Keep Calm and Carry On

While reading an article about the Nobel Prize award to two American economists, I spotted a headline to the right.  It featured a link to a story CNN wrote in honor of International Day of the Girl.  Titled “To my 15-Year Old Self:  Things I Wish I’d Known,” the writer posed that question to notable women in a variety of fields.  The link showed a picture of Oprah, because you always have to ask her those sorts of questions.

I find her rather annoying, so, naturally, I clicked the link.  The problem I have with her is she seems out of touch.  It is easy to talk about “living your truth” and “risking everything to pursue your passion” when you are a multi-billionaire for whom the risks brought great reward.  Do you think the person who just lost everything when his/her business collapsed feels happy and fulfilled because they “followed their dream?”  Doubtful.

Anyway, as I read the quotes from these highly successful ladies, it occurred to me that living in the past can be a dangerous thing.  Sure, it is good to look back and say, “Oh, I really wish I had not done that.”  On the other hand, you can become so paralyzed by fear of making the same mistake that you take no action at all.  The key is to learn from the mistake and get on with your life.

We can do that in our portfolios too.  There was a time when I was reluctant to invest excess cash in my portfolio because of current market conditions.  As a result, I missed out on some of the upticks in the market.  The lesson I learned is emotion has no place in investing. 

You may have similar feelings now with the upcoming election.  What happens if Obama is re-elected?  What would Romney do if he becomes President?  Will this country fall into a Great Depression or have a huge economic boom?  No one knows.  However, I would bet that, if you looked at previous elections, similar comments were said about the president and candidate then.  It happens with every election.  Work the crowd into a frenzy so they will watch the news.

We cannot change the past.  We cannot predict the future.  Let’s focus on what we can control (our behavior), keep calm, and carry on.

Cristy Freeman, AAMS
Senior Operations Associate

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Don’t Blame Me, I Voted for Kodos

“It makes no difference which one of us you vote for. Either way your planet is doomed, DOOMED!!”

This is one of my favorite quotes, from The Simpsons Treehouse of Horror VII – Citizen Kang episode. In it, news anchor Kent Brockman is interviewing presidential candidate Bob Dole, who is actually the alien Kang in disguise. Kodos, the other alien, is disguised as Bill Clinton. When their true identities are revealed, Kodos says, “It’s true, we are aliens! But what are you going to do about it? It’s a two-party system – you have to vote for one of us!”

I was reminded of this episode (well, I’m often reminded of this episode during election years, but most recently) when I came across an article from Knowledge@Wharton, entitled, “Back to the Future: What’s at Stake for the Economy in the Obama-Romney Contest.” In it, three Wharton faculty members say that, while we’re not exactly doomed, the future isn’t likely to look too different from the present, regardless of who wins in November. Basically, the problems facing the economy are too vast to be resolved quickly, and a divided government will keep either party from fully enacting its policies.

As depressing as that sounds, it was a relief to me when I read it, if only because it validated my own feelings about the current situation. Mainly, that a recovery will take time and that there are no quick fixes. The Federal Open Market Committee seems to agree that the recovery has a long way to go. Calling high unemployment a “grave concern,” Ben Bernanke and the Fed extended the bond-buying program with a third round of quantitative easing. They are now expecting to hold the federal funds rate near zero through mid-2015 (after previously saying it would remain low through late 2014). On the positive side, the committee increased its estimate for GDP growth to 2.5-3% in 2013 and 3-3.8% in 2014. The market, of course, loves the announcement of continued stimulus, with the S&P rising above its highest close since 2007 on the news. Of course, not everyone is so sanguine about QE3, fearing that it will fuel inflation at worst, or have a marginal impact at best.  Thus far, the stimulus hasn’t materially affected inflation expectations, according to Bernanke, who cited a Fed study that also indicates the asset purchases have raised the level of economic output by almost 3% and increased private employment by over 2 million jobs.

In the near term, the economic recovery may continue to limp along no matter who is elected in November. In the meantime, we can focus on the inspirational words of Kodos/Clinton, who said, “We must move forward, not backward; upward, not forward; and always twirling, twirling, twirling towards freedom!”

Sarah DerGarabedian, CFA
Director of Research

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A Crisis of Confidence

Self-fulfilling prophesy. You hear that term a lot regarding the stock market. It was coined by sociologist Robert K. Merton, father of economist and Nobel laureate Robert C. Merton, known for his work on options pricing models (Black-Scholes-Merton, anyone? Anyone? Bueller?). Of course, the idea of the self-fulfilling prophesy has been around for ages and is a popular plot device, from Oedipus and Macbeth to Star Wars and Harry Potter.  It’s a fascinating concept, whereby a prediction influences the behavior that indirectly leads to the fulfillment of the prediction. I was talking with some colleagues about the phenomenon as it relates to testing. A person can end up failing a test, not necessarily because they were unprepared, but because they were so worried about failing that their lack of confidence caused them to freak out and freeze up on exam day.

In fact, it’s lack of confidence in the economy that we’ve seen weighing on the stock market lately. Investors hear news of a possible Greek default and subsequent European financial crisis and they worry that it will cause a downturn in global markets. As a result, they sell their investments, which – guess what? – causes markets to go down! A self-fulfilling prophesy. Then, the news turns positive (a possible bailout of Spain) and markets rally as confidence improves and investors buy back in.

It’s interesting to watch the effect of human behavior on the markets, but it can make you downright seasick when you’re invested in the market and riding the waves of sociological phenomena.  I know we’ve said it a thousand times, but the best thing to do is sit tight. If you can resist the pull of the crowd, you can dampen its effect on markets in some infinitesimal way. More importantly, resisting the urge to time the markets has been shown to improve investment returns over the long run.


Sarah DerGarabedian, CFA

Director of Research

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Fill ‘er Up

So, what’s up? Oil prices, for one. Food prices, too. As Americans, we have gotten used to cheap fuel, both for our cars and our bodies. Recently, there have been calls to repeal federal subsidies to the oil industry, in hopes that it will encourage development of alternative sources of energy and lead to long-term relief from oil prices. Some believe that such an action would have the effect of raising gas prices in the short term, and they’re probably right.  I would think that the oil companies have to recoup losses somehow, and it usually winds up being the consumer who pays. As someone wedged smack in the middle of the middle class, I know I’m feeling the pain of higher gas and higher food costs, and I can’t say that I like it very much.  But if I step back and observe the situation in a more impartial light, I have to question the use of subsidies in both industries.

I’m no econ genius, to say the least. I remember the graphs showing supply and demand curves, and some mysterious shaded portion ominously called the “deadweight loss.” And there was something in there about subsidies being a negative, as they prevented markets from functioning at equilibrium levels because they artificially distort market prices. In the US, growers of certain crops receive government subsidies, which have the effect of encouraging farmers to grow a few primary crops in large quantities. These crops (mostly corn, soybeans, and wheat) are the building blocks of much of our processed, inexpensive foods, which are taking the place of more nutritionally dense foods in our diet. Large quantities of inexpensive food sounds like a good problem to have, and I’m sure the original intent of these subsidies was benevolent. However, the alarming growth rate of obesity and related diseases in our country may be due in part to an increase in readily available and affordable processed foods derived from our primary crops. In many cases, food’s affordability and nutritional value have an inverse relationship, so it would seem that we are, in fact, doing ourselves a disservice by making it easy to load up on nutritionally deficient food.

Subsidies to the oil industry are another head-scratcher. We know that fossil fuels are a natural resource in decline – we can’t wait around for organic matter to decompose over millions of years and create more hydrocarbons. Why are we always so surprised when the price of oil goes up? The Europeans laugh at our outrage over $4/gallon gas prices, which is nothing compared to what they’ve been paying for ages. Maybe we do need to take away the subsidies in order to feel the pain and provide the incentive to take the next steps and make the right choices. I’m not a big fan of paying more for gas and groceries, believe me, but I think it’s crucial to look at the big picture and take the long-term view.

Sarah DerGarabedian, CFA

Director of Research

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Decisions, Decisions…

I came across a most interesting article the other day about the burgeoning field of neuroeconomics, written by Robert Shiller. Researchers are attempting to use neuroscience to see how the brain makes economic decisions. Modern economic theory, on the other hand, is based upon the assumption that people are rational and make decisions that will maximize their utility. Rational? Seriously? Have you seen people? Let’s just take the recent events of Black Friday as an example, with the pepper spraying, shooting, and soccer-game-esque riots over bath towels. And what about the market? There’s a reason they call the VIX the “fear index.” As somebody with a background in hard science, I’ve always thought calling economics a ‘science’ is a bit of a stretch. How can you quantify behavior and emotion and all the myriad ways that a person or group of people will respond to a particular situation, when every situation is different? It’s not like testing the boiling point of water or the specific gravity of lead where the answer is always the same.

Neuroscientists are making headway into understanding brain function and the biological structures underlying thought processes, and recently have been collaborating with economists and psychologists to see if a there is a physical basis for economic decision making. Finally, something I can get on board with! Though still in the early stages, I think this is an interdisciplinary field that bears watching. It’s certainly popping up in universities all over the country – if I had to do it again, I’d consider enrolling. I have a recurring dream that I never actually graduated from college, and I’m back on campus to complete my credits. Maybe I can work in a way to study some neuroeconomics while I’m at it. In my dreams, right?

Sarah DerGarabedian, CFA

Director of Research

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The “not-so Super” Committee

As expected, this week the Joint Select Committee on Deficit Reduction (the “Super committee”) failed to come to any agreement on what measures would be recommended to reduce the budget deficit by $1.2 Trillion. Therefore, automatic spending cuts are scheduled to begin in 2013.  The major rating agencies did not undertake a further downgrade of U.S.debt as a result of the impasse. 

Much of the deadlock revolves around whether tax increases will accompany spending cuts in order to move closer to a balanced budget.  At the same time, across many cities in the US, protestors are demonstrating against a combination of things like outrageous executive bonuses and the perception that the distribution of wealth in the country is becoming more skewed towards the top income earners.  I have seen signs both on the news and in person saying “we are the 99%”.  Before you go creating your own sign and joining the movement, let’s have a quick review of the math. 

According to a recent study going back to 1922, the peak level of wealth disparity was in 1929, when the top 1% of households controlled 44% of the country’s wealth.  In 2007, it was 34.6%.  Therefore the concentration of wealth in the country is down over the long run, although it has risen significantly since the 1976 low of 19.9%. 

Now let’s move on to income taxes.  According to the National Taxpayers Union, for the 2009 tax year, the top 1% of household incomes paid 36% of total Federal income taxes. This is approximately in proportion to the overall level of wealth that they control.  The top 10% of taxpayers paid over 70% of the total. 

In 1999, the top 10% of taxpayers paid 66% of Federal income taxes.  Therefore, over the last 10 years, the proportion of taxes paid by the top 10% of taxpayers actually increased. 

The top 10% can pay at most 100% of the income taxes.  So the current argument comes down to what number between 70% and 100% they should pay.     

The top 10% starts lower than many people might think.  For 2009, Adjusted Gross Income on your Federal tax return of $112,124 would put you in the top 10%.  This is within reach of many households, particularly for a married couple where both spouses work.  For a family of four who are fortunate enough to enjoy this level of income, I suggest their lifestyle is comfortable but not extravagant.  For the 90% below this level, things are more challenging. 

The current stalemate about taxes is annoying, and it is likely that some combination of tax increases and spending cuts will be needed to achieve any meaningful reduction in the budget deficit. 

Increasing taxes on the top 1% may be part of the solution.  Over the last 10 years, the top 1% paid a relatively stable proportion of taxes, while the tax burden on the next 9% has increased. But there are simply not that many people in the 1% to where they can be expected to pay the tax burden for the entire country. 

How about increasing taxes on the top 10%? The problem here is that the top 10% includes many dual-income families, and this group already pays a disproportionate amount of Federal income taxes (9% of taxpayers are paying about 44% of the taxes). 

Another part of the solution might be to replace part of the income tax with a consumption tax.  This would capture some tax revenue from the underground economy of people currently working for cash, when they eventually go to a store and spend the money they have earned but not declared as income.  As the election approaches over the next 12 months, particularly in light of the Super committee’s failure, taxes are going to be a pivotal issue.  Hopefully there is a chance for true reform.

Bill Hansen, CFA

Managing Partner

November 23, 2011

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Where are the Jobs?

Today the Bureau of Labor Statistics (BLS) released total non-farm payroll growth for the month of September of +103,000 jobs. This was above the consensus estimate of about +60,000 jobs. July non-farm payrolls were revised upward by +42,000 to +127,000, and August was revised from 0 to +57,000. This makes August the fourth consecutive month with positive revisions. Private sector jobs continue to grow, while government jobs have been declining.

On Thursday it was announced that jobless claims fell by about 30,000, which was also a positive surprise.

Many people are concerned about the unemployment rate, which remained unchanged at 9.1%. In order to reduce unemployment, we will need to see sustained job gains of about 150,000-200,000 per month. Without job growth, there is concern that the economy could tip back into a recession.

We believe this is unlikely, as the economy is still growing, but slowly. In order to have a recession, we would need two consecutive quarters of negative growth. First quarter GDP was +0.7%, and second quarter GDP was recently revised from +1.0% to +1.3%. Current expectations for third and fourth quarter GDP growth are around 2%. Therefore, it appears that economic growth is positive and improving.

Unemployment is a lagging indicator, and is typically the last thing to improve coming out of a recession. By contrast, the stock market is forward looking. Our expectation is that the market will lead job growth, which will in turn push the unemployment rate lower. By the time the unemployment rate improves significantly, the market could be at much higher levels. We advise our clients not to get spooked by short-term focus on any particular weekly or monthly economic indicator, and to avoid dramatic changes to their portfolios based on the mood of the day. The jobs picture is not as grim as many headlines would have you believe.

Bill Hansen, CFA
October 7, 2011

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Stock Market Volatility

It’s been a wild week for stocks.  Not only are stocks down roughly 9% from the end of July as of the close of market August 11, but the pathway down has been marked by extreme volatility.  This month we have experienced six of the 200 most volatile days of the past 50 years.  We have had daily losses of 2.5 – 6.6% and have had daily gains of greater than 4.5%.  These losses were kick started with the political wrangling of the debt ceiling, and were intensified with the ensuingU.S.debt rating downgrade by S&P.  The market losses and volatility are leaving many investors uncertain about the state of the economy and their portfolios.  We offer three scenarios to consider – base-case, worst-case and best-case – and their potential effects on the stock market.

The base-case scenario is the one that we consider most probable, and that is continued slow-growth in the near-term, with eventual normal growth resuming in the long-term.  We’ve seen two quarters of slow growth already, 0.4% for the first quarter of 2011 and 1.3% growth in the second quarter of 2011.  Slow growth quarters are historically not useful predictors of recessions.  Given our fragile economy, such slowing may induce the Federal Reserve to engage in more economic-stimulating measures.  We recognize that an offset to these growth stimulators are high, though slightly improving, unemployment, as well as global political and fiscal uncertainty.

Despite a slow-growth economy, corporate earnings are at an all time high, with expectations that S&P 500 earnings this year will be $100 per share.  This puts the stock market at about an 11.5 price-to-earnings ratio, far below its historical average of 15.  For this reason, we don’t see a catalyst for a further, significant, sustained drop in stocks.

The worst-case scenario is another recession.  Reasons for this possibility are well known:  tax uncertainty, high unemployment, nervous consumers.  General panic is not known to cause recessions, though some fear this could become a self-fulfilling prophecy.  Panic does indeed affect stocks however, which is what we are seeing currently.  Stocks are known to be a leading indicator of recessions.  When recessions do occur, the median historical market peak is about 7 months prior to the start of the recession.  But typically once you know you’re in a recession, it’s actually time to buy stocks.  In fact, the recessions of 1953 and 1990 saw stocks go straight up.

The best-case scenario is the resumption of robust growth.  The record corporate earnings may spur business and investor confidence.  There is said to be pent-up consumer demand waiting to be unleashed at the suggestion that still on the road to recovery.  Too, oil prices have come down considerably.  You may recall that just a few months ago high oil prices were a huge concern for the economy, as this necessary product would hamper other consumer spending.  And though theU.S.debt downgrade has spooked the stock market,U.S.treasuries, the very debt that was downgraded, have actually rallied.  This is because, in the end, investors still believe in the strength of theUnited States.

Our Chief Economist, Jim Smith, predicts year-over-year GDP growth of 1.9% for 2011 and 3.9% for 2012.  Whatever the economic outcome over the next few months, we must accept that our economy is a cyclical one, in which we experience recessions and expansions.  Long-term growth of GDP and corporate earnings leads to long-term appreciation of stocks.  Being a buyer and holder of equities gives you the ability to participate in this long-term growth.

We believe that to be a successful investor in stocks you have to accept the volatility, and the uncertainty that surrounds it.  Corrections and bear markets are part of the territory.  As an investor, it’s tempting to believe that you have the ability to guess the timing and direction of stocks, but attempting to do so is hazardous to your financial health.

Harli L. Palme, CFP®

Financial Advisor

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Don’t Get Sentimental

Today’s headline on Yahoo Finance “July Consumer Sentiment Worst Since March 2009” caught my eye.  What they are referring to is the Thomson Reuters/University of Michigan consumer sentiment index, which is a survey of consumers.  This got me thinking about investor sentiment. 

Investor’s Intelligence publishes a weekly index of sentiment derived from investment newsletters, with data going back over 40 years.  Some of our clients may be familiar with Jeremy Siegel’s book Stocks for the Long Run.  In this book, Professor Siegel used this data to derive his own index of sentiment.  He then measured subsequent stock market returns for the period 1970-2006, as well as for individual decades.  The results vary by time period, and there is no guarantee that future results will be similar to what has happened in the past.  However, some interesting relationships emerge.  I like to look at as much data as possible, so I will focus on the entire 1970-2006 period:

When sentiment went above 80%, subsequent returns over the next 12 months were negative.  When sentiment fell to 50% or below, subsequent 12 month returns ranged from +13.43% to +20.74%.

Investor sentiment is a funny thing.  The human brain is wired to do the wrong thing at the wrong time in the stock market.  I start to get worried when investor sentiment levels are high, and feel better when they come down a bit as they have recently.  Sentiment is currently around 59%.  This is down from a 2011 high early in the year of almost 80%, and up from a low of less than 30% at the recent stock market bottom in early 2009.

There is always something to worry about.  Currently it is the debate over raising the debt ceiling in the US and the continuing credit issues in some of the Euro zone countries.  We are confident that these issues will get resolved.  Something else will then come up, whether inflation or deflation, a geopolitical event, a natural disaster, or something completely unpredictable. 

We are encouraged by rising earnings and dividends in the US stock market.  Consensus earnings for 2011 are about $98 for the S & P 500.  This equates to a price/earnings multiple of about 13.4, below the historical average of around 15.  Many companies are increasing their dividends as well.  Stock prices eventually follow rising earnings and dividends, and we believe the current combination of reasonable valuations with reasonable levels of sentiment are a tailwind for long-term returns. 

Bill Hansen, CFA

Managing Partner

July 15, 2011

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Why We Don’t Think It’s Time to Buy Japan

The respected financial magazine Barron’s published an article this week titled “Invest in Japan”. Many feel that the increased spending needed to rebuild will actually provide a boost to their economy, which has suffered from slow economic growth and deflation for over 20 years. My thinking on the issue is a bit different.  

Prior to the earthquake, we had little or no direct exposure in client accounts to Japanese stocks.  We eliminated our largest holding, the iShares Japan Index ETF, back in 2009 for two reasons:  concern about the level of Japanese government debt relative to the size of their economy and the aging of their population. 

The ratio of Japanese government debt to Gross Domestic Product is over 200%, compared with about 70% for the United States.  One reason that they have been able to operate with such a high debt level is the high savings rate of Japanese individuals.  But with debt already at such a high level, the concern is that interest rates may rise significantly if new debt is needed to finance the reconstruction.

The issue with an aging population is relatively straightforward.  As the population ages, there are fewer and fewer people entering the workforce to replace those who are retiring.  This puts pressure on entitlements such as old age pensions and their national healthcare system.  Without a pickup in economic growth, the only way to pay out the benefits that have been promised is issuing even more debt.

Why not buy stocks?  On Monday, March 14, the Nikkei 225 index closed down 6.2%.  As of yesterday, the Japanese market is down about 7.8% this year. Many investors look at dips such as this as buying opportunities.  The kindest thing that you can say about a “buy-the-dips” strategy is that it works sometimes.  The Nikkei 225 is currently down about 75% from its all time high in 1989.  Even if you bought dips on the way down, you are going to be waiting a long, long time to make money. 

While a price decline may be good reason to review a market, sector or individual company, it shouldn’t be the sole reason for making an investment.  Instead, it should be a starting point for a more thorough review.  In our view, the negatives in our original thesis have not changed.  If anything, the current situation makes the Japanese market even less attractive than before the earthquake.  Despite the currently attractive valuations of Japanese stocks, we believe the macro factors overhanging the economy are significant.  Rather than viewing them as “cheap”, I would say they are “cheap for a reason.”

Why not buy Japanese Government Bonds (JGBs)?  Because of the high domestic savings rate, interest rates in Japan are relatively low.  The 10-year JGB currently yields about 1.23%, compared with 3.40% for a 10-year US Treasury Note.  We do not find the current US Treasury yield to be attractive, so we are not particularly interested in an even lower yield overseas.  An investor in JGBs is also taking on exchange rate risk if the Yen depreciates from its current level of about 80 Yen to the Dollar.  JGBs will also be hurt if Japanese interest rates rise.  There just doesn’t look to be much return relative to these risks.

This article has focused only on the investment implications of the recent disaster.  Our hearts go out to the hundreds of thousands of people who are suffering from the earthquake, tsunami and reactor leaks.  We encourage both our employees and clients to be charitable, and one organization among many that is trying to help is the American Red Cross.  You can go to and donate online, and direct your donation to earthquake relief if you choose.

Bill Hansen, CFA

Managing Partner

March 25, 2011

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