Quarterly Market Overview – Q3 2011

October 21, 2011

Market Overview

We began our last quarterly narrative by expressing concern that the exceptional performance of the S&P 500 and global markets so far in 2011 had left them overstretched and susceptible to a pullback. That being said, we were not expecting to see the worst quarterly performance since the end of 2008 when we were still in the throes of The Great Recession.

During the third quarter of 2011, the S&P 500 lost 13.86% of its value, bringing its year-to-date return to a negative 8.67%. The MSCI EAFE (Europe, Australasia and Far East) fared significantly worse with a third quarter loss of 18.95% which dragged it’s year-to-date performance down to -14.62%.

Domestic equities outperformed foreign equities for the second quarter in a row as developed nations in Europe continued to struggle with their sovereign debt crisis and emerging economies dealt with rising inflation and slowing demand from China. Emerging markets took the worst hit in the third quarter due in part to the more cyclical nature of many of their key industries such as energy and mining. Additionally, the Chinese government had their banks give out $586B in loans during the financial crisis to spur growth, an amount equivalent to about 13% of their economy (the $787B stimulus in the U.S. only accounted for about 5% of our GDP for contrast). Many of these loans were invested unproductively and not all of them will be able to be repaid as they come due over the next several years. It is very possible that the central government could step in to help the problem but there is a severe lack of transparency on these issues so it is nearly impossible to evaluate the extent of the losses. We will continue to follow China closely in the coming months because they are one of the last significant drivers of global growth with the developed economies still stuck in a state of low growth and outright contraction in some parts of Europe.

The U.S. economy continued to expand with GDP growing by 1.3% in the second quarter but you wouldn’t know it by looking at the unemployment rate, which is remains above 9%, home prices which are still bouncing around near the their lows, or food stamp usage, which continues to set new records every time the data is released. Among the unemployed, almost 45 % have been unemployed for more than half a year and there are now a decent amount of unemployed who are no longer being counted in the numbers because they have fallen off of the list of people eligible to receive benefits. These persistent issues appear to be creating a significant change in investor sentiment toward domestic equities. Over the last several months, many of the  sectors that had been driving the earlier rally such as financials, energy, industrials and materials have now become the worst performers as the market declined during the quarter. During this same period the best performing sectors have been defensive areas such as consumer staples and utilities (both of which are well represented in client portfolio’s).

Fixed Income
The picture in fixed income markets was very mixed in the third quarter. In general, foreign bonds sold off during the quarter because of continuing sovereign debt concerns in Europe and rising inflation in emerging markets. Domestic bonds fared better with the Barclays Capital Aggregate Bond Index turning in a gain of almost 4%. That return should be taking with a grain of salt though because the vast majority of the gain was fueled by the biggest rally in U.S. Treasuries since 2008 and was for the most part not representative of the domestic fixed income market, which turned in relatively meager results. Inflation protected treasuries slightly underperformed the index as deflationary pressures re-entered the market and commodities sold off along with crude oil. The third quarter also marked a possible shift in investor sentiment as high-yield bonds experienced a substantial selloff as investment grade corporate bonds continued to generate positive returns. High-yield bonds had been outperforming investment grade bonds almost the entire time since stocks bottomed in 2009 and the recent divergence could suggest that investors are becoming more concerned with the return of their capital rather than the return on their capital.

Foreign Exchange
In our last portfolio update, we mentioned that the U.S. Dollar (referred to as the Dollar from here forward) was consolidating in a range after having spent most of the previous year declining against the currencies of most of our trading partners. This consolidation phase ended during the third quarter as investors fearful of the debt crisis in Europe piled into Dollars and other safe haven assets such as treasuries. The Swiss Franc had been performing the best out of all safe haven currencies during the quarter but then the Swiss Central Bank announced that they would be intervening in the currency markets to prevent their currency from appreciating too much which was negatively impacting their domestic companies. This intervention caused even more upward pressure on the Dollar since it’s safe haven competition took itself out of the race.

Sharp runs up or down happen when everybody is rushing to one side of a trade. When this happens, asset prices usually overshoot to the upside or downside as momentum builds, but eventually, the underlying fundamentals come back to being the key driver of returns. Right now, the dollar is correcting from being temporarily oversold (and may overshoot to the upside) but we remain confident that the long term trend of the Dollar against its major trading partners is downward. In the end, the value of a country’s currency is derived from the demand for the goods/services produced in the country. It is also influenced by the supply of the currency in question.

In the case of the U.S., there is not tremendous demand for products made in the USA (relative to how much we import from abroad) and our Federal Reserve system has enormously more flexibility in terms of increasing/decreasing the supply of money because the European Central Bank has a great deal of restrictions that limit their monetary policy options. It is also very important to note that although three Federal Reserve presidents in the U.S. have been dissenting over what they feel is overly loose monetary policy, they will be almost entirely replaced by more accommodative presidents over the next few years as the board membership rotates.

Commodities & Precious Metals
All commodities that trade on the major exchanges are priced in Dollars so it should not be surprising that most of the commodity complex had a rough third quarter (although they outperformed equities by a nice margin both year-to-date and for the quarter). In addition to the strengthening Dollar, softening demand from China and other emerging markets continued to weigh on agricultural and industrial commodities. A major standout in the third quarter was gold which managed to rally 8.26% even as the dollar strengthened. Live cattle futures also bucked the trend and staged a 9.75% rally due to the extreme droughts in Texas which have prevented farmers from being able to provide the needed food and water to keep their herds alive. This is a disturbing development that will continue to affect cattle prices in the years ahead because many livestock breeders were forced out of the industry and will not be returning because it takes years if not decades to build up a good herd and many are semi-retired or close to retirement.

While further weakness is likely if demand from emerging markets continues to wane, we believe that it would only be transitory because the key drivers of higher commodity prices are still in place. Emerging market growth may slow, but “slow” growth over there tends to be faster than “strong” growth in developed economies. This will continue to result in an expanding middle class in emerging markets, which will increase their demand for protein which will in turn magnify demand in other soft commodities. Scientific progress is also finding new uses for commodities which is increasing demand such as the use of corn in making ethanol fuel (the USDA predicts that 2011 will be the first year in history that more corn goes towards fuel than feeding livestock). Climate change has also be negatively impacting the amount of arable land available in the world as well as water supplies (the Ogallala aquifer, which provides water and irrigation to one of the most fertile areas of the U.S. is predicted by some scientists to run dry in as little as 20 years). Increasing rates of drought and flooding is also hurting crop yields across the world.

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

– The Pacific Mountain Advisors Team


Quarterly Investment Newsletter – Q1 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

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