“The perfect beaureaucrat everywhere is the man who manages to make no decisions and escape all responsibility.” - Brooks Atkinson (1894-1984)

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Despite strong market performance year-to-date in the stock market, there remains clear and present dangers on the horizon. These uncertainties have caused jitters in the market recently, as depicted in the attached performance chart (Exhibit 1). As the quote from “Hank the Deuce” above states, though we have a mess of problems, we have to do something about it. We currently have the time, the means and the capacity. It may hurt to fix the fiscal messes we face, but the alternatives will be much harsher (just ask the Greeks). You may have heard about a US “fiscal cliff” recently, but it has not garnered the type of headlines it perhaps deserves. This year is an all-important election year. But perhaps more importantly, as we ring in a new year January 1, 2013, there are a number of issues that will become front and center, and how they are handled will likely dictate the direction of the economy and capital markets alike.

The Bush tax cuts, if left to expire, coupled with the implementation of surcharges related to the president’s new healthcare law, will mean that dividends will be taxed at 43.4%, up from 15% today (dividend tax rate would revert to 39.6% plus the healthcare surtax of 3.8% on all investment income, including dividends). For the record, pensions do not pay this tax and most corporations have a 70% exclusion on dividend income, so the real hit will come to the individual investor. The full payroll tax would be reinstated which would means less cash in the pockets of consumers, which are already feeling the pinch at the gas pump and the grocery store. Also, the debt ceiling debacle has not been resolved and will trigger further tax increases and government spending cuts, which should be done more surgically as opposed to the across the board brush as a result of inaction on the part of Washington.

The US has serious challenges ahead and the ensuing sacrifices will be painful. We can only hope the second quote from Brooks Atkinson above is not the game plan in Washington. To allow these events to occur while pointing the finger at each other will be a complete dereliction of duty for anyone remotely tied to the Washington scene. There must be chills going down the backs of politicians as they watch elections in France and Europe and see incumbents thrown to the curb. Herein lies their conundrum: do what’s right for the country or do what’s right for their re-election chances.

The US economy has been stronger relative to Europe and the UK, as a number of these countries are either in recession or very close. However, the strength is only relative and as I pointed out last month, the reported numbers should always be taken with a “grain of salt”. While the unemployment rate in April did drop from 8.2% to 8.1%, it should be noted that at least part of the explanation is that 342k people left the workforce and were not counted by the Bureau of Labor Statisics (BLS) (ie, they vanished in the eyes of the BLS). The labor force participation rate has dropped to 63.6%, the lowest level since 1981. For those who are employed, wage growth has been sluggish at best and certainly not exceeding inflation.

While I have been rather cynical thus far, it is more to temper expectations. The economy is growing and we are closer to the bottom in housing than we were last year (see, I can be optimistic!). I am just offering a reminder that we have seen unprecedented central bank involvement both here and abroad. The new phenomenon of “cyber-printing” of money that needs no ink or paper has emboldened many at the behest of the Fed to take more risk and shift the chairs on the deck of the debt-laden Titanic. These central bank actions are not without consequences. The graph below shows the sharp upward movement of money supply, which can be attributed to the Fed flooding the system with the “cyber-printing” of dollars. The declining line is the change in the velocity of money, or how much is actually being used in the system (the second chart depicts the absolute level of the velocity of money). This portends inflation. We may not get there this year or even next depending on the outcome and level of potential calamity with events that are plaguing the world today. But once this money is unleashed, inflation will rear its ugly head.

M2 Money Supply and M2 Velocity of Money

Source: Bloomberg

When this happens, the proud buyers of US Treasury bonds will be swimming in losses (this will also happen once the Fed ceases to be the major buyer in this market, ala end to QE, Operation Twist, etc.). It is true that stocks may very well serve as an inflation hedge to a degree, but it seems logical that resources in the ground will play a large part in hedging the inflationary consequences of the free-wielding Fed and other central banks (US, ECB, Bank of Japan). For example, we have been bullish on gold for some time and continue to be. Diddo for the gold miners, who have been getting cheaper recently, which we happen to like. I believe we will continue to see strong results from these companies, including shareholder returns through increasing dividends, though we will stay tuned to potential tax law changes, as described above.

For the remainder of the year, the uncertain geopolitical risks will continue to dominate the headllines. Corporate America continues to surprise to the upside, with earnings thus far up between 5-10% in the first quarter. These companies also continue to build their war chest of cash due to the uncertainty in the political arena, with potential regulatory and fiscal changes that make committing to certain projects unfeasible at this time.

Please let us know if you have any questions.

All the best,
Troy

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Exhibit 1 (Returns are Price Only through May 4, 2012)

Source: Bloomberg

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 (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, 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 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. Excelsia, Inc. is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

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Most people I believe are inherently positive and optimistic. After a year like 2011 that included the Arab Spring, a devastating tsunami in Japan, the first downgrade in history for the United States and an imploding Europe left many craving good news, or at least a plug in the hole of bad news. As we close out the 1st quarter of 2012, it was more a lack of bad news than anything overtly positive.

As we review the performance of the indices in the first quarter in Exhibit 1, it was clearly risk-on the first two months, which is precisely what the Federal Reserve is hoping to induce by artificially keeping interest rates at record lows. The table reflects the monthly performance in the first three columns followed by the overall quarterly result. The S&P 500 was up 12% while Treasury bonds were negative as investors sought higher yield with a greater appetite for risk. More recently, the market has taken a breather as Fed Chairman Bernanke disappointed the masses by not tipping his hand on a new round of quantitative easing, which would be dubbed QE3.

As previously discussed in last month’s letter, to avert falling into the melting pot, the European Central Bank (ECB) pulled out an old tool called LTRO, which stands for Long-Term Refinancing Operations. While this option has been around for years, the ECB launched a new twist to help stem the threatening debt crisis. Esssentially, European banks are able to borrow money at 1% from the ECB, which will accept most anything, short of Greek bonds, as collateral. The latter is no longer accepted following the downgrade by S&P to default. The term of the loans have also been extended to three years from less than one year.The banks can then loan the money to businesses and consumers or purchase the sovereign debt of their respective countries. In addition to the banks earning a very favorable spread between the cost of funds and the purchase yields of the sovereign debt, it has served as a stabilizer to the likes of Portugal, Spain and Italy, but the fundamental problems remain.

Currently, the jitters in the European market, which have declined for a third week and is the longest losing streak since last August, are being driven by concerns in Spain. The spread between 10-year Spanish and German bonds widened to over 400 basis points (4%), the widest margin since December 12. The ECB is hoping that their LTRO program will buy adequate time for the southern periphery countries to get their fiscal house in order. The reality is that the austerity and deficit cutting demands make it an uphill battle for recovery. These weaker countries are at a competitive disadvantage to their northern brethren. Their marriage to the euro highlights the underlying weakness of such a union. By sharing the same currency, these countries have lost their ability to intervene in ways that would strengthen their competitiveness (ie, force a weakening to their former currency and thus making their products cheaper and more competitive).

In the US, it is an election year and the stakes are high. There will be difficult decisions that must be made in the coming years. If we fail to take the necessary steps to deal with a mounting deficit and liabilities that we cannot afford to pay, the market will make the decisions for us. It is indeed a slippery slope as the consumer is also grappling with the need to deleverage. If the brakes are hit too hard and all at the same time, the risks are to the downside for economic growth. The pendelum for the housing market has swung in the opposite direction. Until the foreclosure debacle is firmly resolved and the system is flushed out, it will remain a headwind to the recovery process and consumers alike.

While the economic data has seen steady improvement such as the unemployment rate down to 8.3%, I remain cautious. I offer a quote from Benjamin Disraeli, former British Prime Minister: “There are lies, damned lies, and statistics.” It is a constant and persistent global challenge. We now know that countries such as Greece cooked their books to gain entrance into the euro. In China, we know there is growth and demand, but it is better to look in terms of a range or the trend rather than absolute belief in a specific number. Back home, we have career politicians that seem to base their very existence on being re-elected. They give the people what they want to hear.

As we move into the second quarter, I fully expect if markets and confidence begin to deteriorate, the Fed stands ready and willing to prop up asset prices with QE3. The geopolitical risks in the marketplace continue to dominate the headlines. Iran, Syria and North Korea continue to be a hotbed of uncertainty. The growth picture in China has been heavily scrutinized, which is probably why we are seeing a greater wilingness of the Chinese to assist in stabilizing Europe, which is a huge trading partner. However, to reiterate, given these headwinds in the midst of an election year, any signs of deterioration will prompt the Fed to swiftly move in with additional stimulus. At that point, we must remember two rules. Rule #1: Don’t fight the Fed; Rule #2: Don’t forget Rule #1.

Please let us know if you have any questions.

All the best,
Troy

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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 (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, 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 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. Excelsia, Inc. is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Excelsia, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

Europe has continued to kick the can down the road which has, to date, prevented a series of cascading defaults throughout the region. The European Central Bank (ECB) has allowed their balance sheet to mushroom much like the Federal Reserve. The recent second round of ECB funding to banks through the Longer-Term Refinancing Operations (LTRO) program has given a reprieve to these institutions. As many European banks invested in the peripheral sovereign bond markets, a Greek (and others) default could have deemed many to be insolvent. Thus, the access to capital from the ECB at 1% will bolster the capital cushion and allow these banks to earn spread income over the next three years. It remains to be seen if banks will invest any of these proceeds in their respective country’s sovereign debt in an attempt to reduce borrowing rates. To be clear, the ECB actions are short-term solutions. It is like having seven garbage cans and six lids…..there will always be one with trash piling out so when you contain one, another pops out. The next to rear its head from the cans are Portugal and Spain. The austerity measures for these periphery countries, if agreed to, will guarantee a seemingly perpetual round of recessions.

In the US, we are dealing with the uncertainty that comes during an election year. I do believe the stakes are high this year. We have an unsustainable fiscal model in place. It matters not where it originated or even how and why. What matters is that we are able to put people in Washington who recognize the urgency needed to make changes now that will prevent much greater pain in the future.

Just as it is impossible to suddenly stop or turn a Navy aircraft carrier, one cannot expect to flip a switch and have the budget and debt/GDP ratios emerge from a deepening hole. It will be important for those in Washington to recognize it is not about politics anymore. It is not a particular party; rather, it is an American party. It will not be an easy task and it will require sacrifices from the wealthiest to the poorest. If we do not address these issues, the bond markets will react just as they have in Europe.

The items on the political agenda list that will need to be addressed include, but are not limited to: taxes, regulation, trade policy, debt and deficit reduction, education, immigration, social contracts including Social Security, Medicare and Medicaid, defense (both spending and wartime decisions) to name just a few. The solutions must be found and they must be clearly articulated to businesses. This overhang of uncertainty has made many companies reticent to hire or deploy capital to job-creating projects. Another elephant in the room are pensions, both private and public, that are struggling to remain viable. The Federal Reserve has deliberately manipulated interest rates which have a huge impact on how pension liabilities are valued. The lower the interest rate (discount rate), the higher the present value of those future liabilities. The ramifications include possible major contributions to these pensions which could hurt profitability at certain corporations.

The economic statistics in the US continue to reflect a “muddle through” scenario as depicted in Chart 1below of consensus estimates. The 4th quarter GDP was revised higher to 3% from 2.8%. The increase was attributed primarily to positive contributions from private inventory investment and personal consumption expenditures (PCE). These factors were offset in part to a decline in government spending and increased imports, which subtract from GDP.

In Chart 2, the unemployment rate has been decreasing, yet remains at uncomfortably high levels. The February rate will be released on Friday, March 9th and is expected to be unchanged at 8.3%. The underemployment rate (U6) is expected to be 15.1%. This rate includes discouraged workers and those working part-time but wanting full-time. This topic will certainly be front and center this election season.

We continue to believe that the one bubble in the market today is US Treasury bonds. The yield on the 10-year is currently 1.94%. The fear factor has kept a lid on yields despite the current fiscal condition in the US. The US still maintains a “flight to safety” for many investors. It also helps when one of the investors is Ben Bernanke and the Federal Reserve. I discussed above one negative consequence of the artificially low interest rates on pension plans. The loose Fed policies are indisputably inflationary, and at some point in the not so distant future, I expect the genie to pop out of the bottle. To many, it may already feel that way as one visits the grocery store or the gas station. Chart 3 shows the consensus forecast for the 10-year US Treasury over the next year. The geopolitical risks in the market make it extremely challenging to accurately forecast interest rates. The message here is that the risk clearly points to rising interest rates rather than a sustaining decline.

The crisis in Iran continues to fester. Iran wants to exert its power in the region and with the US pulling out of Iraq and a withdrawal plan for Afghanistan, the time has arrived. Iran does not want a war. They want to rattle the saber and stall for time and hope to exert at least the perception of having nuclear capabilities. There is also a power struggle in Iran between President Mahmoud Ahmadinejad and the Supreme Leader, Ali Khamenei. Ahmadinejad’s term as president expires next year and their election laws prevent a third term. He will be able to run in 2017, so his challenge is establish a power vacuum much the way Putin has done in Russia.

Iran is also asserting its influence in neighboring Syria, which according to the top US commander in the Middle East, has bioweapons. The instability in the region is creating upward pressure on oil prices which ultimately reach the consumer at the gas pump. The Strait of Hormuz is the bargaining chip for Iran. The strait controls 20% of the world’s oil flow and Iran knows an interruption will cause a spike in prices, though current prices do reflect this potential threat. In the short-term, the increased price of crude will help energy company profits. Longer-term, however, the overall impact of sustained high prices will be a “tax” on consumers as they fill their tanks.

China has the world’s largest export machine. Recently, the country reduced its forecast for GDP growth to 7.5% from 8%. While this is certainly robust growth relative to developed nations in the US and Europe, it is down from the 10%+ growth that has become the expectation. As Europe struggles with recession and the US “muddling” along, the fear is that China does not have the domestic consumption firepower to compensate for any meaningful slowdown in global spending. The country is dealing with an overheated real estate market but the government does have tools available that should prevent a hard landing of their economy.

In closing, we believe we may be in for a soft patch and have attempted to position the portfolios in anticipation. The geopolitical headwinds that are dominating the current landscape will create opportunities for acquiring solid businesses with excellent financial strength and flexibility.

Please let us know if you have any questions.

All the best,
Troy

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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

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