Thoughts on the Current Outlook – April, 2012

After nearly two full quarters of uncertainty last summer and fall, the financial markets settled on the conclusions that (1) the US economy was recovering from the summer soft patch; (2) China’s slowing growth rate was not likely to be a crash but an expected slowing due to a shift away from exports; and (3) the Europeans, with the help of their central bank, were likely to stave off default by Greece for the time being. From the peak in April of 2011 to trough in early October, US stocks dropped nearly 19%, just shy of the magic bear market line. Since then, they have rallied nearly 30%, bringing us to levels not seen since 2007.

Here at home, recent statistics on GDP growth, employment, manufacturing and housing have been positive, if not overwhelming. Bears point out that seasonal adjustments are out of whack because of the warm winter and that future reports are likely to be much weaker. They also point to slowing in Europe and China that will ultimately spread here. Finally, the “tax” of higher gas prices will ultimately drag down consumer spending.

Bulls counter that employment is showing sustained growth, with initial jobless claim numbers supporting solid growth in non-farm payrolls. Risks in Europe and China are well-known and likely to have only a moderate impact on us. The booming market for domestic energy is driving job growth, and that, combined with low prices for natural gas, more than offsets higher gas prices.

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.

Expect us to expand on these themes in future publications as they come increasingly to the fore.

Coming back to what is directly in front of us, we remain in the slow growth camp, and believe there remains a relatively high risk (but likely less than 50% chance) of recession. Employment and housing are typically strong drivers of GDP growth in a traditional post-recession recovery. Without their fuel, it is not surprising that growth is sub-par. Business capital spending may also taper off a bit this year after so much was front loaded into 2011 because of advantageous depreciation rules. One recent bright spot has been cars – auto sales have been strong, boosting employment and incomes.

So why is there such a high risk of recession? Politics and debt. We believe the political environment in Washington is as poisoned as we have ever seen it. No compromise is too small to refuse, no position too unimportant to make a principled stand on. When you layer this poison atmosphere on to the burning need for political compromise to solve our long term fiscal problems, you get self-inflicted wounds like last summer’s debt ceiling fiasco. At the end of 2012, we face monumental fiscal constraints as the Bush-era tax cuts expire, other stimulus programs run out and mandatory spending cuts kick in. To us, this has the makings of more self-inflicted harm. And, no amount of liquidity from the Fed will be sufficient to offset the fiscal drag we will see if Congress can’t or won’t act.

As if all of this wasn’t enough, we are in full presidential election mode so absolutely nothing but posturing will get done between now and November. So put us in the short term cautious, long term bullish camp.

Meanwhile, in Europe, the European Central Bank’s LTRO program provided a great deal of needed liquidity to the banking system, effectively forestalling a liquidity (not a solvency) crisis. The solvency problem remains and the austerity programs forced onto Greece, Portugal and Spain virtually assure a very deep recession in these countries. And with each successive round, the budget targets get harder and harder to meet. We can’t predict how or when this cycle will end but count on another crisis being necessary before politicians take any meaningful action.

In China, short term cautious and long term bullish is also apt. They are turning their aircraft carrier of an economy inward, focusing on wage growth and consumer spending, at the expense of export markets. Long term this is extremely healthy but in the short term, growth will slow markedly, with repercussions across developing Asia.

After nearly two decades of slumber, Japan’s economy is beginning to show some signs of life. What we don’t yet know though is whether this is a brief rebound from post-tsunami rebuilding or something more sustained.

In an uncertain economic climate, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we are finding companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

In client portfolios, we have underweighted international equities dependent on Europe’s economy and maintained exposure to Asian stocks. Early in the year, we added to small capitalization stocks as they will benefit from increased liquidity and an improving economy. In fixed income, we continue to like corporate bonds and high quality municipal bonds but have stayed away from US Treasuries because we believe their yields are artificially suppressed by the Fed and price risk is very high at the current low level of yields.

April 6, 2012                                         © Essential Investment Partners, LLC

2012 Investment Outlook: Euro Drama Drags, Slow US Healing Continues

Euro Drama Drags On

We have long thought of Europeans as much more advanced culturally than the US. If for no other reason than having a history that spans a few thousand – rather than a few hundred years – it seems entirely appropriate that European tastes in all things cultural – theatre, art, food – should be more refined. Until this year though, we hadn’t appreciated how far the Europeans might take their appreciation of theatre.

Since early 2010, the tragic story of the debt problems of southern Europe has been on stage. With only a few short breaks, this play has dragged on despite repeated (and mostly half-hearted) attempts to end it. Today, we remain, like most others, wondering what the next plot twist will be. The European Central Bank has stepped forward most recently with three year liquidity arrangements for the banks – this provides the politicians the window needed for structural reform. But whether they will seize the opportunity is an open question.

We continue to believe that ultimately the choice will be unity but only after (1) strong, centralized fiscal authority is established; (2) debts of the weakest countries are restructured with private participation; and (3) the European banks appropriately value their debt holdings and raise sufficient capital to operate safely going forward. Until these things happen – and we seem only marginally closer as the months roll on – we are stuck here. We find it ironic that after two world wars that defeated Germany’s military aspirations, the Eurozone finds itself desperately in need of Germany’s economic leadership. Knowing that the Eurozone is about promoting prosperity while preserving peace, Germany will ultimately provide the leadership needed but only once it is certain the right structure is in place.

In the meantime, fiscal austerity measures being implemented across the Eurozone virtually assure a recession in 2012. The only question is how severe it will be. This is very difficult to assess as the outcome is so dependent on the actions of governments the course of which is just not very predictable. As a result, we have consciously reduced our weightings in international stocks dependent on the European economy and are focusing instead on opportunities in the US and Asia.

The big story in Asia continues to be China’s struggle to maintain strong economic growth while increasing domestic incomes and consumption, reducing its reliance on exports and limiting inflation, particularly in the housing market. For a large, complex economy, this is a very difficult set of tasks. It appears that China’s policy actions are having the desired effects on inflation and housing prices but the impact on growth – both from policy and reduced export demand from Europe – remains to be seen. We are encouraged that China continues to move its economy in the right direction but a patient, dedicated approach to investing here makes sense to us.

Three Years and Counting: Great Recession Healing Continues

Here at home, the economic news of late has been mostly positive. The employment picture has turned more positive, consumer confidence is up and holiday sales were strong. We have a few short term concerns for 2012 though. A small business tax incentive – that encouraged capital investment in 2011 – has expired so the recent strength we have seen in business investment may have been front-loaded. And, Congress just extended the payroll tax break and unemployment benefits for two months so we will be right back into the debates about further extension when Congress reconvenes later this month.

For some time, we have been talking about the legacies of the Great Recession: high unemployment, consumer savings and debt payoffs, reduced bank lending and the housing drag. Even though the employment picture has become more positive lately, we are still a long way from making a significant dent in the millions of jobs lost. We have made only a few steps on our journey of a thousand miles.

Conversely, consumers’ progress on their debt load has been nothing short of monumental. With interest rates so low, consumers’ monthly debt service requirements are now below long term averages. We still have a long way to go in reducing the aggregate debt levels, compared to income. But with aggregate indebtedness growing slowly and the savings rate having stabilized at a more healthy level, we expect continued progress on this front as well. We think one of the best ways government could help is to put in place a program that would allow those with government guaranteed mortgages who are current to refinance without re-qualifying for the loan.

Speaking of housing, we have seen some encouraging signs in new construction and existing home sales recently. With vacancies dropping and rents rising, it is not surprising to see a flurry of activity in multi-family residential construction. We expect this to continue for some time as the demographics continue to drive greater young household formations. And, for those with the income and savings needed to be active in the home purchase market, today’s existing homes offer exceptional value, relative to new construction. With lending standards still exceptionally tight, we think progress here will be slow and tied to continued employment progress. However, we are not optimistic that new single family home builders will see much demand until the overhang of existing homes gets cleared.

The fourth legacy of the Great Recession – reduced bank lending – continues on. Banking is not a good business to be in today. Heightened capital requirements (fewer loans per dollar of capital), extraordinary volume of new regulations (higher costs), diminished income opportunities (reduced interchange fees, no proprietary trading) and a bad public image, all add up to a bad banking environment. Expect tepid loan growth and less support for the economy.

Bottom line, we are cautiously optimistic about the US economy in the short term and we are making progress on the long term legacies of the Great Recession, albeit slowly. However, more self-inflicted wounds, like those surrounding the debt ceiling debate, could easily derail us. In particular, the lack of any progress on our structural debt issues remains a major long term concern. We believe Congress and the Administration made a major error in not acting on Simpson Bowles Deficit Reduction Commission framework. We can only hope that in the course of the presidential election cycle, this plan or something similar gets revitalized. Otherwise, we could see our debt downgraded again and the dollar’s status as a reserve currency come seriously into question.

2011 was a year of small returns and big volatility – the reverse is much more attractive but we don’t expect that result for 2012. Europe in flux, US presidential politics, China in transition, Iran and North Korea re-emerging as potential hotspots. Any one of these could emerge as the dominant theme of 2012. But whether it is one of these themes or something else completely unexpected, we do expect volatility to continue at a high level.

From an investment perspective, we still like the prospects for large multinational companies with diversified revenue streams. And, with US economic prospects a bit better, we are warming up to small caps after a long period of dislike. Finally, even though hedged strategies did relatively poorly in 2011, we continue to like a mix of absolute return oriented strategies combined with fixed income focused on corporate debt.

January 9, 2012                                   © Essential Investment Partners, LLC

Whither the Eurozone – A Special Commentary

Number three on our list of ten surprises for the coming decade (published in June) was: 

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.

We still believe this is the likely outcome.  However, the process of getting there is turning out to be painfully slow.  This should surprise no one who has ever tried to get a committee to decide anything, much less a committee of 17 governments! 

Germany, who holds the title of most fiscally responsible in the Eurozone, is holding tight on the bailout reins, forcing two things to happen:  (1) the weaker states to put in place meaningful fiscal reforms and (2) setting the stage for changes to the structure of the Eurozone that call for much tighter, centralized fiscal controls and strong penalties for non-compliance. 

Even though the markets may be impatient, Angela Merkel’s strategy is working.  Indeed, look no further than the fact that the heads of the governments of three weaker states – Greece, Spain and Italy – have all lost their jobs to fiscal conservatives who are supporters of the Eurozone policy trajectory. 

Next up, expect focus on the structural changes at the summit this weekend. 

These are all positive developments but there remains very difficult work ahead.  Most importantly, the banking system will need to come clean about the valuations of banks’ sovereign debt holdings. (As will the rest of the bondholders in a forced restructuring for the worst credits and a significant write down on the others.) It is already abundantly clear that they will need recapitalization.  TARP you say?  Not so fast. 

In the fall of 2008, the US was able to put TARP in place (about $800 billion) without any concern on the part of the markets about the creditworthiness of the US Treasury.  In the Eurozone, no one’s credit is above reproach -- the recent downgrade by Standard & Poor’s just reinforced what markets already knew. Germany is the best but it doesn’t have nor does it want to offer the resources to bail out the entire European banking system.  That means a delicate dance will need to take place around how to structure the debt that will ultimately recapitalize the banks.  This will not be quick or easy. 

After the fiscal reforms and tight centralized controls are put in place, then we will see how this recapitalization plays out.  We think that some sort of Eurobond will be necessary but, with Germany in the lead once again, we expect the scope to be strictly limited to the “emergency” lending needed to recapitalize the banks.  All members of the Eurozone will be expected to share in the burden but how the weakest members, already swimming in debt, do so will be a difficult puzzle to solve. 

This process will grind on methodically over the coming year but it will move forward.  The alternative – a breakout of the Eurozone and failure of the common currency – is not in anyone’s interest.  Failure likely puts the entire region into depression – with no country emerging as a winner.  While the grinding continues, Europe will likely be in recession (negative GDP growth) and those who export to Europe will see a significant slowdown. 

From an investment perspective, we expect continued headline risk as good news is mixed with setbacks and delays.  And, with a third of the world’s economy in recession, it will be very difficult for the other two thirds to grow strongly.  Therefore, we will focus our efforts on finding investments that maximize exposure to growing markets and minimize exposure to Europe.  Looking a year or two out, we could easily find ourselves swapping the US for Europe in this equation – as Europe deals with its problems now and we wait until after the 2012 elections before even beginning a discussion. 

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. 

Thoughts on the Current Outlook – October 2011

Markets dislike uncertainty. Unfortunately, uncertainty has been the only thing we have been able to count on for the last couple of months. From the perils of European sovereign debt, to concerns about slowing in China, to dire forecasts for the US economy, markets were faced with uncertainty at every turn. Not surprisingly, investors marked down the prices of any “risk” asset severely, including stocks of all types, corporate bonds and currencies.

Even though the quarter started with the self-inflicted wounds of the US debt ceiling debate, by quarter end, investors focused on the US as the safe haven. As a result, US Treasury bonds reached record low yields and the US dollar rallied strongly.

Focus continues to be on the events in Europe as the daily remarks from French and German officials are parsed for the latest indication of a possible path toward resolution. There are several sets of complex issues that require a solution and the Eurozone is simply not built for delivering them.

The most immediate issue is dealing with the financing needs of the weakest states – Greece and Portugal. While the markets view default as almost a foregone conclusion, government leaders do not as they view an “uncontrolled” default as their “Lehman” moment, which could give rise to a credit crunch that would be reminiscent of 2008.

The credit crunch scenario is a realistic possibility because of the European banks’ exposure to the sovereign debt of the weak countries. Memories of the questionable viability of US banks in late 2008 are still fresh in the minds of policymakers and rightfully so. It is clear that a coordinated plan to recapitalizing the banks is critical before a default is allowed to happen. German Chancellor Merkel and French President Sarkozy have been in close contact about this issue as their countries need to take the lead. However, the rub is that bank regulation is not region-wide. Rather, it remains the responsibility of each government. So, Germany and France can lead, but they can’t force others to follow.

These debates inevitably lead to the question of whether the Euro structure is simply too flawed to fix. As some commentators have pointed out, the structure worked so long as economic growth was strong and debt levels manageable. But with weak economic growth, high debt levels across the region and austerity likely to make the situation worse in the short run, serious questions have been raised about the whole common currency experiment. It is little wonder then that stocks, bonds and the currency fell precipitously in the third quarter.

Germany and France have pledged their support for the currency union and all of its trappings. The resolve of the political leadership, facing tepid taxpayer support, will certainly be tested. For now, we remain cynical and expect that the politicians will do only the minimum required by the markets to put off the next crisis. This isn’t a recipe for less uncertainty in the short term.

Meanwhile, speaking of politicians doing the least amount required, here in the US we have moved into full election mode. This is surely a path toward no progress. Unfortunately, there remains serious work to be done. The Super Committee spawned by the debt ceiling deal is about to start its work and absent action from Congress, payroll taxes will rise and unemployment benefits begin expiring in the new year.

The presidential candidates are all about “jobs” as if their election could turn a tide of high employment on a dime. If only that were so. More likely, regardless of who sits in the Oval Office, we face several more years of a sluggish economy and frustratingly high unemployment. This is simply a result of the need to work off excessive debt accumulated by consumers over the two decades preceding 2008. We have made a good deal of progress but there is still a long way to go.

We expect unemployment to stay high for several years. Even as the private sector is showing modest but consistent new employment life, the public sector – mostly state and local governments -- is cutting jobs to make sure budgets balance. These offsetting trends are likely to persist for a while.

After the failure of a number of ill-advised programs designed to keep people in their homes, policymakers have taken a break from trying to “help” the real estate market. Longer term, we need to let market forces determine home prices, without artificial props from the government. As existing home prices drop to a significant discount to replacement value, buyers will begin to step in. This bodes poorly for new home construction but recovery in that sector will likely need to wait until existing home prices have found a solid base.

Employment and housing are typically strong drivers of GDP growth in a traditional post-recession recovery. Without their fuel, it is not surprising that growth is sub-par. Business capital spending is likely to continue at a good pace as corporate profits and liquidity are solid. But this isn’t enough to drive the economy forward at a faster pace.

There has been much talk of whether the US is headed for another recession later this year or early next. Recent economic reports have been a bit stronger than expected so it looks like recession beginning this year is unlikely. However, absent action from Congress to renew or expand existing stimulus programs, the risk of recession in 2012 is pretty high. We expect a 2012 recession, if it occurs, will be modest and the impact muted as most Americans believe we have never come out of the Great Recession. And, indeed, we still haven’t recovered all of the economic output lost in 2007-2009.

The wildcard remains Europe. A credit crisis there could quickly spill over to the US and cause real dislocations in our markets. While our banks are much better capitalized and corporations far more liquid than they were in 2008, the effects of credit crisis emanating from Europe are hard to gauge.

Even though yields on Treasury bonds reached record lows in the third quarter, spreads on investment grade corporate, non-US sovereign and high yield bonds widened significantly. As a result, yields on these types of bonds look pretty attractive but we need to be mindful of the risks. So we have stayed with a broad mix of these types of bonds (using funds), slanted toward higher quality issues.

In an uncertain economic climate, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we are finding companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

We are also overweight international equities, with a significant exposure to Asian stocks, and continue to be under-invested in small capitalization stocks as they are more directly affected by weakness in the economy. Finally, we continue to add to absolute return-oriented strategies such as hedged equity and managed futures which we believe can provide solid returns with controlled risks.

October 11, 2011                    © Essential Investment Partners, LLC

Thoughts on the Current Outlook – July 2011

From one day to the next, the markets can’t seem to decide whether the European debt crisis or the US debt ceiling debate is potentially more damaging. If you think the former, you want to own US Treasury bonds as a “safe haven.” If you think the latter, then US Treasury bonds are the last thing you want to invest in. No wonder that rates on the benchmark 10 year note have bouncing around a lot lately!

The European debt crisis could be the world’s slowest train wreck in progress. However, it is possible to conclude that the Europeans are actually taking a much more logical approach to their problems than we are in the US. The so-called “PIIGS” have put in place or are considering forms of government austerity programs either as a condition to debt relief from the central bank and the IMF or to hold off the need for such relief. While there is a long way to go, the momentum is shifting toward fiscal responsibility and away from debt-financed public spending. There is still the risk that the markets grow impatient with the slow process, the Euro comes under great duress and the credit markets malfunction.

In the US, it seems clear that we do not have the political will to make the tough choices needed to get our fiscal house in order. The “debate” over the debt ceiling has been little more than both parties reciting their principles and the President wondering why no one will compromise. We think the President missed a great opportunity by not using the report of the Bipartisan Deficit Commission, co-chaired by Erskine Bowles and Alan Simpson. If we were really serious about a grand compromise, this report provides a great starting point. Instead, the current process is likely to drag on until the August deadline when a “mini-compromise” will get done to put off real debate until after the 2012 elections.

As we look at these debt problems, it is important to understand that they will take time and sustained effort to resolve. There is no “immaculate solution,” as one commentator recently described policymakers’ goal for a quick and painless way out of problems that are decades in the making. Because the Great Recession exposed the unsustainable levels of debt throughout developed economies, we will ultimately be forced to “eat our peas” as the President said recently. Until now, we have been able to do what my sister did growing up – scatter the peas around the plate so it looked like most of them were gone. Unfortunately, this time the markets recognize that the problems are too big to scatter around until they disappear. Europe may not have good means for resolving their debt problems, but they have the advantage of starting to address them ahead of us.

In the meantime, the debt debate is a side show to the continuing drags of unemployment and housing on the US economy. As we have said many times before, we expect unemployment to stay high for several years. Even as the private sector is showing some new employment life, the public sector – mostly state and local governments -- is cutting jobs to make sure budgets balance. These offsetting trends will persist for a while. The unemployment rate has now climbed back up to 9.2%, after hitting an artificially low 8.8% a few months ago. Because of the great number of people who left the workforce during the Great Recession, even the 9.2% rate understates the unemployment problem.

After the failure of a number of ill-advised programs designed to keep people in their homes, we are hopeful that policymakers take a break from trying to “help” the real estate market and let the market forces correct their imbalances. We believe that as existing home prices drop to a significant discount to replacement value, buyers will begin to step in. This bodes poorly for new home construction but recovery in that sector will likely need to wait until existing home prices have found a solid base.

Employment and housing are typically strong drivers of GDP growth in a traditional post-recession recovery. Without their fuel, it should not be too surprising that growth is sub-par. We can expect business capital spending to continue at a solid pace as profitability remains very strong. And, perhaps surprisingly, led by autos, the US manufacturing sector had also staged a bit of a comeback until it was sidelined for a few months by the effects of the Japan earthquake.

First quarter GDP growth was 1.9% and most economists expect a similar number for the second quarter. Whether we get a boost in the second half of the year is the subject of much speculation. Optimists point to lower gas prices, a stronger rebound in auto manufacturing as supply chain issues resulting from the Japan earthquake are resolved and consumers’ continuing progress in reducing their debt. Pessimists point to employment, housing and the lack of government stimulus (both monetary and fiscal) as reasons for an even weaker showing.

For our part, we think any second half boost in the US will be modest – not enough to get anyone excited. We expect a continuation of the bifurcated global economy, with the developed economies of Europe, Japan and the US growing very slowly. Meanwhile, developing Asia and the resource-rich economies of Brazil, Australia, Canada and Scandinavia will likely continue to post very solid growth.

We have also believed for some time that the US dollar will remain weak for the foreseeable future. Recently, we added a dedicated currency manager (in mutual fund form) to many client portfolios. That manager has illuminated our thinking on the role of the US dollar in the world economy and we expect to cover this topic in more detail in an upcoming publication.

With the yield on the ten year US Treasury note right at 3% and spreads on corporate and high yield at tightened levels, it is hard to get excited about the return prospects in fixed income. In their search for yield, investors have also driven down the discounts on fixed income closed end funds to very low levels, leaving relatively few trading opportunities in that space.

On the positive side, we have seen an increasing trend of bringing hedge fund strategies to mutual fund form. Recently, we completed due diligence on and invested in several new funds of this type. A couple of these are managers whose hedge funds we were quite familiar with so the investment decision was easy. In many cases, however, the fancy strategies have given rise to high fees and low returns – not a combination we are interested in pursuing for our clients!

While hardly cheap, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth despite the slow growing economy. Technology and health care are two areas of focus where we can find companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

Unlike the markets’ almost daily shifts between “risk on” and “risk off,” we have kept asset allocation in client portfolios relatively stable. We are overweight international equities, with a dedicated exposure to Asian stocks, and also have a significant non-dollar weighting in fixed income. In addition, we have maintained the investments in absolute return-oriented strategies in client portfolios. Finally, we continue to be under-invested in small capitalization stocks, in favor of more reasonably priced larger companies with greater exposure to the world’s growing economies.

July 13, 2011

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.

Thoughts on the Current Outlook – April, 2011

The Great Recession started in late 2007 and officially ended about two years later. As we look back from April of 2011, the recession that ended about 18 months ago is still etched clearly in our minds. Indeed, for many Americans, the recession has not ended. And, how often have you heard “in these tough economic times…” as an introduction for the announcement of a failed business or a cutback in spending or hiring?

Statistically, the recession is long over and we are well into expansion. Expansion is defined as that period of growth after a recession when we have more than recouped the GDP lost in the recession. Private sector employment is finally starting to grow and the unemployment rate has dropped a full percentage point since November. Yet, recent consumer confidence reports have shown a significant drop in consumer confidence. Why is that?

Let’s take a quick look at the statistics. The latest report on GDP (the final revision for the fourth quarter of 2010) showed that the economy grew 3.2%. This is a good, but not great, number. Most economists are predicting growth around this level in 2011. This is slightly below the long term average – respectable, but not exciting. While consumers were solid contributors to growth, they did it by dipping into savings as their incomes rose less than their spending.

What about employment? The unemployment rate fell to 8.8% in March and private employers added well over 200,000 jobs. Again, respectable but not great. The unemployment rate is particularly troubling though. The Wall Street Journal recently reported that if we added back to the unemployed and the base all of those who have left the labor force since the start of the Great Recession, the unemployment rate would be a full two percentage points higher. Looked at this way, the employment picture goes from respectable to lousy.

On top of these woes, we can add a 33% increase in the price of gasoline over the past six months that has the effect of wiping out most, if not all, of the payroll tax break Congress included in the extension of the tax cuts at the beginning of the year. Of course, one of the reasons for the gasoline price increases is the expanded unrest in the Middle East. Uncertainty over the fate of nations across the region, from Libya to Bahrain to Iran to Pakistan, adds to our concern about the impact of disruptions in oil supplies and the possibility of wider conflict into which we might be drawn.

Finally, fights about government fiscal problems are breaking out everywhere. From the capital of Wisconsin to the capital of Portugal, governments are trying to figure out how to implement austerity measures that will put their budgets back on a sustainable path. Here in the U.S., we expect finances at the state level to get worse this year. Even though sales and income tax revenues are bouncing back, real estate tax collections are depressed and will stay that way for some time to come. So we also expect state governments to shed workers throughout this year and next as layoffs and service reductions are the only ways for budgets to be balanced.

As for the granddaddy of them all – the U.S. federal deficit – we just survived a government shutdown showdown over the current year budget. Next up is a similar but potentially more damaging battle over raising the federal debt limit, which we will reach very shortly. These current arguments are just warm ups for the major struggle about how to really control the level of federal spending. Absent a change of course, the U.S. is surely daring the bond vigilantes to force us to change our ways. For now, U.S. debt is seen as a safe haven by the rest of the world and our interest rates are low. While that works for us now, one day it may not.

Even without an abrupt change in market sentiment toward U.S. debt, we might be facing the prospect that the long bull market in bonds is over simply by virtue of an increase in inflation and inflation expectations. 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. The real key to inflation, however, is wages. So long as we have lots of slack in the labor market, wage increases will be constrained. If we begin to make substantial progress on the employment front, look for inflation expectations to show real signs of life.

In the meantime, the stock market is shrugging off all of these concerns as it seems to be focused on solid earnings growth from corporations and the steady stream of liquidity provided by the Federal Reserve. While bargains are much harder to find at these price levels, we are very pleased with the prospects of the companies we own in the Essential Growth Portfolio, relative to their stock prices. As the Fed begins to withdraw its quantitative easing program this summer, we will see how much of the market’s advance was liquidity driven and how much was based on earnings fundamentals.

Several years ago, there was much talk about the possible “decoupling” of the emerging markets from the developed markets, with the former gaining domestic growth momentum so that they were no longer dependent on exports to the developed markets. Now the decoupling discussion is about the emerging economies trying to slow their growth and keep inflation in check while the developed markets are in full stimulus mode, attempting to jump start their economies. We believe the emerging economies of Asia and South America as well as several energy rich economies will continue to be the primary source of worldwide economic growth. This doesn’t mean there won’t be setbacks along the way, both manmade and natural. However, we believe the strong economic and fiscal fundamentals these economies enjoy set the stage for solid growth for many years to come.

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.