September 13, 2011

Pass the Marmalade – European Banks May Be Toast

The Investment View from Prescott, Arizona

Several times over recent months, I have commented on how I felt the market was in for rough times in the months ahead.  Months ago, I cited slowing industrial activity around the world as one of my concerns, and during the past couple of weeks economic news was dominated by reports of slowing economies in China and Europe as well as the U.S.

Having my observations proven accurate like this is sort of like being at the car races, knowing which corner of the track to watch for the next wreck and then getting to see it unfold in slow motion.  So, let me tell you about another wreck about to happen right in front of us.  Hopefully parts won’t come flying our way.

A European banking crisis triggered by sagging values of sovereign bonds (those issued by nations, not companies) in Europe is coming to a head.  Economic problems in Portugal, Italy, Ireland, Greece and Spain (the PIIGS) are nothing new, but clearly seeing the trigger for the crisis was new to me, so I thought I would report it to you so you can watch with me as it unfolds.

European banks are already staggering under the weight of many loan defaults as their real estate issues create a domino effect of problems there like ours do here. Reuters reported on August 31st that the International Monetary Fund (IMF) estimates that European Banks already face a shortfall of 200 billion Euros.  They have problems, to say the least.

Recent IMF “stress tests” of European banks conveniently overlook losses on sovereign debt held on bank balance sheets because banks report sovereign bonds they own at their original purchase prices rather than current market values.  

This phony accounting by European banks is like you and I saying our house is still worth what it was 5 years ago. Talk about burying one’s head in the sand!

One report mentioned that PIIGGS countries have issued 970 billion Euros in debt.  Another report in ZeeNews.India.com mentions that write downs of the value of PIIGS bonds that have occurred have been in the 21-50% range.

Without boring you with the math, if European banks faced reality and wrote down the value of the PIIGS bonds they hold by 21%-50% a lot of those already shaky banks would be insolvent.  It is only a matter of time before this reality rocks European markets big-time.

For sure, there will be a bailout attempt of some sort by the more solvent European countries, but this issue also has the potential to destroy the European Union if more fiscally conservative countries (Germany, in particular) decide to walk rather than keep bailing out spendthrift states.   Another alternative is that Germany will recast the EU in its own image with more German-like controls.

As Sergeant Schultz from Hogan’s Heroes would say “You Vill Pay Your Bills!!”

One bit of wreckage that could come flying our way is markdowns in the value or even complete defaults of sovereign debt held by US money market funds.  Many of the highest yielding money market funds get those yields by investing in junk bonds, and PIIGS bonds are currently among the junkiest of the junk.

If you shop for money market funds mostly by looking for the highest rates, that means your funds are taking high risk and this is the kind of market that high risk comes back to bite investors.  There is an old saying in the investment world that is taking on new meaning these days, “Bulls can make money, and bears can make money, but pigs (now including PIIGS owners) usually get slaughtered.”

This is not a time to be taking a lot of risk.

A Slice of Life

This past weekend my wife, Cathleen, and I had a memorable trip to New York for the 10th anniversary of the 9-11 attacks. 

It was no ordinary trip, however, as Cathleen was asked to sing in a memorial program at Lincoln Center that day along with Prescott friends Jim and Pat McCarver and Jim and Eileen Klein in a group led by composer, conductor and PBS regular, Rene Claussen.

I get to hold the purses while the girls sing.

Seriously, however, it was a moving and very memorable trip with a visit to Ground Zero included.  It looks very different from when I stayed there in 1999, doing business in Tower 2 of the World Trade Center.

But the traffic!!   It was all tied up with security checkpoints and big wigs in motorcades.  Oy Vey!    Give me small town Prescott, any day.

Resources For Seniors And Caregivers

There are several new free resources available to help improve the quality of life for Seniors and Caregivers in our local communities. The Caregiver Connection Newsletter is emailed monthly and includes a list of support groups, meetings and other resources available throughout Yavapai County, as well as informative articles related to the joys and challenges of being a senior or caregiver.  The newsletter is also free.

The Senior Resources Agency Online Directory allows anyone to search within various categories for contact information for hundreds of local companies and agencies that provide services and products for seniors and caregivers.

The first Senior Resources Conference and Expo will be held Friday, September 23rd from 10 a.m. to 3 p.m. The event will include short presentations by local experts, including me, who will talk about the most sensitive issues relating to the challenges of being a Senior or Caregiver, and dozens of local commercial, nonprofit and government Senior Resources Providers will offer free information about their products and services.

The location is the Adult Center of Prescott, 1280 E Rosser Street. Admission is free. Please visit www.SeniorConnection.us to learn more about these free resources or contact Debbie Stewart by email at Debbie@SeniorConnection.us or call (928) 778-3747.

Don’t Believe ’em.  This Is A Recession!

During last month’s plunge in the stock markets, something else was going down.  Bond yields.   The interest paid on ten-year US Treasury Bonds plunged to record lows recently, hitting 1.9% on Friday, September 9th. 

Significant declines in long term interest rates have accompanied the onset of all recent recessions including 1982, 1991, 2001 and 2008.  In fact, interest rate trends are one of the most reliable predictors of recession we have, and they are flashing bright red at the moment.

Another precursor to recessions is rising gasoline prices.  Higher gas costs take money out of our pockets just like any tax.  This is money that can’t be spent on groceries, home mortgages, cars, etc.  Instead it gets spent by Middle East oil barons.

Gasoline prices averaged $1.75 a gallon in January, 2009.  $2.60 in January, 2010.  $3.15 in January 2011 and are around $3.61 now according to the American Petroleum Institute.  The trend toward higher gas prices is unmistakable.

This increased cost is money no longer available to stimulate our economy, and is a primary reason that rising gasoline prices have also preceded, and can be said to have triggered, every recession in recent US history.

It will probably take the government six months to admit it, but my work tells me that the country is in recession right now.  Sometime before the end of the recession, the stock market will bottom, offering a terrific buying opportunity, but right now, investors should be cautious because I don’t think we are there yet.

What Makes Capital Preservation Work

As dark as the stock market may seem at the moment, there is always a bottom to these markets, and a tremendous profit opportunity at the other end as markets rebound off the bottom. 

Some investors think that capital preservation means retreating to CDs the day before one becomes scared by market news.  This is not really realistic since we never know when the market is going to go down or when it will bounce at the end of a decline until those moves are well under way.  We never know when it is time to take evasive action until some losses tell us that.

It is my job to preserve your capital in these tough times, so when the market does turn around we will have as much of your capital as possible in the good times that will follow.

Capital preservation is the single most important thing in keeping you all in the top tier of all investors.  Let me explain.  I’ll keep the math simple.

If the average investor, earning the returns of the stock indexes or the average growth fund, loses half of their money, as has happened twice in the past decade, their $100,000 account becomes worth only $50,000.  When the rebound begins and the market gains, say 40%, their gain is on the $50,000, not the original amount.  A 40% gain only gets them back to 70% of their original amount or $70,000.

Capital preservation does not have to be perfect to be effective.  It can show small losses and still out-perform in the long run.  If one starts investing after the rebound begins with 90% or 95% of their capital intact, that is a tremendous advantage over those who start over with only 50% of their capital.  A 40% gain on 90% of the original capital would put hypothetical investor at 126% of their original investment or $126,000 in this example – way ahead of a traditional, buy-and-hope-it-works-out investor.

Even if our active approach to investing misses the beginning of the rebound, we still have a tremendous advantage over most investors. 

As Richard Russell, writer of the Dow Theory Letters once said, in this type of market, everyone will lose something.  Even CD owners are losing purchasing power.  The winners will be the ones who lose the least.

And that is the real rationale behind capital preservation.

What’s Going On In Your Portfolio?

As you might expect from the tone of recent newsletters, I am in capital preservation mode, more so than at any time since the winter of 2008-09.

As of my last newsletter, our Careful Growth* strategy had greatly outperformed the S&P 500** index up to that date in August, but the month ended with a remarkably strong stock market bounce, and since we were positioned for further declines, we lost a few percent during the last week of August.  We are still a lot better off than the stock market as a whole, but our outperformance over the broad market narrowed at the end of the month. 

Flexible Income* accounts finished August with a small profit, outperforming the average 6-month CD,  and as of this writing after the market’s close on Friday, September 9th, is showing another small profit for the beginning of September.

Careful Growth* portfolios hold a paired trade, where a Japanese fund and a Utility fund are paired with an inverse US Index fund attempting to capture the better performance of the utilities and Japan funds, and using the inverse fund to remove the stock market volatility.  This tactic is called a “hedge”.

Flexible Income* portfolios hold a strong dollar fund which has finally started working well for us, as well as a diversified bond fund which is doing well as interest rates dive.

Both growth* and income* portfolios, and by extension balanced* accounts which hold a little of each, hold some gold and around 40% in cash.  The cash allows us to avoid risk with that portion of the accounts, plus be ready to buy investments at bargain prices when the bottom appears to be in.

Our Spotlight Strategy

For our Socially Responsible Investment clients, we invest using the same methodology as our Flexible Income, Careful Growth and Balanced non-SRI portfolios.  What changes is our use of socially screened stocks, mutual funds and ETFs when they are available in the appropriate market sectors.

*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.

Balanced Strategy Description and Performance Information
Careful Growth Strategy Description and Performance Information
Flexible Income Strategy Description and Performance Information

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.