Thoughts on the Current Outlook – April, 2014

The Weather Strikes Back!

It seems a bit ironic that we used a weather analogy as the framework for our 2014 outlook because the weather itself was the biggest economic story in the first quarter. East of the Mississippi, from Minneapolis to Washington DC, record cold and snow were served up repeatedly.

Against this frigid backdrop, retail sales slowed, car sales stalled and hiring took a hit. About the only thing contributing positively to a growing economy was the big increase in consumption of natural gas for heating! We don’t have a preliminary read on GDP for the first quarter yet but we expect it will be significantly slower than the fourth quarter’s 2.6%.

The weather-induced slowdown in the economy had another surprising effect: the bond market did better than stocks in the first quarter. By the end of 2013, bonds were all but given up for dead with most predicting that interest rate rises were imminent and a bond bear market was about to start. And, conversely, conventional wisdom was that stronger economic growth would help stocks. As is usually the case when a trend is so universally expected, something else happened.

The bond market seems full of surprises these days. Even with new Fed Chair Yellen signaling that interest rate hikes are likely to begin next year, longer term bond yields have barely budged. To be fair, intermediate term rates moved up and mortgage rates continue to creep up. But, the worst performing part of the bond market in 2013 – long term municipal bonds – were the star of 2014’s first quarter.

But Change Is in the Air

Despite all of the uncertainty created by the weather, there is one thing that is certain: the weather will change. And, with it, we expect that economic activity will resume at a respectable pace. Respectable is the key word here. There are many factors that will keep the economy from accelerating too quickly.

First, we believe the snapback in housing is now over and the future gains in home prices will be driven by longer term supply and demand dynamics. While those dynamics are favorable, double digit price gains are likely behind us and more consistent, inflation plus 1-2% gains are more realistic.

The employment picture is still solid, if unexciting. Except in a few, high-skill, high-demand fields, there is still a great deal of slack in the labor markets, meaning income growth will be restrained and wage-driven inflation will be non-existent.

Finally, consumers continue to be financially conservative, taking on little debt and using their credit cards sparingly. This is one of the positive legacies of the Great Recession. But it also constrains growth in our economy.

More Excitement Elsewhere

Ukraine is in focus as the world ponders Russia’s next steps after its annexation of Crimea and troop build-up on Ukraine’s eastern border. We have long expected Russia to use its energy influence and the war-weariness of the US to expand its regional influence. We believe that the markets are Putin’s biggest adversary – the ruble has plummeted and, if oil prices follow, his ambitions will be diminished.

The more important European financial story is its emergence, albeit very slowly, from recession. The peripheral economies still have a long way to come before they can claim recovery. Indeed, central bankers are concerned that inflation remains too low, with talk of more stimulus creating news. Discussions about a possible break-up of the common currency, all the rage just a couple of years ago, are all but dead.

India, the world’s largest democracy is about to embark on its largest election (800 million prospective voters) ever. At stake is a renewed focus on the economy, which has struggled to post decent growth of late. India is in great need of more forceful economic leadership but we remain skeptical whether this election will provide it.

In China, concern has shifted to the magnitude of the debt build-up over the last few years, even as growth has slowed. From a very big picture perspective, this combination of factors is very similar to the US situation in the mid 2000s. As we know, that did not end well. However, there are many, many differences between how China and the US are able to manage these circumstances. We expect the Chinese to accept much lower economic growth as they shift toward a more sustainable growth model. And, they will use their unique “market-oriented” approach to gradually introduce freer float in the currency and more risk of default into the debt markets.

Finally, in Japan, Abenomics has accomplished its first task of shifting psychology away from deflation to modest growth and inflation. Salary growth, a critical element of the shift, is showing signs of taking hold. An increase in the consumption tax is just now going into effect so the next several months will be critical in seeing how this impacts the economy.

The Bottom Line

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We have reduced our dedicated Asia investments but have increased the weightings in international small company stocks, expecting these strategies to perform well in a better economic environment. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to changes in market expectations about the future course of interest rates.

April 9, 2014              © Essential Investment Partners, LLC

Explaining the Unexplainable: US Strategy toward Syria

We have been baffled by the Obama Administration’s statements and actions over the last month in dealing with the Syrian chemical weapons situation.  George Friedman, founder of Stratfor, a foreign affairs consultancy, penned an excellent article which we highly recommend.  It lays out in simple terms why we are so conflicted and unable to articulate a clear path forward.

Fed Riles the Markets

In our “Thoughts on the Current Outlook” dated April 9 of this year, we said:

We aren’t suggesting that you rush to sell all of your bonds immediately because we don’t expect this rise in rates to occur suddenly.  But we are actively reducing the duration risk in client portfolios as we think this rise could happen as rates return to “normal” levels.  This normalization of rates comes with some good news though:  interest rates are likely to rise as the economy continues to recover and approaches its long term growth rate. 

Higher growth will give rise to two conditions leading to higher rates.  First, the Federal Reserve will likely back off of its program for purchasing bonds, which we believe has artificially suppressed bond yields.  Second, better growth typically means a return of inflation as incomes rise, demand rises and prices respond. 

Events of last week jumbled the order we had anticipated.  Prior to last week, the Federal Reserve had only hinted at considering “tapering” their purchases of US Treasury bonds and mortgage bonds if the economy continued to improve.  Last week, in conjunction with the Fed’s regular meeting, Federal Reserve Chairman Bernanke laid out a relatively specific plan for tapering their purchases later this year and stopping them next year, effectively anticipating that the economy will continue to improve, or at least that is how the markets’ interpreted his comments. 

The markets’ reaction to this change in Fed intentions was violent.  Interest rates spiked, bond prices tumbled and stocks followed suit.  To give you a sense of the magnitude of the move in interest rates, the yield on the 10 year US Treasury bond was 1.64% on May 1, 2.16% at the end of May and it closed Friday at 2.51%.  We had expected that this rate might move into the range of 2.75 to 3.00% over the next year.  Instead, we got about three fourths of the move in just a few weeks. 

Markets don’t like surprises, particularly from the Fed, so bond and stock prices dropped swiftly.  And the downward moves in prices of closed end bond funds have been particularly stunning.  However, there is a silver lining.  This negative investor sentiment presents a great buying opportunity in our opinion.  Over the last few days, we have been selling open end bond funds and buying closed end funds at prices we view as exceptionally attractive.  We also expect to add to stocks as well, although those corrections have been more selective and we will be more cautious in our buys. 

We will be publishing our new investment outlook in early July.  It will have a much more complete discussion of the issues that the new Federal Reserve stance has created.  These issues extend well beyond our shores as the impact of the world’s largest economy changing its monetary policy has large ripple effects.

Income and Estate Taxes – A Surprising Bit of Certainty

At a time when it seems that politicians here and abroad are contributing to the uncertainty of the world economy, the US Congress recently delivered a bit of certainty in two very important aspects of our financial lives.  It took two old line Senators – McConnell and (now Vice President) Biden – to hammer out a deal in the waning hours of 2012.  The final deal allowed both sides to claim victory – higher taxes on upper income taxpayers for the Democrats and permanently lower rates in all other brackets for the Republicans. 

Remember the phase-ins and phase-outs and constantly changing brackets of the 2000s?  Gone.  In the end, the lower tax rates initially established under President George W. Bush were made permanent for all but the highest income earners.  In addition, no major deductions or exemptions were modified and that pesky alternative minimum tax fix (that Congress has been doing annually for who knows how long) is now permanently fixed by indexing it to inflation. 

Congress also drastically reduced the applicability of the estate tax by making permanent the estate/gift tax exemption at $5,250,000, also indexed for inflation. Portability (sharing of the exemption between husband and wife) has been made permanent.  The quid pro quo?   A higher estate tax rate of 40%.  

This all seems too good to be true, right?  Well, if you make more than $200,000 (single) or $250,000 (married), your 2013 income tax calculation is about to get a lot more complicated.  We aren’t going to try to explain all of the nuances here but let’s summarize by saying that there are three new ways that your taxes will go up. 

First, the 3.8% Medicare surtax will apply to net investment income to the extent the $200,000/$250,000 threshold income is exceeded.  Second, at incomes above $250,000/$300,000 personal exemptions and itemized deductions begin to phase out.  Finally, at incomes over $400,000/$450,000, a new higher income tax rate of 39.6% applies and the capital gains rate increases from 15% to 20% (in addition to the Medicare surtax).  

Behind each of the these general ways that taxes may rise is a somewhat complicated formula – best left to your tax accountant. 

Stepping back from the details, it seems pretty likely that those with high incomes and estates exceeding $10.5 million will look to shift income-producing assets out of their estates by way of gifts below the gift tax exclusion amount.  The secondary benefit is that the income from those assets could be taxed at substantially lower rates in the hands of a lower tax bracket recipient.  

Our advice – seek the counsel of your tax accountant and estate attorney early in 2013 – as asset and income shifting might be an important part of a smart estate and income tax strategy.  The sooner you look at your options, the more effective they will be in 2013 and future years.

Good News from Essential

2012 turned out to be a very good year – our clients experienced strong absolute returns and we were blessed by the expansion of our client roster.  We closed 2012 at just over $100 million in assets under management and plan to continue to grow in a measured way that puts client service first and foremost.  

Speaking of continued growth, we are pleased to announce that Mark Asaro, CFA,  has been promoted to Portfolio Manager.  Mark has done an excellent job in all aspects of our investment research – he and Jon Zeschin now co-manage all client portfolios. 

In addition, we have named Marce Webster to the position of Client Service Director.  Marce is the consummate client service professional, making sure that all aspects of our clients’ interactions with us and their custodians run smoothly.  

A great deal of the credit for our clients’ investment success goes to Mark and Marce – they are always ready to do whatever is needed for our clients.

Reinventing America’s Economy

The cover of the July 14th issue of The Economist magazine featured a buff, bulked-up Uncle Sam under the heading “Comeback Kid.”  Subtitled “America’s economy is once again reinventing itself,” the cover story described several very positive trends.  Their story largely overlapped our April 2012 “Thoughts on the Current Outlook” in which we said the following:

On a longer term basis, we are increasingly focused on four factors that we see as likely to help our economy over the next several years. We believe these four trends will help lead us away from some of the nearly four year old legacies of the Great Recession, particularly high unemployment and excessive debt.

They are:

  1. the push for energy independence, supported by major discoveries and new technologies in North America as well as a moderately favorable regulatory environment;
  2. the petering out of the housing debacle – with foreclosures concentrated in a few severely depressed markets and affordability at an all-time high, we believe the stage is set for stabilization of home prices nationally;
  3. a new wave of business productivity enhancements, sparked by the convergence of highly functional, user friendly mobile devices and an explosion in software targeted at these devices;
  4. the overarching theme is the emergence of the echo boom generation as the driver of each of the three themes above. Think energy efficiency, housing needs, mobile productivity – we think those six words succinctly summarize the mindset of current 20- and 30-somethings.

Anticipating the view that America’s economy is not exactly humming along now, The Economist said:  “What should the next president do to generate muscle in this new economy?  First, do no harm.  Not driving the economy over the fiscal cliff would be a start: instead, settle on a credible long-term deficit plan that includes both tax rises and cuts to entitlement programmes.”

We couldn’t have said it better.  As our most recent outlook indicates, we are most concerned about the self-inflicted wounds we seem destined for over the next six months as the fiscal cliff arrives.  If we can get through this period with a reasoned approach that sets in place a solid long-term course, there is much to be optimistic about.  Unfortunately, this is a big IF – it seems that both political parties are more concerned with posturing around problems rather than solving them. 

So put us in the short-term cautious, long-term optimistic camp.  Regardless of who wins the election in November, the new president would be well-advised to heed the urgings of Lucy to Charlie Brown: “Lead, Charlie Brown, Lead!”

Essential Investment Partners among 2011 Denver Five Star Wealth Managers

For the second consecutive year, we were selected to be on the list of Denver’s Five Star Wealth Managers.  Five Star Professional partners with 5280 magazine and ColoradoBiz magazine to determine wealth managers in the Denver area who provide exceptional service and overall client satisfaction.  The list is constructed from the results of surveys of more than 73,000 households and more than 8,500 financial services professionals.  A further review of client complaints, regulatory history and civil actions and final review by a panel of experts culls the list to about 4% of Denver’s wealth managers. 

Full details of the selection process and the complete list of wealth managers appeared in the November issue of 5280 magazine. 

Food for Thought – Ten Surprises for the Next Decade

With so much news crossing in front of us each day, it is difficult to keep up day-to-day, much less think about the implications of the changes we are seeing. There are certainly many reasons for pessimism – the continuing sovereign debt issues in Europe, the “Arab spring” and related uncertainties in the Middle East, high unemployment and deficit spending problems at home, the moribund real estate market, to name just a few.

But we thought it might be interesting to speculate on a few major changes we might see play out over the span of this decade. We try to look beyond the news of this week, this month and this year and think about how things could ultimately turn out over a five to ten year period.

So please take this list of “surprises” as food for thought, not as hard predictions. As always, we welcome your comments, criticisms and questions.

  1. With the tacit support of Russia and China (who want the U.S. military out of the region), the regime in North Korea topples after the death of Kim Jong-il. North and South work out their own version of reunification, setting the stage for a new economic engine which works to eclipse Japan in the succeeding decade.

  2. After a shaky start early in the decade, the U.S. real estate market bounces back. Once foreclosures begin to decline in mid decade, home sales begin a sustained pick up to meet pent up demand. Slowly but surely, the echo boom (boomers’ children) spawns a resurgence in single family homeownership that stabilizes and then lifts real estate prices. For much of the decade though, the focus is on existing homes which can be bought for far less than replacement cost.

  3. The Eurozone survives and thrives amid new integration strategies spawned by the age of fiscal responsibility. But this is not before its weaker members survive near-death experiences. Debts of Greece, Portugal, Ireland and Spain are restructured in the first half of the decade, causing the banking system to recapitalize with help from the European Central Bank. By facing the debt crises head on, the Europeans adapt and change well ahead of the U.S.

  4. China redirects its focus to domestic initiatives, putting in place the social safety nets needed to support a consumer-based economy. However, growth slows to the mid single digits as exports fall significantly – a growth scare which brings about a major, but short-lived, bear market in Chinese stocks. Recognizing its rapidly aging worker population, China actively encourages family formation and sets the stage for strong domestic growth for decades to come.

  5. A green revolution ignites the auto industry as consumers are drawn to new technologies that reduce oil dependence. The industry ramps us production to exceed the previous annual peak of 17 million vehicles sold in the US. China sales eclipse the U.S. by a wide margin. Ford and GM once again become industrial powerhouses, chastened by much stronger competition.

  6. Fueled by a huge youth population and languishing economies, the Arab Spring drags on for years without major regime change or progress toward democratic reform in the region. Freed up by lower demand for oil, less public support for terrorist activities and successes in removing terrorist leadership, the U.S. views the region as less strategically important and shifts its focus away from combat to containment. Russia and China, acting in their own enlightened self-interests, become U.S. allies in this effort.

  7. Facebook launches the biggest IPO in U.S. history, coinciding with a peak in U.S. stock prices for the first half of the decade. After another significant setback, stocks begin a long bull phase while bond investors struggle to break even.

  8. America’s unemployment rate stays above 7% throughout the decade, which keeps wage inflation (and therefore reported inflation) at bay. Baby boomers stay at work in record numbers, ironically leaving fewer job opportunities for their own children. Advances in cancer and aging research begin to extend life expectancies significantly, exacerbating the funding crises in Medicare and Social Security.

  9. Ubiquitous high speed internet, device convergence and other technology advances let companies prosper with fewer employees and those employees they do have to work in more mobile/home office environments. Demand for commercial real estate, while stable, faces a long period of very slow growth as corporations shed unneeded office space. New office construction stays at a very low level.

  10. Learning from the economic successes of China and the mistakes of its own economic transition, Russia moves closer to the China planned economy model but with its own twist of exploiting its natural resource assets. These two countries decide they have more to gain through cooperation than rivalry and begin to work together much more closely on mutual economic and defense interests. This new alliance could seriously challenge the economic leadership of the U.S. and Europe in the coming decades.

© Essential Investment Partners, LLC 2011 All Rights Reserved

Feeling a Little Like Bill Murray

The following special market update was emailed to our clients on Friday, June 17th:

Like the famous morning alarm clock scenes in the movie “Ground Hog Day,” we keep waking up to the same themes being replayed in the markets.  Greece on the verge of default, possible contagion to other European countries, a weak U.S. job market, the economy growing slower than we had hoped.  All these themes caused the stock and corporate bond markets to correct very sharply in May and June of 2010

Here we are, one year later, and very little has changed except that the markets’ 2011 correction has been milder so far.  But a significant measure of daily volatility has been re-introduced to the stock and bond markets.  For a bit of perspective, the U.S. stock market (as reflected in the S&P 500) is down about 7% since its peak on April 29th of this year.  Last year, the same index peaked on April 23rd and dropped 16% before bottoming on July 2nd.

The only new concern is that the Federal Reserve’s second round of quantitative easing (buying Treasury bonds for its own balance sheet, which adds liquidity to the economy) is about to end and there is little likelihood it will be extended in its current form.  However, we think this should be more of a market concern than an economic concern as the evidence is clear that the Fed’s program had relatively little economic impact. 

We continue to believe the U.S. economy will grow at a below average rate, unemployment will stay very high and corporate profits will stay pretty solid.  The moderate fall in oil prices will ultimately put some money back in consumers’ pockets and lift spending a bit.  While we don’t expect a recession in the near term, a slower growing economy has far less margin for policy error or shock absorption.    Lack of consumer confidence, if translated to buying habits, can constrain the economy as well.  Finally, we are heading into the presidential election cycle when we will see a barrage of talking heads telling us how poorly we are doing.  This never helps an already weak economy. 

From an investment perspective, we continue to focus on the opportunities we see in individual stocks, carefully selected mutual fund and hedge fund managers and closed end fund special situations.  The market corrections have created some good values and we expect to take advantage of short-term dislocations to your benefit.  Of course, risk control is always top of mind each time we evaluate these opportunities for your portfolios.

Being smart about managing taxes on investments

Jon Zeschin is pictured and quoted in the December 10-16, 2010 issue of the Denver Business Journal in an article entitled “The new diversification class: taxes.”  When asked about the term “tax diversification”, Zeschin said, “[It] is just a buzzword for being smart on how to set up, invest and ultimately withdraw from taxable and tax-deferred accounts in the most tax-efficient manner.”

Zeschin added, “It is even more complicated right now because of the uncertainty about what tax rates will be starting January 1, 2011.”  Of course, even if Congress approves the package that President Obama and Congressional Republicans worked out, we will face the same uncertainty in less than two years, right in the midst of a presidential election. 

The full article is available to subscribers at


Volatility Rules the Bond World

Looking back over 2010, there has been no shortage of major developments affecting bond investors.  The Greek debt crisis in May made its way across Europe to Ireland in November.  The U.S. Federal Reserve embarked on a second round of quantitative easing (essentially printing money to buy debt) in October, believing that the U.S. economy was still quite weak and in need of more stimulus.  Bond investors, who agreed with this assessment much of the year, decided that the economy was doing quite well on its own, thank you, and that the Fed’s actions were likely to lead to inflation. 

With this backdrop, it is no surprise that bond yields have been on a roller coaster ride.  Starting the year at 3.84%, the yield on the benchmark U.S. Treasury 10 year bond rose modestly through the first quarter to peak at 3.99% in early April.  From that perch, it followed a long, slow decline all the way down to 2.38% in early October.  The launch of the Fed’s “QE2” program, along with signs of a strengthening economy, caused yields to change course quickly.  Today, the yield on the 10 year bond is all the way back up to 3.29%, having jumped more than 30 basis points in just the last two days.  

The municipal bond market has been rocked by the developments affecting U.S. Treasury yields along with a few issues unique to that market.  Over the course of 2010, the difficult budget problems facing states across the nation came into focus.  In particular, the budget shortfalls shed light on the yawning gap between promises made to current employees and retirees for pension and health care benefits and the funds available to pay off those promises. 

This fall, concern over the timing and nature of potential renewal of the Build America Bond (BAB) program caused many states to schedule large bond offerings before the end of the year.  This supply glut add further downward price pressure in a weak market.  This pressure will likely abate over the next couple of weeks. 

Finally, announcement of an agreement between the Republicans and the White House to extend the Bush-era tax cuts to all income levels meant that municipal bonds were a little less attractive to investors than they would have been without the extension.  There are many details yet to be worked out, including a final resolution of the BAB program an extension of which was not included in the agreed upon “framework”, leaving some uncertainty overhanging the markets. 

In the fixed income portion of client portfolios, we had been reducing duration risk over the course of the summer and early fall with the decline in rates and concerns about muni credit quality. We have used the recent back up in rates to add to selected longer duration investments.  In particular, discounts on many closed end municipal bond funds widened to attractive levels.  A healthy stock market -- fueled by strong earnings -- is likely to help corporate bonds as credit spreads will likely tighten. 

We will continue to be cautious as continued strength in the economy or excess Fed stimulus could cause rates to rise further.  Credit quality among municipal issuers will be a concern for a few years as states struggle to put their financial houses in order.  On the other hand, corporate credit is exceptionally strong as many companies have built large cash reserves and kept expenses under tight control. 

Essential Investment Partners Named One of Denver’s 2010 FIVE STAR Wealth Managers

In conjunction with 5280 magazine and Colorado Biz magazine, Crescendo Business Services conducts an annual survey among Denver area high net worth households to determine client satisfaction with wealth management firms.  The survey process is supplemented by a review of regulatory history and client complaints and a final review by a panel of judges.  2010’s final list of 568 FIVE STAR Wealth Managers represents approximately 4% of all Denver area wealth managers. 

The complete list appeared in the November issue of 5280 magazine.

Four Simple Questions to Avoid Investment Fraud

Yesterday’s (12/5/2010) Denver Post Business section contained an in-depth profile of the individual behind the latest large investment fraud affecting Denver-area investors.  While the Post focused on the personality behind the fraud, like most other similar stories, they didn’t take the time to tell you how to avoid these frauds.  Learning how to avoid fraud is critical as those who don’t learn from history are doomed to repeat it.  

We originally posted our fraud-avoidance advice in early 2009.  The advice is unchanged and relatively simple.  The execution, however, can be hard in the face of a persuasive sales person. 

No matter how well you might think you know someone, this is about the business of your money so it’s important to always ask a few very basic questions.  The important thing is to ask ALL of them and if you don’t get a simple “yes” answer on any one, move on. 

Here are the four questions you should ask:

(1) Is your firm registered as an investment adviser with the SEC?  If yes, ask for the firm’s official name so you can look up Part I of the firm’s Form ADV on the SEC site and check out the firm’s regulatory history.  If the firm or any individual has regulatory problems in its past, move on.  If the firm is not registered with the SEC as an investment adviser, move on. 

(2) Will my investments be held by an independent custodian?  Most reputable advisers do NOT take custody of their clients’ assets because of the regulatory requirements they should follow.  Your adviser should use an independent bank or broker (think Schwab, Fidelity or TD Ameritrade) as the custodian for your assets.  Your adviser should only be able to make trades in your account but should never be handling your money or investments directly.  If the adviser wants custody of your money and investments, move on. 

(3) Are you paid solely by me on the basis of assets you manage for me?  If yes, the adviser is on your side of the desk – he/she owns earns more money only if you do.  Any other form of compensation – commissions, payments from fund companies, incentive fees – creates of conflict of interest for the adviser which could be bad for you.

(4) Do you have a long history of managing money for clients?  Look at the education and experience of the adviser’s principals that is disclosed in the Form ADV.  Have they worked for reputable companies in the past?  Do they have the appropriate education, experience and credentials to manage your money?   If not, move on. 

If you receive “yes” answers to these four questions, then you should feel comfortable in taking the next steps of evaluating the adviser’s services and fees.  However, if any of the answers are “no”, you should continue your search for another adviser. 

Mark Asaro Promoted to Associate Portfolio Manager – October 6, 2010

Essential Investment Partners, LLC announced today the promotion of Mark J. Asaro to Associate Portfolio Manager. Since joining Essential in 2007, Mr. Asaro has played an important role in the success of the Essential Growth Portfolio℠, the firm’s quality growth equity strategy.

“Mark is an integral part of the investment services we provide to our clients,” said Jerry Paul, Partner and Chief Investment Officer. “This promotion reflects the growing role we expect Mark to play in achieving our clients’ investment goals,” he continued.

Mr. Asaro is a Chartered Financial Analyst® Charterholder and holds a masters of business administration from the University of Colorado, a bachelor of science – finance from Fairfield University and is in the final stages of earning a masters of public policy from the University of Denver.

Essential Investment Partners Presents “Opportunities in a Challenging Economy”

On September 22, 2010, we held a seminar in our offices at which we covered three timely topics: (1) the four headwinds that we believe will hold back growth in the U.S. economy for several years to come; (2) the implications to investors of a slow growth economy; and (3) how the strategies underlying the Essential Absolute Return Portfolio can address the challenges facing fixed income investors today. 

Jon Zeschin covered the first two topics and then turned the program over to Jerry Paul for an interesting discussion of how the inefficiencies of the closed end fund market can be exploited to benefit the Absolute Return strategy. 

To view the presentation slides, click here.

Reflections on the Real Implications of the Flash Crash

It’s been about seven weeks since the “Flash Crash”, in which $1 trillion of the value of American public companies evaporated in about one half hour. Although the Dow recovered more than 600 of its 1000 point drop by the end of the day, it was unnerving to observe. It was clear that for at least a while something very dangerous was happening over which no one had any control.

Initial explanations for the crash ranged from implausible to downright silly. For several days, the rumor was that a trader had pressed the wrong button, initiating a sale of billions, rather than millions, of shares to be sold. This explanation ignored the basic risk controls that are built into virtually all trading systems at major investment firms. Absent an official explanation, however, traders and investors were left to speculate what really happened.

More recently, progress has been made towards understanding the cause of the breathtaking market decline. It now appears that the so-called “flash traders” which account for a very large percentage of the trading volume each day on the stock exchanges simply declined to trade electronically. Absent the market makers who used to inhabit the exchange floors and whose job it was to maintain an orderly market, prices went into a free fall as market liquidity vanished. However, this explanation is not yet official and may turn out to be only a part of the cause.

The Securities and Exchange Commission has already put rules in place to mitigate the risk of a repeat performance. SEC Chairman Mary Schapiro announced last week rules that would suspend trading of any stock in the Standard & Poor’s 500 index that rises or falls 10 percent or more in a five-minute period. “By establishing a set of circuit breakers that uniformly pauses trading in a given security across all venues, these new rules will ensure that all markets pause simultaneously and provide time for buyers and sellers to trade at rational price,” she indicated.

Perhaps. This strikes us as a measure designed to relieve the symptoms without curing the disease. Many commentators have charged that regulators are woefully behind the technology curve. We agree – they don’t have the resources to counter the massive investment that companies ranging from tech-savvy trading shops to Goldman Sachs have committed to, for instance, the instantaneous algorhythmic transactions that now comprise so much of each day’s volume.

Regulation is anathema to the Street. Many in the investment community see the regulatory authorities as hindrances to business and market efficiency, and there’s a lot of anecdotal evidence to support that perspective. But the financial community has pushed the envelope in the last few years, culminating in the near collapse of the system in October, 2008. While Wall Street may regard the various regulatory authorities as the greatest threat to business as usual, there is a bigger issue.

The public perception of the behavior of financial professionals is at an ebb right now, ranging from the anger over the compensation packages of executives that appear to be disconnected from their actual performance, to surprise over the number of private money managers who have treated their clients’ funds as their own ATM. The need for faith in the system on the part of investors is a common cliché, but it may be time to give it an injection of substance. Otherwise, with an administration that is clearly willing to harness populist energy, public anger over the behavior of the financial community may eventually result in a wave of regulation exceeding anything we’ve seen before.

The Flash Crash may represent an opportunity for financial professionals to reconnect with their responsibilities to the public. Here’s our four part plan:

(1) get to the bottom of the flash crash and put in place price discovery mechanisms that eliminate the ability of traders with the fastest computers to game the system;

(2) Congress should pass a real financial regulatory reform bill – we’re in favor of Glass Steagall, the uptick rule, fiduciary standards for brokers, stringent capital requirements/strict leverage limits, banning the originate and distribute model, requiring all derivatives to be settled through a national clearing house, to name a few good ideas;

(3) beef up the expertise of the regulators – all of the current discussion centers around turf rather than capability – so that they can keep up with innovation rather than lagging badly; and

(4) move to international accounting standards and away from the constant shifting of U.S. accounting standards.

For Wall Street, American investors may be a captive audience. They do not have the attention of financial executives, but they do have the ability to influence the behavior of their legislators. If the leaders of the financial industry do not demonstrate a willingness to act on behalf of investors, they may face a wave of regulation that will dramatically constrain their activities. In that case, they would be getting what they deserve.

We believe the banks and brokers would be better off following the model of the mutual fund industry, which has long embraced a comprehensive set of regulations designed to eliminate fraud and conflicts of interest. In the seventy years since the Investment Company Act of 1940 was passed, the industry has worked with the SEC to strengthen and modify the regulatory system to respond to innovation and market changes. The mutual fund industry has recognized that investor confidence is the key to its long term success and that confidence only comes from the trust that investors are appropriately protected. It really should be no surprise that investors too have embraced the mutual fund regulatory model, making it the single, largest repository of investor funds.

June 24, 2010

©Essential Investment Partners, LLC All Rights Reserved

The Importance of Low Volatility in Portfolio Returns

We took a more detailed look at the returns of the Essential Growth Portfolio℠ for the last several years, examining the trailing twelve months’ return at the end of each month. At the height of the bull market in 2007, the Essential Growth Portfolio℠ lagged the very strong returns of the S&P 500® by 700 – 800 bps. Conversely, at the depths of the bear market in late 2008 and early 2009, the Essential Growth Portfolio℠ lost 700 – 800 bps less than the S&P 500®.

This return pattern is exactly what we set out to achieve when we designed the investment process.  A question we often get is: why does it matter so much to be down less if you are going to lag on the upside?

This a great question because the math is not intuitive. If my portfolio is down 5% and then back up 5%, I am even right?  Well, almost. A $10,000 portfolio with the down 5%/up 5% pattern is back to $9,975. Not much difference you say. And we would agree.

But, if we take this example several steps further, you’ll begin to see the importance of minimizing volatility.  The table below shows the two year, ten year and twenty year values of portfolios that are up and down 5, 10 and 15% each pair of years. 

Value of $10,000 Up 5%/ Down 5% Up 10%/ Down 10% Up 15%/ Down 15%
After Two Years $9,975 $9,900 $9,775
After Ten Years $9,876 $9,510 $8,924
After Twenty Years $9,753 $9,044 $7,965

Note: it doesn’t matter whether you are down first or up first in each pair of years, the results are the same.

You get the point -- the more volatile the portfolio returns, the harder it is to make back the losses. So, by trying to lose less, we also don't have to take greater risks to earn back the losses.

We believe this approach serves our clients' best interests. It may not be exciting but after the events of the last couple of years, less exciting sounds pretty good.

Chuck Jaffe Interview with Jerry Paul on Closed End Funds

Chuck Jaffe, a well known financial columnist for MarketWatch, interviewed Jerry Paul yesterday on the topic of opportunities in closed end funds.  The article summarizing the interview is available at

The article does a very good job of outlining the fundamental premise we utilize in investing in closed end funds: this is an underfollowed segment of the financial markets that may give rise to unique opportunities for those who spend the appropriate time researching potential investments and understanding the potential risks.   

Please understand that opinions reflected in this article are NOT recommendations to buy or sell specific securities.  Our opinions regarding markets and individual securities may change daily and without notice. Holdings of individual securities on behalf of clients change frequently and there is no assurance that specific holdings mentioned in the article will be held for any length of time. 

Inflation or deflation – which is it?

We recently put together a white paper entitled “Inflation vs. Deflation – The Most Important Investment Decision You Can Make in the Next Five Years.”  We supplemented this white paper with additional data that Jerry Paul presented to the Denver chapter of the American Association of Individual Investors in late September. 

Not just an academic exercise, these studies pointed to several changes in investment strategies for our clients.  In addition, they provide some data points for investors to keep an eye on over the coming months as these might provide clues to a shift in the interest rate climate. 

The white paper is available by clicking here