Two Front Relief Rally

Acting with unity, purpose and decisiveness, European leaders announced a plan to address their debt problems.  This positive news came at the same time as the announcement that U.S. 3^rd quarter GDP grew at a 2.5% annualized rate.  Clearly, GDP growth at this level dispels the fear that we are in recession or quickly heading for recession. 

So what type of deal did the European leaders strike?

·         Bank Recapitalization to the tune of about $106 billion.  European banks have until June 2012 to raise their Tier 1 capital ratio to 9%.

·         Creditors will take a 50% haircut on Greek debt.  The restructured debt will be guaranteed by a $130 billion combined European Union / International Monetary Fund / Member State bailout fund.

·         The European Financial Stability Fund will be leveraged 4 to 5 times to support approximately $1 trillion in debt. 

Markets surged on Thursday with the Dow Industrials rising 339 points, the S&P 500 index gaining 42 points and the NASDAQ increasing 88 points.  Since September 30, we have seen a 13.5% rise in the S&P 500 index.  We wouldn’t be surprised to see a pullback from current levels over the near term, as is common with rapid advances in the market.  But, the good news on two fronts, Europe and the U.S. economy, removes a dark cloud that had been hanging over the markets. 

Rate Stubbornness

Despite continued Fed policy to lower consumer borrowing costs and spur the economy, mortgage rates have remained at levels higher than economic officials would like.  In fact, since the beginning of October the national average 30 year mortgage rate has climbed roughly 0.5% and Evansville rates generally followed this trend.  For example, banks were offering between 3.75% and 3.875% for 30-year mortgages just two weeks ago- as of today the same figures were between 4.25% and 4.375%.

 Rates are persistently high when compared to similar maturity treasury instruments which historically have rates 0.5% lower than mortgages.  This spread is over 1% now.  When consumers are evaluating whether they should refinance a home mortgage or buy a larger property (to capitalize on weak real estate market pricing) it’s important to gain historical perspective to inform those decisions. 

September 2011 Market and Planning Update

Take calculated risks. That is quite different from being rash.”

General George S. Patton (American General in World War I and World War II)

We selected the quote above for this month’s commentary because in our economy, in the investment markets and in planning for our clients’ financial future we are continually faced with various types of risk.  Understanding these risks, pointing them out and then developing strategies to try to mitigate them is part of the value we deliver.   

PLANNING COMMENTARY

There are risks inherent in retiring, saving for college education, allocating funds toward a major purchase or any other significant financial decision in life.  For example, making the decision to retire at a given point in your career is filled with risks—primarily whether you have enough funds set aside to afford the retirement lifestyle you want.  This risk could cause other risks to emerge as well.  For example, if you retire too early and run out of money there is a risk that you may not be able to return to the workforce and earn your same pre-retirement income.  Examples of other retirement planning risks include the likelihood of healthcare cost increases and changes to income tax rates. 

Making financial decisions blindly could be considered rash, particularly when you consider how important they are to your future.  A deliberate, repeatable process that aids in your decision making process and ensures the quality of your decisions is a key tool used to reduce or eliminate the certain risks.  Additionally, it is important to recognize that there are generally two types of risk one must deal with in their financial plans for the future.  First, there are risks created by outside forces that must be acknowledged yet cannot be planned for or controlled.  The second type of risk can be reduced or eliminated by a thoughtful process (and the appropriate calculations) we describe above.  Control this second type of risk and you will be much closer to reaching your financial goals. 

One issue that continues to present itself is that of debt management during a historically low interest rate environment.  While interest rates are low it is tempting to maximize debt and increase investment portfolio holdings assuming they will outperform the interest rate paid on the debt.  There are risks with this strategy as well as risks created by the opposite approach—paying down debt with investment holdings.  This issue is highly sensitive to your financial plan particulars, goals, circumstances and risk capacity. 

INVESTMENT COMMENTARY

The past three months have certainly been very rough on investors.  It was a quarter marked by the U.S. debt limit debate, a downgrade to the U.S. debt rating, the sounding of double-dip recession alarms, and concerns about if and when Europe will come together to resolve their debt crisis.  As is typical in uncertain times, bonds have been a safe-haven and have helped to reduce volatility in diversified portfolios.  This relationship can be seen clearly in the chart below.
 

Financial Market Indices as of September 30	September 2011	Last 3 Months	Year to Date	Last 12 Months
S&P 500 TR (US Stocks)	-7.0%	-13.9%	-8.7%	1.1%
MSCI Developed EAFE (foreign stocks)	-9.5%	-19.0%	-14.6%	-8.9%
MSCI Emerging Mkt. Equities (emerging country stocks)	-14.8%	-23.2%	-23.5%	-18.0%
Barclays Capital Aggregate Bond – Intermediate Term	0.0%	2.3%	5.0%	4.2%
Barclays Capital Municipal Bond Index	1.0%	3.8%	8.4%	3.9%

Uncertainty Abounds – Opportunities Exist:

Risks to the US and global economy have risen and although the outlook is uncertain, it is important to take a step back from today’s headlines to make rational judgments and calculated decisions about how to balance out a long-term investment portfolio.  Below are some of our thoughts on today’s risks and the opportunities we see:

The US economy has slowed, but has yet to reverse course and slide back into recession.  Consumer confidence polls are down, but the hard data indicates that the business cycle is still moving forward.  Compared to one year ago, retail sales and car purchases are stronger. Last week’s Chicago Purchasing Manager Index showed an uptick and we also saw the release of much better-than-expected durable goods orders and jobless claims data.

Recent fiscal and monetary policy mistakes have scared everyone.  The political dysfunction exhibited from Washington in July with the budget negotiations and debt ceiling vote is one example.  Secondly, European leaders have failed to give any confidence to the markets that they have the will and fortitude to bring their debt crisis under control.  And thirdly, when the U.S. Federal Reserve announced in August that they planned to keep interest rates low until 2013, it sent a very negative signal to investors.  We are keeping a close eye on future policy decisions to see if politicians start to get it right.

We think European leaders well-remember the 2008 Lehman Brothers disorderly bankruptcy and will not allow that situation to be repeated with Greece.  Ultimately, it is in the best interest of all of Europe to help Greece with its debt and economic problems.  Last week the German parliament approved the expansion of the European Financial Stability Facility which should be seen as a positive step forward.

While economic uncertainty is hitting an extreme point, valuation levels for many investments are hitting extremes too.  The S&P 500 index is trading at 11x future earnings while the 10 year US Treasury is only yielding 1.8%.  The last time that the S&P 500 traded at such a low multiple to earnings was over 20 years ago and the 10 year US Treasury Note was yielding 8%, not roughly 2%.

Another measure we like to look at is the earnings yield on stocks (earnings divided by price) relative to bond interest rates.  When comparing today’s 9% earnings yield on the S&P 500 index to the 1.8% yield on 10 year Treasuries, U.S. stocks are at their cheapest level in the past 50 years.   We recognize that we cannot predict the short-term direction of stock prices, but we are confident that the wide gap between price and value will eventually close resulting in stronger returns.  So in August, we used stock price weakness as an opportunity to tactically shift an additional 5% of our client portfolios into global growth companies and emerging market stocks.  Many of the fund managers we invest with are confident in the values of the businesses they own, the free cash flow they generate and the ability the companies have to increase dividends paid to shareholders.

We continue to believe that a bubble is developing in the value of U.S. Treasury bonds.  Thus, we have gradually shortened the average maturity of our fixed income investments this year.  Given the recent decline in Treasury interest rates, we have admittedly been early, but believe in the long run this is the right move.  If interest rates rise just 1%, holders of 10 year Treasuries will see an 8% decline in the value of their “safe” investment.  Buyers of 30 year Treasuries would see a decline of about 16% in the value of their holdings with a 1% increase in interest rates.

In this sort of environment, we believe it is more important than ever to focus on your long-term investment objectives, and stick with the basic principles of asset allocation and broad portfolio diversification.  It is also important to consistently rebalance portfolios to control risk and take advantage of opportunities from declining asset classes.

For more than a decade now, we have invested money with Chris Davis, who is Co-Manager of the Selected American Shares mutual fund.  As a third generation money manager, we find that Chris often has insightful comments about the markets and investor behavior.  We share below an excerpt from his recently released semi-annual report:

“Investor returns come from both the performance of the underlying asset they own as well as the timing of their decision to buy or sell that asset.  In most cases, this timing decision is costly because of the persistent tendency of investors to want to do today what they wish they had done yesterday.  As a result, investors buy what has already gone up and lose interest in what has already gone down.  The fundamental laws of economics and the basic tenets of common sense are timeless, we hope to make an indirect contribution to returns by reminding our shareholders to stay the course when times are uncertain and resist the tendency to get caught up in the fads and manias being pushed by promoters and pundits.” 

EMPLOYEE ANNOUNCEMENTS

September was a busy month for gaining knowledge at our firm.  We had five employees out of town at different times during the month to attend different industry-related conferences.   

Terry Prather and Perry Moore attended the Notre Dame Tax and Estate Planning Institute on September 15^th and 16^th to listen to the industries’ leading experts discuss income and estate tax law changes, strategies for managing the tax impact on financial plans and new developments in various planning areas. 

Taylor Payne attended the Black Diamond Users Conference in Boston, MA on September 12^th and 13^th.   Black Diamond is a leader in web-based client portfolio performance reporting and is now backed by the financial resources of their new parent, Advent Inc.  The conference discussed their strategy for future reporting enhancements, and provided training for maximizing their current platform.

Chad Sander and Bethany Muensterman attended the Tamarac Users Conference in Seattle, WA on September 15^th and 16^th.   Tamarac Inc. is the industry leading provider of sophisticated portfolio management, asset allocation and trading software for independent investment management firms.  Their annual conference provides hands-on training, information on future technology enhancements, and an opportunity to provide feedback to their product design team. 

Terry Prather also attended Ed Slott’s exclusive two day IRA Workshop in Phoenix, AZ on September 23^rd and 24^th.  This was an extensive program for advisors to dive deep into the complexities of planning with retirement accounts.  IRAs present unique planning opportunities for both retirement and legacy purposes.  We believe continuing education in the IRA area is very important to our wealth planning division, especially as tax laws continue to change and new tax court rulings develop.