leads to organic (not debt-fueled) growth.

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Developed Market Growth & Emerging Market Inflation

Our final major concern is the contrasting growth and inflation dynamics between developed market economies, which are suffering from heavy debt loads requiring deflationary austerity measures, and emerging market economies, which are struggling to rein in inflation due to soaring commodity prices. In an effort to calm fears about ballooning deficits in Europe, many Governments such as Ireland and the UK instituted austerity measures to cut costs. The ensuing protests have died down, but it’s possible that the budget cuts are already eating into economic growth as evidenced by the resumed GDP contraction in both of those areas. We are concerned how long public support for the fiscal restraint will last if their economies continue to contract in 2011.

The issue of emerging market inflation is of particular importance right now because the high food and energy costs in these areas are beginning to spur social unrest. The Government of Tunisia has already been toppled and there are currently protests taking place over high unemployment and rising commodity prices in Algeria, Mauritania, Yemen and most importantly, Egypt, a key ally to the U.S. and stabilizing influence in the Middle East. While none of these events by themselves are particularly serious, the situation could quickly spiral out of control if we were to see similar events take place in more economically important emerging economies such as China, India, Pakistan and Saudi Arabia. All of these countries play crucial roles in the global food and energy supply chain and any disruptions could cause a price shock to the global economy. In fact, this may already be happening with the price of oil. If you look at the chart below, you will notice that there has only been one time in the past four decades where the U.S. didn’t end up in recession when the price of oil increased by more than 50% over a two year period. We are crossing our fingers that “this time will be different” but we will watch this closely moving forward.

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Portfolio Update

Although our composite client performance was neck and neck with the stock market through 2010 at the end of Q3, our conservative positioning held back our performance during the end of year melt up where stocks with poor balance sheets and high levels of cyclical economic exposure performed the best. As a result, our composite performance trailed the S&P 500 in the fourth quarter with a gain of 2.18%, bringing the year end return to a 5.82%. While such short-term underperformance is certainly unwelcome, it is an unavoidable result of the absolute-return, value-driven investment philosophy at Pacific Mountain Advisors that has helped us deliver such solidly market-beating returns since our inception and we see no reason to change that any time soon.

Our equity and commodities/precious metals were the strongest performers during the fourth, riding on the back of inflationary expectations arising from QE2. Unfortunately, these same inflationary expectations put pressure on our fixed income holdings which detracted slightly from overall performance. Another detractor from our performance was our above average holdings of foreign equities, which underperformed the S&P 500. This recent underperformance is not worrying at the moment because a period of consolidation is typical following prolonged upward swings like our holdings have.

We continue to be positive on gold, despite a recent pullback in prices, because of the pervasive money printing taking place in the developed world and the inflationary pressures that are building in emerging markets. We are also positive on commodities over the long term because there is simply not enough viable farmland on this planet to produce enough food for the growing population (especially as consumers in developing markets add meat to their diets as their incomes grow). Climate change is also exacerbating the situation as crop yields fall due to fires in Russia as well as floods in Pakistan and across Southeast Asia.

We made two changes to client portfolios during the fourth quarter:

We changed our equity hedge in the beginning of the quarter from ProShares UltraShort S&P500 ETF (SDS) to PIMCO StocksPLUS TR Short Strategy (PSSDX) to achieve the same directional market protection, but without the performance divergences that result from an ETF recalculating its net asset value every day. While this action saved clients money during the quarter relative to the performance of SDS, the gradual improvements in economic conditions, coupled with the asset price boosting policies of the Fed, caused us to reconsider our position and we sold PSSDX for a loss (or hedged it by buying the Schwab US Broad Market ETF (SCHB) in client accounts where short term redemption fees prohibited us from selling). We always prefer to sell positions for gains but cutting losses is just as important as locking in gains. John Maynard Keynes may have said it best when a critic accused him of flip-flopping on policy recommendations during The Great Depression when he said “When the facts change, I change my mind. What do you do sir?”.

The other significant change  involved client portfolio’s that were holding the iShares S&P California Municipal Bond ETF (CMF). We have had a cautious eye on the municipal bond market for the last year but it wasn’t until the end of Q3 that we really started to get worried. Municipal bonds had been on a multi-year rally and CMF was hitting new all time highs. These new highs meant that the yield on CMF was falling and we began to question whether yields that low would be enough to compensate bond holders for the increasing threat of municipal defaults. Municipal bond investors have always enjoyed the presumption that the Federal Government would bail out the states if things became bad enough, but the new Republican Senate is less likely to allow this. The final straw for us came when we began hearing chatter in Congress about amending laws so that states and cities could declare bankruptcy. While this would help the states to get out of their tremendous debt burden, it would also be disastrous for bond holders. These concerns led us to sell all holdings of CMF in early November at $108.48 per share and protected our clients from the ensuing 10%+ drop that erased almost two years of gains.

Moving forward, we will be looking for pullbacks in the market to boost our equity exposure with an emphasis on high-margin sectors that are benefitting from demand based fundamentals such as global technology and energy.

In general, our equity holdings are higher quality and more conservative relative to the overall stock market, which includes many smaller companies that are dependent on a fast growing economy. These smaller companies may have done well since the rally in risk assets began (outperforming large-cap by a wide margin), but they do not offer the same degree of protection for investors if the economy falters because of their lower average dividend yields, inferior access to capital and weaker fundamental cash flow generation.  These issues are important to us as value investors because as they say in the industry: “In the short-term, the stock market is a voting machine, but in the long-run, it’s a weighing machine”. Therefore, we would expect to underperform (although less so than in Q4) the S&P 500 if the current trend of ignoring fundamentals in favor of momentum continues but we are confident that the positioning of our portfolio’s will reward our clients over the next few years as it has done in the past.

Concluding Thoughts

Heads, they win; tails, you lose has returned to the markets and some money managers are feeling pressure to fill client portfolios with high levels of equities in an effort to beat their benchmarks (which is the basis for how many of them are compensated). If the market keeps going up, they get extra bonuses and their clients make money so everybody is happy. However, if the rally loses momentum (which is one of the key drivers of the market at the moment), their clients lose their shirts like they did in from 2000-2002 and from 2007-2009. In this case, the client is the only one that really loses because the money manager will keep his job since he/she performed in-line with their benchmark (even though the benchmark fell).

At Pacific Mountain Advisors, we are very proud of what differentiates us from that mentality. We don’t get extra bonuses for beating benchmarks and when our clients lose money, we lose money – regardless of what our benchmarks did. Giving up potential additional gains when the stock market is racing blindly towards the sky can be emotionally trying, but we are not here to feel comfortable. We are here to make decisions that often feel very difficult at the time but are aimed at safeguarding and growing the life savings of our clients – not just over the next three to six months, but over the next three to ten years – and as we said earlier, we don’t plan on changing that any time soon.

Word of Wisdom for 2011

“Beware of silent dogs and still waters”

~ Old Portuguese Proverb


Quarterly Investment Newsletter – Q3 2009

October 10, 2009

Overview and Outlook
2009 has so far been shaping up to be a rather historically exceptional year for the stock market. The CBOE Volatility Index (also known as Wall Streets Fear Gauge”) has averaged about 20 since it was created in 1990. It has never fallen below nine and it only rose into the 40’s a handful of times during periods of severe economic trouble. During 2008, the volatility index peaked above 80 and stayed above 40 for several months.

U-6 unemployment (which includes normal unemployed, marginally attached workers, part time who would like to work full-time, and unemployed who have been discouraged from the labor force do to the economy) has climbed all the way to 17%. The only time since the Great Depression in which U-6 unemployment rose this high was 1984, but the market did not rally until U-6 unemployment had peaked in that case. Meanwhile, the Dow Jones Composite Index is on track to set one of its’ biggest yearly gains in history.

Although many economic indicators are no longer in free fall, they still do not resemble any form of real growth and in many cases are still getting worse. We have had recent upticks in GDP over the last three quarters. However, this growth is off of a very low baseline and has been fueled largely by government stimulus programs as well as central banks from around the world flooding markets with excess currency and creating artificial growth through historically unprecedented low interest rates. The true fundamentals affecting our economy such as unemployment, home sales and corporate profits are not significantly better than they were during the March lows preceding our recent rally and improved productivity has come mostly from layoffs. The stock market usually turns up before the rest of the economy, however we still view this rally as very delicate because the key drivers of the recent rally are likely to be short lived. There are several key factors which we feel could derail this fragile situation.

  • Government Legislation – We took a giant backward step in free market capitalism over the last year. The actions by our government may have prevented a complete collapse of the financial markets, but they also served to eliminate the competition of the large incumbent financial firms and solidified their position as too big to fail. This new Government sponsored financial oligopoly has lower incentives to lend because of diminished competition and this lack of credit will in term inhibit the growth of other smaller – but better managed – financial firms.
  • Federal Funds Rate – The Federal Reserve made history for the United States back in 2008 when they lowered rates to an effective level of zero. This would normally cause extreme inflation but it hasn’t yet done so because banks are still not lending even when they can effectively borrow the money for free. At the first sign of even a moderate recovery (most likely before we see any improvement in employment), the Federal Reserve will be forced to increase rates to prevent hyperinflation because of the already precarious position of the Dollar due to our high debt to GDP ratio. This would most likely cause a double dip recession like in the early 1980’s and could severely shake the confidence of the markets.
  • The U.S. Dollar – Low interest rates and monumental federal debt levels (accompanied by a political environment in which the government has strong pressure to spend more to keep employment up) are currently putting strong downward pressure on the Dollar. This is positive for U.S. exporters in the short term, however, our country is a net importer so consumers whom account for a large portion of domestic spending and demand, are having their pockets pinched by the invisible government tax of poor monetary policy. Oil and many other commodities that we depend on are also priced in Dollars which will exacerbate the already high price of oil.
  • Too Much Money Chasing Too Few Assets If things are so bad, why is the stock market setting records for growth? It comes down to simple supply and demand. Markets are being flooded with money by central banks and a great deal of money remains in money market accounts after last years fall. The amount of stocks to buy has remained relatively constant although fewer stocks are worth owning now. This phenomenon of more money chasing fewer investments has caused a artificial rise in their price (but not value). This can be seen by the simultaneous rise in gold, stocks and bonds which typically do not rise in unison.
  • Gravity of Reality Markets tend to overshoot in both directions due to excess pessimism on the way down and excess optimism on the way back up. We undoubtedly overshot on the way down as many asset managers were discounting the possibility of a complete meltdown of the financial markets comparable or worse than The Great Depression. That scenario was taken off the table when unemployment and GDP appeared to have ceased their free-fall and stocks took off rallying. A large boost in confidence came from the return to profitability of many major banks. Unfortunately, their profitability has been buoyed by taxpayer support and new accounting rules that let banks determine the value of their assets for themselves and not based on market realities. Consumer credit and commercial real estate are continuing to deteriorate which will weigh on financial earnings moving forward. Many other companies have also seen growth in earnings but it has mostly been from layoffs and cost cutting. Very few companies are seeing growing revenues going forward which is a more important measure of growth. When people realize that things are only less worse and not actually better, the market will likely pull off of these euphoric levels and back to a more conservative valuation

We will be revisiting our investment thesis regularly over the next quarter as we continue to carefully watch these indicators and incorporate new information into our models. Our primary goal at Pacific Mountain Advisors is to preserve the capital that our clients have entrusted to us, with achieving growth coming in a close second. We expect to maintain a somewhat skeptical stance on the market due to the extraordinarily uncertain business environment and regulatory landscape that we face going forward. By avoiding severe losses such as in 2008, we are not forced take on additional short term risk in order to outperform in the long term. Therefore, we expect to underperform the market on the upside in the short term as we strategically add to equity positions in a cautious manner.

Market Summary
The S&P 500 composite gained 15.6% during the third quarter, however, it is still down almost 7% during the twelve month period ending 9/30/2009. Our average composite client portfolio is handily beating the market over the past twelve months with a loss of less than one quarter of one percent and a gain of 2.95% during the third quarter.

The MSCI EAFE (European, Asian & Far East) index outperformed U.S. equity markets with a gain of 19.52% in the third quarter and is now up almost 4% over the past twelve months. We feel that they will continue to outperform because of lower levels of leverage as well as their greater potential for economic growth when the world reemerges from recession.

The U.S. bond market performed quite well during the third quarter despite the large equity rally as the Barclays Capital U.S. Aggregate Bond Index gained 3.74%. The index is now up 10.56% over the past year with a large portion of the move taking place in junk bonds and other riskier forms of debt. This growing appetite for risky debt could be a reflection of the unprecedented low yields that investors are receiving on their safer short-term Treasuries which have been bid up in price by risk-averse investors.

Portfolio Update
We feel that we are in an enviable position at the moment relative to other asset managers and advisors because of our prudent risk management which helped us sidestep the majority of the 2008’s carnage. With the benefit of time on our side, we have the freedom to be opportunistic in our investments rather than buying out of a desperate need to recoup losses from last year.

We have been gradually entering and accumulating select global positions with strong secular growth potential as well as high quality dividend and fixed income yields. This strategy boosts portfolio cash flow and helps put a floor under prices because of the inverse relation between price and yield which makes stocks and bonds more attractive as they fall in price. Equity dividends also mitigate the effect of inflation on portfolio performance over the long term because their payouts are on a nominal basis.

Investing Words of Wisdom

The most common cause of low prices is pessimism… It’s optimism that is the enemy of the rational buyer [of stocks].
– Warren E. Buffett


V, W, L, or √? and What it Means for Your Financial Future

September 30, 2009

In today’s volatile market, it can be hard to understand the logic and reason behind the seemingly whimsical swings in stock prices – or to know if there even is a reason. Investors are tired of hearing from supposedly educated people on television that our economic recovery (or lack thereof) can be captured in the letters you find in canned alphabet soup.

So What do These Letters Mean?
V-Shaped Recovery:
The stock market rebounds extraordinarily fast without retesting lows on its way to setting new highs. A great example would be the recovery following the Dot-Com Bust.
Causes: V-shaped recoveries often take place after severe panic selling or external shocks to the financial system. In the late 1990’s, the economy was booming because of the seemingly infinite potential of the Internet and strong spending on IT equipment in preparation for Y2K. The Federal Reserve had also been steadily raising interest rates in order to slow growth and suppress what it felt was a speculative bubble. After Y2K passed, growth slowed as companies cut back on spending because they already had everything they needed. This drop in spending rippled through the rest of the economy and the market began its descent. The strong rebound was the result of a excessively low interest rates which encouraged speculative investment in hard assets like real estate and the growth of the credit bubble which has recently burst.

V-Shaped Recovery

V-Shaped Recovery

W-Shaped Recovery: The economy bottoms and begins to recover, but falls again before returning to normal growth. This happened in the back-to-back recessions that took place from 1980-1982 in the United States.
Causes: W-shaped recoveries happen when the initial recovery is fueled more by inventory restocking than by growing demand or when the recovery is accompanied by high levels of inflation. Companies cut back production when a recession approaches, causing an initial drop in GDP. They eventually need to restock which causes a brief  jump in production followed by another drop before real demand begins emerging. Recoveries accompanied by high levels of inflation put pressure on the Federal Reserve to raise interest rates, which also can cause a second dip in GDP because high interest rates slow economic growth.

W-shaped Recovery

W-Shaped Recovery

L-Shaped Recovery: The stock market falls and does not return to a normal level of growth for many years, if ever. This type of recovery is most associated with Japan following the bursting of their asset-price bubble in 1990.
Causes: L-shaped recoveries are typically caused by either severe asset-price bubbles or high unemployment, also accompanied by inflation. Japan had been growing robustly from the end of World War II through the 1980’s. This created excess liquidity (too much money chasing after too few assets) in their economy, putting upward pressure on prices. When their bubble burst in 1990, it triggered a severe and lasting fall in the stock market from which they are yet to recover.

L-Shaped Recovery

L-Shaped Recovery

Square Root-Shaped Recovery: The stock market falls and then recovers quickly before plateauing or progressing at a growth rate that is lower than the prior growth rate. There are some economists who believe that the current credit crises may turn out to be an example of a square root recovery.
Causes: The initial drop in the market is usually caused by an external shock which causes panic selling in order to meet margin calls and fund redemptions. These forced liquidations drive the market lower than its intrinsic value which is why the initial bounce back upward is so forceful and doesn’t retest the lows. However, growth in the following years is constrained by weak credit and job markets as well as people continuing to save more and spend less.

Square Root-Shaped Recovery

Square Root-Shaped Recovery

More Importantly, What do These Letters Mean for You?

Even though so much hype goes into debating about what letter our recovery will look like, it is mostly irrelevant to the investment management process. We stand by our convictions and do not move blindly with the rest of the herd (you only need to look at what the herd did in 2008 to see why).At Pacific Mountain Advisors, we focus on equity market fundamentals, ‘big picture’ macroeconomic trends, and strategic asset allocation among sectors.

Our time tested investing discipline is designed to remove emotion from the equation by rotating client funds away from sectors that are frothy with speculation and into undervalued ones based on our blend of proprietary quantitative and qualitative analysis. Our methodology of locking in client profits on the way up during bull markets, while building exposure to “the next big thing” of tomorrow ensures that our clients are able to participate in bull market moves, while sidestepping the majority of the carnage from bear markets.

I hope that you have found this of value and I encourage all of you to leave comments/ questions below. Also, please feel free to email me with any other questions or topics that you would like to learn more about.

All the best,

Michael Meara