Draghi Senses A Crisis

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In 2008, the world was on the edge of financial collapse when banks were so suspect of each others’ balance sheets that they would not lend to one another.  Almost all were massively overleveraged and required unprecedented intervention by U.S. monetary authorities.  Suffering only a few casualties, the banking industry was saved from its financial miscalculations – even rewarded after the initial rescue with essentially free money with which to profit from Fed-supported U.S. Treasury investments.

Notwithstanding the most aggressive central bank stimulus program in history, the U.S. economy continues in the most sluggish recovery from recession of the post-WW II era.  Most of the rest of the world is similarly slogging through a barely perceptible recovery.  To break out of a quarter-century long economic malaise, Japanese monetary authorities have thrown all caution to the winds. They are currently adding debt to their central bank balance sheet in even greater amounts than is the U.S. Federal Reserve.  Theirs is a life or death survival bet on huge amounts of additional debt solving the problems created by too much debt in the first place. With Japan as its third largest member, implications for the world economy are huge.

Enter Mario Draghi.  In a much anticipated announcement, European Central Bank President Draghi unveiled a collection of monetary measures designed to weaken the Euro, boost inflation and revive a Eurozone economy struggling to remain above recessionary levels.  To promote bank lending, the ECB has introduced a negative interest rate of 0.1% for funds held as deposits.  Because the amounts held on deposit at the ECB are relatively small, this provision is more symbolic than economically important.  It does, however, underscore the urgency with which the bank is attempting to encourage lending.

A major problem for European banks is a lack of loan demand from qualified borrowers.  The ECB finds itself in the unfortunate position of having to promote more lending to boost economic activity while simultaneously pushing banks to shore up their still precarious capital positions.  In fact, after years of central bank support, European banks have just recently brought their leverage levels down into the mid-twenties, the level where U.S. banks were just before the 2008 crisis.  The banks certainly can’t afford to add debt that bears any appreciable risk of default, which calls into question the wisdom of easing collateral rules as part of the ECB’s current stimulus program.

Market prices and currencies immediately reacted favorably to Draghi’s Thursday announcement and press conference.  As the day wore on, however, stock price gains fell from their highs. Worse yet, the Euro actually ended higher on the day, calling into question the ultimate effectiveness of these extraordinary measures.  No one wants a strong currency in today’s environment of weak worldwide demand.  Should efforts like these not produce their desired ends, it is likely that the ECB and other central banks will resort to even more aggressive programs to weaken their currencies, pursuing “beggar thy neighbor” policies similar to those that contributed mightily to global economic contraction in the 1930s.

As I have frequently discussed, excessive debt is an insidious problem, leading ultimately to a great many negative economic and securities market outcomes.  So far, central bankers have succeeded magnificently in convincing investors that everything is under control.  Sooner or later, if positive results are not measurable on Main Street as well as on Wall Street, that confidence will wane.

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20th Anniversary Reflections

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In just over a month Mission will celebrate the twentieth anniversary of opening its doors in Tucson.  On April 24 of this year, Mission’s staff had the pleasure of joining with clients, business associates and retired staff in a rollicking celebration of Mission’s first two decades.  The highlight of the evening was an encore performance by the Motown group True Devotion, who had helped us celebrate our first decade at a client conference earlier in the century.  A few of Mission’s officers offered reflections on the firm’s history and its outlook for the future.  The following is a reprise of my comments that evening.

Let me add my thanks and appreciation to all of you who have made our first two decades so successful and fulfilling.  It has been my privilege and pleasure to work with you through the last 17 of Mission’s 20 years.  All of Mission’s current and retired staff are extremely pleased that we have been able to provide a positive return for clients in all but one of those years.  (In 2008 our client portfolios declined by less than 1% while the S&P 500 plummeted by 37%.)

Those of you who have been regulars at our conferences and seminars over the years know that we profile stocks’ progress through history over a repeating series of long strong and weak cycles.  Most of you here this evening are of an age that allows you to view the last 20 years in a longer term context, as do I.

I started in the investment industry in the late-1960s and have observed a great many cyclical bull and bear markets.  We view these relatively frequent rising and falling markets in the context of much longer secular strong and weak cycles.  My introduction to the investment industry came during the long weak cycle that began in the mid-1960s and extended into the early 1980s.  The Dow Jones Industrial Average peaked at 995 in February 1966.  It rested at 777 more than 16 years later in August 1982.  While a difficult period in which to produce profits, that long weak cycle provided valuable lessons about how long markets can stagnate while erasing the excesses of the prior long strong cycle.

From the depressed prices in 1982, the major stock market averages exploded upward by 15 times into the early months of the 21st century.  Although Mission opened its doors late in that long strong cycle, most of its existence has taken place in the long weak cycle that began in 2000.

The S&P 500 reached 1550 in early 2000.  The average was still below that level 13 years later in early 2013.  The Nasdaq Composite is still below its 2000 peak.   Investors have experienced two massive declines (50% and 57%) and two powerful rallies so far this century.  Even with massive government support over most of the last decade, equity investors have earned only about 3.5% per year so far century-to-date.  Mission’s clients who have been with us since the beginning of the long weak cycle have had a better return with a far more risk-averse portfolio structure.

For two centuries, long weak cycles in the United States have served to eliminate the excesses built up in the preceding long strong cycles.  Excessive debt in this long weak cycle has not only not been reduced but rather multiplied into grossly excessive debt.  Consequently, we anticipate at least one more major stock market decline to eliminate the debt excesses before the long weak cycle runs its course.

Most of Mission’s existence has taken place in an era of monumental government interference in the economy and securities markets.  Beginning at least with the rescue of Long Term Capital Management in 1998, government committed itself to the bailout business with all the moral hazard that produces.  Failed businesses have been rescued; debtors have been rewarded, savers penalized; and free markets have been dramatically distorted.

The unwillingness of the Fed and Treasury to allow giant firms to fail has effectively painted these government institutions into a corner.  They have produced unprecedented levels of debt to conduct their bailout activities and now can’t afford to allow a recession that could topple the debt edifice.  There will inevitably be future recessions, and the Fed may well be out of tools to assist in promoting stability.

The precarious debt picture is best illustrated by looking at the Federal Reserve’s balance sheet.  In its first 95 years of existence, the Fed developed debt on its balance sheet of about $800 billion.  In just six years, the Fed has multiplied that amount five times to more than $4 trillion, and that amount is still growing rapidly.  Total debt in the U.S. economy puts us uncomfortably in the range at which excessive debt has led to severe economic slowdowns over the centuries in countries throughout the world. (This time Is Different, Reinhart & Rogoff).

There are a great many similarities today (excessive debt, valuations, sentiment and speculation) to the conditions near the peaks in 2000 and 2007, which produced stock market declines of 50% and 57% respectively.  Current excesses place our securities markets in a very high risk environment.  At the same time, so long as investors trust that the Fed and other central bankers will keep us from serious market declines, prices can continue to rise.  Should that confidence fade, however, we could experience the third significant market collapse of this still young century.

Having begun my investment career in the late-1960s during the then prevailing long weak cycle, and now having lived through the 21st century weak cycle, I’m eager to experience again the kind of long strong cycle that covered almost all of the 1980s and 1990s.  I hope you’ll enjoy it with us.  As explained earlier, I expect we’ll first have to endure at least one more serious decline to wipe out persistent valuation and debt excesses.  I believe, however, that Mission is well prepared to protect today’s asset values and leave them primed to participate fully in the safer long strong cycle ahead.

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1st Quarter 2014 Market Commentary

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The persistence of stock market gains, accentuated by the nearly two-year absence of positive returns from the fixed income area, has drawn increasing numbers of investors into equities, despite valuation levels that have led to substantial losses twice over the past 14 years.  Many have justified defying valuation danger with the acronym TINA – There Is No Alternative. So far, that acceptance of risk has been handsomely rewarded, just as it was in the late-1990s and in 2006 and 2007.  The twice repeated lesson of this century-to-date, however, is that overstaying your welcome in overvalued equities will be severely punished: stock prices plummeted by 50% and 57% in the prior two retreats from overvaluation.  Make no mistake; stocks are seriously overvalued today.  Only price-to-earnings ratios, while well above long-term average, are less than extreme.  Price-to-sales, cash flow, dividends or book value are near all-time highs but for brief periods in the bubbles surrounding the 2000 and 2007 stock market peaks.

Notwithstanding extreme valuations, stocks have advanced on the wave of liquidity supplied by the Federal Reserve in this country and by other central banks elsewhere in the world.  And prices could continue to rise so long as investors remain confident that central bankers will prevent any untoward equity price retreats.  While central bankers are powerful, they are not omnipotent, and their best efforts have been insufficient to halt the ravages of serious intermittent bear markets over the decades.  Recent supportive stimulus efforts have failed to hold down interest rates, despite massive direct intervention by the Fed for exactly that purpose.  There is no guaranty that their persistent efforts to support equity prices will continue to succeed.

Longstanding clients know that, because of a combination of overvaluation and excessive debt throughout the economy, we began to caution against danger to equity prices before prices peaked in 2000.  We anticipated a long weak cycle that could well last a decade and a half to two decades and that would ultimately expunge the valuation and debt excesses.  So far within that long weak cycle, markets have experienced two massive declines and two powerful rallies resulting in low single digit annual returns since the market peak in 2000.  Mission’s clients have earned a better return over that span of time while maintaining a far more risk-averse portfolio structure.

With valuations only modestly improved from their peaks and national and international debt levels far worse today than in 2000 or 2007, we anticipate at least one more major stock market decline in this cycle to remove the excesses.  Whether such a decline is imminent or a year or more in the distance is unknowable.  In whatever time frame, the retreat will likely take stock prices well below where they sit today.  Permanent equity positions will prove profitable from here only if prices can avoid such a precipitous decline.  While possible, such an outcome would defy historic precedent.  Our preference over permanent equity positions is to employ our strategic equity allocation process, which has historically captured a significant portion of stock market gains while protecting well against major declines.

For money that is not equity-risk-oriented, returns are problematic at best.  Risk-free securities continue to yield nothing, and the Fed remains intent on holding short rates near the zero bound.  Most bonds have shown losses for the better part of the past two years, although rates declined slightly in the first quarter, putting a plus sign before the quarter’s bond index returns.  Many investors have gravitated to “high yield” bonds to scratch out some measurable return.  So far, that has worked and, as with equities, it could continue to work so long as investors retain confidence in central bankers.

Any number of factors could eliminate that confidence quickly, however, including such non-investment issues as a sovereign exit from the Eurozone, a flare-up in the Middle East and, of course, an escalation of the Russia-Ukraine dispute or fallout from more severe sanctions imposed on Russia.  We remain in a very high-risk environment.  Should confidence disappear, investors may suffer painfully for chasing stocks and bonds whose prices have been artificially elevated by central bankers trying to rescue overindebted economies by creating a confidence-building wealth effect.  Our attention to valuation levels has protected client assets extremely well through the century-to-date, and we expect it will be necessary again before the long weak cycle ends.

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Another Debt Milestone

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4-4 Editorial Pic Smaller

Source: Lisa Benson, Washington Post Writers Group

Switzerland-based Bank for International Settlements recently announced that global debt passed the dubious $100 trillion milestone in mid-2013.  That’s almost twice the mid-2013 $53.8 trillion world equity value.  In the six years since mid-2007, just before the financial crisis, equities declined in value by more than 6.5% while debt levels exploded by 42% from $70 trillion to $100 trillion. The prime causes were governments piling on the debt to rescue economies from recession and corporate treasurers taking advantage of record low interest rates.

With the U.S. and Japan promising to add far more debt to central bank balance sheets this year and Mario Draghi pledging to “do whatever it takes” to lift the Eurozone’s stagnant economy, debt levels will inevitably march higher.  Most major equity markets have risen appreciably since 2009, confirming investor belief that growing debt is certainly no roadblock to higher stock prices.  Those, in fact, who point to debt levels as a danger are frequently ridiculed for repeatedly crying wolf.  True, excessive leverage has been offered as a reason for caution for a decade and a half, yet many equity markets are near all-time highs.  It’s perhaps worth recalling, however, that in 2008 excessive debt levels necessitated an unprecedented central bank bailout to prevent a collapse of the world banking system.  Greece, Portugal, Ireland and Cyprus were essentially bankrupt without restructuring or coordinated rescue efforts.  In this country, Detroit is a recent example of debts having risen to unserviceable levels.

Rising stock prices, declining interest rates in financially stressed countries, and silver-tongued central bankers seem to have eliminated fear in most investors.  It is irrational, however, to ignore centuries of history that testify to the damage done to economies from debt relative to GDP even far lower than that prevalent today throughout most of the developed world.

Central bank efforts to shore up bank capital levels have certainly succeeded to a degree.  Leverage in the U.S. has been roughly cut in half from pre-crisis levels.  That many assets are not yet marked to market, however, argues that our banks are not yet in the clear.  On top of that, many have again begun to issue large amounts of the covenant-lite loans that became all too common leading up to the 2008 crisis.

A recent Morningstar report demonstrates that, despite deleveraging, major European and Japanese banks are just now getting down to leverage levels in the mid-twenties, where U.S. banks were just before the 2008 crisis hit.

Not only is the quantity of debt worrisome, quality is as well.  On April 2, Financial Times reported that Europe’s banks hold more sovereign debt than at any time since the Euro crisis.  Because Basel II rules allow regulators to treat sovereign debt as risk free, banks do not have to hold any capital against it.  When the European Central Bank gave banks the opportunity to borrow at 1%, many invested the loan proceeds in the higher yielding sovereign debt of countries like Spain, Italy and Portugal, all of which had and still have precarious finances.  These countries and their banking systems are dangerously intertwined.

Not having experienced many countries or major banks going unrescued, today’s investors have become overly complacent.  Excessive debt levels are a real danger.  In a recent International Monetary Fund working paper, Carmen Reinhart and Ken Rogoff offered a cautionary historical precedent.  There was a widespread default on World War I debts to the United States by both advanced and emerging nations.  Those debts were never repaid.  In today’s extremely leveraged environment, a similar outcome is not out of the question.

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Janet Says: Take That Seniors

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Janet Yellen held her first press conference as Chair of the Federal Reserve Board Wednesday. She promised to continue to penalize the elderly retired and others who are income dependent.

The Fed having now kept short-term interest rates at the zero bound since 2008, Janet reassured bankers that they can count on free money at least into next year and very possibly longer.  By the way, Seniors, you can count on no return from risk-free investments.  That wasn’t enough, however.  Janet also pledged to keep trying to push inflation up, which will assure that the things you have to buy will cost more.  Lest you think that push might at least give you Seniors a shot at higher income, Janet said: “Not so fast.”  Even after inflation gets to 2% or more, she promised to help bankers by keeping rates near zero for a “considerable period of time.”  Sorry, Seniors.

Perhaps you could get a little yield if you did what the Fed has been trying to “force” you to do (their word).  However, because longer interest rates have risen since late-2011, if you made bond purchases in that period of time, you’ve probably lost money despite the Fed’s best efforts to keep bond prices elevated.  If longer rates continue to rise, which is the Fed’s forecast, bond holdings could lose money for years.  Maybe that’s not a great idea for Seniors who likely will never be able to replace lost capital.

Instead, Seniors might want to ramp up the risk level even higher by adding equities to their portfolios.  After all, the Fed has admitted that one of the purposes of its ultra-stimulative monetary policy is to boost asset prices to create a positive “wealth effect.”  It certainly has succeeded in boosting stock prices to the point at which they are today overbought, overvalued and overloved.  It’s an open question whether Seniors should count on a continuation of that positive effect as the Fed tapers and ultimately ends extraordinary stimulus.

Almost all analysts with a knowledge of history anticipate that the Fed’s explosive debt creation will end badly, but there’s no timetable for such an outcome.  As long as investors’ faith in central bankers remains strong, the good times can continue to roll.  How many Seniors will have the foresight to step away before stock prices experience significant damage?  Will the Fed soon lose control of equity prices as they have lost control of longer interest rates over the past two years?

If the Fed’s historic monetary experiment ultimately fails, not only will Seniors have been deprived of income for much of their retirement, they may also have been prodded to lose their capital.  Talk about unintended consequences.  Thanks, Janet.

On a far happier note, for those of a similar persuasion, Go Cats!

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Retirees And Non-Profits May Need To Exercise Extra Caution

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This week I had the pleasure of meeting with the CEO of a socially important not-for-profit organization. Our conversation turned to dramatic changes in the investment markets in recent years, especially since 2008, when central banks began history’s greatest monetary experiment to pull the world’s banking system back from the edge of collapse.

The gist of our conversation was that investment consultants, investment committees and others charged with sculpting investment policies and strategies for not-for-profit organizations were unwittingly putting such organizations directly in harm’s way by doing business as they have been trained. Our analysis applies equally to retirees or other individuals with largely irreplaceable capital.

Investors who have learned their craft in the past four decades–including a growing cadre of CFAs–have become firm believers in the wisdom of a buy and hold strategy and in the importance of structuring a proper asset allocation to match the risk-bearing capacity of the client. Underlying those beliefs are some fundamental assumptions, born of experience:

1) Don’t worry excessively about bear markets; stocks will always come back;
2) Fixed income securities provide a valuable offset to the volatility and risk of equities;
3) Except to meet liquidity needs, cash is trash.

Admittedly, if allowed a multi-decade time frame, the first two assumptions usually prove true. And in most years, stocks and bonds outperform short-term cash equivalents. But there are noteworthy exceptions to these generalizations, and history proves that very few individuals and not-for-profit organizations have the patience necessary to wait out lengthy negative disruptions.

After a five-year, stimulus-fueled stock market rally, investors evidence little fear of surrendering much of their profit. Such confidence is typical when extended rallies have been largely uninterrupted by significant declines. By many measures of investor sentiment, today’s investors are more enthusiastic about stock ownership than at any point in more than 100 years, except at the height of the turn of the century dot com mania that was followed by a devastating 50% stock market collapse. The accompanying table shows the destruction done to years of profits from major stock market declines that all began at even lower peaks of positive investor sentiment.

Table

When markets fell from earlier peak levels of investor confidence, gains earned in the prior 10 to 18 years were erased. Recovering to former stock market highs took from 9 to 25 years during the twentieth century. With unprecedented Federal Reserve assistance, the recovery took only 4 years from the 2009 market trough, which partially accounts for today’s great investor enthusiasm. Should markets fall from the current level of euphoria, it would be highly unlikely that the Fed would be able to provide similar stimulus.

A worst case scenario unfolded in Japan, where the stock market peaked at about 39,000 on the last trading day of 1989. At that time, the Japanese stock market was the largest in the world, and many believed that Japan had discovered the new industrial paradigm. Belief was strong that this would be a one-way market for years to come. While that turned out to be true, the direction surprisingly was down. In a series of lengthy contractions interspersed with rallies, prices fell to below 7,000 in 2009. Even after more than doubling to today’s 15,000 level, the index is still more than 60% below its peak and rests at a level first reached in 1986. Past performance and powerful investor confidence clearly do not guarantee even respectable future performance.

In the past, proper diversification and a prudent asset allocation have at least provided some portfolio support when stocks have been weak. Today’s investors, however, may not be able to count on traditional support from non-equity securities. Despite interest rates having risen for the better part of the last year and a half, rates are not far above historic lows. There is precious little yield on any but the riskiest bonds. When rates fell to near present levels more than 70 years ago, that marked the kickoff of a four-decade long rising interest rate cycle that lasted into the early 1980s. Over a period of more than 40 years, reasonably diversified bond portfolios failed to keep pace with inflation. Even unmanaged cash equivalents outperformed virtually all bond portfolios over that four-decade span. Having just experienced the exact opposite fixed income environment, with rates falling for three decades until mid-2012, few of today’s investors and consultants have experience of multi-year unproductive, even counterproductive fixed income portfolios. If we have seen the beginning of the next rising interest rate cycle, bonds may not only NOT protect portfolios during weak stock market cycles, they may contribute losses, as they did in 2013.

The fact that 1) the U.S. stock market is at historically high valuations accompanied by extreme investor enthusiasm and 2) interest rates are near all-time lows offer reasons why stocks and bonds could be in danger of turning down. Alone, the specter of possible bear markets would not persuade most prudent investors to shy away from traditional diversified asset allocations. There is, however, a far larger concern that should give serious pause to any investor unable to replace lost capital.

We are in the middle of the greatest monetary experiment in history. To rescue the banking system and the broader economy from forecasted collapse, the Federal Reserve Bank and major central banks across the globe have flooded the world with new money. By 2008, over its then 95-year history, the Federal Reserve had acquired debt on its balance sheet of about $800 billion. To stem the financial crisis, the Fed has exploded its balance sheet almost five fold to about $4.5 trillion, with more to come. As Dallas Fed President Richard Fisher has warned, the Fed has no realistic plan to unwind this massive debt burden. Past experience with far smaller amounts in other countries is hardly reassuring. In This Time Is Different, Carmen Reinhart and Ken Rogoff provide copious detail about hundreds of financial crises around the world over the past 800 years. While details understandably differ from episode to episode, some clear conclusions emerge. Governments almost invariably attempt to inflate their way out of debt crises. Occasionally, severe inflation unfolds. In almost all cases, economic growth is markedly stunted for a decade or two before economic normalcy can be restored.

Relative to the size of our economy, the U.S. has reached debt levels at which major problems have unfolded in other countries over the years. And we’re not alone. Extreme levels of debt-to-GDP are now typical in most developed countries.

So far, soothing words and promises from central bankers have maintained investor confidence throughout most of the world. But such confidence could shift quickly. Notwithstanding the success of central bank stimulus in boosting stock and bond prices, there has been a far smaller increase in broader economic growth. Many critics of the effectiveness of aggressive monetary stimulus–including some from within the Fed–are arguing for the rapid ending of quantitative easing. It is not at all apparent that the economy and markets can resume historically normal function without such artificial government support.

When assessing potential risks, former St. Louis Fed President William Poole’s admonitions should not be ignored. He famously contended that when you look at the numbers, the U.S. is only a matter of years behind Greece, which has survived economically only by the grace of its European rescuers. Should debt levels overwhelm the U.S., there is no rescue net big enough.

The above stated concerns are not forecasts; they are statements of realistic possibilities based on the lessons of history. No one knows how the future will ultimately play out. Some investors, however, are better situated than others are, should worst cases materialize. Those least able to recover from severely negative market environments, especially if consequences persist for a decade or more, may have to forego some significant potential for profit in strong markets to protect against unacceptable losses in the weakest markets, which unfortunately materialize from time to time over the decades. For years, we have urged strongly that investors build flexibility into investment programs in place of the traditional relatively fixed asset allocation approach. The latter will backfire badly if the central bank monetary experiment fails and equity markets fall into a lengthy decline, especially if that equity decline were accompanied by rising interest rates.

Very few of today’s consultants and investment committee members have significant professional experience of long lasting weak stock or bond markets, the last of which ended in the early 1980s. As a result, their beliefs have been profoundly influenced by three decades of favorable or at least rapidly recovering markets. An understanding of longer history argues for a more circumspect policy approach by those that cannot easily replace lost capital.

Unfortunately, the common approach to investing today is well characterized by the words of Chuck Prince, former head of Citibank, in explaining the bank’s commitment to risk assumption. Acknowledging, in the middle of the past decade, that financial commitments then being made would likely end badly, Prince infamously said that you had to keep dancing as long as the music is playing. The sad lesson, as in the game of musical chairs, is that not everyone gets a safe seat when the music stops. In fact, decades of history demonstrate clearly that the best and brightest in the world’s biggest financial firms are almost invariably wrong at every major market top. Should we descend into another lengthy bear market, they won’t ring a bell in advance, nor will even the brightest consultants and investment committee members urge greater restraint before the top.

CEOs, CFOs and other senior members of not-for-profits have an additional consideration. Consultants and investment committee members typically cycle in and cycle out, most providing best efforts while there. Should their counsel to structure a traditional investment program result in debilitating losses in a worst case environment, they will eventually move on. It’s the top officers and long-term members of non-profits who will bear the stigma of having presided over the loss of effectiveness of that organization’s mission if the ability to function as desired is compromised. Unfortunately that scenario has played out in decades past just at the time when weakened economies have placed the greatest demands on social service agencies.

Because it’s uncommon to build significant flexibility into portfolios, finding consultants or investment managers with a proven expertise in providing such service is not easy. In the current environment with the overhanging threat of possible failure of history’s greatest monetary experiment, prudence suggests that a more intensive search should be worth the effort.

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Which Way After A Negative January?

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With the S&P 500 index having recorded a -3.6% return this January, newspapers and other financial publications have trotted out their “January Effect” stories. Such stories, with minor variations, follow the theme that “As goes January, so goes the year.” Not surprisingly, that’s not always true.

Using data from the Ned Davis Research Group, since 1950 the S&P 500 index has declined 25 times in January. Excluding 2014, the index has been down in 13 of those calendar years that began with a negative January. If we exclude the effect of January itself, the index has declined from February through year-end in 11 of the 24 years. As a predictor of market direction, the January Effect is not much better than a coin flip. Since markets rise in most years, however, it might provide benefit by simply raising investors’ level of caution. When January has been positive, the index has averaged a 12% return over the subsequent 11 months. When January has seen the index decline, the S&P 500 has been effectively flat for the rest of the year.

Of course, averages can’t tell us what will happen in 2014. While the following 11 months after a negative January have substantially underperformed those with a positive first month, there have been a few significant exceptions: +29.9% in 2003 and +35.0% in 2009. Those were both years in which the Federal Reserve Board was actively stimulating the economy and markets to pull the country out of recession and away from major stock market troughs.

In 2014 the Fed announced its intention to continue its aggressive stimulus, while gradually reducing the amount of its new money creation as the year progresses. We are left to discern whether the effects of stimulus will have the same positive effects as in 2003 or 2009, or whether the air comes out of the balloon with investors losing confidence in central bankers’ ability to control economic and market outcomes. It promises to be an exciting year.

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Warning Flag Waving

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It’s easy to vent against excess speculation. On the flip side, most in the investment industry deplore excessive regulation. Honest observers recognize clearly, however, that with implicit guarantees against failure, giant investors have aggressively assumed increasing levels of risk the farther away they move from the 2008 financial crisis. In order to continue such behavior, they have lobbied–largely successfully–to prevent potentially damaging incursions onto their turf by such forces as Dodd-Frank and the Volcker Rule.

Last Wednesday, Greg Roumeliotis reported on Reuters that the Office of the Comptroller of the Currency “…has already told banks to avoid some of the riskiest junk loans to companies, but is alarmed that banks may still do such deals by sharing some of the risk with asset managers…. Among the investors in alternative asset managers are pension funds that have funding issues of their own.”

It’s a longstanding truism on Wall Street that the longer a bull market persists, the junkier the deals that come to market. In the current zero interest rate environment, orchestrated by the Fed and other central bankers, the quest for yield is venturing into increasingly dangerous territory.

U.S. leveraged loan issuance hit a record $1.14 trillion in 2013, up 72% from 2012, according to Thomson Reuters Loan Pricing Corp. And the riskiness of these loans has simultaneously risen year over year, reaching the highest level of debt to EBITDA since 2007, preceding the economic collapse and 57% stock market crash.

Because regulators’ efforts are more readily designed to limit excessive risk-taking by banks, there are potentially greater levels of systemic risk in the shadow banking sector, including such non-bank financing sources as hedge funds, private equity funds and money market funds. As they did in the early years of this century, these entities are stretching for return in the highest risk deals and frequently levering them up imprudently. The last crisis unfolded when many such deals imploded.

When left to their own devices, as bull markets get long in the tooth, investors lose fear and stretch for return, and Wall Street is ever ready to meet such demand with increasingly suspicious product. Such behavior recurs in cycle after cycle and is a compelling reminder that lessons of the past are readily discarded as we travel farther from the most recent financial crisis. Current behavior is certainly waving a warning flag.

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Quarterly Commentary 4th Quarter 2013

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Today’s investors face extremely problematic decisions. Risk-free options provide essentially no return. Traditional low-risk investments in fixed income securities have produced losses for the past year and a half. Common stocks have surged higher with only minimal interruptions for nearly five years. Ignoring equity risk has not only been the best approach since 2009, it has been spectacularly rewarded. But the risks have not disappeared; they have been successfully papered over. Apparently off most investors’ radar, they have risen exponentially.

According to the Federal Reserve, the picture won’t be improving soon for those who desire a return on risk-free investments. The Fed’s “forward guidance” indicates no intention to raise short-term interest rates for many quarters at the very least.

Notwithstanding the Fed’s best efforts, longer-term interest rates have risen substantially, with the ten-year U. S. Treasury yield doubling from July 2012 to present. As a result, long maturity Treasury bonds experienced double-digit losses in 2013. The Fed’s policy of financial repression, with an avowed purpose of forcing investors to forego safety and assume risk, led many into bonds or bond funds in the latter years of the past decade. When rates were declining with the Fed buying vast quantities of Treasury and mortgage-backed securities, those bond purchases proved profitable, leading an ever-increasing number of investors to seek such Fed-supported returns. That strategy worked until it stopped working. By the time rates reached historic lows in mid-2012, the number of bond investors reached all-time highs, just in time to participate in the bond losses accrued over the past 17 months, despite continued Fed bond buying. Should interest rates continue to rise over the quarters and years ahead (which is the Fed’s forecast), an increasing number of bondholders will be saddled with losses. Following the Fed’s suggested paths can sometimes be hazardous to your wealth, especially when the Fed attempts to distort normal interest rate or valuation boundaries.

Fed stimulus efforts continue to support stock prices, however. So far, investors who have trusted in the Fed’s support have profited handsomely. To the extent that would-be equity investors have let valuations or sub-par fundamental conditions dampen enthusiasm for stock ownership, they have missed profit opportunities.

The question facing investors today is whether or not to trust the Fed to keep the party rolling. Despite slumping stock prices both domestically and around the world in the early weeks of 2014, historically reliable technical indicators suggest that it’s likely this equity rally hasn’t breathed its last. The persistence of positive price movement, favorable advance/decline figures, far more volume going into advancing than declining stocks and Lowry’s buying power and selling pressure data all point to stock prices likely having at least months to go before finding a ceiling to this already 58 month-long rally. On the other hand, many measures of investor sentiment closely resemble their levels in 2000 and 2007, immediately preceding stocks’ losing half or more of their values twice so far in this still young century. Stocks are clearly overbought, overvalued and overbelieved. Speculative margin debt has exceeded even its prior 2000 and 2007 peaks. With money essentially free, stocks are doing what real estate did in the middle of the last decade, and which led to the biggest real estate crash in modern times.

It remains to be seen whether or not stocks are ultimately fated to travel a similar path following misguided Federal Reserve interventions.

It has been almost universally acknowledged–even by Fed supporters–that the elevation of asset prices has occurred with only minimal benefit to the broader economy. Just five years ago, the multiplication of the Fed’s balance sheet from $800 billion to today’s $4 trillion–with more to come–would have been inconceivable. That increase in debt in the pursuit of higher stock and house prices has prompted surprisingly little outrage. By contrast, I have condemned it repeatedly, and have heard not one credible plan for the ultimate reduction of that debt level. The vast majority of analysts, strategists and commentators simply ignore it.

In a December 2013 International Monetary Fund Working Paper, Carmen Reinhart and Ken Rogoff warned of the potential folly of such complacency. They chastised advanced country central bankers and other policymakers for their apparent belief that first world countries will escape the consequences of massive debt levels that regularly occur in overindebted emerging countries. Reinhart and Rogoff state: “The magnitude of the overall debt problem facing advanced economies today is difficult to overstate… and the current level of central government debt in advanced economies is approaching a two-century high-water mark.” They argue from considerable historic precedent that advanced countries are likely to have to resort to some or all of the same approaches to emerge from massive debt levels that emerging countries regularly employ. Those approaches include: debt restructuring or conversions, financial repression and significant inflation (all forms of default), affecting debtors and creditors alike. The authors make the point that history argues strongly that the potential for major countries to simply grow their way out of today’s debt levels is minimal. If and when such events occur, the potential consequences to the world economy and markets are severe.

With history arguing strongly that unprecedented debt levels are likely to lead to multiple instances of debt default around the world, holding substantial permanent equity positions is a high-risk proposition. Mission has instead chosen to employ a strategic equity allocation approach based on a time-tested reading of dozens of fundamental and technical data points. Over the past 33 years, this process has provided an average return about 400 basis points above that of the S & P 500 with fewer and smaller losses than that index has experienced. In 2013 this strategy provided a double-digit return with a mere 37% exposure to equity risk. With monumental overhanging debt uncertainty, we strongly believe a proven strategic equity allocation approach to be far more prudent than a sizeable permanent equity position.

Thomas J. Feeney
Managing Director
Chief Investment Officer
January 21, 2014

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Year-End Valuation Update

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The traditional year-end parade of investment analysts and strategists has been painting a rosy picture for 2014. A frequent argument emphasizes that a powerful up year such as 2013 is typically followed by another positive year, albeit one with a far more moderate return. Positive momentum could, of course, produce such a result.

At the same time, honest skeptics have reason to question whether central bankers will remain willing and able to continue unprecedented stimulus and, if so, whether such aggressive policy will remain effective in supporting equity prices.

Those of us who believe that valuations ultimately determine stock prices invariably sneak a peek at numerous measures of value. After having just received a year-end collection of valuation graphs from the outstanding Ned Davis Research data gatherers, now is a perfect time to evaluate market prices relative to historic valuation criteria.

While few analysts and strategists currently categorize market prices as “cheap”, most consider them “reasonable.” Very few, however, discuss valuation measures other than price-to-earnings. Chart 1 shows the S&P 500 selling at 19.1 times its trailing GAAP earnings. To put the current level into a clear historical context, we have drawn a solid line from the present level left across the entire date spectrum.

Chart 1 (Click on chart to enlarge.)
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While high, today’s 19.1 reading is obviously far below the peaks recorded so far in the twenty-first century. Observing that precedent, many commentators suggest that multiples could climb even higher before the current rally runs its course. It’s instructive to recall, however, that investors have rarely made money when purchasing stocks at or above the current PE multiple. Such purchases in the past two major market rallies preceded the two biggest stock market collapses since the 1929 crash and the Great Depression that followed.

If we consider today’s PE multiple relative to all cycles preceding the late-1990s, the current level is obviously high, typically exceeded only marginally near prior stock market peaks.

A look at other important measures illustrates that the market is, in fact, significantly overvalued. Chart 2 and Chart 3 demonstrate that price-to dividend and price-to-book value ratios never came even close to current levels before recent bubble readings.

Chart 2 (Click on chart to enlarge.)
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Chart 3 (Click on chart to enlarge.)
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The market crashes that began in 1929 and 1973—two of the worst of the twentieth century–each began at far less egregiously stretched multiples.

Chart 4 and Chart 5 paint the same picture with respect to price-to-sales and price-to-cash flow.

Chart 4 (Click on chart to enlarge.)
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Chart 5 (Click on chart to enlarge.)
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While these charts are current only through the third quarter and only go back to the 1950s, the message is nonetheless compelling. Almost certainly the multiples will be even higher when fourth quarter data are included.

While valuations are excellent long-term guides, they leave a lot to be desired as short-term market price forecasters. It is, of course, wise not to forget the old saying that markets can remain irrational longer than you can stay solvent.

While markets very rarely adjust instantly to any historic mean, it can be a helpful exercise to see where markets would be if they were currently at their long-term average levels. Doing a rough calculation of how much above average each valuation measure is today, it would take a 34% decline to just above 1200 for the S&P to reach its “normal” valuations. That level was first attained in late 1998 and, in the current rally, in March 2010. Prices are above that level today because valuations have risen far above normal.

We cannot know how long investor confidence will justify valuations remaining far above average. Next year we could again be celebrating a succession of stock market highs. On the other hand, there is a genuine risk that valuation measures could revert to or below long-term norms. The prime determinant probably remains central bankers’ ability to keep investors confident that they know what they’re doing and are capable of effectively carrying out their policy. The year 2013 demonstrated clearly the upside while that confidence prevailed. From today’s prices, reaching mean valuation levels would create great investor distress should that confidence wane.

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