Educational Information

October 2011

Dear Clients and Friends,                                                                                    

The stock market suffered through its worst quarter in nearly three years as investors concern grew over the European sovereign debt crisis and whether the International Monetary Fund (IMF), European Union (EU), and European Central Bank (ECB) are making sufficient progress to avert a disorderly Greek default.  After the quarter ended, Greece announced that it would not meet the budget target it had agreed to, Italian debt was downgraded three notches, and a large Franco-Belgian bank collapsed, suggesting that the European sovereign debt crisis is not likely to be resolved easily or in the near future.

As difficult as the US market has been this year, almost every other global market suffered as much or more. Investors sought refuge in the US, a country still known as a safe-haven, in spite of its significant budget deficits and lack of progress addressing them.  As investors moved money into the US, the US dollar reversed course and appreciated 6% during the quarter. 

The Federal Reserve announced it will implement “operation twist” by selling short term bonds and use the proceeds to buy longer term bonds.  This will lower the rates on longer term bonds and make it easier for companies to borrow and expand.  It will also incent savers and investors to reduce holdings in bank accounts and short term bonds and instead invest in equities and longer term bonds as well as bonds with greater credit risk.  “Operation twist” will not in itself result in net new purchases of US treasury bonds, so should not contribute to inflationary pressures. 

The ten year US Treasury bond declined from 3.2% to under 2%, the lowest level in 50 years, and 1.9% below their 2011 peak in February.  The declining rates provided a boost for bond markets and the Barclay’s Aggregate Bond Index (a broad bond market index with a high allocation to government bonds) advanced. 

Returns for key indexes (including dividends) were:

Economic and Market Outlook    Although the US economy continues to expand and corporate profits are rising, economic growth is slowing and market uncertainties created by government policies in Europe and the US are increasing.  A sovereign debt default could significantly affect and undermine the solvency of large European banks, shake investor confidence and severely disrupt global financial markets.  In addition,     “Act II” of the US budget debate is set to begin before Thanksgiving as the Congressional “Super Committee” is tasked with making recommendations for $1.5 trillion in deficit reductions over a ten year period.  If their proposal is not accepted, the previously passed increase in the debt ceiling becomes subject to Congressional disapproval which could potentially lead to a partial government shut-down, disrupting the financial markets.   

However, before we paint an overly gloomy outlook, it’s helpful to remember that the Federal Reserve said they will keep interest rates low for several years, which is very positive for the stock and bond markets and brings to mind the old Wall Street adage: “don’t fight the Fed”.  By historical measures, stocks in the US and many other locales are attractively priced, especially Europe.   In addition, we are in what is typically an unusually good year of the “presidential cycle”.  Since 1939 there have been no down years in the stock market in the third year of any president’s term (and the average return has been in excess of 20%) as each administration does its best to keep the economy growing to score a ballot box victory.

The primary risks we face arise from Government policies, actions or inactions emanating from Washington and Europe.   Due to their inherently political and sometimes illogical nature, government actions and their outcomes are more difficult to predict than risks involving economics or finance.  As a result of a rising level of uncertainty, it is prudent to take a cautious approach with investments.  This is not meant to be a prediction about Congress, Greece or the markets, but rather a reason to exercise caution.  Appropriate strategies include maintaining a higher level of cash than usual, maintaining a relatively low level of international investments and emphasizing high quality US large stocks and bonds.

While market volatility can be uncomfortable, it can also be our friend.  A market recovery will likely begin at the point of maximum pessimism and the strongest market advances will likely occur early in the recovery.  It will be important for investors to both anticipate and participate in market advances and not be influenced by the then prevailing bad news in the media.  European stocks are now inexpensive by historical measures and it would not be surprising to see them advance strongly before becoming even less expensive if the sovereign debt crisis worsens.

Madeleine Albright was quoted as saying: “To understand Europe, you have to be a genius - or French”

Plan for significant tax increases in 2013         The extended Bush tax cuts are slated to expire at the end of 2012.  In addition, the new “Obama Care” tax on investment income is scheduled to go into affect at the same time.  This will occur at a time of budgetary pressures and Congress will have little time after the 2012 election to reach another solution, so it’s likely we will see higher taxes.  These tax increases will be substantial.  The top rate on ordinary income is slated to go from 35% to 44%, the top rate on capital gains, will go from 15% to 24% and the top rate on dividends will go from 15% to 44%.  It is wise to consider ways to accelerate income and capital and recognize them before 2013 if possible.

Budgeting 101  Imagine a family in the following financial situation:

• Annual Income:  $217,000
• Annual spending:  $382,000
• Amount borrowed this year to sustain spending (the difference between their income and their spending):  $165,000
• Outstanding balances on their mortgage, credit cards, and other borrowing now totals:  $1,427,100
• Vast underfunding of their retirement and future medical needs
• Family Action plan:  After much heated and acrimonious debate, the family cut $3,850 (1%) from their budget. Any Certified Financial Planner (CFP ®) would give this family a grade of F-minus in Budgeting 101 and recommend drastic changes before it is too late.

The rest of the story

• If you add seven zeros to each of the above numbers, it portrays the financial dilemma of the United States and Congressional action resolving it.

John W. Eckel CFP®, CFA