Monday, September 26, 2011

Heidi's Place

TRUE TO FORM, SEPTEMBER has been volatile and for the most part, down. For the three weeks ended Friday, September 23, 2011, the Dow Jones Industrial Average closed at 10,771, off 469 points, or 4.2%. The Standard & Poor’s 500 closed at 1136, down 37 points, or 3.6%, and the NASDAQ Composite closed at 2483, up 3 points, effectively flat.

What wouldn’t surprise us at all is to see a very solid week in the markets this week, as we approach the end of the month. We will know next week, when we write to you again.

Boeing has shipped the first 787 Dreamliner, three years after their targeted delivery date. All Nippon Airways appears to be pleased, however. Research In Motion continues to struggle, reporting another disappointing quarter. I like my Blackberry, though I have nothing to compare it to.

Netflix may have stepped on itself, with its recent price restructuring. This move has Redbox, Blockbuster, and others out in force to nab customers. The real competition for DVD’s however, is from the various streaming services. UBS said recent trading losses are $2.3 billion. UBS chief Oswald Grubel has chosen to return to retirement, which I suspect is not a bad personal move.

It remains to be seen whether the Solyndra story is simply classic mismanagement, or a case study in what happens when attempts are made to have the government intervene in private markets. Moody’s has cut ratings on Credit Agricole SA and Societe Generale SA, citing concerns about funding and liquidity needs.

The inability of government leaders around the world to wean themselves of promises that require cash continues to create concern, and have a negative rippling effect. These promises make perfect sense though, if we understand that the ultimate goal of those in power is to stay in power.

In economic news, residential foreclosures were up 7% in August, compared to July. Consumer credit was up $12 billion in July, with auto loans increasing sharply, and credit card debt continuing to decline. Initial jobless claims continued in the low 400,000 range. The CPI was up 0.4% in August, with gasoline and food prices leading the way.

Retail sales were flat in August, while industrial production was up 0.2%, and inventories were up 0.4%. What’s interesting is that consumers appear to be buying new autos, rather than new school clothes. This has stumped a few commentators. It makes sense though, given that alcohol, chocolates, and cosmetics were growth industries during the 1930’s. If the outside world appears to be a mess, people will do a variety of things, and spend money in interesting ways, in order to look good and feel good.

Since we wrote to you last, the FOMC has met, and their comments released for public consumption did nothing to assure investors that they had a meaningful game plan. Of course, some operate from the assumption that the government can create jobs in the private sector, which it most assuredly cannot. What government can do is create an environment that causes companies and business owners to want to deploy capital and make new hires. At the moment, both sides of the aisle in Congress, and the White House, are doing nothing of the sort, and are, in fact doing the opposite.

Perhaps the best approach would be to adopt a flat 10% sales tax, and do away with any and all income or estate taxes. Tie this to a federal legislature that meets for eight weeks a year, and mandate an 80% reduction in federal programming and employees? Something certainly needs to change.

President Obama introduced his new tax plan. The proposed plan would extend the 2% payroll tax cut for employees through 2012. The employer share of payroll tax would be cut from 6.2% to 3.1% on the first $5 million of payroll, and eliminate it entirely for any net increase in payroll. The plan would also extend current enhanced depreciation provisions, and create a “Returning Heroes” tax credit of up to $9600 for hiring unemployed veterans.

Mitt Romney has proposed a tax plan that would move some of the current percentages around, and generally lower. John Huntsman has proposed a plan with similar features, though his plan would offer rates of 8%, 14%, and 23%, do away with the AMT, and eliminate tax on capital gains and dividends. Huntsman’s challenge is that he isn’t faring well with those most likely to vote in a Republican primary.

Herman Cain’s tax plan would eliminate payroll taxes completely, cut corporate and personal taxes to 9%, and impose a 9% national sales tax.

Derivatives Explained: Heidi owns a bar in Detroit, whose customers are mostly unemployed alcoholics who can no longer afford to patronize her bar. Heidi introduces a new plan to allow her customers to drink now and pay later. Heidi tracks her customers’ drinks, effectively lending them money. Word gets out of her new plan, and Heidi is swamped with business. Since her customers are relieved from the need to pay now, Heidi gets no resistance as she raises prices at regular intervals. At year end, Heidi shows unprecedented growth in both gross revenue and net profits.

A young bank vice-president at Heidi’s bank recognizes these customer debts as future assets and increases Heidi’s borrowing limit. The bank’s underwriters express little concern, as they have the resources of unemployed alcoholics as collateral. Over at the banks trading desk, expert traders find a way to make huge commissions, and transform these loans into DRINKBONDS. These bonds are bundled and traded on international markets, and are given an investment grade rating.

Investors don’t understand that the DRINKBONDS (Symbol: DUMB) they are buying are really debts of unemployed alcoholics. The bond prices continue to climb, and soon become the hottest selling items at some of the country’s leading brokerage houses.

One day, a new risk manager at the local bank decides it’s time to demand payment on the debts incurred by the drinkers at the bar, and so informs Heidi. Heidi lets her customers know, but being unemployed alcoholics, they cannot pay their debts. Heidi can’t pay her loans and is forced into bankruptcy. She and her eleven employees lose their jobs.

Overnight, DRINKBOND prices drop by 90%. The collapsed bond prices destroy the banks liquidity, preventing it from making new loans, thus freezing credit and economic activity in the community. Heidi’s suppliers had granted her generous terms, and had invested their firms’ pension funds in the bonds. They now write off the bar’s bad debts, and face the prospect of a seriously impaired retirement plan. The wine supplier also declares bankruptcy, closing the doors on a family business. The beer supplier is taken over by a competitor, who closes the local plant and lays off 150 workers.

Fortunately, the bank and brokerage firms, and their executive suite, are bailed out by cash infusions from government loans. The funds for this bailout are obtained by new taxes levied on employed, middle class, non-drinkers who have never been to Heidi’s bar.

This is how many see the events of the last few years. Thanks to my friend David Burrell for the analogy.

Quotes of the week:

“According to the latest poll, a record 73% of Americans think the country is headed in the wrong direction. The good news: Gas is so expensive we’ll never get there”.
                                                                                          -Jay Leno

“The U.S. Census Bureau reports that American homes are 650 square feet larger today than they were in 1980. Unfortunately, so are most Americans”.
                                                                                           -Conan O’Brien

Tuesday, September 6, 2011

Preferred Cash Flow

IN VERY TYPICAL END OF MONTH fashion, the major equity indices were up last week. By the numbers, for the two weeks ended Friday, October 2, 2011, the Dow Jones Industrial Average closed at 11,240, up 423 points, or 3.9%. The Standard & Poor’s 500 closed at 1173, up 50 points, or 4.5%, and the NASDAQ Composite closed at 2480, up 139 points, or 5.9%.

Uncertainty, and to some degree fear, seems to be dominating conversations regarding the economy and the markets. The price of gold is a good way to measure this concern in dollar terms. While it’s difficult to do anything practical with a one ounce gold coin, gold has been seen as a safe haven in the face of fiat currencies, such as those that dominate our globe.

What’s interesting is that the major equity indices have followed a very traditional pattern this year. During most years, the stock market advances from January through spring, meaning April or early May. During early summer, the major indices are down, and during late summer, the indices are down even more. September has historically been an off month. Finally, within a month, the last few days of each month tend to be good days in the public markets. A study of 2011 to date indicates that it is following a very traditional pattern. If this pattern holds, September will be off, and the fourth quarter will be one of the best fourth quarters we have had in several years.

The Federal Housing Finance Agency plans to sue more than a dozen large banks, claiming they misled Fannie and Freddie regarding mortgages. The Jackson Hole Federal Reserve meeting has concluded, with little to show for the taxpayer dollars spent.

Warren Buffet just gave Bank of America $5 billion. In return, Buffet’s Berkshire gets 50,000 shares of cumulative preferred stock with a 6% coupon, all of which can be redeemed at a 5% premium. In addition, Berkshire gets warrants to purchase another 700 million shares of BAC common at $7.14. This means that Warren and company get $75 million in quarterly cash flow, and a built in gain of at least $250 million. At the moment, the warrants are underwater, but I suspect it will all work out for Berkshire.

According to RealtyTrac, 31% of home sales during the second quarter were on properties in some stage of foreclosure. This is up from 24% for the same period last year. Homes in foreclosure or bank owned had an average sales price that was 32% less than those properties not in distress.

Over the last few weeks, I’ve seen several emails that attempt to communicate our country’s financial situation in easy to understand terms. Here’s one. If the U.S. were the Jones family, the Jones’ would have an annual income of $21,700 and annual spending of $38,200. This year, the Jones’ have added $16,500 to their credit card balances, bringing these balances to $142,700. Realizing they were in a crisis, the Jones’ had a family meeting, and decided to reduce spending by $385 a year.

On the economic front, there was no net new hiring in August, with the 17,000 private sector jobs being offset by 17,000 layoffs in the government sector. We applaud the decision of state and local governments to get their fiscal houses in order, and would suggest that the federales take lessons from these folks. The official unemployment rate continued at 9.1%.

The revised GDP report for Q2 2011 showed annual economic growth of 1%, substantially less than the 3.5% needed for robust economic health. Corporate profits rose 3% during the second quarter, up from a rate of 1% in each of the two previous quarters. Over the last year, corporate profits are up about 8%.

Auto sales are showing strength, as consumers appear to be choosing cars over homes. At the close of the market on Friday, August 26, the yield on the 90 day T Bill was showing as -0.01%. Reflecting a negative interest rate is an interesting statistical anomaly that may mean little in reality, but speaks volumes about where we are as a country.

A recent national survey of persons earning six figure incomes showed that 14% were living paycheck to paycheck, 6% said they weren’t making ends meet, 24% had missed a bill payment in the last 12 months, and 55% had either reduced retirement plan contributions, or were making none.

What’s fascinating in all this is that one third of the homes being purchased are being paid for in cash. The take away? The macro economic environment and our personal economic environment may have little correlation to each other. The key to long term financial health is a consistent discipline of no debt, consistent savings and giving, and spending less than we make. Not rocket science, but not practiced by many on a consistent basis.

Quote of the week:

“The income tax has made liars out of more Americans than golf.”
                                                                                                          Will Rogers

Wednesday, August 24, 2011


FEAR HAS DOMINATED DOMESTIC equities over the last two weeks, driven by some combination of the uncertainty coming from Washington, Mideast unrest, and worldwide sovereign debt loads. By the numbers, for the two weeks ended Friday, August 19, 2011, the Dow Jones Industrial Average closed at 10,817, down 627 points, or 5.4%. The Standard & Poor’s 500 closed at 1123, down 76 points, or 6.3%, and the NASDAQ Composite closed at 2341, down 91 points, or 3.9%.

Over the last four weeks, the Dow has given up 1864 points, or about 15% of its value. The S&P 500 has given up 222 points, or 16.5% of its value, and the NASDAQ has given up 417 points, or about 15% of its value. A number of professionals are suggesting this may be the time to return to a neutral weighting in domestic equities, especially as the S&P 500 approaches 1100. We tend to agree.

At the moment, Treasuries and CD’s are offering no income. Gold, silver, and other metals, as well as food and other commodities, have been on a rocket ride. Regression to the mean suggests that these assets are up next for downward pressure on prices. Corporate America is sitting on hundreds of billions in cash, and continues to grow their top line, in spite of the uncertainties both domestically and around the world. It wouldn’t surprise us to see a major upswing in stock prices over the next fifteen months, as we head into the 2012 election season.

The Federal Reserve has said interest rates will remain low until at least mid-2013. The European Central Bank has begun buying bonds, in an attempt to pull Italy and Spain from financial ruin. English Prime Minister David Cameron has said he will consider blocking social media sites, in an attempt to reduce the riots, and their coordination.

Cisco reported a solid quarter, with $11.2 billion in revenue, and $1.2 billion in income. For the year just ended, revenue was $43.2 billion, up 8% over the previous year, while net income was $6.5 billion, down more than 16% from the previous year. The top line is growing, but at the expense of margin. Cash and equivalents year end were $44.6 billion.

Parents surveyed by the National Retail Foundation said they expect to spend an average of $603 on back to school clothing, supplies, and electronics, for each of their children. Total spending on children in kindergarten through 12th grade is on track to reach $22.8 billion. Adding spending on college students brings this total to $68.8 billion.

Gold has been on a tear over the last six weeks, closing within just a few dollars of $1900. Some suggest it’s time for a correction, others are predicting gold at $3000 to $5000 per ounce. Hewlett-Packard has decided to exit the PC market. HP appears to be deciding what it wants to be in the future, with some question about the answer.

Google has decided to buy Motorola Mobility Holdings, at a 63% premium to its recent stock price. Bank of America stock is trading near 52 week lows, with stock prices of much of the financial sector showing weakness.

Recent studies have shown that those who maintained a disciplined allocation through the turmoil of 2008 and early 2009 did better than those who attempted to move in and out of the market.

In economic news, the U.S. trade deficit was $53.1 billion in June. Initial jobless claims were down a bit to 395,000, but still in the 400,000 range, with job absorption still far below that needed to reduce unemployment.

Retail sales were up 0.50% in July, meaning consumers are continuing to spend.

According to the Congressional Budget Office, federal taxes as a function of GDP are at their lowest level since 1950, at 14.8%. This compares to a post-war average of 18.5%. We are not suggesting that taxes are too low, or even where they should be. It is very clear to us that governments collect far more than what is required to run an effective, lean, operation. Our suggestion would be to build a tax system that would have taxes at about 10% of GDP.

In other economic news, the Philadelphia Fed’s report on economic activity showed slowing economic activity, with a few bright spots. Industrial production was up 0.9%, driven mainly by auto production. Leading economic indicators rose 0.5%, the third straight monthly gain.

With the information overload many of us live with, perhaps a useful exercise is to step away, and evaluate our lives in terms of something other than a financial statement. What is the quality of our relationships? Where do we find meaning? Is there joy and peace that’s distinct from a growing portfolio or financial statement? Just a few questions to ponder.

Quote of the week:

“Worship is what we give our hearts to, hoping to receive life in return.”
                                                                                                               John Eldredge

Tuesday, August 9, 2011

Budget Control Act

SUMMER TIME AND POLITICAL INEPTITUDE HAVE combined to create a difficult few weeks for domestic equities. By the numbers, for the two weeks ended Friday, August 5, 2011, the Dow Jones Industrial Average closed at 11,444, down 1237 points, or 9.6%. The Standard & Poor’s 500 closed at 1199, down 146 points, or 10.9%, and the NASDAQ Composite closed at 2532, down 326 points, or 11.4%.

The last two weeks have been challenging in the publicly traded equity markets, and there is almost no escaping the news. Whether it’s around the clock cable, email alerts, the car radio, or something as simple as hitting a news report while channel surfing, bad news seems to abound. Part of that is pure business – bad news brings viewers and listeners, and sells advertising. Another piece of it seems to be our need for white noise in the background of our lives.

So what happens if you escape to silence? What are you talking to yourself about? What does life look like? Do you ever think about what you think about, or is the noise of life so constant that the idea to do so has never crossed your mind?

Congress reached an agreement on the debt limit, and Standard & Poor’s downgraded the U.S. credit rating, from AAA to AA+. The U.S. credit rating now joins the ranks of China and Spain. Netflix, one of the companies to challenge Blockbuster, is now having challenges of its own. Between a change to their pricing model, and competitors who provide streaming video, Netflix is giving up customers, and the related recurring revenue.

Many U.S. companies are having new hires agree to a social media background check, as part of the hiring process. This gives employers a more rounded view of the behaviour of potential hires, as Facebook, Youtube, and other social media outlets have a strong personal use component, and many can’t resist posting far too many tidbits about their personal lives.

ExxonMobil’s earnings of $2.18 a share for the second quarter missed analyst’s estimates of $2.30, apparently due to their natural gas exposure. The CBOE volatility index, or VIX, almost doubled in the last week, and is on its way to a 52 week high. Bank of New York Mellon is telling its best customers, those with more than $50 million on deposit, that they will start paying for the privilege of leaving those funds on deposit. Effectively, a negative interest rate?

America’s largest companies continue to show solid profits, and continue to hold large cash positions. No doubt this will remain the case until our federal politicians and their employees can articulate certainty about how they will interact with us from a tax and regulatory standpoint.

Speaking of uncertainty as fostered by the federales, the U.S. Treasury Dept appears ready to audit GM’s quarterly results. Perhaps the government should have left GM alone to start with.

On the economic front, it’s more of the same. There were new hires, but not enough to meet the demand for jobs. Consumers are paying down debt, instead of spending, which is a positive. Many consumer goods companies continue to be profitable worldwide, in spite of the domestic spending slowdown.

The Budget Control Act of 2011, the recently passed legislation that allowed the government to continue to function, will result in the formation of a bipartisan joint committee. This committee’s responsibility will be to propose tax changes to be voted on before year end, which will raise $1.5 trillion over ten years. At this point, it is unknown what tax changes may take place to raise this $1.5 trillion.

It is foolish to speculate on what Congress may do regarding taxes. The White House has long been a fan of higher income taxes for those individuals and families above the $200K/$250K annual AGI mark. Other ways to raise funds include making the value of employer provided health benefits taxable as income to the employee, eliminating the AMT, or changing the tax calculations on capital gains.

Congress could also restrict “tax expenditures” – that which the rest of us consider income. This could include restricting or eliminating deductions for property, sales or state income taxes, mortgage interest, charitable contributions, and a number of miscellaneous itemized deductions. This could also include health insurance costs above the 7.5% limit, and perhaps even above the line deductions such as tuition deductions, and deductions for self-employment taxes and health insurance. Tax credits such as the child tax credit and the unearned income credit are also up for consideration.

Keep in mind that, under the Act just passed, Congress must vote on these changes before year end. Any changes may, and most likely will, alter the extension of the current tax regime that took place in December of 2010.

In a summary attributable to Dave Ramsey, he describes the U.S. as a family, with a household income of $58,000, annual spending of $75,000, and $327,000 in credit card debt. The recent Budget Control Act would reduce spending to $72,000.

Quote of the week:

“A wise and frugal government, which shall leave men free to regulate their own pursuits of industry and improvement – and shall not take from the mouth of labor the bread it has earned – this is the sum of good government”.
                                                                                          Thomas Jefferson

Wednesday, July 27, 2011

Snail Mail or E-File?

EQUITY MARKETS HAVE BEEN BOTH up and down over the last three weeks, yet this volatility has done little but create more uncertainty. By the numbers, for the three weeks ended Friday, July 22, 2011, the Dow Jones Industrial Average closed at 12,681, up 99 points, or 0.7%. The Standard & Poor’s 500 closed at 1345, up 6 points or 0.4%, and the NASDAQ Composite closed at 2858, up 42 points, or 1.5%.

Apple completed its finest quarter ever, reporting revenue of $28.57 billion, and income of $7.31 billion, for gross margins of 41%. This compares to $15.7 billion in income and $3.25 billion in profits for the same period a year ago. Results were driven in large part by the sale of more than 20 million iPhones and 9 million iPads during the quarter.

New wireless technology may make it easier to provide WiFi coverage in even the most crowded spaces, including sports stadiums. Look for new wireless promotions at a stadium or sporting venue near you.

The Swiss Parliament is expected to begin discussion this year of a gold franc, a parallel currency to the Swiss franc. This initiative is part of “Healthy Currency”, a campaign endorsed by politicians from the Swiss People’s Party, a conservative group, and the country’s largest political party. These discussions in Switzerland are part of a larger global question about the place and value of national currency that is backed by nothing more than the taxing or printing authority of the issuing entity. With the “full faith and credit” that supports most currencies in doubt, and the obvious inability of any elected official to make meaningful financial decisions, it is time for discussions about the meaning of currency and the value of federal reserve notes, regardless of who issues them.

The smile on JK Rowling’s face is permanent, though her place on the Forbes 400 list will vary, depending in part on her ability to manage her new found wealth. “Deathly Hallows Part 2”, the latest, and apparently the last, Potter film, brought in an estimated $43.5 million on its opening day, setting a revenue record, according to

Though Las Vegas real estate has had a tough couple of years, it appears that Las Vegas could be the best place to own residential rental property; this according to HomeVestors of America. The employment outlook remains flat, as businesses continue to find ways to be profitable without adding new hires. We expect this to continue, as long as uncertainty remains in Washington. Some analysts are suggesting an official unemployment rate of more than 10% before year end. We will soon find out. Where do you think unemployment will be at year end?

Gold has continued to climb, breaking the $1600 per ounce barrier. Silver has climbed even faster. The gold/silver ratio currently stands at 40, whereas at the end of 2010, this ratio was 46. The gold/silver ratio was set at 15 in 1792, with passage of the First Coinage Act. Since the late 19th century, the ratio has ranged from the low teens to nearly 100, with the average between 47 and 50. Historically, the ratio has dropped during precious metals/commodities bull markets.

Express Scripts is buying Medco for $29.1 billion in stock and cash, combining two of the largest pharmacy benefit managers. My grandma would have a difficult time believing or understanding the debt foolishness going on in Washington. During the seven years between my grandfather’s death and her death, she saved enough from a $350 monthly social security check to pay for her own funeral.

On the economic front, government spending in 2011 will reach about $3 trillion, with 40% of that federal spending, and 60% attributable to state and local jurisdictions. Both the Consumer Price Index and the Producer Price Index declined in June, according to the Labor Dept. Initial jobless claims remain above 400,000, and housing starts remain at about 35% of 2006 levels.

In our last commentary, we noted that debt as a function of GDP in the U.S. was approaching 350%. This number includes official debt, as well as an estimate of a number of off-balance sheet items. Official debt as a function of GDP is 99% in the U.S., with 31% of this debt foreign-owned. By comparison, Japan’s ratio is 204%, with 7% owned by foreigners, and Greece’s ratio is 137%, with 75% owned by foreigners. This offers no comfort, as both Greece and Japan are in difficult situations.

According to some economists, if the U.S. economy grows by 3.9% annually over the next decade, our debt to GDP ratio drops to 83%. If economic growth averages 1.8%, our ratio comes in at 144%. Historically, the solution to economic growth has been legislative and regulatory certainty, combined with a favorable tax climate for the accumulation and deployment of capital.

Last year, two out of three Americans filed tax returns electronically. Some state and local governments are mandating electronic filing of certain returns. The New York Dept of Taxation and Finance mandates e-filing of sales tax returns, and they want taxpayers’ phone numbers and Social Security numbers.

Generally, this is no problem – unless you are Amish. The Watertown Daily Times, in an area that’s home to the Swartzentruber and Heuvelten Amish clans, reports some challenges with compliance among the Amish business owners. The Amish furniture makers and shopkeepers aren’t intentionally trying to be difficult. It’s just that they don’t have electricity, or phones, or social security numbers. Some of these shopkeepers have received letters suggesting a $50 penalty for every return not filed electronically, though the Dept. of Taxation and Finance says it wants to be helpful. This doesn’t include their discussions with bureaucrats over photo ID’s, and other requirements that don’t gel with the Amish lifestyle. What’s your opinion on the issue? Should we let the Amish maintain their way of life, or force them to comply?

Quote of the week:

“He is no fool who gives up what he cannot keep, to gain what he cannot lose.”
                                                                                                   -Jim Eliot

Wednesday, July 6, 2011

Debt to GDP

APPARENTLY BUYERS WERE EXCITED about the upcoming Independence Day celebrations, as stocks reported a solid week. By the numbers, for the two weeks ended Friday, July 1, 2011, the Dow Jones Industrial Average closed at 12,582, up 578 points, or 4.8%. The Standard & Poor’s 500 closed at 1339, up 68 points, or 5.4%, and the NASDAQ Composite closed at 2816, up 200 points, or 7.6%.

Some believe the government of Greece will be able to implement and maintain austerity measures. They won’t. Weaning politicians from buying votes today with promises paid for tomorrow is some multiple worse than getting a meth head clean. The reflection in the mirror when I look at Greece is the U.S., about twenty to thirty years out. The good news? We can change that future. Do we as citizens care enough to make the changes necessary, so we can say once again that America’s best days are still in the future?

Corporate America deployed $124 billion of its substantial cash reserves, during the first quarter, buying back stock, with the goal of increasing share price. Bank of America will take a $14 billion charge during the second quarter, to settle claims related to sales of mortgage backed securities.

Microsoft launched a web-based version of its Office Suite on Tuesday, in its efforts to capture cloud market share. U.S. home prices rose in April, for the first time in eight months. This is good news according to Case-Schiller.

Frank McCourt, according to reports, has enjoyed a very comfortable, debt financed, lifestyle. McCourt, currently going through an ugly divorce, has also filed for Chapter 11 bankruptcy protection for the LA Dodgers, blaming the move on Bud Selig’s refusal to approve a long term broadcasting deal with Fox.

On the economic front, jobless claims were 428,000 for the week ended June 25, 2011. The four week average remains below the near term peak of 440,000. U.S. consumer confidence declined again in June, following a decline in May. This decline was in both the “present situation” and “expectations” components. This confidence, or lack thereof, seems driven by the continuing challenges in the labor markets, as well as the ongoing deterioration in housing prices and conditions.

Some are suggesting the end of America as we know it, with the complete deterioration in the value of the dollar, and scenes reminiscent of a Mad Max movie. These scenarios are very attractive to many, probably for the same reasons that newscasts tend to open with bad news first.

Those whose livelihood and future depend on our centrally planned economy, essentially all of Washington, will do anything necessary to prevent this. In fact, in the next few months, we expect the White House and all of Congress to introduce all manner of initiatives designed with one goal – strengthen the economy and increase employment. After all, they have an election to win in the fall of 2012.

It is very possible that the economy will drag along, with meaningful underemployment, and a tired housing market, for several years. Real inflation, meaning what actually hits our pocketbooks, will remain in the 4% to 6% range for the next few years.

What must be controlled is federal spending. During the long depression of the 1870’s, debt to GDP stood at 166%. During the Great Depression of the 30’s, debt to GDP peaked at 300%. Today, debt to GDP is 350%. A 2010 McKinsey study showed that periods of de-leveraging tend to last six to seven years. We must stop spending beyond revenue, starting with the federal government, and pay down our debts.

However, in all of this, there is opportunity. Down cycles give all of us the opportunity to sharpen our decision making capacity, to learn new skills or new ways of working, to pay close attention to the dollars that pass through our fingers. These new skills will allow us to multiply our return in any number of ways as and when the economy hits a strong up cycle.

Those who are unemployed or underemployed will continue to go through tremendous change, as they learn new ways or working, and making a living. I can think of no better reason to start and build a business than to provide employment for those who want to work.

Supply chain managers are pricing oil at $150 a barrel, as they project costs over the next few years. This will continue to bring manufacturing jobs back to the states. As much as a centrally planned economy runs counter to the free enterprise system, America remains the Golden Land. We have the best infrastructure, the largest consumer base, and overall, the most highly skilled workforce in the world. In addition, more than anywhere else in the world, we are open to immigration, being a nation of immigrants. Add these together, and in spite of our problems, America’s future looks bright, compared to much of the world.

If we will choose to turn from the European model, which clearly doesn’t work, and return to a free enterprise, capitalist model, I believe America can restore its greatness. On a side note, the Wall Street system is not a free enterprise model, as they get substantial rewards, but bear little or none of the risk, associated with their poor decisions.

Quote of the week:

“America was not built on fear. America was built on courage, on imagination, and an unbeatable determination to do the job at hand.”
                                                                                                 Harry Truman

Tuesday, June 21, 2011

SpaceShip Apple

EQUITY MARKETS APPEAR to be tired of late, seemingly burdened with the worry of the world. By the numbers, for the two weeks ended Friday, June 17, 2011, the Dow Jones Industrial Average closed at 12004, down 147 points, or 1.2%. The Standard & Poor’s 500 closed at 1271, down 29 points, or 2.2%, and the NASDAQ Composite closed at 2616, down 116 points, or 4.2%.

George Soros sold $800 million of his gold holdings during the first quarter of 2011. Citigroup suffered a security breach at the hands of online hackers. Expect the security breach stories to become more common.

One more step in the move toward a nationalized economy is a Federal Reserve proposal to make annual decisions regarding whether the country’s largest banks can pay dividends or repurchase stock. The rest of the financial services industry – everything from mortgage brokers to independent advisory firms such as ours – will simply be regulated out of existence.

Steve Jobs plans to build an earthbound space ship as Apple’s new headquarters. I’ve always admired creativity and originality. Here’s hoping this investment also represents a solid return for Apple shareholders. In the meantime, Ron Johnson, head of Apple’s retail store operations, has joined JC Penney as its new CEO.

It appears that Greek debt holders are about to be stiffed. U.S. banks would take about a $41 billion hit. Some question whether this could happen in the States. Some are certain it will, with our elected federal officials apparently oblivious to the long term consequences of their actions. Others aren’t prepared to give up on the resiliency, sense of fairness, and love of freedom of the American people. Personally, I don’t expect the end of our country. It seems to me though, that the Golden Age of America is behind us. Here’s hoping I am completely wrong on that last count.

Some cities are realizing that they must get their financial lives under control. Brea and San Francisco California are both reducing pensions and benefits for their employees as a way to cut costs. Illinois is choosing to deal with massive budget deficits by increasing a wide range of personal and business taxes. Camden NJ recently laid off more than a third of its firefighters and police force, as voters refused to raise taxes.

In economic news, both the PPI and CPI showed modest signs of inflation. Residential construction grew more than expected in May, though annualized housing starts are about 600,000, compared to 2 million in 2006.

Larry Elliot, economics editor of The Guardian newspaper in the U.K., recently penned an article titled “Decline and Fall of the American Empire”. It makes for interesting reading, and can be found in the Guardian’s June 6th edition. In the article, Elliot draws parallels between America in 2011, and Rome in 200AD. Some of the warning signs he cites include military overstretch, a widening gulf between rich and poor, a hollowed-out economy, consumers using debt to live beyond their means, and more.

The news isn’t all bad. In fact, the good news is that within and in spite of what may seem like trying times, there is always opportunity. There is certainly economic and business opportunity, as one person or company’s problem is someone else’s profitable solution. Even more, there is the opportunity to show by example and counsel how to live an abundant, joyous, and peaceful life in the face of what many consider overwhelming challenges. I suspect this may be one of the greatest opportunities of all, as so many are simply looking for one person to show them how to live.

Even when we don’t understand, or have no clarity about what’s actually going on, God has not abandoned us. Neither has He forgotten us, or turned His back on us. Lean hard into Him, and trust His character. He is good for His word.

Quote of the week:

“…what does the Lord require of you? To act justly, and to love mercy, and to walk humbly with your God.”
                                                                                                  Micah 6:8

Monday, June 13, 2011

May Investment Review

The mood shifted sharply in May from one of optimism about a self-sustaining recovery to one in which the myriad concerns about which we’ve been writing for some time weighed increasingly heavily on stocks and other risk assets around the globe. These concerns include Eurozone debt problems, the significant fiscal problems of our own government, weakness in both the housing and labor markets, and signs that the economy is again slowing. A final-day rally trimmed May losses a bit, but markets have continued their slide into June. Large-cap U.S. stocks lost 1.2% in May, while small-cap stocks lost closer to 2%. Mid-cap stocks held up best, losing only about 0.4% (see back cover table for benchmarks and returns). Domestic fixed-income delivered good returns, with the broad high-quality bond index up 1.3%.

Both foreign-developed and emerging-market stocks were down close to 3% in May. Emerging-market bonds were down a little over 1%, while developed-market foreign bonds were close to flat. Where does that leave us through the first five months of the year? Stocks still have good gains for the year to date, from the high single digits for U.S. equities, to the mid-single digits for developed foreign markets and low single digits for emerging markets, though those gains have been further trimmed through the early part of June.

Monday, June 6, 2011

Turned Tables

A DESCRIPTION OF LAST week’s market performance offered by one journalist was “June Swoon”. By the numbers, for the week ended Friday, June 3, 2011, the Dow Jones Industrial Average closed at 12,151, down 290 points, or 2.3%. The Standard & Poor’s 500 closed at 1300, down 31 points, or 2.3%, and the NASDAQ Composite closed at 2732, down 2.3%.

Nokia is having a rough go of it. Last Tuesday, they warned that second quarter revenue would miss targets due to sliding sales and prices. In addition, they suspended their full year forecast for 2011.

Microsoft is showing off Windows 8, which appears to be heavy on touch-screen features, and is running on devices using ARM-based chips. Microsoft appears serious about catching rivals Google and Apple.

Groupon has filed for an IPO, saying it expects to raise as much as $750 million. The company will need to do better than its first quarter loss of $146 million, in order to continue to impress investors.

It appears that doctors across the country will spend an average of $40,000 on software to build digital databases of patient records, responding to government led efforts tied to the 2009 economic stimulus plan. Questions remain as to whether these efforts will allow doctors to send patient records to other doctors who could benefit from having rapid access to medical histories. Altruism aside, one key business question is how one physician directly benefits from being able to forward this information on a timely basis to another physician.

Japan’s Prime Minister Naoto Kan survived a no-confidence vote in parliament. The European Central Bank and the IMF are attempting to determine what to do with Greece. Portugal’s elections have given the winning edge to a fiscal conservative, Pedro Coelho, of the Social Democratic Party, with the Socialist government of Jose Socrates admitting defeat.

Other economic news remains consistent, with new unemployment claims staying just over 400,000 from one week to the next, official unemployment just north of 9%, and home prices very soft. This continued uncertainty is reflected in the lack of direction in the publicly traded markets.

In spite of news that could be considered disheartening, life is good for most of us, especially compared to conditions of many around the world. In addition, there is always opportunity, especially if we are inclined to look for and prepare for it.

According to CBS News, the Nyergers of Collier County Florida paid cash for their home. About five months ago, Bank of America filed foreclosure papers on their home. In court, the homeowners were able to prove they didn’t owe BofA anything on the house, and were able to confirm that they had never had a mortgage on the property.

A Collier County judge agreed with the Nyergers, and ordered BofA to pay the couple’s legal fees. Five months after the judge’s ruling, BofA still hadn’t paid the legal fees, so the couple’s attorney foreclosed on the bank. Sheriff’s deputies, movers, and the Nyergers attorney went to the bank, padlocked the doors, and began removing desks, computers, filing cabinets, and teller trays. About an hour after being locked out of the bank, the branch manager handed the attorney a check for the legal fees, with apologies for the misunderstanding.

Quote of the week:

“I don’t know what your destiny will be, but one thing I know: the only ones among you who will be really happy are those who have sought and found how to serve.”
                                                                                       Albert Schweitzer

Tuesday, May 31, 2011

Sovereign Debt

THE OLD ADAGE OF “SELL in May and go away” would appear to apply so far in May, though we don’t suggest that as a strategy. By the numbers, for the four weeks ended Friday, May 27, 2011, the Dow Jones Industrial Average closed at 12,441, down 369 points, or 2.9%. The Standard & Poor’s 500 closed at 1331, down 32 points, or 2.3%, and the NASDAQ Composite closed at 2797, down 76 points, or 2.6%.

Commodities and metals have been especially hard hit the last few weeks, after peaking on Friday April 29th. In fact, during the first week of May, silver was off 27% from its high. While this sector has recovered some, professional opinions are all over the board as to the future of commodities and metals prices.

Much of this opinion divergence comes from the uncertainty and unknowns associated with sovereign debt. Around the world, including the U.S., nations are drowning in debt. In addition, the legacy or entitlement promises made by elected officials are completely unsustainable. Some politicians, including a few in the states, are finally realizing this. Most of us have known this for years, since we must balance our personal and business budgets on a regular basis.

The challenge is that no one knows how the debt issue will be resolved, or what the fallout will be. What does it look like when a country goes bankrupt? Their currency is effectively worthless, but what other negative results are there? These are the issues that economists and other macro thinkers are dealing with. There is little in modern history to give us guidance. Modeling 10,000 scenarios gives some input. Until we can accurately forecast human behaviour, in large groups and in worst case scenarios, it will remain difficult to forecast with any accuracy. Our estimates, in the meantime, are a combination of quantitative analysis, and the subjective, or qualitative, which is heavily influenced by our worldview.

GM and Ford both posted double digit percentage gains in April. Industry wide, deliveries rose 17.9% from April 2010, with GM posting a 26% gain, overtaking Ford as the leading car seller in the U.S. Brett Arends of MarketWatch is suggesting that Apple will be the first company with a $1 trillion market cap.

Zillow, the real estate information company, shows housing prices down 8% from a year ago. It appears that housing prices are dropping about 1% per month. We have said it before, and it bears repeating. Home prices should be two to two and a half times annual household income. With annual household income in the $52,000 range, average home prices should settle at something less than $130,000. Depending on whether you are evaluating new or existing stock, average home prices are still in the $170,000 to $185,000 range. For the sake of our many friends in the residential real estate world, we hope we are wrong on this one.

Microsoft announced that it is buying Skype for $8.5 billion in cash. LinkedIn, the business networking site, saw its shares more than double on its first trading day, closing at $94.25. This from an initial offering price of $45. Liberty Media has made a $1 billion bid for Barnes and Noble.

Dominique Strauss-Kahn, head of the International Monetary Fund and one time French presidential contender, was arrested and charged with assaulting a hotel maid. His wife, Ann Sinclair, is funding his journey through the courts. Her wealth comes from the art trading of her grandfather.

The G-8 summit ended with a pledge by the member nations to cut debt. This pledge reminds me of a favorite quote, attributed to Molier. “All men are alike in what they dream, and all men are alike in what they say. It’s what they do that makes the difference.” We’ll see what these politicians actually do about the debt they have incurred.

On the economic front, signals continue mixed. Initial jobless claims have been running just over 400,000 each week. Home construction and prices remain soft. The Producer Price Index is up 6.8% over the last 12 months, while the Consumer Price Index, ex food and energy, is up 3.2%.

There is always information to review, absorb, and evaluate. Often, we can allow it to have a negative or depressing impact on our outlook. If we step back and attempt to look objectively, however, life is good. This past long weekend gave us the opportunity to reflect on that. Millions of young men and women, serving through our armed forces, have worked to keep us free. Many have paid the ultimate sacrifice, giving their lives so that we can enjoy the freedoms that we enjoy.

There will always be problems to solve, things that don’t fit with our plans, and outcomes that we don’t prefer. In spite of that, all of us reading this commentary live wonderful lives. I have found that gratefulness and depression can’t exist at the same time in the same person.

Quote of the week:

“In everything give thanks, for this is God’s will concerning you.”
                                                                                                            St. Paul

Thursday, May 5, 2011

PT Barnum

THE LAST THREE WEEKS HAVE BEEN KIND TO stocks, with all three major equity indices up nicely. By the numbers, for the three weeks ended Friday, April 29, 2011, the Dow Jones Industrial Average closed at 12,810, up 430 points, or 3%. The Standard & Poor’s 500 closed at 1363, up 35 points, or 2.3%, and the NASDAQ Composite closed at 2873, up 93 points, or 3.1%.

Momentum in the equity markets has been driven in part by continuing strong performance in first quarter earnings. Ford Motor posted its best first quarter profit since 1998, and ExxonMobil profit topped $10 billion, with income up more than 50% year over year.

Ben Bernanke held his first ever press conference, his comments suggesting that he is comfortable with current policy positions. He has no plans to make changes in order to address inflation or slower growth. Meanwhile, gold and silver continued their rocket ride, with silver pushing $50, and gold well over $1500.

Research In Motion is having a tough year. Not only has its stock performance been underwhelming, but it isn’t competing well in its core business markets. J.P. Morgan’s profit was up 67%, to $5.6 billion. JPM increased its dividend to $0.25, and plans to buy back $8 billion in stock this year. Apple reported a 95% increase in profit, citing strong sales of iPhones and Macs.

Obama released his long-form birth certificate, and Mr. Trump is making noise about a presidential run. P.T. Barnum at his finest couldn’t orchestrate what is shaping up to be a most interesting election year.

Glencore, Groupon, and Dunkin Donuts are all preparing for IPOs. Glencore is a Switzerland based commodities trading house, Groupon provides online discount coupons and related services. Dunkin sells lots of caffeine and sugar, staples of the American diet.

The quality and viability of municipal and sovereign debt has been the subject of much debate over the last year. In fact, S&P is now questioning the sterling credit rating of U.S. debt. Wall Street’s line is that government debt of developed Western countries is the safest available. The challenge with that thought is that if it weren’t for Germany, then Greece, Ireland, and Portugal would most likely be in major default at this point.

Personal preference, if I’m evaluating sovereign or municipal debt, is to get input from those who stand to lose if the bonds default, rather than those who are often simply looking to move inventory. The insurance companies that offer bond default insurance seem to have lower rates for countries such as Australia, New Zealand, and the Scandinavian countries, than they do for much of the rest of the world, including the U.S.

On the tax front, the budget deal reached recently in Congress to keep the federal government open cut funding for high speed rail and the EPA, and increased the Pentagon’s budget by $5 billion.

In 2010, Congress had the gall to include legislation mandating business to business 1099s, beginning in 2012. This legislation ranked near the top of stupid laws, in terms of the cost/benefit ratio. The good news is that on April 5th, the Senate approved HR 4, which retroactively repeals the expanded 1099 reporting rules. For the moment, we can relax. As a rule though, we must remain vigilant, to protect our freedoms and liberties.

On the economic front, housing starts were up 7.2% in March, to an annualized 549,000. According to economists, a healthy economy should see 1 million new home starts annually. The Commerce Department announced that GDP grew at an annualized rate of 1.8% during the first quarter, substantially less than the 3.1% growth during Q4 2010. In addition, Commerce is officially recognizing the inflation that the rest of us have been experiencing at the gas pump and grocery store for at least the last year.

In 1862, roughly 10% of Americans, mostly affluent Northern citizens, paid income taxes. The income tax at the time was a temporary war time measure. This according to Joseph Thorndike, director of the Tax History Project at Tax Analysts, a Falls Church, VA non-profit.

During the war, citizens would pay no more than 10% of their income in tax, and this only if income was greater than $10,000. For those with incomes at or below $5000, the tax rate was closer to 5%. Income included profits from business or trade, earnings from sale of stock, gold, or real estate, and rents and interest on real estate, bonds, or securities. Income from farming operations or livestock sold was also taxable.

Deductions included a $1000 exemption, losses sustained from fire, shipwreck, or business losses not already recognized. Also deductible were wages paid to hired labor, and the cost of livestock purchased. There was a flat tax on gold watches, gold and silver, billiard tables, and carriages.

The tax law of the time was designed to be a rich man’s burden, as very few could afford a gold watch, billiard table, or carriage. The tax burden was gone in 1872, when the income tax law was repealed. It’s time to repeal it again.

To see how far we’ve come in accepting income taxes as part of the white noise of life, the IRS has announced its “Dirty Dozen” tax avoidance scams. These include hiding income offshore, identity theft, filing false or misleading forms, abuse of charitable giving, abusive retirement plans, and disguised corporate ownership, among a few others.

Quote of the week:

“Taxing oneself into prosperity is like standing in a bucket and lifting yourself up by the handle.”
                                                                                 -Winston Churchill

Wednesday, April 20, 2011

Q1 2011 Investment Commentary

STOCKS CONTINUED their upward march in the first quarter, with large-caps gaining almost 6%, while mid- and small-cap stocks posted gains approaching 8% (see table on back cover for index returns). Overseas, returns were not as strong, though still good. Developed-market foreign stocks were up more than 3%, while emerging-market equities gained just under 2% for the quarter. Domestic high-quality intermediate-term bonds didn’t fare as well, barely gaining ground in the first quarter, while foreign bonds did a bit better, with developed-market government bonds gaining 0.7% and emerging-market bonds climbing by almost 3%.

We Are Not Perma-Bears, But We Are Cautious Now

For various stretches over the last 13 years we have been cautious towards the stock market based on our assessment of market valuations and expected returns. This has frustrated our clients at times, the late 1990s being the most notable example, as the S&P and Nasdaq rocketed higher during the late stages of the tech bubble. We wrote about our market concerns at that time, and our caution proved to be warranted. Despite another bear market in 2008, all of our portfolio models outperformed their benchmarks during this period, though there were a couple of performance slumps along the way—notably in 1998 and 2008.

As we reflect back and look forward, there are several points worth emphasizing.

1. Our valuation-driven, scenario-based approach is designed to help us make good decisions over the long-term. We know we can’t predict the short-term with consistent accuracy.

2. Even in the midst of long periods where returns are low there are still opportunities. In fact, these low-return periods are often characterized by higher volatility that can offer occasional fat pitches in “risky” asset classes like equities, REITs, and high-yield bonds.

3. We are not perma-bears. There have been extended periods over the past decade where our equity exposure was at a neutral level and/or our actual “equity like” exposure was at or above neutral (taking into account exposure to asset classes that have some equity-like risk such as high-yield bonds and REITs).

Currently, we are positioned somewhat conservatively with our portfolio allocations, and there are a few important points to make in this regard.

First, our longer-term analysis suggests that stock returns are likely to be mediocre over our five-year time frame–most likely somewhere in the low-single-digit range. We analyze return ranges for stocks by considering the possible economic scenarios we could see, and then considering how the “building blocks” of equity returns—dividends, earnings growth, and multiples— stack up under each. A challenge is that the range of possible outcomes is unusually wide, ranging from another re-cession to a return to the “old normal” patterns of borrowing and spending. We believe the odds skew towards the more negative outcomes, and this impacts how we want to allocate our portfolios.

Second, likely returns from bonds are even lower than stocks. With interest rates quite low, and longer-term inflationary pressure likely to result from our government’s fiscal policies and challenges, it is far more likely that we will see rising rates (which push bond prices lower) than falling rates over our investment horizon. Without the tailwind of falling rates, and with yields on bonds starting at low levels, we expect only very low single-digit returns from core high-quality bonds. Ordinarily, if we believe equity returns are likely to be higher than bonds, it would argue for being fully weighted to equities to capture that higher return.

That brings us to our third point, which is that with low expected returns for stocks and bonds, and with significant big-picture risks out there that could damage returns (especially in the shorter-term), we are underweighted to both stocks and core bonds in our balanced portfolios in favor of invest-ments that we think collectively offer better or at least competitive returns at less risk.

Examples of portfolio positions that we believe offer a better risk-reward tradeoff include: short-term high-yield bonds that offer better yields but generally low default risk thanks to their short ma-turities and careful credit research (Osterweis Strategic Income); flexible, absolute-return-oriented bond funds that have a broad toolkit with respect to the types of bonds they can own and their ability to limit the risk of rising rates (PIMCO Unconstrained); floating rate funds that generate good yields but that are not exposed to the risk of rising rates, and arbitrage strategies that are able to earn a return without the tailwind of rising stock prices.

These investments are generally a little riskier than core bonds in that they would provide less pro-tection from a severe downside scenario such as recession or deflation, but they are significantly less risky than equities. Since these positions are funded from reductions in both stocks and bonds, the net effect of these positions is to reduce overall portfolio risk while generating as good or better re-turns in most scenarios.

We have two other fixed-income investments that come with a notch-higher risk than the invest-ments described above, but that similarly offer better bang for our risk buck. The multi-sector Loomis Sayles Bond invests in (among other things) carefully selected high-yield bonds and foreign bonds, mainly of commodity producing countries, which provides some hedge against a falling dollar. The other fund—PIMCO Emerging Local Bond—invests in the bonds of emerging-markets countries and is a more direct-dollar hedge. It offers an attractive 7% yield and the chance for greater currency appreciation if our longer-term assumptions that the dollar will decline prove correct.

Our core investment-grade bond exposure is achieved mostly via PIMCO Total Return and munici-pal bond funds for taxable portfolios. Given the media focus on state and municipal finances, we want to share briefly our view on municipal bonds.

For taxable portfolios, municipal bonds are still a core position. This sector of the bond market has been in the headlines for months with some commentators making doomsday forecasts of massive defaults. This asset class is hard to evaluate on an aggregate basis because of the lack of underlying fundamental data and the fact that there are about 60,000 different bond issuers. We’ve approached our analysis by talking to and reading the analysis of experts in our network, reviewing research and data, and studying the structural factors that affect the finances of different types of muni issuers. We believe the massive default forecasts are greatly exaggerated. While defaults are almost certain to increase among smaller local issuers and will likely be higher than in past cycles, we believe there are plenty of solid muni credits available to bond managers.

Scattered high-profile defaults are entirely possible and these could spook investors and trigger more temporary nasty sell-offs for the broader municipal bond market, so we expect higher volatility than taxable investment-grade bonds. But the overall market is currently pricing in a default level that we believe is much too pessimistic—many muni bonds are offering tax-free yields that are higher than taxable U.S. Treasury yields. If municipal yields relative to taxable bond yields normalize over five years (the muni yields normally are lower since they are exempt from tax), investors may be able to capture returns that are nearly as high as the current yields, even in light of the rise we expect in the general level of interest rates. This should equate to pre-tax equivalent returns of around 5%, much better than the returns we expect from taxable investment-grade bonds. This makes municipal bond funds a decent asset class to own for the conservative portion of our portfolios for those who can ac-cept the higher shorter-term volatility.

The final point we would make about our conservative positioning is that if we continue to see strong stock returns, it is likely our portfolios will lag their benchmarks. And while we did manage to outperform in 2010 despite a sharply rising stock market, we trailed in the very strong fourth quarter and again in the first quarter of this year. It may seem odd to be cautioning clients about the “risk” of stocks continuing to march higher, but it is worth considering what that risk really is. The risk is that rising markets leave investors feeling that they missed the boat, which leads them to increase their equity exposure at a time when high stock market valuations offer less longer-term return potential and greater vulnerability to a correction.

We are often asked: “What if you are wrong and stocks just keep going up”? Stocks can keep going up in the shorter-term, and this is not something we are confident in our ability to predict. But over the longer-term, which we can analyze with more confidence, an important driver of stock returns will be earnings growth, and this is highly correlated to the overall economy. So could the economy perform well enough to continue to drive the kinds of stock returns we’ve been seeing? Consumers could ramp up spending, and take on more debt, and the jobs and housing pictures could improve more quickly than we expect. But even if that happens to some degree, the deepest underlying prob-lems aren’t going to go away as a result.

The deeper problem is that we have gone through a massive build-up of debt that occurred over many decades, and a lot of it still remains. Some of it has effectively been shifted to the government. With large deficits, a growing national debt, and entitlement spending on track to make these prob-lems significantly worse over coming years and decades, it is inevitable that at some point as a nation we will have to take our medicine. When we do, it will mean we borrow less and spend less, which will reduce economic growth, and that will be a drag on corporate earnings and therefore stock returns.

It is in considering the headwinds the economy faces in the years ahead, and factoring in other big-picture risks such as Europe’s debt problems, unrest in the Middle East, Japan’s disaster, and other possible shocks we can’t foresee, that we conclude that the returns stocks are likely to earn aren’t sufficient to compensate us for taking on the risk. We’ve often said that we view investing as a ma-rathon, not a sprint. We all are investors over a lifetime and any one year is a small slice of our in-vestment timeline. Over our investing lives there will be periods when it pays to be conservative and others when it makes sense to be aggressive. Sometimes these periods will be short, others times they will last for years. Along the way there will be ups and downs within each of these periods. Our challenge is to ignore the ups and downs and focus on the potential returns we believe we can cap-ture and weigh them against the risks.

Ultimately, what drives our risk-taking is the presence of a margin of safety, i.e., a significantly un-dervalued asset, such that even in a bad scenario it shouldn’t have much downside. Today we be-lieve there is an inadequate margin of safety in the stock market. Valuations are not attractive enough to compensate for the many serious concerns we’ve mentioned that could impact investment funda-mentals. And because we have other investments that can generate competitive returns at less overall risk, we are not concerned that over the longer-term we are giving up a lot of opportunity even if we see a scenario that is better than we expect.

Meanwhile, it is worth noting that despite our significant equity underweight, our net “risk un-derweight” is less than it seems because many of the investments described carry higher risk than bonds, from which they are partly funded.

Two final points about return expectations are that the equity managers we own can boost returns through outperformance, and many are indicating that at the stock-picking level they are finding good opportunities. Additionally, we are confident that inevitable periods of fear will drive certain asset classes lower and present us with opportunities to earn much more compelling returns in exchange for ratcheting our risk higher. This discipline and longer-term focus, along with careful underlying research, is the core of what we bring to the table as investment advisors.– Centurion Advisory Group Research Team (4/11/11)

Thursday, April 14, 2011

Makers vs Takers

THE WEEK WAS FLAT ON THE DOMESTIC EQUITY side. By the numbers, for the week ended Friday, April 8, 2011, the Dow Jones Industrial Average closed at 12,380, up 4 points, representing almost no change from the previous week. The Standard & Poor’s 500 closed at 1328, down 4 points, and the NASDAQ Composite closed at 2780, down 9 points.

Politicians came to an agreement late Friday evening that avoided shutting down the government. Each side trumpeted the success of favorite programs, or the saving of what’s been described as $39 billion. If these decisions didn’t weigh so heavily on the future of our country, at least the posturing and grandstanding of Congress would provide a bit of comic relief.

This continuing uncertainty, both at home and abroad, sent gold to new highs, and oil to new highs for the year. In the last couple of days, however, fear and profit taking have sent the market down 2% and change.

Kerri Shannon, writing for Seeking Alpha, has suggested a real inflation rate of 9% to 12%, compared to the 3% or less suggested by the feds. Gasoline prices are up 19% over the last year, and the producer price index was up 1.6% in February, double the January increase and more than twice the expected 0.7%.

Wholesale food prices were up 3.9% in February, the largest monthly increase since November 1974, and up 7.3% in the last twelve months. Given these increases, it will be tough for retailers not to raise prices, as they have been absorbing most price increases so far.

Stephen Moore, writing in the Wall Street Journal, offers insight into why so many states are operating at or near bankruptcy. According to Moore, there are 22.5 million government employees, and 11.5 million manufacturing employees. In 1960, manufacturing employed 15 million, and government 8.7 million.

“More Americans work for the government than work in construction, farming, fishing, forestry, manufacturing, mining, and utilities combined. We have moved decisively from a nation of makers to a nation of takers”, says Moore.

The future? Surveys of college graduates are finding that more and more of our top minds want to work for the government. In recent years only government agencies have been hiring, and government employment offers near lifetime security in this era of economic turbulence.

In economic news, the Institute for Supply Management’s service sector index dropped in March to 57.3 from 59.7. Any number above 50 is a positive, though this change indicates a slowdown. Initial jobless claims dropped to 382,000 last week, and consumer credit increased in February by $7.6 billion.

According to a very unofficial survey of several mortgage brokers, business is booming in terms of new loan applications. A larger number of these loans won’t be placed compared to three or four years ago, due to actual underwriting, but the activity is encouraging. Apparently, the buyers are those who are taking advantage of foreclosures and lower prices to become homeowners.

Quotes of the week:

“Unforgiveness is like drinking poison, in the hopes that someone else will die.”

“When the people find that they can vote themselves money, that will herald the end of the Republic.”
                                                                                         -Benjamin Franklin

Thursday, April 7, 2011

Capital - Human, Shared, Financial

IN SPITE OF UNCERTAINTY AROUND the world, the domestic equity indices have turned in a solid performance the last two weeks. By the numbers, for the two weeks ended Friday, April 1, 2011, the Dow Jones Industrial Average closed at 12,376, up 518 points, or 4.2%. The Standard & Poor’s 500 closed at 1332, up 53 points, or 4%, and the NASDAQ Composite closed at 2789, up 146 points, or 5.2%.
For the first quarter of 2011, the Dow gained 6.4%. This put the quarter’s return in the 70th percentile of returns over the last 120 years, and represents an annualized return of more than 28%.

Non-farm payrolls grew by an adjusted 216,000 in March, the best growth since May of 2010. This puts the official unemployment rate at 8.8%, though we suspect that the unofficial unemployment and underemployment rate is closer to 20%.

David Sokol has left Berkshire, presumably to run the Sokol family office. Maybe he should have had a V8, instead of buying Lubrizol for his own account first.

Home prices in 20 major U.S. markets fell 1% in January, according to Case-Schiller, the sixth consecutive monthly decline. Only Washington, D.C. saw an increase in home prices. At least someone is benefiting from our grandchildren’s tax money.

In other economic news, consumer spending was up 0.7% in February, though consumer confidence dropped. Factory orders and manufacturing growth, as well as public and private construction spending, fell in February.

As noted more than once in this space, we continue to have concerns about domestic and international equity markets. Sovereign debt, both domestically and around the world, combined with the plantation mentality that seems so prevalent, doesn’t bode well for strong growing economies, and the consumers and companies that participate in those economies.

Financial planning as a discipline has, for about twenty five years, centered on financial analysis and investment management. The missing links for many have been the coordination of these number crunching exercises with a client’s work life, which we can call human capital, as well as the client’s choice to give back, which we can call shared capital.

Would it help to engage in a way such that financial analysis and investment management was integrated with how you engaged with work and business, as well as your vision of how you wanted to make an impact? Let us know. We are exploring this question internally at the moment, and would appreciate any feedback you care to share.

Pain is a gift. It lets us know something is wrong, and that it’s time to pay attention. What if the nerve endings in your fingers were gone? You could pick up a hot skillet from the stove, but would lose your hand at some point, due to burn damage. More on this topic later.

Quote of the week:

“Being unwanted, unloved, uncared for, forgotten by everybody, I think that is a much greater hunger, a much greater poverty, than the person who has nothing to eat.”
                                                                                                       Mother Teresa