The Markets	9/30/11   Close	6/30/11    Close	3rd   Qtr.  Change	9/30/10    Close	12 Mo. Change	YTD       Change
Dow	10,913	12,414	-12.09%	10,788	+1.16%	-5.74%
NASDAQ	2,415	2,774	-12.94%	2,369	+1.94%	-8.97%
S&P 500	1,131	1,321	-14.38%	1,141	-0.88%	-10.10%
MSCI EAFE	1,373	1,708	-19.60%	1,561	-12.02%	-16.79%
10-yr Treas. yield	1.92%	3.16%	-1.24%	2.52%	-0.60%	-1.39%
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)

Sacre bleu!! Despite plenty of political theatrics in the US, the quarter’s results were driven by growing concerns over the European debt crisis. In addition to the increasing likelihood that Greece will default on its debt, European banks were seen as being in grave danger because of their exposure to weak sovereign debt. French banks in particular were downgraded, as was Italian sovereign debt, and the Swiss central bank set exchange limits on the Swiss franc to slow the franc’s increase (investors were heavily buying Swiss francs as a safe currency compared to the euro). In attempts to contain the crisis in confidence the major central banks (including the Federal Reserve) agreed to provide liquidity loans in US dollars to European banks and Germany approved its participation in the EU bailout fund following German court rulings. All this led to the worst quarter for market performance since the fourth quarter of 2008, with international stocks firmly in “bear market” territory. Even gold was off sharply from a record high above $1,900 an ounce as investors took profits to offset losses elsewhere.

The debt ceiling stalemate was resolved (sort of) at the last minute, leading to the lowest confidence in ratings in history for Congress. Any real budget cuts were left to a bipartisan “super committee” (see Looking Forward). A week later S&P downgraded US government debt to AA+ from AAA, with the other rating agencies maintaining their AAA rating. Still, the downgrade led to the first of four consecutive 400-point daily moves for the Dow.

Jobs, jobs, jobs has become the focus of the US economy. Less than 64% of eligible workers are either working or looking for work, the lowest in 27 years, making the employment picture worse than the official 9.1% unemployment rate. The number of jobs added each month slowed from the start of 2011 and was actually zero for August. President Obama ultimately proposed a $450 billion jobs bill that focused mostly on cutting taxes related to hiring.

The Fed’s position in August was that there would be no new Fed action to boost the economy and that Congress should promote growth; the Dallas Fed president said the monetary policy had exhausted itself and could do no more. Then, with concerns about a “double dip” recession, the Fed in September announced another $400 billion market operation to lower interest rates. The Fed had already stated its intention to keep short-term rates low until mid-2013, and some large banks even began charging large depositors to hold cash at the bank.

Consumer confidence slid to its lowest level in two years and housing prices sales drifted even lower, with prices mixed. Productivity declined but that may be good for hiring if companies have already cut to the bone and are working employees too hard. Both manufacturing and services continued to expand but at slower rates than earlier in the year. The net result is that GDP growth for the second quarter came in at a disappointing increase of 1.3% and the first quarter GDP increase was lowered to 0.7% from the prior 1.9%.

Looking Forward

Greece has become almost an afterthought as the debt crisis has engulfed all of Europe and contributed to a global slowdown. It is still a concern, however, and some reports have Greece only weeks away from bankruptcy and default. The exact time frame is impossible to determine, but Greece has acknowledged that it is unable to meet its fiscal targets and protests continue against government cutbacks.

The broader question is whether the European Union will be able to get their act together and take meaningful action to address the crisis. Thus far there has been only a lot of talk, proposed solutions and theoretical bailout funds but other than aid to Greece there has been neither actual restructuring of sovereign debt nor any steps to improve bank liquidity. Even Germany’s recent approval of a larger presence in the bailout funds requires another approval by German legislators before it is final. In the meantime, Americans can claim the victim role due to Europe’s lack of discipline, and we suspect there is some grim satisfaction that at least the US did not cause this crisis.

Here at home we have moved seamlessly from the debt ceiling impasse to the next deadline, the recommendations of the budget “super committee”. The technical deadline for the committee to recommend $1.2 trillion in cuts is Thanksgiving but the Congressional Budget Office says they would need the recommendations by early November if there is to be any objective analysis. If the committee cannot reach agreement, or if Congress rejects its proposals, automatic spending cuts will kick in. Programs that benefit low-income Americans are exempted and Medicare cuts are limited to 2%. And in typical Washington fuzzy math, $170 billion in savings would come from lower interest payments on the debt. So, fully half of the automatic spending cuts over nine years would come from defense.

Let’s not forget that nagging unemployment level. As discussed below, monetary action is limited in its impact and President Obama has proposed some measures that are intended to encourage hiring. It is hard to see any direct jobs stimulus such as infrastructure programs getting through Congress without major progress on the long-term budget problem.

Our Portfolios

Excessive volatility, the recent market decline and concerns about a slide into global recession have renewed the chorus that holding investments over the long term is a “loser’s game”. The markets are controlled by short-term speculators and any idiot (with the convenient benefit of hindsight) can see when downturns are coming.

And the prescribed solution to traditional portfolio management? Why, the use of more complicated investment vehicles and strategies and obscure asset classes which are made available by the very firms which contributed to the decline. Many of these have not stood the test of time and add complexity and reduced flexibility to a portfolio.

This “if you (are told you) can’t beat ’em, join ’em” approach just does not make sense to us. Sure, there may be some feeling of regaining control, and there may even be some occasional successes which mainly serve to suck investors further into the game. But the learning experience can also be very expensive in terms of added risk and unintended consequences. (An acquaintance recently told me he is implementing an options strategy known as an “iron condor”; don’t ask.)

We maintain, without apology, that a properly diversified portfolio is the best way to ride through volatility and reap the benefits of long-term growth. While knowledgeably managing the portfolio is important, it is just as important to look at the portfolio as part of a broader financial plan rather than as a stand-alone effort. Budgeting, education and retirement saving, insurance, estate planning, taxes and other issues will also contribute significantly to long-term financial success. And that, rather than indulging in short-term and speculative investment techniques in an attempt to avoid inevitable market cycles, is the greater goal.

Pushing On a Rope?

The Federal Reserve has arguably been more active in its monetary policy role in the last three years than at any time in its history. First came its role in TARP, including providing a backstop for money market funds and expanding its balance sheet by more than $1.5 trillion in mortgage bond purchases. Then came “QE2”, a quantitative easing program intended to encourage lending by purchasing Treasury securities and injecting more money into the financial system. All this occurred with the backdrop of keeping short-term interest rates at historic lows for years and announcing their intention to keep rates low well into 2013.

Now, the Fed has announced Operation Twist, a nine-month program to sell $400 billion in short-term government bonds and buy government bonds that mature in 6 to 30 years. The goal is to further lower long-term interest rates, since more demand (purchase by the Fed) typically raises bond prices and lowers rates. (The Fed also reversed its earlier position of reducing its bond holdings when the mortgage securities it owns mature. Instead, the Fed will now reinvest those bond proceeds in more mortgage bonds, hoping to keep mortgage rates low.)

But will these moves really help stimulate the economy and, in particular, spur hiring? There is some concern that monetary policy has done all it can, and that rather than stimulating the economy these lower rates will just make it even harder on savers, who are already getting paid next to nothing on their savings. Daniel Gross, economics editor at Yahoo! Finance, offers a number of reasons Operation Twist won’t have much of an impact.

• The Fed “telegraphs” its moves and the market reacts ahead of the actual implementation of the policy. The yield on the 10-year Treasury bond has already dropped from 3.2% on July 1 to 1.9% today; the same kind of market anticipation happened last year as the Fed announced QE2.
• Interest rates are already so low that another slight decrease really does not matter that much. Demand for credit is low, with both consumers and businesses reluctant to take on any significant risk. (In layman’s terms, when’s the last time anyone did not borrow because the cost of borrowing – the interest rate – is too high? They don’t borrow either because they don’t want to take on the burden of additional debt or because they are not creditworthy.)
• At the same time it has kept money cheap, the Fed has also given incentives to banks to sit tight and not lend. Since October, 2008 the Fed has paid interest on the reserves banks keep at the Fed. Although the interest amount is small, it is paid on required reserves and on reserves in excess of requirements. As a result, banks have over $1.5 trillion in reserves in excess of requirements on deposit at the Fed, up from $981 billion a year ago.

Whether Operation Twist is a good idea is open to debate. What does seem clear is that, even if it is a success, it will have only a very indirect effect on jobs. At the same time, the financial system has still not resolved the fallout of the debt binge of several years ago, and there is still no fundamental resolution of financial institutions that are “too big to fail”. We still have a long way to go.