Quarterly Investment Newsletter – Q1 2011

April 21, 2011

Market Summary

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

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

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

Positive Developments

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

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

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

Headwinds for 2011 & 2012

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

Jobs & Housing

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

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

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

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

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

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

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

European Sovereign Debt Crisis

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

Domestic Budget Deficit

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

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

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

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

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

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

Valuation of Market

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

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

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

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

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

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

Global Macroeconomic Risks

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

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

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

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

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

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

In Summary

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

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

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

– The Pacific Mountain Advisors Team

Words of Wisdom for Q2

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

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

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


Quarterly Investment Newsletter – 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 2010

October 29, 2010

Overview & Outlook

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Market Summary

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

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

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

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

Words of Wisdom for 2010

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

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

Quarterly Investment Newsletter – Q2 2010

July 27, 2010

Overview & Outlook

As the euphoria faded from the large rally of the first quarter, the S&P 500 fell dramatically under price action that was reminiscent of 2008, giving back all of the gains from the first quarter and bringing the year to date performance down to a negative 6.65%. There have been a few much ballyhooed “rallies” on the way down but so far they have turned out to be nothing more than hopeful bounces.

Our cautious stance helped our clients to outperform the market during the second quarter by almost 8%. Needless to say, we are glad that we kept our powder dry by being underweight equities. We welcome the weakness in the market because our large cash position will allow us to strategically re enter at better prices when conditions begin to turn around. So far, our patience has been well rewarded.

Below, we will examine key developments and the important economic data that have been on investors’ minds and moving the markets, both domestically and around the globe.

Domestic Developments:

Gross Domestic Product (GDP) Data
Corporate earnings and economic data had been strong going into the second quarter but we had expressed concern over the sustainability of this trend as well as the many caveats to the good news. The strong GDP growth of 5.6% from the fourth quarter of 2009 was not repeated in Q1 and GDP growth fell dramatically to 2.7% as we expected given that a large portion of the growth from Q4 was related to inventory restocking. Wall Street analysts went into the second quarter of 2010 with bullish GDP growth estimates as high as 4.5% but over the course of the quarter, they were slowly lowered down to where they now stand at approximately 2.5% (which we still consider to be a bit optimistic).

Even if we don’t get a double dip recession, a considerable contraction from previous levels of growth is likely similar to what took place in 2002 except with a few key differences: 1.) Back then the Central Bank still had the flexibility to lower interest rates, 2.) Former President George W. Bush had the fiscal leeway to dramatically cut taxes, 3.) Consumer credit was still expanding but it is now contracting at double digit rates and 4.) We started a war, which is very stimulative to the economy.

The biggest drivers of our recovery to date have been bailout spending, fiscal stimulus, monetary stimulus and inventory restocking. Bailout spending has likely seen some of its last days with strong popular backlash against further increases in our deficit and fiscal stimulus could actually contract in 2011 as expected higher taxes come into effect. The effect of inventory restocking has likely run its course which leaves monetary stimulus as our last leg of support and even this one looks weak because rates are already at all time lows as a way of begging investors to speculate in risky assets.

Labor Markets
The official unemployment rate fell from 9.7% to 9.5% during the second quarter but a larger portion of the unemployed have been jobless for over six months. When workers are unemployed for long periods of time, they tend to miss out on gaining valuable job experience and become less attractive to potential employers who may think there’s something wrong with them. They also may become discouraged and stop looking for jobs entirely. The median duration of unemployment is now at an all time high of approximately 26 weeks and is about twice as high as any other time since they began tracking the data in 1965. It also goes to further support the notion that many of the jobs lost during the recession will not be coming back.

To give a better picture of the real impact of this recession, a recent survey found that 55 percent of the labor force has “suffered a spell of unemployment, a cut in pay, a reduction in hours or an involuntary spell in a part-time job” since it began.  The most recent unemployment claims report showed a sharp drop but it was in large part because of the political stalemate over extending unemployment benefits which caused many people to not be eligible to make claims. The number would most likely have been somewhat disappointing without this statistical anomaly. Other leading indicators such as the ISM Manufacturing PMI and the Philly Fed Manufacturing Index have also begun to reverse course after months of positive gains.

Leading Indicators
One leading indicator of particular concern is the ECRI Leading Economic Index. Over the past 42 years, there has been an 80% chance that the economy was in recession or about to enter one whenever the index registered a reading of -3.5% or less and it has had 100% accuracy when the reading falls to -10%, although not with a large enough sample data set to consider it statistically significant. The latest reading was -9.8% and seems to go along with the recent steep drop in the manufacturing and lower GDP estimates.

Although leading indicators are valuable, there’s nothing better than looking at the actual data coming out of important sectors of the economy. Financial institutions and the real estate market are two of the best areas to watch because of their sensitivity to some of the most important drivers of our economy such as the credit and real estate markets, which play a large role in the strength of household balance sheets and contribute significantly to GDP.

Many analysts and commentators are arguing that the market is cheap on a forward earnings basis but analysts have been historically horrible at accurately forecasting earnings except for in very strong bull markets. Over the past 25 years, consensus estimates have been too high by almost 100%. The current forward price earnings ratio is ~14 which is still about the 6-10 that markets cycles have historically bottomed at. Even if we give analysts a chance and assume that they are only off by 25% instead of 100%, the P/E ratio would jump to 18 which certainly is not cheap.

Banks and Real Estate
Although financial institutions have been able to post pretty good numbers lately, their ability to continue doing so in the future is very linked to the residential and commercial real estate markets which are on very shaky footing. The problems in the residential market are well known and after years of foreclosures, banks now own a greater share of residential net worth than all other homeowners combined for the first time in history. The banks are still holding onto their shadow inventory to avoid taking write downs which would make their earnings look bad and because they are hoping that prices rebound. The problem with this is that they can’t make new loans to consumers when their balance sheets are tied up in non-performing assets. The major banks have been recapitalized by the Government for the moment, but there seems to be more trouble to come and it’s unlikely that this will work again if there is a second round of losses because of popular and political outrage over taxpayer money being used to support the banking industry.

Leading indicators for the domestic housing market have also not been very good. Building permits have fallen by over 17% since the new homebuyer tax credit expired and month over month pending home sells had their biggest drop on record during June, falling 30%. Approximately 31% of sales are now distressed, which will put further pressure on prices. It is especially disconcerting that all of this bad data is coming out despite the fact that the Government and Federal Reserve are doing everything possible to stimulate growth in the sector.

Market commentators have been talking about the commercial real estate shoe that’s “about to drop” for so long that it is beginning to sound like a boy crying wolf but we believe that the threat is still real. This is evidenced by the recent surge in commercial loan restructurings (more than three times the normal amount) which allow the banks to kick the can further down the road like was done in Japan in the 1990’s. When prices never rose, it caused the economy to stagnate and we can expect similar reactions in the United States as well. Analysts currently estimate that 9% of commercial loans are delinquent and that real estate values are approximately 42% their 2007 peak. If this shoe does drop, it will drop hard.

Politics – Regulation and Taxes
Going into 2010, there was a great deal of uncertainty around the end result of healthcare reform and financial regulation. Healthcare was resolved last quarter and financial reform was finalized at the end of the second quarter, allowing the markets to digest and evaluate the potential effects. As with health care reform, the details of the legislation matter much less than the fact that the uncertainty has been removed. The companies affected by the regulation can now decide how to proceed going forward with much more confidence.

Unfortunately, there is now a great deal of uncertainty in the energy sector because of the disaster in the Gulf of Mexico, which may cause a regulatory clampdown on one of our biggest contributor to growth and jobs. Also, it is extremely difficult for analysts to accurately gauge the full economic aftershocks from the spill. Some economists are estimating that it could take up to 2% off of our annual GDP while others predict that the money spent on cleanup activities could actually contribute to GDP in the near term.

The last major source of uncertainty relates to what tax rates people will be paying in 2011. Many people are already worried that the Government will increase their federal income tax rates to help fund our country’s increasing deficits but there is also a fear that the Bush Tax Cuts on capital gains and dividends could be allowed to expire in 2011. There is already a great deal of uncertainty regarding where the market will be a year or two from now and if the Government were to announce that the Bush Tax Cuts will be eliminated, it would provide a pretty big incentive for ultra high net worth investors and financial institutions to take profits at a lower tax rate while they can. These groups hold a very large portion of all financial assets and could potentially move the market dramatically as they attempt to sell.

Foreign Developments:

Although a lot took place domestically in the second quarter, much of it was overshadowed by concerns about the rest of the world such as the slowing growth in China, the sovereign debt crises in Europe and by extension, the wild fluctuations in the value of the Euro which could crimp profits for their trading partners.

Slowing Growth in China
China exploded out of the recession because of a domestically oriented stimulus package that was more than five times as large as ours was relative to the size of their economy. Their stimulus was also particularly effective because their command style government was able to get banks to significantly increase their loans (even to bad credit cases) in order to stimulate growth. The stimulus has been almost entirely spent already and some recent studies indicate that a lot of the easy money went into Chinese real estate and their stock markets. Currently many new commercial properties remain vacant and the Hang Seng, Shanghai and Shenzhen indexes have been declining for months. These combined factors would indicate that a lot of the lent out money is underwater and that many of the loans made by the Chinese banks may go sour if growth does not continue at its current double digit pace.

Other indicators of Chinese growth have been cooling of late such as commodity prices and the Baltic Dry Index, which effectively measures demand for the raw materials that are essential to fueling China’s large manufacturing industry. The U.S. and Europe are large sources of demand for China so the deteriorating growth in those respective countries could strain its already fragile economy. It is becoming doubtful that China will be able to carry on as the engine of global economic growth in the same way that it has been. Lower growth in China would also lead to lower demand for commodities and raw materials, which would negatively affect resource producing countries like Russia and the emerging Latin American economies.

A key issue that we will be watching is whether or not Chinese consumers begin to save less and spend more. Stronger domestic demand in China would help alleviate global trade imbalances (such as with the U.S.) and will foster longer-term sustainable growth. China’s recent decision to let their currency fluctuate against a basket of other currencies is also a step in the right direction. We continue to feel that the shorter-term risks to growth in China are outweighed by the longer-term opportunities but we will nonetheless proceed with caution given the fragile state of the global economy.

European Troubles
During the peak of the recent financial crisis, investors were panicking over the build up of toxic assets on private sector and financial balance sheets. In Europe (as well as in the U.S.) they alleviated much of that fear by removing the bad debts from private balance sheets, and placing them on to sovereign balance sheets. This strategy of brushing the toxic assets under the rug worked for a bit but now investors are beginning to question whether even entire countries are strong enough to handle the debt burden because of declining tax revenues. The investor concern is currently already up in the form of widening yield spreads on sovereign debt and the inability of countries such as Greece and Spain to borrow money from the international community at non-usurious rates.

In order to counter the deflationary debt environment, governments have been simply creating more debt over the past couple of years. This has worked as a temporary bandage to the problem but by delaying the inevitable, the ultimate process of reducing debt-service to GDP ratios back to normal levels will become even more difficult and the social consequences could be even more severe. The nations of Europe are now facing an important dilemma and neither option looks very good. They can either A.) Continue deficit spending in order to fund social services and stimulate their economies out of recession, or B.) They can cut social services, welfare payments and draw back stimulus measures in order to reign in their deficits.

Fiscal conservatives argue that hyperinflation will be the result if deficits are not reined in within a timely manner and that governments need to cut spending. This would normally be a valid point except that we are currently in a deflationary environment (which is arguably much worse than inflationary) with high unemployment. Both of these factors put downward pressure on prices. The purpose of restoring the health of sovereign balance sheets is to rebuild confidence in the Euro and so that banks can resume lending and companies can go back to hiring. Unfortunately, cutting government spending is likely to have an almost opposite effect (in the short run at least) because governments are large employers and also represent a great deal of demand for private goods and services (solar subsidies for example) so any cutbacks in government spending would almost immediately translate to a worsening recession which is unlikely to inspire confidence.

On the other hand, you have the Keynesians who argue that the only way to get out of the recession is to use government spending to fill the gap left by the fall in private demand. This makes complete sense except that Keynesianism is based on the assumption that governments create surpluses during good times so that they can draw them down in times of crises. There is also very little popular and political will to continue deficit and bail out spending so even if governments do go this route, it may not get very far. However, we’ve already seen the effects of austerity measures being enacted in Greece where there were riots in the streets.

Market Summary

The S&P 500 took quite a tumble in the second quarter of 2010, shedding 11.43% of its value as economic data began to turn around to the downside. Our average composite client portfolio performed relatively very well with a decline in value of only 3.58%, benefitting from our cautious positioning going into the quarter.

The MSCI EAFE (European, Asian & Far East) index fared even worse, losing 13.75% of its value during the second quarter. The EAFE is now up only 6.36% over the past year compared to 14.42% for the S&P 500. We believe the recent underperformance to be directly related to the concerns over European sovereign debt and the value of the Euro.

The Barclays Capital U.S. Aggregate Bond Index had a good second quarter gaining 3.49% and setting a new multi-year record on June 30th. The index is now 9.5% over the past year reflecting a more cautious feeling in the market as investors begin returning to safer assets like bonds and away from equities.

In Conclusion

The global economy is facing many daunting challenges as we enter the third quarter of 2010 but there is nothing new to this. We have faced seemingly hopeless challenges in the past and we have persevered and grown out of all of them. Even if you had bought during the peak before the Great Depression and then dollar cost averaged for the next five years buying at the beginning of each year, you would have made a profit of almost 100% by the end of the fifth year. This is why it is so important to maintain a long term perspective.

We believe that the global economy is going through a significant period of structural change in order to alleviate the imbalances that have led up to the current crisis such as under consumption/over saving in Asia and overspending and a reliance on foreign credit in developed countries. These changes will take time and are likely to have many false starts along the way as investor sentiment fluctuates between fear of losses and greed for profits, but we are confident that the U.S. and global economies will emerge from this transition much stronger (and sustainably so) than when we began. As human beings, it is easy to be afraid of the unknown but from an investing standpoint, pragmatic optimism has historically been much more profitable over longer time periods.

The challenges of today are laying the groundwork for the opportunities of tomorrow. For example, increased American consumer saving is a negative in the short run because they will be spending less, but it is a required step in restoring household balance sheets so that we can spend in the future. The slowing growth in China has so far been well controlled and will hopefully prevent their economy from overheating like many economists had feared and will enable them to continue contributing to global growth. Another major trend is the coming of age of many developing economies such as the Brazil, India, China, South Korea, etc. which are now emerging as major players in the global economy. Their increased strength and consumer demand will likely be a positive force in helping the struggling developed nations to get back on their feet.

Progress and innovation to do not stop for anyone or for anything. Even during the darkest days of recessions, there is research taking place that has the potential to revolutionize the world. The Internet as we know it, has only been around since the mid 1990’s, but it is already apparent how much of an impact it has had on the world, both socially and economically. Today, scientists are almost done mapping the human genome and technology (including biotechnology) is advancing by leaps and bounds. We do not know what the ultimate catalyst will be but we also expect the limited supply of oil and growing global demand to eventually spur massive public or private investment in clean energy technologies which could drive the economy for years to come.

We are certainly on a very bumpy road right now but we remain convinced that the road leads to a good destination. In the meantime, we are keeping our eyes wide open to spot potential potholes and maintaining a cautious outlook as we attempt to balance the favorable longer term opportunities with the current weak market environment.

We continue to be very proud of our long-term market beating track record as well as our performance during downward trending markets like we’ve had recently and we believe it is a testament to the effectiveness of our pragmatic investment approach and methodology. Over the previous five years, our composite portfolio performance tallied an increase of 18.78% net of fees and commissions compared to a loss of 3.93% for the S&P 500, and we did it with less than half of the volatility since inception*.


Words of Wisdom for the Third Quarter

“The return of principal is far more important than the return on principal.” – Will Rogers

Why is Capital Preservation so Important?

November 17, 2009

As the economy has rallied from the March lows, analysts have become increasingly bullish and investment managers  have been growing greedier by the day for every last point on the S&P 500. Unfortunately, many of these people have forgotten one of the key tenets of asset management – Capital Preservation. I will illustrate this point with a simple graph and some sage words of wisdom from legendary investor, Warren Buffett.

“You only have to do a very few things right in your life so long as you don’t do too many things wrong.” – Warren BuffettMr. Buffett must have had this graph in mind when he said that but you don’t need a chart to know that bigger losses mean longer required periods of time to break even. What is interesting though, is that the relationship between losses and years to recover is not linear. This means that each percent of lost money requires an even greater percent gain to get back to even. You can see this effect at work on our portfolio performance as well. We have outperformed substantially on the downside so that we are not forced to take on too much risk by investing aggressively on the upside. This bring us to the next point.

“Be fearful when others are greedy and be greedy only when others are fearful.”   – Warren E. Buffett

At the peak of market excess in 2007, we began pulling client money out of equity markets and putting it into fixed income and high yielding stocks. We felt that overall economic fundamentals were deteriorating and took pause with how investors were scrambling into the riskiest stocks to get out sized returns but with no regard for the downside potential. In other words, the entire market was pricing in only the rosiest of potential outcomes which left little room on the table for additional gains.

Market pundits are now saying that the recession is over for good and that we are in a new bull market. While this is possible, we remain somewhat skeptical because once again, analysts are pricing in increasingly rosy forcasts and investors are rushing to ‘catch the rally’ with little regard to what could happen if the forecasts don’t come true.

We remain well positioned for a wide range of market outcomes and we will continue to closely monitor the markets and make adjustments to our strategy as new information emerges and the situation evolves.

All the best,