November 2010 Market and Planning Update (Posted to our blog two weeks after sending to clients.)

"It takes far less courage to cling to the past than it does to face the future"

- Sandra Brown (author of over fifty-five New York Times bestsellers)

MARKET COMMENTARY

The markets faced renewed challenges in the month of November due to the continued debt crisis in Europe (most recently affecting Ireland), monetary tightening in China, North Korea’s military attack on South Korea, and FBI raids on several well-known hedge funds for possible insider trading violations.

Although the “wall of worry” has reappeared after a 2 ½ month hiatus, we take comfort in the gains we have experienced for the year and over the past 12 months. As we wrote in last month’s commentary, year-to-date returns from both stocks and bonds have likely exceeded investor expectations coming into this year. This leaves everyone with the question of how to properly position investment portfolios for the future.

Our expectations for bonds in the US are tempered with a concern that present low interest rates and a second round of “quantitative easing” (QE2) will combine to result in upward pressure on bond yields and downward pressure on bond prices and returns. We are concerned that inflation expectations will build as the Federal Reserve continues to pump money into the bond market. How and when they start to remove this additional stimulus and can they do it before inflation starts to escalate is a big question? We may also see foreign investors demand higher interest rates on our Treasury bonds to compensate for additional US government credit risk.

On a positive note, the US economy continues to improve. The latest revision to GDP for the third quarter was a better-than-expected 2.5% and many economist estimates for the fourth quarter of 2010 are heading higher. Key leading economic indicators, like falling unemployment claims, are rebounding after a summer lull. Consumer spending has been ahead of expectations for five straight months. Business and consumer confidence are recovering and recently, hours worked and real wages/salaries have been increasing.

We continue to position investment portfolios based upon the following longer-term themes:

1. The US and Europe will see slower economic growth in the years ahead.

2. Emerging market economies, like Brazil, India and China, will continue to grow more strongly than the rest of the world.

3. Emerging market currencies will have long-term strength against slow growth, debt-burdened developed markets. Thus, we expect the US dollar to continue to weaken over time.

4. It’s important to have some protection against higher inflation rates.

5. Active equity mutual fund managers can add substantial value as they find those companies that will succeed in a world that rewards winners and punishes losers more than ever before.

6. Active bond mutual managers can add value through diligent credit analysis and trading expertise in a world where debt levels and credit risk have increased significantly.

Our guidance to investors and to ourselves: Be prepared for short-term volatility, but use it as opportunity to tactically position for maximizing long-term returns.

PLANNING COMMENTARY

As we referenced on our blog last week, the draft proposal issued by Simpson and Bowles as co-chairmen of the Federal Deficit Commission released earlier in November created quite a stir. The draft is not an official proposal, yet it still came under a great deal of scrutiny particularly regarding the reductions in “entitlement” benefits (primarily Social Security and Medicare). It is important to note that any official proposal must receive 14 votes out of the 18 member commission to be submitted to Congress- something that no one sees as likely. Furthermore, even if a proposal survives the commission’s vote there is no requirement for Congress to address the recommendations. This speaks to the tendency to “cling to the past” and avoid making difficult, often contentious decisions needed to improve our future.

Of course it doesn’t take much courage to attack difficult proposals that include shared sacrifices on the basis that everyone is “entitled” to benefits, low taxes, social programs and pork projects. What does take tremendous courage is to face today’s challenges and be proactive about shaping the future in a positive way. This action inevitably leads to controversial decisions that are difficult to make but absolutely necessary for a positive future.

What we really need is a proposal from the Federal Deficit Commission, un-amended, that Congress must vote up or down. That would take courage on the part of Federal Deficit Commission members, Congress and citizens of this country alike. What all this means to a personal wealth plan is an understanding of the responsibility one has for their own financial future and how these important decisions made (or not) in Washington, Indianapolis and here at home affect that plan. Tax policy, “entitlements,” the state of the domestic and world economy along with many other variables will change as these developments occur. We continue to monitor client wealth plans in context of these developments and keep working to provide proactive recommendations that help our clients face and control their future.

Tick Tock

President Obama agreed to work with Republican leaders earlier this week in dealing with Bush-era tax cuts set to expire at the end of this year. The compromise, which we still await details on, includes a temporary (2 year) extension of current income and capital gain tax rates for all taxpayers. In order to reach this agreement there will be an extension of unemployment benefits and temporary payroll tax reduction (2% cut in Social Security tax collected in 2011) among other sweeteners for Democrats. Some Democrats are fighting the deal and may derail the current version (see http://tinyurl.com/2awtu4w for more details), largely due to the estate tax reductions included in the deal when compared to 2009 estate tax law.
While these are good signs that our leaders are finding their way to compromise so that action can be taken to address key issues, these decisions remind many of “business as usual” as it relates to deficit spending. There was no mention of revenue raisers or spending cuts now or in the future to even partially offset the costs of this compromise (i.e. all new spending). While a weak economy needs to be addressed we must also realize that the clock is ticking as it relates to facing our financial responsibilities as a country.

Kick the Can

Today, the Federal Deficit Commission held their vote (originally scheduled for Wednesday) to determine whether a formal proposal would be released for Congress' consideration.  As many predicted, the commission failed to garner the 14 votes required for this to occur, out of the 18 member panel.  There were 11 votes for the proposal, more than what many predicted the vote would generate.  This is why some are arguing that we may see action from our nations leaders, yet others feel this is the reason Washington was looking for to go back to business as usual.  A member of the panel, Andrew Stern, was quoted as saying "We have changed the issue from whether there even should be a fiscal plan for this country, to what is the best fiscal plan for this country."

The fact that it has taken this long and this much debate for someone to realize our country needs a fiscal plan is precisely why it is easy to believe our leaders will keep playing the political games- "kick the can" if you will, as long as they have the room to do so.  The goal of the game- kick the issue down the road so we don't have to deal with it now.  The good news- the terrain is all uphill from here- the longer we chose to kick the can, the harder it will become to continue doing so.  Hopefully this will spur our leaders into acting to face these challenges sooner rather than later.