June Off To A Bad Start

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Following the worst May for stocks since 1962, June has likewise gotten off to a bad start.  Despite two days of this shortened week finishing on the upside, the week as a whole lost 2.3% as measured by the S&P 500.  The second quarter-to-date is now down by 8.6%, and 2010 is down by 3.7%.  Stock prices reached their 2010 peak in late-April, but the rapid 12% decline from the highs over the last six weeks has put the year into negative territory and has reawakened fear among bullish investors.

This morning’s announcement that Hungary is now included among nations in danger of default supplemented the already palpable fear about much of Southern Europe’s solvency.  That had pre-opening quotes for the U.S. markets leaning to the downside.  There was considerable hope, however, that May employment statistics would confirm expectations that a substantial number of Americans found work last month.  Those expectations were buoyed two days ago as the President and Vice-President both anticipated a strong labor report.  When far fewer new jobs were reported in this morning’s release, pre-opening market prices plummeted.  No rally attempts of any consequence developed, and prices eroded throughout the day to close very near their lows for the day and the week.  It was evident that short-term traders wanted to avoid going home for the weekend with long positions.  Volume continued its negative pattern of rising on the week’s down days and falling when the market advanced.  For the second week in a row the S&P 500 tried unsuccessfully to rise above its 200 day moving average, which many technicians use as a line of demarcation between bullish and bearish market conditions.  Today’s collapse away from that moving average did more technical damage.  Little can be taken from this week to support the bullish case, except to say that stocks became more oversold and overdue for a rally.

Because conditions have not changed appreciably, I repeat my final thoughts from last week’s post, which are even timelier today.

“As the indexes remain severely oversold, the probabilities favor a rally soon.  On the other hand, it is always worrisome when oversold markets don’t rally when they should.  Some of the market’s biggest declines have occurred with conditions already oversold.

With the world financial system in a precarious condition, there is legitimate danger that a major mis-step somewhere in the world could unleash a cascade of stock market selling.”


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Quite A Recovery

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Those most enthusiastic about the economic recovery are highlighting the fact that nominal (not adjusted for inflation) consumer spending has recently risen above its 2008 prior peak. If the present trend continues, real (after inflation) consumer spending should very shortly exceed its prior peak as well.

Consider the reality. The government has handed us an unprecedented amount of money over the past year and a half. That money did not exist in this country before its distribution. It has been borrowed or printed, with the liability passed on to future generations. We spent the money. Therein lies the economic recovery.

Forget the morality question of bailing ourselves out with our grandchildren’s money. Is the plan even likely to succeed? While we have bought ourselves time, there is still no assurance that we won’t experience the systemic collapse that the bailout was designed to remedy. Many banks and some countries are essentially bankrupt. Recent reaction to the attempted rescue from a similar potential economic catastrophe in Southern Europe is far from encouraging. Succeed or not, we are passing along a massive economic dead weight that will drag on the economy for future generations. What a legacy we are leaving!

End Of A Weak Month

 

This week provided stock market investors with quite a ride.  The Dow Jones Industrial Average closed last week just below 10,200.  In this week’s five days the average traversed from several peaks to troughs and back by a total of about 1565 Dow points – down 420 points, up 400, down 275, up 310, down 160, then some smaller bounces to end down 56 points.

This month was the worst May since 1962.  The Dow declined by almost 8%, the S&P 500 by just over 9% and the Nasdaq Composite by a bit over 8%.  The S&P 500, which most investment managers use as a benchmark, is down for the year as a whole by about 1.5%, back to the levels of last October as well as the levels of 1998.

In last week’s post I mentioned fear has reemerged.  A few severe plunges have called into question the almost unanimous opinion of investment professionals that this is merely a correction in an ongoing bull market.

The plunge to the week’s lows on Tuesday morning left the markets severely oversold and more than overdue for a meaningful rally.  As mentioned earlier, markets did bounce aggressively, but traders could not string strong days back to back.  Markets retreated again early today and tried to rally into the close, but selling came in the last half hour to leave the Dow off 122 points at the close.

As the indexes remain severely oversold, the probabilities favor a rally soon.  On the other hand, it is always worrisome when oversold markets don’t rally when they should.  Some of the market’s biggest declines have occurred with conditions already oversold.

With the world financial system in a precarious condition, there is legitimate danger that a major mis-step somewhere in the world could unleash a cascade of stock market selling.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Fear Reemerges

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Stocks ended a bad week with a large bounce off the Friday morning lows.  Despite a 125 point Dow Jones Industrial Average gain for the day, the Dow shed 426 points for the week.  Most major domestic stock market averages dropped between 4% and 5% this week.  The week’s losses put the market indexes into the red for the year to date and returned prices to last October’s levels.  Extending even farther back, most market averages are trading at levels first reached in 1998. At that time we warned of the imminent onset of a long weak stock market cycle that would ultimately eliminate many of the excesses resulting from the extended bull market of the 1980s and 1990s.

As we have indicated in many articles and seminars, we believe that those excesses have not yet been eliminated, and that the long weak cycle very likely has longer to run.  It is in that context that we view the shorter term.

Notwithstanding our longer term macro view, our own investment decision-making process is bottom-up.  On the equity side, we will acquire stocks with growing earnings if we can buy them at prices reflecting historically attractive values.  As clients know, we have found none over the prior two quarters as market prices approached their recent peaks.  In fact, we used the market strength of the past year to sell positions that we did not want to hold over the longer term.  We did, however, add a few stocks on days during the past three weeks when the market plummeted.  This doesn’t constitute a bullish market call.  It simply indicates that a few stocks reached levels at which they represent historically attractive value relative to the broader market.

While our equity investment process is highly formularized, we nonetheless pay close attention to domestic and world economic and market factors for purposes of gauging various asset categories’ risk and reward levels.  The current landscape looks particularly dangerous.  Here are a few of our concerns.  The world financial system is highly fragile.  The collapse of world stock markets shortly after the announcement of the Greek rescue plan indicates serious doubt that the plan, if implemented, will ultimately succeed.  The reality is that many countries throughout the world have no realistic prospect of ever repaying current debts.  Most also have massive additional liabilities because of promised future government transfers.  The banking systems that hold these debts are similarly endangered.

Investor concerns that have surfaced over the past few weeks reflect renewed anxiety over solvency of major financial institutions as well as of sovereign nations.  Recent hesitancy of banks to lend to other banks could be an early sign of a renewal of the credit crunch that precipitated the financial crisis in 2007 and 2008.

Sharp stock market declines over the past three weeks have reintroduced the specter of fear.  Market breadth has deteriorated significantly.  Volume has been much heavier on declining days than on advancing days.  Prices this week cut decisively below the 200-day moving averages of most market indexes.  A great deal of technical damage was done to the markets so far this month.

Even emerging country stock markets have weakened.  At this point the 20 world markets that we regularly monitor are all correcting, some quite drastically.  China, for example, is down by more than 25% from its high of less than a year ago.

Real estate, which represents the primary source of wealth for most the world’s population, remains weak in nearly all areas.  In this country, the huge supply of potential foreclosures will keep pressure on prices for some time to come.  In fact, deflationary price pressures are evident in many areas.  Oil and other commodity prices are weak.  Wal-Mart has recently announced price reductions on 10,000 items.  Even gold has come off its recent highs in the past two weeks.  Deflation is bad for business and bad for common stocks.

Despite all the rescue promises around the world, both the supply and velocity of money have slowed.  This is not good for stocks.

Optimists point to growing corporate earnings and still improving business statistics in most areas.  What is happening in the global securities markets, however, is not about earnings or business growth.  It’s about credit availability and solvency.  The memories of the all-too-recent credit crisis are still fresh, and early signs of its reemergence are sending waves of fear around the world.

We can’t know how this will unfold.  Will even greater bailouts be attempted?  Will the stronger countries be willing to participate?  Will weak countries accept mandated austerity measures?  Will such measures lead to severe economic slowdowns that impact the world economy?  Will lenders continue to fund needed bailouts?  No one knows the answers.  Fear is a rational response and can easily feed on itself.  When major world financial institutions are insolvent but for government largesse, there is real danger.  In such an environment, avoid remaining locked into a fixed asset allocation strategy.  Stay flexible and properly defensive to be able to respond quickly if rescue efforts fall short.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Inflation or Deflation? The Critical Question

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The following article was published in the May 17 issue of Inside Tucson Business.

Last week we had the pleasure of welcoming clients from around the country to our 27th annual investment conference.  Recent violent stock market moves generated a great many questions, but we focused our formal presentation on what we see to be the critical question for investors in the years ahead:  Will we experience inflation or deflation?

It has been well documented by government officials and such eminent investors as Warren Buffett that our financial system was on the brink of a collapse in late-2008.  This was the natural outcome of an uncontrolled debt and derivatives expansion over the prior decade.  As debt grew, we saw bubbles develop in such areas as dot.com companies, the broader stock market at the end of the millennium and housing in the middle years of the last decade.  When each bubble burst, the government’s answer was to reflate the economy to avert a debt collapse.  Banks and other major financial firms including the government’s own Fannie Mae and Freddie Mac were bailed out.  In rescuing everything “too big to fail,” the government has effectively transferred well over a trillion dollars of debt from private balance sheets to the public balance sheet.  Consequently you and I, our grandchildren and probably our grandchildren’s grandchildren are now responsible for the debts created in the various bubbles.

The average person’s common response to the situation is that the U.S. dollar will likely decline and inflation will increase because the government will probably print lots of new money to pay off a big portion of the debt.  While it might happen that way, there are other issues that could change the picture dramatically.

So far the government’s rescue efforts have succeeded in halting the economic decline and have promoted a surge in most economic statistics and corporate profits.  To date those favorable effects have been accomplished without a resurgence of inflation.  The latest reading shows year over year growth in the Consumer Price Index (CPI) of just 2.3%, with Core-CPI (less food and energy) a meager 1.1%, well below the long term inflationary norm of 3%.

Looming in the background, however, are inflationary threats.  Prices of gold, oil and a broader base of commodities have surged with the business recovery.  Worrisome signals are coming from overseas as several emerging market nations like India, Brazil and China are experiencing eruptions of inflation.  History argues persuasively that countries running up excessive debt, as we are doing, ultimately experience increased inflation, even runaway inflation in a few extreme instances.

There are, however, a number of factors leaning strongly against inflation.  Unemployment is severe.  At 9.9% the basic unemployment rate trails only the 1982 rate as the worst since the 1930s, the last time our economy experienced a lengthy deflation.  Far worse than in 1982, however, is the more comprehensive measure of unemployed, underemployed and those who have given up seeking employment, which has risen to 17%.  The measures of those who have now been unemployed for at least 27 weeks and those whose jobs have been permanently eliminated are at rates not seen since the Great Depression. Manufacturing Unit Labor Costs fell by 6.6% over the past year, the worst decline on record going back into the 1940s.  Unemployment rates are expected to remain very high for years.  This will keep heavy pressure on wages and will significantly reduce consumer enthusiasm.

The tremendous overhang of residential real estate will likely keep a lid on any rapid increase in house prices and will discourage new home building.  Current excess manufacturing capacity is discouraging capital expenditures to build more capacity.  By weighing on business growth these conditions all lessen price inflation.

Large budget deficits at the federal level are deflationary, and it is almost certain that we will be living with massive deficits for years to come.  Slowing tax receipts to state and local governments have put severe pressure on their budgets.  Of necessity, they will be spending less, which will depress business growth.

We pulled ourselves back from the brink of financial crisis, not by solving the problems that led to the crisis, but by papering them over with money pledged from future generations.  The European Union and the International Monetary Fund have just done the same to buy time for Greece and other Southern European debtor countries.  Such rescue efforts will succeed only if investors believe in their success.  The United States relies on continuing massive loans from Japan, China and the OPEC countries, not all of which are political allies.  If they should, for financial or political reasons, step away from such lending, our interest rates could skyrocket, creating financial chaos in a debt-laden society.

History argues that inflation is more likely than deflation.  Federal Reserve Chairman Ben Bernanke has vowed that we will not have deflation.  Current economic conditions, however, have pushed us very close to price deflation, and if lender confidence is lost, a debt collapse could lead to deflation, as it did in the 1930s.

The difficulty for investors is that what succeeds in an inflationary environment differs dramatically from what works best during deflation.  During inflation, all fixed income securities do poorly except for very short-term cash equivalents and inflation-indexed bonds.  While stocks may do well during moderate inflation, they typically do poorly if inflation becomes severe.

Business conditions are generally very weak during deflation.  Stocks do poorly.  Government bonds and the very best quality corporate and municipal bonds would normally do well, but most bonds would suffer to the extent that their creditworthiness would be called into question in a weak economic environment.

While one might safely bet on inflation over a 20-year time frame, deflation in the near term could derail an investor’s long term plans.  Severe deflation stemming from a debt collapse could do serious damage to asset values.  We urge investors to maintain a flexible asset allocation policy and to evaluate carefully how much risk exposure to assume.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Conference Week

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I will not have time to write a post this week. Out of town clients will be in town for our annual conference on Friday, May 7. Readers who would still like to register can call Steve at (520)577-5559.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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QUARTERLY COMMENTARYFirst Quarter 2010

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The Great Gamble

Fool me once; shame on you.  Fool me twice; shame on me.  That old aphorism certainly applied to the two giant common stock rallies over the past dozen years or so.  In the late 1990s tremendous advances in internet technology spurred a fantastic surge in common stock prices to levels totally disconnected from the underlying valuation fundamentals.  The investing public came to accept that there was no need to be bound to traditional valuation norms; this time was different.  Unfortunately, the bursting of the dot.com bubble precipitated a stock market collapse.  Almost all stocks declined, with the S & P 500 falling by about 50% from its peak in 2000.

Monetary authorities decided that economic and market conditions were so fragile that ultra-cheap money was called for.  The Federal Reserve Board dropped short interest rates to multi-decade lows, and asset prices surged.  Stocks rallied for years.  Real estate prices exploded upward at rates unsurpassed in over a century. A few voices warned of developing bubbles, but they were largely dismissed. Stock and real estate investors were making money.  The equity bear market from 2000 to 2003 was in the rear view mirror.  Concerns about extreme valuations were again ignored.  After all, The Maestro Alan Greenspan and other wise men were dictating monetary policy.  This time was different.

Unfortunately, the bubbles again burst.  Real estate values plummeted.  Stock prices were cut at least in half for the second time in a decade.  From late 2008 to early 2009 there were real fears that our financial system was so structurally damaged that it might freeze up and become non-functional.  Monetary authorities and legislators were convinced that the only way to escape the next Great Depression was to pump unprecedented amounts of money into a rescue effort.  They bailed out banks, insurance companies and automobile manufacturers.  They gave money directly to buyers of homes, cars and appliances.

The Fed acknowledged buying over $1.2 trillion (with a “T”) of mortgage-backed securities that otherwise had no market.  The government abandoned even the appearance of free markets by openly buying shares in major financial firms.  They are suspected of having also promoted bullish sentiment more covertly by strategically buying stocks when natural support was absent.  That the money to do these beneficent things didn’t exist was apparently of little concern.  We would simply write an IOU to future generations and hope the bailout worked.

To date that tremendous infusion of government money has slowed the collapse of real estate prices, encouraged reluctant home and car buyers and has turned most business trend statistics upward.  While most economic analysts are encouraged that the depressed mood of the public has been elevated, few are yet confident that the improvement in economic statistics is sustainable without the artificial stimulus of government support.  Unless the government abandons any semblance of maintaining a stable currency, they will soon have to halt the infusion of rescue money and begin to withdraw funds.  A critical question remains as to whether or not the economy has sufficient strength to continue its growth without government stimulus.

Questions about the sustainability of economic strength have certainly not slowed the advance of equity prices.  The stock market rally off the March 2009 lows has been the strongest such bounce in more than half a century.  While valuation measures of common stocks have not reached heights observed at the market tops in 2000 and 2007, they are virtually at all time highs but for those two bubble peaks.  It is curious that we hear most analysts characterizing today’s valuations as reasonable, even moderate.  That is only true if the frame of reference is limited to recent years.  Inasmuch as the most recent decade produced two of the worst bear markets in U.S. history and ended with a negative total return, it is absurd to consider the then prevailing unprecedented valuation levels to be relevant standards.

We have never been believers in the traditional “buy and hold” approach to investments.  History has demonstrated clearly that long-weak cycles unfold periodically, which can produce negative stock market returns for a decade or more.  We began to issue warnings against heavy stock ownership in the late 1990s, because investors were paying excessive prices for stocks relative to such value measures as earnings, dividends, book value, sales and cash flow.  While not good short-term timing tools, valuations are excellent long-term gauges of stock market potential.  Toward the end of the millennium, as investors were clearly caught up in the wave of dot.com enthusiasm, they ignored the more prosaic lessons of valuation history.  Again in 2007, investors’ confidence in historically low interest rates and the wisdom of the Fed overwhelmed any concern about excessive valuations.

In addition to our warnings about extended valuations, we argued in the late 1990s that levels of debt and the explosion of derivative use had reached a point that seriously threatened the economy and the investment markets.  That caution was well founded, and we protected our clients from losses in every year but 2008.  Even then, in one of the worst stock market years in U.S. history, we limited client losses to a minuscule 0.9% on average.  We have accurately navigated a dangerous investment environment over the past decade.

That brings us to today.  For the third time in a decade stocks are surging, and investment analysts are almost unanimous in their belief that prices are inevitably heading higher.  We remain cautious for essentially the same reasons that have concerned us in the most recent two stock market surges.  Debt and derivative levels remain no less worrisome and in some cases are even more severe.  As explained earlier, stock valuations, while not as extreme as at the prior two market peaks, are near dangerous historic highs but for the bubble decade.  Compounding these problems is the critical uncertainty about whether the economy can thrive absent continued government stimulus and whether the remnants of the economic collapse will lead to a lasting profound change of social mood.  Therein lies the great gamble for stocks.

The current rescue plan has been crafted by those same monetary authorities and legislators who failed to see the crisis coming and who downplayed its potential when the first signs were evident.  Why should we have confidence that government will get it right this time?

Fixed income securities always offer an alternative to equity ownership.  There are, however, no easy answers in that area either.  The Federal Reserve has reduced risk-free short-term interest rates essentially to zero, deliberately forcing investors to accept risk to obtain any return.  The Fed has succeeded in promoting risk taking over the past year, and the greatest rewards have accrued to those willing to accept the greatest risks.  Many junk bonds defaulted when the economy imploded two years ago.  Those that survived, however, returned over 60% over the past twelve months.  The worst credits among junk bonds returned double that amount, a very productive speculation.

Interest rate direction in the year ahead is highly uncertain.  It will largely depend upon whether inflation or deflation prevails.  There are strong forces pulling in both directions.  I will be addressing that subject in much greater detail at our May 7 conference.  I hope all of our clients will register and join us for that event.

While we could make a case for either rising or falling interest rates, there is far more room above current rates than below.  With either direction possible, there is considerably more danger to portfolio values should rates rise than there is reward should they fall.

Bond investors have been protected over the past year by the government’s implied guaranty of nearly everybody.  That support is almost certainly nearing an end.  Before the government rescue programs began, corporate bond holders became increasingly worried about the potential for default, even among supposedly high quality credits.  That potential will return if the economy fails to grow in the absence of government support.

Municipal finances have deteriorated badly despite a large dose of rescue money.  Just this month Moody’s assigned a negative outlook to the creditworthiness of all local U.S. governments.  This is the first time in over 100 years that Moody’s has issued such a blanket ratings warning.

Investors can gamble for yield on corporates or munis, but a single default could cost more than the yield on an entire portfolio.  Investors can gamble on interest rate direction, but if rates rise, bonds could easily produce negative returns, as long U.S. Treasuries did this past year.  If the flood of promised new money in the various rescue packages should lead to rampant inflation, the return on all but the shortest bonds could be negative.  If investors choose not to gamble, they barely get paid, but they retain flexibility to make new choices as conditions change.  We are in an unstable condition that will certainly change, potentially quite dramatically.

On the equity side, there is no way to know how high the current rally may rise.  That was likewise the case before the market peaks in 2000 and 2007.  Recognizing the debt and derivative dangers on top of excessive valuations, we chose in the prior instances to remain in a very conservative stance and await more attractive conditions.  Ours proved to be the correct decision in each instance.  We see largely the same situation today.  While we cannot guaranty that we will again be right by paying more attention to fundamentals than market momentum, we strongly believe that patience will again be rewarded.  That view is buttressed by the fact that our equity selection process, which has selected stocks with far better performance records than the overall market for a quarter of a century, is finding no attractive stocks to buy in the current environment.

There are times when the wisest course is not to gamble but rather to protect assets and keep them available for upcoming opportunities.  We did exactly that before the last two major stock market peaks. That restraint enabled our portfolios to outperform the S & P 500 through the new century’s first decade by more than 60 percentage points.  We strongly believe we remain in an environment in which similar conservative action will protect portfolio assets and will eventually maximize portfolio returns.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Are There More Cockroaches?

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We first introduced the unpleasant little creatures in a November post about the threatened default on securities issued by Dubai. We suggested that according to the cockroach theory, if you can see one Dubai, there were likely others eventually coming to light. Sure enough, in just a few months fears about potential defaults in the P I I G S (Portugal, Italy, Ireland, Greece and Spain) surfaced.

Now comes the U.S. Government’s suit against Goldman Sachs, alleging fraud. Again applying the ubiquitous cockroach theory, we forecast that Goldman will be just the tip of the iceberg. Public opinion is changing and growing darker. The economy is improving with free money from the government, but the public is hurt and angry. And that anger crosses the political spectrum. The Tea Party movement appears to be expanding and becoming more strident. Across the aisle, anger is growing at the bonuses and other payouts rewarding senior executives of companies whose survival was endangered but for government rescue just a year or so ago.

While ostensibly good news, Tuesday’s Bloomberg headline “Home Sales in the Hamptons More Than Double; Prices Up 51%,” will probably add to the public’s ire. For those not familiar with New York City area geography, the Hamptons are a Long Island residential playground for the rich. Who is bidding up and purchasing these homes? In all likelihood, it’s the massively compensated Wall Street executives whose hands were all over the toxic investments that were the most immediate cause of the recent market and economic collapse.

It’s a longstanding practice for wounded investors and other citizens to seek retribution. After history’s great financial calamities, those hurt seek scapegoats. Placing blame is psychologically far more satisfying than facing up to one’s personal failure to recognize the danger preceding the prior collapse.

It is probable that if perceived economic disparities grow even greater, public rage will swell. Unemployment, further foreclosures and the eventual end to extended unemployment benefits will foment further unrest. Politicians of all persuasions will demand for their constituents a pound of flesh from any who appear to have benefitted unfairly. The process is likely to become increasingly contentious and unpleasant.

For those interested in delving deeper into the patterns of shifting social mood, look at Robert Prechter’s views on what he calls Socionomics. Prechter, founder of Elliott Wave International, is an excellent technical analyst with traditional and non-traditional approaches to his analytical work. Agree or disagree, Prechter is well worth reading.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Are Bond Investors Getting It Right?

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The following article was published in the April 16 issue of Inside Tucson Business.

Investors have a long history of betting that current securities price trends will continue into the indefinite future. The longer a prior trend has been in place, the stronger the belief.

We may acknowledge that securities prices are cyclical, but our behavior proves we are momentum players at heart. While common stocks comprise the glamour segment of the securities universe, for a great many individual and institutional investors, bond returns determine the success or failure of their investment portfolios.

Over the past year mutual fund investors have flocked to bond funds instead of stocks. After a decade in which stocks lost money and annual bond returns averaged high single digits, investors followed the momentum and wagered that bonds would continue their dominance. The strength of that conviction was amplified by the bond markets’ unprecedented returns for almost three decades. From yield peaks for U.S. Treasury securities above 15% in 1981, rates plummeted to just above 2% in December 2008 – the strongest long-term bond market environment in U.S. history.

Treasury rates have nearly doubled from their lows of sixteen months ago, but the resulting negative government bond performance has been largely concealed by rapidly declining rates on most corporate and municipal bonds. Although Treasury bonds have experienced negative returns over the past year, higher risk bonds have provided very strong returns, reflecting investors’ willingness to accept greater risk.

Junk bonds, for example, returned over 60% for the twelve months through this year’s first quarter. The junkiest of the junk, CCC bonds (one step above default) produced an astounding total return of more than 125% over the same twelve months.

It’s easy to understand why enthusiasm for bonds has grown. There is a danger, however, in extrapolating from past returns and making a linear projection into the future. Obviously with long U.S. Treasury bond rates hovering above and below 4%, the current potential for positive multi-year returns pales in comparison with those existent in the early-1980s and in all but a few of the years since then.

Investors will earn more than the coupon rate only if rates decline from current levels. While that possibility certainly exists if economic conditions falter, there is clearly much more room above current rates than below.

At today’s levels, the potential danger to investors’ total returns is greater should rates rise than the potential benefit should rates decline.

The persuasive power of nearly three decades of consistently strong returns helps to explain today’s enthusiasm for bond ownership. Few of today’s investors, however, remember well the bond market environment that preceded these latest three decades. It was essentially the mirror image of what we have just experienced. Short-term counter-moves notwithstanding, interest rates rose from 1941 to 1981.

A broadly diversified portfolio of investment grade corporate and long and intermediate government bonds would have yielded barely 3% per year on average. Unmanaged 91-day Treasury Bills yielded 3.6% per year. Prudent cash management would certainly have added at least a fraction to that return.

In other words, for more than four consecutive decades, essentially risk-free cash outperformed virtually all investment grade bond portfolios by about one percent per year. Virtually no fixed income security kept pace with the 4.7% rate of inflation over that 41-year period.

This is not meant to be an argument against bond ownership, but rather an argument against dogmatic asset allocation that mandates bond ownership. Just as the last three decades highlighted the attractiveness of bonds in a falling interest rate environment, the preceding four decades demonstrated their unproductiveness in a rising rate environment.

The critical question then is whether interest rates are likely to rise or fall in the years ahead.

Most analysts expect higher rates in response to unprecedented government stimulus. That could, of course, unfold. On the other hand, the stimulus has pushed debt levels far into unparalleled territory. Excessive debt levels can lead to debt destruction, which can lead to deflation.

There are numerous economic, monetary and policy conditions tugging in opposite directions – some toward inflation, some toward deflation. In a subsequent article we will evaluate that tug of war in greater detail. With interest rate direction highly uncertain, investors will be better served by a flexible asset allocation policy than by one permanently committed to any asset class that could perform poorly for a decade or more.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Voting Machine or Weighing Machine

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There is an old saying in the investment industry that in the short run the stock market is a voting machine but in the long run it’s a weighing machine.  Essentially this means that investor sentiment determines price movements in the near term but that ultimately stocks revert to their long term valuation means.  Because of excess enthusiasm or excess caution, investors’ votes periodically push prices well above or well below such time-tested measures of value as price-to-earnings (P/E), price-to-dividends (P/D) and price-to-book value (P/B).

According to Ned Davis Research, Inc. (NDR), an outstanding data collection and analysis firm, those S&P 500 valuation measures at the end of March were: P/E 19.7; P/D 53.4 and P/B 2.5.  Standing alone those numbers mean little except to analysts who are very familiar with their normal ranges.  Let me provide some context.  NDR measured those valuation levels at the last six major U.S. stock market peaks and the last six major market troughs.  At the peaks of 1937, 1966, 1968, 1972, 1987 and 2000, the average valuation ratios were: P/E 20.9; P/D 43.4 and P/B 2.6.  On balance our current ratios are quite similar to those at the major stock market tops of the past three-quarters of a century.  Contrast these ratios with those on average at the lows of 1932, 1942, 1949, 1974, 1978 and 1982: P/E 7.5; P/D 14.1 and P/B 0.9.

Valuation measures are notoriously inadequate short-term guides, but at extreme levels they have never failed to offer accurate guidance as to whether the next major stock market move should be up or down.  Clearly what investors in the aggregate are currently paying for a dollar of earnings, dividends and book value is about what they have paid at history’s major market tops.  They are paying a few times more than what they have paid at history’s greatest buying opportunities.  The weighing machine is warning that stocks are very expensive.  The message would be the same if we expanded the study to include such other valuation measures as price-to-sales or price-to-cash flow.

History has also taught us there is no clear limit to human optimism or pessimism, the emotions that in the past have led investors to ignore historical valuation yardsticks.  The unprecedented flow of government rescue money has obviously brought a halt to the decline in most business statistics (housing the most notable exception).  In fact, coming off the seriously depressed levels of a year ago, most readings of business conditions are showing remarkable growth.  Dramatic growth rates notwithstanding, the absolute levels of most business statistics are far below normally healthy readings.

The voting machine is still registering a highly optimistic verdict, and stock prices can proceed higher as long as positive sentiment continues to grow.  When valuations are stretched, however, sentiment can turn quickly. Risk levels remain high.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Who Is To Suffer From Our Debt Excesses?

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In the late 1990s we announced our concern about the explosive growth of debt in the United States.  Because of the extreme leverage inherent in many forms of derivatives, even the reported nominal debt levels of the past dozen years were significantly understated. At our investment seminars and conferences we repeatedly featured graphs and tables profiling the growing debt crisis.  Especially when stock and real estate prices were rising, our report readers and attendees at our public forums seemed to shrug off such concerns as unnecessarily alarmist.  When we voiced our fears that the ultimate result of such unfettered leverage would very possibly be defaults and the collapse of various financial structures, we were occasionally dismissed as “gloom and doomers.”

The events of the past two years have at least focused the world’s attention on the destructive potential of excessive debt levels.  The greatest government rescue attempt in history has, however, restored calm to world financial markets and seems to have moved worry to the back burner.

U. S. financial authorities had to infuse massive amounts of capital into our banking system to prevent its collapse.  They then had to give the largest banks free money so they could invest it in government guaranteed bonds to “earn” enough to pay back the original rescue dollars.

Then came Dubai in November of last year, supposedly one of the world’s wealthiest municipalities.  Suddenly they were in danger of default.  Reports began to circulate that the states of California and Illinois could not pay their bills.  Enter the P I I G S: Portugal, Italy, Ireland, Greece and Spain.  The form of the pending Greek rescue has been hotly debated for many weeks.  Tuesday Ireland outlined its plan to take the first block of bad loans off the books of its banks at a 47% discount to their face value.  Far more bad loans await that rescue process.  At least $43 billion must soon be added to keep those banks in conformity with required capital ratios.

At the time of the Dubai revelation, before these later sovereign concerns hit the press, we hypothesized under the well known cockroach theory that if you can see one Dubai, you can assume that there are many more in hiding.  Unfortunately more and more are emerging.

This week the financial press highlighted the point that the unfunded liability of the fifty state pension funds is far larger than has been previously estimated.  If the typical 8% assumption for annual returns– rarely achieved in the past decade–is reduced, the unfunded liability will jump substantially.

It is important to recognize that financial institutions and the markets have been rescued with money that does not exist.  Unless others remain willing to continue lending us enough money to cover our ever expanding deficits, the only way to meet these monumental obligations is either to tax future generations or to monetize the debt by printing our way out of the problem.  In either case, someone gets hurt.

The massive new debt stemming from the rescue effort will put a huge debt service burden on future generations.  While our generation created these financial problems, we have attempted to solve them with money from our children’s children and beyond.  Because of our profligate ways, they will be saddled with a debt service burden that will substantially inhibit their societal progress.  Future generations obviously have no lobby, so we hear no outrage.  When the ultimate reality hits, resentment and anger will be showered upon us who dug the hole into which we forced them.

Since we might well choose not to pass along that legacy, we may instead choose a more politically expedient alternative.  We could simply print enough money to pay our debts.  That course of action has obvious moral consequences as well.  We are able to run deficits only to the extent that investors are willing to lend us enough to bridge that gap between what we earn and what we spend.  Increasingly more of the lending is coming from outside our national boundaries.  The largest of those offshore investors are now Japan and China.  Logically they are willing to make such loans because they expect to receive the promised rate of interest, then be repaid the principal in dollars worth roughly what they were worth when the loan was made.

Should we take the politically easier route of satisfying future generations of Americans at the expense of foreign lenders by printing our way out of the debt crisis, we would effectively be stealing from those who loaned money to us based on the assumption that we would honor those debts.  Are we willing to abandon our moral compass to that degree?

There is no easy way out of this dilemma.  Perhaps we should have addressed the moral questions when we were blithely spending more than we were producing or when we permitted our government representatives to promise future generations’ money in an attempt to paper over our financial sins.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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