Financial Commentary – Public

As the third quarter came to a close, eyes were on Washington as the House of Representatives escalated what has been an annual brawl over the budget into a shutdown of mostly non-essential functions of the Federal Government. Congress has been rehearsing for this Kabuki dance since the last government shutdown in the mid ’90’s. They have made sure to insulate themselves from the most powerful constituencies by exempting Social Security, Medicare, Federal Aviation Administration and National Security related entities from the “shut down.” This keeps most voters from flooding Congress with hate mail for a while, unless they happen to have planned a national park vacation. If predictions that the stand off will continue for weeks is correct, then the buffalo in Yellowstone will be free to roam without those annoying cameras clicking, at least for a while.

Should you be worried? Bullish equity markets are said to "climb a wall of worry."  The media can be reliably counted upon to magnify the crisis du jour, but economic fundamentals trumps temporary crisis in the long-term. I believe there is a good chance that the shutdown and the debt ceiling debate to come will cause a market sell-off. Since Trusted Financial Advisors invests based on long term fundamentals, a healthy sell off will likely be an opportunity to pick up some good merchandise for client portfolios.

The positive fundamentals driving the US equity market at this time are:

Bond and stock markets are having a summer correction, focused on interest sensitive securities. This has occurred against a backdrop of mixed economic news not just in the United States but also in Europe and China. The US economy crawls forward, the Chinese economy is expanding at a slower rate than in recent years. Europe appears to be at the nadir of its recessionary contraction, but there is little prospect of vigorous economic expansion on the continent, which is constrained by stiffening banking regulation and a soggy real estate market. The basket case nations of Europe continue to force the EU central bank to expand its balance sheet, but it does so at a far slower pace than we have seen under the Bernanke Fed in the United States, suggesting prolonged doldrums across the Pond. European nations suffer from greater unemployment than the US because the unemployed are an entitled class in most nations, and laws that give labor extraordinary power discourage new hiring and new enterprise. A spokesperson for the "League of Unemployed" has a solution: cut the official work week from 36 hours to 32 hours so more people will have to be employed. To this group, Karl Marx had an even better solution, except that it failed the last time it was tested, didn’t it?

Since the USA‘s expansion out of the Great Recession may not be gaining speed, investors are, it seems, retreating from the frantic buying that characterized the first quarter of 2013. The damage has been focused on those instruments that attract income investors: bonds, REIT’s and MLP’s. This is because interest rates have been ratcheting upward since the Federal Reserve Chairman suggested it might back off on the extraordinary level of bond purchases known as “quantitative easing” (QE III) that it began about 10 months ago.

As a strong quarter progressed, I became increasingly uncomfortable with the euphoria that seemed to be infecting investors, especially those who like interest sensitive holdings. Sure enough, the air was let out of that balloon with Fed Chairman Bernanke's comments in mid-May. He indicated that the Fed might let up on the credit creation gas pedal sooner than later, because the US economy appears to have gained a growth momentum that no longer requires dirt cheap credit to nudge it along. Horrors! Good news like this was anathema to many bond market participants, who have become addicted to ridiculously cheap credit. Panic ensued.

Along with bonds of all classes, interest sensitive sectors like MLP's, REITs and utilities took a hit, many falling 15% from recent highs. Because our clients are well diversified, and we had already raised cash levels, shrinkage was confined to low single digits. 

Our policy for the past year has been to not replace existing bond positions when they mature or (more commonly) are "called" in by the issuers. I've bemoaned these early bond redemptions in previous newsletters because our clients' bonds are generally paying generous income, something nearly impossible to find today. Nearly all bonds we own are institutional grade, purchased between 2007 and 2010 when nervous investors avoided this asset class in the doleful days of the Great Recession. Most of the cash generated from bond redemptions or bond fund sales have been left in cash, as few bargain stocks were available, in my judgment. 

June 17 Flash:

Bernanke about to announce an end to extraordinary bond purchases? Fear not, the economy is gaining moment, it seems, see our comments from about ten days ago below: 

June 7, 2013

Things are so dull in this slowly expanding US economy that financial media have taken to treating the release of a […]

There is little doubt that the US economy is on the mend. Commentators who continue to refer to “the ongoing recession” or “our lousy economy,” (and there seem to be many of them), are strangely out of touch. Economic recovery so far has been of primary benefit to active investors (bonds, stocks, real estate) rather […]

There are multiple actions you can take to better prepare yourself financially for retirement.
Here are six tips that may help you make the most of your final working years.

1. Catch up. If you have access to a 401 (k) or other workplace-sponsored plan at work, make the
$5.500 catch-up contribution that is available to participants aged 50 and older. Note that you are
first required to contribute the annual employee maximum, $17,500 for 2013. before making the
catch-up contribution.

2. Fund an IRA. Investors aged 50 and older can contribute $6,500 annually (the $5,500 annual
contribution plus an additional catch-up contribution of $1 ,000). An investor in his or her 50s who
contributes the maximum amounts to both a 401(k) and an IRA could accelerate retirement
savings by more than $25,000 a year.

An Ill Wind Blows Through the Holiday Season
Conventional marketing wisdom dictates that during the holidays people like to hear cheerful news and positive predictions.  I’ll keep this focused on finance, but cannot help but express my deep grief at the horrific tragedy that has befallen so many families in Newtown, Connecticut. It is difficult to maintain the holiday spirit when others are suffering so.

Financial winds are not promising.  The chasm that exists between people holding radically different financial and political philosophies seems to have widened, demanding that the financial markets send a signal to all concerned that compromise and shared sacrifice are no longer desirable but well overdue. When under stress, people cling in a most uncompromising way to their beliefs, losing flexibility of thought and any sense that their beliefs may be subject to question. Usually it is only after reality shakes people loose from their cherished beliefs that compromise comes. So I fear a sharp tumble in financial markets may be required to focus the attention of decision makers in government.

The view from Orange County California, one of the highest net worth counties in the United States...

When judged by indexes, it has been a grand year for the stock market. Bonds have done their part too. Our Balanced/Value portfolios have generally seen a gain of about 8% year to date. This is below the stock indexes, as is normal for our “Balanced” style during a bull market.  We shine most when the Applesauce hits the fan, so you will see from the figures found at the end of this article that over the past five years, which encompass the Great Recession Bear Market, our clients enjoyed annual returns of over twice the rate experienced by stock index investors. Speaking of Applesauce (and Google) these were principal drivers of stock market indexes in the quarter. If you were not heavily invested in them, you “underperformed”.

A quarter in which global financial indicators began to turn southward ended with a roaring finish on June 29, 2012.  As with last year a leading cause for equity market concern was the confused and deteriorating state of balance sheets in Europe. Leading banks in the southern tier as well as governments appeared close to collapse in a scenario not unlike that which dominated the U.S. financial industry from 2007 until 2009. I'm currently reading Andrew Ross Sorkin's Too Big to Fail, a reminder of how very human the people are making decisions that will affect the well being of billions of people across the globe.  In the case of the USA, then Treasury Secretary Hank Paulson and his brilliant team of dedicated public servants shine through for knocking heads together to avoid a domino effect as Lehman Brothers went through bankruptcy.  Fed Chairman Ben Bernanke and then New York Fed President Timothy Geithner also did yeoman work. 

In the nearly three weeks since our last blog entry, equities markets have tilted toward the more negative outcome we discussed as a possibility.  In response, we've raised our allocation to cash as nearly all the signals have retreated. The one positive trending major economy on the globe, the USA, seems to be faltering and recent stats confirm a small contraction in output of goods and services and importantly a slowdown in hiring.  Below are some selected quotes and opinions from some of our favorite observers of the big picture.  First, Alan Ableson, who I've followed since I was a neophyte investor at age 24 (I'm 63 today..my goodness how old is Alan?), scoffs at the annual cheerleading that emanates from the home marketing industry. Then, thoughtful Martin Wolfe, columnist for the Financial Times, highlights the abyss into which Europe seems to be falling. Finally, Greg Valliere a Washington economic/politics  observer talks about a surprising improvement ini Mitt Romney's prospects for the presidency this November (note, he predicted Hillary Clinton would be the Democratic candidate in 2008).

Clients can be assured I continue to be watching things closely and that positioning is defensive but not cowardly!