Inflation Ahead?

With the extraordinary amount of fiscal and monetary stimulus pumped into the financial system over the last 12-18 months, many investors are concerned with the prospect of future inflation. The large U.S. budget deficit is another potential inflationary factor if it is financed by the government expanding the money supply.

Despite these factors, inflationary expectations in the bond market are quite low. There is even a small but vocal minority of market participants that believe that deflation remains a significant risk. One way to determine the markets’ expectation for inflation over the next ten years is to compare the yields of U.S. Treasury Notes against those of Treasury Inflation Protected Securities (TIPS) of similar maturity. The current yield on the 10-year U.S. Treasury Note is 3.33% as of this writing, while the 10-year TIPS yield is 1.5%. The difference of these two numbers is the implied inflation rate over the next 10 years of 1.83%. If inflation over the next 10 years turns out to be higher than 1.83%, then you would be better off buying the inflation-protected security. Since 1926, inflation has averaged about 3% annually. While we do not believe that there will be a sharp increase in inflation over the next 1-2 years, it certainly is a possibility over the longer term. Therefore, within the fixed income allocations of our client portfolios, we have been avoiding purchases of traditional Treasury securities in favor of TIPS.

 What asset classes would perform better in an inflationary environment? Among fixed income investments, we would expect inflation-protected bonds and high-yield bonds to perform better. Although the short-run impact of inflation on stocks has historically been mixed, stocks typically act as a hedge against inflation over longer time periods. This is particularly true of companies and industries that have the ability to pass along price increases to consumers, or those that have comparatively low levels of fixed assets. Our core strategy of broad diversification and no market timing would remain unchanged, whether the environment is inflationary or deflationary. The main determinant of a portfolio’s return is the asset allocation. Having the discipline to stick with your chosen allocation is more important than the specific allocation that you choose.

Within the equity portion of client portfolios, we may overweight certain sectors or industries that we believe would fare better in a particular inflationary environment. However, since the future is uncertain, our main goal remains to create client portfolios that will perform well in a variety of economic scenarios.

 Bill Hansen, CFA

October 9, 2009

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Things Seem to be Getting Less Bad…

Stocks are up today after comments from Federal Reserve chairman Bernanke that the economy is on the verge of recovery.  We believe that the recession has either ended, or is in the process of ending, although the official date will likely not be known until sometime in 2010.  By the time the end date is officially proclaimed, the recession will be long over, although there are some that believe there is still a risk of a “double-dip” or that a second recession may occur.

 There are a number of factors that contribute to our optimism:

 –Existing home sales reported today were better than expected at +7.2%;

 –The four-week moving average of unemployment claims has been declining from the peak in early April;

 –Investor cash levels, although down from their record high in March (at the recent market bottom), are still equivalent to about 40% of the value of the entire U.S. stock market.  Even a small percentage of this cash entering the market would be a significant positive for stock prices;

 –The level of housing starts is below that needed to absorb the formation of new households, and the level of auto manufacturing is currently below scrappage levels, indicating future improvement in these industries;

However, there is still negative news.  The delinquency rate on home mortgages was reported at 9.2% for the second quarter, 4.3% of which were already in the process of foreclosure. About half of these foreclosures were “prime” borrowers. While future inflation is a risk due to the extraordinary recent fiscal and monetary stimulus measures, we do not see an immediate threat given the current unemployment rate of over 9%.

While the economy is not without its challenges, fear indicators such as the CBOE VIX index (of implied volatility in options contracts) and TED spread (difference between U.S. Treasury bills and interbank interest rates) have returned to more normal levels similar to those before the failure of Lehman Brothers.  We have seen a significant improvement in the overall mood, both in the media and among people we talk to. 

With the stock market up over 50% from the recent bottom on March 9, many are wondering whether the current rally can continue and for how long.  It is important to remember that the S&P 500 index is still 35% below the peak reached in October 2007, which coincidentally is about the peak reached in March 2000.  The current decade is on pace to be one of only three 10-year periods in modern history with negative stock market returns.  Because this decade has been so terrible for investors, we believe that better times lie ahead and that stock market returns will revert upward toward their historical average of 9-10% annually.  Nobody knows for sure when this might happen.  While it is possible that we may retest the recent lows, the improvement in the mood and slowly improving economic news makes us believe that there is significantly more upside than downside from here.

Bill Hansen, CFA

August 21, 2009

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A letter from Bart Boyer, Chairman and CEO

The longest and most severe recession since the Great Depression is coming to an end! GDP for the second quarter was -1% compared to a brutal -6.4% in the first quarter. That momentum should carry the economy into positive numbers the third (current) quarter. That would follow our chief economist, Jim Smith, predicting the recession ended May 15. We won’t know the exact date of the end for months, but it looks over to us. Also, many economists are joining Dr. Smith and are predicting 2-4% positive growth for the third quarter, a normal +3% or so year in 2010 and better yet in 2011!

As we anticipated, the $7 trillion on the sidelines in short term fixed income investments is beginning to flow into the market. A modest move of 5-10% of these balances would have a significant upwards impact on stock prices. Already the S&P is up more than 50% from the March 6 intraday low of 666.79.

We are thrilled that the vast majority of our clients avoided the fear trap and have participated nicely during the recovery. Nothing goes straight up, there will be profit taking corrections for certain, but we believe there is much more to come on the upside.

Over the last 100 years there have been three terrible decades for the economy and stock markets, the 1930’s, 1970’s and the current decade. Unless this year is better than +38.4% (very unlikely), this decade will go down as the worst ever – even worse than the 1930’s. Terrible decades have historically always been followed by well above average outperforming decades (plural). After the 1930’s, the next three decades were outstanding. After the 1970’s we had the 80’s and 90’s, two of the best decades ever, with each having six years of +18% or better returns. We believe it is a high probability that the next 20-30 years will be above average, even with one in every three or four years negative.

Thanks again for your patience and the opportunity to be of assistance. We’ve all just suffered the worst decade in stock market history and are well positioned for better times ahead.

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Unemployment Rate Falls

The big economic news today is that the unemployment rate unexpectedly fell. The rate dropped to 9.4% of the labor force, versus last month’s 9.5%. While any rate in this range is considered high, a move in the downward direction is a very good thing. This is particularly true when that drop is unexpected. In response, the stock market has surged today.

Because the unemployment rate is a lagging economic indicator, one would expect this rate to continue to climb even after the general economy improves. On average, the unemployment rate peaks 4.7 months after the end of a recession. This rate may continue to climb after a brief dip. However, the rate dropping for the first time since April of 2008 is one signal that the recession has ended, or will end in the near future. Good news!

Harli L. Palme, CFP®
Financial Advisor

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S&P credit ratings and GE

In case you are curious, only five companies now have the pristine AAA credit rating by S&P. They are: Automatic Data Processing, Exxon Mobil, Johnson and Johnson, Microsoft, and Pfizer.

The headlines today are that S&P cut GE one notch to AA+. Apparently many analysts have breathed a big sigh of relief fearing that S&P might cut deeper to AA or AA-. Nearing the close, the stock is up 13%.

S&P has indicated that if GE Capital were a stand alone company, its credit rating would be A or smack in the middle of the pack of investment grade debt ratings.

Mark A. Lewis

Research & Trading Associate

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2008 – A Year to Remember

As this year comes to a close everyone is hoping that 2009 will be better, and we think it will be better. Having said that, there are good lessons to be learned from past events and in the long run corporations and individuals will benefit from these difficult times. Spending less, saving more and living within our means should be the mantra going forward for individuals. Corporations and large institutions will need to be more transparent to regain trust from individuals, especially in light of the Madoff scandal. One can only hope there will be more honesty and less greed in the future.

The media is saturated with gloomy, depressing predictions and it is difficult to find any positive news out there at all. It could be worse – gas prices could still be at $4.50 a gallon so we’re thankful those prices have come down. Household net worth in the U.S. is at $45 trillion dollars – not bad. One-third of American households have no mortgage. Interest rates are extremely low and mortgage refinancing will be good for the economy. As quickly as things went sour in the economy they can also stabilize and begin to improve.

We have grown over the years in large part from client referrals and we are thankful for the vote of confidence from our clients. We wish for everyone a better 2009.

Barbara Gray, CFP
Partner

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Random Thoughts

Investors around the world have been affected by the recent alleged fraud committed by Bernie Madoff, a well-known New York investment manger.  Madoff is accused of running a giant Ponzi scheme, where money from new investors is used to pay returns to existing clients.  Some wealthy families had all or most of their net worth invested with Madoff, and it is likely that these people will lose everything.   The losses are tragic for the families and charities involved.

 

This scandal highlights one of the major disadvantages of hedge funds, or any other type of pooled investment vehicle, where monies from more than one client are combined into a single account.   Called “lack of transparency,” it means that you never really know what you own or how much it is worth. Our business is set up differently in order to eliminate this risk, and there are two primary reasons why this type of scandal could not happen at Parsec.  First, we do not take custody of any client assets.  Client accounts are all held at a reputable third-party custodian such as Charles Schwab & Co., Fidelity or TD Ameritrade.  Your assets are always in your name in your account, where you can see them online or call the custodian and get a current balance and list of holdings.  Second, we do not have the authority to get money out of your account without your signature.  These protections are key distinctions between our approach and a pooled account.

 

As of this morning, the 10-year Treasury Note yield is 2.12%.  This implies deflation over the next 10 years, as historical inflation has been significantly higher than this level.  The government has pumped a huge amount of liquidity into the financial system in the form of interest rate cuts and various bailout packages, and we believe this will eventually be inflationary.  Keep in mind that inflation is one of the major risks to fixed income investments over time.  The dividend yield on the S & P 500 is currently about 3.1%.  The implication is that stocks at this level would outperform Treasury Notes even with no capital gains over the next 10 years.  For this reason, we are not particularly interested in buying Treasury Notes at current prices.  For our clients that have an allocation to fixed income, we are currently focusing on inflation-protected Treasury securities, and high-quality corporate and agency bonds that are currently trading at wider than normal yield spreads.

 

One benefit of the current interest rate environment is the decline in 15 and 30-year fixed rate mortgages, both of which are currently just under 5%.  While it is possible that mortgage rates could move slightly lower, we do not believe that they will stay at these levels for long.  We encourage all of our clients with fixed rate loans at higher interest rates, or those of you on adjustable rate mortgages, to consider refinancing in order to lock in your borrowing costs at currently low levels.

 

We thank all of our clients for their perseverance over the past year, and wish you and your families a happy and healthy holiday season.

 

Bill Hansen, CFA

Managing Partner

December 19, 2008

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A Year in Review

 

As the year comes to a close we can all breathe a sigh of relief that it is over; 2008 will go down in history as one of the worst investing environments ever seen.  Obviously, the stock market was terrible; both domestic and international, but so was real estate and most all bonds outside of the treasury market.  Even the commodity prices crashed with prices on oil, gas, soybeans, wheat and corn. dropping precipitously during the second half of 2008.  As we enter 2009, we can be hopeful that we have seen an end to the bubble theme of the last nine years.  As you recall we first had a stock market bubble in the late 90s, followed by a real estate bubble in the mid decade, then finally the commodity bubble in 2007-2008.  Unfortunately for some it appears to us that another bubble is inflating in the treasury market as the flight to quality has brought the yield on the ten year treasury down to levels not seen since the end of World War II.  When credit markets stabilize and the panic subsides we could see a spike in inflation with the big increase in monetary supply; this would be a bad situation for someone locking in 2.8% for ten years.  It would be nice to get back to some normal markets. 

 

The year saw a number of stock market records broken.  The largest monthly decline, the biggest ever point gain and point advance, the worst year in modern history.  The amount of bad economic news feels almost unprecedented.  All the tell tale attributes of a bad recession abound: rising unemployment, multi-decade lows in industrial production, sagging real estate prices, and record home foreclosures.  The equity markets have sold off for all of these reasons and more.  Seemingly stocks are beginning to take bad news in stride.  Expectations are so reduced and markets are so sold out that any sign of a lessening of of the crisis will be met with a strong stock market rally. 

 

You have to look carefully but there are some positives for us all to consider:

 

  • The declining price of oil, natural gas, home heating oil is saving consumers billions of dollars every month.
  • The governments of the world are making sound and coordinated policy decisions, injecting trillions of dollars into the credit markets.
  • Mortgage rates have been in a falling pattern, stoking the refinance opportunity and allowing people to begin buying excess inventory in housing.
  • Dividend rates on stocks are higher than bonds for the first time in decades.

 

The reality is that the economic and financial conditions have changed markedly in the last three months of 2008.  However, the long-term objectives of investors have not.  We all still want to retire and spend in retirement according to our lifestyle.  The need to grow wealth is as important today as ever before.  There is only one way to grow wealth and that is through ownership.  Ownership of real estate and businesses (public and private) represents equity and over the long-term the owners of equity will see their wealth grow.  Bonds, CDs and cash do not grow wealth.  They do play an important role in protecting and preserving wealth, but they do nothing to grow wealth.  We feel strongly that investors that have left the real estate and stock market will return when prices begin to rise.  Many people will fail to get back in or will at much higher prices than when they got out.  We and our clients will have seen the bottom and by definition will be in place to get the full recovery when it comes. 

 

Rick Manske, CFP

Managing Partner

 

 

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November Pain

Recently we have experienced one of the most severe market sell offs in history.  The S&P 500 is now down over 22% since the start of November.  This sell-off would be clearer if there was a specific tangible event that we could grasp onto to justify this market move.  Instead, this market is being driven down by investor panic, a lack of buyers and huge redemptions at hedge funds and mutual funds. 

 

Our economy and stock market has survived a number of stock market crises and panics.  First, take the crash of 1962.  In this panic, the stock ticker ran four hours late.  Then in the 1973-1974 bear market, the S&P 500 fell 48% and the average stock fell 70%.  In October of 1987 the market fell over 20% in a single session, more than twice as much as the largest daily decline during October 2008.  Then, of course, there was the 2002 “tech bubble” with the S&P 500 down 49% and tech stocks down over 75%.

 

As I write this email, the S&P 500 is down over 48% in the 2008 calendar year.  If we finish the year at these levels, 2008 will go down as being the worst performing stock market since 1926 (with the prior worst being 1931 with a return of -43.3%).  As of October 27 the Emerging Countries were down an average of 66% (China down 75%).  Like the previous bear markets cited above, now is absolutely the wrong time to bail out of the market.  Emotion is an investor’s greatest enemy, be it greed, or in this case fear.

 

Consider the following:  The global liquidity crisis, the probable cause of the last half of the current decline, has peaked and is now easing thanks to the concerted efforts of governments around the world, including new support from China, Russia and the Middle East.  Economies in the U.S., Europe and Japan are now in recessions with the U.S. recession getting under way about a year ago (in hindsight).  The stock market, being a leading economic indicator, typically turns positive about midway into a recession.  If the U.S. recession lasts 20 months (which would make it the longest since WWII – with the average being approximately 12 months), one would predict that the stock market could begin to rebound in December of 2008. 

 

Although it seems extremely difficult to believe that the market could rebound under the current dreary economic cloud, markets typically begin advance while economic news is getting worse.  In our view, this is a terrible time to reduce or liquidate stock market holdings.  Since 1900, the market rebounded an average of 47% in the 12 months following a bear market bottom and 60% over the next two years.  Although this constant drumming we are taking in the market on a daily basis is hard to bear, we must visualize how difficult it will be if we sell at these levels and watch the market advance to levels much higher. 

 

What can we do?  We can all revisit our budget and look for ways to reduce spending during these difficult times.  We can harvest tax losses in order to make sure we do not pay any more taxes (this year and in the future) than necessary.  We can reallocate our portfolio into higher dividend yielding stocks (which there are currently many) in order to maximize portfolio returns (or minimize losses) while we wait for market and economic conditions to improve.  We can stay strong and not allow the daily panic to lessen our confidence in the fact that ownership in companies and real estate are the only proven way to build long-term wealth. 

 

Michael J. Ziemer, CFP®
Partner

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