Rumors And Politics Move Markets

As we approach year-end, equity markets are at the mercy of the rumor mill and the comings and goings of politicians.  Throughout the entire day, financial television speculates on the outcome of the political tug-of-war that is the fiscal cliff.  Clearly, nobody–not even the main political actors–knows how this will unfold. So I won’t weigh in with needless speculation.  The resolution will, however, have significant short-term effects on market prices one way or the other.

Far more important will be the long-term effects.  It’s essential to recognize that there are no easy solutions and that all alternatives bear a considerable amount of pain.  As has become increasingly clear, the U.S. has rung up greater debt and promises than it will ever be able to meet in dollars worth anything resembling the value of the dollar today.  The rating agencies know that better than anyone else.  Should the ultimate fiscal cliff agreement fail to reduce deficits and debt significantly, undoubtedly the ratings on U.S. federal debt will again be reduced.  While the first debt downgrade had little negative effect in the marketplace, further downgrades will eventually make it more difficult for the U.S. to float and service its debt.

Should politicians surprise us all by crafting a deal that makes meaningful dents in projected deficits, almost certainly large segments of the U.S. population will end up paying substantially more in taxes.  Additionally, large amounts of government spending will almost inevitably be cut back.  The combination of those two factors will inhibit Gross Domestic Product growth for years.

By spending more than we have produced for three decades, we have painted ourselves into a financial corner from which there is no comfortable escape.  The open question is what path we will take and what consequences that will entail.

When the chosen path becomes clearer, there will be a plethora of subjects to address.  I will attempt to identify and clarify those with the greatest implications for investors.

Until next year, I wish you all a very Happy New Year.

 

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Insights From A Market Veteran

Over a long career, I’ve developed a short list of authors, analysts and commentators whose views are consistently worthy of attention.  Head of floor trading for UBS, Arthur Cashin, is one of those individuals.  While his work on a day-to-day basis is oriented to short-term trading, Art is one of the most reliable repositories of market history and investor trading patterns.  He offers valuable insights.

CNBC commentator Bob Pisani interviewed Art this week and asked about his expectations for the year ahead.  For those who missed the interview, I’ll relate the major thoughts offered.

Regardless of how the fiscal cliff is resolved, taxes will be increased and government spending will be reduced.  This austerity will provide “a bit of a pinch.”

A strong believer in reversion to the mean, Art expects record corporate profit margins to begin to shrink.

Pointing to past episodes in which bondholders tried to anticipate and frontrun Fed actions, Art cautions that when the Fed wants to unwind its balance sheet–currently so big it “could sink a battleship,”–bondholders may well try to step in front of the Fed.  That becomes all the more likely now that the Fed has provided unemployment and inflation targets that will guide its actions.  The result could well be that the Fed will realize far less than optimal returns when it begins its balance sheet unwinding process.

Staying on the theme of central banks, Art marveled at the success over the past year the European Central Bank has had in preventing runs on many European banks.  He worries, however, that such runs could yet appear, should depositor faith disappear.  He anticipates that it may be a delicate balance for the ECB to maintain the necessary confidence.

On the positive side, Art observes some signs of China’s slowdown bottoming.  At the same time, however, he recognizes that there is widespread doubt about the accuracy of the Chinese government’s official numbers.

Incoming Japanese Prime Minister Shinzo Abe has verbally pushed hard for the Bank of Japan to assume a pro-inflation stance.  Indications are that the markets may experience aggressive yen weakening.  With that tendency evident in much of the world, we could well experience currency wars in 2013.

Art has long cast doubt on the wisdom of unfettered Fed money printing, and has cautioned investors not to have blind faith in central bankers’ ability to succeed in overcoming deteriorating fundamentals.  On a short-term basis, he recognizes the upward seasonal bias as year-end approaches.  At the same time, so strong are the political crosscurrents, that he expects rumors or actual successes or failures relative to fiscal cliff negotiations to be the most important market-moving factors in the days ahead.

From all of us at Mission, I wish our readers a Merry Christmas and a new year filled with good health, enjoyment and great satisfaction in all that you do.  Each of us should consider how our behavior affects the wellbeing and happiness of those with whom we interact.

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Worst Central Banker Ever

Not unexpectedly, the Fed committed to much greater amounts of new money printing at Wednesday’s meeting.  In 2013, the Fed will change its orientation from the “sterilized” Operation Twist, in which short maturity debt has been sold to offset the amount of long maturity debt purchased.  Instead, the Fed will resort to outright purchases, which serve to “monetize” the debt–a euphemism for money printing.  Given its proposed acquisition schedule, the Fed will purchase 52% of the marketable U.S. treasury securities to fund 2013’s anticipated deficit.  If those transactions are not unwound, more than half the deficit will be neutralized by newly printed money.

As has been the case with prior announcements of quantitative easing (QE), the stock market bounced.  The immediate reaction was an 80-point pop in the Dow.  As has also become the case, however, the longevity of the rallies has progressively diminished.  All of the gains were given up before the close of Wednesday’s session, with most major equity averages closing essentially unchanged.

Not likely coincidentally, but for uncertain reasons, The Wall Street Journal ran a front-page article titled, “Inside the Risky Bets of Central Banks,” on Wednesday morning preceding the Fed’s announcement.  Author Jon Hilsenrath has recently been considered the most prominent journalistic mouthpiece of the Fed.  Many suspect that he is the anointed leaker of upcoming Fed action trial balloons.  It seems all the more confusing that Hilsenrath would pen an article calling into question the propriety of Fed actions when the Reserve Board was about to announce another stimulus action.  Hilsenrath characterized central bank actions as a “high-stakes experiment.”

Attributing criticism of central bank actions to the Bank for International Settlements (BIS), the Journal article expressed concerns with the “massive scale” of monetary stimulus.  “Another worry: Boosting stock markets and easing credit costs allow rational governments to postpone difficult political decisions to fix such problems as swelling budget deficits.…”  Expressing a concern voiced previously by other Fed critics, the BIS stressed that: “Central banks cannot solve structural problems in the economy.”

Even fellow Fed Governors have voiced their doubts about the Fed’s ability to withdraw the massive amount of newly printed money when its objectives are met or when inflation becomes a significant concern.  The BIS agrees that “…pulling back so much money, at exactly the right time, could become a political and logistical challenge.” On Dec. 10, Financial Times pointed out that assets in fixed income hedge funds are about to overtake those in equity-oriented funds for the first time ever. Those assets could well be heading for the exits as soon as the Fed tips its hand about lightening its own balance sheet, making the Fed’s job far more difficult.

Hilsenrath concluded his article by saying that: “…the central banks may again be steering toward long-term troubles in their elusive quest for short-term growth.”

Harvard economics professor Ken Rogoff, co-author of “This Time Is Different,” adds his caution: “They are taking risks because it is an experimental strategy.”

These commentators typically have a stake in maintaining a relatively high degree of public confidence in central bankers and their actions.  As readers of my previous posts and articles know, I have no such mandate.  I believe and have stated repeatedly that the Fed and other world central banks are betting much of the world’s economic future on a grand experiment in money creation.  On a personal level, there is no evidence that Ben Bernanke beats his family or his pets, and by all accounts, he appears to be a kindly gentleman.  Should his grand experiment fail, however, and generations to come suffer severely diminished economic wellbeing, he will deserve history’s mantle of “worst central banker ever.”

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Yield Comes With Risk

There has been a dramatic global change over the past few years as investors have sold stocks and bought bonds. The Financial Times recently announced that British pension funds are holding more bonds than stocks for the first time in over 50 years.  Part of the attitude shift flows from fear generated by catastrophic stock market declines during 2000-03 and 2007-09.  Part also flows from the gradual aging of the investor base, as more people move toward stages in which they can afford less risk and need greater income assurance.  The primary driver of the shift, however, is almost certainly performance chasing, which is always what drives the majority of investors. That pursuit accounts for the unfortunate consequence of people buying most heavily at market highs and selling most heavily at market lows.

Since the turn of the century, bonds have markedly outperformed stocks.  And now that the Federal Reserve has begun to buy massive quantities of bonds directly, both high and low quality alike, interest rates have fallen to near all-time lows.  The Fed has further enthused bond investors by promising to keep rates at current depressed levels into 2015.  If they retain that resolve and as long as they are able to accomplish their goal, bonds–at least treasuries and agencies–should remain relatively safe.  At current minimal rates, however, top quality debt will provide very little return.  Earning any appreciable yield requires investing further down the quality scale.

Unfortunately, a great many bond investors fail to appreciate how much risk attends most fixed income portfolios today.  Fed pledges and best intentions notwithstanding, there is no guaranty that the Fed will succeed in keeping rates at rock-bottom levels.  Should inflation unexpectedly begin to rise aggressively, rates would undoubtedly rise, possibly even propelled by the Fed reversing its stance and raising short-term rates.   Political winds could shift, and an outcry could arise against the money printing that supports record levels of Fed bond purchases.  Political or economic factors outside U.S. borders could precipitate heavy bond selling.  Foreign holders now own 17% of all U.S. credit market instruments.  China and Japan, holding roughly $1 trillion each, own giant amounts of our debt.  Should either–or any of several other large holders–choose to reduce their positions significantly, they would exert powerful upward pressure on U.S. rates.  Even top quality bonds would lose value if rates rise.

Far greater danger exists for lower quality bond portfolios, to which many investors have turned to scratch out a little extra yield.  So far, that strategy has succeeded under powerful central bank support.  Europe is in recession; much of the rest of the world is slowing; and the U.S. is struggling to stay on a growth path despite massive amounts of government support.  Should the widely discussed Fiscal Cliff or any number of other factors tip the U.S into recession, lower quality debt rates will almost certainly rise, as fears of default potential grow.  Of course, if rates rise at the higher quality end of the spectrum, bonds of any quality will feel that effect.  Even short of default, bond portfolios could suffer significant losses if rates rise appreciably for any reason.

By way of precedent, it is instructive to remember that when the last rising rate cycle began in the early 1940s, it lasted for four decades.  Over that span, bond investors failed even to keep pace with inflation.  In fact, for four decades, keeping money in risk-free treasury bills was more productive than holding virtually any corporate or government bonds.

Should the Fed succeed in keeping interest rates down for a few more years, bond investors might be able to eke out a bit more return.  To keep that return, however, bond holders will eventually have to make a timely sale decision or hold bonds to maturity and hope that the return has not been eaten away by inflation.

 

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Cowardice Leads To The Fiscal Cliff

If you regularly read or watch the news, especially on financial TV, you will undoubtedly have more than your fill of the term “fiscal cliff” over these last few weeks of the year.  That we have to hear it at all is a tribute to our feckless legislators, who have shown true political cowardice in failing to deal with the country’s burgeoning debt problems.

Earlier this year, faced with the task of making at least a dent in our trillion-plus dollar annual deficit and the resultant growing debt, Congress punted.  Admitting their inability to craft even the beginnings of an agreement, our leaders scheduled “the sequester” for yearend, such a “horrible of horribles” that no legislator would dare let it unfold.  Supposedly with that deadline for across-the-board budget cuts scheduled for December 31, even mildly enlightened lawmakers would certainly forge an agreement before doomsday.  Now that we’re less than 40 days from the self-imposed deadline, with no progress made and the holidays complicating schedules, the chances of any substantive agreement range from slim to none.  The best we can reasonably expect is a sketchy outline of actions that will be negotiated in 2013 in return for deferral of the sequester for a few months.  At the same time, some “split-the-baby” compromise on expiring tax breaks might buy time for the promise of a more serious examination of comprehensive tax reform.

Or perhaps not!  In which case, we will tumble over the cliff.  If we do suffer that perilous fall, economists have forecast various impacts ranging from about a 1% to 4% decrease in 2013’s GDP.  With GDP forecasts clustering around 2% for the year–apart from the cliff–any appreciable impact may well push the economy into another recession.  On Wednesday of this week, Fed Chairman Bernanke added his voice, warning that failing to deal with the cliff would “topple” the economy back into recession.

In discussing possible outcomes, most commentators talk about “solving” the fiscal cliff.  One can only talk about “solution” in the context of preventing all its consequences from hitting in the same time period.  In a static analysis, every dollar of tax forgiveness that continues past its deadline is another dollar of deficit and cumulative debt.  Every dollar that is sequestered out of government expenses may cut the deficit, but also cuts GDP.  By spending more than we have earned for about three decades, we’ve painted ourselves into a corner from which there is no complete escape.  All extrication actions have negative consequences.

We are faced with the unpleasant choice between accepting economic pain today or deferring some of that pain with the probable cost of even greater pain tomorrow.  Given the political reality that candidates are rarely elected by promising pain today and a possibly better tomorrow, we can count on our dysfunctional Congress to kick the can as far down the road as possible.  If they succeed, they may be retired before the consequences of their cowardice are fully realized.

Unfortunately, past delays may have already pushed the economy to a day of reckoning.  Harvard economics professor Martin Feldstein said recently that the U.S. may fall into recession even if the worst effects of the fiscal cliff are deferred.  Should Congress go all out to avoid immediate negative consequences to the economy, however, deficit and debt prospects will suffer.  The major bond rating agencies have already warned that the US’s debt rating will take another hit if we fail to take meaningful action to control our deficits and debt.

There is no “solution.”  We as a populace, through our legislators, have to decide how and when we want to square our books.  We have lived and spent beyond our means for years, and our bills are coming due.  Every one of us should be lobbying our legislators to act like statesmen and to make sure that we don’t leave a legacy of excessive debt to our grandchildren and their grandchildren.

Tom’s Plea To His Legislators

The following is a letter Tom sent out today to his Arizona legislators: Senator John McCain (R), Senator-elect Jeff Flake (R) and Representative Ron Barber (D).  He urges you to make your voices heard in your own constituencies.

For years I have written and spoken about the dangers arising from our politicians’ unwillingness even to approach a balanced budget.  The consequences of that negligence are becoming increasingly manifest with the most immediate of which, the fiscal cliff, only weeks away.

I am enclosing my most recent blog entry encouraging readers on our own site, plus those of other sites which regularly pick up my work, to lobby their legislators to act like statesmen instead of ideological vote solicitors in addressing the many questions related to our deficits and debt. 

I am a constituent who cares deeply about the condition of the country that we will leave to subsequent generations. I implore you to act with a conscience that treats the rights of generations ahead equally to those of today’s voters.  Please work in the upcoming years to change the venal image of Congress.  Make us proud of legislative bodies that work toward long-term positive outcomes rather than ideological victories before the next election.

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A Technical Update

The election is over; the fiscal cliff looms; corporate profits are slowing; and Europe remains in disarray.  All are reasons that stock prices could be falling.  At the same time, the Federal Reserve continues its attempts to boost stock prices. Just this week it intimated that even more monetary support will be forthcoming when the current iteration of quantitative easing (QE) expires.  We’ve stated for the past few years that the stock market’s ultimate success will depend on whether or not investors retain confidence that Fed money printing will succeed in overcoming deteriorating fundamentals.  This week I want to look at the markets themselves to see what technical conditions can tell us about the prospects for stocks in the months and quarters ahead.

Over the past six weeks, stock prices have fallen quite aggressively with the Dow Jones Industrials down almost 1200 points from its September highs.  Almost all major stock market indexes have broken below their respective 200-day moving averages, a line of demarcation for a lot of technicians between bull and bear markets.  Many technicians look for further confirmation of a changing trend by looking at the juxtaposition of moving averages of varying lengths.  So far, the current downtrend has pulled 20-day below 50-day moving averages, which is indicative of at least a moderate correction.  Far more important in the eyes of most technical analysts is a crossing of 50-day and 200-day moving averages.  To date, that important crossing has not taken place for the major averages.  Should that occur in the weeks ahead, a good number of analysts will turn from bulls to bears.

Many technicians pay close attention to trend lines.  All major indexes except the New York Stock Exchange Composite have broken below the 14-month trend line from October 2011.  At the same time, however, the trend line from the March 2009 beginning of the current cyclical bull market remains intact.

Several other factors point toward a likely continuation of recent market weakness.  Chart patterns show a series of lower highs and lower lows since September–never a positive sign.  Volume in declining issues clearly exceeds that going into advancing issues, demonstrating weak demand.  And volume generally has been in decline for the past few years, contrary to the pattern categorizing lasting bull markets.

Buying has become increasingly selective, with 52-week highs contracting and 52-week lows expanding.  Advancing issues are diminishing and declining issues are becoming more numerous, especially among operating companies, the study of which eliminates the distorting effect of interest rate-sensitive issues.

It is worth noting that over the past two years, as prices have risen, momentum oscillators have diverged, a pattern that often foretells a major change of trend, although with little timing precision.

Some technicians prefer to examine investor sentiment for clues to coming price action.  Ironically, at extremes, strongly positive market outlooks usually precede market declines and vice versa.  Currently the CBOE Volatility Index (VIX) shows remarkable complacency, despite the persistent price downturn.  Major market bottoms typically don’t materialize until fear levels have risen significantly.  Similarly, there is no sign of panic in Put/Call ratios–not what you would expect to see at major market bottoms.

Notwithstanding VIX and Put/Call readings that have longer-term implications, many short-term sentiment readings have turned very gloomy.  While they have not yet descended to levels normally seen at important price bottoms, they are certainly in a neighborhood from which rallies can start.  Prices have also descended to levels not far above the May-June lows, which should provide some support.  Add to that positive seasonality from before Thanksgiving into January, and the proverbial Santa Claus rally becomes likely.

To put all these considerations in context, it is important to view where we are over a longer time frame.  Of the 18 major international markets that I review daily, only the Philippines is higher today than it was five years ago.  Most are also below where they were two and three years ago as well.  In such a context, it is easy to view the rally from 2009 as a cyclical bull market within a larger secular bear market.  As such, the longer-term risks remain to the downside.

In the short-term, stocks are significantly oversold and are overdue for at least a relief rally.  As long-term market pros know well, however, when rallies from oversold conditions fail to occur, major waterfall declines can appear.  Such an occurrence would put huge pressure on the Fed to step up and try to pull another rabbit out of its hat to keep stock prices rising.

Addendum

It’s with great professional and personal pride that I highlight two recent awards given to Mission’s CEO and, more importantly, my wife, Carmen Bermúdez.  This morning she was honored as one of Tucson’s Women of Influence for reasons outlined in the following Inside Tucson Business profile.

Earlier this year Carmen was named one of Arizona’s 48 Most Intriguing Women, in such august company as former Supreme Court Justice Sandra Day O’Connor, former Arizona governor and current U.S. Secretary of Homeland Security Janet Napolitano, two other former governors and arguably the world’s best female basketball player Diana Taurasi.

Women of Influence 2012 from Inside Tucson Business

Carmen Bermúdez wants to help others ride the elevator of success.  She’s not afraid of heights regardless of how scary the journey.  As founder and CEO of Mission Management and Trust, the nation’s first independent trust company run by a minority woman, Bermúdez manages $300 million in assets.

As Honorary Consul for her native Costa Rica, she lobbies for free trade and promotes using seasonal migrant workers.  As a former competitive tri¬athlete she regularly finished in the top five of her age class.  And, as a bull¬fighter she headlined in both Costa Rican and Mexico City bullrings.

What motivates Bermúdez isn’t fame or money or the number of boards she’s on.  It’s reaching out.

At Mission, a company she started in 1994, Bermúdez developed an internship program to train students.  So far, 25 students from the University of Arizona’s Eller School of Management have worked in the program and four have landed jobs with Mission.  Tucson “must find a way to keep our talent and not lose students to Los Angeles, Chicago or New York,” she says.

Bermúdez also works with those not as fortunate as her interns.  Mission’s philanthropy program reaches minorities and women, providing educational scholarships, supporting nuns who work in slums in Central America and underwriting programs which better the lives of underprivileged children.

“I want to help others rise to the top of their chosen career, whether they get off at the first floor or step into the penthouse,” she says.

Bermúdez started her own ride in the subbasement.  “I grew up in the jungle.  There weren’t any roads or telephones or shoes to wear.  I didn’t feel deprived because nobody had anything.”  Her mother, a single parent of four, struggled to put food on the table.  “But she always managed to,” Bermúdez said.  “My mother told me I was special and I believed her.”

In Costa Rica, one way out of poverty was bullfighting.  In 1950, at age seven, Bermúdez decided to fight.  By the time she turned 18 she was one of Costa Rica’s leading bullfighters.  “I loved the thrill and danger.  Once I en¬tered the ring there was no way to go but forward.”

Bermúdez took that lesson to heart.  The only way to succeed was to keep reaching out to others. Perhaps she should add “elevator operator” to her long list of accomplishments.

What keeps you in Tucson?

“Tucson has been my home for 18 years.  Our friends are here.  Tucson has a great potential for growth, yet it retains a small community feel.”

If you had the power, what one thing would you most like to see happen in Tucson?

“I would demand that the City Council get their act together and stop stalling the progress toward a productive downtown.  We need a bigger convention center, more hotel rooms to house large groups for the gem show, rodeo and future events we could attract.  We need a downtown stadium and/or arena for soccer, baseball, football, even U of A basketball.  I would also like for Tucson to be foresighted and start doing more business with northern Mexico. Commerce between Arizona and the northern cities of Mexico could be a gold mine.”

Outside of home or what you do, where are you most likely to be found in Tucson?

“One of my great enjoyments away from home and business is to play golf.  I also swim and, with my husband, attend as many U of A games as I can.”

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Sheila Bair – No Good Ole Boy

Having appreciated her sincere, forthright approach for years as head of the Federal Deposit Insurance Corporation (FDIC), I am eager to read Sheila Bair’s new book, Bull By The Horns. Although I have not yet gotten into it, I have read a few reviews, and I listened to her interview by Charlie Rose on Bloomberg TV yesterday afternoon.

Quite naturally, most of us tend to appreciate those whose views resemble our own. Having objected to almost all of the rescue efforts that our government entities have conducted since 2008, I relish hearing Bair characterize those efforts as seriously flawed. She rails against government’s actions that have once again promoted moral hazard. Watching government bail out the bad with the good, she rightfully recognizes that the message again has been reinforced that bankers can pursue profit irresponsibly and count on government bailouts if they fail. Why exercise prudence when you can keep the profits if you win and can count on a deep-pocketed backup if you fail? Most businesses don’t have that luxury, forcing them to more careful decision-making.

Bair goes into detail in arguing that bondholders as well as stockholders should have been punished rather than relying on taxpayers to fund the rescues. I have argued further that, to the extent taxpayer rescue money was needed, taxpayers should have become owners of the various institutions. In a national emergency–which this was–the essential executives, who were responsible for dragging the banks down, should have been conscripted and kept in their jobs at reasonable salaries until private investors could repurchase the shares and eliminate the further need for taxpayer money. It was absurd that we allowed these people to be bid away by the highest bidder then get rewarded with outsized bonuses for making profits in a game subsidized with taxpayer money.

This “protect the banks and bankers first and foremost” approach lies at the heart of Bair’s disagreements with Treasury Secretary Tim Geithner. Bair describes Geithner’s overriding goal to have been strictly making banks, especially big banks, profitable. She argues that the goal should have been to make them both profitable and responsible.

I am eager to read her arguments for requiring significantly greater bank capital and for getting rid of any kind of “too big to fail” financial institutions. And in yesterday’s interview, she pointed to the weakness inherent in many banks due to the abundance of legacy mortgage loans still on bank balance sheets. I have in the past highlighted each of these as dangers to our system, and I look forward to learning more from her insights.

Bair’s positions certainly deviate from those held by many top executives of the banks she regulated for years. I suspect few of them view her as a member of the “good ole boys” club that has ruled Wall Street and the banking industry for generations.

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Quarterly Commentary – Third Quarter 2012

The Federal Reserve Board and other central bankers around the world have taken control of most major stock and bond markets. The quandary facing all who make investment decisions is whether or not they can count on a continuation of that pattern. It is essentially a two-part question: 1) Will central bankers choose to continue their interventional practices? and 2) If so, will their efforts continue to be successful?

The issue has come into sharp focus over the past several months as economic fundamentals have deteriorated markedly in virtually all corners of the world. At the same time, to prevent “bad” from turning into “dangerously bad,” central bankers have flooded their countries’ financial institutions with unprecedented amounts of new money. So far, those efforts have warded off disaster but have had little noticeable positive effect on economic conditions, which continue to decline–even in formerly strong emerging countries. The main beneficiaries have been world stock markets, with only a few exceptions (China most notable among them). Because much of the new money has also been directed to bond purchases, central bankers have depressed interest rates and boosted bond prices.

To appreciate how successful this coordinated central bank policy has become, one need only observe stock market behavior on days of negative fundamental news announcements. When stocks go up immediately after negative news, it is apparent that buyers are concentrating on the increased probability of additional central bank rescue stimulus rather than on the weak underlying fundamental condition. That optimism is precisely the effect central bankers hope to produce – investors’ positive response in anticipation of a future central bank action, reducing the need for the action itself. So far, faith in central bankers is trumping deteriorating fundamentals, as most world stock markets have been rising since 2009.

Overwhelming Debt Burdens

To understand the prospect for ultimate economic and investment outcomes, it is essential to understand the underlying reality. The United States and numerous countries throughout the world will never be able to pay for existing debt plus existing promises of future benefits. Mature economies simply cannot grow fast enough to satisfy those liabilities. There remain only two alternatives – defaults on some of those obligations, or enough inflation to diminish the debt burden (another form of default).

Almost certainly, the major central banks of the world fully appreciate the severity of the situation. Very few investors, however, much less the general public, have any real appreciation of the hopelessness of the debt dilemma. Politicians (at least not since Ross Perot) have no incentive to shed light on the problem. They have to condemn the policies of the other guy and offer hope that their administrations will provide economic growth and good times. Reality would not win votes. Voters want candy, not castor oil.

With debt burdens at unsolvable levels, recession has become an unacceptable condition. Throughout history, recessions have been the necessary cathartic to rid economies of the excesses of prior expansions. So severe are the debt excesses in the present instance, however, that recession has already led to the need for rescues of some of Europe’s weaker countries. The current broad European recession is tightening the noose on three of the four largest Eurozone economies: Spain, Italy and France in ascending order of size.

The European Central Bank is faced with an extremely difficult situation, compounded by the complexity of needing to satisfy 17 autonomous governments, many of which have warred with one another repeatedly over the centuries. The prospect of a lasting monetary union is remote at best. The ECB is doing what it can, however, to contain the damage from a condition it can’t cure. Central banks can usually deal with liquidity issues but can’t overcome solvency problems, which the ECB is wrestling with today. The financially stronger northern European countries are faced with the dismal choice between providing an ongoing stream of bailouts for their weaker southern neighbors or allowing defaults, which would decimate their banks holding the bonds of the countries in danger of default. Consensus on how to proceed has been hard to come by. European leaders lurch from meeting to meeting followed by optimistic progress reports, yet no real progress. By preventing collapses so far, they have effectively “kicked the can down the road” and provided hope to investors in both stock and bond markets.

The Fed’s Rescue Attempts

Our Federal Reserve doesn’t have to worry about 17 separate economies – just one. But like much of Europe, the United States is burdened by monumental debt problems. The Fed has made the determination that we cannot withstand a recession, so it has resorted to a series of rescue efforts unprecedented in the history of our nation. Its zero interest rate policy has been in place since 2008, and the Fed has vowed its continuation until at least 2015. The Fed’s rescue efforts are being borne on the backs of savers, disproportionately the elderly retired. Having run out of short term interest rates to reduce, the Fed then turned to active money printing, more than tripling its balance sheet in just a few years. Most recently Fed Chairman Bernanke and his board majority have prescribed Quantitative Easing “Open Ended,” pledging unlimited new money as the Fed determines its need. With nearly $2 trillion in cash still sitting in the banking system, even Chairman Bernanke admits that new money will be unlikely to have any appreciable effect on the underlying economic problem of severe unemployment. He believes, however, that such money will have a positive “wealth effect,” boosting housing and stock prices and impelling Americans to spend more, thereby lifting the economy.

Not everyone agrees that the benefits will exceed the costs. St Louis Fed President James Bullard warns that any benefits today will be paid for with future inflation that could persist for years. Philadelphia Fed President Charles Plosser warns of a risk to the Fed’s credibility. Dallas Fed President Richard Fisher, a frequent outspoken critic of Fed policy, recently said, “The truth…is that nobody on the committee, nor on our staffs at the Board of Governors and the 12 Banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course. And nobody – in fact, no central bank anywhere on the planet – has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank – not, at least, the Federal Reserve – has ever been on this cruise before.” While not speaking directly about current Fed policy, former St. Louis Fed President William Poole succinctly summarized the magnitude of the underlying problem by saying: “We’re only a few years behind Greece when you look at the numbers.” Clearly, we are not in a “business as usual” environment.

The Investor’s Conundrum

The ambiguity of today’s situation puts a huge burden on anyone making investment decisions, including our investment management team. Can central bank money printing overcome deteriorating economic fundamentals? So far, at least in terms of stock prices, central banks are winning. Will investors retain confidence in central bank efficacy if economic fundamentals continue to deteriorate? If confidence remains, stocks could continue to rise. If confidence disappears, world economies could fall into serious recessions, and stocks could plummet. We are faced with atypical risk/reward considerations, because nobody knows how or when these questions will ultimately be resolved.

Central Banks Don’t Always Win

Because most firms in our industry focus on quarter to quarter returns, they’re essentially forced to stay relatively fully invested whether they perceive a highly uncertain environment or not. That approach would have been well rewarded over the past three years, but would expose clients to huge risk of loss if deteriorating fundamentals ultimately overwhelm the best efforts of central banks. And while central banks are succeeding in the current cycle, they don’t always win. Most notably, despite aggressive central bank action, stocks dropped by 89% from 1929-32, 50% from 2000-02 and 57% from 2007-09. In Japan, stock prices are down by 77% since 1989 despite constant central bank efforts to revive the economy.

Relying On Value

Mission’s equity selection process is based on a deep appreciation for and understanding of historically sound value. We buy value when we find it and don’t force equities into client portfolios when stocks don’t meet all our selection criteria. The annualized performance of the equities we have owned since inception at the beginning of 1986 is 17.28% compared to 9.97% for the unmanaged S&P 500. In recent years, as sound values have become scarce, we have found a diminishing number of stocks meeting our strict criteria. That scarcity has kept us from participating heavily in stocks over the past three years, although it has produced safe, far better than average total portfolio returns for the century-to-date. By holding to such a conservative course (relying on a reversion to normal valuation levels), we will avoid serious negative consequences should weak fundamentals drag stock prices down again. On the other hand, conservative portfolios will lag more aggressive portfolios as long as central banks are able to keep stock and bond markets elevated.

An Alternative Approach

Not knowing how long central banks will be able to dominate world equity markets in this cycle has forced us to search for an approach to employing more stocks while still limiting exposure to risk. We have always been strong advocates of formularized evaluation processes. Formulas take ego and emotion, the two biggest roadblocks to investment success, out of investment decision making. For years we have reviewed literally hundreds of studies in an attempt to identify a composite of economic and market criteria with a strong, long-term track record of highlighting periods in which stocks perform positively. A good many criteria and combinations of criteria have met that standard. We have also demanded that any acceptable formula be able to recognize quite consistently periods in which stocks perform poorly. Several sets of criteria also met that standard, but virtually all have experienced rare, but substantial losses. To us that was unacceptable, especially in an environment as dangerous as is the present. To avoid unacceptable losses, it is essential that any formula have the proven ability to correct and reverse position when markets go contrary to an earlier forecast.

We have finally identified a set of criteria that have satisfied these requirements for more than the past three decades. A two-mode process identifies periods in which to hold stocks and periods in which to remain safely in cash equivalents. A separate three-mode process identifies periods to own stocks, a smaller number of periods in which to sell stocks short, and lengthy periods of time in which price direction is less predictable and cash equivalents are the asset of choice. Over the multi-decade history of the study, the two-mode process has earned more than 4% per year on average above the unmanaged S&P 500 index. The three-mode process earned more than 6% per year more than S&P 500. Over the 31 completed years of our study, the S&P 500 has declined in six of those years. Each of these formularized processes had negative results in just three of the 31 years. The S&P’s worst one-year decline was -37.0%. The worst year for the two-mode process was -3.4%; for the three-mode, -6.7%.

While there can be no guaranty that what has worked successfully in the past will necessarily work well in the future, we believe there to be a strong probability of success for a few reasons: 1) Results have been quite consistently successful for a multi-decade period of time. Good long-term results have not been built on just a few periods of strong outperformance; 2) The criteria measured in the formulas are numerous and diverse, reducing the potential that a few becoming less well correlated with market performance will negate the formulas’ efficacy; and 3) The heavy weighting of stocks’ price movements protects significantly against getting locked into an equity position which fundamental considerations support powerfully, but which is experiencing an opposite price reaction.

Detailed descriptive materials about the new processes will be available soon. Please let us know if you would like to receive them. The addition of these new processes will in no way alter our primary value-based investment strategy that has proved its long-term worth over a quarter of a century. These will be optional alternatives for those willing to assume a little more risk in a quest for greater equity returns.

Fixed Income

Our outlook on fixed income is unchanged. Fixed income yields are near historic lows, although they have bounced off July’s all-time lows for most U.S. Treasury securities. Most central banks around the world are committed to keeping them as low as possible. Markets, however, don’t always follow the dictates of central bankers. Should rates rise for any reason (inflation or China lessening its U.S. bond holdings, for example), minimal positive returns could quickly turn negative. The potential loss from being wrong in a bond portfolio is greater than the potential reward for being right. We’re facing a poor risk/reward equation at current yields.

Gold

Because both the Federal Reserve and the ECB have clearly indicated their intentions to make new money readily available in unlimited amounts, we began to build a position in gold in late-2011. Our average purchase price is about $1600 per ounce on spot gold. We have no strong conviction about the probable near-term price movement. Gold has rallied nicely from our purchase levels and could continue higher from here. If so, we will have a nice profit on a still modest position.

But gold’s price could also fall–even precipitously–should the best efforts of central bankers fail and the world fall into a widespread recession. Under such circumstances, stocks could fall aggressively, generating margin calls. As happened in 2008, quite a bit of gold might be sold to meet stock margin calls. Should prices decline, we would be pleased to add to our gold positions. Over the long run, a larger position acquired at lower prices could offer substantial profit potential.

Serious Concerns

We face the uncertainty of the period ahead with a number of serious concerns:

1) Debt levels are so extreme that they may be beyond the reach of central bank efforts. It is highly unlikely that central banks can in the long run stabilize economies and put them on the path to sustainable growth.

2) Negative outcomes could unfold quickly although central banks will bend every effort to defer them.

• One or more countries could be kicked out or choose to leave the Eurozone.
• Iran and Israel could get into an armed conflict.
• Problems in Syria could spread violence.
• Any of these events could happen overnight.

3) Positive investment returns are dependent upon investors retaining confidence in central bankers. That won’t go on forever.

4) Consequences of central bank failure could lead to extreme market volatility and losses.

In such an environment, investors should maintain flexibility in all investment portfolios. This is not a time to buy and hold.

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Facing Difficult Fiscal Choices

In last week’s posting on this site, I argued that the Federal Reserve may be overestimating its ability to restimulate consumer enthusiasm with its aggressive interest rate and new money policies. Diminished resources and the past decade’s multiple financial disruptions may have convinced former free spenders to reduce debt and to tuck away some assets for the proverbial rainy day.

While that decision to save or to spend may be extremely important at the household level, it has even greater implications at the national and international level. We see this dilemma playing itself out most dramatically today in Europe.

With most world economies in serious recessions in 2009, the International Monetary Fund (IMF) strongly urged many of its member countries to increase deficit spending. Combined with aggressive action from leading central banks, this widely employed approach succeeded in calming the financial crisis, albeit at the cost of adding heavily to already bloated debt loads.

Recognizing the dangers of outsized deficits and debt levels threatening many countries’ long-term stability, the IMF quickly urged fiscal discipline once the panic of 2009 had passed. By 2010, the IMF pushed stronger countries to slash annual deficits in half by 2013 and to prudently plan to reduce their burgeoning debts as quickly as possible.

Unfortunately, the best laid plans sometimes backfire. European countries that have implemented strong austerity measures have seen their economies fall into recession. Recent violent riots in Greece and Spain vividly reflect public attitudes toward losing cherished benefits.

Bowing to that social pressure and reevaluating the apparent inability of many economies to stabilize under austerity programs, the IMF has reversed course and acknowledged that slashing deficits and debt may be preventing economic growth.

But what’s a country to do? If austerity is imposed or continued, recession may be the result with no progress made against deficits and debt. Should austerity be abandoned, existing deficit levels may continue for years with the resultant annual addition to debt. As we have seen all too tragically in recent years, when debt reaches unsustainable levels, defaults or bailouts become the alternatives. The inability of European countries to grow out of their problems indicates that an increasing number of countries will face that unfortunate choice in the years ahead.

Bringing the dilemma closer to home, we’re faced with the same choice in the United States. We will begin to hear more and more about this choice as we move ever closer to the year-end “fiscal cliff.”

Almost certainly, our debt level has reached a point from which there is no easy recovery. Our legislators’ inability even to put a dent in the projected debt load is clear testimony to the difficulty of the task. That failure of the super-committee earlier this year prompted an immediate downgrade of the US’s formerly sacrosanct AAA debt rating. A similar legislative failure in the next few months is highly likely to precipitate another downgrade.

Having spent and promised our nation into its untenable debt position, largely over the last three decades, no good choices remain. How we deal with a few unpleasant alternatives will dictate the economic background that we and subsequent generations will inherit. That background will powerfully influence the opportunities available to investors in the decades ahead.

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Can The Fed Rescue The Consumer?

A great many households learned to their dismay over the past decade that failing to prepare financially for a rainy day can be a roadmap to disaster. From the end of the 1970s, our society turned increasingly from prudent savers to borrowers and spenders. Credit cards became integral to our lives, and purchasing on credit became commonplace.

Dramatically loose credit from the Federal Reserve paved the path to financial profligacy. A quarter century bull market in stocks and the strongest bond market in U.S. history emboldened Americans to enter the new century with confidence and financial aggressiveness. Why save when the economy and the markets march inexorably higher? Certainly there’s no need for a financial margin of safety when businesses are growing and job security is not even a passing concern.

While the stock market crash from 2000-03 rattled that equanimity and brought doubt into the equation, our good friends at the Fed had a powerful antidote. The Fed’s easy money policy helped the stock market to recover, and we collectively began to upgrade our living conditions. As home prices rose, McMansions became the tangible trophies of those who prospered in a loose money, high debt environment. The turn-of-the-century stock market crash was soon viewed as an aberration in the powerful financial advance that had begun decades earlier.

A combination of greed, overconfidence and early success led a remarkable number of entrepreneurs to quit their jobs for the far easier and far more profitable employment as condo flippers. Unfortunately, virtually all of these would-be real estate magnates left their chosen field of battle with far thinner wallets. They might have preserved much of their wealth had they been able to draw parallels between their behavior and that of the ill-fated plungers who abandoned nine-to-five work for the glamor of day trading stocks just a half decade earlier.

The housing crash and a second-in-a-decade stock market collapse changed the attitudes of vast segments of the American populace. Financial conservatism replaced aggressiveness. The need to repair household balance sheets led many to abandon the stock market. In general, diminished financial wherewithal has prompted Americans to keep their wallets on the hip, and the economic recovery from the 2008-09 recession has been the weakest in the post-World War II era.

Holding short-term interest rates near zero, the Fed has admitted trying to force investors to accept risk with their assets, whether that’s appropriate for them or not. The Fed is simultaneously pushing banks to lend more and consumers to borrow more, seemingly oblivious to the immense irony that they are attempting to solve a problem caused by excessive debt by creating and promoting yet more debt.

While the need to shop aggressively seems to be deeply embedded in our genes, the Fed may be facing a sea change in American attitudes. Twice burned in this still-young century, investors may have pulled in their horns for years yet to come, despite the Fed’s support for common stock prices. As large numbers of baby boomers enter or move toward retirement, they may be coming to grips with the stark reality that it makes no sense to cut their margin of financial safety too thin.

Economists may be grossly overestimating the public’s spending resiliency in light of their diminished resources and the financial distress apparent in much of the world. The Fed may be putting future generations in severe financial danger, despite having no realistic prospect of rekindling immediate economic prosperity with its ongoing flood of newly printed money. The American consumer may have turned a page.

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