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