2012 Third Quarter Performance Report and Investment Outlook

If MCS clients’ assets were one big portfolio, performance year to date was up 5.5% through September 30.

Individual client returns ranged from 2.4% to 11.3% year to date. These asset value increases compare with 16.5% for the S&P 500 (stock index) and 4% for the Barclays Capital Aggregate Bond Index (taxable bonds). MCS clients own primarily tax- exempt and taxable municipal bonds for fixed-income exposure, which makes for a less-than- perfect comparison with the Barclays index.

In the third quarter, stocks climbed a wall of worry as deteriorating global financial conditions caused market participants to bet that bad news for the economy was good news for stocks. In Europe, the European Central Bank (ECB) turned bad news turned into good when its head, Mario Draghi, stated that the ECB would do whatever it takes to keep interest rates in troubled Euro economies like Spain and Italy from getting so high that sovereign default would appear inevitable. This policy means that the ECB is willing to buy bonds of troubled countries in sufficient quantities to keep interest rates low. Since the 2008 global meltdown, many have held ongoing concerns that financially troubled countries would experience panic selling in their bond markets, which in turn would further increase interest rates and create even more selling in a self-reinforcing negative feedback loop. The feared result of such a loop would be a collapse of confidence in the European financial system and a global depression.

In the United States, the Federal Reserve (Fed) continued flooding money into the banking system by creating money to buy mortgages in an effort called QE3 (Quantitative Easing #3). Fed actions were designed to encourage more lending and to assure markets that interest rates would remain low for the foreseeable future. Growing evidence of a slowing global economy was seen as a positive for markets, because it implied an accommodative central bank policy of low interest rates for a prolonged period, which the Fed has affirmed by policy. Generally, the stock market responds favorably to low rates, because lower interest rates usually stimulate economic activity. The next six months should tell us whether more Fed interest rate manipulation encourages renewed economic growth; the stimulus effect is questionable because the cost of credit does not seem to be the problem. Many doubt the effectiveness of Fed policy; I am among them.

INVESTMENT STRATEGY
My assumptions:

    • The extraordinary measures taken by central banks to avoid a global depression have worked in the short run, but we don’t know the unintended consequences of such measures.

 

    • The Fed’s goals consist of 1) keeping inflation and inflationary expectations low, and 2) stimulating enough growth to increase employment. These goals can lead to conflicting policy prescriptions.

 

    • Americans are concerned about the current level and growth of the national debt, the sluggish economy, and taxes. At the same time, they seem to want these problems fixed without incurring any personal pain or sacrifice — which is impossible. This pattern is a prescription for dysfunction. Government policy is meeting the needs of people in the system enough to make people resist changes that personally impact them. The only way systems change, however, is when the pain becomes so great that change seems better than maintaining the status quo. Apparently we have not yet reached that point.

 

    • Low interest rates and hence low returns on safe investments like government bonds, high-quality corporate bonds, and insured certificates of deposit increase the risk and uncertainty of financial outcomes for savers.

 

    • Because of the globalization of economies and economic policy, diversification is not as effective in times of crisis. In a crisis, most asset values go in the same direction: down. Globalization is evident in tiny Greece; had it not been part of the European Union, its financial failures would have had limited impact on the global economy.

 

    • Any swift, significant increase in interest rates will impact most assets negatively. There is nowhere to hide. Money funds would be relatively unaffected, yet because they yield zero they carry a cost burden if you stay there.

 

    • Interest rate scenarios (The Good, The Bad, and The Ugly):

      The Good — A benign scenario would likely include a gradual recovery in the economy characterized by falling unemployment and a pickup in growth. Most bonds would perform poorly relative to riskier assets like stocks. It’s not clear to me how well stocks would do, because this scenario would mark the end of low rates.

      The Bad — The United States enters a prolonged Japan-like low-growth period in which U.S. creditors accept the fact that they must continue to buy low-yielding U.S. debt, because to stop doing so would cause as much damage to creditors as it would to the U.S. economy.

      The Ugly — A toxic scenario in which   investors lose confidence in U.S. efforts to resume steady economic growth and reduce debt, hence interest rates climb quickly on fears of a hard landing. Most assets perform poorly, with some exceptions (gold and some foreign currencies, for example).

 

    • It’s unclear to me what influence, if any, the presidential election will have on the economy. Economic direction during a president’s four-year term is often determined by forces unrelated to the president’s governance.

 

  •  The fiscal cliff describes the implementation (on 1 January 2013) of automatic cuts in discretionary government spending, plus the expiration of favorable tax breaks, which implies a high probability of a recession. My best guess is a compromise that mitigates the economic impact, but that 2013 will be a trudge through heavy snow.

Five Year Performance Report Ending 09/30/2012

My strategy:

    • At the most basic level, seek out investments that produce good cash flow even under difficult economic conditions. We can’t control securities’ prices during a financial panic, but strong cash flow will enable prices to recover.

 

    • I continue to sell select zero-coupon bonds in favor of high- coupon bonds. High-coupon bonds sell at a premium (i.e. above the bond’s maturity value) because the interest rate paid is much higher than can be found in current interest rate vehicles. These bonds tend to yield more even after adjusting for the cost of the premium. Compared with zero-coupon bonds of the same maturity, high-coupon bond prices are much less sensitive to interest rate changes.

 

    • In my previous newsletter, I mentioned that I was looking at alternative investments or non-publically traded income- producing investments. The search continues; however, I remain mindful that the attractiveness of the net return vs. the risk must more than offset any direct costs related to alternatives investing. Many Wall Street firms offer alternative investments, but I find them unattractive on a risk-adjusted basis because the fees are too high.

 

    • I am building a dividend-paying stock portfolio one company at a time when the price is attractive, if expectations are low or modest because of a current problem that can likely be overcome in the next few years.

 

  • I am expecting more risk/volatility and uncertainty in the financial markets. As the global economy slows, efforts to stimulate economic growth through commitments to lower interest rates and increased deficit spending will clash with fears related to increased government debt burdens. Something has to give, but I can’t tell you when.