Second  Quarter 2012 Review

The Markets	6/30/12   Close	3/31/12   Close	2nd  Qtr.  Change	6/30/11    Close	12 Mo. Change	YTD       Change
Dow	12,880	13,212	-2.51%	12,414	+3.75%	+5.42%
NASDAQ	2,935	3,092	-5.08%	2,774	+5.80%	+12.67%
S&P 500	1,362	1,408	-3.27%	1,321	+3.10%	+8.27%
MSCI EAFE	1,423	1,553	-8.37%	1,708	-16.69%	+0.71%
10-yr Treas. yield	1.66%	2.22%	-0.56%	3.16%	-1.50%	-0.21%
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 stock markets started the quarter positively (the Dow flirted with its highest close since December, 2007), promptly lost around 8% and then recovered fairly well to narrow the losses for the period. The one year performance looks more positive and the year-to-date performance for the NASDAQ and the broader S&P 500 are encouraging. The benchmark 10-year Treasury hit new lows as the European Central Bank, the Bank of England and China’s central bank all cut rates and proposed further stimulus. Gold, that supposed sanctuary of value, hit an 11-month low, oil was down 20% and commodities were lower across the board as the global economy slowed.

The roller coaster was mostly driven by events in Europe. The entire Eurozone announced a 2011 deficit of 4.1% of GDP, down from 6.2% in 2010, but the deficits were climbing again. Spain faced increasing borrowing costs throughout the period as the markets anointed the country as the next to be in need of a bailout. Eight of the17 Eurozone countries fell into recession and unemployment reached 11.1%, the highest since the introduction of the euro currency in 1999. Left-leaning governments were elected in France and Greece with pledges to resist austerity measures and the European Central Bank (ECB) stopped monetary operations to some Greek banks. Cyprus became the fifth Euro country to ask for a bailout.

The leftist Greek government was unable to form a coalition and in something out of a bad Hollywood script, one political candidate slapped an opponent on live TV. This seemed to unify the Greeks and the next election brought in parties that supported the bailout. The French leftists did not cause disruptions as expected and the ECB announced a $100 billion bailout for Spanish banks with no further austerity required. Then, at the nineteenth summit since the crisis began and which was seen as something of a “last chance”, a new plan would provide bailout funds directly to banks rather than through countries’ central banks. This will take some pressure off governments by reducing direct government debt obligations, but the ECB is still ultimately supported by the governments collectively. Germany received broader support for its calls for expanded Eurozone unity, which means more coordinated involvement by the ECB and Eurozone bodies in banking and fiscal matters in each country.

First quarter US growth was revised down to 1.9% from the previous 2.2% and down from the fourth quarter’s 3.0%. The concerns over slowing growth were reflected in employment, with an average of 73,000 jobs added in April and May after an average of 226,000 in the first three months. Stockton, California became the largest US city to declare bankruptcy and consumer confidence hit the lowest levels since January. Services growth was the slowest in 18 months and manufacturing actually contracted for the worst reading in three years. The Fed made no commitment for further monetary stimulus tactics but stayed “prepared to take further steps” if deemed necessary. S&P pegged the chances of another recession at 20%.

Housing was a surprising bright spot, but it is still too soon to call a recovery. Pending home sales in May were up over 13% from 2011 and new home sales were up nearly 20%. Existing home sales were flat but median prices were up almost 8% from the prior year. Housing starts and permits hit three and a half year highs and distressed sales made up only 25% of existing sales, the lowest level since 2008. However, foreclosures were up 9% as the fallout from the “robo-signing” scandal wore off.

Looking Forward

It is hard to conclude that our current political process is anything but dysfunctional. Political leanings aside, very little is getting accomplished in the face of obvious economic and fiscal crises. The upcoming presidential election just provides more excuse for both sides to further entrench themselves. And we are rapidly approaching the 2013 “fiscal cliff” of expiring tax breaks and forced spending reductions.

There is a lot more to the fiscal cliff than “tax breaks for the 1%”. While it is unlikely that Congress will actually enforce across-the-board spending cuts, the potential abrupt disruption could create havoc for military and social programs. The expiration of the 10% income tax bracket will increase taxes for just about everyone and the expiration of the waiver for reporting forgiven debt as income (in the case of a short sale or foreclosure of a house) could hinder any budding housing recovery. Changes in dividend and capital gains tax rates could upend investment markets. And the uncertainty of all this just increases fear and makes it hard to have any confidence that we can manage our affairs like grown-ups.

But, whaddya know, Congress actually resolved a couple of issues, passing a transportation bill and heading off the increase in student loan rates. (Somehow these seemingly unrelated issues were both part of the same legislation, but at least it got through.) So, there is now the glimmering possibility that there could be progress on some other pending items, despite both parties’ determination to do nothing until after the election. Common sense and the fear that doing nothing will be seen as worse as doing what the other guys want could chip away at the long list of pending issues. Any further progress would at least start to rebuild confidence, which would be a very good thing.

Even though we would love to consider action on underlying long-term structural problems both here and in Europe to be on the horizon, and despite the recent progress by the EU, we still don’t see it happening anytime soon. Short-term fixes and stalling will unfortunately prevail for quite a while.

Our Portfolios

Last quarter we discussed the wisdom and relative risk of continuing to maintain a bond allocation in this period of record low interest rates. This quarter we’ll look at another side of income investing – the frequent lament of investors these days that “I just can’t take this uncertainty and volatility, can’t I just make income and leave it at that?”

There is a lot packed into that simple statement. The first part suggests that fear has won out over keeping an eye on long-term objectives, but managing fear and greed are fundamental to long-term success. Besides, without the benefit of hindsight, there is rarely if ever a point at which there is not uncertainty and volatility. If one waits for the “perfect” time to invest, when it seems clear that further gains are certain, there will likely be one of three outcomes: that perfect time will never come, all the expected gains took place before the perfect time, or shortly after that point things will take an unexpected turn for the worse.

More fundamentally, an “income investor” requires a different mindset than a growth and income or a balanced investor. An income investor is most concerned with the reliability of the future income stream, and retention of principal value is a much lesser concern. This can work fine, as long as the generated income is sufficient to meet ongoing needs, accommodate inflation and allow for unexpected expenses. In today’s market, however, the desire for income has led to plenty of suspect investments, including “products” that actually return principal as part of regular distributions, leveraged investments that produce income with magnified risk and reported income yields that are based on the most recent distribution, which may not be indicative of the sustainable income stream. In other words, today’s income can come at unanticipated risks and costs.

We prefer the greater balance and flexibility of a long-term portfolio that uses income as part of an overall plan but also looks to growth as the best way to keep pace with inflation. At the same time, the income component of the portfolio can act as a stabilizing factor during short-term volatility, without entirely substituting the risks of income investments for those of growth-oriented investments. It is a tried-and-true approach that remains valid with the current issues of uncertainty.

Credit Where It’s Due

The consumer is still seen as the driver of our economy and consumption in emerging countries is seen as the most likely source of global growth. Consumer spending was flat for May after increasing every month since November. In simple terms, though, consumer spending is a function of incomes, saving and borrowing. Incomes were up slightly but so was the savings rate, offsetting the higher income.

Consumers have been “deleveraging”, or reducing debt, since the financial collapse in 2008. Credit card balances are down around 15% since then and other “nonrevolving” debt (car, personal and student loans) are up around 10%. All of that increase, however, has been in student loans, which have grown over 50% since 2008. There are questions as to whether this student loan is as productive for the economy as other debt, since many students never graduate and the loans are not discharged in bankruptcy. Credit cards have higher delinquency rates than student loans (11.3% 90 days overdue compared to 8.7%) but credit cards charge much higher interest rates and the taxpayers are not involved with any subsidies for credit cards.

All of this reflects the painful correction of many years of excess borrowing. The question is what debt level is sustainable for the US consumer. Credit card debt is flat over the last year alone and car loans have actually increased with new car sales. On the other hand, a report by consulting firm McKinsey concluded that households may have two more years of deleveraging before total debt is sustainable.

As we have so painfully experienced, debt is essential to growth but too much debt is ultimately damaging despite short-term economic benefits. Stephen Cecchetti and other economists at the Bank of International Settlements found that growth can be impaired when household debt (including mortgage debt) hits 85% of gross domestic product (GDP). Household debt in the US has fallen to 84% of GDP from a peak of 98%.

If incomes can continue to creep up, the consumer may be approaching a reasonable zone for debt which will allow for steady growth. The lesson seems to have been learned, and it’s far less likely that we will see the good times roll any time soon.