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 – 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

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

July 8, 2010

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

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

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

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

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

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

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

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

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

All the best,
Pacific Mountain Advisors Team

Quarterly Investment Newsletter – Q1 2010

April 21, 2010

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investing Words of Wisdom for Q2 2010

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

– Paul Samuelson

Wishing you all the best,
The Pacific Mountain Advisors Team

“We’re Here, to Take You There

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

Annual Investment Newsletter – Q4 2009

January 1, 2010

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investing Words of Wisdom for 2010

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

– Warren E. Buffett