Week of 07/15/10

Q2 2010 Market Review: Fear Rules

The S&P 500 was down 11.43% in the second quarter of 2010, the index’s worst performance since the fourth quarter of 2008.  The Financial Crisis of 2008 has clearly left investors jittery in the face of almost any market turbulence. 
Here are some of the challenging events that headlined the last quarter:

• Culmination of the Greek debt crisis, and concerns that it would spread to other Euro Zone countries and send the whole continent into another recession.
• The explosion of BP’s well in the Gulf of Mexico.
• The “flash crash” of May 6.

All of these events were important and certainly newsworthy.  But there was a lot of good news as well, it’s just that good news stories are not as interesting and do not sell as many newspapers, get us to watch more on our TVs, or make us click on a link.  Fear sells.  Media companies all know this or they would not cover these events with as much zeal.  Below we highlight a few factors that we see as positive for the market going forward, along with several charts to help visualize the data. 

• Cheap Money.  This past week, mortgage rates dropped to a 50 year low.  The 30 year fixed rate is now at 4.57%.  For certain, housing is a long way off from a real recovery but low interest rates are a very important part of that recovery.  Loans on other credit products such as autos and credit cards are also low.  Short term rates look to remain low as the Federal Reserve has signaled rate increases are not likely in the near future. 

• Low inflation.  Right now inflation is only up 2.0% year over year (as measured by the Consumer Price Index) and oil prices are reasonable.  Both these things are positive for the economy and consumers. 

• High levels of pessimism.  It may seem counterintuitive, but we would be more concerned if consumer sentiment was high and investors were very bullish on the markets. That is the environment that tends to breed complacency, and is usually when things start to go south.

Despite some positive data, there is a persistent focus on the negative items of the day, and this has helped create significant volatility in the market.  According to Bespoke Investment Group, the S&P 500 has had daily declines of 3% or more 87 times in the last 50 years.  40 of those declines have occurred since February of 2008!  We must accept the fact that higher volatility is something we may have to deal with going forward.  This is not necessarily a bad thing, but to piggyback on last month’s theme of “Are you tall enough?” volatility should be viewed as a negative based only as it pertains to your overall comfort level.

Summary

It is our job to see through the daily noise to decipher what is actually going on in the market and overall economy.  We anticipate that growth will be more sluggish in the second half of the year and early next year, but that we will avoid the so called “double dip” recession.

The relentless daily flow of negative news breeds uncertainty and market volatility. A disciplined, objective approach with a focus on long term goals is the best way to handle these chaotic markets. 

As always, we appreciate your business, and welcome any questions or comments you might have.

Rush Zarrabian, CFA

All information is based on sources deemed reliable, but no warranty or guarantee Is made as to its accuracy or completeness.  Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice.  Past performance is no guarantee of future results.

Week of 05/21/10

Why Europe’s Problems are Good for the US

Over the past week we have experienced excessive volatility, some of it due to the European debt issues and the questionable status of the Euro. However, Europe's loss is our gain…

According to Reuters May 17th article;

NEW YORK, May 17 (Reuters) - Foreigners bought a record $140.5 billion of long-term U.S. securities in March, the Treasury Department said on Monday, and more than doubled purchases of U.S. government bonds.

Many of you have read, or have heard of books such as “Aftershock” or “The Coming Economic Collapse”.  Most of these Armageddon books point to the risk of our trading partners (China, Germany, Japan etc.) creating a vicious cycle of economic destruction by not buying or perhaps even selling Treasuries.  This is a real scenario, but one that is unlikely to play out.  Just 18 months ago we were hearing about oil being traded in Euros, and the Euro being the world’s new reserve currency…how quickly things change!  The Dollar is currently viewed as a safe haven because of its strength in relation to the rest of the world.  Europe, and its problems have played a big part in the dollar strength (or Euro weakness), but the bottom line is an incredible amount of capital is coming into the United States.

This is not the ultimate resolution to our own issues, but is a short-term bonus for our economy.  This also dovetails with our view that the US will remain in recovery mode for the next year.  We are not suggesting investing Nirvana, but rather a short term reprieve while we get our own house in order.  What better way to do so than to use other countries' money?

We greatly appreciate your business. 

Scott Airey

Week of 04/08/10

Training Wheels

You remember the kind, small hard rubber wheels sticking out in the back of your favorite bike for stabilization. Think back to when you had them. Well, Dad has decided the training wheels must be removed, and has enlisted your handy Uncle to make it so.  The big event is today and the whole family is watching. You are riding the bicycle and peddling like mad, and good old Uncle Ben, who is running by your side, thinks you’re heading in the proper direction and with enough speed….lets go…. What happens next?

Well most of us know, it can go well, or it’s just another trip to the hospital. 

Our economy is on training wheels.  Dad is President Obama, and Uncle Ben is Ben Bernake.  The training wheels are economic stimulus and Uncle Ben’s controlling hand of safety is monetary policy.

Currently, the training wheels are still affixed and Uncle Ben is still running by our side.  The real question, and one that we are dealing with every day, is when will the eventful day occur when private industry must again take the weight of economic responsibility. 
When the change occurs, when the training wheels come off, is also the time of greatest risk.  We know that interest rates cannot be this low forever, and we know that the Government cannot continue to print money.  The ONLY question is when. 

This brings us to management of your assets.  We are properly positioned for the current state of affairs, but we stand ready to remove risk, or change the allocation of your assets given the above scenario is accelerated or delayed.  What do we want to see?  Slow and steady real improvement in the economy, with small adjustments to interest rates and the reduction of spending (not just increased tax revenues).  We feel we can make money in the US market currently, and may need to be in markets outside the US in the future. The biggest issue continues to be keeping the money you’ve already amassed, and sticking your neck out only far enough to make progress. 

To finish the analogy, we have added a proper fitting helmet, knee and elbow pads.  But in the end, it may not be a time to ride at all, but wait on the sidelines while your first cousin takes the ride!  We stand ready to do all of the above.

We greatly appreciate your business. 

Scott Airey

Week of 01/29/10

The Lost Decade: Lessons from the Aughts

In all of the “decade in review” articles released over the past few weeks in periodicals and on the Internet, you may have come across several pieces discussing how poor the past decade has been for stocks, specifically the S&P 500.   Without a doubt, the past 10 years have been trying for those invested in equities.  With two major bear markets during that time, the S&P 500 index had its worst calendar decade on record (even worse than the 1930s).  The 2000s gave us a strict reminder of one major key to investing:  valuation matters.

Let’s explore this issue further.  In January of 2000, the S&P 500 reached valuations never before seen in its history.  The index was trading at over 40 times earnings, and the growth needed in the economy to justify such valuation was greater than anything it had ever achieved in the past.  You may remember the justifications given at the time for such rich prices.  “It’s different this time” because the Internet was going to “change everything” and that we had entered into a “new” economy.  Stocks of tech companies who never made a penny in earnings were soaring on the belief that the world had changed, and a new era of doing business had begun.  While all this was going on, valuation took a back seat, as the market kept making new highs through 1998, 1999, and into 2000. 

Famed value investor Benjamin Graham said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine."  By the end of 2000, reality started catching up.  Investors began realizing that most of these New Economy companies were never going to make any money.  The market as a whole had grown to such high levels, with such high expectations, that disappointment was almost a sure thing.  Hence, we saw a major correction that lasted to the end of 2002.  The market run from 2003-2007 helped recoup many of those losses, but we gave it all back and then some during the brutal bear market of Nov 2007-March 2009.

One hopes that the ‘10s will hold a better result for equities than the ‘00s.  Going forward, one must remember that stocks will not necessarily go up just because they are stocks.  The same applies to bonds, gold, or real estate.  You are not guaranteed positive returns simply by being invested in a certain asset class.  The price you pay for that asset ultimately has a very high correlation to the return you will receive.

Levels of overall market valuation do not mean that positive returns are unobtainable.  We believe that during periods of overvalued markets, one has to go beyond a pure buy and hold approach.  Keys to success include careful security selection, partnering with managers who have a go-anywhere mandate, and diversifying across many different asset classes with strict and disciplined rebalancing.  Taking these steps creates no guarantees, but we believe it puts the investor in a better position to meet their ultimate goals.
               

Rush Zarrabian, CFA

The S&P 500 index is a basket of 500 large cap stocks.  You cannot invest directly in an index.

Week of 01/12/10

Change in Roth IRA Conversions

The ability to change Traditional IRAs to Roth IRAs has been available since 1998.  Recently, Congress has changed the rules and made it more palatable for everyone.

1. As of January 1, 2010, there will no longer be income limitations for transferring from an IRA to a Roth IRA. This presents an attractive alternative for older, high-income tax bracket clients.
   
   
2. Roth IRAs are NOT subject to Required Minimum Distribution (RMD) rules.  This allows your investment to grow tax free throughout your lifetime, without the annual withdrawal requirement.
   
   
3. If you participate in a Roth Conversion in 2010, you may report the resulting tax over the course of 2011 and 2012!  The ability to report these taxes over a 2-year spread will only apply to 2010 conversions.
   
   
4. Income limitations placed on IRA contributions only apply to current contributions (not transfers).  This means that little stands in the way of contributing to a Traditional IRA, and then converting that contribution to a ROTH in subsequent years!

The value of this opportunity will vary per client.  The loss of value due to taxes, versus keeping the Traditional IRA in tact and having it grow tax deferred until you remove it (by choice or RMD), must be factored into the calculation.  How many years will take to offset the lower invested amount (after taxes) in the Roth to make up for the tax paid?  Will taxes be higher in the future?  Will the new estate laws change the potential benefit?  All of these issues could negate any advantages.

Currently, our recommendation is to wait until more information is released, and/or congress passes the new estate laws (that may alter the benefit to you) to implement any change.  If you have any questions about this or would like to discuss it further, please contact a member of our team.

As always, we appreciate your business.

Scott Airey

Week of 12/30/09

It's a Wonderful Life

Another year has passed.  It is times like these, when I am sitting in the unusually quiet office on Christmas eve that we tend to reflect on life and the business of life.  The last two years have been very trying.  2008 and the first part of 2009 brought us the perfect financial storm, and like George Bailey in the movie “A Wonderful Life”, an old fashioned run on the bank (with modern twists) occurred and the system seemed to spin out of control.  Even during the recovery in 2009, we are still dealing with the weakened economy and the fallout of many financial scandals that rocked the world’s marketplaces.  Through it all, we have remained diligent in our approach to managing your accounts and appreciate your faith in our abilities.

2010 will be another year of shadow economics and therefore volatile markets. We cannot yet count on the private sector to pull our economy from its doldrums, and the consumer simply will not spend their way to full recovery with 17% unemployment.  Like the loss of $8,000 (stolen by Mr. Potter), we also expect radical events to occur (like Dubai and other credit or debt issues).  However, since we do expect the same level of volatility, we are prepared in many different ways to mitigate the effects to your portfolios. This includes positioning the portfolios in areas we feel will be less volatile, keeping fixed income relatively in short duration, investing more of your money in non-US denominated revenues, investing in demand inelastic services and goods, and finally keeping an eye on our economic statistics for indications of strength or weaknesses throughout the world.

Unlike the movie (George Bailey had always tried to leave Bedford Falls for adventure), we love what we do, and personally I cannot think of anything more rewarding than working with our team and wonderful clients like you.

Thank you very much for your business.  We look forward to a prosperous 2010.

Scott Airey

Week of 12/23/09

Tiger Woods and the USA

There can be little doubt about the meteoric fall from grace of Tiger Woods. Time and time again we are disappointed in our heroes and disenchanted with our leaders.  Even as a country, we look at our actions and sometimes cringe.

There are many opinions about our country’s fall from grace.  I have recently read books that call for the end of the world, the default of our Government, and the worst depression in recorded history.  I have also read other books and articles that state that the next economic and market upturn is upon us.  The truth, as always, lies somewhere in the middle.

A distinct difference in our economy and markets today versus 2008 (or even the beginning of 2009), is that we seem to have obtained a level of stabilization.  This is an incredible shift of perception from March of 2009, when the markets future was by no means guaranteed. 

There are still many issues to be resolved, but the larger issues are as follows:

- Unemployment.  You can chop and dice all of the macro economic numbers available, but the engine that has fueled our economy is now far from optimal.  True unemployment is around 17%.  Of those that are employed, most have cut back on their spending.  For this reason alone, our economy must go through a transition.  Theoretically, the transition is being assisted by Government spending to bridge the gap until happier days appear.  The eventual changing of the guard, from Government spending to private investment, will be tumultuous.

- Credit.  Our major banks have made repaying the Government their first priority.  Once their debt has been repaid, I believe credit will start to become available again, as this is fundamental to their business model.

- Housing.  The giant credit card (also known as the home equity loan) is not going to see a quick rebound.  It will take years to see a normal market, whereby the consumer has equity in their homes to the point of making a HELOC possible.

- The Government’s deficit needs to be addressed.  Continued spending, without the resources to repay, will eventually cause massive problems for our economy.  There is currently no plan by the present administration to solve this issue.  An estimated deficit as of this writing is $12,112,460,184,375.

Despite our transgressions, our flawed system, and the facts listed above, our market and our system of Government is the envy of all other nations.  Just like Tiger, whose “perfect” persona has been indelibly altered, he remains the greatest golfer in the world.  I would not bet against him, nor would I the USA.  It is only a matter of time before he wins the next tournament and it is only a matter of time until our system is fully healed.    

All of us at VZN thank you for your business.  We look forward to a prosperous 2010!

Best regards,

- Scott Airey

Week of 10/16/09

It’s a Small World After All…

No, I am not going to Disneyland.  The negatives of our economy have been highlighted over several of our past updates, but I want to take this opportunity to talk about some of the positives, and how we potentially (without help from our Government) could get out of this mess.

First, we believe the true recovery will take time.  We believe that the current rally is largely false, or to coin a popular term, “a dash to trash,” and will eventually give back a substantial portion of its gains.  The market will respond to large macro improvement and a sustained reduction of unemployment, followed by slight job growth, and the reversal of demand destruction.

Next, we believe the coming macro expansion will be fueled by the educated, motivated and currently unemployed or underemployed citizens who decide they can and will start their own business.  All large companies start small and most great ideas and inventions are initiated by a single visionary.  They do not come from czars, congressional committees or subpanels.  Small businesses are the lifeblood of the “American Dream,” and currently employ substantially more of our country than large corporations.  The next wave is being created now, with the “reduction in force” (laid off) employees and current small business owners who have survived the economic tempest.

To that end, the VZN Group would like to play a part.  Many of you have heard a VZN Group member state “know how or know who.”  We would like to take that statement to the next level and assist those clients who own a small business, or would like to start one, by making them available to other clients of ours that may need your service(s).  We have a very diverse client base, whose vocations range from homebuilders, to surgical, to “think tank”, to legal, and everywhere in between.  We would like the ability to refer our clients to you (and your business) and to assist you in being successful and/or getting the word out about your services.  In order to do so, we need your permission and more information about the type(s) of service(s) you provide.

It is a small world after all, and we feel we should do our part to ensure that your small business not only survives, but thrives!  If you would like us to include you (and your business) in our referral network, please contact a member of our team.  Upon contact, we will ask you questions about your business and the type of client that is appropriate for your service.

Best regards,

- Scott Airey

Week of 09/17/09

MARKET UPDATE:  WHAT ARE THE LONGER TERM PROSPECTS FOR EQUITIES?

As of Friday, September 11, the S&P 500 stood at 1042.73, up 15.44% for the year.  The Dow Jones Industrial average is at 9605, up 9.45%.  Both indices are still well below their all time highs, with the S&P needing to go up another 50% and the Dow another 45% to reach those milestones.

Last month we observed the potential for the market over the short run.  In this month’s update, we want to take a look at the longer term potential for stocks.  Focusing on the long run may seem difficult in the age of the Internet and 24/7 Cable News Cycle, but we must remember that investing remains a marathon and not a sprint. 

One measure of valuation that we like to observe is the P/E 10.  Normally, when viewing data on various financial websites, the Price to Earnings ratio you see is simply the current price of the stock divided by the company’s earnings per share over the past 12 months. As an example, if a company’s stock is trading for $100 a share, and its 12-month earnings were $5 per share, the P/E Ratio would be 20.  To observe the market as a whole, you would simply divide the current level of the S&P 500 by the earnings of all the companies in it.  Earnings data is available at S&P’s website (http://www2.standardandpoors.com).

Unfortunately, the basic P/E Ratio does not tell you much about long-term valuations, because it fluctuates significantly depending on where we are in the business cycle.  We feel the P/E 10 on the S&P 500 is a better measure.  The P/E 10 is the current level of the S&P 500 divided by the average earnings over the past 10 years.  By looking at earnings over a longer period, you can smooth out the fluctuations over the entire business cycle.   As of Friday, September 11, the P/E 10 was around 18.7; slightly above its historical average of 16.3.  It is important to note that this number came down from extreme levels of overvaluation. Before this year, we had not observed a P/E 10 of 18.7 since December 1991!  At this level, even after the rebound in the markets since March, equities are priced (based on the P/E 10) to deliver better returns than they were at the beginning of this decade, where the metric was at the highest level on record. 

The P/E 10 is not meant to be a market-timing tool.  Stocks can remain over or undervalued for long periods of time, so you can’t depend solely on the metric to guide your investment decisions. Nevertheless, it can give you a general idea of whether or not the market is over or under valued, and could be a key part of the overall investment decision process.

- Rush Zarrabian

Data for the P/E 10 is available at the website of Yale Professor Robert Shiller:  http://www.econ.yale.edu/~shiller/data.htm

Week of 09/03/09

Yogi Should Have Been An Economist

“If you come to a fork in the road – take it”.  (Yogi Berra)

Are we out of the recession?  This question matters mostly to TV hosts and members of Congress when Bernanke is on the hot seat. 

Let’s take a look at the information supplied by Briefing.com

Let's first review Q2:

The only sectors that produced a positive contribution to GDP were government spending and net exports.  Net export growth was only positive because consumer demand for imports continued to fall faster than global demand for exports.

Personal consumption expenditures account for approximately 70% of GDP, and, as you can see, the numbers look abysmal.

The fixed investment data looks worse.

The only data that looks strong is a result of government spending!

What about Q3 and Beyond?

"I knew I was going to take the wrong train, so I left early." (Yogi Berra)

Economic trends are very important.   Many point to the improvements in the numbers (declining less) as a sign that we are working our way to pre-Lehman highs.

The question now seems to be what will the recovery look like?  Will the recovery take the shape of a “U”, a “V”, a “W”, or an “M”?  The answer is yes, depending upon your time-frame.  Short-term we have already experienced a portion of the “U” recovery, but most people (we are of this mind as well) do not think a “U” or “V” is possible under the strain of debt that is on the books for the long-term (greater than 1 year).  We expect increased volatility and a mixed version of the UVWM recoveries, as the markets come to terms with our new reality.  What we are witnessing is a hyper focus caused by the abundance of data.  To illustrate our point, we’ll take a look at silk.  While it is smooth to our touch and eyes, when put under a microscope, the steep peaks and low valleys of the fabric are revealed.  We have been able, through technology, to remove the smoothing effects of the macro view, for the unsettling effects of our economy under a microscope.  With our microscopic view, comes an increase in volatility, as the masses (now globally) react to every piece of data, however small in meaning or duration (monthly or weekly changes).  The media only exacerbates the issue, with graphs and full-color charts (with complete with sound effects).  This is the new reality of hyper information.

This micro view translates into a new reality of volatility, and shorter, but more abundant, corrections of scale.  While we have experienced two “bubbles” in the last decade, we foresee these events becoming more frequent and of the norm, rather than the exception.  For that reason, we need to be ever more vigilant in our protection of the downside, or losses in the market.  As we all have experienced, the market takes away value far more quickly than it gives back.

"A nickel isn't worth a dime today."

You can say that again.  And a dime tomorrow is not worth a dime today.  Our present administration is betting very heavily that John Maynard Keynes and his followers are correct (see http://en.wikipedia.org/wiki/Keynesian_economics for  a brief explanation).

For those of you looking for the results of quantitative easing, please read this article from FT (http://blogs.ft.com/economistsforum/2008/12/quantitative-easing-lessons-from-japan/) written in December 2008.  The horse is out of the barn on this one, but at least we can be prepared for the bond bubble (previously formed in Japan) that is now forming in the US.

"If you don't know where you are going, you will wind up somewhere else."

In today’s world of conflicting opinions, we understand what he means.  We will not take our eye off of the ball and will continue to seek the best, safest return possible for our clients.  In the end, it is the total number of runs that wins the game.  It is of little importance in what inning they were scored.

As always, we appreciate your business.

- Scott Airey

Week of 08/14/09

Market Update

As of Friday, August 7th, the S&P 500 stood at 1010.48, up 49.5% from its low on March 9th.  The market has not seen such an advance in so short a time since the 1930s.  The swiftness of the advance leads directly to the question, how much further can it go?  Are we due for a pullback, or does the market still have room to grow?  In this month’s article, we will be looking at signs about what the market may hold in store for the short run.  Next month, we will look at the longer term potential of stocks.  

We will define the short term as the next 12 months.  Before delving in to the data, it is important to note that no one can consistently predict where the market is headed, but we can observe history to give us a good sense of what has happened in previous times of market distress.  The first measure we will observe is the S&P 500’s 200-day Moving Average.  Moving Averages are useful when looking at trends.  The following data from Bespoke Investment Group1 illustrates how long the S&P 500 Moving Average was in a downtrend, and how it subsequently performed when that downtrend stopped. 

You can see that the duration of the most recent downtrend was the 3rd longest in history in terms of length, and 2nd worst in terms of the S&P’s performance during that time period.  In previous instances, the Index was higher in 4 out the 5 times 6 months later, and was higher in all cases one year later.  This does not suggest that the market will be higher in one year this time around, but it does show that it is perfectly plausible, given what has happened in the past.

Another measure that shows the market may have some life left is current corporate bond spreads.  Chris Watling of Longview Economics suggests that the market can continue to rally as long as spreads remain above normal, which it has done in 7 of the 9 previous recessions since WWII2.  Although these spreads have come down significantly since last November, they are indeed still high by historical standards, as are High Yield spreads.  Again, Watling’s observation does not suggest that the rally will continue this time around, but history shows us that the potential is certainly there.

Although it is important to observe short run tendencies as we have here, long term trends are much more important in determining client wealth.  Next month, we will take a closer look at what kind of potential stocks have over the next decade given current valuations.

- Rush Zarrabian

1 http://bespokeinvest.typepad.com/
2  http://www.economist.com/blogs/buttonwood/2009/08/bonds_equitiesand_a_bit_more_h.cfm

Week of 07/30/09

Columbus and the Santa Maria

How many zeros are in a Trillion?  12.  I had to look it up.  My HP Business calculator could not display a number that large.  To provide you an idea of the size of a trillion, please take a look at the link below.  

http://www.pagetutor.com/trillion/index.html

The market has responded very favorably lately, as we have seen a mediation of negative trends and some profits from our leading corporations.  However, as we move along the road to recovery, I have to continue reminding myself that seven trillion dollars need to be paid back.  As painful as the last year and a half has been, I believe our present “fix” to the economic downturn is simply exploring new ways to spend money we do not have.  This week, the Government is auctioning off $200 Billion (mostly to foreign countries).  In essence, this is a global “I.O.U.” of monstrous proportions, and one of many to come.  We have sent out our ambassadors to find locations of greater wealth to fund our problem.  Christopher Columbus and the Santa Maria have been replaced by Geithner and Clinton, jetting around the world to find pockets of money willing to lend.

While I do not wish to get too much into the political or global economic issues, I do want to speak to what all of this modern day “exploring” means to you.  There is still an incredible amount of uncertainty in the market.  It has responded well over the past 2 months, based on the expectation that the worst is over and that our markets will return to the OLD “normal”.  The expectation is that our Government’s new exploration will return us to the land we left behind!    

Given the numbers, we believe that the old normal, will most likely never return.  We have entered into a realm of the unknown and, as such, need to be cautious.  Not unlike the early explorers, the fact that there is danger, does not mean that we do not explore (invest).  However, the fact that we can not quantify the danger, does translate into a cautionary approach.  Currently, understanding the long-term risk is much more important than trying to reap the short-term reward.  Our job is to make sure that the ship reaches its destination.  Right now, the markets are sailing on a sea of debt, with waves twelve zeros high.  We are willing to sacrifice some upside return in order to help ensure that your money is safer.  We believe that caution is mandatory and that staying objective and looking at the facts (without emotion) is part of our job.

As always, we greatly appreciate your business.

- Scott Airey

Week of 06/09/09

Marathon Man

There is an incredible amount of data coming through our system.  For those of you who were paying attention 6 months ago, the fact that we have a functioning system currently is reason enough to celebrate.  The market has responded and the DOW sits some 2,000 points above its lows.  On October 12, 2007, the Dow was at ~14,000.  March 6, 2009, it was at ~6600.  We now stand around 8500. 

Is it safe?  The answer lies in our own translation.  Economically, we are starting to show signs of life.  When you have the flu, and are finally able to sip soup without getting sick, you may feel slightly better, but are you fully functional?  I use the analogy because at this stage, you understand that you are on the road to recovery, but also realize that eating a ton of Mexican food is probably not the best idea.  The economy is no different.  Currently, we are sipping our chicken noodle and hoping for signs of further recovery.  We have seen increased consumer confidence and the expected GDP for the second quarter is estimated to be “less negative” than expected.  On the surface, we are seeing signs of hope as leading trends are beginning to stabilize. 

Our concern lies not in the accuracy of the data, but in the incredible amount of stimulus enacted by our Government.  The continued deleveraging of consumers and businesses alike, have caused a sea change in both the economy and the market.  We are currently in uncharted waters and, if Geithner and Bernanke were honest, they would say that they were leery of the next 12 months as well.  We do feel that inflation will become a problem.  The question is when (not if) and the severity of the resulting pressure.  The market made a very big assumption that the Government would provide better leadership coming out of the crisis than it did getting itself into the problem.  In addition, we are assuming that the U.S. consumer can spend its way back into debt, after it has gone through the pain of its own deleveraging.  This poses a problem.  Unemployment needs to be reduced and housing needs to recover, so that the consumer sees a better tomorrow than today’s reality.  Buying on credit is not much more than confidence in your ability to pay in the future.

We need to see more signs of recovery - increased trade, more liquid credit markets, and unemployment reduced.  We need to understand if the stimulus plan(s) will work, and we need to avoid getting caught up in the emotions that our marketing masters put forth on TV every day.  Staying objective, we are still cautious.

Is it safe?  No it is not.  Is it getting safer or more stable?  Absolutely.  We are staying away from the herd because we feel there is not enough justification to get aggressive.  If we underperform slightly over the next two quarters, but have substantially mitigated the risk of slaughter, then we feel we are acting properly.

As always, we appreciate your business.

- Scott Airey

Week of 04/23/09

Patience Is A Virtue

As a nation, we need to stop expecting a silver bullet to fix the economy.  Short term spending, regardless of the amount, will not reverse the economic cycle.  Periodic adjustments to the way we govern our financial system are akin to plugging a dyke with your finger.  It is amazing to me that 3 months ago we were worried about the survival of many institutions and now we are penalizing them for not making enough profit or not making it quickly enough.

The VZN Group believes the following:

1. For the market to perform, we need macro trends to improve.
2. We cannot spend our way into prosperity, and the hangover of TALP, TARP and PPIP will be realized in the future.
3. The cost of the financial system rescue is incalculable, but will certainly mutate the normal operation of our system for years.
4. The rules of engagement have changed.  The past remedies and methodologies will be less effective in dealing with our new reality.
5. Inflation will return and will necessitate more government action.

In total, the only cure for a recession is time.  The average recession is ~17 months in duration theoretically, placing the start of the recovery in the July/August timeframe.  So far, several leading economic indicators have stabilized and some of them have reversed, which is a positive sign.  Unfortunately, we are not out of the woods and feel strongly that investing cautiously will reap greater rewards, as the risk in the market is still excessive (but lowering) when compared to the potential return (which is increasing).

As always, we appreciate and thank you for your business.

- Scott Airey

Week of 04/07/09

G20 – Why it Matters

Country Specific Problems

Japan has a problem.  The cost of its own Government’s debt, will soon exceed its GDP of  +/- 3%.  Currently, the demographics of Japan are working to accelerate this problem.  Long known to be the nation of savers, the population is aging, and instead of saving and buying government bonds, they are redeeming and spending on their needs.  This places the Government in a very tough position, lacking the “internal” capital to meet their huge debt needs.  Why does this matter?  Japan is currently the #2 holder of U.S. Treasuries.  To feed its own leverage problem, Japan (in the not too distant future) may not only stop buying U.S. Treasuries, but sell them in order to meet its own massive obligations.  This, in turn, would place incredible pressure on our own overleveraged Government (and so on and so on).

Protectionism

Doha Development Round – this was the agreement by the World Trade Organization in November 2001 to lower trade barriers around the world, increase trade globally and promote wealth across nations.  The bottom line is this never got ratified and it looks as if it may be ignored for many more years by the G20.  Proof of this failure is all around us.  Since November 17th, members of the G20 have instituted 47 separate protectionist measures.  Many leaders are speaking about keeping global trade, but their actions are clearly showing the opposite.

IMF

The U.S. is asking that the IMF “fund” be tripled to $750 billion.  The idea that the top world economies can spend its way out of recession using leverage is currently not a popular one internationally.

The G20 matters because it will affect where and what we will invest in.  Our job is to look ahead, not week to week, but year after year, to make sure that the risk taken is not excessive for the return provided.  The second and third derivative of these events is played out every day in our bond and equity markets.  The old “rules of thumb” for investing are being challenged each day, and for good reason.  The system is changing to the point of rewriting the rules of engagement.  As your advisor, we must be prudent in our investing (realizing that the rules have changed) and monitor the amount of risk we are willing to accept.  For example, corporate debt may provide excess returns over the next 12 to 24 months.  Bonds with the potential for equity-like returns is outside the norm, but a direct result of our current situation and the future policies of the G20. 

We appreciate your business in these trying times.

- Scott Airey

Week of 04/01/09

Macro Trends

As many of you know, part of our methodology in managing accounts is the “top-down” macro economic forecasting.  We use the data compiled by The Conference Board to ascertain in what phase the economy currently resides (expansion, prosperity, contraction, or recession).  The phase of the economy, in this case recession, is then broken down further into cycles (early, mid and late).  Currently, the data indicates that we are in the late cycle of the recessionary phase.

March’s Conference Board data is consistent with February’s showing the following:

• *Leading Economic Indicator (LEI) Index declined 0.4% in February
• *Coincident Economic Index  (CEI) declined 0.4% in February

What is not shown in the data, is that the negative trend is slowing (a small silver lining among the dark clouds).  Many of our clients have expressed enthusiasm about our latest rally, and while we enjoy an up market for our clients, our opinion is that the underlying economic indicators do not support the rally.  We believe that a sustainable increase in the value of our markets is still two to four months away (expecting the first cycle of the expansion phase in the mid to late 3rd quarter).

As always, thank you for your business.

- Scott Airey

*Source: The Conference Board

Week of 03/24/09

Genie In A Bottle

As most of you know, we have been waiting for the “bad debt” bailout/rescue plan for months.  If I could have three wishes, my first wish would be for Geithner to have unveiled this plan in February instead of today.  The idea that the Government is making a market for what was previously untradeable is a good one, and one that I believe the industry can work within. 

My second wish would be for private capital to enter the market and buy the bad debt.  There are trillions of dollars on the sideline, both domestic and international, and buying into the Public Private Investing Program (PPIP) is a show of faith in the United States.

My third, and most important wish, would be that the printing presses stop now.  No more.  We are projecting a deficit of 1.5 – 1.8 TRILLION dollars.  The “hangover” related to this liquidity binge will be around for a decade.  Every dollar is more costly than the last.

OK – my fourth wish (it is my update, so I can make the rules) would be that our Government started removing itself as quickly as possible from the free enterprise system.  Although imperfect, it is still the best system that civilization has yet created.  Let the markets dictate the survivors and remove Big Brother as fast as possible.  Many people have cried out that we cannot forego our civil liberties at the cost of fighting terrorism.  I hope people become just as passionate about capitalism, which has helped make this country the envy of the world.

 - Scott Airey

Week of 03/19/09

Lost in Translation - Quantitative Insanity

Some of you may have heard the term “quantitative easing” being used in the media recently.  Many of you may be wondering what exactly it is and how it works.  The simple definition is that it is the creation of a pre-determined quantity of money, thereby increasing money supply.  This leads to the easing of the reserve requirements for banks, who, in theory, will lend to businesses and consumers alike.

The translation is simple.  The government will create money out of nothing by printing it.  Call it whatever you would like, but I refer to it as quantitative insanity.  The Government seems to have ignored the cost of massive leverage being used in the very same private sector that it loathes publically every day.  It has forgotten that Japan used this same tactic in 2000 for its ailing economy with disastrous effects.

The short term result is a positive market that will devour as much liquidity as the government will supply.  While we have always stated that “bad debt” assistance was needed, I feel quantitative easing is mortgaging tomorrow for today (pun intended).  Ultimately, we believe this will cause inflation and the normal business cycle will contract (shorter expansion and prosperity, followed by a steeper contraction phase).

This means that we must be diligent in the future to realize gains in the face of a shorter expansion cycle and watch carefully for inflation, as this will affect the fixed income portion of you portfolios in greater magnitude.

As always we appreciate your business.

 - Scott Airey

Week of 03/02/09

The Destination, not the Journey

The data coming through is not pretty.  GDP fell 6.2% in Q4 2008.  We have experienced the worst month (February) in the last year since October 2008.  It is very difficult to look at the current situation and garner any bright points.  There is a palpable tension in the markets and in our everyday activity.  Yet, if the question was asked, “Do you feel that we will be better off in 12-18 months?” the answer tends to be the same.  Most people say yes, most economists say yes, and I believe we will be as well.  “Do you believe that the United States will recover and prosper again?”  Again, the majority of people are answering “yes”.

There are several indications of stability.  For example, many leading economic indicators, such as interest rate spreads, new orders for non-defense capital goods and consumer goods are stabilizing.  Yet each day, we hold our breath, as names like Citigroup and GM dominate the headlines.  Psychologically, it is difficult to imagine these giants falling and this results in an emotional crisis in the market.

Our emotions, raw as they are, are continuously being played by the mass media and our leadership.  Much of the time, we are looking to point fingers and generally spin ourselves into an emotional state.  Everyday, we are exposed to propaganda that is designed to inflame the situation, to cause fear and to manipulate your mind and your actions for another’s benefit.

We believe strongly that while this is extremely difficult to witness and live through, we have seen the worst and the healing process has begun.  Tough medicine to swallow as we look at a proposed $3 Trillion budget, higher taxes and a period of time (perhaps 1 to 3 years) that our overall wealth will not increase.  Panic is for amateurs, emotion is for your local theatre and now is not the time to “run for the hills”.  We all understand that prosperity is a “when” question, not an “if” question.  We can, and will, adjust the risk in your accounts, but realize that to reap gains in the future, we need to stay the course.

 - Scott Airey

Week of 02/19/09

Scrambled or Over Easy

Inaction by the administration is causing our market to suffer.  Mr. Geithner laid an egg last week with a campaign speech that was purported to be a plan.  We need leadership; we need action, not promises of facts to be delivered at some point in time.

Unlike many, I feel the solution to the “bad debt” is as simple as fixing the price.  My solution would be for the Government to buy, from the banks, any bad debt on their books for $0.30 on the dollar.  In turn, the banks would have to guarantee to repurchase these same assets 10 years from now at $0.60.  This would provide an obvious return to the Government (taxpayers) and allow the bank to start operating as normal.  In addition, if the value 10 years hence is above $0.60 then the banks would be able to recover some of their original loss.  By basically creating a straddle option contract, the issue duration mismatch issue would be resolved.

Albeit a simplified solution, and one that may have pitfalls, there are many alternative solutions that could be enacted.  My point is that something needs to be done. The market needs order from chaos, and action versus inaction.  Failure to act has created a market vacuum that needs to be addressed quickly, not with words but with real identifiable steps toward an ultimate solution.

We remain in a holding pattern, as we anxiously await Geithner to move again.  At some point soon, his lack of action will force us to move the portfolios.  For now, we are cautious in making a tactical decision in advance that could later prove detrimental to the strategy of the portfolios.

 - Scott Airey

Week of 02/11/09

Trust, Honesty, Fairness, Fear and Greed

As Americans, we not only expect trust, honesty and fairness in our leaders, we expect it in our markets.  If we don’t receive it, we vote out those whom we do not trust and the market rewards or penalizes accordingly.

Presently, we are dealing with real economic issues.  Unlike the media’s representation, the vast majority of these issues are part of the NORMAL economic cycle (expansion, contraction, recovery, etc).  Deleveraging is the abnormal issue and is being witnessed on a scale never seen before in our history.  This is a result of the incredible amount of credit we allowed to balloon over the past ten years, culminating in our housing bubble.

At the same time, there is a compounding effect due to a lack of faith in the system and our leadership, and the fear that tomorrow will not be better than today.  Over the past year, we have seen outright lies from CEO’s, a lack of leadership from our Politicians, greed, theft, and a clear representation that the rules of the game are only being enforced upon the masses (us) and not the lucky few (them).  Truly, those who make the rules are not abiding by them.

To make order from this chaos, we need to be on the same playing field.  The rules need to apply to all.  Justice needs to be vetted out from the crooked politician to the dishonest CEO.  If you and I are paying taxes, we certainly expect our leaders to do the same.  Our citizens need their faith in the system to be restored, and a portion of that faith could come through a game plan that is less like a political pork-ball and more like a well thought out and executed solution. 

Currently, we feel that we are properly positioned, but if the Government's answer to all of the above is more politics as usual, printing money that they do not have,  and/or political and judicial favoritism, then the recession will be longer and steeper than we had forecast.  Given the aforementioned circumstance, we may move many of the portfolios toward more conservative investments.

- Scott Airey

Week of 01/29/09

Darkest Before Dawn

Over the past few weeks, we have been readying ourselves for an onslaught of bad news.  What we felt in Q4 2008, is now being realized in the paper every morning.  Earnings are down or non-existent, GDP is expected to show a contraction of over 5%, and layoffs are coming in by the thousands, as companies pull back on their efforts to grow.  Even healthy companies are jumping at the opportunity to prune their ranks of employees.

President Obama has a trillion dollar stimulus plan.  Let’s call it TARP 2.  In the plan, our politicians promise a new, more effective approach to the markets.  Bigger government is most likely here to stay over the next 4 to 8 years.  This result should come as a surprise to no one, as we respond to years of overspending by consumers and the Government, by “fixing” the problem with more money that we do not have.

The markets, acting efficiently, have thumbed their nose at the efforts thus far, and will continue to correct on its own timeline.  We expect the numbers (whether earnings, GDP, or unemployment) to reach their respective lows or highs this quarter.  The market will respond to the relative state of those numbers versus the projections provided.  The market can appreciate in this environment, and even more so in Q2 if the numbers are trending toward a recovery (GDP being less of a negative, unemployment stabilizing, etc).

We do not see a repeat of last year’s calamity.  The bad bank debt must be dealt with, credit must flow and counterparty risk must return to normal.  The road to recovery is complex, but if we show signs of stabilization in Q1 2009 numbers versus those of Q4 2008, then the only question is the timing of the recovery (versus the depth of the recession).  We believe that Q4 2008 numbers are the darkest we will witness and the economy will start mending in the early part of Q2 2009.

As always we appreciate your business.

Scott Airey