June 2010

June 4, 2010
This past month has been a time of market turmoil. We saw Greece having to come to terms with year’s worth of poor fiscal management and a large portion of wealthy Greeks paying little to no taxes. On May 6th we had a brief drop in the market that was unusually large. Then, there was an almost equally large gain that returned the market to slightly below where it had been before the activity began. All this occurred within 20 minutes! We also saw a number of days with large market movement. This type of activity can understandably lead to investor nervousness. Below is a summary of what I see when looking at all these events.

Previous Crises
Greece is going through a troubling time right now that is impacting European economies as a whole. However, this is not an unprecedented situation. You may recall turmoil across the Asian markets in 1997, Russian defaults in 1998, and an Argentinean default in 2002. All of these problems were large enough to affect U.S. and European markets. They did not however cause the end of economics as we know it.

In 1997 the Thai government decided to unlink the value of the baht to that of the U.S. dollar (USD) due to problems with their debt levels. The country was basically bankrupt at the time and the baht collapsed. The collapse of the Thai currency caused problems within the economies of the rest of Southeast Asia and in Japan ranging from devalued currencies and stock market drops to a large increase in private debt.¹ Foreign debt-to-GDP ratios rose from 100% to 180% in the countries most affected.² Lesser affected nations also saw increases in debt ratios, although not as dramatic. The IMF stepped in during the crisis and there was rioting and political turmoil in some places. The crisis was large enough to greatly impact the global price of oil, leading to the Russian crisis of 1998. The Dow dropped and the U.S. initiated a $3.625 billion bail-out, but was unable to keep problems from spreading to other emerging market nations like Argentina and Brazil. However, by 1999 the economies of the region were showing signs of recovery. These same countries have really turned around in recent years and are now core economies within the emerging markets sector.

The Russian crisis of 1998 that was precipitated by the Asian crisis of the previous year. Given that Russia’s Asian trading partners were not importing Russian raw materials due to their economic troubles, Russia was unable to pay what it owed on its sovereign debt. Government issued bond interest rates rose to a staggering 150%, state workers were not paid, and inflation reached 84%.³ I would note that endemic corruption in Russia allowed $5 billion of IMF and World Bank loans sent to support the Russian economy to be stolen.⁴ The crisis created recessions of varying degrees of severity in a number of newly created nations that had previously been part of the Soviet Bloc. A change in oil prices spurred recovery and Russia was running surpluses as early as 1999.

Argentina faced its own economic collapse from 1999-2002. Argentina had built up a large percentage of debt, had high levels of corruption, and a large percentage of unemployed citizens. When the ability of import partners to buy Argentinean goods declined in 1999, Argentina faced a day of reckoning. The currency collapsed, inflation reached a monthly rate of 10.4% in April of 2002, and rioting was seen throughout much of the country.⁵

A new government came to power in 2003 and GDP has grew at about 9% annually from 2004-2008, slowing only as the U.S. recession spread to the rest of the world.⁶

The histories of economic turmoil in the last 15 years in Asia, Russia, and Argentina all have details that sound familiar to anyone following the current Greek crisis. Unsustainable levels of governmental debt, corruption, and the response to the problems by the citizens of the regions largely parallel what we are now seeing in Greece. Greece is a problem, but is only 2 1/2% of Europe’s economy. It is large enough to have an impact on markets throughout Europe due to European bank holdings of Greek debt, however, just as with other previous emerging market nation crises, I don’t think it is large enough to cause the implosion of the entire economic system of either Europe or the United States. I would note here that one particular data point currently coming under scrutiny is the Euro/USD exchange rate. Some commentators are making much of the fact that the rate likely will fall from 1.00EU/$1.25USD to 1.00EU/$1.20USD, or perhaps even a bit lower. A 10-year graph of the Euro/USD exchange rate shows $1.20 USD to be well within the norm.⁷ The 10-year low for the Euro was in 2000 with 1.00 EU bringing only 83 cents USD. The Euro is declining in value, not collapsing. The lower Euro value makes their exports cheaper to foreign buyers, which should help European exports.

A big problem for Greece is their inability to devalue their currency. If Greece still had the Drachma (former currency), it could be devalued. This would be a much less painful route out of their economic crisis for the average Greek citizen as a devalued currency would leave internal prices relatively unchanged. Imported goods become much more expensive with devaluation, but these goods are more often luxuries than necessities. Currencies were devalued in all of the emerging market crises noted above. More than a few economists are saying Greece should be pushed out of the European Union, devalue and restructure their debt, and then come back to the Euro when their economic condition strengthens.

Long-term Perspective
Assume you have a friend with a house that you both believe is worth $450,000. Imagine that this friend consults with a realtor and instructs the realtor to constantly monitor bids for the house. If there is a bid for at least $350,000 your friend will take no action. If at a given moment there are no bids for the house then the realtor is to immediately auction the house to the highest bidder that can be found. You would likely shake your head at the irrationality of your friend’s behavior as that is no way to sell a house. However, this is pretty much how a stop loss order works in the stock market. Most of the time they do work fine, but sometimes they can really hurt you. As a reminder, stop loss orders are instructions to sell if a stock’s current trading price falls below a certain level. Stop loss orders do not require the use of any judgment in deciding what assets to sell from a portfolio, they are just automated sales based on the activity of other investors.

Long-term investors do keep an eye on current investment trends and market changes, but with a view of how these trends fit into a larger picture. A number of investors in today’s market are not long-term investors. I would note that a fair bit of the commentary regarding the market both on TV and in print tends to focus on shorter-term factors.

Bonds
Interest rates continue to remain low in historical terms, yet there are still a number of bond market holdings that enhance client portfolios. The yield on 10-year U.S. Treasuries has fallen from 3.85% at the beginning of the year to 3.31% as of May’s close.⁸ As the situation in Greece has played out a number of investors have left the European stock market, seeking safe haven in U.S. Treasury offerings. This buying activity en masse has pushed Treasury prices up and yields down.

Investment grade corporate bond offerings are influenced by governmental rates, but do differ from them. As of June 1st, Bloomberg shows corporate bonds averaging near 5%, with an average duration of about 4 1/2 years.⁹ At a rate of 5%, corporate bonds that are short-term in nature do offer reasons for investment. Mutual funds with exposure to these assets are still doing well. The income component of these funds is not to be overlooked either as a way of increasing principal through reinvesting or as a vehicle for providing income during retirement. The high yield sector has already realized much of the potential growth seen there just a year or two ago. Many of the offerings that were undervalued just a year or two ago have gone from exceptionally cheap to somewhat undervalued. Yields are still good (about 9% on average)⁹ and are expected to remain a reason for investing in these assets. Bonds continue to play a role in a portfolio due to their ability to provide income with lower risk than stocks. I will continue to slowly lighten exposure to the high yield sector in client portfolios as appropriate, but bonds continue to be an area I will utilize in most accounts for the short-term.

Inflation in the next few years is still a concern. The U.S. government is still stimulating the economy via very low interest rate lending to banks and infrastructure spending. As the government pulls back from their low rate lending over the next 2 years or so we will likely see a higher inflation rate than what we are accustomed to. Banks will likely raise their rates on lending, which in turn will push interest rates up. There is also a contributing factor from U.S. government debt. Although we have seen the rate on Treasuries drop due to investors seeking alternatives to the European markets, this situation will not likely last over the long-term. Once investors begin to again exit Treasuries for various stock market and corporate bond offerings, interest rates on Treasuries will rise. As these changes occur, do expect to see me lighten the bond exposure in many portfolios. The extent to which I will do so will depend greatly on exactly how the bond market changes, but I do expect to utilize bond offerings less over the next few years.

Corporate Earnings
Corporate earnings remain one of the best indicators of overall economic health in this country. The biggest single driver of the U.S. stock market is earnings growth. A recent article in the Wall Street Journal shows the S&P 500 trading at about 12.8 times 2010 estimated earnings.¹⁰ When compared to a historical average of 15 and to an average of over 20 through most of the past 15 years, 12.8 is low.¹¹

source: Wikimedia Commons—modeled on a plot from the book Irrational Exuberance by Robert Schiller, with data taken from http://www.econ.yale.edu/~shiller/data/ie_data.xls

Corporate profits have rebounded from 2009. In fact, Barclay’s analysts expect to see 3.4% growth in the U.S. economy this year.¹⁰ Below is a chart of a range of 2010 first quarter earnings figures for six U.S. companies. This is a small list of companies. I have picked these companies not due to the unusual earnings and sales figures they posted, but rather because they represent a good cross section of the U.S. economy. Ford sells cars. Costco is in retail oriented more towards middle class consumers rather than the unemployed, low wage workers, and other consumers with more limited resources. Whirlpool makes large appliances. DuPont is classified as diversified by some economic analysts but still earns the bulk of its revenue from chemicals. Hewlett-Packard makes computers and related items for consumer and business use. Union Pacific is a leader in railroad transportation. I would note that there weren’t any stimulus programs in place to help boost revenue for any of these companies during the first quarter of this year. These figures are derived purely from demand of either their goods or services.

As you can see, many companies have seen substantial growth since last year’s recessionary environment. The bottom line is that U.S. companies are seeing a recovery.

Food for Thought
Lastly, I wanted to comment on an article I recently read on Morningstar. (link here: http://www.morningstar.com/1/3/170303-making-a-portfolio-retirement-ready.html) This article noted the importance of diversification in a portfolio and allocated a model portfolio amongst several Vanguard Index funds. Vanguard Index funds are some of the industry’s leaders due to good tracking and low expense ratios. As much as I agree with the points the author made regarding diversification, it did appear that other client needs were ignored in making this point.

Index funds can be fine for the person who wants a do-it-yourself diversified portfolio, they are often not the best investment option. The client in question was a new retiree with a total of $830,685 in assets and a goal of 5% annual income withdrawal from the account. The model portfolio recommended in the article has a total 5-year return of 23% with a 2.41% yield (based on Morningstar data for 5/1/2005-4/30/2010 and a money market yield of 0.1%). This means that about half of the 5% this person needs to withdraw each year would have to come from principal withdrawals as the account is only generating 2.41% in income. An ever decreasing principal base would result in lower income levels later in retirement. I am uncomfortable with half of the withdrawals coming from principal.

I compared the average performance of a number of Koenig Investment Advisory, LLC managed accounts to that of the index fund mix proposed in the article. This comparison covers portfolios of retirees currently using the income generated by their accounts as well as those of younger savers still a number years from retirement. I looked at accounts with at least a 5 year history under my management that were also worth at least $250,000 as of May 30, 2010. The combined average balance of this group of accounts was $478,669 as of May 1st, 2005 and $797,333 as of April 30th, 2010. The average 5 year return for these accounts was 39%, far greater than the 23% of the index fund model portfolio. I would note that this average 39% rate of return is net of management fees—meaning that even paying a management fee these accounts saw greater rates of return than the hypothetical index portfolio suggested in the article.

Of course, this comparison is not the definitive word on the use index funds. In some situations they may be appropriate, and may even outperform client accounts in some scenarios. It is simply an illustration of why it’s a good idea to take the advice dispensed in the articles we read and scrutinize the information presented. Playing “what if” can sometimes be a maddening proposition, but other times can be a useful way of gaining perspective on what really has transpired and what to expect in the future.

1) http://en.wikipedia.org/wiki/1997_Asian_Financial_Crisis

2) http://www.adb.org/Documents/Books/Key_Indicators/2003/pdf/rt29.pdf

3) http://en.wikipedia.org/wiki/1998_Russian_financial_crisis

4) http://www.worldbank.org/html/prddr/trans/julaug99/pgs11-13.htm

5) http://en.wikipedia.org/wiki/Argentine_economic_crisis

6) http://www.indexmundi.com/argentina/gdp_real_growth_rate.html

7) http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html

8) http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical.shtml

9) http://www.bloomberg.com/markets/rates/corpbonds.html

10) http://online.wsj.com/article/SB10001424052748703957604575272872615235854.html?mod=WSJ_latestheadlines

11) http://en.wikipedia.org/wiki/P/E_ratio

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different. The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.