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Thomas J. Feeney's Measure of Value offers periodic commentary on leading financial issues of the day. Additionally, we present occasional articles explaining the philosophical underpinnings of the investment approach that our firms have employed successfully since 1986. Our thinking frequently differs from the common wisdom of the investment industry. The investment approaches we employ always recognize this as a probability business, not a certainty business. In evaluating any investment action, we always weigh the potential damage should the market prove us wrong.

While we have great respect for investment history, we recognize that each era introduces unprecedented specifics. In all that we do, we attempt to identify value, in both a relative and absolute sense. History has demonstrated that long run investment performance leaders need not be the leaders in bull markets as long as they avoid giving up significant portions of their assets during bear markets.

We firmly believe that one need not be fully invested at all times. In fact, we far prefer to assume relatively large levels of risk when assets are historically cheap and to be heavily risk-averse when assets are historically expensive. This approach has proven successful for our clients over more than a quarter century.


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Investors have long been counseled to diversify investments among several asset types.  Over the past two years, however, any diversification away from common stocks has diminished portfolio returns.  Thanks to the Federal Reserve’s zero interest rate policy, risk-free cash equivalents provide effectively no return, as has been the case for nearly six years.  This has severely penalized retirees or others with little appetite for equity risk.

The traditional refuge for risk-averse investors has been ownership of U.S. Treasury bonds and notes.  Unfortunately, that strategy has produced losses since yields bottomed in mid-2012.  Despite rising rates over the ensuing two-year period, fixed income yields remain near historic lows.  There remains little defense against potentially rising rates and inflation in the years ahead.

Those who have built substantial anti-inflation positions in gold have similarly realized losses over the past two years.  While inflation risk in the years ahead is very real, it has not yet materialized in the world’s major economies.

Notwithstanding a relatively stagnant world economy, historic central bank money creation has successfully boosted stock prices worldwide.  When stocks have threatened to decline in the past few years, central bankers have quickly stepped in to promise continued stimulus.  That promise has overcome concerns about valuations, banking system vulnerability, the threat of sovereign bankruptcies, military conflict and anything else worried investors could imagine.

Not surprisingly, when equity prices have risen for more than five years, especially when other asset categories have been non-productive, there is a clamor for more money to be deployed into equities.  A growing number of investors have been increasing allocations to equities from bonds and cash.   History inconveniently reminds us, however, that performance of any asset class is inversely related to its popularity at extremes.

In recent months, the U.S. stock market has demonstrated many parallels to conditions that prevailed around the historic price peaks of 2000 and 2007.  Because all pleas for caution over the past few years have been sternly rebuked by ever rising prices, any such comparisons today are dismissed by many as “crying wolf.”  Nonetheless, common sense demands that investors respect conditions that have historically proved dangerous, even if markets have sidestepped such dangers so far in this cycle.

The greatest contributing factors to the market collapses that began in 2000 and 2007 were excessive valuations and extreme levels of debt.  A composite of the most commonly employed valuation measures puts today’s figures at or above those of the most important stock market peaks in U.S. history–exceeded only by the extremes reached in the dot.com mania.  Warren Buffett’s favorite measure of value (stock market capitalization as a percentage of GDP) shows the current market to be more overvalued than any in history but the peak in 2000.

Debt figures paint an even more ominous picture.  While debt was extreme in 2000 and 2007, it is more extreme today.  Nearly every major Western country has taken on substantially more debt since 2007, with debt levels now excessive in all corners of the globe.  This month, the chief investment officer of Europe’s largest insurer, Allianz, stated that the euro crisis is not over, that European countries are still building up their debt piles, raising the probability of trouble.  The Bank for International Settlements (BIS), the central bank’s central banker, recently declared that debt levels in many emerging markets, as well as (supposedly conservative) Switzerland, “are above the threshold that indicates potential trouble.”

Former chief economist at the BIS, William White, gave an extended interview with a prestigious Swiss business newspaper earlier this year under the headline, “I see speculative bubbles like in 2007.”  Several of his contentions deserve serious consideration.

1. Not even during the Great Depression in the Thirties has monetary policy been this loose.  And if you look at the details of what these central banks are doing, it’s all very experimental.  They are making it up as they go along.

2. The fundamental problem we are still facing is excessive debt.  Not excessive public debt, but excessive debt in the private and public sectors.  To resolve that, you need restructurings and write-offs.  (In other words, defaults.)

3. It’s worse than 2007, because then it was a problem of the developed economies.  But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise.

4. We are back in a world where the banks get all the profits, while the government socializes all the losses.

5. The strengthening growth might be a mirage.  And if it does not materialize, all those elevated prices will be way out of line of fundamentals.

Most investors are apparently unconcerned, or they believe that they will be able to exit their equity positions before serious damage may be done.  Such complacency was last seen prior to the 2000 and 2007 peaks. The exits during the ensuing price declines proved far too narrow to allow timely escapes.

Other parallels to the conditions surrounding the 2000 and 2007 peaks include the desire to speculate and the willingness to assume great risk.  Earlier this year, margin debt exceeded the prior peaks reached near the 2000 and 2007 market highs.  And investors are willing to use those margin loans for increasingly speculative securities.  Also earlier this year, investors achieved the dubious distinction of supporting initial public offerings (IPOs), 79% of which had “negative earnings” – i.e., losses.  That figure matched the percentage of money losers brought to market in February 2000, a month before 2000’s price peak.

Wall Street has proved nothing but resourceful, bringing to market far more junk bonds than ever before at increasingly suspect levels of quality.  Today’s bond buyers either don’t know the sad history of such low quality debt, or they’re banking upon the belief that this time will be different.  Such financial recklessness, even at far lesser degrees, has attended all prior important U.S. stock market peaks.

While the dangers are certainly real, and have been a legitimate concern for quite some time already, stock prices have continued to climb a wall of worry.  That trend is testimony to the power of copious quantities of free money.  And while the latest iteration of quantitative easing is scheduled to end in October, Fed Chair Yellen has pledged to maintain a highly accommodative monetary policy for a considerable period beyond that.  With ominous parallels to 2000 and 2007, yet a still generous Federal Reserve, it is an open question whether stock prices can continue to power ahead.  Much depends on investors’ degree of confidence that central bankers can maintain control of dangerous underlying fundamental conditions.

In dealing with a market that could still provide more profits if confidence prevails but could suffer dramatic and lasting losses should that confidence disappear, Mission employs a strategic equity allocation process that has outperformed the S&P 500 over the past 33 years with fewer and smaller losses than that index has experienced.  It is designed to participate in (not beat) equity markets in strong periods and to protect assets in questionable or dangerous environments.  After back-testing the strategy for nearly a third of a century, Mission introduced it to clients in late-2012.  In just over a year and a half, the process has produced a return of approximately 13% while being exposed to equity risk about 32% of the time.  We believe it to be ideally suited for the equity portions of portfolios in a highly uncertain environment.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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Federal Reserve Chair Janet Yellen was prominently in the news again last week. Most of Wall Street’s ire was directed at her for her comment that “…valuation metrics in some sectors do appear substantially stretched – particularly those for smaller firms in the social media and biotechnology industries….” Imagine the temerity of the Fed Chair for looking askance at securities bearing an increasing resemblance to those that made a brief but costly appearance during the dot.com mania.

On the other hand, Wall Street largely applauded her assertion that “…valuation measures for the overall market in early July were generally at levels not far above their historical averages….” The latter comment left the investment community confident that for months to come it could count on a continuing stream of new money in the context of the Fed’s zero interest rate policy.

Right or wrong, the Fed Chair is entitled to her own opinion. She is not, however, entitled to her own facts. As I have pointed out in previous valuation reviews, price-to-dividends, price-to-book value, price-to-sales and price-to-cash flow are at or very close to all-time highs but for parts of the bubble period from the late 1990s to 2007. And to use valuations from that period is to make a completely specious comparison. Investors lost huge amounts of money twice in stocks purchased at those historic valuation levels.

The accompanying graphs from the excellent Ned Davis Research service make the point very clearly. We have annotated the graphs with a horizontal line at current levels to illustrate how little time valuations have spent above where they are today. No one doing an honest appraisal can argue that these are “…generally at levels not far above their historical averages….”

Chart 1 (Click on chart to enlarge.)

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Chart 2 (Click on chart to enlarge.)

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Chart 3 (Click on chart to enlarge.)

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Chart 4 (Click on chart to enlarge.)

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Price-to-earnings (Graph 5) is the measure of value most easily “engineered”, and it is the only one of the most commonly used measures that is not extreme. It is just very high and in the neighborhood from which most of history’s bear markets have begun.

Chart 5 (Click on chart to enlarge.)

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Of course, a composite of valuation measures near historic highs does not indicate an imminent bear market. As the dot.com era conclusively proved, disbelief can be suspended for remarkably long periods of time. We do, however, have dozens of decades of data verifying that stocks bought at far above average valuations produce far below average multi-year returns. Precipitous and long lasting market declines also tend to start from similar environments in which valuation warning flags fly.

It is disingenuous at best for the Fed to claim that current valuation measures are anything but dangerous.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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In his fact-filled economic commentaries, Gluskin Sheff’s David Rosenberg regularly provides helpful insights. His June 20 issue of Breakfast With Dave offered some stock market information that I had never before seen, despite having paid pretty close attention over a 45-year career in the investment industry.

David argued that in each stock market cycle – at least since 1980 – “each fundamental peak in the S&P 500 actually represented a ‘failed’ peak,” with the market forming a double top at the highs. Additionally, the momentum leading up to the peak was extremely strong, averaging an 11% price increase in the preceding 30 days. He profiled important market tops in 1980, 1987, 1990, 2000 and 2007.

As an avid student of market history, I went back over those time periods and a few more, confirming David’s findings in broad strokes. Not surprisingly, although his conclusions are accurate, putting them to practical use is not quite as easy as looking carefully for the requisite conditions and acting in a timely fashion. Over the decades, there have been numerous instances in which markets have put in a potential double top after a powerful rally in the month preceding the first peak. Many of those did not initiate meaningful declines; the most recent of which was a mere few months ago. This year the S&P 500 jumped about 8% (using intra-day prices) from early February to a peak at about 1880 in early March. A slight pullback ensued, followed by a rise into the 1890’s on declining momentum in early April. While the conditions had been fulfilled, the decline that followed was barely in excess of 4%. The equity market then moved higher in the second quarter.

Experience has taught us that major market tops don’t all look alike. Otherwise, managing investments would be a much easier business. The five major market peaks that David identified did conform to the pattern he outlined. There was, however, a painful 22% decline from mid-July 1998 into October of that year that exhibited no double top, despite a 10% price runup in the month prior to the July peak. And the most devastating decline in U.S. market history, the 89% collapse from 1929 to 1932, began with a rolling single top that accelerated rapidly to much lower levels.

At the very least, David has identified a set of conditions that have historically raised a caution flag. Double tops don’t necessarily lead to major declines, but many major declines follow double tops. The danger is compounded if the initial peak is preceded by a sharp runup in prices. Rosenberg’s computation of an 11% rise in the 30 days before the first peak in his examples includes rallies that ranged from about 4% to about 17%–a significant spread. A loss of momentum leading to the second peak should also raise some concern.

As I mentioned above, these conditions were met earlier this year with no dire consequences. Today we witness similar conditions to a smaller degree. June 9 saw an intra-day peak of about 1956 preceded by a 5% price rise in the prior month. A minor pullback led to a second peak at about 1968 on less breadth and momentum on June 24. While the caution flag flies again, the market continues higher, buoyed by the most monumental monetary stimulus program in the history of mankind. The short-term outcome is uncertain, but the investing public’s overwhelming complacency feels misguided.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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Draghi Senses A Crisis


June 6, 2014

In 2008, the world was on the edge of financial collapse when banks were so suspect of each others’ balance sheets that they would not lend to one another.  Almost all were massively overleveraged and required unprecedented intervention by U.S. monetary authorities.  Suffering only a few casualties, the banking industry was saved from its financial miscalculations – even rewarded after the initial rescue with essentially free money with which to profit from Fed-supported U.S. Treasury investments.

Notwithstanding the most aggressive central bank stimulus program in history, the U.S. economy continues in the most sluggish recovery from recession of the post-WW II era.  Most of the rest of the world is similarly slogging through a barely perceptible recovery.  To break out of a quarter-century long economic malaise, Japanese monetary authorities have thrown all caution to the winds. They are currently adding debt to their central bank balance sheet in even greater amounts than is the U.S. Federal Reserve.  Theirs is a life or death survival bet on huge amounts of additional debt solving the problems created by too much debt in the first place. With Japan as its third largest member, implications for the world economy are huge.

Enter Mario Draghi.  In a much anticipated announcement, European Central Bank President Draghi unveiled a collection of monetary measures designed to weaken the Euro, boost inflation and revive a Eurozone economy struggling to remain above recessionary levels.  To promote bank lending, the ECB has introduced a negative interest rate of 0.1% for funds held as deposits.  Because the amounts held on deposit at the ECB are relatively small, this provision is more symbolic than economically important.  It does, however, underscore the urgency with which the bank is attempting to encourage lending.

A major problem for European banks is a lack of loan demand from qualified borrowers.  The ECB finds itself in the unfortunate position of having to promote more lending to boost economic activity while simultaneously pushing banks to shore up their still precarious capital positions.  In fact, after years of central bank support, European banks have just recently brought their leverage levels down into the mid-twenties, the level where U.S. banks were just before the 2008 crisis.  The banks certainly can’t afford to add debt that bears any appreciable risk of default, which calls into question the wisdom of easing collateral rules as part of the ECB’s current stimulus program.

Market prices and currencies immediately reacted favorably to Draghi’s Thursday announcement and press conference.  As the day wore on, however, stock price gains fell from their highs. Worse yet, the Euro actually ended higher on the day, calling into question the ultimate effectiveness of these extraordinary measures.  No one wants a strong currency in today’s environment of weak worldwide demand.  Should efforts like these not produce their desired ends, it is likely that the ECB and other central banks will resort to even more aggressive programs to weaken their currencies, pursuing “beggar thy neighbor” policies similar to those that contributed mightily to global economic contraction in the 1930s.

As I have frequently discussed, excessive debt is an insidious problem, leading ultimately to a great many negative economic and securities market outcomes.  So far, central bankers have succeeded magnificently in convincing investors that everything is under control.  Sooner or later, if positive results are not measurable on Main Street as well as on Wall Street, that confidence will wane.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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In just over a month Mission will celebrate the twentieth anniversary of opening its doors in Tucson.  On April 24 of this year, Mission’s staff had the pleasure of joining with clients, business associates and retired staff in a rollicking celebration of Mission’s first two decades.  The highlight of the evening was an encore performance by the Motown group True Devotion, who had helped us celebrate our first decade at a client conference earlier in the century.  A few of Mission’s officers offered reflections on the firm’s history and its outlook for the future.  The following is a reprise of my comments that evening.

Let me add my thanks and appreciation to all of you who have made our first two decades so successful and fulfilling.  It has been my privilege and pleasure to work with you through the last 17 of Mission’s 20 years.  All of Mission’s current and retired staff are extremely pleased that we have been able to provide a positive return for clients in all but one of those years.  (In 2008 our client portfolios declined by less than 1% while the S&P 500 plummeted by 37%.)

Those of you who have been regulars at our conferences and seminars over the years know that we profile stocks’ progress through history over a repeating series of long strong and weak cycles.  Most of you here this evening are of an age that allows you to view the last 20 years in a longer term context, as do I.

I started in the investment industry in the late-1960s and have observed a great many cyclical bull and bear markets.  We view these relatively frequent rising and falling markets in the context of much longer secular strong and weak cycles.  My introduction to the investment industry came during the long weak cycle that began in the mid-1960s and extended into the early 1980s.  The Dow Jones Industrial Average peaked at 995 in February 1966.  It rested at 777 more than 16 years later in August 1982.  While a difficult period in which to produce profits, that long weak cycle provided valuable lessons about how long markets can stagnate while erasing the excesses of the prior long strong cycle.

From the depressed prices in 1982, the major stock market averages exploded upward by 15 times into the early months of the 21st century.  Although Mission opened its doors late in that long strong cycle, most of its existence has taken place in the long weak cycle that began in 2000.

The S&P 500 reached 1550 in early 2000.  The average was still below that level 13 years later in early 2013.  The Nasdaq Composite is still below its 2000 peak.   Investors have experienced two massive declines (50% and 57%) and two powerful rallies so far this century.  Even with massive government support over most of the last decade, equity investors have earned only about 3.5% per year so far century-to-date.  Mission’s clients who have been with us since the beginning of the long weak cycle have had a better return with a far more risk-averse portfolio structure.

For two centuries, long weak cycles in the United States have served to eliminate the excesses built up in the preceding long strong cycles.  Excessive debt in this long weak cycle has not only not been reduced but rather multiplied into grossly excessive debt.  Consequently, we anticipate at least one more major stock market decline to eliminate the debt excesses before the long weak cycle runs its course.

Most of Mission’s existence has taken place in an era of monumental government interference in the economy and securities markets.  Beginning at least with the rescue of Long Term Capital Management in 1998, government committed itself to the bailout business with all the moral hazard that produces.  Failed businesses have been rescued; debtors have been rewarded, savers penalized; and free markets have been dramatically distorted.

The unwillingness of the Fed and Treasury to allow giant firms to fail has effectively painted these government institutions into a corner.  They have produced unprecedented levels of debt to conduct their bailout activities and now can’t afford to allow a recession that could topple the debt edifice.  There will inevitably be future recessions, and the Fed may well be out of tools to assist in promoting stability.

The precarious debt picture is best illustrated by looking at the Federal Reserve’s balance sheet.  In its first 95 years of existence, the Fed developed debt on its balance sheet of about $800 billion.  In just six years, the Fed has multiplied that amount five times to more than $4 trillion, and that amount is still growing rapidly.  Total debt in the U.S. economy puts us uncomfortably in the range at which excessive debt has led to severe economic slowdowns over the centuries in countries throughout the world. (This time Is Different, Reinhart & Rogoff).

There are a great many similarities today (excessive debt, valuations, sentiment and speculation) to the conditions near the peaks in 2000 and 2007, which produced stock market declines of 50% and 57% respectively.  Current excesses place our securities markets in a very high risk environment.  At the same time, so long as investors trust that the Fed and other central bankers will keep us from serious market declines, prices can continue to rise.  Should that confidence fade, however, we could experience the third significant market collapse of this still young century.

Having begun my investment career in the late-1960s during the then prevailing long weak cycle, and now having lived through the 21st century weak cycle, I’m eager to experience again the kind of long strong cycle that covered almost all of the 1980s and 1990s.  I hope you’ll enjoy it with us.  As explained earlier, I expect we’ll first have to endure at least one more serious decline to wipe out persistent valuation and debt excesses.  I believe, however, that Mission is well prepared to protect today’s asset values and leave them primed to participate fully in the safer long strong cycle ahead.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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The persistence of stock market gains, accentuated by the nearly two-year absence of positive returns from the fixed income area, has drawn increasing numbers of investors into equities, despite valuation levels that have led to substantial losses twice over the past 14 years.  Many have justified defying valuation danger with the acronym TINA – There Is No Alternative. So far, that acceptance of risk has been handsomely rewarded, just as it was in the late-1990s and in 2006 and 2007.  The twice repeated lesson of this century-to-date, however, is that overstaying your welcome in overvalued equities will be severely punished: stock prices plummeted by 50% and 57% in the prior two retreats from overvaluation.  Make no mistake; stocks are seriously overvalued today.  Only price-to-earnings ratios, while well above long-term average, are less than extreme.  Price-to-sales, cash flow, dividends or book value are near all-time highs but for brief periods in the bubbles surrounding the 2000 and 2007 stock market peaks.

Notwithstanding extreme valuations, stocks have advanced on the wave of liquidity supplied by the Federal Reserve in this country and by other central banks elsewhere in the world.  And prices could continue to rise so long as investors remain confident that central bankers will prevent any untoward equity price retreats.  While central bankers are powerful, they are not omnipotent, and their best efforts have been insufficient to halt the ravages of serious intermittent bear markets over the decades.  Recent supportive stimulus efforts have failed to hold down interest rates, despite massive direct intervention by the Fed for exactly that purpose.  There is no guaranty that their persistent efforts to support equity prices will continue to succeed.

Longstanding clients know that, because of a combination of overvaluation and excessive debt throughout the economy, we began to caution against danger to equity prices before prices peaked in 2000.  We anticipated a long weak cycle that could well last a decade and a half to two decades and that would ultimately expunge the valuation and debt excesses.  So far within that long weak cycle, markets have experienced two massive declines and two powerful rallies resulting in low single digit annual returns since the market peak in 2000.  Mission’s clients have earned a better return over that span of time while maintaining a far more risk-averse portfolio structure.

With valuations only modestly improved from their peaks and national and international debt levels far worse today than in 2000 or 2007, we anticipate at least one more major stock market decline in this cycle to remove the excesses.  Whether such a decline is imminent or a year or more in the distance is unknowable.  In whatever time frame, the retreat will likely take stock prices well below where they sit today.  Permanent equity positions will prove profitable from here only if prices can avoid such a precipitous decline.  While possible, such an outcome would defy historic precedent.  Our preference over permanent equity positions is to employ our strategic equity allocation process, which has historically captured a significant portion of stock market gains while protecting well against major declines.

For money that is not equity-risk-oriented, returns are problematic at best.  Risk-free securities continue to yield nothing, and the Fed remains intent on holding short rates near the zero bound.  Most bonds have shown losses for the better part of the past two years, although rates declined slightly in the first quarter, putting a plus sign before the quarter’s bond index returns.  Many investors have gravitated to “high yield” bonds to scratch out some measurable return.  So far, that has worked and, as with equities, it could continue to work so long as investors retain confidence in central bankers.

Any number of factors could eliminate that confidence quickly, however, including such non-investment issues as a sovereign exit from the Eurozone, a flare-up in the Middle East and, of course, an escalation of the Russia-Ukraine dispute or fallout from more severe sanctions imposed on Russia.  We remain in a very high-risk environment.  Should confidence disappear, investors may suffer painfully for chasing stocks and bonds whose prices have been artificially elevated by central bankers trying to rescue overindebted economies by creating a confidence-building wealth effect.  Our attention to valuation levels has protected client assets extremely well through the century-to-date, and we expect it will be necessary again before the long weak cycle ends.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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Another Debt Milestone


April 4, 2014

 

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Source: Lisa Benson, Washington Post Writers Group

Switzerland-based Bank for International Settlements recently announced that global debt passed the dubious $100 trillion milestone in mid-2013.  That’s almost twice the mid-2013 $53.8 trillion world equity value.  In the six years since mid-2007, just before the financial crisis, equities declined in value by more than 6.5% while debt levels exploded by 42% from $70 trillion to $100 trillion. The prime causes were governments piling on the debt to rescue economies from recession and corporate treasurers taking advantage of record low interest rates.

With the U.S. and Japan promising to add far more debt to central bank balance sheets this year and Mario Draghi pledging to “do whatever it takes” to lift the Eurozone’s stagnant economy, debt levels will inevitably march higher.  Most major equity markets have risen appreciably since 2009, confirming investor belief that growing debt is certainly no roadblock to higher stock prices.  Those, in fact, who point to debt levels as a danger are frequently ridiculed for repeatedly crying wolf.  True, excessive leverage has been offered as a reason for caution for a decade and a half, yet many equity markets are near all-time highs.  It’s perhaps worth recalling, however, that in 2008 excessive debt levels necessitated an unprecedented central bank bailout to prevent a collapse of the world banking system.  Greece, Portugal, Ireland and Cyprus were essentially bankrupt without restructuring or coordinated rescue efforts.  In this country, Detroit is a recent example of debts having risen to unserviceable levels.

Rising stock prices, declining interest rates in financially stressed countries, and silver-tongued central bankers seem to have eliminated fear in most investors.  It is irrational, however, to ignore centuries of history that testify to the damage done to economies from debt relative to GDP even far lower than that prevalent today throughout most of the developed world.

Central bank efforts to shore up bank capital levels have certainly succeeded to a degree.  Leverage in the U.S. has been roughly cut in half from pre-crisis levels.  That many assets are not yet marked to market, however, argues that our banks are not yet in the clear.  On top of that, many have again begun to issue large amounts of the covenant-lite loans that became all too common leading up to the 2008 crisis.

A recent Morningstar report demonstrates that, despite deleveraging, major European and Japanese banks are just now getting down to leverage levels in the mid-twenties, where U.S. banks were just before the 2008 crisis hit.

Not only is the quantity of debt worrisome, quality is as well.  On April 2, Financial Times reported that Europe’s banks hold more sovereign debt than at any time since the Euro crisis.  Because Basel II rules allow regulators to treat sovereign debt as risk free, banks do not have to hold any capital against it.  When the European Central Bank gave banks the opportunity to borrow at 1%, many invested the loan proceeds in the higher yielding sovereign debt of countries like Spain, Italy and Portugal, all of which had and still have precarious finances.  These countries and their banking systems are dangerously intertwined.

Not having experienced many countries or major banks going unrescued, today’s investors have become overly complacent.  Excessive debt levels are a real danger.  In a recent International Monetary Fund working paper, Carmen Reinhart and Ken Rogoff offered a cautionary historical precedent.  There was a widespread default on World War I debts to the United States by both advanced and emerging nations.  Those debts were never repaid.  In today’s extremely leveraged environment, a similar outcome is not out of the question.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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Janet Yellen held her first press conference as Chair of the Federal Reserve Board Wednesday. She promised to continue to penalize the elderly retired and others who are income dependent.

The Fed having now kept short-term interest rates at the zero bound since 2008, Janet reassured bankers that they can count on free money at least into next year and very possibly longer.  By the way, Seniors, you can count on no return from risk-free investments.  That wasn’t enough, however.  Janet also pledged to keep trying to push inflation up, which will assure that the things you have to buy will cost more.  Lest you think that push might at least give you Seniors a shot at higher income, Janet said: “Not so fast.”  Even after inflation gets to 2% or more, she promised to help bankers by keeping rates near zero for a “considerable period of time.”  Sorry, Seniors.

Perhaps you could get a little yield if you did what the Fed has been trying to “force” you to do (their word).  However, because longer interest rates have risen since late-2011, if you made bond purchases in that period of time, you’ve probably lost money despite the Fed’s best efforts to keep bond prices elevated.  If longer rates continue to rise, which is the Fed’s forecast, bond holdings could lose money for years.  Maybe that’s not a great idea for Seniors who likely will never be able to replace lost capital.

Instead, Seniors might want to ramp up the risk level even higher by adding equities to their portfolios.  After all, the Fed has admitted that one of the purposes of its ultra-stimulative monetary policy is to boost asset prices to create a positive “wealth effect.”  It certainly has succeeded in boosting stock prices to the point at which they are today overbought, overvalued and overloved.  It’s an open question whether Seniors should count on a continuation of that positive effect as the Fed tapers and ultimately ends extraordinary stimulus.

Almost all analysts with a knowledge of history anticipate that the Fed’s explosive debt creation will end badly, but there’s no timetable for such an outcome.  As long as investors’ faith in central bankers remains strong, the good times can continue to roll.  How many Seniors will have the foresight to step away before stock prices experience significant damage?  Will the Fed soon lose control of equity prices as they have lost control of longer interest rates over the past two years?

If the Fed’s historic monetary experiment ultimately fails, not only will Seniors have been deprived of income for much of their retirement, they may also have been prodded to lose their capital.  Talk about unintended consequences.  Thanks, Janet.

On a far happier note, for those of a similar persuasion, Go Cats!

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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This week I had the pleasure of meeting with the CEO of a socially important not-for-profit organization. Our conversation turned to dramatic changes in the investment markets in recent years, especially since 2008, when central banks began history’s greatest monetary experiment to pull the world’s banking system back from the edge of collapse.

The gist of our conversation was that investment consultants, investment committees and others charged with sculpting investment policies and strategies for not-for-profit organizations were unwittingly putting such organizations directly in harm’s way by doing business as they have been trained. Our analysis applies equally to retirees or other individuals with largely irreplaceable capital.

Investors who have learned their craft in the past four decades–including a growing cadre of CFAs–have become firm believers in the wisdom of a buy and hold strategy and in the importance of structuring a proper asset allocation to match the risk-bearing capacity of the client. Underlying those beliefs are some fundamental assumptions, born of experience:

1) Don’t worry excessively about bear markets; stocks will always come back;
2) Fixed income securities provide a valuable offset to the volatility and risk of equities;
3) Except to meet liquidity needs, cash is trash.

Admittedly, if allowed a multi-decade time frame, the first two assumptions usually prove true. And in most years, stocks and bonds outperform short-term cash equivalents. But there are noteworthy exceptions to these generalizations, and history proves that very few individuals and not-for-profit organizations have the patience necessary to wait out lengthy negative disruptions.

After a five-year, stimulus-fueled stock market rally, investors evidence little fear of surrendering much of their profit. Such confidence is typical when extended rallies have been largely uninterrupted by significant declines. By many measures of investor sentiment, today’s investors are more enthusiastic about stock ownership than at any point in more than 100 years, except at the height of the turn of the century dot com mania that was followed by a devastating 50% stock market collapse. The accompanying table shows the destruction done to years of profits from major stock market declines that all began at even lower peaks of positive investor sentiment.

Table

When markets fell from earlier peak levels of investor confidence, gains earned in the prior 10 to 18 years were erased. Recovering to former stock market highs took from 9 to 25 years during the twentieth century. With unprecedented Federal Reserve assistance, the recovery took only 4 years from the 2009 market trough, which partially accounts for today’s great investor enthusiasm. Should markets fall from the current level of euphoria, it would be highly unlikely that the Fed would be able to provide similar stimulus.

A worst case scenario unfolded in Japan, where the stock market peaked at about 39,000 on the last trading day of 1989. At that time, the Japanese stock market was the largest in the world, and many believed that Japan had discovered the new industrial paradigm. Belief was strong that this would be a one-way market for years to come. While that turned out to be true, the direction surprisingly was down. In a series of lengthy contractions interspersed with rallies, prices fell to below 7,000 in 2009. Even after more than doubling to today’s 15,000 level, the index is still more than 60% below its peak and rests at a level first reached in 1986. Past performance and powerful investor confidence clearly do not guarantee even respectable future performance.

In the past, proper diversification and a prudent asset allocation have at least provided some portfolio support when stocks have been weak. Today’s investors, however, may not be able to count on traditional support from non-equity securities. Despite interest rates having risen for the better part of the last year and a half, rates are not far above historic lows. There is precious little yield on any but the riskiest bonds. When rates fell to near present levels more than 70 years ago, that marked the kickoff of a four-decade long rising interest rate cycle that lasted into the early 1980s. Over a period of more than 40 years, reasonably diversified bond portfolios failed to keep pace with inflation. Even unmanaged cash equivalents outperformed virtually all bond portfolios over that four-decade span. Having just experienced the exact opposite fixed income environment, with rates falling for three decades until mid-2012, few of today’s investors and consultants have experience of multi-year unproductive, even counterproductive fixed income portfolios. If we have seen the beginning of the next rising interest rate cycle, bonds may not only NOT protect portfolios during weak stock market cycles, they may contribute losses, as they did in 2013.

The fact that 1) the U.S. stock market is at historically high valuations accompanied by extreme investor enthusiasm and 2) interest rates are near all-time lows offer reasons why stocks and bonds could be in danger of turning down. Alone, the specter of possible bear markets would not persuade most prudent investors to shy away from traditional diversified asset allocations. There is, however, a far larger concern that should give serious pause to any investor unable to replace lost capital.

We are in the middle of the greatest monetary experiment in history. To rescue the banking system and the broader economy from forecasted collapse, the Federal Reserve Bank and major central banks across the globe have flooded the world with new money. By 2008, over its then 95-year history, the Federal Reserve had acquired debt on its balance sheet of about $800 billion. To stem the financial crisis, the Fed has exploded its balance sheet almost five fold to about $4.5 trillion, with more to come. As Dallas Fed President Richard Fisher has warned, the Fed has no realistic plan to unwind this massive debt burden. Past experience with far smaller amounts in other countries is hardly reassuring. In This Time Is Different, Carmen Reinhart and Ken Rogoff provide copious detail about hundreds of financial crises around the world over the past 800 years. While details understandably differ from episode to episode, some clear conclusions emerge. Governments almost invariably attempt to inflate their way out of debt crises. Occasionally, severe inflation unfolds. In almost all cases, economic growth is markedly stunted for a decade or two before economic normalcy can be restored.

Relative to the size of our economy, the U.S. has reached debt levels at which major problems have unfolded in other countries over the years. And we’re not alone. Extreme levels of debt-to-GDP are now typical in most developed countries.

So far, soothing words and promises from central bankers have maintained investor confidence throughout most of the world. But such confidence could shift quickly. Notwithstanding the success of central bank stimulus in boosting stock and bond prices, there has been a far smaller increase in broader economic growth. Many critics of the effectiveness of aggressive monetary stimulus–including some from within the Fed–are arguing for the rapid ending of quantitative easing. It is not at all apparent that the economy and markets can resume historically normal function without such artificial government support.

When assessing potential risks, former St. Louis Fed President William Poole’s admonitions should not be ignored. He famously contended that when you look at the numbers, the U.S. is only a matter of years behind Greece, which has survived economically only by the grace of its European rescuers. Should debt levels overwhelm the U.S., there is no rescue net big enough.

The above stated concerns are not forecasts; they are statements of realistic possibilities based on the lessons of history. No one knows how the future will ultimately play out. Some investors, however, are better situated than others are, should worst cases materialize. Those least able to recover from severely negative market environments, especially if consequences persist for a decade or more, may have to forego some significant potential for profit in strong markets to protect against unacceptable losses in the weakest markets, which unfortunately materialize from time to time over the decades. For years, we have urged strongly that investors build flexibility into investment programs in place of the traditional relatively fixed asset allocation approach. The latter will backfire badly if the central bank monetary experiment fails and equity markets fall into a lengthy decline, especially if that equity decline were accompanied by rising interest rates.

Very few of today’s consultants and investment committee members have significant professional experience of long lasting weak stock or bond markets, the last of which ended in the early 1980s. As a result, their beliefs have been profoundly influenced by three decades of favorable or at least rapidly recovering markets. An understanding of longer history argues for a more circumspect policy approach by those that cannot easily replace lost capital.

Unfortunately, the common approach to investing today is well characterized by the words of Chuck Prince, former head of Citibank, in explaining the bank’s commitment to risk assumption. Acknowledging, in the middle of the past decade, that financial commitments then being made would likely end badly, Prince infamously said that you had to keep dancing as long as the music is playing. The sad lesson, as in the game of musical chairs, is that not everyone gets a safe seat when the music stops. In fact, decades of history demonstrate clearly that the best and brightest in the world’s biggest financial firms are almost invariably wrong at every major market top. Should we descend into another lengthy bear market, they won’t ring a bell in advance, nor will even the brightest consultants and investment committee members urge greater restraint before the top.

CEOs, CFOs and other senior members of not-for-profits have an additional consideration. Consultants and investment committee members typically cycle in and cycle out, most providing best efforts while there. Should their counsel to structure a traditional investment program result in debilitating losses in a worst case environment, they will eventually move on. It’s the top officers and long-term members of non-profits who will bear the stigma of having presided over the loss of effectiveness of that organization’s mission if the ability to function as desired is compromised. Unfortunately that scenario has played out in decades past just at the time when weakened economies have placed the greatest demands on social service agencies.

Because it’s uncommon to build significant flexibility into portfolios, finding consultants or investment managers with a proven expertise in providing such service is not easy. In the current environment with the overhanging threat of possible failure of history’s greatest monetary experiment, prudence suggests that a more intensive search should be worth the effort.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.

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With the S&P 500 index having recorded a -3.6% return this January, newspapers and other financial publications have trotted out their “January Effect” stories. Such stories, with minor variations, follow the theme that “As goes January, so goes the year.” Not surprisingly, that’s not always true.

Using data from the Ned Davis Research Group, since 1950 the S&P 500 index has declined 25 times in January. Excluding 2014, the index has been down in 13 of those calendar years that began with a negative January. If we exclude the effect of January itself, the index has declined from February through year-end in 11 of the 24 years. As a predictor of market direction, the January Effect is not much better than a coin flip. Since markets rise in most years, however, it might provide benefit by simply raising investors’ level of caution. When January has been positive, the index has averaged a 12% return over the subsequent 11 months. When January has seen the index decline, the S&P 500 has been effectively flat for the rest of the year.

Of course, averages can’t tell us what will happen in 2014. While the following 11 months after a negative January have substantially underperformed those with a positive first month, there have been a few significant exceptions: +29.9% in 2003 and +35.0% in 2009. Those were both years in which the Federal Reserve Board was actively stimulating the economy and markets to pull the country out of recession and away from major stock market troughs.

In 2014 the Fed announced its intention to continue its aggressive stimulus, while gradually reducing the amount of its new money creation as the year progresses. We are left to discern whether the effects of stimulus will have the same positive effects as in 2003 or 2009, or whether the air comes out of the balloon with investors losing confidence in central bankers’ ability to control economic and market outcomes. It promises to be an exciting year.

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Tom Feeney is Chief Investment Officer for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more, you are invited to email your interest to Tom@missiontrust.com or call (520) 577-5559 to speak with one of the Portfolio Coordinators.




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