Let's Get Real!

In what does America have confidence right now? The stock market? Congress? The Judicial branch? The Executive branch? Corporate profits? The Federal Reserve System ?

Everyone of these has a massive impact on our economic system. For example, recall the stock market sell off in May. Our market was down just under 6% within 48 hours when Chairman Bernanke announced that things were looking up and they provided guidance on when they would begin to close down their asset purchase programs and let interest rates rise. He essentially undid his guidance. Never mind. 

Instead, they are more cautious. Their NEW guidance arrived last week indicating they have lowered their growth forecast by about 12% for 2013 and anywhere in a range of 3%-11% in 2014. Providing guidance has consequences. The more important lesson of this is that while there is little question we are in an economic recovery is not without larger than average bumps in the road. All recoveries are characterized as “climbing a wall of worry”. This one, however, is exceptional.

The Fed has helped MAKE the present economy what it is by artificially lowering interest rates. This has helped us ease through our current credit depression. The Fed is feeling its way through it. There are varying opinions among Fed governors on how to proceed. What once seemed to be a collective , unified body now openly discusses future uncertainty.  Our country has only been through a couple of these in its history, and they did not turn out well. The Fed really wants this to turn out well. It is using all of the tools at its disposal. They have had success. This one has been far easier, but at a price. The price has been credit uncertainty for our overall system. The Fed offered up its good name in exchange for money it didn't have to purchase government bonds. It likely paid prices higher than would have been paid in the open market. As a result, its balance sheet has now expanded by about $3.5 trillion. This is not a small sum for the Fed. Eventually, they will need to begin selling these assets to recoup their money and pay down their very real debt. Rational market players are apprehensive about to whom these will be sold and at what price. When prices decline, yields go up. Hence, interest rates rise. This can be counterproductive to a recovery. It can impact lives. There is much at stake here. 

As a society, we need to act as if we understand this. I fear much of the country does not.  Part of the population wants to spend and run up debt like it always has.  Part of the country wants to live within a budget that will cause hardship.  All of the country wants the problem to go away so it can get on with life.

You and I must make smart choices.  We have four primary choices when we invest: stocks, bonds, cash, alternative investments.  Next week will go through what makes sense for now and why.

Please feel free to contact us at 952-230-1340.

Chris

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury bonds and bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

Stock investing involves risk including loss of principal.

Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.


Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.


The LPL Financial registered representatives associated with
this page may only discuss and/or transact business with residents of the following states:  MN, TX, IA, WI, VA, NM, CO, AZ.

Wristwatches and Hurricanes

Against the overall backdrop of an economic recovery, along with a series of unusual conditions

that I described in our last issue of FinancialMuscle.com, I believe these are on the short list of

issues of which to remain aware when building a sound financial strategy. Each has a large

component of government intervention and each is very large. The goal here is not

recommending a strategy. Instead, it is educating on issues that are real and should have weight

in any personal financial strategy.

Japan: Japan has suffered since the 1990s what we are suffering now. They haven’t been able to

cease propping up banks and real estate developers, even now over 20 years later. According to

the International Monetary Fund, from a 2010 estimate for 2012, Japan’s gross government debt

as a percentage of its GDP was 236%. The United States number was 107%. According to one

researcher Japan has been able to keep their economy from tragic contraction because private

citizens funded government debt at low interest rates. This is changing because Japan’s

population is aging. The quote I recall is “last year, they sold more adult than baby diapers.” The

aging population is cashing in bonds for retirement, rather than remaining a net buyer because so

many are in retirement. Now Japan has to go out to the international marketplace to issue new

debt at higher costs. Interest expense will rise. Average government bond yields of 2% or higher

means their interest expense is not covered by tax revenue. They would be forced to respond by

printing even more money while going further into debt.

US Entitlements, and Pensions: Entitlements are obviously out of control and un-affordable.

The only way to come up with the money is to raise tax at the risk of lowering private sector

growth even more. This is not a good option, but it is happening.

US Housing and Commercial Real Estate Markets: It is very obvious that these marketplaces

are being propped up by artificially low interest rates. Our risk is that interest rates increase

making housing and commercial real estate, far less affordable. A hypothetical 3 ½% 30 year

mortgage for $200,000 generates about a $900 monthly payment. Raise the rate to closer to a

long-term average of about 6% and that payment jumps to about $1,200. That’s a 33% increase.

Raising interest rates can have a bad effect on the stock and bond markets also. We saw this in

May of this year when Fed Chairman Bernanke indicated that his organization was on course to

allow interest rates to move up about a year and a half from then. Within a couple of days the

stock market was down by almost 6% (S&P 500 high on June 19, 2013: 1652.45 and low of 1560.33 on June 24, 2013).

Complex systems: What I am going to write here is a bit complex. If your eyes glaze over a bit,

just skip to the emboldened sentence below. Recent research writings by Rubino [2013]

explained that there are complicated mechanisms in finance as well as complex systems. A

complicated mechanism is like a car engine or a wristwatch. It has many moving parts that don’t

talk to each other. They simply move around doing what they’re supposed to do. A complex

system is more like a weather front. It has parts too, but they communicate with each other and

can respond by growing and shrinking. He refers to an “epic feedback loop” that turns a tropical

depression into a category five hurricane. As one component speaks to another within the system

exponential growth can occur. Double the size of one component and perhaps the entire system

grows 50 fold. The component here that can increase leverage many fold is bank balance sheets.

Long and short leveraged asset positions result in what appear to be moderate risk positions.

They actually represent far more risk than appears for a key reason. Consider that in year 2000,

volatile leverage positions approximated $30 trillion. Today they are about $596 trillion.

The way they are structured indicates the system is growing in a nonlinear fashion while the net

risk position appears to be moderate. This is exacerbated by the fact that everyone is everyone

else’s counter-party. Essentially, systematic risk is not priced into the value of these volatile

leverage positions. An International Monetary Fund working paper from 2012 essentially says it

like this: “The network topology where the very high percentage of exposures is concentrated

among a few highly interconnected banks implies that they will stand and fall together.” They go

on to further explain that one of the benefits of such a small, clustered group of banks

maintaining the lion share of [leverage] makes regulation far easier than it was in 2008”.

As always, please feel free to contact me at 952-230-1340. If you have any questions or would

like to discuss what is written here.

Warm regards,

Christopher Gerber, CFA




Stock investing involves risk including loss of principal. 

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The LPL Financial registered representatives associated with this page may only discuss and/or transact business with residents of the following states: Minnesota, Wisconsin, Texas, Florida, Arizona, New Mexico and Virginia.

Current Portfolio Key Issues

Your Financial Muscle

I read recently an old fighter saying that says, “The punch you don’t see is the one that gets you.”

This FinancialMuscle edition is meant to discuss some key issues that I feel should affect our judgment. It is not meant to give advice. It is only meant to inform and educate.
Over the last year it’s easy to assume that if we put everything in the stock market, we could have made great returns. That, however, is not what investors do. They look forward. They have to make smart choices about their money based on the data that they have at the time. I call this “being in it”. You make your best decisions based on the information you have. Recently, I was able to go to the 150^th anniversary of the Battle of Gettysburg and its reenactment. I remember thinking at the time that the generals running the battle were really “in it”. Soldiers had to eat and sleep, not everyone was compliant, no one knew when the next battle was or what the outcome would be, and sometimes bullets and cannonball were flying everywhere, while men were screaming and horses were wailing. Add to that the fact that you could barely see because the fog created by the gunpowder clouded the skies. It was all out of their control. In 1863, when all they had were messengers on horseback to let them know what was happening miles away, generals still had to make decisions. There were no iPhones or sophisticated communications like we have grown used to. There were no satellite pictures showing troop movements. They made their best efforts appraisal given the information at hand. It’s noteworthy how that hasn’t changed. With sophisticated communications and mountains of historical data, you still can’t predict the future. We are still in the business of making decisions with much at stake when it comes to your money.

What We Know

So, what information do we have at hand? The numbers indicate that we are in a recovery. The recovery is barely. Here’s how we know this:

·         Gross domestic product is inching up net of inflation (the little under 2% annual rate),

·         Light vehicle sales have been inching up, albeit in fits and starts for several months,

·         Housing starts have broadly inched up, although they are nowhere near the long-term average,

·         Inventories have been inching up and are roughly equivalent to their long-term average,

·         Capital goods orders have been broadly inching up since 2012 and are above their long-term average,

·         Household debt as a percentage of disposable income has dropped pretty consistently since 2007 while household net worth has been inching up through the second quarter of 2013.

All of these indicate that things are generally on the mend, albeit at a very, very slow rate. These are generally indicators of the business cycle, but the credit cycle is a different story.

Yes, we have a credit cycle, too. Interest rates go up and credit becomes more expensive, interest rates go down and borrowing becomes cheaper. That’s a credit cycle. Credit has been easy for several years and pretty much all of the bullets have been shot from the Federal Reserve gun. Yet, the economy can barely get off the runway. We have a mismatch between the normal credit cycle and the normal business cycle. Usually they move in unison. As business heats up interest rates go up to slow business down, and as business decreases interest rates go down to speed it up. That is not exactly what’s happening now and that creates uncertainty.

More of What We Know

Asset Prices: Having important issues is nothing new. These are different, though. They are big:

1) Increasing government regulation over private industry which has in some cases come close to paralyzing free market business operations.
2) Moving private debt to the public balance sheet through treasury, fed, and fiscal operations.

The casualty of these behaviors is lowered asset prices. Starting in 2008 prices of assets corrected. They had been propped up by government and private easy money programs. Think: low-doc and no-doc mortgages at low interest rates. We found out the hard way that cash flow does not lie. When people could no longer pay their mortgages on time investors dumped the underlying securities and lowered asset values…as they should have…to be in line with the real abilities of debtors to pay back. Housing prices, business prices, most asset valuations in society crashed. The recovery has gone slowly since.

Since 2008 free and easy cash from the Fed has eased the pain. Unfortunately, easing the pain is essentially a valuation lie. The full measure of pain eventually happens no matter what. Investors ultimately vote based on real value as opposed to fictitious value. All easing does is prolong pain while increasing debt, hence making more pain along the way. Since government creates little value, the money it uses to ease pain is of lesser and lesser value because it is backed up by decreasing ability to pay. The hope from the Fed is while easing the pain the economy can gain momentum and pick up where the Fed leaves off. It could work. It has worked in the past, but not on this scale. This is new scale. The jury is out.

Looking Forward

Operating intelligently means evaluating where our system is against where each of us are personally. For those who have plenty of financial cushion in their lives taking large scale stock market risk could pay off. For those for whom a mistake is more meaningful, remaining conservative can be a very smart option. Even if the market goes up another 20% or even 30%, the risk of loss - which is just as large - can be devastating. This plays out in a retiree’s life in a way that is generally undesirable. Perhaps he has to lower his lifestyle or go back to work. Most people do not like being forced to be in this position. This is where having a realistic, workable strategy pays off. Living well can result from designing a strategy that realistically considers goals, resources, and risk.

Please feel free to contact me if you have any questions or would like to talk at 952-230-1340.

Warm Regards,

Christopher Gerber, CFA

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The LPL Financial registered representatives associated with this page may only discuss and/or transact business with residents of the following states: Minnesota, Wisconsin, Texas, Florida, Arizona, New Mexico and Virginia.