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 ( 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.

Market Update 1/13/2012

*** 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 2012 as part of that communication effort***

Those of you who review your quarterly reports will notice that much of the downturn in Q3 was reversed in Q4 as markets calmed and fears of a Europe-led global financial meltdown were at least temporarily eased. As we stated in previous updates, as the probability of a European meltdown is reduced, the value of all risk-based assets tends to increase. That certainly held true in Q4.

In my view, the primary reason for this is a new loan facility put in place by the European Central Bank (ECB) by which member banks can borrow money at low rates from the ECB, using virtually any types of assets as collateral, for a term of up to three years. This is a much broader loan program than is typically in place, both in the ECB’s acceptance of risky assets as collateral and also in the length of time that the banks can utilize the loans. This facility, known as the Long-Term Refinancing Operation (“LTRO”) essentially removes the possibility of a major European bank failure in the next three years because the banks know they can access cheap money from the ECB, even if no one else will lend to them. That in turn instills confidence in the inter-bank lending markets because if no banks are going to go bust, then loaning money to each other at reasonable rates suddenly has little risk associated with it. Additionally, because the ECB is willing to accept risky assets as collateral for the loans, the banks can borrow money cheaply from the ECB and they can purchase the debt of European governments (which have much higher interest rates than the ECB charges, due to the recent increased risk of government defaults). The banks can earn the spread on the interest of the debt they purchase and the low-interest they pay to the ECB to borrow the money used for the purchase. In this sense, the ECB has provided a way for governments like Italy, Spain, and Portugal to borrow money without having to lend large amounts to them directly (which would violate the treaties that created the ECB and the Euro). While the LTRO is a bit of a shell game that moves risky government debt to the balance sheet of the ECB, and therefore to the responsibility of the stronger countries in the Euro-zone like Germany and France, it is much more politically acceptable than Germany and France funding those other nations more directly. So, if we know banks aren’t going to fail anytime soon, and we know that European governments aren’t going default anytime soon (with the exception of Greece which is too far down that road to help), much of the financial catastrophic risk is off the table for the time being. Don’t read this to say that Europe’s problems are behind them, but the urgency to resolve them before the financial world ends has eased. That’s the primary reason why stock markets are improving, volatility is decreasing (for now), and credit markets are normalizing.

Along with improvements in Europe, the U.S. economy has been showing mild signs of life. Recent economic readings show mild expansion in both the manufacturing and services sectors of the U.S. economy. Jobs are being created (albeit at a slow pace and it should not be forgotten that we’re still down six million jobs from the peak in 2007). Housing is showing some signs of stabilizing as the inventory of homes available for sale has fallen to more balanced supply/demand levels over the last few months (though prices and sales are still falling in many areas). It remains to be seen whether this is an emerging trend that instills confidence in consumers and corporations to trigger more spending, more investment, more hiring, higher wages, and the virtuous cycle that follows. I’m skeptical that we can quickly return to the old-normal of 5% unemployment and 3-4% real annual GDP growth while the government is focused on cutting deficits and the consumer is focused on cutting debt and facing higher taxes. But, I do believe there is room for slow to moderate growth through productivity and population growth. There are certainly opportunities for both government and the private sector to be more efficient in our use of resources and in the way we create economic incentives for people to work hard, innovate, and deliver value back to the economy. That efficiency can drive growth for years to come even during an aggregate deleveraging cycle.

Speaking of economic incentives, there are some rather large changes to the tax code that will take effect in 2013 and will have an impact on all of you in their current form. In the coming months, look for a summary from me of what is headed your way from these changes (hint: it’s not lower taxes). We’re in a somewhat strange situation where the changes are already legislated because they come from expiring temporary changes to the tax code. So, the only way to stop them would be to pass new laws that prevent the old laws from returning. Given the political situation in Washington… let’s just say that I think it’s prudent to plan for higher taxes starting next year and that the higher up you are on the income scale, the more dramatic that increase is likely to be. More to come on that. We’ll also be formally kicking off 2011 tax season shortly with a blast message indicating what you need to do if PWA is preparing your taxes this year.

I hope you all had a wonderful holiday, that your 2012 is off to a great start, and that you continue to move closer to achieving all your personal and financial goals. As always, if you have any questions, please feel free to contact me.

Market Update (10-07-2011)

*** 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 after a terrible September 2011 and in the escalation of the European sovereign debt crisis as part of that communication effort***

Many of you will remember my messages at the beginning of Q3 which indicated that the Fed-provided updraft in financial markets was likely behind us with the end of their Quantitative Easing program as well as my fears about what seemed to be a troubling situation in European government debt (specifically Greece). I pointed out that despite 7-8 consecutive quarters of seeing account balances move up, you should be prepared for more typical up-and-down quarters to come. Those issues in Europe have intensified and put pressure on markets around the world as you’ve undoubtedly heard and noticed by now. U.S. stocks, as measured by the S&P 500 were down almost 14% for the quarter. Small-cap U.S. stocks and international stocks were down over 20% for the quarter with some sectors and emerging markets fairing even worse. Consequently, you will see that your account balances for aggressive portfolios have fallen along the same lines in Q3, while more conservative portfolios have had a more muted response, but have fallen nonetheless. Each day, and often multiple times per day, I ask myself if the fall in stocks is appropriate given the circumstances in the global economy. Should we be getting more aggressive because the markets have overpriced the probability of a global recession and another credit crisis led by Europe’s woes? Should we be getting more conservative because the markets haven’t priced in that probability enough? As I’ve discussed with all of you in the past, I believe that markets are generally extremely good at processing information and letting the aggregate intelligence of millions of participants determine the right price for a given security and the market as a whole. While there is sometimes misalignment for spectacular reasons, I don’t think we have that misalignment right now.

World economies have problems, very big problems, especially in Europe. Their government debt issues have the capability to bring down banks like our mortgage problems brought down banks here in 2008. If European banks fail, a chain of events will take place which will spill over to the U.S. in multiple ways. First, Europe as a whole is a bigger economy than the U.S. So many of our companies do a significant portion of their business in Europe. If Europe slows, so will those companies. Second, many U.S. banks own assets that derive their value in one way or another from European companies and countries. Those assets will fall in value, putting the same kind of strain on our banking system as it faced when mortgage assets fell in value. Third, the U.S. dollar will likely strengthen vs. European (and other global) currencies via a safety / liquidity trade. This will hurt U.S. exports and especially when combined with the bank issues which will make credit harder to obtain, it will stop any recovery we’re seeing dead in its tracks. As the probability of a Greek default rises, unless there is a credible plan in Europe to stop the chain of events (think dominos falling) that would occur because of it, values of markets around the world will fall. Along those same lines, as the probability of a Greek default falls, or containment plans that would stop the domino effect emerge with more credibility, markets rise. This impacts global markets in that they all begin to move in the same direction at the same time and, depressingly, that impact swamps the impact of individual company, industry, or even country performance.

The situation in Europe seems grave, but there are a few underlying mitigating factors that are seldom discussed. Companies have gone through major cost cutting in the last three years and have increased their own emergency funds drastically. In aggregate they have almost double the cash on hand than they did in the 2008 downturn which leaves much more room to survive another downturn without severe additional cost cutting and layoffs. Banks have been recapitalized and continue to be supported by lending programs from the Federal Reserve, lowering the odds of another Lehman-like failure dramatically from where it was pre-Lehman. Consumers have been paying down debt rather than taking on more of it over the last few years. House prices have continued to fall (yes, I’m calling that a good thing for the future even though it has been a bad thing for homeowners to date), while mortgage rates are at historic lows (30-year fixed avg’d 3.94% last week!!). Housing is the largest expense for most of people, and it hasn’t been this cheap in decades. Energy prices continue to move with the economy, softening the blow of a slow down with reduced prices for heating this winter and at the pump where many areas in the country have seen a 20% reduction in gas prices over the past few months.

My conclusion to all of this is that the market seems to have appropriately priced the risks that are present in the global economy. It’s also appropriately pricing in the fact that companies and individuals are more capable of handling an economic slowdown than they have previously been. It will continue to operate on a binary level, Europe’s looking better – the world’s not ending – stocks up… vs. Europe’s looking worse – we’re all doomed – stocks down. Eventually, governments and federal reserves will stop taking the headlines and company productivity and innovation will win it back. Until then, expect the volatility to continue, again, in both directions, and with all but the safest of asset classes moving in tandem.

We’re of course taking advantage of this volatility in two ways. One, through rebalancing, selling bonds (which have generally increased in value through the turmoil), and buying stocks (which have fallen) to re-establish the stock/bond ratio that is appropriate for your goals. When the market turns around, you’ll have more stock than you would have which means you’ll gain more than you would have, allowing us to sell stocks and buy bonds again to re-establish the proper ratio. This provides for a natural, non-emotional, buy low / sell high rhythm to the portfolio. Second, where possible, we’re beginning to take advantage of losing positions by selling them, realizing the capital loss, and reallocating the money in similar assets. This process, called “tax-loss harvesting”, allows us to capture the loss for tax purposes, either offsetting other gains in your portfolio, or allowing you to take a deduction for losses on your 2011 taxes, all while leaving your exposure to the asset the same so you’ll benefit when the market starts to rise again.

So what does this all mean to you? Well, it means that nothing has really changed from a financial planning standpoint. Your emergency fund money is in cash and continues to protect you in the case of an emergency. Money for short-term goals is protected in lower-risk portfolios with a higher percentage of short-term, high quality bonds that continue to pay interest though a downturn. Money for long-term goals is exposed to the short-term whims of the market in exchange for the likely higher average returns that will be earned over the long-term. In reality, long-term money is better off if the market would stay low for a while and let individuals get more into it before it rises over the long-term.

As long as the emergency fund is big enough (but not too big to impact your ability to fund future goals)… as long as the short-term portfolio is consistent in size with what’s needed for your short-term goals… and as long as the long-term portfolio is defined properly (i.e. you’ve communicated your lack of need for that money in the short-term properly)… then your ability to achieve your goals remains intact despite the stock market’s past quarter of performance. As always, I encourage you to communicate with me whenever something changes in your life that could impact the size or timing of your need for your money. Take your annual review seriously and really think through what you want for the future well in advance of needing money to get it. If you don’t know where you’re going, any road will take you there (thanks Lewis Carroll). But if you do know where you’re going, you have a map, you have the right vehicle for the bumps you might encounter, and you have the help of someone who understands the road, there’s a pretty darn good chance you’ll make it.

As always, if you have any questions, please feel free to contact me.