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Part II: What’s going on

The preliminary Gross Domestic Product for the 4th quarter of 2012 printed minus .01%. That is not good. True, looking at the individual components shows some upside. Consumer spending grew 2.2%. Housing advanced off a low bottom. Tech spending was up. Inventories and exports fell while government spending, which needed to decline, did. However, our Government still borrowed a huge amount; $312 billion in the fourth quarter alone. (link). Overall, 2012’s GDP was about 2.2%. That is not good (link).

Yet the stock market looks to continue to rally. Is the market wrong? No. Up is up.

Lazlo Birinyi, a veteran market historian to be respected, argues that bull markets have cycles. He breaks these cycles into four stages: Reluctance, Consolidation, Acceptance, and Exuberance. These cycles are driven by psychology and play out despite other factors. Of course, a major event will dominate. However, desperate U.S. Government policy and the failing economic recovery, the debt tsunami in Europe, or the Arab spring have not broken this cycle.

Birinyi remains positive for 2013. He believes the fourth stage of Exuberance began last July. Furthermore, his analysis shows that, historical bull markets he sees as similar to today’s resulted in a 38% average gain.

“History never repeats itself, but it often rhymes” – MARK TWAIN

Heady stuff.

A Golden Age

It’s easy to forget and lose perspective about what is happening in this world. From uncertainty in our economy and in Europe, the looming fiscal cliff, and most recently the tragedy in Newtown, we may be feeling lost and unsure about the future. Just turn on any news program. The pundits, news anchors, talking heads, supposed experts, and politicians are talking about the problems we face.

But let’s not forget some amazing accomplishments that have occurred in recent years:

· People throughout the world are now living longer than ever before, here.

· Extreme poverty has been dropping year over year, thanks in a large part to the improving economies in Asia, here. . (For a fascinating comparison of population size and prosperity over the past 200 years, visit here. )

· The cell phone is playing a huge part in reducing poverty. “A 2010 U.N. study, for example, found that cell phones are one of the most effective advancements in history to lift people out of poverty.” Time Magazine.

· Global food production continues to increase, here.

· GDP per capita has been rising throughout the world, here.

· Scientific and technical journal articles have been increasing each year, leading to more and more health and science breakthroughs, here.

· On a global scale, people are building and inventing more new technologies than ever before. Patent applications have been rising each year, here.

· Deaths related to battles, conflict and wars are showing a downtrend, meaning there are fewer death than ever before due to conflicts, here.

· For more trends that point to an improved and improving world visit here.

“Never has there been less hunger, less disease or more prosperity. The West remains in the economic doldrums, but most developing countries are charging ahead, and people are being lifted out of poverty at the fastest rate ever recorded. The death toll inflicted by war and natural disasters is also mercifully low. We are living in a golden age.” (link to full articlelink to full article)

The above article is a fresh perspective and provides a positive view of a world that many are unsure about. The fiscal cliff just doesn’t seem as important now as it did a few moments ago.

We hope that you have a wonderful holiday and when you have a conversation with family or friends that delve into what this world is becoming, think back to this newsletter and all the good things that are happening.

Maybe we are living in a golden age and we can’t see it.


Part I: Ignoring the Fundamentals?

Is The Fiscal Cliff is now behind us?

“…$620 billion in tax increases is spread over 10 years, so it is only $62 billion in 2013. To put this in perspective, the Federal budget deficit in 2011 was a whopping $1.089 trillion. This amounts to only 5.7% of the 2011 budget deficit!” (link)

Not 6% of the total debt, not 6% of the Federal Budget, but just 6% of the $1 trillion-plus deficits to be incurred in each of the following years. Moreover, this assumes that revenue (taxes) meets projections. Remember that the rich are also the successful and have proved adept at changing behavior to manage their tax bill.

So, the answer is: no. The Fiscal Cliff is still very much unsolved.

Furthermore, a measure of how expensive stocks are relative to earnings is the Shiller Price/Earnings ratio. It is above historic averages at 22x’s. This generous premium surely signals good times are soon to appear. Or are they? Chart after chart of economic data still shows little sign of this. So what’s up?

This stock market is on a liquidity-driven rocket ride as the U.S. Federal Reserve mints new dollars from nowhere to accommodate the massive debt binge of our Government. Currently, our Federal Reserve is purchasing $85 billion of bonds per month to maintain our record low-interest rates. This is $1 trillion per year compared to U.S. GDP of about $16 trillion. It is estimated that 42 cents of every dollar spent by our Government is borrowed (link). All this liquidity pumped into the system by not just our Federal Reserve but, by the Bank of Japan, and European Central Bank, is driving stock prices with no apparent end in sight. This market is on a rocket ride.

This news is not new. It was the case a year ago when I was recommending caution. It seems nothing has changed. Our government is still irresponsible, the economy is still mired down, the Euro is still a bankrupt idea, and the stock markets continue to go up.

After proofing the above for me, one of my managing partners sent me a copy of the Daily News dated 11/29/1949 titled “Ode To The Welfare State”. This article foretold the end of American prosperity. It reminded me that our Country has been here before and survived to scale to new heights. He also reminded me that there are currently many highly successful companies driving their stock prices higher.

Laszlo Birinyi, a veteran market historian to be respected, was right last year and is still bullish. His recommended portfolios were up 3%, 7%, and 15% for 2012. He chooses his words carefully and, is very positive for 2013 (link). Birinyi’s newsletter is provided to me by my other managing partner.


Are You at Risk of the Tail?

If you’re an investor worried about another major decline in the markets like the one experienced in 2008-2009, then you’re worried about something called “tail risk”. Just like the probability illustrated on a bell curve, the majority of gains and losses are usually within a certain range. But there is a chance that your portfolio could decline so much that it hits the far tail of the curve. PIMCO has an excellent illustration of tail risk.

Bell curve showing tail risk

You’re not alone in thinking that another major decline is on the way. A recent survey reported by Financial Times shows that many of the worlds biggest investors foresee another major market drop (Read more: Investors fear imminent tail-risk event).

As discussed in the article, some of the strategies that could limit your losses if such an event were to happen again include: managed volatility equity strategies, direct hedging and other alternative asset allocations (such as property or commodities), or going all to cash since inflation would likely be low. And for what it’s worth all of these strategies are included in The Active Asset Allocation Portfolio.

Then again, have you considered the possibility that we are entering a significant bull market and that we at the other end of the tail?


Duration Duration Duration

Duration is a very important concept for bondholders in today’s world of low dividend yields. It measures the degree of risk of principal loss should interest rates rise from our current historically very low levels. For example, a leading investment company offers an exchange-traded fund (ETF) which I believe they correctly state is “representative of the broad, U.S. investment-grade market.” It has an
SEC yield of 1.6% and a duration of 5.0 years. Simply put, if the relevant interest rate rises by 1%, the current market value should drop about 5%. Given a meager 1.6% SEC yield, that is not much reward for
that much risk.

It is no secret that our Federal Reserve is ‘managing’ interest rates in an effort to generate economic growth. Many argue that this policy is unsustainably suppressing interest rates and that the free market or ‘correct’ level of interest rates is much higher.

Predicting and timing moves in interest rates is a “fool’s errand”. The world is full of turmoil. U.S. interest rates could remain low for an extended period. However, government policies often fail and interest rates could spike upward. This would leave many investors with unexpected losses.

One must consider that current dividends may not be sufficient to pay for the potential risks. Caution is recommended.

Is It Safe? Stocks: Pro, Con, and the Dividend Bubble

The U.S. stock market is at post-crash highs in the middle of domestic and world economies optimistically seen as struggling. Does it make sense? Is the market reasonably priced? Is it safe?

Well, it depends who you talk to:

Pro: The S&P 500 is currently about 16 times earnings on a 12-month trailing basis. This is about average on a historical basis (link). Additionally, we are in the recovery stage of the business cycle where earnings slowly improve. Furthermore, price/earnings multiples are inversely related to interest rates and interest rates are extraordinarily low. The average dividend alone on high-quality stocks is paying far more than what C.D.’s offer. Lastly, the charts are pointing up; as the saying goes, “the trend is your friend”.

Con: Shiller’s methodology for calculating the S&P 500’s price-earnings ratio is based on average inflation-adjusted earnings from the previous 10 years (link). It is currently at 23 times earnings with a historic average of about 17. The S&P 500’s current dividend is currently substantially below the historic average meaning prices are high (link). Additionally, corporate profits as a percent of GDP are not as high as some claim, but high none the less (link). Profits could decline as a percent of national income as wages start to reestablish themselves. Lastly, the end of borrowing the difference between what is spent and what is earned is here. Politicians call it ‘austerity’. It is inevitable and will depress economic activity.

The Dividend Bubble: The Federal Reserve’s Zero Interest Rate Policy (ZIRP) intervention has forced normally conservative savers into the stock market looking for yield. Dividend stock has been bid up distorting their price (a bubble). The resulting elevated P/E of these stocks has raised the overall multiple of the market. The other side of this is many other stocks remain at more traditional P/E multiples.

For example, a currently popular dividend stock is now priced at 18 times earnings and a 4.3% dividend yield. According to Valueline, its historical average P/E is 14x and its average dividend yield is 5.0%. This implies a ‘fair value’ of over 15% below its current price.

With the stock market at post-crash highs it may be a good time to do some math.