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


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)


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


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