The Markets	12/31/12   Close	9/30/12   Close	4th  Qtr.  Change	12/31/11    Close	12 Mo. Change	YTD       Change
Dow	13,104	13,437	-2.48%	12,218	+7.25%	+7.25%
NASDAQ	3,020	3,116	-3.08%	2,605	+15.93%	+15.93%
S&P 500	1,426	1,441	-1.04%	1,258	+13.35%	+13.35%
MSCI EAFE	1,604	1,511	+6.17%	1,413	+13.55%	+13.55%
10-yr Treas. yield	1.76%	1.64%	+0.12%	1.87%	-0.11%	-0.11%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

The incessant debate of the fiscal cliff has been enough to drive any observer over a real cliff. Finally, late on Jan. 1, the White House and Senate Republicans had reached an agreement with more political benefit – at least they can get something done – than fiscal benefit. Both the House and Senate passed the measure. Income tax rates will go up only on incomes over $450,000 for married couples ($400,000 for singles) as will tax rates on capital gains and dividends and the “middle class” was spared from the Alternative Minimum Tax. The 2% reduction in the Social Security tax will be eliminated, the estate tax rate will increase on estates over the $5 million threshold and extended unemployment benefits will be retained. Identification of spending cuts was mostly deferred until at least March.

It goes without saying that the proposed compromise barely scratches the surface of the fiscal problems. The Congressional Budget Office estimates that this deal, if it is the only measure taken, will actually add $4 trillion in debt over the next ten years. But stay tuned, the federal debt ceiling was hit on December 31 at $16.394 trillion and “extraordinary measures” by the Treasury will extend government borrowing perhaps two more months unless some agreement can be reached in Congress.

Through it all, the stock market closed on a positive note for the year, with the broader market outperforming the Dow Jones Industrials and developed international stocks turning in similar results. International stocks made up ground in the fourth quarter while US stocks were choppy on fears of the cliff and slowing growth.

The consumer provided plenty of mixed news for the quarter. Household debt service (the percentage of income necessary to make debt payments) was the lowest since 1983 but one reason is that the consumer continues to be judicious in spending; holiday sales for the two months before Christmas were up only 0.7% from 2011, far below expectations. On the housing front, existing home sales and median prices for new homes were both up over from 14% from a year earlier and existing home prices showed their first full-year price increases since 2006. Foreclosures hit their lowest rate in five years but are still 2 ½ times the healthy level. Auto sales were strong at a 15 million annual rate, the best since March 208. Consumer confidence was not immune from fiscal cliff worries, falling significantly in December and hitting a five-month low.

Factory output was positive, one of the few “silver linings” from Hurricane Sandy as more goods were needed for reconstruction. Overall, service sector growth was stronger than manufacturing. In Europe, Greece was successful in cutting its debt by $52 billion but also increased its overall debt limit target. The entire Euro zone officially re-entered recession but the European Central Bank decided against further stimulus. ECB president Draghi indicated that weakness in Europe will continue for the foreseeable future.

The Fed set a precedent by announcing specific targets for their interest rate objective, vowing to keep rates low until unemployment goes below 6.5% or inflation goes over 2.5%. Unemployment is currently trending lower at 7.7% (although that figure is still being driven partly by more people abandoning their search for work) and both producer and consumer inflation are below 2%. In addition to buying $40 billion of mortgage bonds monthly, the Fed will now be buying $45 billion of Treasuries monthly, increasing their total assets by $1.1 trillion to $4 trillion. The Treasury sold its last shares of AIG with a $22 billion total gain and announced its plans to sell its remaining GM shares, but will almost certainly take a loss of over $10 billion. All in all, third quarter was revised upward to a positive 3% from an initial 2.7% as both government and consumer spending were revised upward.

Looking Forward

Typically we have new issues for Looking Froward, but it is hard to ignore that the next chapter of the fiscal crisis is the elephant in the room. A deal has not been approved, and the first version of any deal will most certainly be short-term and subject to adjustment and revision. Along the way, the uncertainty and confusion will only serve to further confound businesses, taxpayers and government employees alike.

Also unclear are the near and long term effects on the economy of any fiscal changes. Estimates of the impact of the full cliff – tax increases and across-the-board spending cuts – were around 2-3% of GDP. Regardless of the financial details, the whole affair continues to erode confidence in our ability to address even a crisis as immediate and important as this. Though it is largely a crisis born of prior failures, it can only be resolved through thoughtful and unselfish compromise by politicians and citizens alike.

The Fed’s easy money could be expected to inflate asset prices. While we are concerned that low interest

rates have forced income investors into areas they do not understand in search of higher yields, maintaining a balanced approach could allow gains while still managing risk.

Our Portfolios

Despite the recovery of stock prices since 2009, investors have lost confidence in stock investing. The Associated Press reports that since April 2007 individual investors have pulled $380 billion from US stock funds and institutional investors have sold a net $860 billion. Even foreign investors have been selling, pulling out $16 billion in the last year. As companies have been reluctant to make investments in expanding their business they have been stock buyers, but mostly shares of their own stock. At the same time, individuals have poured more than $1 trillion into bond mutual funds since April 2007, even as interest rates have fallen and stayed at historic lows.

According to Ulrike Malmendier, an economist who has studied the effect of the Great Depression on attitudes towards stocks, this illustrates the power of the “experience effect”, the tendency to over rely on your most recent experience even if it runs counter to logic. It explains why investors are still reducing their stocks even three years after the Great Recession and suggests that it could take quite while longer for investors to again embrace stocks.

It is instructive to recognize that the stock market actually has multiple purposes. One is the very dramatic trading arena, the focus of most media and pundits. It is the world of over-hyped sales, arcane, split-second trading strategies, hedge funds and even insider information. So, let’s be honest – that activity is “rigged” in the sense that only professional players have any business even being involved. It’s akin to going to Las Vegas and walking cold into a high stakes poker game with professional gamblers, and the gamblers are getting an occasional peek at the cards.

The other main purpose of the stock market is a critical source of capital for companies and a vehicle for investors to participate in the success of those companies. This purpose has been sullied by the behavior of financial companies in the late 2000’s and by the mistaken association of the mistrust of trading with the entire market. But equity capital remains extremely important to fueling economic growth and providing potential growth to investors. Rather than get seduced into gambling, it’s far more productive to bet on the house. Besides, the rush to bonds in a low interest rate environment is an invitation to principal losses if interest rates rise, which they certainly will at some point.

We know from experience that is impossible to exit the market and somehow re-enter just as attitudes change. We are sticking with our stock allocations and if the herd mentality creates a temporary imbalance in market participation, we’ll be happy to benefit from dividends and any growth along the way and be patient until balance returns.

Kicking the Tires (But Barely Looking Under the Hood)

Gordian Advisors provides comprehensive financial planning services, of which investment management is a critical part. To give investment advice, Gordian Advisors is a registered investment adviser, registered with the state of Arizona, a designation that allows us to be paid for our advice rather than being paid as a result of transactions or the investments chosen. (Larger investment advisers are registered with the SEC rather than with their state of residence.)

Gordian was recently examined by the Arizona Department of Securities, which is part of the Arizona Corporation Commission. The objective of these examinations is to determine that an adviser is in compliance with proper procedures and that the clients are protected from improper or unethical practices. (All this has nothing to do with competence, other than confirming an adviser’s credentials; incompetence is not a crime, as is often demonstrated by business, political and public figures.)

The examiner conducted an interview to identify our business practices, the types of investment products we recommend or purchase for our clients and whether we had any other business interests. It was clear from the questions asked that there are still plenty of conflicts of interest in which advisers have a direct financial benefit in the products, often at the expense of the client’s best interests. (Our business model is very simple – we have no other business interests other than our services as financial planners and investment managers – and it is amazing to us that these conflicts are still so prevalent.) He also reviewed all our disclosures, our financial statements and contracts and selected client accounts, files and communications.

However, the examination relies on the disclosures and responses that we provided, with very little independent verification. There was a lot of focus on advertising, which apparently includes business cards and any emails that include our name and business contact information. Compared to other examinations I’ve experienced, there was a better recognition of the spirit and intent of our practices, rather than focusing solely on “checking off the boxes”, so errors in form that did not create any harm to clients were easily corrected. And there are always harmless fouls because the rules are quite fluid.

But what is the greatest risk to clients of investment advisers, far greater than any conflict of interests in the investments? It is the possibility that the adviser has misappropriated (a nice word for stolen) client funds. So, while we talked about our clients’ accounts being held by Charles Schwab and Shareholders Service Group, there was no verification with those firms. There was no review of bank accounts to identify suspicious activity. There was likewise no confirmation or direct contact with clients that their accounts were actually held at those firms and that they received statements directly from the custodian. The sampling of a few client accounts is intended to uncover any improper investments or missing funds but a firm could simply lie and maintain dummy records. In other words, it is quite possible for a determined crook to pass an examination with flying colors and still be stealing their clients blind.

That leaves all investment advisers, ethical or otherwise, in the same boat – at the end of the day, regardless of disclosures and examinations, we have to ask our clients to simply trust us. It is a responsibility and obligation we take very seriously and we are truly honored to have been granted that trust. Caveat emptor is a sound principle and nowhere more than with financial professionals. As Ronald Reagan said, trust but verify.