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Third Quarter 2012

Europe Burns As We Stare Over The Fiscal Cliff

STOCKS: If all one did was look at the performance of the equity markets this year, a logical person would conclude that unemployment is low, deficits are under control, Congress is working well together, there is no fiscal cliff—and there is peace in the world. If only this were the case. 

At the three quarter point of the year, we are reminded of why we don’t make short term predictions. If we had, surely we would have concluded that the markets would struggle this year—maybe even producing losses. We are also reminded that economists’ predictions do not drive stock market performance. 

Despite all of the bad behavior from governments around the world, corporate balance sheets look better now than in decades. Net profit margins are as high as they have ever been and companies are sitting on the highest cash balances in twenty years. The combination of high profits and strong balance sheets gives a strong indication why stock markets have done so well--when governments are imploding worldwide. 

EUROPE: Although the domestic markets have performed well, Europe is still mired in problems. Spain announced a severe austerity budget that promises to hold budget deficits to 6.3% while slashing spending almost 9%--and raising taxes. They assume growth will only fall to -0.5% due to austerity. This is laughably optimistic. Making matters worse, the Spanish region of Catalonia wants to secede. About 20% of the Catalonian population (1.5 million) turned out for a march supporting independence last week. I guess they were all off from work that day. 

Germany, the cornerstone of European stability and profits, is now stumbling towards a recession. If Germany falls into recession they may not have the financial firepower necessary to bail out the rest of the European Union.

The complexities of the problems associated with the EU are well beyond our pay grades. Although it is fun to guess as to who will be in or out, or other outcomes—they are just guesses. Needless to say, the issues the EU faces are far from being contained and far from over.

Central banks were very active on a global basis. Action by the Fed, the European Central Bank, the Bank of Japan and others lifted asset values through a variety of manipulations. These manipulations are designed to keep interest rates down--which punishes fixed income investors, driving them to embrace the stock markets.

THE FED/INTEREST RATES: Domestically, the Federal Reserve stated they see no need to increase interest rates until mid-2015—at the earliest. They must have an amazing crystal ball. Furthermore, the Fed announced they will go into the open market and buy up mortgage backed bonds to the tune of $40 billion per month—indefinitely! That is half a trillion a year!! The net effect of this manipulation is to increase demand for mortgage backed bonds which in turn decreases the yield. It is great news if you are a borrower—and horrible news if you need interest income. Retirees, amongst many others, are getting the short end of the stick from this action.

Our attitudes toward US Treasuries have not changed. They are horrible investments. Investing in a 10 year US Treasury amounts to nothing but an amortized default. People who think there is no risk in an investment of this nature are fooling themselves

If you lend money to our government for the next ten years, with all the kindness in their hearts, they will pay you 1.65% a year. After factoring in taxes (up to 35%) and inflation (around 7%)—the seemingly “safe” investment actually delivers guaranteed losses. We will pass.

FISCAL CLIFF: The fiscal cliff looms large in the near distance. Most economists agree that if the full reversal of the Bush tax cuts are not heavily modified, the US economy will careen towards recession. Fortunately, we understand there are two drafts of tax bills aimed at alleviating the fiscal cliff. The two bills are designed around estimated outcomes of the election and should be submitted shortly after the election.

GDP: With GDP growth being revised down from 1.7% to 1.3%, it will not take much of a push to send us into recessionary territory.

The slowdown in GDP should not surprise anyone. For quite some time we have been pointing out the difference in the official unemployment rate versus the labor participation rate. Although official unemployment stands at 8.1%--even this “cooked” number is way too high to produce decent growth. The Bureau of Labor Statistics Labor Participation Rate is at a 30 year low of 63.5%--meaning that only 63.5% of the people in the US age 16 or older are working. Given that 70% of GDP is comprised of consumer spending—when people don’t have jobs—they have a hard time spending money.

CASH: As an asset class, we often hear that “cash is trash.” Although it is unfortunate that we are not earning much of anything on the greenback currently—cash buys us flexibility. When volatility returns to the marketplace, the value of cash will be far in excess of any interest we may earn. Understanding this, we have elevated our cash positions as a hedge against market values, global instability, a lack of resolution on the fiscal cliff, etc. Our security values have done better than expected--but the good news may already be baked in.

Volatility markers are at very low levels—indicating that traders think all is well in the world. Anytime we get such a happy consensus—we get nervous.

Given the obvious headwinds, we continue to favor investments that can withstand, and thrive, in the event of another major downturn. Make no mistake, if there is a major market selloff our investments will incur PRICING volatility. However, their ability to make money—their true value—will not be materially affected. As such, they will be able to continue to operate efficiently, expanding their market share and increasing their dividends to shareholders.

THE ELECTION: If forced to make a guess, we think Obama will be re-elected and the Republicans will take control of Congress. This is only a guess since most of the major polls showing Obama ahead in the swing states are all within the margin of error. Furthermore, a short while ago it appeared the Republicans would easily take the Senate. Now that does not appear so certain.

Regardless of political leanings, the election does not sway our investment philosophy. No matter who is in office, the discipline of analyzing financial statements, reducing risk and finding high quality, low priced assets never changes.

If you have any questions on this, or anything else, don’t hesitate to stop by or give us a call. 

Sincerely,

Dave                                                                                        Warren

Dave Sather, President                                                        Warren Udd

CERTIFIED FINANCIAL PLANNER™                              CERTIFIED FINANCIAL PLANNER™