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November 2012 Outlook

In June we quoted Alexis de Toqueville with regard to the developed world’s attempt to come to grips with fiscal burdens of increasingly hefty magnitudes.  With the 2012 national elections behind us, we’ll return to his observations of American democracy;

“In democracy, we get the government we deserve.”

The tongue-in-cheek implication here being that the November 7th results have left us with precisely the balance of power that existed on November 6th.  Though no survey has been undertaken, we think it fair to say that CCR Wealth Management’s clientele likely cancelled out each other’s vote last week, and therefore read different conclusions into the above quote.  But fear-not dear readers of either stripe!  November 7th also marked the beginning of the 2014 congressional election season!

Predictably, the market and media attention has finally turned to the larger issue of the approaching Fiscal Cliff.  Trying to predict the outcome of this political and economic conundrum would be foolhardy; however we will observe that the consequences of this debate will likely have a much more immediate and measurable impact than the election.

The Fiscal debate looms larger than the current macro-economic picture because its outcome can affect things like the attractiveness of dividends, or even the attractiveness of the equity markets (cap gains and dividend tax policy being part of the discussion).  Whenever an investment class is made less attractive due to tax policy, we can expect a reaction from the markets.  Even the break-even point between taxable and municipal bonds could be changed for many Americans, placing pressure on one category to the benefit of the other.

These potential influences on the capital markets of course are only one aspect of the Fiscal Cliff issue.  The other aspects have wide-ranging near and longer term economic implications—one that we’re sure many more congressmen and women are taking seriously.

CCR Wealth Management remains cognizant of the issues, vigilant of the proposals, debates, and possible deals being “trial-ballooned” by both parties.  However, we caution individual investors about being swayed into pre-mature action by “narrative”, or even trains of thought which may seem logical—but rely none-the-less on the business of political prediction rather

than the logic of financial planning or investment objective.

Lastly, we do believe, despite the divided nature of this government, that a bridge past this cliff will be reached—neither side benefited politically from the 2011 debt-ceiling debate.  With the 2014 congressional election season having begun just this past November 7th, we think policy makers will be cognizant of the gravity the Fiscal Cliff carries into 2013 and beyond.  Unfortunately we think it too much to expect a “grand bargain” which would result in more permanent tax policy, and we can also not be assured compromise will even come prior to January 1.  But any deal that yet-again kicks the can down the road will at likely be met with a relief rally, in our view.

EQUITY:

CCR Wealth Management’s Equity Model remains balanced between growth & value, while we have stressed buying into higher dividend yields on market dips.  Our small cap target weightings remain muted (8%-10%), and geographic weightings continue to favor US over non-US equities.  These weightings have not changed year-to-date, and we believe they represent the best posture going into the fiscal negotiations.

While we continue to favor US equities, we certainly have not abandoned non-US equity markets, developed or developing.  Given local growth challenges stemming from very poor macro global economic conditions, however, we believe “stock selection” is critical.  As such, CCR WM has spent considerable time and effort this year vetting and honing our mutual fund matrix—with special attention being paid to non-US specialties.  We would place more emphasis on a managed approach (funds) in this environment than on broader exposures (indices).

FIXED INCOME:

The bond market remains enigmatic.  This year the Barclay’s Aggregate Bond Index underperformed last year’s return, no doubt due to the lack of event-driven flights to quality.  Our fixed-income models have stressed (and benefitted from) higher yielding and high-yield bond categories for several years now.  We once again remind clients, and ourselves that in large swaths of the bond market (MBS, gov’t), there is no upside.  We recently met with portfolio managers of some of our own preferred bond funds, and they have confirmed as much.  Yet billions of dollars have poured into index-hugging bond funds.  Our efforts in reviewing fixed income allocations continue to diversify clients away from the index—though for the first time in years we are noticing the yield spread of higher yielding bonds (BBB) approaching that of the pre-financial panic of 2008.  In short—we feel a squeeze, which is particularly uncomfortable with a recession being possible fallout from the Fiscal Cliff issue.

We continue to stress yield, as well as geographic diversification in the bond market.  Emerging market bonds (and bond-funds) continue to attract significant inflows for the reasons we have previously pointed out; strong fiscal comparables, growth and demographics, along with an acute need for yield from large institutional investors.

COMMODITIES/ALTERNATIVES:

The “secular story” with regard to commodities is clearly over.  Early this year CCR Wealth Management eliminated our base metals position, and our current model is weighted to precious metals (gold and silver), with lesser exposures to oil (a geopolitical relief-valve) and REITs (a low-correlation yield source).

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June 2012 Outlook

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”–Friedrich A. Hayek

As we approach the mid-point of the year, we can’t help but feel that we’ve seen this movie before; a relatively optimistic first quarter—followed with evidence of slowing growth—resulting in heightened volatility in the second and third quarters (often accompanied by external shocks), and ultimately ending in a fourth quarter rally based on renewed optimism that what didn’t transpire this year may transpire next.  Whoops—don’t want to jump ahead just yet!  We must admit that the uncanny repetition of this cycle, now in its third year, sparked our skepticism of stock market levels in our April Outlook; “Sell in May and Go Away”.

The underlying fundamentals are frankly more problematic than the simple prospect of “inching” incrementally higher through each cycle.  This year has seen numerous democratic elections across the globe, the most prominent of them getting underway here in four months.  Reflecting on recent and current financial events, our impression is that we are witnessing developed democracies all over the world coming to grips with what we’ll term a long term cognitive dissonance among electorates.  Politicians do what politicians do, yet for decades voters have repeatedly placed the architects of today’s seemingly intractable fiscal conundrums in federal office, oftentimes for multiple terms, presumably in return for their promised chunks of public largesse.   Politicians are simply the artists practicing the art of carving these electorates into their necessary strategic groupings.

Hayek’s comment listed at the top of this page was made in the mid 20th century classic, The Road to Serfdom, and refers to the “elitism” within the hierarchy of western political and academic circles in their pursuit of planned economies.  About 100 years prior to Hayek’s observation, Alexis de Tocqueville wrote in Democracy in America; “The American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money”.  The irony here is that de Tocqueville was a Frenchman (a “European” in today’s world) observing America’s nascent self-government, and today we can gaze across the Atlantic back at Europe and observe the product of top-down redistribution of the public’s largesse.  Why shouldn’t the Greeks be able to retire at 47—as long as the German’s have the capacity to pay for them?  As we speak with clients around New England and the country, our impression is that individuals all seem to grasp that the slow-moving European fiscal disaster that has taken place over the last few years is, in fact, our future given the current trajectory of the US fiscal imbalances.  Yet cognitive dissonance is being counted on as our political leaders begin to ply us with their focus-group tested campaign narratives.

Spain has indeed become the EU’s newest and largest albatross, as we surmised it would in our January Outlook.  Spain is not Greece.  Spain “matters” in terms of economic size—and potential drag on the entire continent.  As Gerald Driscoll wrote in a recent Wall Street Journal column, “How the Spanish banking situation is handled will determine the future of the euro and possibly of the larger European Union.  Will [Germany’s] tax payers and those of other solvent countries be willing to fund an even larger bailout of Spanish banks to save impecunious Spaniards?”  The question is unsettling to us, given the drawn-out bureaucratic process we’ve witnessed thus far in dealing with the much smaller economy of Greece.

As we write these words, Stockton, CA is set to become the largest US city ever to declare bankruptcy, illustrating the fact that public fiscal fecundity is not a purely European problem.

YIELD

CCR Wealth Management continues to stress portfolio yield as a strategy to smooth out volatile capital markets, and as a source of return in an extremely low growth economic environment.  We are actively using equity market dips to pick up high yielding US index ETFs, and we remain committed to yield spread over Treasuries as an important component in our fixed income models (through high yield, floating rate and emerging markets bond investments).  We are also adding to portfolio yield with additions to REIT and MLP peripheral sectors.

EQUITIES

  • Despite our focus on dividend yield, CCR Wealth Management’s model portfolios seek to remain balanced between “value” and “growth” equity styles. While broader “value” indexes clearly carry higher dividend yields, they are also home to the Financial and Banking sectors.  We are on our fifth year of avoidance of these stocks.  Banks and Financial issues seem to us better “trading” vehicles than strategic holdings at this point.  There remains a distinct void of understanding about how Dodd-Frank regulations will affect their ability to hedge themselves, or even profit from an eventually expanding economy.  Additionally—there are too many unknowns in our opinion with regard to the European counter-party risks among some of the larger institutions.  For the broader sector, we think risks outweigh rewards at this point.
  • Our model small cap equity weighting remains at 10%, and remains distinctly US-oriented.
  • We have been analyzing individual portfolios in our client reviews for instances of heavy weightings in Greater European equities. We should note that we remain international investors; however Europe-specific exposure should be reviewed and in some cases reduced, given the longer-term nature of their growth problems.

In contrast to our European outlook, we actually remain steadfast in our allocations to emerging markets.  Unfortunately, it is unrealistic to expect significant performance advantages in the near-term given the economic slow-down in the United States and the recession in Europe.  However, we reiterate a point we made a few years ago in that the rise of these growth economies is largely tied to demographics and global technological advancement.  Strategically, their future remains bright—though on a relative basis.  One tactic we have pursued within the last two years is the meaningful inclusion of emerging markets debt as a component of our model allocations.  Emerging markets bonds, along with stocks, had a bumpy ride in 2011—yet these bonds have bounced back with significant advances.  We attribute last year’s dip to pressure from forced selling by European Banks (what else?) as they strove to raise cash in the midst of last year’s pandemic fears.  We are reasonably confident that this particular risk is in the past.

COMMODITIES:

Perhaps nothing has reflected global economic sentiment more acutely that the commodity markets.  The WTI crude price has slipped 26% from its March levels ($110 to $83.5), and Brent has seen a similar tumble.  Industrial metals, particularly copper have also reached new lows recently after an initial rally at the start of the year.  Gold remains flat for the year—but seems precariously perched around the $1,550/oz technical support level, and Silver is down year-to-date.  About the only commodity group showing positive pricing are certain agricultural crops (corn, cotton)—due primarily to weather conditions in the US.

Most CCR Wealth Management portfolio models include a long-term allocation to commodity elements.  We have recently reduced our weighting to 4%-6% from 6%-8%.  On a relative basis, we view the most favorable commodity holdings to be oil and gold at this point.  Oil prices are approaching cyclical lows—and putting aside the myriad of other economic concerns—we hope lower oil prices help sustain what economic activity there currently is.  As we’ve mentioned before—oil also has the property of a geo-political “hedge” to justify its place in the portfolio.  Gold, of course, is a widely held commodity which can offset the multitude of currency concerns that exist in today’s world.

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April 2012 Outlook

We commented in January that “we expect the continued, gradual growth rate of the US (2%-3%) to support an ultimately improved investment climate domestically—but we are convinced we will remain in a low-return environment…”  The troubling issue for us as investors now is that we continue to be convinced that both parts of that statement remain true, and yet most major domestic equity indexes finished up the first quarter in (or near) double-digit return territory.

We think economic data released within the last two months is more of a “mixed bag” than what has been reflected in the markets—particularly in the month of March.  This leads us to conclude that much of the 12% upward thrust of the S&P 500 through Q1 this year was driven by investor sentiment rather than hard evidence, and we expect follow-up economic news in the quarter ahead to disappoint.  Note that investor sentiment is a fickle thing.  In fact the data has already begun to suggest that GDP forecasts will likely begin to be revised down towards the lower end of the 2%-3% range mentioned in January.  Consider these recently reported facts:

The March unemployment report was a disappointment.  Like last November’s report, while the overall unemployment rate fell (from 8.3% to 8.2% in March), the number of people actively looking for work—the labor pool—shrank as well.  A shrinking denominator in the unemployment ratio renders the ratio itself less relevant.  We think this was largely ignored by the markets (and media) last December, but less so this month.  We would attribute a perceived lower unemployment rate as a big component of investor sentiment.

Industrial Production (as measured by capacity utilization) has been flat for the last two months.  This is generally a highly visible indicator of manufacturing output, and a leading indicator of manufacturing growth within the economy.  We actually noted the growth in this number in our October Outlook as a reason to be more optimistic than the general sentiment at that time.  It is possible that easing global demand is finally taking a toll on US manufacturers.  Two flat months do not make (or reverse) a trend, of course, but we will view this monthly indicator with interest in the near-term.

Much has been made this year about the unusually mild winter weather we have experienced nation-wide, and particularly in the Northeast.  Soft housing start figures over the last two months, and particularly in March, despite this benign weather are concerning.  In fact housing starts through March are over 8% lower than they were at the beginning of the year.

Certainly none of the points made above signal an imminent recession—or even guarantee softer GDP numbers ahead.  However, neither do they jibe with double-digit Q1 stock returns, in our view.  We expect meaningful market correction in the near term if domestic economic and employment data does forecast growth with less ambiguity in the coming months.

EUROPE:

No  news is good news as it relates to the European fiscal woes of the last few years—and for most of the first quarter this year there was  a comparative lack of news (therefore “good news”) pertaining our largest trading partner.  The implementation of the LTRO (Long Term Refinancing Operation) in December and its subsequent second-round funding last month have been credited with tamping down concerns (and volatility) related to the immediate issues within the EU peripheral countries.  We’ll accept that as far as it goes—but the problem is that it doesn’t go nearly far enough.  LTRO is a short term mechanism to deal with liquidity issues, and does not address any of their underlying solvency issues—issues which actually threaten the union itself.  As such, our concern is that given the relative size of the economies of Italy and Spain (relative to Greece, that is) additional bail-outs could require enormously greater sums than have been rendered to LTRO to-date.  And additional bail-outs will be necessitated by the judgments of market participants (including sovereign, private, foreign and domestic bond holders) on local politics, “austerity measures” and their growth implications, as well as the prospects for better risk/reward trade-offs elsewhere.  Our belief is that these forces will test European resolve once again this summer.  While investors may have become somewhat more accustomed to the volatility—the stakes are higher with the economies now in focus.

OIL; Global Implications

A year ago we drew a connection between the Fed’s long-term easy-money policy and the rising price of oil, surmising that higher oil prices as a “tax” on economic growth alleviated the Fed’s concern about inflation prospects given the more optimistic economic growth hopes of last spring.  As it turned out, other factors acted to curb US growth, and therefore inflation prospects.  Surveying the global economic landscape today, we are less optimistic that current oil prices (~$103 WTI, ~$120 Brent) accurately reflect global economic demand for the remainder of this year.  Handicapping geopolitical confrontation in the Gulf is beyond the scope of our analytical input, and we have already noted the premium this tension commands per barrel oil in previous Outlooks.  Our anticipation is that without continued high-intensity rhetoric (and low intensity military posturing), this premium will dissipate.  Coupling this dynamic with lower global demand could result in meaningfully lower oil prices ahead.  The upshot of this, of course, would be a mitigating effect on many of the economic pressures previously mentioned in this paper.

We also have lower pricing expectations of other economically sensitive commodities, particularly industrial metals.

BONDS:

As we wrote last summer, a stopped clock is right twice a day.  There remains, (in our view) no mathematically justifiable reason for investors to keep piling money into “safe-haven” bonds like Treasuries.  But then again, we’ve held this view for some time, and there’s no denying that Treasuries ended up 2011 with very impressive returns yet again, due primarily to European-inspired panic starting last summer.  This year’s interest rate and bond return records looks eerily similar to last year’s at this time.  We are out of the interest rate prediction business, but we continue to recommend a “barbell” approach to bond portfolio allocations, with short-term corporate high-grade emphasis on one end, and high yield and emerging market sovereign debt on the other.

“Sell in May, Go Away” is the infamous Wall Street saying.  As outlined, CCR Wealth Management believes a more difficult near-term is in store for investors based simply on economic fundamentals.  While it is possible most investors have become accustomed to market volatility given the experiences of the last several years, we note that there remains an enormous amount of liquidity in the markets given the Fed’s continued easing policies.  As we pointed out in January, this can have an accelerating effect on volatility, particularly when ignited by external (i.e. non-fundamental) forces.  In short, while we don’t think an absolute repeat of 2011 (Q2 and Q3) is likely, investors would do well to prepare for something close to it.

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January 2012 Outlook

By now most of us have read our fill of 2011 post-mortems—but we’re compelled to add a few thoughts of our own before we look ahead, seeking to apply the experience and perspectives gained to our outlook on global markets in 2012.

A year ago we remarked on three items which we saw as potential underpinnings of a better year both economically and market-wise than we actually ended up with.  They were; 1) the expectations borne out of the Fed’s QE2 policy announcement in late 2010, 2) Post mid-term political loggerheads, and 3) freedom (if temporary) from income tax uncertainty.  In truth, we commented at the time that we were more impressed with the expectations of growth from QE2 than the actual quantifiable results from QE1.  Certainly we witnessed a sharp slow-down in economic activity in the middle of the year that ultimately justified this suspicion.  Political gridlock, on the other hand, seems to have had an interesting impact:  First, we can clearly trace the historic loss of America’s AAA credit rating to this impasse.  Ultimately, given the events of the year, this development had zero economic or market impact from our perspective.  Credit strength is a relative metric.  Given the concurrent credit meltdown in Europe this year, the immediate result of the US downgrade was an influx of funds into US Treasuries (hence the relativity).  The second impact of this grid-lock has been an effective end to the current administration’s policy implementation, pending the outcome of this year’s election.

In the end, what eventually trumped all these considerations in 2011 was the panic surrounding the European PIGS (Portugal, Italy, Greece and Spain), and its influence on global markets.  We’ll touch on several specific topics throughout this Outlook, but in our view the dominant investment theme that kicked-off in late summer with the break-down of EU member cooperation was a global correlation compression.  In essence, the “lingo” in investment media became hyperbolically concerned with “risk-on”, “risk-off”, meaning that risk assets (i.e. anything that was not backed by the full faith and credit of a AAA rated sovereign with a printing press) all moved in the same general direction based on daily, often overwrought headlines rather than reacting with more nuanced and predictably distinctive responses that logic and fundamental basics would otherwise dictate.  We touched on this “headline risk” in our August Outlook, and again briefly in October.  While the measure of volatility was less pronounced than in 2008, diversification lost its “buffering” properties nonetheless, as in that fateful year.

We’ll close our post-mortem with two reflections.  The first is really just a reminder; the media’s principal role is to sell advertisement.  The quality, consistency, or objectivity of their reporting does not feed their quarterly bottom line.  The number of eyeballs they attract does.  “Bears” are trotted out during declining markets to foretell further gloom and doom (i.e. Mark Mobius, Exec. Chairman Franklin Templeton on CNBC in October), and “Bulls” make up the majority of interview experts when markets are rising (including Mark Mobius on CNBC in December).  Thus has it always been.  Allowing this characteristic to influence one’s investment decisions can have unfortunate long-term consequences. Just something to consider in the midst of the next bout of market volatility—which is coming.  In truth, the S&P 500’s fall from the top in May to the bottom in August was never more than 18% (a standard market correction).

Our second reflection is actually a recognition and acknowledgement of the fatigue some investors may be feeling as a particular result of volatility like that witnessed in 2011, not to mention recent years.  We all feel like the mythological Sisyphus—condemned to push a boulder up a mountain for eternity, only to watch it roll back down again.  The US broad market index levels are essentially where they were last March, in September of ’08, December of ’04, January of ’01, and in April of 1999.  The only difference among these periods was which direction the market was heading when it passed through this level.  In fact we addressed this in our January 2008 Outlook:

The 10 year total return for the S&P 500 index (reinvesting dividends) through October 1, 2008, is 3.059%.**  Factor in inflation—and the real return is basically nil.

Here too, there is historical precedent:  There have been two other “lost decades” in the last century: 1929–1942, and 1966—1982.  In both these periods, stocks floundered, rallied and failed, but ultimately ended with flat returns over the periods listed.

The silver lining:  One must examine the returns after these extended periods of lack-luster performance.  Both the late 1940’s into the 1950’s, and again the 1980’s into the 1990’s were marked by extraordinary stock market returns.

We continue to believe the “silver lining” lies with a meaningful allocation to emerging markets in both equity and fixed income asset classes.  While these markets were also roiled last year (and very much so in 2008), investors must note these average annual returns for the MSCI Emerging Markets Index through 2011:  3yr: 25.31%, 5yr: 2.39%,  10yr: 11.94%.

2012:

We are today digesting both positive recent stock market performance and economic data which has (thankfully) trended as such for the last six weeks or so.  Encouraging manufacturing ISM data since the fall, coupled with a generally positive trend in weekly unemployment filings and the last two months’ payroll data seem to give hope for continued strength in domestic consumption, which is vital.  However, for balance, we should also take into account the most recent Fed comments following the FOMC meeting in which Fed Chairman Ben Bernanke announced the need to keep near-zero interest rates in place for another three years—extending the already unprecedented policy horizon originally made in August by another year!  He even floated the possibility of another QE should growth trends falter.  Either Mr. Bernanke sees the US economic condition as continuing to be excessively fragile, or the Fed has virtually abandoned one of its two mandates.

The predictable short-term stock-market response, as has been the case for the last three years, is to cheer these reaffirmations of easy money.  In April last year we commented on the “Power of Zero Interest Rates” as the primary driver of capital flows from one asset class to another—or even from one geographic region to another.  But it is clear now that this policy is also at least partly responsible for the increase in volatility that investors have experienced within their own portfolios, and in our view, will likely continue to experience in the quarters ahead.  This policy is, in part, the cause of correlation compression.  Mohamed El-Erian (co-CEO of PIMCO) summed this up in a recent Wall Street Journal commentary, saying, “Investors must…stay ahead of a whole range of “unconventional” policy interventions that alter the very functioning and liquidity of markets, including large-scale use of public printing presses by central banks in Europe and the U.S.  By driving interest rates to very low levels, central banks are pushing investors out on the risk spectrum.”  He goes on to say “being pushed into an activity by the actions of others feels (and is) very different than being pulled in by the inherent attractiveness of the activity.  It is a fundamentally less stable situation” (emphasis ours).

In sum, we expect the continued, gradual growth rate of the US (2%-3%) to support an ultimately improved investment climate domestically—but we are convinced we will remain in a low-return environment in 2012 as it seems cash-rich corporations have by and large opted to remain very cautious in deploying this capital.  A fear of external risks (most perhaps emanating from Europe) has trumped zero returns on cash for the time being.  In addition, we think investors should gird for bouts of volatility as European dithering will likely continue throughout the year.

Speaking of volatility; did we point out that it’s an election year?

US EQUITIES:

  • Our equity model today is balanced between large-cap growth and value, particularly as it pertains to “new money”.  In the September-October period we discussed with our clients the need to take advantage of significant dividend yields which became available as a by-product of the down-side volatility of that period, in part to offset future expected volatility with the total-return characteristics of dividends.  As a result, some accounts may screen slightly to value, which is fine.  We think most of the “low hanging fruit” has been picked as stock prices have recovered (and yields have dropped).  We would likely return to this exercise should volatility increase significantly in 2012 to once again pick-up yield for the long-run.

Within the value universe we have positive expectations for the energy and materials sectors, particularly as it appears Chinese and Brazilian demand should stabilize.  For the fifth year running, we recommend avoiding the banking sector.

Within the growth universe we expect computers (and smart phones), network technology and biotechnology to continue to attract dollars, and therefore investors.  One caveat remains corporate technology spending, which a recent Goldman Sachs survey suggests could be somewhat lower than that of 2011, so “tech” returns will likely be divergent among the many sub-categories.

  • In October we moderately reduced our small-cap weighting, and it currently stands at a 10% equity weighting within our model.  Our move was predicated on our skepticism of the business cycle then.  We remain comfortable at 10% today—though it was recently voiced in our Investment Committee meeting that economic sentiment could possibly shift later in this election year, in which case we could be revisiting this weighting.

NON-US EQUITIES:

  • We have reduced our broad non-US equity weighting to 36% from 40%, simultaneously increasing the growth market weighting within the category to maintain its 16% weighting of total equities.  The net result is primarily a reduction in European exposure.
  • EUROPE:  It became difficult in 2011 to comment on European developments and their impact on both macro-global economics and portfolio implications without regurgitating the granular details that so much was being made of in the daily news cycles.  This has limited utility in portfolio strategy discussions.

In short, we’ve witnessed policy implementation in Europe being carried out by diplomats, which is why they are really no further along in solving the Greek debt crisis than they were two years ago, in our view.  We expect the bizarre ritual of faux-summits & grand announcements to continue for some time.  Ultimately, Greece will default (it’s a mathematical certainty).  By the time it does, maybe this year, it likely won’t be termed a “default” anymore.  Something more diplomatically palatable will replace that word—but the end result will be the same.

Europe is heading into (if not already in) a recession.  In our view, this is not the end of the world.  As with all recessions—this fact has been telegraphed by the MSCI European Index which was down 15% last year.  Like the US, Europe is home to many multi-national corporations in the energy, pharmaceutical and technology sectors that will continue to benefit from non-EU global growth, and may even reap further benefits from the decline in the Euro.  Valuations in many cases now look attractive.  We also believe Spain and Italy will prove more stalwart in reform than many suspect.

We have reduced our weighting to this region for two reasons: 1) the inability of EU policy makers to agree on and implement a solution for the more fiscally dire members has negative long-term internal growth implications for the entire region, and 2) in the near term, our concern regarding the health of the European Banking sector, which is inextricably tied to the so-far fumbling crisis response from EU governments.  European Banks will be at the epicenter of future risk-volatility in Europe.

  • EMERGING MARKETS:

 

We narrated the entire decline of the emerging markets indices last year in our 2011 Outlook series.  Central governments from China to Brazil implemented tight hawkish policies (both fiscal and monetary) in an attempt to stem rising inflation.  Markets reflected this in their price decline.  In our July Outlook we pointed to evidence that suggested a “soft landing” ahead for the Chinese economy (a major barometer within the growth market universe) in both their manufacturing and GDP data.

Skipping ahead to today, it is apparent that this soft-landing thesis has come to fruition, though market responses lagged somewhat.  Chinese GDP growth has slowed, and continues to slow—likely hitting a pace of 7.5%-8% later this year.  More importantly, this engineered economic slow-down seems to have occurred in an orderly fashion, with manufacturing production within the economy remaining relatively strong.  We feel investors should sit-up and take notice of this successful monetary endeavor, as it contrasts sharply with the havoc-causing devaluation responses we witnessed in emerging economies in the 1990’s.  Both the MSCI BRIC and Emerging Markets indexes have outperformed the S&P 500 for the past 6 weeks.  While we don’t want to make too much of such a short time-frame, this hasn’t happened for over 18 months, and we feel there is a significant turn of sentiment in the markets.

Growth markets in general, and certainly BRIC and Frontier market indexes have shown sharp declines throughout 2011 in our portfolios.  While we’ve made adjustments in our models pertaining to Europe, large and small cap equities, and within the fixed-income allocations, we’ve remained steadfast that investors must embrace growth markets for the long-term, and with a meaningful allocation.  It is here where the words of Mohamed El-Erian intersect with the growth-realities of the developed world, and where, in our opinion, investors will gain the long-term risk premium they seek on invested dollars.  China in particular, along with Brazil and most of the developing world represent the future of global economics, and global markets.  Demographics and technological proliferation drive this, and are immutable forces.  As advisors we must empathize with the higher volatility many of these investment categories engender, but we say again—this should be addressed on the asset allocation level.

Both the Chinese and Brazilian policy makers have publicly announced the end to their hawkish monetary policies.  Our comfort level will be higher when we see inflation in China dip towards 3%–hopefully in the first half of this year.

CCR Wealth Management’s emerging market allocation remains at 16% of equities in our models.

FIXED INCOME:

It is said a stopped clock is right twice a day.  If that is truly the case, then less than six hours have passed since our initial supposition that interest rates must go higher given a modicum of economic growth in the system (circa 2010), and that higher market rates would eventually trump low Government and gov’t-backed yields (meaning we haven’t been right yet!).  Clearly we’re still waiting….and Mr. Ben Bernanke seems determined to continue priming the pump.  Being wrong about the direction of interest rates in 2011—and particularly about the valuations of Treasury and related debt has us in good and plenty company, which is of no solace.

  • A year ago CCR Wealth Management made the call for significant use of short-term bank loans (floating rate bond class) within our fixed income models.  The “August Surprise” (loss of AAA, yet ever-lower bond yields), along with subsequent announcements from the Fed caused us to re-think this weighting.  While floating rate funds remain an allocation in our models, their weight has been reduced in favor of more “fixed” fixed-income funds (traditional bond funds).
  • We believe investors should make an effort to understand the math (or physics) of the bond market—particularly that of sovereign governments (our own especially) as it differs substantially from that of the equity markets.  In the bond market, an investors chooses to loan $X in return for $Y interest payments for Z years.  If $X continually moves up, and $Y continually moves down, eventually you will reach a point of a negative return by the time you arrive at Z.  As we know, in the short-term Treasury universe, Y interest rates have been virtually zero now for nearly three years—yet $X has continued to climb.  Conversely—no one can really put a cap on the stock price of, say, Apple Computer.  AAPL’s price will always be a function of investors willing to pay $X for what they believe will be $Y earnings—which itself is a complex derivative of how many devices they sell, revenue they reap on-line, ect.  Theoretically there is no cap on the stock price of Apple (or any other equity share), whereas mathematically there is a point where logic must break down for investors to buy certain bond yields.  We have reached that point.  Investors in any Treasury instrument less than three years in maturity are receiving a negative real return.  Even investments in Treasury TIPS (Inflation Protected Securities) are priced to produce a negative nominal return, as buyers seem content to net less than 100% of the inflation adjustment.  Investors seem to be content with the “devil they know” (a known short-term loss in US Treasuries) rather than the devil that must exist somewhere further out on the yield curve.
  • In general, we’ll characterize our current approach to the bond market as a “barbell” strategy, employing plenty of short duration on one end of the barbell, with higher yielding, higher duration on the other.

COMMODITIES:

We have not adjusted our commodity models since our October Outlook commentary.  We’ve seen the resurgence in oil we anticipated in July (below $80/barrel), and it closed the year roughly where it began—around $100/barrel.  Gold is off from its “panic” high in September of just below $1,900 an ounce (it stands at $1,731 today).  Base metals prices were hammered in 2011, in full correlation with global economic fears—particularly that which afflicted emerging markets.

  • We continue to favor crude oil based on more optimistic global economic assumptions, particularly those of the Americas and China.  It is true that oil prices could be subject to spikes as tensions remain in the supply bottlenecks across the Middle East region—however we do not speculate on such things.
  • Gold has historically been viewed as the quintessential inflation hedge, but the spike we witnessed in late Summer 2011 was driven by the financial, fiscal and political chaos emanating from Europe (with an assist from S&P’s US downgrade).  We reiterate that gold’s real dollar all-time high was $2,400/ounce some 30 years ago.  We see upside potential from both continued EU chaos, as well as inflation potential, however precious metals have generally taken a back seat to oil in our allocation model due to elevated volatility at these levels.  It is for this reason as well that we have further reduced silver positions.
  • We are focused on buying industrial metals (copper, aluminum, zinc) at opportune times given the drubbing these prices took last year.  While we do not necessarily pin pricing hopes on the continued (or resurgent) infrastructure-building explosion in China, their prices generally reflected overly pessimistic assumptions about growth market prospects, to which they’ve been correlated for the last decade or so.

Our investment models continue to reflect a 6%-8% allocation to non-correlated assets, primary commodities.