April 2010
Climbing on a "Wall of Worry"
The health care debate is over. But little attention in the 2,600-page final bill was paid to real medical cost control. Combined tax rates for those privileged enough to subsidize this new and other Federal entitlements could rise by nearly 15 percentage points in the coming years! The Federal government budget deficit is ballooning out of control with no apparent concern on the part of our political class. State budget deficiencies (new Federal mandates, under-funded pensions, contracting tax revenue base, etc.) are gaining attention. A seemingly unrelenting unemployment rate dominates media headlines. Inflationary expectations seem destined to escalate. Short-term interest rates will be raised (the consensus opinion is now lengthened to expecting the Federal Reserve to first increase the Federal Funds rate in early 2011). China increasingly discriminates against its Western investment "partners," as our politicians rage about Beijing's undervalued currency. The threat of protectionist trade wars looms. All this and a Washington, D.C. political environment in which civil discourse has been displaced by rancorous rhetoric, for the most part blocking meaningful policy reform.
Despite these widely recognized dire circumstances, the continuous stream of ginned-up media coverage about the under-performance of our economy, and the readily apparent weak job market, those sensitive reflectors of investor sentiment (equity markets around the world) not only hold their ground but appear locked in an upward trend! What are we missing?
"The Recovery is on Track" (Wishful Thinking or Emerging Confirmation?)
As painful as it has been for the unemployed (9.7% "temporarily out of work" or 17% so-called "total jobless rate," depending on how you tally the jobless headcount), the readjustment that the U.S. economy has endured these past two years has positioned it for a recovery of perhaps surprising strength in the months ahead. There is growing evidence that in the U.S. our economic recovery, although fragile, is moving from Wall Street to Main Street. Almost imperceptively, consumer sentiment is improving, retail sales growth is ahead of expectation, and manufacturing output increases here and abroad appear widespread. Corporate balance sheets are awash in cash. Lean and mean, American businesses appear poised to reap the benefits of recent difficult cost reduction measures.
Most importantly for corporate profits, this attention to cost containment will appear in the form of continued labor productivity growth. Although burdened with new health care expenses and added taxes (U.S. corporate tax rates are now among the highest on the planet), our private sector entrepreneurial spirit continues to uncover avenues to generate new products and services (business-to-business, as well as consumer) which find ready markets here and around the world. Given time and the absence of a cataclysmic geopolitical event, the global economy looks to be on a multi-stage recovery track, and the "double-dip" recession threat has diminished significantly.
Notwithstanding the continued housing market malaise, U.S. corporate profit reports appear positioned to surprise on the upside throughout the remainder of this year, and perhaps even in 2011. Aggregate operating earnings per share estimates for the companies in the S&P 500 Index (i.e., the largest U.S. publicly-traded corporations) are creeping above $80 for this year and could exceed $100 in 2011. At current stock market price levels (near 11,000 for the Dow Jones, 1,180 for the S&P 500), U.S. equity market valuations seem quite reasonable at 13 times 2010 and 11 times 2011 earnings per share. Perhaps this is the prospect our equity markets are attempting to discount currently? If so, stock prices may be headed higher.
Skeptical Individual Investors Prefer Bonds, Stay on the Sidelines
Happy Anniversary! A year ago many investors (individual as well as professional) were panicked, certain that global stock markets were headed for oblivion. Traumatized, many sold out, locked in their losses, retreated to the sidelines and sought riskless yields in the high quality fixed income markets. But Federal monetary and fiscal policy drove short rates down to near zero, where they remain today. Regardless of continued low yields, individual investors even today persist in pouring money into intermediate and longer maturity bond funds and bond ETFs, potentially setting a classic whipsaw trap for themselves. When the structure of interest rates is "normalized" by Chairman Bernanke and his Federal Reserve rate fixing policy committee, it seems probable that rates will be raised (bond prices will decline) and those who sought safety and higher income yields in longer dated bonds will suffer further capital losses. Against this possibility, as clients are aware, we have shortened duration in the bond segment of portfolios to less than two years, hoping to avoid the potential capital losses which could materialize when rates rise.
Financial Services Regulatory Reform Legislation and Other Compliance Matters
The Dodd bill ("Restoring American Financial Stability Act of 2009") has cleared the Senate Finance Committee and will soon be the subject of Senate floor debate. Despite the global financial system meltdown just weathered, and all the regulatory shortfalls revealed, as well as the unearthing of the Madoff scam, the proposed Senate reform fails in a number of ways to address the root causes of the near collapse of the U.S. credit markets. The provisions of this proposed reform legislation can be reviewed elsewhere, but one section requires the attention of individual investors and should concern us all.
Due to the lobbying clout of the Wall Street broker-dealer community (i.e., the "sell side"), in the Dodd bill the question of differing standards of customer/client protection was avoided. Currently, a Registered Investment Advisor (RIA), such as TFC, by case law and the SEC's definition, owes its clients a fiduciary obligation, in all instances, to place the client's interests first. Brokers, on the other hand, are governed in their relationship with customers by a vague standard of "suitability." Or stated another way, brokers need only ask themselves, "Should I sell this security to my customer?" RIA's must concern themselves with whether they should buy a particular investment for their client. Most individual investors are not aware of this subtle but important legal distinction. Indeed, it has been a long-held goal on the part of RIA's that the difference be resolved in favor of a higher standard of responsibility for brokers/dealers. The Dodd bill had seemed an opportunity to accomplish this objective. The "compromise" reached in the Senate Finance Committee on this attempt to "harmonize" the fiduciary standard for all parties, thereby raising the broker's standard of conduct, was to refer the matter to the SEC for a one-year study of the issue. Stay tuned, but it feels as though a much needed opportunity to even the playing field for individual investors may have been squandered.
Bernie's Legacy (More Fallout from the Madoff Fraud)
Madoff may spend his remaining years behind bars, but the SEC is still trying to determine how to remedy the systemic risks for investors revealed in his Ponzi-like scheme. The veil of secrecy insisted upon by Madoff depended upon the fact that he was both advisor with full discretion and sole custodian of client assets. Therefore, he controlled the information flow; no independent verification of account holdings was incorporated in the client reporting cycle.
To correct this weakness in the system, the SEC has initiated a surprise inspection routine for RIA's: an asset, or account holdings, verification program. On the whole this is a constructive approach which should improve client account security. As part of the SEC's RIA surprise inspection process, you may be contacted directly by an agent or representative and asked to complete a Routine Account Information Confirmation Form to substantiate your account balances, as well as your last account deposit and withdrawal. The SEC has insisted that you should not construe any request for information of this nature as a negative reflection on our firm or as an indication that any violation of the law has occurred or been alleged.
Responding to the SEC's request will be voluntary, but if you are contacted, we would encourage you to cooperate. We have been assured by the SEC that all such communications with clients are non-public, but we suggest you ask for confidential treatment of any information that you provide. Such requests may be made by the SEC via telephone or in writing, but not by e-mail. If contacted by phone, and you would like our assistance in validating the official nature of the inquiry, let us know and we will provide support in confirming the authenticity of the request.
A Recap of TFC's Portfolio Strategy for 1st Quarter 2010
Fixed Income: Having captured a rare opportunity (and excess returns) presented last year by the significant yield differential/spreads between U.S. Treasury and non-government bonds during the financial and economic crisis, we have implemented some changes to our fixed income portfolios this past quarter.
With short and intermediate term interest rates expected to increase this year (although the timing remains unclear), principal protection of fixed income investments is our primary concern, perhaps foregoing some modest income/yield in the interim. To this end, we have shortened our overall portfolio duration. Post-rebalancing, our current average bond duration is under two years for taxable portfolios and three years for retirement portfolios (lengthened by Treasury Inflation-Protected Securities bonds, or TIPS). We are maintaining our diversified mix of short-term government-guaranteed agency, national municipal (for taxable accounts) and high-quality U.S. and global corporate bonds (primarily through low-cost bond funds).
Equities: Most global equity markets continued on a modest uptrend in the first quarter, particularly in March, supported by improving economic fundamentals and the containment of the Greek debt crisis. General weakness and fear of instability in the Eurozone economies triggered a sharp rebound in the U.S. Dollar against the Euro (+5.7% for the quarter). The U.S Dollar also appreciated against the British Pound (+6.1%) and marginally vs. the Japanese Yen (+0.5%). Against emerging market currencies, the U.S. Dollar was off by 1%.
The recent strength of the U.S. Dollar dampened international equity returns for the quarter relative to U.S. equities. The MSCI All Country World Index ex. U.S. had a positive return of 3.5% for the quarter in local currency terms, but increased by only 1.6% in U.S. Dollars. By contrast, the Russell 2000 Index (which represents U.S. small companies) and the S&P 500 Index were up 8.9% and 5.4% respectively.
Strategically, we made one minor asset allocation shift this past quarter, increasing our U.S. and international small company weighting vs. large companies by 5 percentage points to a total of 40% of our equity holdings. We are also rebalancing client accounts to portfolio policy targets and raising cash for anticipated withdrawals, if any.
We expect value-oriented and high quality companies to continue leading markets during this next phase of the economic and stock market recovery. Last year, as the economy was emerging from the Great Recession and financial crisis, over 90% of the stocks in the S&P 500 Index posted gains, with the lowest quality stocks gaining the most. So far this year, 376 stocks in the S&P 500 Index are up, but 124 have declined in price.
With the "relief" and momentum rally behind us, valuations and quality of companies should be market differentiators going forward, particularly in a more normalized equity return environment. Using carefully screened, actively-managed fund strategies (e.g., Alger SMid Cap Growth, FMI Large Cap and Scout International Funds) and passive strategies (e.g., DFA Small and Large Cap Value Funds) in our equity portfolios, we hope to be well-positioned for the more selective markets ahead.
As always, we welcome your comments and suggestions.
Sincerely,
Sincerely,
James L. Joslin
Chairman & CEO
Renée Kwok
President