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October 2013 Outlook

We’ve felt a reticence to begin writing market commentary for the third quarter with the partial government shut-down now in its fourth day.  The sentiment revolves around a general premonition that “everything could change” on a dime with a political resolution (or a deepening) of already entrenched positions in Washington, thus rendering our commentary moot.  But we think that would make us guilty of a fallacy we often caution our client’s against—that of paralysis or impulsion in the face of soap-opera dramas presented by the news media, who by the way are the only winners in this showdown.  Besides, we’ve been here before (and quite recently).  The stakes are too high to flirt with failure and ultimately default; party affiliation will not insulate anyone, all parties to the impasse know it (despite the rhetoric), and we must operate under these premises.  More on this later.

Let us turn our attention to the more germane pursuit of analyzing current economic conditions, market trends, and look ahead to what might be expected in the quarters before us.  2013 has been an interesting year in the markets to-date as we have seen significant decompression of correlations among both asset classes and sectors.  If nothing else, major index performance over the last nine months has been a vindication for the principals of diversification.  Early in the year the S&P 500 quickly achieved double-digit returns while bond prices accelerated their negative trend.  Non-US markets measured by the EAFE index trailed US returns, but showed a positive trend due largely to the Japanese rally in response to their economic stimulus initiatives.  Over this period, emerging markets fared the worst as investors worried about the effect of rising interest rates in the US impacting economies highly leveraged to capital inflows.  But since the end of June, we have seen a significant outperformance of both emerging markets and the EAFE over US markets.  Bonds have trimmed their year-to-date losses somewhat.

Throughout this year we have made certain judgments of equity market valuations, particularly in the context of addressing questions about “all time highs” for two of the three major US equity market indexes.  We pointed out that the Dow Jones Industrial Average, for example, was trading at about 12.54 times 2013 earnings estimates in January, whereas the 2007 forward earnings multiple (marking the previous “all time high” for this index) was up around 16 times.  Today this multiple has expanded to 13.99 times the forward 12 month earnings estimate*.  In short, the index as a representation of US large Cap stocks, is not as “cheap” as it was at the beginning of this year (the Dow having climbed over 2,000 points thus far)—but neither is it trading at unheard-of valuations, considering that a purchaser of the Dow was paying just 10% less a year ago for a dollar of this year’s earnings than a purchaser today pays for a dollar of next year’s earnings.  On a total return basis, January’s buyer of the Dow is up near 15% on their investment (this is a hypothetical illustration; investors can not actually “buy the Dow Jones Industrial” index).  One of the primary reasons the P/FE ratio does not increase linearly with the advance of the index is that the forecasted earnings component of the P/FE relationship has increased as well.  Scaling these index levels to something comparable across market segments, or over time should be a priority exercise when making generalized value judgments about the market.  This is especially true when we’re bombarded with shouts and warnings of “all time highs” coming through the media.

Stepping back from the US and looking around the globe reveals even more compelling valuation metrics for stocks in virtually all geographic and economic categories; from Europe to Japan, and yes, emerging markets. Roughly two years ago CCR WM slowed our investment into Europe-centric equity investments given the roiling uncertainty of the EU’s role (burden) in supporting the unworkable balance sheets of Greece, Spain and Italy.  While “austerity” leaves much to be desired as an economic policy, the growth challenges in Europe have been somewhat lubricated by the monetary policies of the EU as a whole.  While we do not intend a macro-economic discussion of Europe here; it is at least important for investors to grasp the contrast in confidence that exists today as opposed to that which existed two years ago.  To some, Angela Merkel’s triumph in last month’s German elections signals the end of the euro zone’s debt crisis, though longer term uncertainty over the union and the currency remain.  This relative stability has allowed astute investors to recognize true fundamental value in many global corporations domiciled across Europe.  Economically, Europe has outperformed the consensus negative growth forecasts we cited in January—but still only remains a GDP “flat line” year to date.  Our view is in agreement that given comparative equity valuations, the glass is half full.  We continue to recommend a managed approach though, rather than a broad-based index strategy as secular recovery is likely some way off.

We argued good news would be bad news with regard to US economics early in the year—at least in terms of the Free Money punchbowl tended by the Fed.  First quarter non-farm payroll averages (233K per month) significantly exceeded their to-date average last August (130K per month) when Bernanke pledged open monetary spigots in perpetuity. Manufacturing, consumer sentiment, and housing metrics all ticked higher early in the year which could have been the catalyst for a public musing by the Fed Chairman that QE tapering by year-end was all but imminent.  Retribution was swift in the bond market, with the ten year Treasury showing a sharply negative reaction in Q2 with yields spiking 64 basis points (from 1.84% to 2.47%), and the Barclay’s Aggregate Bond Index losing roughly 4% by Labor Day.  As we cautioned earlier in the year, “balanced” portfolios, or portfolios otherwise heavily allocated to bonds have shown evidence of significant headwinds in their performance metrics this year.

Evidence suggests that higher interest rates over the spring and summer has slowed economic activity—particularly in housing.  Permits for multifamily homes dropped 15.7% in August, suggesting higher mortgage rates could be making developers cautious about taking on new projects.  This in-turn would likely feed directly into the job-market data in the months ahead, and this may be the primary reason the Fed surprised markets last month in not beginning a taper of the bond-buying program.  While bonds in general (and Treasuries in particular) may have been given a “stay” by the Fed’s lack of action—we continue to believe that this year’s bond market returns are only a harbinger of things to come.  Expectations should be calibrated to higher interest rates ahead, and portfolio durations should be kept as short as possible.

Back to the Washington Fiasco; there’s an old adage attributed to John Maynard Keynes that it’s “better to be roughly right, than precisely wrong”.  We’re certain this calculus plays out inside the Federal Open Market Committee meetings every 6-7 weeks.  As advisors, we understand that politics, policy and political philosophy are related tangentially to long-term investment climate.  What we must continually remind ourselves as both advisors and investors though is that human nature is essentially consumed with self-preservation.  To this end, we can at least be relieved that Congress is made up of humans!  We do not know what the next week brings in terms of debt-ceiling developments—but we are unaware of any party to the conflict who is willing to throw themselves (and their party) out of office due to an unwillingness to negotiate—if even in the 11th hour.  A prominent politician recently quipped, “This is not a game”, referring to the current political impasse.  But that is precisely what it is.  A game of “chicken” being played out through the media, and unfortunately this is part of the process these days.  We witnessed this process play out two years ago and we urge investors to get past the posturing, and above all, to avoid doing anything which carries the risk of being “precisely wrong”.

*as reported by Birinyi Associates

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January 2013 Outlook

Last year we were looking for US economic growth in the 2%-3% range, an improved investing environment here in the US as well as a stabilizing of non-US and particularly developing markets.  While US GDP growth will likely be confirmed at the low-end of that range, clearly the stock market trumped our single digit expectations in 2012, and pockets of expected volatility were shorter-lived, and tamer in scope than we expected.

With the benefit of hind-sight, we must attribute much of this performance to both the European and US central bankers who made very vocal commitments to “keep the punch bowl out” at all costs in the face of slow growth in the US, and even more intractable problems in the Eurozone.

We also cited views by PIMCO’s Mohamed El-Erian on unconventional central bank policy interventions, and the fact that investors (large and small) have been “pushed” into higher yielding—and riskier assets by the lack of yield available from more traditional, and safer instruments like money markets, savings accounts, Treasury notes, etc. This is in contrast to being “pulled” into action based on the inherent attractiveness of opportunity.  Those still funding the Treasury (primarily other sovereigns and the Fed itself in a round-about way) receive less than the rate of inflation for holding this debt for ten years, a known loss in real terms.  As bond prices and yields have an inverse relationship, the ultra-low yields of recent years have meant a concurrent inflation in the value of these bonds—a bubble.  Because government debt is the underpinning foundation of the rest of the vast fixed income market, this inflation has spread across all types of bonds—from municipal to high yield.

Furthermore, the Fed has seemingly gained such control over the interest rate markets that the distortions do not end with the price of bonds.  The stock market itself seems to take its economic queues not from actual economic data—but from the Fed itself.  Recent examples of this distortion include a tendency for the market to rally on news that could only be interpreted as negative in any other time and place.  On September 13, the Fed announced QE3 in response to a steady, months-long dose of negative GDP revisions and flat economic indicators, with Ben Bernanke himself stating “Employment remains a grave concern.  The Weak job market should concern every American”, and hewent on to cut the GDP forecast for the remainder of the year—and firm up an unemployment range for 2013 of 7.6%-7.9%.  The response of the markets, of course, was to celebrate this ray of sunshine with a nearly 2% rally (this is on top of the rally based on a similar announcement from the EU’s Mario Monti earlier that week).

This paradigm has continued throughout the last several years—and we saw the counter- reaction in the first week of this year when the minutes from the Fed’s December policy meeting were released.  Showing dissention within the OMC committee’s ranks about the open-endedness of QE3, it resulted in the most pronounced turbulence the market has seen year-to-date.  Presumably this dissention concerned the possibility of improving economic metrics later this year.

In our view (though perhaps less relevant to the question at hand), the Fed’s actions have rallied the stock market—but failed to rally the economy much, which is what they are designed to do in the first place.  A prime example would be the recently released Q4 GDP figures which actually shrank, despite the renewed and open-ended commitment to providing liquidity made by the Fed in September.

Bad news is good news in this paradigm—so logically, investors should be extra-wary of good news in the months and quarters ahead.  This could take the form of an improvement in the labor market, improvement in leading economic indicators, or better than expected GDP figures in the quarters ahead.

 Priced to Perfection

“Perfection is achieved not when there is nothing more to add, but when there is nothing left to take away”

–Antoine de Sainte-Exupery

 CCR Wealth Management is actually less concerned at this point about possible reactions in the equity markets than we are about implications for bonds.  It is true we’ve been cautious on the bond market for the last three years—we even quipped about the wisdom of “fighting the fed”, but we have personally spoken with management team members of some of our bond funds—and even they are not enthusiastic about large chunks of their own assets classes.  We were recently on a conference call with PIMCO’s Bill Gross, who was expounding on the “viable alternative of cash”—as is related to the fixed income markets. Managers with broader mandates have even turned to equities to provide the yield they require—which makes sense in some cases.  Consider a recent random spot check:  A Verizon 5 year bond was priced to yield 1.178%.  Verizon stock (VZ) yields 4.736% on the same day.  We know the comparison is not “apples to apples”, however the yield difference is significant, and requires a thorough risk/benefit analysis that includes interest rate risk as well as credit and equity market risk.  This type of analysis is being conducted more and more as interest rates languish near 2% or less for ten-year benchmark Treasuries.

One of the more noteworthy occurrences within the stock market in recent months has been the significant fall from grace of Apple Computer (AAPL) from its September ’12 high of $705 to its recently traded price of $458 (down 35%).  It was only a year ago (when AAPL’s price was also $458) that Apple could do no wrong with the analyst community, which tripped over themselves to raise the price target to $1,000, 1,100, and even $1,101!  This Outlook communication has never dissected the merits of individual securities—and we will not begin now.  We cite the Apple story because it is one with which most investors are familiar, and one that illustrates what can happen when an investment (stock, bond or even asset class) becomes “priced to perfection”.  Valuations reach such levels that tolerances for even slight deviations from expectations are infinitesimal—and when such deviations do occur, market retribution is swift.

Returning to our multi-year concerns about bond market valuations, we do not mean to suggest that AAPL’s recent fall can or should be a harbinger (in scale or scope) of what’s in store for the bond market.  Rather, we highlight that when priced to perfection—any asset or asset class is susceptible to market forces, which will ultimately trump the most reasoned analyst—or regulator.  Investors should heed the power of the market to correct distortions–eventually.

FIXED INCOME:

We should make note immediately that all bonds are not the same—and different classes of fixed income have differing levels of exposure to interest rate risk.  Here we will only reiterate that we see no upside in US Treasuries, and most government-backed bonds—save for unforeseeable panic events elsewhere in the markets.  Today we strongly caution our clients against waiting around for these “Black Swan” events, and focus on the reality of an improving, if ever-so-slowly US economy.  Because of price inflation in these particular types of bonds, their influence in the widely cited Barclay’s Aggregate Bond Index has grown to such an extent that the term “bond market” has come to invariably refer to these types of fixed income investments.  CCR Wealth Management continues to recommend diversifying away from these exposures—and away from the index.

In fact a vast universe exists beyond US Government debt, and we continue to see pockets of value that investors should be exploiting.  CCR WM continues to recommend meaningful allocations to emerging market debt (both local currency and USD denominated), and we have recently taken renewed interest in the senior loan (“floating rate”) market.

While bonds will always be generally correlated to interest rates, we firmly believe that coupon yield will offer a scaled buffer against an orderly march higher in interest rates, mitigating somewhat against interest rate risk should this occur later this year or next.

EQUITIES:

We are comparatively more comfortable with equity valuations—despite the continually subdued GDP outlook here in the US and around the globe.  We think it’s important at this point to understand that equity markets are very “forward-looking” mechanisms, and in fact trade higher based on potential GDP rather than forecasted GDP.  Much has been made in the media about major US market indices reaching or approaching new numerical highs—but we would hasten to point out that a much truer gauge of value would be a P/E comparison to prior highs.  In 2007, the Dow Jones Industrial average traded at a lofty 16 times 2008 earnings estimates.  Today, while the index recently has recently matched its 2007 highs, it trades at only 12.54 times forward earnings estimates (as reported by Birinyi Associates).

Most would agree that developed economies around the world—the US included—are far from having achieved their potential.  Furthermore, it must be clear to investors at this point that while political, policy, and economic challenges lie ahead for both developed and developing markets—stocks are not having difficulty attracting money—and there remains much money on the sidelines still.  Another anemic growth year (~2.1% 2012 GDP) garnered an S&P 500 return of 16%.  While we do not expect a “repeat” necessarily, investors who require a return on their assets are increasingly turning to equities.

CCR WM’s model portfolios remain straddled between value and growth investment styles.  Dividends remain important components of total return in our view, though we acknowledge that dividend yields have shrunk over the trailing 12 months due to appreciation.  We expect another “spotty” year on the growth side as earnings guidance from many high profile technology companies has been less than bullish—but be aware that “managing expectations” down for the year is often a major role of Q1 conference calls.

China has stabilized, and emerging markets as a whole staged an impressive rally in 2012, recovering from the prior year’s pessimism.   Emerging markets securities continue to be essential long-term portfolio components, both stocks and bonds.  However the EM universe looks different today than it did 5 or 10 years ago, and as previously communicated, CCR Wealth Management has tilted our allocations to favor a more managed approach rather than an indexed approach.  Secular trends have been replaced by more isolated opportunities which fundamental bottom-up research can uncover.

The managed approach is also best applied to European equities as well, in our view.  Consensus economic outlooks for Europe in 2013 are pessimistic, with most suggesting economic contraction in the 1.50% neighborhood.  It is critical however that we don’t paint “Europe” with a single brush at this point—the EU is comprised of many separate economic zones, many of which are much more economically healthy than the EU as a whole.  These opportunities present themselves in an otherwise subdued environment, and in our view these are the environments most conducive to picking up longer term values.

COMMODITIES/ALTERNATIVES:

There remains no “secular trend” within the commodities universe.  Monitoring outlooks for emerging market health (and infrastructure investment) as the year progresses will be an important element in deciding whether to expand our current precious metals, oil and REIT holdings to include additional economically sensitive components.