2011 Investment Outlook

In recent reports, we have been talking about the four pillars that inform our view that the U.S. economy will exhibit slower than normal growth for the next several years. Three of these pillars involve excess debt that needs to be worked off by consumers, banks and governments. The fourth pillar, under-saving by boomers for retirement, requires strong financial markets, increased savings and a stable or rising real estate market to fix. We are happy to report significant progress in resolving some of these structural problems. Let’s look at the good news first.

Consumers’ progress on their debt load is perhaps most striking. After reaching an historic peak of 13.9% in 2007, the percent of consumers’ income devoted to debt service has dropped to 11.9%, nearly back to its pre-2000 long term average. This reduction was achieved through repayments, lower interest rates, defaults and lack of growth in the base. Until October, aggregate consumer debt had fallen every month since late 2008. While still slow, this indicator grew in October and November, supporting holiday sales. If we can make headway on the employment front and see consumer incomes grow, we could see even more progress by consumers in handling their debt, clearing the way for more spending.

With the U.S. stock market up about 90% off of its lows in early 2009, boomers who stayed invested have recovered a substantial portion of the savings they lost in the Great Recession. And with the savings rate now stabilized at a mid-single digit rate (up from zero pre-recession), individuals are restocking their savings at a healthy rate. However, the uncertain state of the residential real estate market means that home equity remains an unreliable form of retirement savings. A lasting impact of the Great Recession, however, will be that boomers were reminded how fragile their savings picture really is and that working longer might be a desirable thing to do.

The picture for banks is mixed. Many larger banks have rebuilt their capital bases to the new higher standards and seem past the worst in terms of loan losses, at least outside of residential real estate. The larger banks also have the resources to cope with the blizzard of new rules arising from the Dodd-Frank financial reform bill.

For smaller banks, though, the picture is less bright. Long a bastion of real estate lending, many of their loan problems remain in work out. And capital is less available to them via the public markets. If that weren’t enough, Dodd-Frank raises their cost of doing business dramatically. In the banking business, talk has changed from “too big to fail” to “too small to exist.” With community banks often the source of lending to small businesses, we fear the availability of credit will continue to be restricted for some time to come.

Having helped the rest of the economy struggle through the Great Recession, many governments now find themselves in dire financial straits. Federal governments from the U.S. to Ireland to Greece to Japan are awash in deficits, with austerity programs and growth incentives running at odds with each other. While we believe it was smart to extend the Bush-era tax cuts, the Federal government is paying a higher price for its heavy debts as the Federal Reserve’s latest round of quantitative easing was met with substantially higher interest rates. (And all those who poured tens of billions into bond funds in 2009 and 2010 suffered bruising paper losses in a very short time.)

The budget problems of many large U.S. states have now come sharply into view as the press has homed in on the excessive promises -- and concomitant lack of funding – made to current and retired employees. Virtually no progress has been made in reconciling this problem even as state and local governments face declining property tax revenues as property values are marked down to reflect current market conditions. Increases in sales and income tax receipts in 2011 will provide a bit of relief. But with federal stimulus money running out in 2011, state and local governments face the prospect of draconian service (read, jobs) cuts to try to match revenues and expenses.

So there is reason for real optimism as we move toward resolving the structural problems left in the wake of the Great Recession. As we have previously reported, corporations are in great shape – earnings are strong, balance sheets are solid and revenues are growing. When we combine business investments with a solid, if not strong, contribution from consumers, we expect to see the U.S. economy grow around the long term trend (about 3%) in 2011. The biggest risk we see to the domestic economy is the lack of progress on employment and the real possibility that government sector cutbacks could make the problem worse in the near term. Residential real estate remains a wild card.

Looking back to the 1990s, it is fascinating to see how much has changed on the international front. Emerging markets have become the drivers of worldwide growth even while they have their fiscal houses in order. The developed markets of the U.S., Europe and Japan have become the laggards, with large, structural debt problems. In the short term, it is possible that markets have overplayed the stories of the emerging middle classes of India and China and the resource rich economies of Australia, Canada and Brazil. However, we believe these economies will be the primary source of global growth in the years ahead. In 2011, we expect to move client portfolios even more toward these growing economies as opportunities arise.

With a new spirit of cooperation in Washington (we’ll see how long that lasts!) and a realization that there is a great deal of work to be done to get our economy into jobs-producing mode, we are heartened that the spirit of optimism that has broken through near the end of 2010 will continue to drive the economy forward in 2011. Of course, markets often run ahead of the good news so we would not be surprised to see some consolidation of the gains in the first half of 2011.

The bigger change we will be watching for is whether the nearly 30 year rally in long term bond prices is finally over. If we are starting a long economic recovery with higher input prices (oil, grains and a broad range of other commodities), then we could see interest rates start back up the long down staircase they have been on since the early 1980s.

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  http://www.bizjournals.com/denver/print-edition/2010/12/10/the-new-diversification-class-taxes.html

 

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 http://www.sec.gov/investor/brokers.htm 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.

Economic and Investment Outlook – Fourth Quarter 2010

The fixed income markets seem to have decided that economic growth will be slow, inflation will be non-existent and debt defaults are unlikely. Pretty much a “Goldilocks” scenario. Retail investors have bought into this scenario in a big way – pouring literally hundreds of billions of dollars of new investments into bond mutual funds in the latter part of 2009 and so far in 2010.

Until September, the equity markets couldn’t decide whether to go along with this “Goldilocks” theme. However, with talk from the Federal Reserve of “QE2”, the stock market finally joined the party. QE2 is not referring to an aging cruise ship but rather a second major round of “quantitative easing.” This is “Fed speak” for easing monetary policy further through direct Fed purchases of securities.

We are skeptical of this newfound optimism because the Fed has little ability to control the structural problems our economy faces. In a normal post recession period, the Fed’s current policies would have been more than sufficient to get the economy moving. Low interest rates would have stimulated consumers to buy houses and cars and businesses to respond by hiring people and making capital expenditures to meet this renewed demand. But things are different this time.

There are four pillars that inform our view that the U.S. economy will be stuck in low gear for a few years. First, the consumer continues to be overleveraged. After years of layering in more and more debt, consumers now need to pay down debt to get their financial houses in order. Indeed, they have been doing so either through repayments or defaults. Since peaking in July of 2008, the amount of consumer credit outstanding has been falling – not a sign of a healthy, growing economy.

Second, banks are overleveraged. This has come about in two ways – by regulators increasing the capital requirements and by customers not paying off loans as quickly as they did in the past. As a result, many banks are effectively out of the lending business until they too can get their balance sheets adjusted to the new regulatory model. Throw on top of this the pressure from bank regulators to write off any loan that looks potentially troublesome, and it will be a few years before banks will realistically be looking to expand their books of loans.

Third, the stock market declines of 2007-2009 had a deep impact on the retirement savings of baby boomers. As a result, many, if not most, will need to defer their plans to retire, increase their savings and extend their working careers.

Finally, governments are overleveraged. Just look at the massive federal debt that was incurred in 2008 and 2009 much of it in an effort to stave off the recession. Now that the fear of depression has passed, the staggering deficit has raised the debate about how big government should be and makes it less likely that additional spending “stimulus” will be forthcoming from the Federal Government.

Almost all fifty states face similarly difficult fiscal issues. Unlike the Federal Government, however, most states need to balance their budgets so they face large service (read, jobs!) cutbacks once federal stimulus money runs out next year. The real problem facing many state and local governments is that they have for too long over-promised and under-funded the liabilities for future pension and health care benefits. This problem will force several changes – a greater share of budgets devoted to funding, cutbacks in current retiree benefits and very significant reductions in new employee benefits.

All four pillars will result in a continuation of high unemployment and underemployment. Nearly eight million jobs were lost in the Great Recession and, with these four structural headwinds, we believe it will take a very long time before the economy returns to anything resembling full employment.

Is there any good news? Certainly. Corporations are in great shape – earnings are strong, balance sheets are solid and revenues appear to be growing. This is one of the reasons GDP is growing – business investment will continue as companies strive to make their operations more efficient while responding to limited consumer demand. If we could get some certainty surrounding tax policy and the costs of health care under the new scheme, we could see corporations expand their investments more and tiptoe back into the hiring market.

In addition, the low absolute level of interest rates is good for both businesses and consumers. Many large businesses have been able to lock in low cost, long term financing by issuing debt. And many consumers have seen their debt service costs come down significantly as rates on variable rate debt have plummeted.

We continually remind ourselves of the need to look at alternative viewpoints to make sure our sober view doesn’t miss the return of a strong cyclical recovery. Positive news can beget confidence which turns into optimism and then, before you know it, we are back to growth mode. Recently, the markets seem to think that we have enough positive news to sustain a recovery. And, if we don’t get positive news, the Federal Reserve will manufacture some. We are cautiously hoping that proves to be correct but investing as if the path may be bumpy.

Client portfolios remain relatively conservatively positioned, with significant over-weights to absolute return oriented investments. The fourth quarter will be dominated by election news and speculation about what may happen thereafter. For our part, we will be happy when we no longer have to listen to negative campaign ads. Now that should put everyone in a better mood!

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.

Third Quarter 2010 Investment Outlook

Just about the time the markets were thinking that the economy was going to deliver strong growth, the reality of the harsh headwinds we face hit home. The expiration of the housing tax credit has left the housing market teetering on the brink of further declines. While corporate profits are still quite healthy, companies are reticent to add full time employees, preferring the flexibility of longer hours for current workers or adding temporary employees.

To these domestic concerns, we can add the sovereign debt issues facing Greece and other southern European countries. The austerity measures that accompanied the agreement by the EU to backstop the debt of Greece, Spain and Portugal will put a drag on Europe’s growth. However, the quick devaluation of the Euro – about 15% versus the dollar so far this year – will make German and French exports much more competitive. The export growth from these large economies should more than offset the drag of austerity from the smaller economies.

We continue to believe that four fundamental factors will give the Great Recession of 2007-2009 a lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers need to pay down the astounding levels of debt they accumulated over the last two decades; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply put pressure on prices.

Right now, the markets are focused on the downward pressure these factors are placing on the U.S. economy. First quarter growth was revised down a couple of times to finish at 2.7%, hardly a robust showing. And, expectations are that the second quarter will be weaker. We do think that one or two quarters of negative growth are likely over the course of the next twelve months. However, we don’t expect a repeat of the sharp declines we saw in late 2008 and early 2009.

The U.S. economy has demonstrated once again its unique ability to withstand enormous strains and move forward. So we expect the economy to muddle along, with slower than typical growth. The employment picture will improve very slowly with the unemployment rate staying uncomfortably high. The real estate market will remain in a precarious position as foreclosures and excess inventory get worked off. Consumers will increase their spending slightly less than their incomes grow, raising the savings rate. Corporate profits will continue to be very good, helped by the dramatic cost reductions that were taken over the past eighteen months.

Relative to earnings, we think stocks have become inexpensive. The question is whether earnings gains will hold up. The stocks in the Essential Growth Portfolio℠ are chosen for their ability to deliver consistent earnings so we have seen many opportunities to buy great companies at very attractive prices.

As concerns about the economy and sovereign debt in Europe took center stage, prices of U.S. treasury notes and bonds soared in the second quarter, driving yields to very low levels. This flight to quality hurt prices of corporate bonds, which we believe are now very attractive, relative to both inflation and default risks.

About nine months ago, we did a special report entitled “Inflation vs. Deflation – The Most Important Investment Decision of the Next Five Years.” That report concluded that deflation was much more likely to become a problem than inflation, citing the four major headwinds described above. We think it will take several more years for these headwinds to dissipate so our conclusions are still the same.

We continue to believe in the strong growth stories emanating from Asia and have maintained dedicated equity investments there. Certainly there is the probability of setbacks along the way, but the sheer size and momentum of the growth of the middle classes in China and India strongly argue for robust growth for a long time.

Just published is a piece on the real implications of the “Flash Crash” in which we call for a fundamental rethinking of the financial regulatory structure. This piece is posted on the Blog section of this website.  Unfortunately, the bill currently pending in Congress is long on text and short on progress on the important issues underlying the credit crisis of 2008.

The effect of the expiration of the housing tax credit stunned many observers. More important, we believe, will be the effects of the tax increases associated with the new health care bill and the expiration of the Bush tax cuts.

Client portfolios remain relatively conservatively positioned, with significant over-weights to fixed income and absolute return oriented investments. The third quarter could continue to be rocky for the equity markets – a rough patch on the long road to overcoming the structural headwinds we face.

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

Second Quarter 2010 Investment Outlook

Perhaps we shouldn’t be too surprised in retrospect that Americans seem to have such short memories. Wasn’t it just eighteen months ago that our financial system came within a hair of complete collapse? And now, even a watered-down set of financial regulation changes draws a yawn from the American public. Dow 12,000 here we come!

We continue to believe that four fundamental factors will give the Great Recession of 2007-2009 a lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers need to pay down the astounding levels of debt they accumulated over the last two decades; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply put pressure on prices.

While these four factors will continue to weigh on the rate our economy is growing, the fact is that the economy is back in a growth mode for now. And this growth seems to be stronger than these restraints would have allowed. Why has this been the case? One answer is the large government stimulus programs that have been put in place over the last year. But we think there is more to the story.

Being so close to the financial markets, we sensed a high likelihood of serious fundamental changes after the Great Recession – a re-pricing of risk, the return of a savings culture, unwillingness to take on debt, reduced demand for real estate as an investment and a new era of financial regulation.

However, even though many families are fundamentally changing their ways, in the aggregate these changes have only a marginal impact. They are marginal because the vast majority of Americans – once their confidence in the financial system and the security of their jobs was restored – returned to their normal lives.

Those normal lives included making a decent living, paying their rent or mortgage, shopping for necessities and periodically splurging on extras for themselves and their families. In particular, the highest earning households that account for a disproportionate share of consumer spending have begun spending again. For many, lower mortgage rates have provided some extra monthly cash.

Are they doing these things within the context of a financial system that has fundamentally changed? Certainly. The limits on the credit cards are lower, there is no home equity line to serve as a piggybank and bank rules for car loans and leases are tighter. So in the aggregate, consumer credit outstanding has fallen significantly, rather than rising as it would typically do in a recovery.

But, the U.S. economy has demonstrated once again its unique ability to withstand enormous strains and move forward. Have we returned to the “old normal?” Certainly not. The four limiting factors we mentioned above are still very much in place, preventing us from returning to the old normal for several more years. The employment picture will improve very slowly as companies will be cautious about adding costs back. Residential real estate remains a precarious market as foreclosures continue to rise, but with strong demand appearing in some regions particularly at lower price points.

In the meantime, we expect the economy will muddle along, with slower than typical growth. Corporate profits will continue to be very good, helped out by the dramatic cost reductions that were taken in late 2008 and early 2009 and now by rising revenues. Strong earnings should put a reasonably solid floor under stock prices for now and may allow stocks to move even higher in the months ahead.

While the U.S. stock market was staging a dramatic rally off of the March 2009 lows, the bond market, particularly municipal and corporate bonds, pulled off an historic rally as well. In the aftermath of this rally, we just published a special report on the fixed income markets entitled “Where Do We Go from Here? Seeking Attractive Returns on Fixed Income Investments” – it follows this piece.

On the international front, the fragile state of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) continues to dominate the economic news. There is broad concern that Greece’s sovereign debt problems could be the equivalent of our subprime mortgage problem for the European Union. We think it is more likely that a solution is found that continues to hamper prospective growth for the European economy.

We continue to believe in the strong growth stories emanating from Asia and prefer to focus more of our equity investments there. Certainly there is the probably of setbacks along the way, but the sheer size and momentum of the growth of the middle classes in China and India strongly argue for robust growth for a long time to come. In addition, we think the resource-dependent economies of Canada, Australia and Brazil will fare well in a healthy commodity pricing environment.

Investors’ current complacency can swiftly be replaced by fear arising from unexpected events beyond their control. And the effects of the tax increases associated with the new health care bill and the expiration of the Bush tax cuts bear close watching. The lessons of 2007-2009 are still important: stay very broadly diversified and closely monitor downside risk, relative to return potential.

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.

Annual Investment Outlook 2010

In 2009, the gloom of the first quarter gave way to euphoria in the financial markets in the last three quarters, as investors rejoiced that we had avoided a depression. Instead, we experienced a so-called Great Recession. If you look at the decline in GDP, this recession was roughly on par with the severe recessions of the early 70s and early 80s, with aggregate GDP dropping about 4% from peak to trough.

We believe that four other factors will give the Great Recession its lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers have begun to pay down the astounding levels of debt they accumulated over the last two decades and the nation’s saving rate will rise significantly; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply keep downward pressure on prices.

While many of the government’s actions over the past two years have been designed to restore stability and confidence in the financial system, other actions have created uncertainties that we believe will weigh on the economy in the coming year. In particular, uncertainties regarding health care costs and income tax rates may cause small businesses to be more reluctant than normal to create new jobs. And, extraordinarily high deficits leave open the distinct possibility of much higher interest rates in the future, effectively crowding out private borrowing, traditionally the source of capital for small business job creation. It is also tough to sort out the impact of stimulus programs for cars, housing and state/local governments – did these programs provide a bridge to a better environment or will problems resurface when stimulus ends? Finally, a protectionist orientation has been growing in our trade relations with Asia, which may limit U.S. exports, a promising source of growth in a weak dollar environment.

On the positive side, we see a bifurcated consumer recovery. Affluent consumers – those with high incomes and somewhat restored net worths – have begun to spend once again. Those with lower or no incomes will continue to struggle mightily, with full employment difficult to come by. Businesses that had drawn inventories down to very low levels will need to rebuild their stocks to meet nascent demand. All in all, we expect the economy to post positive, but anemic, growth of 2-3% in 2010.

Corporate profits will continue to benefit from the draconian cost cuts put in place in late 2008 and 2009. With revenues rebounding somewhat on top of a lower cost base (and financial stocks providing a positive contribution as write offs begin to fall), aggregate profits should show a very healthy increase in 2010.

Missing from the Great Recession has been the high level of credit defaults predicted a year ago. With liquidity having returned to the bond markets quickly, many issuers have been able to refinance ahead of maturities. Most affected are those smaller businesses that depend on bank lending, where defaults and charge offs continue at a high rate. In the public debt markets, credit spreads have collapsed to average levels.

On the international front, we continue to believe in the long term story of the growing middle classes in the large emerging markets. China will continue to be a major source of global growth, as will India. However, that growth will become more internally focused, rather than export- or outsourcing-focused. The command structure of the Chinese economy gives us some concern about potential excesses but the sheer size of the economic engine they have created ensures its growing dominance of the region.  The European Union will continue to struggle with very slow growth and the debt problems of some of its lesser members, while the resource-dependent economies of Canada, Australia and Brazil fare well in a healthy commodity pricing environment.

In retrospect, we were wrong in not hopping aboard the risk train in the early spring of 2009. Instead, we were content to take a much lower risk approach to earning very strong absolute returns for our clients, focusing on high quality U.S. stocks, international stocks and corporate/municipal bonds. Despite investors’ newfound appetite for risk, we do not think this is the time to significantly increase exposure to riskier equities. However, high quality stocks offer attractive return potential, particularly given the outlook for much stronger earnings in 2010. Many of the companies represented in the Essential Growth Portfolio℠ are heavily invested in the growth of developing markets. When valuations warrant, we expect to continue to increase direct exposure to these areas of long term growth. In addition, we plan to maintain a small but dedicated exposure to a broad-based basket of commodities.

In the fixed income area, we have brought durations (exposure to interest rate increases) down and quality up, as most of the easy money has been made. We have added exposures to non-U.S. debt securities and merger arbitrage strategies while continuing to exploit special situation opportunities in fixed income closed end funds.

As 2010 progresses, there is a wide range of variables that could have unexpected impacts on the global economy and financial markets. These include: withdrawal of US monetary and fiscal stimulus, demand for the large supply of U.S. government debt, ever-present geopolitical risks in the Middle East, actions of Congress on health care, tax policy and financial regulation, sovereign debt problems in southern Europe and terrorist activity, just to name a few. With the economy growing very slowly, an unexpected setback could easily trip the economy back into negative growth territory.

We remain very cognizant of the dramatic increases in market values we have witnessed since last March, virtually without correction. Investors’ current complacency can swiftly be replaced by fear arising from unexpected events beyond their control. In this risky environment, we are keeping client portfolios very broadly diversified and closely monitoring downside risk, relative to return potential.

January 6, 2010

© Essential Investment Partners, LLC

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 http://www.marketwatch.com/story/be-open-to-closed-end-bond-funds-2009-10-21?siteid=yhoof

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

Harvard Describes Benefits of “Hybrid Model”

If you have taken a look at our website, you will see that our investment processes are a hybrid of internally managed investments and a selection of external managers.  We strongly believe in this model as the most effective way to manage our clients’ investments. 

In the September 2009 Harvard Management Company Endowment Report Message from the CEO, President and CEO Jane L. Mendillo describes the benefits of the hybrid model as Harvard sees them.  We couldn’t agree more so we’d like to share her eloquent description:

“While we have made many changes in recent times, we continue to emply a ‘hybrid model’ – a unique approach to endowment management.  We use a mix of internal and external management teams that focus on specific investment areas.  We believe this gives us the best of both worlds – top-quality investment management by our internal team and access to cutting edge capability from specialized teams around the world…we will use the mix of internal and external managers that best represents our conviction regarding opportunities and gives us access to the best possible strategies.

The benefits of the hybrid model and both broad and deep:

  • Harvard’s partnerships with investment management teams around the world provide diversification, insight, and perspective that goes beyond what could possibly be achieved through our relatively small team in Boston;
  • Our internal investment management team…is our eyes and ears on the markets – constantly attuned and responsive to changing conditions, and frequently ahead of the curve in recognizing market inefficiencies and ways we might profit from them;
  • In addition to this close feel for the markets, our internal management approach gives us increased control, total transparency and greater nimbleness in the face of changing market conditions…Finally, our internal team in extraordinarily cost effective – with total expenses equal to a fraction of the costs of employing outside managers for similar asset pools with similar results.”

While the scope, scale and range of the Harvard Endowment investments far exceeds those available to Essential Investment Partners and our clients, the shared philosophy of combining internal and external management to greatest effect is an important tenet in successful investment management. 

Cost Cutting Key Theme in Quarterly Earnings Reports

Beating expectations has become quite commonplace among the companies held in the Essential Growth Portfolio.  The second quarter’s earnings reporting season is a little more than half over for us and the scorecard looks pretty good.  15 companies have exceeded consensus earnings estimates, four have met expectations and three reported disappointing results.

Beneath these generally cheery headline results though lays a sign that this harsh recession is far from gone.  With a few notable exceptions, companies have been able to beat expectations by cutting expenses more than analysts had expected.  Revenue declines are still the norm and most companies have issued guarded outlooks for revenue growth in the coming quarters.  The exceptions have been in health care supplies (typically recession-resistant) and outsourcing (helping others cut costs). 

As a result of the top line strain, most companies intend to hold very tight on their expense controls – limiting hiring, restricting raises and bonuses, reducing travel expenses, deferring capital expenditures – until they see clearer signs that demand for their goods and services is accelerating. 

We continue to believe that the markets have run well ahead of the underlying economic fundamentals.  While it is certainly encouraging that the economy is no longer shrinking as quickly as it was late last year, we believe that strong economic growth in the near term is very unlikely.  We could get some growth as companies restock inventory this fall, after having drawn down inventories to very low levels.  However, this bump is likely to be temporary as most companies will be slow to rehire workers, instead raising the average work week from its current low level and supplementing those hours with overtime as necessary.  Those who stay employed will continue to pay down debt and increase their savings. 

 

Investment Outlook, July 2009

“Once-dreadful financial and economic metrics are now merely bad.” This line, from a recent publication by Morgan Stanley Smith Barney LLC, captures the essence of the “optimism” that has pervaded market thinking for the last few months.
This optimism brought the US stock market a very strong return of nearly 16% for the quarter. Not to be outdone, corporate bonds rallied too, bringing spreads versus comparable Treasury securities down to typical recession levels. And, municipal bond prices rallied while Treasury prices fell, bringing municipal yields closer to their normal yields relative to taxable alternatives. While we too prefer to be optimists, we think a dose of realism is most important at this point.

“Less bad” is better than “bad” but it is a long way from “good.” We do believe that with timely and mostly correct actions by policymakers, we have avoided an economic and financial meltdown. However, the markets have rallied to a level that real economic progress is needed to continue the advance. We don’t expect progress to be quick so we expect stocks to tread water or even move lower from here. As we have said previously, there are many reasons why restoring economic growth will take some time and it will come slowly.

The unemployment rate has now jumped to 9.5% and job losses so far this year are estimated at well more than three million. The ranks of the under-employed continue to grow as the average weekly hours worked number continues to fall. It is now clear that the unemployment rate will top out in excess of 10% during this recession. Even though growing unemployment bodes ill for consumer discretionary spending, it also means that companies are making themselves leaner and more efficient. When revenue does begin to turn around, corporate profits should bounce back pretty quickly. But aggregate consumer demand will remain tepid, making this profit recovery uneven.

The savings rate for individuals surged to nearly 7% in May, up from near zero over the past few years. We expect the savings rate to stay at this level or move even higher over the next couple of years as consumers rebuild their “personal balance sheets.” This means a greater focus on paying down debt (aggregate consumer credit outstanding has been dropping since September, 2008) and adding dollars to savings to replace value that has been lost through falling home and stock prices. These are positive trends for the long term health of the U.S. economy but in the short run, they mean less discretionary spending and lower growth.

Who would have thought a year ago that we could absorb the bankruptcies of GM and Chrysler within a matter of weeks without endangering our entire economy? Well, with Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and AIG all going bust ahead of the automakers, the markets, policymakers and creditors were all much more prepared than for the others that went before. These bankruptcy filings will allow GM and Chrysler to dramatically restructure in ways that would have been nearly impossible outside of bankruptcy. The short term pain will be great but the result will be a healthier, more competitive manufacturing sector over the longer term.

We were happy to see the government allow the healthiest banks to repay their TARP money. Policymakers wanted to make sure that those who repaid now won’t need to come back to borrow again in the next year or two. Perhaps most important was that this first test of a government “exit strategy” from the private sector worked reasonably well. There are many more private sector investments the government will need to exit in coming years – we expect that some of the others will be more difficult to navigate.

Another positive development in the second quarter was the resumption of companies issuing debt. Starting first with the highest quality companies and later continuing down to lower rated companies (although still excluding the lowest rated), companies found surprisingly strong demand for their debt securities among investors. This healthy functioning of the credit markets is critical to the functioning of the US financial system and investors’ spirits were raised by the sense of movement toward “normalcy.”

Finally, concerns about the prospects for re-emergence of inflation entered some investors’ minds during the quarter. While we believe it is reasonable to have some inflation-protected investments as part of a well-diversified portfolio, we continue to believe that deflation, not inflation, will be the problem we will likely battle for the next few years. Labor markets are exceptionally weak and are likely to stay weak for some time so labor demands simply won’t be a contributor to price increases. Similarly, capacity utilization is very low in industrialized countries so there is a great deal of slack to be taken up before supply shortages could contribute to inflation. Commodity prices alone are not likely to drive inflation because they don’t represent a large enough share of production costs to drive a sustained increase in prices. Finally, the large government stimulus is only inflationary if the velocity of money stays constant or increases. All indications are that velocity has likely fallen recently, as it has in similar periods in history.

We continue to maintain a conservative investment posture. Despite the rally of the second quarter, bonds continue to offer very attractive returns relative to long term expected returns on stocks. Within stock allocations, we continue to use the Essential Growth Portfolio℠ alongside mutual funds that tend to offer more downside protection. We remain significantly underweight in small capitalization stocks, contrary to what might be expected at the beginning of an economic recovery, as we think the markets have gotten ahead of the economic fundamentals. We have maintained our investments in international stocks, particularly in Asia, as we expect the Asian economies (ex Japan) to perform better than the U.S. and the dollar to continue to be weak.

July 7, 2009

© Essential Investment Partners, LLC

Quarterly Earnings Roundup for EGP Companies

Despite a terrible economic backdrop, the companies held in the Essential Growth Portfolio(SM) did surprisingly well in their recent earnings reports.  Of the forty companies that reported earnings while they were held in the Essential Growth Portfolio(SM) during the second quarter, 29 (72.5%) beat the consensus earnings estimates prevailing prior to the report. 

Another seven companies (17.5%) met consensus estimates for quarterly earnings.  Only four companies (10%) failed to meet estimates for quarterly earnings.

It is important to point out that analysts’ expectations have been marked down pretty significantly over the last several months.  However, many of our companies faced substantial headwinds as much discretionary spending by businesses and consumers was put on hold in the first quarter of 2009.  In addition, the U.S. dollar gained against many foreign currencies during the first quarter, meaning that non-U.S. sales were worth less when translated into dollars for financial reporting purposes. 

Finally, the key to short term earnings success was cost-cutting.  Companies slashed discretionary spending and headcount in order to bring expenses in line with lower revenues.  While these reductions continue to show up in the monthly reports of job losses, the good news is that companies have become much more efficient, making it possible that earnings may recover more quickly once revenues begin to grow.