January 2007: Liquidity, Liquidity, Liquidity...
The Dubious Achievement Ribbon for 2006 goes this year to the world’s central bankers. Collectively, these arbiters of monetary policy continue to provide the world’s financial markets with more than enough liquidity to fuel investors’ appetites for a seemingly endless supply of creative financial instruments. And yet, it is just possible that these central bankers (in the U.S., our Federal Reserve Board), armed with modern information technology and financial modeling techniques, can fine tune our economy, producing the hoped-for soft landing and prolonging the solid GDP growth experienced these past 4-5 years. In such an environment, for 2007 there is an expectation of modest corporate profit growth (+7-9%), a controlled inflation backdrop and continuing accommodative monetary policy. Economically, U.S. prospects for growth seem well grounded, as is the case for most other developed-nation economies, and global stock valuations appear rational (e.g., S&P ‘500’ Index at 14.5 x 2007 estimated earnings for the aggregate of all of the companies in the index).
Our portfolio rebalancing programs during the next few months will most likely reflect only minor realignments in asset class structure, a modest increase in international equity exposure and a build-up within the international sector toward a market-neutral weighting in Japan (until now, client portfolios have been significantly underweighted in Japan when compared to the composition of the Morgan Stanley International EAFE developed country index.)
"Wha' Happen"?: Why Were the Experts' Calls for 2006 so Wide of the Mark?
Punditry is a hazardous undertaking. Luckily for the average prognosticator most readers forget the predictions freely offered almost as soon as published. However, you might remember that as 2006 began there was a longer than usual menu of cautionary futures lofted, certainly enough to discourage most investors about the prospects for the pleasantly surprising year just ended. Analysts were suspicious that corporate earnings would disappoint as the year unfolded, and that the U.S. economy would not grow sufficiently to provide for the expanding needs of the work force for new jobs and employment. At the beginning of 2006, a mood of foreboding prevailed; expectations were low, globalization was under attack and the geopolitical scene unsettled. How could global financial markets be expected to prosper in this context?
So much for the conventional wisdom. The average U.S. business firm not only survived but thrived in this setting, as did most well-managed companies in the developed world outside the U.S. Particularly in the European community, benefiting from the application of information management tools, skilled managers have been able to work through an otherwise daunting maze of regulatory hurdles, optimizing the allocation of corporate resources, generating expanding-profit margins, surprising the analysts with a stream of greater-than-expected quarterly earnings reports. World-wide, (despite the experts’ admonitions) equity markets climbed on this “Wall of Worry.” And there is a reasonable prospect that, although at a somewhat diminished rate, 2007 will prove to be a continuation of these conditions.
What Could Go Wrong?
At a November international investment strategy conference attended by the writer in New York (more than half those present were from outside the U.S.), the speakers, panelists and audience all seemed to be struggling to explain why the markets had performed so well in 2006. One didn’t (doesn’t) have difficulty citing the positives. Corporate profits are at an all-time high, unexpectedly robust Federal tax revenues (despite, or due to, the “Bush tax cuts”?) have reduced the Federal budget deficit to levels no one foresaw. Nearly record-low unemployment, seemingly rational equity valuations in the U.S., as well as elsewhere in the developed world, slower but continued GDP growth in the U.S. and abroad into the New Year, all contribute to this supportive background. The question running through the day’s conference presentations last November, as well as today, was (is) what can (will) go wrong and change the current comfortable environment for equities?
One potential problem which needs careful monitoring is the fact that most analysts (if not yet individual investors) are now turning bullish in their outlook. If one were a confirmed contrarian, increasing optimism in the investment markets is not a positive. If this enthusiasm amongst investment professionals spreads to the average investor and stock valuations (e.g., price to earnings ratios or P/E’s) expand, a strategic reassessment of our portfolio asset class structure may be in order.
Other causes for concern:
(1) Savvy professional real estate operators (e.g., Sam Zell, Mort Zuckerman, etc.) are liquidating commercial properties. Zell’s Equity Offices REIT just signed a $21 billion deal with Blackrock to unload a major portion of his holdings. Real estate rental return rates are at their lowest levels in years, reflecting super-abundant liquidity in the hands of institutional investors. The seemingly insatiable appetite for risk in the commercial real estate markets strikes one as an aberration awaiting realignment;
(2) Initial Public Offerings (IPOs) are bypassing U.S. capital markets, instead moving to London and Hong Kong. A number of major non-U.S. companies are delisting their stock from the New York Stock Exchange. Sarbanes-Oxley is having the anticipated negative impact on the willingness of corporate managers to endure the strictures and severe reporting requirements imposed by this Enron-era corporate regulation legislation. Longer term, if this trend continues, U.S. financial markets will lose the competitive advantage enjoyed since the mid-twentieth century;
(3) Hedge funds, and many other so-called alternative investments, today require massive amounts of leverage (i.e., assuming greater risk) to achieve the sought-after returns expected by participants. In general, hedge funds during 2006 underperformed the 15.9% return of the S&P 500 (see Dow Jones Hedge Fund Index table below). Cash flows into these alternative vehicles continue to put pressure on managers to produce superior risk-adjusted net returns, a challenge many managers are finding it increasingly hard to live up to.
12/29/2006 Year Ended
| Index Level | YTD Change (%) | |
| Convertible Arbitrage | 131.36 | 10.69 |
| Distressed Securities | 175.70 | 15.30 |
| Equity Long/Short | 114.44 | 8.26 |
| Equity Market Neutral | 108.33 | 7.12 |
| Event Driven | 141.58 | 12.55 |
| Merger Arbitrage | 124.11 | 9.29 |
For private equity funds, takeover bid premiums have narrowed from a heretofore usual 20-30% to 10-15%, indicating the market has more intelligently priced target company stock, and implying that the potential for extracting restructuring profits has diminished; and
(4) 144 new Electronically Traded Funds (ETFs) were introduced in 2006 bringing the total now available to more than 350. With 15,000+ mutual funds ($10 trillion aggregate market value), plus another $400 billion of ETF offerings, one is tempted to ask whether this trip is necessary. Equity ETFs are baskets of stocks selected by formulae or unidentified managers whose selection and rebalancing strategies are opaque at best. Often internal ETF fee structures and trading costs, carefully analyzed, are high when compared, for example, with DFA’s and Vanguard’s passive funds. As temporary parking places, or market sector place-holders for investment prior to a more permanent commitment, they may have a role to play. Longer term, ETFs seem redundant, but Wall Street promotes them, brokers enthusiastically write tickets and collect commissions.
To the above also could be added the continuing saga and plight of the U.S. dollar, concerns about the U.S. trade imbalance with our global trading partners, a very full agenda of geopolitical issues, and not least by any measure, the changing political scene in Washington D.C. As difficult to manage as all these concerns would seem, most appear workable in an atmosphere of constructive compromise. However, if out of this firmament protectionist trade policies should emerge, or even appear a serious prospect, the global economic picture would change dramatically. As a leading indicator, watch for developments in the recently revived Doha Round World Trade talks.
TFC in 2006; Prospects for the New Year
In the year just ended with the continuing goodwill of our clientele, the firm grew measurably in a number of ways. We moved to new quarters in mid-summer, and with little disruption, continued to implement our financial planning and portfolio management approaches. New clients joined us and portfolio assets under management today exceed $550 million; gratifyingly, account investment return results were strong relative to most benchmarks. And client turnover was non-existent.
As an enterprise, the firm with the guidance of our Administrative Manager, Cheryl Bateman, has restructured its business procedures with the future in mind. We have added capacity to our portfolio administration and service team, enabling Senior Client Advisors to focus more on client planning issues. Cost structures have been examined, new compliance procedures are in place. Our client contracts and fee schedules have been reviewed, as well as all outside research and consulting arrangements. Our website was redesigned and we have instituted a limited direct access (password-secured) portal which is today being tested by a few stalwart clients. You will be hearing more about the conclusions drawn from these reviews in another letter at the beginning of next month.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO
P.S.
As mandated under the Gramm-Leach-Bliley Act, we have developed and implemented the firm’s client information privacy policy. A copy of this policy is enclosed in this annual mailing, as is required by the SEC. Also we are in the process of amending our Form ADV disclosure document (on file with the Securities and Exchange Commission), a copy of which will be available upon request.
TFC FINANCIAL MANAGEMENT, INC.
Privacy Policy
Pursuant to the Gramm-Leach-Bliley Act as implemented by Regulation S-P promulgated by the Securities and Exchange Commission, we are pleased to inform you of the firm’s privacy policy. Our policy is as follows:
We collect non-public personal information about our clients from information we receive on financial planning questionnaires, investment management account applications, all Charles Schwab, T.D. Ameritrade, National Advisors Trust, and Fidelity forms, and personal phone calls, faxes, e-mails and letters. We also collect non-public information about our clients from their securities transactions. We do not disclose any non-public personal information about our clients to anyone, unless requested to do so in writing by the client or except as required or permitted by law. We will furnish specific account information to a designated accountant, attorney or fiduciary of a client if so requested in writing by the client.
If a client decides to terminate her or his engagement with us, we will adhere to the privacy policy and practices described herein.
All of TFC’s employees have been counseled to keep client non-public personal information within the confines of TFC. All employees are prohibited from sharing any client non-public personal information with anyone outside TFC other than the client or, if so instructed by the client, his/her designated attorney, accountant, fiduciary or other third parties. We maintain physical, electronic, and procedural safeguards to guard client non-public personal information.
Please do not hesitate to contact us if you have any questions about this policy.
TFC FINANCIAL MANAGEMENT, INC.