The Road to Greece

Global equity markets popped yesterday, intensifying their October rally to 15% for the MSCI US Broad Market Index and 21% for the FTSE All World Index (ex-US). The enthusiasm was sparked by two events that equity investors broadly took as good news. European Union leaders agreed on a deal to theoretically end the two-year financial crisis with Greece at its center. And in the US, Gross Domestic Product grew in the third quarter 2.5%, more than was expected and following a 1.3% rate in the second quarter. But while conditions may be improving ever so slightly, the disease remains without serious work for cure.

The road to recovery mapped by Europe’s finance ministers comes in overdue, over-budget and strewn with potholes. Instead of cutting straight through the obstacles of massive debt, they’ve snaked around it, taking the short view by employing excessive financial engineering and leverage. After criticizing US remedies these past two years, European leaders are doing the same and worse.

Similar to the 2008 crisis, Greece will undergo a controlled default whereby banks who own their debt agree to shoulder a 50% write-off of their value. This arrangement is designed to prevent the triggering and payment of credit default swaps on Greek debt. At least two groups of speculators are bailed out by the new road to recovery; credit default writers and banks owning Greek debt. Now European taxpayers will get a taste of what happens when the natural selection process of markets are interrupted by socialist bureaucrats. If that sounds a bit strong, hear the arrogance of Nicolas Sarkozy’s boast of a year ago. “By ensuring that capitalism and the market economy do not become caricatures of themselves, we will save the market economy and capitalism.”

Francesco Guerrera of the Wall Street Journal warns of the longer range issues. He says that by undermining the value of Greek credit default swaps CDSs, “European leaders have created a precedent that will weigh heavily on the market in future crises. While CDSs attract speculators, a lot of banks and fund managers buy them as protection against catastrophe. Paradoxically, the second key element of the Greek plan is a CDS-like instrument for Italian and Spanish debt.”

Yesterday, we got good news at home that the US economy grew more than expected in the third quarter. We also learned that the value of goods and services produced in this country surpassed the pre-recession highs. But it took 15 quarters to do so, which is three times longer than the average for the 10 previous recoveries since World War II according to the Wall Street Journal. Neal Soss, chief economist of Credit Suisse said “the American economy finally has accomplished the recovery and has now entered the expansion, but the growth is clearly too slow to solve the most significant problems the economy faces: jobs and getting the public budgets under control.”

Companies increased purchases of equipment and software. The consumer also stepped up purchases significantly. Unfortunately spending came from savings and perhaps new debt as consumers suffered the biggest drop in incomes they have seen in two years. Declining incomes combined with weak confidence and high unemployment bring into question the sustainability of their part in economic growth.

Consumer confidence reported this week is at its lowest point since December, while expectations are at their lowest point since the recession. The consumer confidence index fell 6.6 points in October to 39.8 with the current conditions component down a sharp seven points to 26.3 and the expectations component down 6.4 points to 48.7.

The declining value of homes has not been constructive for consumer confidence. The best hope is that the declines are slowing. Case-Shiller data released earlier in the week show no change in the adjusted composite-20 index for August. The unadjusted reading, at a very weak 0.2% compared to 0.9% and 1.1% in the two prior months, indicates prices are still declining somewhat because the monthly readings are three-month averages.

Because of lower prices, new home sales jumped 5.7% in September. The median price of $204,400 fell 3.1% in the month for the third time. The annualized rate of 10.4% is the steepest since the recession in early 2009. The average price of $243,900 is down 3.9%, also for the third month. Annualized contraction is 9.9% and is also the steepest since the recession. The South and the West accounted for the bulk of the sales.

Don’t look to the special congressional deficit-reduction committee for any near-term good news either, specifically in the area of revamping the massively complicated and growth-inhibiting US tax code. According to the WSJ, as the Thanksgiving deadline approaches, some lawmakers from both sides of the aisle have started to view tackling a full rewrite of the country's myriad tax laws as too challenging, especially coupled with the larger mandate of trimming at least $1.2 trillion from the federal budget deficit over 10 years.

On that front it appears the same tired divisions exist. According to the WSJ, Democrats offered a $3 trillion deficit-reduction proposal that included $1.3 trillion in increased taxes, which was dismissed by Republicans. The GOP's plan to cut about $2 trillion from the deficit over 10 years was rejected by Democrats because it raises far less in revenue, taxes and fees.

If these guys don’t credibly deal with the outrageously large US debt and US deficit, another downgrade of Treasuries is not only possible, but likely. There is no way to prepare for that likelihood, just as there was no way in August. There are no alternatives to US debt at the present time. Perhaps that fact is what perpetuates the arrogance and stubbornness in Washington. Unless we address the core problems in this country of debt and entitlement, we will become more like Greece with every passing year, and the developing world led by China will eventually become our reluctant and demanding rescuers. If there is still a silent majority, it’s time to wake up and elect leaders who have the guts, statesmanship and complete lack of political ambition to deliver the cure.

Sideways

Markets yo-yoed this week on news of Europe’s progress and lack of it in addressing their increasing debt concerns. Domestic economic news, both good and bad had little impact indicating that Europe’s problems may ours for months to come.

The New York Fed reported that business conditions contracted for the fifth month in a row. The Empire State index for October showed only slight improvement from minus 8.82 to minus 8.48. Later in the week we heard from the Philly Fed which showed the Mid-Atlantic region’s manufacturing sector stabilizing and improving. The business conditions index ended two months of contraction with a reading of 8.7 compared to minus readings of 17.5 in September and minus 30.7 in August. The Richmond Fed reports next Tuesday on the conditions of the Southeast.

Nationally, industrial production continues to sustain the economy. It improved 0.2% in September following no increase in August. Manufacturing improved 0.4% during the month compared to a 0.3% rise in August. On a seasonally adjusted year-on-year basis, overall industrial production was up 3.2 percent in September, compared to 3.3 percent in August.

The Federal Reserve’s Beige Book is released two weeks before the next Federal Open Market Committee meets. The next one is scheduled for November 1&2. The report indicates that the twelve District Banks found that overall economic activity continued to expand in September, though many tempered their optimism describing growth as “modest” or “slight.” Contacts described their outlooks as weakening due to uncertainty and weak business conditions.

Manufacturing and transportation activity were strongest, with some improvements noted in construction and real estate activity. Little change was reported in labor conditions in September. But it was noted that firms in manufacturing, transportation, and energy were hiring more broadly. Most Districts reported that wage pressures remained subdued.

But the PPI showed that prices at the producer level surged in September by 0.8%. The core rate which removes food and energy was up more than expected as well at 0.2%. ON an annual basis, the overall PPI rose to 7.0%, compared to 6.5% in August (seasonally adjusted). The core rate in September held steady at 2.5%.

Inflation at the consumer lever was also higher than comfortable at 0.3%, but a milder 0.1% when food and energy are removed. Year-on-year the CPI increased from 3.8% in August to 3.9% (seasonally adjusted). The core rate held steady at 2%. On Wednesday, the government announced that Social Security payments will be increased by approximately 3.5% in January.

Homeowners living in our area interested in selling their homes got a bit of good news on Wednesday. The Triangle housing market sales were up 17% over the same period a year ago. A total of 4,471 homes were sold in Durham, Johnston, Orange and Wake counties, according to MLS data. Pending sales for the quarter were up 27%, and showings increased 7%. But at least some of the increases are the result of comparisons to a stalled market same time a year ago when the federal homebuyer tax credits expired.

On a national basis, existing home sales dropped 3% in September. Supply on the market rose a bit to 8.5 months while prices fell by 3.4% at the median to $165,400 and a 3.1% decline for the average to $212,700. Foreclosures continue to weigh on the market adding to supply. But new homes showed refreshingly better in September. Housing starts in September jumped 15% after declining 7% in August. Strength was centered in the multi-family component with a 51.3% surge, while single family homes rose by a more modest 1.7%.

Reasons to expect higher stock markets

• It’s earnings season and analysts’ estimates for corporate earnings have consistently trailed actual results since the recovery began in 2009.
• Since bottoming October 3^rd, the Dow has jumped more than 8%, the S&P 500 is up more than 10%, and the MSCI Total US Market is up more than 11%.
• During the same period investor demand for safe-haven US Treasuries has declined substantially. The Barclay’s 20-year plus US Treasury index is down 7.7% and the Barclay’s 7-10 year US Treasury index is down 2.8%.
• Commodity markets expecting stronger US demand are also up. Crude-oil prices have risen 15% and copper is up more than 8%, and the euro rose almost 4% against the dollar last week.
• Leading Indicators report rose 0.2% primarily by the Fed’s loose money policy. The Fed is pondering further measures to support the struggling economy. DON’T FIGHT THE FED.

Reasons to expect lower stock markets

Tom Lauricella of the Wall Street Journal provides the following reasons to temper exuberance.

• On October 23 European officials are expected to officially advance a proposal to bolster the balance sheets of their battered banks. The plan may once again fall short of investors’ hopes as happened in July and August as they struggled to deal decisively with Greece’s debt problems. Big rallies in the US markets have come on European unity. Lack of unity can have the opposite impact.
• If Europe’s plan leans heavily on government money, it could fuel worries about cash-strapped Italy and Spain and deepen concern that France could lose its triple-A credit rating.
• If European banks are left to fend for themselves, financial market volatility would increase and bank lending might evaporate at a time when Europe is already flirting with recession.
• Remember the secret US Congressional super-committee? Their deadline for finding a mere $1.5 trillion in budget savings is up November 23^rd. If they come up short or are not convincing, the US’ credit rating may be in danger of further downgrade.
• Many of the big market gains have come on days of low trading volume, suggesting little buying from big institutional investors that would reflect greater confidence in the rally.

The inevitable conclusion remains one of continued uncertainty. But taken together the odds of a worsening global economy added to the odds of an improving one are still considerably smaller than the odds of a stagnating global economy. Governments and policymakers of developed nations must abandon their useless, reactionary remedies and offer bold new initiatives aimed at addressing both the staggering debt and the debilitating trend toward government dependence.

The Occupy Wall Street crowd incorrectly focuses their energies on one narrow component of the sub-prime debt crisis. The debt crisis was going to happen eventually anyway; greed and corruption aside. It was a bubble caused by excessively low interest rates at the hand of the Federal Reserve, dangerously relaxed lending policies mandated by Congress 30 years ago, Congressional repeal of the Glass-Steagall Act in 1999 which barred banks from securitizing and selling their assets, rating agency duplicity, and yes, Wall Street greed.

If the OWS group is truly not the creation of Democratic political operatives designed to “deflect attention from Mr. Obama’s failed economic policies” as presidential hopeful Herman Cain claims, they would gain much broader and powerful support from the American public if they would simply aim their protest at the real problems facing them and their futures squarely in the face: BIG GOVERNMENT AND BIG DEBT.

"A Foolish Consistency is the Hobgoblin of Little Minds" - Ralph Waldo Emerson

Psychologists have uncovered a fascinating phenomenon about people at the racetrack. The moment after placing their bet on a horse they become much more confident of their horse’s chances of winning than they were immediately before placing their bet. Is it possible that the very same thing happens the moment we invest in a stock or a mutual fund?  

In his book entitled Influence, Robert Cialdini says that the need for consistency “lies deep within us directing our actions with quiet power.” It is quite simply our nearly obsessive desire to be (and to appear) consistent with what we have already done. Once we have made a choice and taken a stand we will encounter personal and interpersonal pressures to behave consistently with that commitment.” 

In this increasingly busy, networked world, information could easily overwhelm us if not for automated responses. They offer us “shortcuts through the density of modern life” according to Cialdini. “Once we have made up our minds about an issue, stubborn consistency allows us a very appealing luxury: We really don’t have to think hard about the issue anymore. . . . We need only believe, say, or do whatever is consistent with our earlier decision.” Sir Joshua Reynolds put it this way, “There is no expedient to which man will not resort to avoid the real labor of thinking.” 

But even more troubling according to Dr. Cialdini is the second and more perverse attraction to mechanical consistency. “Sometimes it is the cursedly clear and unwelcome set of answers provided by straight thinking that makes us mental slackers. There are certain disturbing things we simply would rather not realize.” He goes on to say that preprogrammed, mindless automatic consistency can effectively barricade us from the sieges of reason and reality we don’t want to face.

Last Sunday there was a fascinating article in the Wall Street Journal on a phenomenon which occurs among stocks that could be explained by the theory of automatic consistency. The article by Russell Pearlman, entitled Dead Stocks Walking illustrates the surprisingly large number of large company stocks that have provided no returns (or losses) for their investors over a full decade despite fundamentally good earnings performance. Blue-chip companies like WalMart, Cisco, General Electric, Pfizer, Merck, Amgen, Medtronic, Intel, Microsoft, Ford, Dell, and Time Warner. These are industry-leading companies long held by widows and orphans and hundreds of mutual funds. Pearlman adds up the market capitalizations of the 30 worst performers to find that a staggering $2 trillion has gone nowhere in a decade.

Pearlman attempts to explain why individuals and professional portfolio managers alike would tolerate such lousy performance for such a long time. One reason he thinks is the old buy-and-hold strategy, proven effective by experience. From 1980 to 2000, the average annual return for the 100 biggest U.S. stocks was 62%. Pearlman says “that wasn't a fluke of the calendar, either. Indeed, during any 20-year period from 1970 to 2010, investors saw large-cap stocks' average annual return rise 13%. Managers interviewed by Pearlman said they have no intention of changing their buy-and-hold strategy. They say “investors get into trouble when they change their stripes or discipline.”

Wall Street analysts consistently like the big guys too. Pearlman notes that as many as “13 pros had buy ratings on [WalMart] in 2004, and a near-equal enthusiasm can be found among securities analysts in virtually every quarter since. (Only one of them, during this stretch, has slapped a SELL on the stock, according to Zacks Investment Research, and even then, the rating lasted a mere two months.”

Another reason cited by Pearlman is that the large-cap category of managers “have no choice but to buy these stocks: There are only so many large-cap equities. Adding smaller names carries a risk, managers say: having their fund no longer classified as a ‘large cap’ fund by Morningstar, Lipper or another ratings firm. These classifications might not matter to individual investors, but they do to financial planners and pension plan administrators looking for a particular type of asset mix.” Hear Mr. Emerson whispering ‘foolish consistency’ yet?  

Still another reason cited by Pearlman is intellectual discipline. Value investors want to buy stocks that seem undervalued relative to its growing earnings and shrinking stock price. As the stock keeps falling they simply buy more (automatically and consistently).  

Take Abbott Labs for instance. Since 2001, Abbott has more than doubled its annual profits, yet its stock price, while outpacing the broad market since then, has essentially remained flat. Rather than being disgusted, though, Robert Zagunis of Portland, Ore. actually likes that he can continually buy the stock. ‘Investors would love to be able to buy a private company that was increasing profits like that,’ he says. But since Abbott is public, ‘you get a weekly, daily, even hourly reminder of what other people think,’ which makes the task of sticking to one's guns ‘more difficult.’  

Whether one justifies behavior with ‘buy-and-hold,’ ‘analyst favorite,’ ‘large-cap allocation,’ or ‘value’ the outcome for the last eleven years has been inarguably painful. Automatic consistency has quite literally stolen wealth, and lifestyle from a huge majority of investors for nearly one fifth of their investing lifetime.

What’s the alternative?  

Change the focus and energy of your life from selecting (or endlessly holding) stocks, mutual funds, and active managers to setting goals and continually evaluating your confidence of reaching and exceeding them. You know your goals and dreams, we can help you marshal your resources (including, but not just your investments) to confidently achieve those dreams.

Using sophisticated probability analysis, we continually stress test plans to determine, based on the latest information, whether they are properly, under- or over-funded to meet their objectives. While we can quantify goals and their timing, we cannot know with certainty what impact the capital markets will have on our assets as we plan to save and spend over our lifetimes. But we can measure the uncertainty and manage it to an acceptable level of confidence, enough for comfort and not so much that you sacrifice today for future wealth you have said you will not need in your lifetime.

We use exchange traded funds which efficiently and effectively capture the broad and diverse capital markets. We allocate stocks and bonds appropriately for each client’s plan to provide sufficient future wealth, with no more risk than is required to maintain sufficient confidence of meeting or exceeding their goals. Our portfolios virtually eliminate the risk of underperforming markets as did the ‘dead stocks walking.’ We also eliminate the risks added by active managers who make outsized bets on under-diversified selections. 

Active managers increase uncertainty in your portfolio, which quite simply translates into reduced lifestyle; working longer, saving more, taking more risk, or enjoying fewer financial rewards in your future. Why risk your future trying to improve on the already sufficient returns of the capital markets? Over the last decade the allocation we use for our Growth model has returned 3.9% per year, while our most conservative portfolio has yielded 5.23% annually, comparing favorably to the ten-year average for the S&P of 2.9%.

We generally value and approve of consistency. But no one wants to consistently do the wrong thing, or even wonder consistently if they are doing the right thing. We help our clients consistently re-evaluate where they are relative to their goals and objectives by controlling what we can in costs and underperformance and by quantifying and managing uncertainty through sophisticated planning. 

Consistency by any other name would be foolish.