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If Greece wishes to remain in the euro, it seemingly will cost them their sovereignty. Germany is pushing for Greece to transfer national budgetary sovereignty in exchange for another lifeline of rescue funds. Greece is on a rather slippery slope. The country is already in recession and is having continued heavy doses of austerity required of them, which will only serve to exacerbate the weakness. As it stands, Greece is technically in default and they are currently negotiating for private investors to take even deeper “voluntary” reductions to the value of their bonds. The Greek people are revolting and the politicians are reticent to accept the harsh reality that is needed for other member countries to approve another round of bailout money. Portugal appears to be next in the crosshairs, though Ireland, Spain, Italy and others (even France) face an uphill battle. The European Central Bank (ECB) has already quietly allowed their own balance sheet to explode through purchases of sovereign debt and the December move (LTRO – Long-Term Repo Operation) to stem the potential freeze-up of interbank lending. The ECB intervention has certainly had a calming effect to the markets, which in part explains the positive performance in equities thus far in 2012.

In the US, it is election year. Politicians are well-versed in the art of re-election. They will ensure an abundance of lipstick is applied to the proverbial pig. We should expect further announcements in the coming months to inspire voter optimism and the belief that Washington has our best interest at heart. The most recent program is intended to aid the housing market by flushing out the foreclosure pipeline. It appears that homeowners who stopped paying their mortgages and have little skin in the game (read: little to negative equity) are in for a potential windfall. If these folks will agree to short sell their home, the bank will forgive part or all of the deficiency and even provide cash for relocation assistance. If you put say 20% down and the housing collapse has eroded your equity, yet you continue to pay your monthly obligation, you will not qualify for this program. I still believe tax incentives that would allow for large capital losses (as opposed to $3,000 per year) remain a viable option.

The chart below depicts foreclosures as a percent of total loans. There has been little change in three years. It is estimated that over $250 billion is currently in the foreclosure pipeline. Fed Chairman Bernanke indicated Friday in a speech to the National Association of Home Builders that declines in home prices continue to have a negative impact on consumer spending, which accounts for nearly 70% of economic activity. He further contends that the broader economy will not fully recover until the depressed housing market reverses course.

The next chart reflects mortgage delinquencies, which may be trending lower, but are still at elevated levels. The efforts by the Fed to lower mortgage rates have provided little relief to homeowners who are unable to refinance as declining home values have eliminated equity, or worse, the value is much less than what is owed. The situation is further complicated by banks that have tightened lending standards that make it difficult now for even creditworthy borrowers to refinance. It was just a few years ago that banks were willing to lend to most anyone with little or no documentation. This is an area I expect Washington will exert significant effort in order to show improvement as November approaches.

Overall, the US economy continues to muddle through. While the US may be in a better position than Europe, we certainly do not have the winds at our back. The fact that the Fed recently forecast that short-term interest rates would remain near zero through 2014 (from mid-2013) clearly speaks to the concerns for economic growth in the eyes of the Fed. Next week is filled with various economic reports, including producer and consumer inflation, industrial production, retail sales and others (see 3 attached chart). The ECB and Fed are on alert and are “locked and loaded” to respond to any crisis that may erupt from Europe. We must also not lose sight of the saber-rattling from Iran. President Ahmadinejad announced that Iran will soon unveil “big new” nuclear achievements. As UN sanctions continue to be implemented, the Strait of Hormuz has repeatedly been threatened to be disrupted by Iran, potentially choking off 20% of all oil traded worldwide.

Please let us know if you have any questions.

All the best,
Troy

Deleveraging……No Pain, No Gain

The level of debt accumulated by developed nations, both in the public and private sector, has raised the standard of living to a level that would have been unimaginable just a couple generations ago. In the US, consumers used their homes as an ATM machine. From 2003 – 2007, the American consumer withdrew over $2 trillion from the equity in their home. In Europe, the formation of the euro allowed the weaker countries to borrow heavily at interest rates that were only deserving of their stronger brethren to the north. The newly filled government coffers were then used to increase the standard of living through large wage increases, extravagant benefits and a general sense of entitlement, particularly to public sector workers (though it is reported that in Greece, most households have at least one family member that is a public worker).

Then the wheels began to fall off. In the US, it was inconceivable that housing prices could actually go down. In Europe, it was inconceivable that a sovereign country may actually default. The addiction to debt is hard to break. It reminds me of the movie Top Gun when Commander Stinger had a terse conversation with Lieutenant Mitchell, or “Maverick” (Tom Cruise) after buzzing the air control tower at something over 400 knots. Stinger shouted, “Son, your ego is writing checks your body can’t cash!” This is precisely what has occurred in the world’s gorging on debt. It is also referred to as living beyond our means. It cannot be sustained.

The deleveraging process is painful, but not impossible. Typically, the private sector needs to deleverage or reduce debt while the public sector continues to fill the void, lest the risk of recession or depression increases. As the private sector resets its finances and begins to strengthen, the natural progression should then be for the public sector to begin its pullback in spending. The US private sector has actually been deleveraging. To some extent, it has been forced, as extraction of home equity has been significantly curtailed for homeowners. Also, there has been material deleveraging within the financial sector, as the recent crisis forced the collapse of legacy firms like Lehman Brothers.

According to a McKinsey Global Institute study, debt among US households has fallen by 4% in absolute terms since 2008. Strikingly, it is estimated that two-thirds of the reduction came from defaults on mortgages and other consumer debt. It is also estimated that $254 billion remains in the foreclosure pipeline that would further reduce consumer leverage. While low-income households are experiencing the greatest level of foreclosure, it is further estimated that up to 35% of mortgage defaults are strategic decisions to simply leave the keys on the counter and walk away.

The public sector will need to deleverage, but at a rate that ensures an environment exists that is conducive to capital attraction. It needs to resist the temptation of protectionism and establish a tax environment that makes the US a “no-brainer” for corporate executives. We live in a global economy. The competition is fierce. We cannot afford to have our heads in the sand. When I read emails that are titled, “If Apple was a Country”, it would be ranked 29th based on its market value versus countries and their respective GDP, I am in awe. A US company that began a few decades ago in a garage in California is now being compared to entire countries. We must ensure an environment that continues to breed this type of entrepreneurial spirit. The current gridlock in Washington is of great concern. As you may recall from a prior quote, Lincoln professed that no outside power could conquer the US. If it happened, it would come from within.

The earnings season is in full-swing, and we continue to see growth, led currently by strong technology earnings. The economic news continues to be respectable, but we still believe 2012 will be a muddle-through year. Fourth-quarter GDP was up 2.8%, but was primarily due to an inventory adjustment rather than overall robust strength. Consumer confidence continues to improve, though expectations should be tempered. The ATM machine discussed above that was used so liberally a few years ago by consumers has now been removed much like the payphone has at gas stations. A clear plan on dealing with the housing glut and clarity on the regulation and tax front for businesses will remove a large impediment for restoring economic growth. On the housing front, we know the pendulum has swung hard the other way. The perception now is that prices will only go lower, which keeps many potential buyers on the sidelines.

The Federal Reserve met this week and indicated we can expect exceptionally low rates (near zero) through 2014. It also appears likely the Fed will enact a third round of quantitative easing (QE3). Treasury bonds rallied on the news, pushing the 10-year Treasury to 1.9% and the 30-year to just over 3%. With inflation currently running 3% and fiat currencies being freely printed (inflationary), the purchasing power of these investors will be eroded mightily if held to maturity. The Fed has induced artificially low interest rates that continue to inflate a bubble that is reminiscent of technology companies that once traded at stratospheric multiples during the late 1990’s.

The economic calendar is attached for your review. It will be a busy week of economic data that will provide numerous insights into the current state of affairs for the US economy.

Please let us know if you have any questions.

All the best,
Tro

“Success is relative. It is what we can make of the mess we have made of things.” T.S. Eliot

The Eurozone could certainly be referred to as a mess. This weekend, the Greeks and private investors are re-negotiating the 50% voluntary “haircuts” agreed to in October. The main sticking point is related to the coupon payment, which is expected to be around 4%. The Germans and IMF are pushing for an even lower rate in an effort to bring the Greek debt-to-GDP ratio down to 120% by 2020 (never mind that Italy is currently at these levels). The consequences of a failure to agree to terms could induce a disorderly exit for Greece from the euro and trigger payments for credit default swap (CDS) contracts. The latter could lead to trouble for the already fragile European banks that sold the CDS insurance contracts.
The more important implication of these negotiations is that the rules of investing in sovereign, risk- free debt has materially changed. When the euro began its existence in 1999, it was considered to be a riskless investment. As such, banks were not required to reserve capital against this risk-free investment. A pension fund or insurance company could safely invest their capital against future liabilities with the knowledge that a sovereign country would not default on their debt. Today, however, we have Greece and perhaps others, who are in serious danger of default. The current negotiations the Greeks are having with private investors regarding voluntary “haircuts” exclude the ECB, IMF and other public institutions. Consequently, private investors must now accept the fact they purchased a security with credit risk and was not compensated accordingly. Rest assured Mr. Market will not forget these series of events.
The ECB intervened in December offering unlimited access to funds for European banks. The move was critical as a freeze-up of inter-bank lending would be disastrous. The banks have borrowed nearly half a trillion euros through this program and currently have the funds on deposit with the ECB, as banks do not have confidence in each other, nor are they are willing to risk the capital through lending. Again, we have the can being kicked down the road.

The fiscal discipline that will be required of periphery countries to remain in the euro area will greatly inhibit any chance of growth and recovery. The weaker countries are overloaded with debt and run trade deficits with their stronger northern neighbors. As part of the euro currency, they have lost their independence to be able to print money, depreciate their currency and reduce the value of their debt through rising inflation. The only solution if they remain in the Eurozone is to become more competitive through increased productivity and significant cuts to salaries, benefits, retirement and other social welfare programs. Despite the dire consequences of inaction, the political will remains absent in these countries to make these difficult changes. The politicians may realize what needs to be done, but they also realize it is political suicide to actually implement the tough changes.
In the US, we continue to deal with political paralysis, which will continue until after the November election. Fourth quarter earnings reports have begun with 77 companies from the S&P 500 having reported. The equal-weighted increase has been 1%, with the market-cap weighted increase at 5%. If financials are excluded, the equal-weighted increase has been 7.4%, with the market-cap weighted increase at 9.7%. The results reflect a drag from financials and relatively stronger earnings from larger, multi-national companies.
Next week, there are a number of economic reports that are listed in the attached chart. The economic activity has been better overall than expected. The Fed meets Tuesday and Wednesday and Chairman Bernanke is expected to reveal a new protocol for sharing information with increased transparency. It remains to be seen if or when the Fed will announce a new round of quantitative easing, or QE3. The economic results and the favorable start this year in the stock market may be keeping the Fed on hold for now. I believe a program that would allow homeowners the ability to take large capital losses on their homes would have a greater impact than the continued manipulation of interest rates. Mortgage rates are not the issue. The banks are not lending and many people are weary of trying to “catch a falling knife” (ie, no confidence of when housing prices will stabilize). A favorable tax treatment for losses and a program to flush out the foreclosure pipeline is needed for the reset button to be pushed. Until the inventory is moved, a recovery in housing will continue to be a drag on economic growth.
Please let us know if you have any questions.
All the best,
Troy

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Economic Data, Week of January 23, 2012

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article) (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.

I have remarked in prior first-quarter newsletters that, somehow, this is about the only time of year when most people reflect on the past, ponder the present, and plan/predict the future. The new year always brings with it the crystal-ball question, “Cliff, where do you see the markets over the next year?” Like most market pundits I am tempted to answer with absolute numbers, but experience has taught me that these types of predictions tend to prove me far smarter or dumber than I deserve. There are, however, several themes we have identified that will affect our asset-allocation discipline for 2012. As I commented in November, the market risks are geopolitical and the sentiment is driven by government policies. Our themes for 2012:

• Germany’s Euro
• Inflation versus Deflation
• Election Year
• It Isn’t All Bad

Doing Nothing – Nothing Done: for the year 2011, stocks basically broke even, although the 37 days where the Dow was plus or minus 200 points certainly made for a wild ride.

By now, equity investors should be getting used to the volatility. Looking at the S&P 500 Index returns over the last 11 years indicates that we are in the midst of a long-term secular bear market, and while in it we will experience pockets of bull and bear runs. From a valuation perspective, if we are to experience a severe market downturn from here, then it will begin at a forward P/E level of 11.8, by historical standards a cheap valuation. Considering that the market low of March 9, 2009 had a forward P/E of 10.3 then the odds of a severe stock decline from here do not seem that high. However, I cannot ignore that the credit super-cycle of debt expansion over the past sixty years ended in 2008. The problems of Europe and the US are attributable to the tremendous amount of debt that is now choking our ability to grow and that threatens the solvency of countries and a fractional banking system that is built on trust. The black cloud of deleveraging will continue to hang over the heads of investors until government policies are put in place to ensure solvency of the euro and fiscal responsibility in the US. Emotions trump valuations in this environment.

Germany’s Euro

“We are asking the nations of Europe between whom rivers of blood have flowed to forget the feuds of a thousand years.” Winston Churchill

Europe has an solvency issue, not a liquidity issue. There are insolvent banks backing insolvent countries and insolvent countries propping up insolvent banks. In my opinion, a money manager’s chances of success or failure in 2012 will be dominated by whether he or she correctly assesses Europe. Will or will not Germany have the resolve to rescue the euro, and under what terms? We have been and are still witnessing a giant game of chicken, with Germany versus the Western world in an attempt to turn a European problem into a potential global financial Armageddon. Germany well understands that they either pay up by moving to a full fiscal union or continue to kick the proverbial can toward an expanded role for the European Central Bank that Germany will eventually control. After creating the euro in 1992, Germany has successfully done in 20 years what it failed to do in 60 years and two world wars: conquer all of Europe.

The Armageddon case is created by the financial leadership of the euro zone doing nothing in order that nothing gets done. But if nothing is done, investors and bankers will lose their trust in the weaker countries and financial institutions. The results will be a credit freeze and runs on banks and/or countries as investors attempt to get their money out before a bank is nationalized or borders are shut down. There will be a 1930’s style depression for all of Europe and a certain decline in global GDP; neither the West nor the East will be immune from the fallout. Germany’s willingness to push the default envelope to the edge of bursting is risking an unmitigated disaster of colossal proportions.

Our assessment is that Germany eventually pays up, by either (a) creating a eurobond where all euro countries assume joint responsibility for the debts of the continent or (b) supporting the ECB as central banker, with the same type of liberty to print money that the US Federal Reserve enjoys. Although German Chancellor Merkel has stated that neither of these ideas is permissible, the alternative is far worse. A euro zone breakup would create a currency crisis, global stock declines of 30% or more, a global recession, and legal chaos with the unwinding of contracts that were entered into based on the existence of the euro. As my friend John Mauldin says, there are no easy choices from here; just hard and harder. Therefore you have the following two camps in which to base your 2012 investment position:

Camp Optimist

• Euro zone is maintained
• Global GDP grows 3-5%
• Europe has a mild recession
• Financial contagion is limited
• US and other nations continue stimulus policies

Camp Pessimist

• Germany loses the game of chicken; euro breaks apart
• Widespread financial crisis from the detonation of the neutron bomb of the financial world: credit default swaps
• US ceases stimulus programs in favor of more austerity
• Global recession

Inflation versus Deflation

For the record, CPI has been reported on a monthly basis since 1919. The index has been revised several times through the years, in 1940, 1953, 1964, 1978, and lastly in 1995. The changes approved by Congress in 1995 eliminated food and energy from the “core inflation” calculation, and therefore the chart above provides both “headline” and “core” inflation numbers.

The combination of global wage competition and deleveraging is keeping a lid on the inflation statistics, even as governments globally continue to expand fiat currencies via the printing press, in the attempt to monetize their debts.

The chart above shows the expansion of US money supply as measured by M2, which encompasses M1 plus savings, time deposits, overnight repos, and noninstitutional money market accounts. Since the beginning of the financial crisis the US has increased the money supply by almost 30% in less than four years. And yet the velocity of money, which is the average frequency with which money is spent over a period of time, has fallen from 1.89 to 1.60 during the same period, as demonstrated in the chart below.

These graphs are telling us that much of the Federal Reserve’s expansion/stimulus policies have been focused on recapitalizing what has become a zombie banking system here in the US. Regardless of the amount of money available, the banks are not lending, as the regulators are essentially running the banks. Whether we want to admit it or not, the expansionary powers given to the government as a result of Dodd-Frank are choking private industry’s ability to grow and expand, because companies cannot obtain credit from traditional bank sources. My friends in the private-equity and mezzanine-debt arena indicate that the volume of high-quality financial needs from private businesses is growing at an exponential rate. Private-equity and mezz-debt funds are becoming the sources of capital that used to be the domain of the small to mid-sized banks. I would recommend that accredited investors look into these alternatives, if you do not already employ either strategy.

In the short term, deflation will continue to rule, as our system rids itself of the excess debt accumulated during the debt super-cycle. However, as Reinhart and Rogoff reminded us in the book This Time Is Different, governments cannot continue to aggressively expand debt and print money without consequences at some point. From David Rhodes and Daniel Stelter:

It is also a matter of trust. Take, for example, the history of hyperinflation in Germany in the early 1920s. The German Reichsbank funded the government with newly printed money for several years without causing inflation. But once the public lost trust in money, people started to spend it fast. This led to higher demand and an inflationary spiral. Today the velocity of money in the U.S. is at an all-time low of 5.7. If the number of times a dollar circulates per year to make purchases returned to the long-term average of 17.7, price levels in the U.S. would rise by 294 percent over that period — unless the Federal Reserve simultaneously reduced its balance sheet by $1.8 trillion. Some inflation is probably attractive to those seeking to reduce debt levels. The problem is stopping the inflation genie once it has left the bottle.

For this reason I continue to recommend an allocation to commodity-driven assets.

Election Year

The democracy will cease to exist when you take away from those who are willing to work and give to those who would not. Thomas Jefferson

For the record, I have become apolitical as it relates to my faith in our polarized Congress and President to do anything other than get re-elected. The polarized government creates problems at a time when we need leadership and policy changes. Without tough choices we will probably experience stalemate: Doing Nothing – Nothing Done. The European crisis is the fallout of socialistic systems where governments (Greece, Italy, etc) could borrow unprecedented amounts of money to pay for promises on which they could not deliver. The current rates of US spending on health care, Social Security, and the military are simply unsustainable. The following graph demonstrates the polarization of our political system that dares a Congressman or Senator to cross their party line.

In my opinion, the introduction of term limits would improve the system by eliminating the constant need for re-election. Representatives who know their terms are ending are far more likely to cross the aisle of Democrat versus Republican and do what is right for the country. Our problems are fixable, and we have a road map in Simpson-Bowles, introduced a year ago. However, if our representatives continue to vote 90% or more along party lines and leadership remains too idealistic, the US will remain in a stalemate.

It Isn’t All Bad

Despite the problems of the euro, the continued printing of fiat currency by central bankers, and a US government at the helm of a rudderless ship, the corporate world continues to bang out profits and capitalize on global growth. Looking at the following charts one would assess that the large multinational US corporations will survive regardless of what happens in Europe or the US.

Corporate cash is at all-time highs and dividend-payout ratios are the lowest in ten years; and if governement would get out of the way, we would see a return of capital expenditures. I make the argument that with valuations at these levels, high-quality US multinational corporations with strong dividend histories will prove a better investment over the next five years than a ten-year or thirty-year treasury. In the short term, with the potential for euro breakdown and other geopolitical risks, the flight to safety in US treasuries may enable bonds to outperform stocks. During this time, fear will trump valuations. Long-term (3-5 years), equities outperform treasuries.

Mutual fund flows are indicative of individual investor moves, as opposed to institutions. Individual investors typically make investment decisions based more on emotion than an investment discipline. In a recent Dalbar Inc. study, they looked at returns of the S&P 500 from 1987 to 2007 and found that stocks had an annualized return of 11.81%. During the same time period, Dalbar found that the returns of an average individual investor in S&P 500-type funds was a mere 4.7%. Why? Emotion. Investors buy and sell funds based on market swings and chase last quarter’s hottest fund. Disciplined investors, on the other hand, make money when others sell in a panic. Here at Excelsia, we view the mutual fund flow chart as one of many indicators that leads us to favor stocks over bonds at this time.

A key component of our Tactical Asset Allocation investment discipline at Excelsia is that we use forecasted returns for the asset classes, as opposed to historical averages, in developing our allocations. A key feature of the forecasting process is defining where we are in the interest-rate/inflation cycle. The chart below shows how we define the inflation cycle in four quadrants and compare the returns of bonds, stocks, cash, and commodities during various types of inflation cycles. We are in a low and rising inflation cycle now, which should bode well for stocks and commodities – the caveat being Europe and the potential for another global financial crisis. As I said at the beginning, assess Europe accurately and your returns will outperform in 2012.

Closing Comments

“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.” – Abraham Maslow

People make mistakes when they invest. They do so as a result of bias in their judgment, or by mistaking their perceptions as reality. There are several basic mistakes:

• Excessive optimism – Most investors tend to exaggerate the positive and minimize the negative.
• Overconfidence – Leads investors to overstate their knowledge, underestimate risks, and exaggerate their ability to control the situation.
• Cognitive dissonance – Investors often operate with incredible levels of denial.
• Heuristic rules – Rules of thumb that we employ for dealing with the daily information deluge, through evaluations based on how closely a situation, person, etc. resembles someone or something, rather than examining or questioning what is actually in front of us; i.e., we “frame” and/or “anchor” the event/person/action.

Freud once said, “Thinking is rehearsing.” What he meant was that after you accumulate the data and analyze the opportunities, you need to take action. In the world of investing there is no substitute for taking action. Savvy investors make rational and prudent decisions based on facts and understand the risks inherent in their decisions. Each of you will always read about someone who made more money than you last year; always. The critical factor to ask is, what amount of risk was taken for the performance? Losses are inherent in any investment process; the key is to limit the size of the loss. Case in point would be John Paulson’s Advantage Plus Fund. In the crisis of 2008 the fund made billions off the mortgage crisis, and his fund grew from $5 billion to over $35 billion as institutions and individuals alike flooded the fund with dollars. According to Reuters, the Advantage Fund was down 52%, as of December 1, for the year 2011. Ouch.

I know that our investment process of Tactical Asset Allocation has produced consistent returns over time. I know that, from a psychological standpoint, during down markets you want your returns to be absolute and during up markets you want your returns to be relative. I assure you that we at Excelsia will remain disciplined in our process during what promises to be another turbulent year.

Cliff W. Draughn, President

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly above (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information referenced above serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.

It’s Groundhog Day, Again, and Again….

For those who remember the movie “Groundhog Day” starring Bill Murray the plot is when he wakes up every morning, it is Groundhog Day again and again. The world today bears a striking resemblance to the movie. Our “groundhogs” are Europe with their never ending charade of rescue plans and the US Congress repeated gridlock over the budget. First, we will look at Europe.

From last week’s letter the market seemed to briefly sober up, but Europe is still ugly. Germany is insisting on playing a dangerous game of “chicken” with the rest of the world. Chancellor Merkel and company do so by stalling on definitive actions that only exacerbates an already unstable position. Today, the German Bundesbank announced there was no “urgent need” for a final decision on loans to the IMF. And again, it’s Groundhog Day with the same stuff, just a different day. The Germans are willing to pay their “fair” share, but only if non-European countries participate as well. IMF Chief Lagarde spoke to the US Treasury Department yesterday and warned the world is looking at a repeat of the 1930’s depression unless the EU comes together and the rest of the world participates by providing money to bail out Europe. Legarde fears the risks of economic retraction, rising protectionism and isolation, much as it occurred in the ‘30’s, is imminent if the US, China, Japan and others do not agree to supply the IMF with bailout funds. These comments were offered a day after the Fed indicated the US had no plans of contributing to the Eurozone bailout. A dangerous game of chicken.

In a similar vein Washington finds itself in the midst of another impasse which could shut down a number of Federal agencies giving us another Groundhog Day event. Gridlock. Temporary extensions. We have written about the probability of nothing getting done until after the 2012 elections. The can that continues to be kicked down the road will be unrecognizable by election time. It is politics as usual. During the latter part of the Civil War, Lincoln faced an uphill battle with McClellan in 1864 for re-election. He knew that his opponent would issue a cease-fire if elected, given the growing discontent of voters regarding the heavy losses sustained by Union forces. Lincoln was convinced the Union must win the war, and do it convincingly. Otherwise, the country would be split and fragmented which would only lead to the children of current soldiers to fight the same war again in a few years. In short, he knew for the country to survive, it could not become Europe. Europe is

1playing out today just as Lincoln saw it in 1864. A land of many countries with different governments that have typically resulted in disagreement or war. Lincoln also knew that our country, as one, could only become conquered by internal destruction. Washington today is making a noble effort.

The geopolitical risk in the world today continues to dominate the economy, the capital markets and all things seen and unseen. Fear and uncertainty trump valuation. Money Managers must consider both when evaluating the investment landscape. US Treasury bonds continue to offer bubble-like yields with the 10- and 30-year bonds under 2 and 3% respectively. In addition to a safe-haven for investors, the Fed has also been a buyer of Treasury bonds, so yields are artificially depressed to a level that precludes our participation. Equities offer good, long-term value relative to bonds. The geopolitical clouds discussed above increase the risk, but also provide opportunities. I always prefer to buy something on sale rather than full price. We continue to seek companies that offer reliable dividends and are financially sound and can weather the storm clouds and emerge at a competitive advantage when the sun begins to shine again. Gold has been under increased selling pressure as the dollar has strengthened due to the perceived safety of the currency. The continued printing of money on a global basis ensures our thought that in the near-term gold remains a bullish alternative. Emerging markets are experiencing a deceleration of growth, but still at levels that are much more robust than the developed markets. Despite the relative attraction, this market will experience heightened volatility when the market is in crisis mode. It will also recover at a much greater clip than developed markets. Many of these emerging countries run surpluses and their central banks have the latitude for an easing policy which will temper the threat of declining growth.

The economic news in the US continues to be respectable, given current global conditions. Europe is in a much more precarious situation regarding economic growth. In the absence of a complete European meltdown, we believe the US economy will avoid recession. It will not be overly robust, but we do not believe it will be a contraction. The jobless claims filed this week were lighter than expected. A favorable indication, but uncertainty out of Washington will continue to make companies pause before adding to their ranks. The jobs picture is worse in Spain, with unemployment at 21%. Their U-6 unemployment rate (includes part-time looking for full-time and those that have given up) is 35%. Why? The government forces any company who releases an employee to pay them a full year of full pay for severance. Given the uncertainty in the world, why would a company add a full-time employee?

Next week, there are a number of economic reports to be issued (see attached). The first part of the week is dominated by housing, while the latter part is filled with GDP, University of Michigan Confidence, Leading Indicators, Capital Goods Orders, and Personal Income. The revised 3Q GDP number is expected to remain at 2%. Looking to 2012, the median estimate from 82 economists for GDP growth is 2.19% (source: Bloomberg). Again, nothing spectacular, but not a contraction.

Please let us know if you have any questions. Have a great weekend.

All the best,
Troy

Economic Data – Week of December 19, 2011

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“I may be drunk, Miss, but in the morning I will be sober and you will still be ugly.”
-Winston Churchill

The European summit concluded in Brussels today. The outcome was better than many expected and the markets rallied in unison. While the president of the ECB, Mario Draghi hailed the results from the European Council as a step in the right direction, investors were disappointed that the ECB would not escalate their bond purchases of ailing country debts. So, while the results from Brussels were positive, they are not the panacea, and the region will still look ugly tomorrow. The accord implied the following actions: 1) a new “fiscal compact”, and strengthened economic policy coordination; and 2) the development of stabilization tools (EFSF rescue fund) to face short term challenges (escalation of the start date to 2012).

In a nutshell, there will be a greater fiscal union with increased oversight from central authorities and a concerted effort to inject capital into the IMF, which would then fund weaker countries who need assistance next year when their debt matures. This last point is critical as yields on Italian and Spanish debt have soared the past few months, despite limited intervention from the ECB (see attached chart on page 2). As evidenced by the chart, Italian and Spanish yields are at unsustainable levels, with spreads to the German bunds continuing to be punitively wide. Investors want the ECB to do more, but they have refused to step up their purchases, after getting “burned” in August. The August ECB purchases led to complacency by the weaker countries. The new accord agreed to today is the type of accountability that is needed if the euro is to survive.

Crisis creates market turmoil, which enabled Germany to elevate or heighten the desperation of those directly and indirectly exposed. Any attempt to alter the original treaty would be futile during benign or uneventful times. The Germans have been adamant about making these changes to better align the Euro Area with their discipline. Interestingly, the UK (one of 27 EU members, but not Monetary Union member) decided to go it alone when they were denied veto power over future financial regulation. This leaves Europe’s balance of power in question, since the UK will not be privy to future amendment agreements. Finland, who is one of the 17 in the Monetary Union, appears likely to leave as well, given their objection to specific language in the new accord.

Italian and Spanish Yield Spreads (to the German Bund)

Source: Bloomberg

The additional steps taken by the ECB did provide some monetary stimulus, though it disappointed some by stopping short of accepting the role of “lender of last resort”. The following market actions were taken:

• Lowered interest rates by a quarter percent to 1%
• Pledged unlimited cash to commercial banks for three years
• Relaxed collateral conditions for banks that will facilitate increased borrowing

These actions are heavily tilted toward helping the banking industry since the ECB is restricted on direct intervention of sovereign countries. The interconnections between the banks and the sovereign governments are deep but for now, banks will be the primary beneficiary of central bank intervention.

The US equity markets were further comforted by the University of Michigan Confidence Board survey that surprised to the upside today. There are some who believe we are currently in a recession, present company excluded. The bottom line is the events in Europe continue to dominate the headlines and markets, though US equity markets have fared much better than other parts of the globe. There are a number of headwinds that threaten economic growth not only in the US but also in other developed and emerging economies. We continue to look for pockets of opportunities to invest as they arise. Our asset allocation work provides us with the ability to participate in the market rallies, but limiting the downside with capital preservation.

Next week, the focus will again be on Europe and the prospects for implementation of the recent accord. The Fed will render their FOMC rate decision (no change) on Tuesday, but more importantly, we will be attuned to their opinion of economic conditions. The attached chart reflects the economic events for the upcoming week. Of particular interest will be Advanced Retail Sales, Business

2Inventories, Inflation data (PPI & CPI), the weekly Jobless Claims, Industrial Production and Capacity Utilization. These results, if positive and coupled with continued good news out of Europe, could be the boost the markets need for a strong rally going into year-end. If the market senses yet another empty bag of promises from Europe, the economic data will once again take a seat in the back row.

Please let us know if you have any questions.

Have a great weekend.
All the best,
Troy

Economic Data – Week of December 12, 2011. Source: Bloomberg

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Troy Gayle, CFA, CAIA Chief Investment Officer

The Lesser of Two Evils?

The United States and Europe continue to test the markets will by continuing to travel an already beaten down path of inaction. They share a parallel inability to offer a credible, long-term plan for deficit reduction. This week, a more pronounced scrutiny of the US surfaced as talk of the supercommittee turned into super failure. Consequently, automatic cuts of $1.2 trillion will be implemented beginning in 2013. The committee was formed this summer in a deal to raise the debt ceiling and avoid a potential US default. The result should come as no surprise as the exercise was destined for failure from the start. If there were genuine interest for bipartisan resolution, the committee should have been charged with making the Simpson-Bowles agreement as the starting point and negotiate from there. I remain perplexed as to why the Simpson-Bowles commission was ever initiated, as most in Washington have been dismissive of their recommendations. Instead, we saw six Republicans and six Democrats essentially start with a clean slate, with each side predictably sticking to their respective ideology. We have been vocal for some time that no real movement will be observed in Washington until after the 2012 elections. In the interim, Congress will act to avert a doomsday scenario from playing out…just enough to enrage the masses, but not enough to actually cause such a scenario that would leave them culpable.

As I have previously stated, the market continues to perceive the US as a safe haven; a flight to quality. It is why the current US predicament is much lesser the evil than our friends across the pond in Europe. It explains why the bond vigilantes are having their day in Europe, as bond yields continue to rise with Italy and Spain at dangerously unsustainable levels. I have written recently that France finds itself in the crosshairs and it now appears that even Germany, the strongest and safest European country is being slighted in the debt market. Today, Germany was unable to sell 35% of their maximum target of €6 billion of 10-year bonds. It is becoming clear that swift action is needed, though the fragmented structure of the EU with differing agendas make this highly unlikely. The ECB and Germany remain united that the central bank will not simply print money or guarantee member bonds as a firewall. In a similar vein that was articulated by the Federal Reserve this summer, the ECB is pushing back and insisting that governments need to do their part. The ECB has tersely stated their frustration by asserting that their modest purchases in the secondary market of

1particularly Italian debt have only yielded complacency on the parts of politicians in enforcing the needed fiscal reforms.

The lack of a cohesive plan and no established backstop from the ECB leaves Europe in a vulnerable predicament. The magnitude of debt within certain countries and their respective banks leave many to wonder if they are too big to save. Banks were allowed to buy debt from weaker countries and subsequently present this sovereign debt to the ECB as collateral for further borrowing. The bill has come due and Germany does not want to be on the hook for the weaker countries lack of fiscal discipline and profligate spending. To further exacerbate the problem, the debts that are generally discussed do not include future pension obligations, which only add, in many cases, to the unsustainability of the burden. In the US, a conundrum has surfaced as US yields continue to drop despite an S&P downgrade of the debt and no resolution in sight for reigning in runaway spending. The answer follows that the money has to go somewhere. It has chosen at this point to go with the lesser of two evils.

The economic data, while soft, is not dire. The 3rd quarter GDP number was revised down from 2.5% to 2% with the reduction due primarily to a drop in inventories. At least for the current quarter, this portends a likely pick-up in growth, but given the uncertainty around the world, it is difficult to predict the sustainability in 2012. Next week brings a large amount of economic reports (see attached). New home sales are expected to decline following a healthy increase in the prior month. The Case-Shiller Home Price Index is expected to be flat month over month with a decline of 3% year over year. If a silver lining exists, it would be that the monthly number is not negative. The annual decline is also less than the previous month’s year over year decline. Productivity is expected to be revised down for the 3rd quarter to 2.8% from 3.1% while Unit Labor Costs are expected to have declined -2.1% from a prior estimate of -2.4%. The unemployment rate is due out Friday, December 2nd and is expected to remain unchanged at 9%.

Please let us know if you have any questions.

We hope you all have a safe and Happy Thanksgiving.

All the best, Troy

Economic Data – Week of November 28, 2011

Click here to download a PDF of this article

Click here to download the pdf of this article.

The Saga continues…..

The crisis in Europe rages on as we continue to see plan after plan come and go. As the crisis broadens, it has now forced the ouster of Greek and Italian prime ministers. The market is very deliberate in exploiting cracks in the foundation of capital markets. The past several months have been consumed with Greece and despite a proposed bailout, she appears destined to default and to ultimately exit the euro. As the politicians continue to argue over which hose to use, the fire is slowly engulfing the region. The lack of a clear intervention has caused Italian bond yields to spike to over 7% this week. Italy has one of the largest debt burdens in the world. The ECB has once again stepped into the market to actively purchase Italian debt and consequently, yields dropped back today to around 6.5%. If a resolution is not implemented soon, Italy will be forced to refinance (no guarantee they will have access to private market) with “high yield” type rates. The subsequent interest burden will not be sustainable. The continued uncertainty has now begun to spread to core countries like France. The spread between French and German bonds have widened to approximately 150 basis points (1.5%). The risk to France and by extension, the Eurozone, is a downgrade from AAA. This would be emasculating to the European Financial Stability Facility (EFSF) with France being its second-largest backer. A downgrade to France would currently imply a less than top rating for the EFSF, which would greatly diminish its ability to leverage existing funds.

There have been a number of solutions proposed, but many still believe the silver bullet for extinguishing the crisis is for the ECB to become the “lender of last resort”. This would allow the ECB to become a “firewall” to limit collateral damage. Currently, this is not allowed in the current treaty, though that rulebook has long been dismissed. The resistance to this idea is coming from Germany and the ECB itself. Germany has not forgotten the hyperinflation that occurred after World War I which ultimately provided a platform for Adolph Hitler to rise to power. The German people are also reticent to absorb the ill-fated profligacy of other member countries. Mario Draghi (Italian), the new ECB president, has strongly dismissed the call for the central bank to unleash the euro printing press. Draghi contends the ECB would quickly lose credibility by stoking inflation when their primary role is price stability. To further complicate matters, the ECB has stipulated in exchange for bond purchases, the weaker countries must implement austerity measures at a time when Europe is on the precipice

1of a double-dip recession. At the end of the day, the ECB will need to print money or the euro will most likely not survive.

In emerging markets, there are clear signs of slower growth, but still much higher than developed countries. The European crisis, coupled with tepid growth in the US and other developed countries, will present challenges for continued robust growth. The silver lining for emerging markets is that inflation appears to have peaked, which affords these countries latitude for lowering interest rates and other forms of stimulus.

In the US, the attention has turned to the Congressional supercommittee and the question of whether a bipartisan deal can be reached prior to the November 23rd deadline. It is difficult to be sanguine when it comes to Washington, so I will offer a quote from Ray Devoe (The Devoe Report) to keep in mind as we approach not only next Wednesday, but subsequent deadlines as well: “Reality very rarely exceeds the square root of expectations.” The consequences of committee inaction will trigger automatic spending cuts of $1.2 trillion for defense and non-defense beginning in 2013. In the interim, we would have the 2012 elections, but “if voting could change things, they would make it illegal” (Emma Goldman, Anarchist: 1869-1940). The market has yet to put Congress on notice as the perceived “flight to quality” has kept a lid on Treasury yields, with the 10-year bond hovering around 2%, despite a downgrade from AAA. The time has come to pick up the can, as we cannot afford to kick it any longer.

The economic reports this week were generally to the upside. Producer (PPI) and consumer (CPI) prices were less than expected, which calmed inflation fears. The next few months will be telling for the annual inflation gauge as we begin to drop monthly price changes from 2010 that were rather benign and begin picking up more robust readings beginning in December 2010. The Fed gravitates to the core numbers and the chart below graphically depicts this potential scenario. It could in fact be the reason Bernanke has not pulled the trigger on QE3, but the encouraging economic news has also perhaps contributed to his restraint. I am certainly not advocating another round of quantitative easing, but the possibility is very real. If it does occur, history would suggest that the “risk-on” trade would once again be in vogue. With that said, the wildcard remains Europe and how they deal with crisis intervention to head off a potential replay similar to the 2008-09 financial collapse.

CPI Less Food & Energy YoY

Source: Bloomberg

We are concluding the 3rd quarter earnings season with 482 of the S&P 500 reporting thus far with strong growth: 28.1% market-cap weighted and 19.5% equal-weighted (as previously noted, this implies larger, multinational companies with global reach generating more robust growth), with nearly 70% beating analyst estimates.

The attached chart reflects the economic statistics due out for the shortened Thanksgiving week. GDP for the 3rd quarter is expected to be unchanged at 2.5%. The consumer, despite the need to de- leverage, continues to remain resilient and was supported this week with strong retail sales numbers. The holiday shopping season is upon us, but the persistently high unemployment rate of 9% is a concern for retailers. Personal consumption is expected to remain at 2.4% for the 3rd quarter. On Wednesday, personal income and personal spending is expected to have grown 0.3% in October. University of Michigan reports their confidence number for November, which has begun to rebound off lows comparable to 2008-09. The durable goods report, due Wednesday, is expected to show zero to negative growth, which reflects the apprehension of companies to tap their war chest of cash, as continued uncertainty remains prevalent both here and abroad.

Please let us know if you have any questions. Enjoy your weekend. All the best, Troy

Economic Data – Week of November 21, 2011

Click here to download the pdf of this article.

While this quote was in a different context when spoken in 1948, it rings the bell in 2011 with the confusion and unpredictability that continues to emerge from Greece. After securing a bailout plan from the EU last week, Prime Minister George Papandreou shocked the world by announcing a referendum to allow the Greek citizens to vote on whether to accept the bailout package. This was essentially a vote on being in the EU or not.

The proposed austerity measures that are conditioned on future bailout support are not popular with the masses in Greece. Presumably the prime minister was hoping to gain leverage by holding the EU hostage in an attempt to secure even more generous terms for their rescue. The global markets responded to this news by driving global markets sharply lower and pushing yield spreads on Greek, French and Italian bonds over German bunds to euro-area records. Consequently, the G-20 meetings in Cannes, France were forced to deal with this shockingly turn of events rather than focusing on more pressing issues, such as securing non-euro investments for the European Financial Stability Facility (EFSF).

The pointed response from the EU, led by Germany and France, was an ultimatum: take the deal or exit the currency. This was the first time, at least publicly, that the EU has contemplated the idea of a Greek exit. The question remains as to why Papandreou dared make such a bold move. Perhaps it is in his DNA. In the 1980’s, his father, then prime minister, held out a “yes” vote on allowing two countries into what is today called the EU. It worked, and Greece was able to secure billions from their fellow members. Clearly, history will not repeat itself for the current Papandreou. In fact, this latest stunt will ultimately cost the prime minister his job. A Greek parliament confidence vote on the prime minister is scheduled tonight at midnight Greece time (6 pm EST). Whether the vote is for or against, the “dye has been cast” and Papandreou will be forced to step aside. Unfortunately, this will leave a dysfunctional country even more rudderless as it attempts to transition to a new government. The first priority will be acceptance of the bailout or face default, as no additional funds will be given to Greece unless it commits to drastic reform.

The grim reality of this story is that Greece should have never been allowed to enter the European Monetary Union. The government had manipulated the real financial and economic health of the country, and it continued this charade until the global financial crisis began to reveal the truth. Upon independent investigation, it was determined that Greece grossly underestimated metrics such as Debt/GDP that would have precluded them entry into the euro. As Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked”.

“Most of the energy of political work is devoted to correcting the effects of mismanagement of government.”    Milton Friedman

This is certainly the case in Europe, and is playing out in the US and other parts of the globe. Today, the glacial moves that are transpiring in Washington on deficit reduction have become “business as usual”. Richard Nixon once said, “Any change is resisted because bureaucrats have a vested interest in the chaos in which they exist.” Our country is in need of structural reform. I only hope we get it voluntarily. The Fed appears to be setting the stage for another round of quantitative easing (QE3) based on recent comments from bank officials. As in times past, this is an effort to push us into riskier assets, as little growth occurs from money parked in cash earning next to nothing.

In Europe, the European Central Bank (ECB) has the firepower to ease the current anxiety, as it has unlimited resources to be the “lender of last resort”. However, the current EU treaty does not afford them this opportunity, though this treaty also precluded bailouts. The apprehension to have the ECB simply print money to avert further crisis is that by doing so would remove the pressure on the countries that desperately need to implement social reform. When the ECB began buying Italian debt in an effort to reduce borrowing costs, it led to more complacency than action on the part of the Italians. The incoming president of the ECB, Mario Draghi, did surprise the market by lowering interest rates by a quarter-point. The downside was his acknowledgement of the economic decline that has gripped the Eurozone.

On that point, it is inconceivable that Europe can avert a recession. The political uncertainty, coupled with proposed austerity measures (double-edged sword) do not bode well for economic growth. The uncertainty will surely cause companies to delay investments and hoard cash in the event of further political and economic deterioration. In the US, the economic news continues to at least provide evidence of avoiding a double-dip recession. Our third-quarter earnings season is winding down and the results have been strong. The balance sheets of US companies remain solid, which will provide resilience through these uncertain times. From an investment perspective, it is a time of caution, and we have pared back a small amount of risk in the portfolio. We continue to favor high quality, multinational companies that are reasonably priced and offer a secure and growing dividend.

In economic news, housing and unemployment continue to be a drag on the consumer, and is evidenced in the consumer confidence surveys. As the consumer contributes approximately two- thirds to economic growth, it continues to be a notable concern. While the unemployment rate declined from 9.1% to 9.0% in October, the change in non-farm payrolls were lower than expected at 80k. The attached chart reveals the economic reports that will be released next week. There are several reports that will provide insight on consumer and business sentiment. There will also bereports on Wholesale Inventories, the Import Price Index, Trade Balance and the weekly Initial and Continuous Jobless Claims.

Please let us know if you have any questions. Enjoy your weekend.

All the best,
Troy

“Oh God, please just get me off this boat and back to the dock. Please God, just get me back to land.” – Cliff Draughn

There are certain moments in your life that you never forget: your first car, first date, first day of college, first paying job. These are life events that bring a smile to your face. And then there are those events that are gut wrenching: first heartbreak, first car wreck and, for those of us unlucky enough to suffer from motion sickness, that first deep-sea fishing trip where you spend the day feeding the fish. As I stare at the abyss of the third-quarter stock market statistics, I am reminded of how I hung onto the rail of the boat for hours, pleading to be returned to shore and enduring the laughter of the captain and my friends. As the markets roiled and flowed, with 20-foot waves hitting investment portfolios, stocks were tossed around as if they were toy boats in the perfect storm. For the record, Q3 2011 returns for the major equity indices were:

1. S&P 500  -13.87%
2. MSCI EAFE  -20.55%
3. MSCI Emerging  -26.27%

The stunning part regarding the third quarter was the amount of volatility we experienced, which is the reason investors are getting seasick. There were some compelling market statistics that causes one to pause – or puke:

• Of the 64 trading days during Q3 2011, we had 33 event days and 31 nonevent days. An event day is one where the market moves more than 1% in  either direction.
• 16 days with returns greater than +1%
• 17 days with loss returns greater than -1%
• Largest single-day gain was +4.74% on 8/9/11, with volume of 1,861,723,648
• Largest single-day loss was –6.66% on 8/8/11, with volume of 1,938,670,720
• Average volume for event days and positive returns greater than 1% = 924,521,060
• Average volume for event days and negative returns larger than –1% = 1,077,991,360
• Average volume for non-event days = 841,337,350

The month of October provided the best monthly percentage increase in the S&P 500 since December of 1991, with a 10.77% recovery from Q3. And, we experienced the third largest monthly gain ever measured by the Dow Jones Industrial. However, October was no less volatile:

• No. trading days = 21
• Event says (returns greater than +/- 1%) = 15  (71% of the time)
• Non-event days = 6
• 10 days with returns greater than 1%
• 5 days with losses greater than 1%
• Average event day gain was 2.071%; highest return = 3.43% (10/27/11)
• Average event day loss was -2.104%; lowest return = -2.85% (10/3/11)

So, as we continue to hang on to the rail of volatility and suffer the rolling sea, one has to ask, “When can we please get back to land and dock this boat?” And, in the manner of the captain and my friends consoling me on the first and last deep-sea fishing expedition of my life, my answer to you is: When the forces that govern the EU and the USA understand the perils of government-promoted, debt-driven economic bubbles that lead to currency debasement followed by severe recessions, then the seas will calm. Until then, hang on to that rail and, no, don’t take off your life jacket.

Our focus factors for the remainder of 2011 and going into Q1 2012 are as follows:

• The Numbers: Valuations and Economic Activity
• Apocalypse Now?
• Greek Default or Voluntary Concessions: The Lunacy of Credit Default Swaps

The Numbers

From a consumer and earnings perspective it is difficult to substantiate all of the gloom and doom forecasts due to geo-political risks that have roiled the markets. Unemployment, while not being significantly reduced, has seemingly found a bottom, as evidenced by September’s increase in nonfarm payrolls. This is confirmed by ADP’s report of an 110,000 increase in nonfarm for the month of October. These moderate employment gains are consistent with a sluggish, muddle-through GDP growth, which is what we are predicting going into Q1 of 2012. The ISM Manufacturing Composite stands at 50.6,and this represented the 27th straight month of manufacturing growth.

Although the Consumer Confidence Index, at 39.8, is at a low not seen since Q1 of 2009, personal consumption for the month of October increased 0.6%, with increases in both motor vehicles and durable goods. The spending coincided with a reduction in the personal savings rate from 4.1% to 3.6%. Loss of confidence typically means a reduction in spending, but this was not the case for Q3 2011. My conclusion is to go against the ECRI and the consensus that a double dip is inevitable and predict we are going to continue to muddle through, barring some sort of Armageddon event from the EU.

Equity markets around the globe rebounded sharply in October, reflecting hope that the ECB and European nations are going to resolve the Greek debt crisis. Behind the stock moves, however, a number of positive forces are at work:

1. Dividend yield is consistently the most positive value factor for large-cap equities. For the first time since the Great Depression, dividend yield on the S&P 500 is greater than the 10-year Treasury yield.
2. Average earnings growth for Q3 2011 versus Q3 2010 is higher. With 392 out of the largest 500 S&P companies having already reported earnings for Q3, the average growth for the cap-weighted index is 25.1% and equal-weighted 18.4%. If we drop out financials, the numbers improve to 28.9% in the capweighted and 22.4% for equal-weighted.
3. As evidenced in the difference between the above-stated cap-weighted versus equal-weighted earnings growth, we can conclude that large-cap stocks are growing earnings at a faster rate than their mid-cap or small-cap brethren.

Third quarters are often cruel, as the -13.87% decline in the S&P 500 reminded us. Since WWII the S&P 500 has produced 10 quarters of -14% or more. Six of the ten were third quarters. The good news is that in 89% of the cases where we experienced a huge negative quarter, the following quarter was positive. The following chart documents investor sentiment, as recorded by the Ned Davis Research Crowd Sentiment Poll. We pay attention to the trend in this chart, as our discipline is to be contrarian to the crowd. At the first of October, we tilted our allocations to be more favorable to high-quality, dividend-paying stocks, and view bonds as having significantly more downside risk than the other asset classes.

The next two graphs after the NDR Crowd Sentiment indicate (a) the superiority of dividend-paying stocks as opposed to non-dividend stocks and (b) the cheapness of stocks when using a comparison of T-Bill yields to S&P 500 dividends. In the case of dividend-paying versus non-dividend, compare the black and red lines versus the green line. In the case of comparing T-Bill yields to dividends, we have entered a valuation territory not seen since the Great Depression.

We recognize that fear trumps valuations when geo-political risks become the focus point of the markets. Political paralysis on both sides of the pond (US debt debacle and Euro Sovereign debt defaults) have been the jet stream for investment returns. These geo-political risks will remain a feature of the investment landscape that we will not ignore. Major market disasters such as Lehman in 2008 rarely occur when everyone is expecting one. By definition, black swan events are unpredictable. Today, everyone and his brother recognizes the European disunion and the impending bankruptcy of Greece.

Apocalypse Now?

For the past 22 months the question has lingered: when will Greece default? The markets are beginning to learn from the prior three Euro-crises what to expect from European policymakers. In the end it will be what Germany wants, as they are seemingly content to amputate the leg of Greece six inches at a time. Even prior to this past weekend’s summit, German Chancellor Merkel complimented now former Prime Minister Papandreou for stepping down but implored the new Greek policymakers to carry out the Brussels decisions completely and immediately. This past weekend’s summit to end all summits of the G-20 at Cannes followed a nowfamiliar pattern:

1. Let’s play Liar’s Poker. Policy makers are amplifying the problems in attempts to get as many concessions as possible from European bank bond holders and capital assistance from the international banking community. The attempt is to bring in the IMF, US, Chinese, and any other international player who fears contagion risk and is willing to be a part of the solution (i.e., give away money).
2. As various lines in the sand get stepped over, Germany is more and more assuming the role of dictator, imposing its will on the other European nations. The ECB, while under new leadership, is clearly taking direction from Merkel and company. The announcement from Merkel that Greece is free to leave the euro is a protectionist action based on the notion that euro-zone countries should not become liable for each other’s debts. Really?
3. The European financial crisis is in reality a political crisis. Germany is intent on not engaging in any large-scale fiscal transfers to countries like Greece or Italy or any other struggling euro-zone country. This will play on until December, when the German constitutional court will decide whether the Bundestag can approve funding of the EFSF (European Financial Stability Fund). Although it is more than likely the court will rule in favor of funding the EFSF, there is always the political risk that Germany will play an even tougher hand.

The Euro-crisis is far from over. Any solving of the problems facing Europe will require a complicated coalition of European banks agreeing from both an economic and political perspective that it was not a handful of small countries making poor decisions that brought them to brinksmanship of the highest order; but rather it was the banking community’s willingness to continue buying the bonds of these countries when their economics were clearly deteriorating. One needs to remember that the European banks were the primary purchasers of sovereign debt, and no one held a gun to the heads of the banks to purchase what will eventually be defaulted obligations. Nevertheless, European policymakers are conscious of the mistakes the
US made during the Lehman bankruptcy and the counterparty risks that surfaced in the credit default swap arena. I expect that each partial Greek amputation will be commensurate with a rising pain level, and with the pain the remaining countries will become more and more politically aligned rather than also face disownment by Germany. Greece will eventually default and leave the euro, but the real struggle here is a political one as to who is going to solidify and control the euro, as though the euro zone were one state. In our opinion, the political risks of a European meltdown have been overpriced in the financial markets, though there does remain a chance of financial meltdown.

Greek Default? Or Voluntary Concessions?

In efforts to increase earnings, large US and European banks have sold huge amounts of insurance against both sovereign and corporate bond defaults, in the form of an instrument known as a “credit default swap” agreement. Credit default swaps (CDS) originally had the purpose of giving institutions the ability to insure against bond default for securities they owned. The seller of the insurance hopes to pocket the premium and never pay a claim; the buyer of the insurance is attempting to insure against a loss. During the US mortgage meltdown in 2008, firms such as AIG and Lehman were net big sellers of insurance against mortgage default, which put multi-billions of risk on their trade desks. As with all insurance, everything is fine
until something goes wrong, and then claims have to be paid. The term that then surfaces is counterparty risk, when firms such as Lehman and AIG declare bankruptcy and state they cannot honor their commitments, thereby imperiling the likes of CitiGroup, Goldman, and Morgan Stanley, who were buyers of insurance and ended up both (a) losing the premiums they had paid to AIG and Lehman and (b) staring at large losses from mortgage paper they owned and being forced take the losses from the positions they thought they had insured against.
In the CDS world, there is supposedly a winner and a loser, but the US government decided in 2008 to socialize the losses by bailing out AIG and paying off the CDS claims with taxpayer money. What did US banks learn from that experience? One, if you make really BIG mistakes and are too big to fail, then you get bailed out. And two, as a trader on a bank prop desk, you have no risk, so load up the wagon with big bets and collect your year-end bonus. If you are right, then the bank pays you for performing. If you’re wrong, then the bank or financial institution whose capital you exposed to risk may face the threat of going under and need bailout money; but you as the trader simply walk away, ala Joe Cassano. Who is Joe Cassano? He was the head trader for AIG’s CDS unit, who ended up with the moniker Mr. Credit Default Swap. His unit caused the bankruptcy of insurance giant AIG and resulted in a $280-billion-dollar bailout from the US government (us taxpayers) to settle AIG’s CDS liability claims. In 2008 (the year AIG declared bankruptcy) Mr. Cassano received a $34-million-dollar bonus, and his total bonus compensation from 2000-2008 for writing CDS agreements was $280 million. Mr. Cassano never faced any criminal or civil charges and walked away a very rich man at the expense of you and me.

The Lunacy

According to Bloomberg, US banks greatly increased their sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish, and Italian debt during the first half of 2011. According to the Bank for International Settlements, guarantees from US banks on debt of those countries rose from $80.7 billion to $518 billion. The banks counter that their “net” positions are far less than this number, as they have other trades where they too have purchased CDSs to reduce their exposure. Five banks – JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America, and Citigroup – underwrite 97% of all credit default swaps in the US – that statistic from none other than the Comptroller of the Currency. The banks refuse to
disclose/identify the counterparty risks should a default occur.  Just this past week Bank of America, according to Bert Dohmen, reportedly shifted derivatives in its Merrill Lynch investment banking unit over to BofA’s depository arm, thereby gaining FDIC protection from the derivatives exposure. According to Bert,  “This means that the investment bank’s European derivatives exposure is now back stopped by U.S. Taxpayers. Bank of America did not get regulatory approval to do this; they just did it at the request of frightened
counterparties. Now the Fed and the FDIC are fighting as to whether this was sound. The Fed wants to give relief to the bank holding company, which is under heavy pressure.”
Rest assured that if BofA is allowed to do this, JPMorgan, Morgan Stanley, Citigroup, and Goldman Sachs will not be far behind. This is insanity. This is the reason the European governments structured the Greek debt haircut of 50% as “voluntary,” thereby technically not triggering default and avoiding claims from owners of CDS insurance. But what good is buying CDS insurance when there is no default … technically?

The probability is that there is going to be another AIG moment, because DoddFrank did absolutely nothing to deal with the CDS markets. In my opinion, Congress should enact legislation to prohibit any financial institution that has governmentinsured deposits from engaging in any derivative transaction that is unregulated and not part of a listed exchange. The massive amounts of CDS being floated do absolutely nothing to promote the formation and allocation of capital and do everything to create a leveraged gambling casino within our financial system, where traders use house money (taxpayer guarantees) as their betting capital. The credit default swap market, in its present form, is a cancer within our system and will come back again and again if not eradicated.

Summary

The past four months have proven to be a challenging time to be a money manager. Stock prices are moving in step with news surrounding the euro-zone debt crisis and the US deficit rather than business fundamentals. Economic conditions are not great, but not bad either. Earnings season has proven that corporate America is healthy and has increased the amount of cash being held on the sidelines. If Europe falls prey to the cold reality of political paralysis, dogmatism, and deep philosophical divides, we could experience another meltdown. If Merkel and company can come up with a credible plan, then we will have a melt-up. The safety of depositor funds in European banks must be unconditionally guaranteed for any EFSF funding to work. My prediction is that eventually there will be some form of euro monetization, with the Germans in control. Greece eventually opts out of the euro, probably in March of next year. The risk of a euro implosion, while low in probability, cannot be discounted. US GDP, while declining, will remain sluggishly positive. Global GDP will suffer from a potential Euro recession but the emerging markets should continue to propel positive growth.

In closing, I attach a link of Phil Donahue interviewing Milton Friedman in 1979. Take 2:24 minutes and watch this; it sums up the case against Occupy Wall Street and class warfare of the rich versus the poor. Our issues in 1979 were very similar to our issues today. Copy and paste the following to your web browser:

http://www.youtube.com/watch?v=RWsx1X8PV_A

Keep a cool head and maintain your discipline in these types of volatile markets. It’s very easy to find yourself tossed overboard and searching for a lifeline. And if you don’t have a captain to steer the boat and kid you over your seasickness, get one, take some Dramamine, and maintain your sleeping point.

Cliff W. Draughn
President