May 2012

Kreitler Financial:

Turbulent World

The stock markets enjoyed a strong start to the year, with the S&P 500 up 11.9% through April 30. Since October 1, the S&P is up even more at 25.1%. Our portfolios have enjoyed nice gains during this period.

More recently the markets have sold off, and we are not surprised. We have mentioned in prior newsletters that the markets seem to be either "risk on" or "risk off". We have just been through a six month period of "risk on". Investors felt better about what was happening and put their money in risky investments. Recent events in Europe may have triggered a period of "risk off" as individuals flee to "safer" investments such as US government treasury securities. If we have entered a "risk off" period (which we still don’t know is true), how long will this period last and how will the markets react? Some of the current uncertainty may already be priced into the markets. We just don’t know how much.

Recent events remind us that there are still large issues to resolve in the world. In this newsletter, we will review some of the big risks we see around the world today. Then we’ll close on a more optimistic note. Stay tuned.

European Woes

As we write, Europe is seriously considering the possibility of Greece leaving the European Union. Earlier discussions over the last several years were hypothetical. This time it sounds a lot more serious and perhaps by the time you receive this, it will be a fait accompli. The impact is much larger than just Greece as the future of the entire European Union is on the table. We believe the long term solution will be either a) one or more countries leaving the EU or b) the EU moves to a more centralized power structure. Which will eventually prevail is unclear. We have already been surprised at how long Europe has been able to muddle through, and this could happen again with the resultant market volatility along the way. Europe does not have easy options to Southern European sovereign debt problems, which is reflected in the challenges of negotiating a solution.

On the positive side, we are optimistic that the threat of a global banking crisis is somewhat contained due to steps taken in the past six months by the European Central Bank. We anticipate that periodic bouts of fear from Europe will trigger global market volatility going forward.

United States Unease

In the United States, leading up to November we could experience the hottest political rhetoric in recent years. It is easy to say the politicians are too polarized and unwilling to compromise, but we think they are reflecting the views of voters. They are struggling with major issues such as the future role of the government. No wonder that Washington is in gridlock. We think the debates will continue for quite a while and may not be resolved by the November elections.

On a more immediate issue, people are finally talking about the "fiscal cliff" that is approaching next January 1 when legislated tax increases and spending cuts automatically go into effect. The politicians have procrastinated on major issues for years by "kicking the can down the road". The end of the road is now January 1. We have heard some experts suggest if nothing is changed the impact of the spending cuts and tax increases will remove approximately 3 ½ percent of the gross national product, all at one time, and probably enough to throw the economy into another recession. No politician will want the financial consequences to occur on his or her watch, so it seems highly probable that whoever is in power will take whatever action is necessary to prevent us from going over the cliff. Perhaps kicking the can down the road once again.

The automatic tax increases will have an effect on everyone. We will be discussing planning strategies with clients during the course of the year.

Longer term, the country still has to deal with long term unfunded liabilities, particularly Medicare and Social Security. Instability in Europe has given us time to work on solutions, but this breathing room is not unlimited. This leads us to our next area of concern.

Interest Rates and Fixed Income Markets

The biggest challenge that investors face today actually may not be the large stock market swings we’ve experienced. Instead, it may be the extraordinarily low interest rates.

Real rates (adjusted for inflation) in the U.S. are actually negative. This is because monetary authorities around the world (the Federal Reserve and the European authorities) are doing everything possible to keep interest rates close to zero. Combined with the negative impact of inflation, this policy-driven effect is called "Financial Repression." It assists debtors in reducing their burdens at the expense of the creditors and bond holders who lent them the money. The governments are overriding normal market functions. One commentary says that "capitalism has been put on hold". We think the consequences are huge.

This has profound implications for investors. Bonds historically provided investors two functions: good income and preservation of principal. With today’s ultra-low rates, they can’t provide both. Low rates are making the interest payments meager (just ask any retiree who was planning to live off CD’s or interest from bonds). Additionally, bonds can lose value if interest rates rise. Interest rates have fallen for thirty years to their lowest in history[1], but we think at some point interest rates will begin to move higher.

When and how quickly rates rise are critical questions. A rapid increase would cause many bonds to drop in value, a big surprise for investors who think their principle is safe and for thirty years have seen favorable returns. Investors are in a difficult spot, forced to choose between relative safety with no income versus buying riskier assets to generate some yield. It’s not clear they understand these risks.

Finding Opportunity While Managing Uncertainty

The changing role of bonds is just one example of the many challenges we face as we structure portfolios. Since 2008, we have been designing portfolios with the belief that the future is extraordinarily uncertain, there are no 100% safe investments, and preserving capital is more important than ever. Yet, we still need to be able to provide reasonable after-inflation returns to meet our clients’ objectives. We have been using what we call "Multi-Scenario Investing" to balance all of this. As an example, the past two years we have been repositioning fixed income portfolios in an attempt to reduce the potential negative consequences of rising interest rates. We encourage you to speak with us about this.

There are actually some very good things happening from which investors may benefit. U.S. companies continue to drive strong profits. The private economy in the U.S. excluding homebuilding and government spending is growing at a slow but steady pace. Emerging market growth continues to be strong, albeit slower especially in China than in recent years.

We also note how extraordinary it is that for the past 10 years, U.S. stock prices have essentially had no meaningful increase. However, U.S. companies have gone through massive innovation and improvements during this decade, making themselves more valuable. We think the markets will eventually recognize this increase in value. This is one of the reasons we believe that, even though volatility remains high, investors who can afford the risk should keep stock positions in portfolios. Owning companies may also be a hedge against Financial Repression.

Other News

We recently had the privilege of joining a small group of other Raymond James advisors to visit several of the financial power houses in New York. We spent a half day each with Goldman Sachs, J.P. Morgan, and BlackRock. We also spent additional sessions with two smaller firms, Third Avenue Value and the Central Park Group. All five gave us extraordinary access to their top strategist and portfolio managers. Our sessions were very worthwhile. The most important takeaway was the issues they are working on are the same issues that we have been working on. This alone made the trip worthwhile.

On the home front, if you have been to our office recently you have seen our latest new portfolio reporting system which is now displayed on our wide screen wall monitor. One of our strengths is our ability to oversee accounts at many different institutions. Clients have found the summary reports (consolidating all accounts) showing information such as total amount in equities and ten-year actual returns particularly valuable.

Our series of lunches at Mory’s and the Graduate Club continued to be popular this spring. We will take a break from them in the summer months while so many of our clients and friends take well-earned vacations. We will resume them in September, so watch for your next invitation.

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Kreitler Financial and not necessarily those of RJFS or Raymond James. Past performance may not be indicative of future results. Investing involves risk and you could incur a profit or loss regardless of strategy selected. U.S. Government Bonds and Treasury Bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
Bottom Bar
Contact a Financial Advisor