Market Update 7/5/2012

*** We believe communicating with our clients is of utmost importance, especially during turbulent times in the market. While we don’t claim to have a crystal ball on the future of any financial market at a given point in time, we do believe that keeping clients informed on why things are happening increases their comfort level and understanding. This post contains a message initially sent to clients just after the start of Q3 2012 as part of that communication effort***

Q2 2012 proved to be yet another roller coaster quarter in the financial markets led mostly by continuing debt problems plaguing European governments & banks, and the economic slowdown driven in part by fear and in part by the austerity measures that are being put in place to try to rectify the debt overhang. After losing much of the Q1 gains through the month of May, markets rallied back in June on hopes of progress in Europe following the latest Greek elections (a win for the party that wants to stay in the Euro), a hint that Germany may be willing to concede to a cross-country banking union of some sort, and the extension of Operation Twist by the U.S. Federal Reserve (thereby also extending hope of more easing in the future). US stocks a whole lost just over 3% for the quarter, with international stocks losing just over 7%. U.S. interest rates continued to fall with short-term rates pinned near zero and long-term rates plunging to historic lows (U.S. 10-year yields just under 1.6% as I type this note). This helped bond funds to perform fairly well in aggregate, up about 2% for the quarter. Commodities fell on global growth concerns, down 4.5% for the quarter with energy components leading the way down. While investments in commodities lost value, the economy as a whole likely felt some relief from declining energy prices which helps consumer confidence and more importantly, consumer budgets. As we noted in our Q1 update, we expect risk assets like stocks and commodities to continue to remain volatile, both up and down, for the short-term, with bonds in aggregate generating fairly constant, albeit low returns. Interestingly, the national average rate on a savings account is now 0.12%. While it doesn’t get much safer than an FDIC-insured savings account, with year over year inflation running close to 2%, that’s a guaranteed loss of almost 2% per year by keeping money in cash.

While much has been blamed on Europe over the last two years, the U.S. faces its own issues heading into 2013. At current pace, we borrow approximately fifty cents of every dollar we spend as a government. This completely unsustainable way of running of the country will take its toll at some point in the future. The good news is that we seem to know that we have a problem. The bad news is that the method by which we fix it is heavily debated by our two political parties, each seeming to move toward a more extreme position as time goes by. It would be difficult to call them deadlines, but at least strong milestones loom in the not too distant future with the major credit ratings agencies noting that if the U.S. doesn’t come up with a credible plan for reducing the deficit by the start of 2013, another rating downgrade will follow. As current law stands, three dramatic changes are scheduled to be implemented in 2013. These have become known in aggregate as “The Fiscal Cliff”. They include the sequestration of defense spending budgets, the repeal of the 2001 & 2003 tax cuts which will increase tax rates on everyone who pays U.S. taxes, and the next steps in the implementation of the new healthcare laws which will institute a new Medicare surtax on certain individuals. If these changes go into effect, they combine spending cuts with tax increases in a slowing economy that is plagued by high unemployment already. This dramatically increases the possibility of another sharp recession. If the changes don’t go into effect and no other credible plan is put into place to balance the budget over time, the credit worthiness of the U.S. will come into question. If/when that happens, borrowing costs will start rise, putting more pressure on the budget (higher interest payments) and that spiral of debt that is all too familiar in southern Europe could attack the U.S. in much the same way. The answer to this problem in our opinion is one that Congress will get to eventually. That is, easing the Fiscal Cliff for the short-term and simultaneously publishing a credible plan for the long-term, likely through an overhaul of the tax system and a review of programs like Social Security and Medicare that are growing to levels we can’t support over the long-term. What’s not clear is whether the will exists to accomplish this before sharp and severe economic realities hit.

Led by the election in November, we believe the issues in the U.S. will come to the forefront over the next few months. It is likely that the stock market will gyrate, perhaps wildly at times, as solutions are brought forward and political power for the next 2-4 years is revealed. Further stimulus by the Federal Reserve, possibly in a coordinated effort with central banks around the world, will become more likely if economic conditions deteriorate. Monetary stimulus would continue to provide a temporary floor to the economy and to asset prices by simply pumping more money into the banking system. If the Fed does this, cash is one of the worst places to be as interest rates will continue to near zero while inflation would likely pick up as more money enters the financial system.

What all of this means is that we’re unfortunately stuck in the middle of a potentially deflationary bout of economic deterioration (where we’d want to hold cash and bonds and avoid stocks and commodities) and a potentially inflationary move by the Federal Reserve and other central banks to offset that economic deterioration (where we’d want to avoid cash and bonds and own stocks and commodities). The market in aggregate continues to do a very good job of pricing the risks to both sides. The current best course of action is to maintain asset allocation targets and continue to take advantage of volatility through portfolio rebalancing. We are monitoring the economic landscape closely and are prepared to take action if risk/reward does come out of balance in the coming months. If the market rally significantly from here on a perception that the world’s problems are solved, we will likely move toward more conservative portfolios by adjusting all models and using hedging positions where appropriate. For now though, we believe the inflation/deflation scenario is well-balanced and that stocks, especially in comparison to other asset classes, remain well-priced.

More on the fiscal cliff, stock valuations, Europe, and a host of investment and other personal finance topics will be presented on the new PWA blog which is officially live as of today (blog.perpetualwealthadvisors.com). In future quarters, rather than sending you emails like this, we’ll be posting shorter, more easily digested ruminations on the blog. You can subscribe to receive emails on new blog posts if you prefer to receive the content in your inbox rather than on the sites. Our Facebook and Twitter pages are also live, though with each still under construction and notably light on content (as is the case for all new pages). We’ll rectify that shortly. Feel free to provide encouragement by “Liking” & “Following” us. You can find links to all the pages via the icons in the signature below. For those of you who have made it this far into reading this email, you’ll be receiving a second notice about the blog, Facebook, and twitter pages in the coming days specifically because I’m guessing only a few of you made it this far (which I find as solid confirmation that a blog will be more useful than long emails each quarter). You have my apologies in advance for the double notice. As a reward however, reply to this message with a suggestion for a future blog post topic and you’ll be entered into a drawing to receive a gift card at the end of the quarter. As always, if you have any questions or comments about this message or anything else, please don’t hesitate to ask. Thanks for reading and enjoy the rest of the summer.

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