With a timely rally in the last two weeks of the year and with enormous amounts of Federal Reserve stimulus, major U. S. equity indexes escaped the fate that befell virtually all the rest of the world. By interesting coincidence, the S & P 500 closed 2011 at 1257, exactly where it closed 2010. A small dividend resulted in the S & P providing a positive return in contrast to the average U. S. stock’s decline of 6% for the year. Even that loss was far better than the damage done throughout the world as a whole, which averaged 12%. Against that difficult backdrop, our client returns in the low single digits were at least a minor victory. That marks the twenty-fifth time in its twenty-six year history that our controlled-risk/flexible allocation process has earned positive returns. We lost a perfect record in 2008, when clients’ portfolios averaged a 0.9% loss when the S & P 500 was down 37%.

Despite the many trillions of dollars of wealth wiped out in 2011, world governments and central banks warded off the danger of systemic collapse with a flood of newly created money. While reliquifying banks in greatest danger, the lending countries involved, including our own, greatly weakened their own balance sheets. Debt downgrades were commonplace around the world. As downgrades proliferated, governments increasingly denigrated the ratings services. Notwithstanding their checkered history through the subprime mortgage debacle, it doesn’t take much financial sophistication to acknowledge that the ratings services are merely pointing out the obvious: Financial stability has deteriorated dangerously as countries throughout the world attempt to counter the logical consequences of excessive debt. The most important question facing investors again in 2012 is whether or not those debt dangers can still be controlled.

The record amount of stimulus that has flowed from the Federal Reserve has kept the U. S. from falling into the recession that is apparently beginning to grip the Eurozone. There is discussion of yet another round of stimulus. Corporate profits were strong in 2011, and analysts are forecasting another year of profit growth in 2012, although year- ahead forecasts are being ratcheted down by a great many companies currently announcing their fourth quarter results. Productivity remains strong, which is great for corporate profits, but a negative for employment. While improving slightly, the nation’s unemployment problem remains severe. Interest rates have declined to historic lows, which lowers business costs but penalizes savers, and the Fed has pledged to keep short rates near zero at least through mid-2013. If all other factors around the world remain static, U. S. stock prices are not unreasonable, with valuations in the aggregate high but not as extreme as they have been through most of the past decade and a half.

Unfortunately, it is highly unlikely that conditions around the world will remain as they are. Leading indicators for Europe and the major Asian countries are declining. China’s economy, the engine of growth for much of the world, is slowing. Its stock market, down by more than 60% from its 2007 peak, is screaming loudly that something is not as sanguine as the bullish government statistics proclaim.

The most immediate problems lie in Europe, where bankruptcy is pending in Greece. No one seriously believes that Greece can survive without a succession of sizeable bailouts from stronger European neighbors and possibly China and the International Monetary Fund. It is a complete unknown whether or not the political will is sufficiently widespread to generate such a rescue. If Greece, or another fragile European nation, should default, the consequences are unpredictable. Banks that hold the defaulted bonds could in turn default, setting off a domino effect, which could expand far beyond Europe. Billionaire hedge fund pioneer George Soros has characterized the current crisis as more severe than that of 2008, which would have led to a worldwide financial collapse but for history’s greatest-ever government bailout.

The debt crisis that we began to warn about in the late -1990s is coming ever closer to its denouement. We can’t know whether we will experience sovereign defaults in the year ahead or whether governments will again succeed in “kicking the can down the road” for a while longer. Which course unfolds will have a huge influence on equity potential in 2012. The hope for the world’s markets is that governments and central banks will again provide the needed rescue money. While it could work, that’s hardly a sound basis on which to make investment decisions.

When we made the case in the late – 1990s that stocks were about to enter a long weak cycle, in which equity profits would be scarce, we wrote that such cycles over the past 200 years have on average lasted about a decade and a half. Our caution at the time was that this one might last even longer because the excesses built up in the prior long strong cycle were more severe than any before. There was more debt accumulated relative to the size of the economy than ever before, and valuations had soared far above any others in history. Notwithstanding strong stock market returns in 2009 and 2010, the performance record for stocks century-to-date is weak, as indicated on the table below.

Annualized Returns for the S & P 500
For the Periods Beginning in the Following Years
Through December 31, 2011 

Clearly there have been virtually no profits made in stocks since the beginning of the century. We are pleased that our clients’ portfolios have grown by more than 65% over that time before fees, which vary by portfolio size. There have been two powerful rallies in the long weak cycle that began in 2000. The first from 2003 to 2007 convinced many investors and analysts that the bear market from 2000 to 2003 was a stand-alone event and that the bull market that began two decades or more earlier was back in force. Over the past three years rising stock prices have again convinced many investors and analysts that the worst is behind us and that a new long-term bull market has begun. At the very least, the advance has been durable enough that money could have been made by turning bullish at the right time. It is instructive to note, however, that very few investors who profited in the 2003 to 2007 rally were astute enough to retain those profits through the 2007 to 2009 decline. Since we believe it unlikely that the long weak cycle has ended, we believe that it is similarly unlikely that beneficiaries of the rally that began in 2009 will ultimately retain those gains. While valuations have declined somewhat from their extremes, the underlying debt situation has worsened. Over the past two centuries, equity markets have never begun a new long strong cycle without ultra-cheap valuations and with debt levels still at excessive levels. It is improbable that historical precedent will be broken in the current instance unless governments and central banks give up the fight against debts and simply print so much money that inflation minimizes the debt burden. Because that action could become the long-term solution, we have begun to build a position in gold that would benefit from significant inflation, unlikely as inflation looks at present.

Many investors typically choose to put their money in the asset class that has just performed best. Even with interest rates beginning 2011 at extremely low levels, the Federal Reserve bought bonds directly and pushed rates even lower, leading to good bond returns over the full year. Because bonds have also marginally outperformed stocks over the past 30 years, there is an increasing tendency to move money into fixed income securities to sidestep the volatility that has plagued stocks in recent years.

High quality bonds could perform well in 2012 if we experience a recession or other deflationary or disinflationary event, which would probably be bad for stocks. If rates remain stable, a ten year U. S. Treasury note will return about 2%, its current interest rate. If the economy strengthens, interest rates will likely rise and bond prices fall. Should debt begin to fail around the world, interest rates on secure bonds could plummet and prices rise. Because of default risk, lower quality bonds could conversely see interest rates soar and prices collapse.

While we believe that the ultimate resolution of the debt crisis will involve significant levels of money printing and substantial inflation, we would be surprised to see that unfold over the next year or two. More likely it will come further down the line. We consider a disinflationary, even deflationary environment more likely in the short run, which would be best for top quality bonds. With yields so low, however, the reward for being right about bonds in the year ahead is relatively small. Should yields rise, however, for any reason, even top quality bonds could lose money this year and for several years ahead. When bond yields began their last long rising phase, even unmanaged Treasury bills outperformed bond total returns for more than four decades from the early-1940s to the early-1980s. Although we anticipate the likelihood of a disinflationary environment this year, we are not recommending bonds because the reward for being right about bonds is significantly less than the penalty for being wrong. And even if investors should profit in bonds this year, they will only retain those profits if they eventually make a timely sell decision before aggressive money printing promotes significant inflation in the years ahead. From current interest rate levels, the odds are against bond holders over a multi-year time frame.

We go into 2012 with great fragility in the world economy and great uncertainty in world markets. Should governments and central banks fail to maintain investor confidence, the potential exists for waterfall price declines. That poses great danger to traditionally allocated stock and bond portfolios, but it presents the potential for great buying opportunities at far lower prices for investors properly anticipating such an outcome. That scenario need not unfold this year, but the unraveling of the Eurozone could precipitate it. Stay alert!

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.

Bailing out the overextended remains the headline of the week. Will bondholders come to an agreement on restructuring Greek debt? Will Greece receive the proposed bailout that allows a rollover of the debt coming due March 20? Are Portugal and others lining up behind Greece to negotiate further bailouts?

The International Monetary Fund (IMF) announced this week that it will seek an additional $500 billion from its members to fortify its bailout war chest. The United States, which provides 17% of IMF funding, quickly declined to contribute. Hooray! Finally, someone rejecting the concept that we must bail out bankers and other bad decision-makers at all cost. Perhaps this is the first in a succession of actions needed to eliminate moral hazard. Companies, governments and investors must be allowed to fail when they make fatally flawed decisions. If, instead, they are bailed out, others are encouraged to repeat the risk-taking, hoping for a big reward if successful, and comforted in the assurance that major losses will be covered if a bailout becomes necessary.

The inequity is obvious. At the investor level, the risk-taker can win big if the risk is rewarded. On the other hand, if the market penalizes the risk, but the loss is covered by a bailout, the taxpayer eats the loss.

Now we read headlines out of Europe claiming that austerity required to pay back some of the debt load should not be pursued to the extent that it jeopardizes growth. In other words, don’t let the difficult get in the way of the desired. If reducing debt becomes uncomfortable, add a little more debt to promote desired growth. Unfortunately, at current debt levels in many countries, there is no realistic way that they can grow their way out of the hole. The hole just keeps getting deeper because of the cost of servicing the existing debt.

Meanwhile in our country we hear that the Fed is seriously considering QE3, another attempt to promote growth by adding to the debt load. Some speculate that the Fed will again try to prop up the housing market by buying more mortgage-backed bonds, as they have done in earlier quantitative easing episodes. Besides again promoting moral hazard, that behavior would penalize investment managers such as ourselves, who correctly forecast the losses that would flow from the irrational overleveraging in real estate. Investors who blindly chased yield in low-quality real estate investments were rewarded with high returns when that sector was soaring. Without Federal Reserve support, many of those investors would have given up those gains and more in lost principal when real estate prices collapsed. Instead, they were bailed out and received their principal back in addition to the high yield. Managers like us, who avoided such securities because of the correctly perceived danger, settled for lower yields in securities that survived the downturn without government rescue.

Today investors face a similar quandary. Far more asset types–even whole countries–are threatened by excessive debt. Should investors settle for lower returns from investments that will survive inevitable debt implosions in the years ahead? Should they invest more aggressively, betting that the world’s governments and central banks will be willing and able to prevent destructive debt collapses? Or should they acknowledge the long-term debt danger but invest more aggressively anyway with confidence that they will successfully time their exit from risk before serious damage is done? A sobering consideration was voiced recently by former Federal Reserve Governor Bill Poole, who said that the United States is just a few years behind Greece when you look at the numbers. In choosing a path, investors need to assess their ability to withstand losses, should governments and central banks fail to solve the debt dilemma or if investors’ timing is less than precise.

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.

The financial market’s focus remains on Europe.  The financial press directed its attention today to the rumored Standard & Poor’s downgrades of European sovereign debt, confirmed late in the day.  Most European nations have now been downgraded, and the downgrades have reached Europe’s core with France and Austria losing their prized AAA rating.  A few nations, including giant Italy, were dropped two notches.  At the most fragile end, Portugal joined Greece, as S&P downgraded Portugal to junk with a negative outlook.

Markets reacted calmly.  Since the potential for such downgrades was announced several weeks ago, the markets have apparently had an opportunity to factor them in and adjust.

Perhaps just an interesting coincidence, but a rumor floated this morning on CNBC that the Federal Reserve is seriously considering QE3.  That prospect served to remind investors worldwide that governments and central banks remain alert to the problems and stand ready to bend every effort toward avoiding economic downturns that would penalize banks, individuals and other entities that made the mistake of excessive leverage.  The Fed stands poised to once again attempt solving problems brought on by too much debt by creating even more debt.

A potentially more important news story emerging this morning was the apparent breakdown of the latest talks regarding the restructuring of Greek debt.  Before today, there had arisen some level of confidence that bondholders would accept a negotiated price reduction or–“haircut”–of perhaps 50%, and that Greek debt could be restructured on a “voluntary” basis.  If such a reduction of principal value were “voluntary,” no credit default event would be triggered, and the writers of insurance against bond defaults would not have to pay.  Of course, to contend that the acceptance of any such “haircut” would be “voluntary” is pure fiction, but such intellectual contortions are necessary to ward off the potentially calamitous repercussions that could flow from a credit default event.  The breakdown of today’s talks reduces the likelihood of an orderly Greek default.

While the financial consequences to counterparties who wrote credit default swaps are unknown, according to banking analysts, they are potentially severe.  Investors don’t know which financial institutions would be exposed to losses from a disorderly Greek default.

Last weekend, hedge fund pioneer George Soros warned that the current European crisis is more dangerous than the 2008 crisis that, but for the greatest government intervention in history, nearly led to the breakdown of the world financial system. Chinese officials voiced the same alarm a month earlier.  Soros indicated that a breakup of the euro, which could follow a disorderly Greek default, could precipitate a collapse of the European Union, which could in turn have “catastrophic consequences” for the global financial system.

Since the next rollover of Greek debt is not until March 20, it is likely that negotiations will continue for several more weeks.  Those discussions, however, are no safeguard against investors starting to handicap in advance the odds of a “voluntary” agreement.  Spanish and Italian debt was brought to market today relatively successfully.  Huge volumes of debt are scheduled to come to market throughout Europe over the next several months.  If potential buyers become wary that Greece’s problems will lead to a Eurozone breakup, they may boycott those auctions.  Destructive contagion could spread rapidly even in advance of a formal default.

Our markets experienced no violent reaction to today’s negotiations breakdown.  Just a few months ago, the morning news from Europe moved U.S. equity markets by hundreds of points day after day.  Minor changes in investor confidence could again precipitate such volatility.  As we head into a long weekend in the U.S., there is added time for events or rumors of events in Europe to again reach a boiling point.

This is not simply traditional market volatility.  Debt is threatening the world financial system.  Governments and central banks may again successfully “kick the can down the road,” as long as they can maintain investor confidence. But that can’t be guaranteed.  Governor of the Bank of England, Mervyn King recently said: “The crisis in the euro area is one of solvency and not liquidity.  And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected.”  If investors start to focus on solvency–and Greek default could force that–the return of capital will become far more critical than the return on capital.

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.

Although not very precise short-term tools, valuations are the best long-term determinants of stock market direction.  Valuations become particularly helpful forecasters when they reach either positive or negative extremes.

Throughout the past very difficult year for the equity markets, analysts have repeatedly predicted rising stock prices.  The most common justification, despite the worsening European debt crisis, has been that stocks are cheap.  In other words, they argue that valuations are extremely low.  As we turn the calendar to 2012, let us take a closer look at the valuation argument.

By far the most commonly quoted measure of value is the price-to-earnings multiple (P/E).  According to Standard & Poor’s, which is the source of all of the data in this post, using Generally Accepted Accounting Principles (GAAP), the trailing 12-month P/E ratio of the S&P 500 at year-end was 14.0.  That is below the 17.0 average going back to 1926, but it is far from cheap.  Before equity valuations went into the stratosphere beginning in the mid-1990s, the long-term P/E average was between 14 and 15.  When S&P 500 earnings went negative briefly in 2009, the effect was to artificially lift the eight and a half decade long P/E average.  That unique episode distorts history.

Reading the financial press or watching financial television, you have likely heard P/Es reported below 14.  Because forecasters work hard to bolster their case, they employ other measures than trailing 12-month GAAP earnings, which used to be the industry standard.  Now more analysts choose to use operating earnings, which eliminate non-recurring items.  Some cynics refer to operating earnings as “everything but the bad stuff.”  Another common method of reducing the P/E is to use forecasted earnings, rather than trailing 12-month results, which have always been the standard.  Because analysts tend to be perpetual optimists, actual earnings over the decades typically fall short of forecasts.  All that notwithstanding, stocks trading at 14 times earnings are only slightly undervalued compared to median P/Es since 1926.

Analysts run into far more inconvenient truths, however, when they examine other commonly employed measures of value.  But for the valuation extremes for most of the period since the mid-1990s, price-to-dividends, price-to-book value, price-to-sales and price-to-cash flow look expensive, not cheap, when compared to their valuation readings going back over many decades.

Another way to measure the value of stocks is to see how high investors have bid prices of all domestic stocks relative to the size of the U.S economy.  Ned Davis Research computes the value of domestic stocks at 96% of current GDP.  While that is below the extreme readings of the past decade and a half, it is above all preceding periods.  By comparison, even the most extreme reading before the crash of 1929 was only 87%.

Because it is common to weight recent experience more heavily than that from more distant years, it is understandable that today’s analysts view current valuations as cheap.  They are, in fact, far cheaper than are those that have characterized the past decade and a half.  The fatal flaw in such reasoning, however, is that those valuations, unique in U.S. history, distort sound analysis.  We know in retrospect that stocks bought at those extreme valuations have produced, at best, virtually flat returns.  Most equities purchased at those extremes have produced losses.  To describe stocks today as cheap relative to such unprecedented levels is to damn them with faint praise.  If we properly disregard such extreme valuations, investors should realize that, apart from P/E, which is slightly below average, all commonly used valuation measures are closer to their all-time highs than to levels from which major advances have been launched.  Stocks are not cheap.

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.

The S&P 500, the investment community’s most widely-watched index, fell in the last few minutes of today’s trading session to close the year at 1257.60.  It closed 2010 at 1257.64.  We finished a year marked by surging corporate profits, mega-doses of government stimulus, plummeting treasury bond yields, headline-grabbing bankruptcies of American Airlines and MF Global, ongoing armed conflicts, overthrows of Middle Eastern governments, violent protests in Europe, “Occupy” protests here at home, unresolved housing and unemployment problems, our AAA credit rating diminished, politicians who can’t craft a compromise, and European banks and countries on the edge of bankruptcy.  All that action notwithstanding, the S&P 500 closed the year virtually unchanged.  Beyond the S&P, the Dow Jones Industrials and Utilities tacked on gains, while the Dow Transports, Nasdaq Composite, New York Stock Exchange Composite, Mid-caps, Small-caps and the most inclusive Dow Jones Total U.S. Stock Market Index all showed losses.  Overseas the carnage was more significant, with both emerging and developed markets falling.  All but a very few countries experienced declines ranging from about 15% to 40%.  Not a happy year for equity holders.

We enter 2012 with hope but with far more questions than answers.  Let me list a few:

• Will recently improving employment, manufacturing and consumer confidence statistics continue into the new year as government stimulus and tax incentives wind down?

• Will housing prices halt their declines in 2012?

• Can we make a meaningful dent in the overhang of homes for sale?

• With Real Disposable Personal Income now declining, will the U.S. consumer continue to cut his/her savings rate in order to maintain spending?

• Can U.S. corporations continue to grow earnings in an environment of weak housing and massive unemployment?

• Will our major political parties reverse the trend of moving farther away from common ground?

• Will Occupy Wall Street simply mark the beginning of growing social unrest?

 

Europe and the Euro were the dominant financial stories in 2011.  With their multiple problems still unsolved, these are likely to remain the primary themes at least through much of 2012.  That probability raises additional questions.

• Can the Eurozone escape a serious recession despite rapidly declining economic indicators?

• Can several European countries roll over massive amounts of debt coming due in 2012 at rates that will not worsen already serious debt conditions?

• Can the Eurozone hold together?

• Will more European countries introduce austerity programs sufficient to meet Eurozone standards without sinking their economies?

• Will the European Central Bank need to obtain a changed mandate to print its way out of the worsening debt crisis?

 

The United States is faced with an equally problematic debt dilemma, although less imminent.  We have so far been spared European-type pain, because the world remains willing–even eager–to fund our massive deficits.  Whether or not we begin to experience Europe’s problems depends upon the sustainability of investor confidence.  The reality is that we can never pay for all our past promises with a dollar possessing anything like its current value.

• Will our politicians cobble together a debt reduction plan to sufficiently placate rating agencies in order to keep the U.S debt rating from being lowered further?

• Will the Federal Reserve resort to some form of QE3?

• Will we begin to renege on some past promises, either domestic or international, to keep budgets from exploding?

• Will we ultimately resort to dramatically rapid money printing?

• Will foreign sources continue to buy U.S. debt at historically low interest rates despite our huge deficits?

• Will gold prices rise for the twelfth consecutive year if investors fear the inevitability of massive money printing?

 

Many bullish investors argue that, despite growing debt problems in the developed world, the emerging economies will provide the engine of growth that will keep the world financially steady.  That prospect raises some difficult-to-answer questions.

• Why did the world’s emerging country stock markets significantly underperform those of the developed world in 2011?

• Why did the stock market of China, the economic giant of the emerging countries, fall precipitously in 2011?  Why is it down by almost two-thirds over the past four years?

• The most powerful influences on markets often flow from events that are totally unanticipated. What currently unforeseeable events, good or bad, will unfold in 2012?

 

With so many open questions facing investors in the coming year, we will remain extremely flexible and ready to adapt to the unfolding story.

As we close 2011, we wish you and your families a new year filled with good health, happiness, peace and prosperity.

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.

Last week’s blog post about Mission adding gold to client portfolios elicited a few questions and comments.  Among others, there were questions about the relative attractiveness of bullion, exchange-traded funds or gold mining stocks.

For the purpose of our purchase, which is to hedge against the probability of money printing, bullion is the best pure play.  Gold is heavy, however, and presents the problem of storage and possibly also of transport.  For our purposes, investing in physical gold for large numbers of individual clients would be impractical.

While investing in the common stocks of mining companies would be an easy alternative, mining stocks do not always move in concert with the price of gold.  Often, the direction of the overall stock market has a greater influence on gold stocks than does the direction of gold’s price.  While mining stocks pay a dividend, unlike the metal itself, that dividend yield is typically below the already low average yield of most common stocks.  Despite the fact that gold’s price has risen for a decade, the stocks have been far less consistent.  Most major gold stocks are trading below their levels of four to six or more years ago.  In fact, giant Newmont is trading barely above its price in early 1994.  Periodically gold stocks do very well, but they are not as consistent a hedge against the perils of the printing press as is gold itself.

The exchange-traded fund GLD presents the best combination of direct correlation to the price of gold and ease of ongoing ownership for large numbers of investors.  It’s not perfect.  In an extreme market disruption, access to the value of the asset could be temporarily compromised, as would be the case with any tradable security.  It does not, however, suffer the inconveniences of storage and transportability, which burden physical gold.

A separate question was why we bought now and not years ago.  As longstanding readers of our commentaries and attendees at our seminars know, I have long been an advocate of individuals owning some gold.  I have characterized such ownership in those communications as more an insurance policy than an investment.  Its purpose has been to protect against unpredictable and dangerous economic, political or monetary events.

What has changed our thinking about adding gold positions to client portfolios is the growing belief that we are now faced with predictable and dangerous events.  Over the past six months there has been clear evidence in this country and Europe that governmental and monetary authorities are unwilling to take meaningful actions to deal with our respective debt crises. Europe’s unwillingness has precipitated the dramatic rise in sovereign bond yields in recent months.  While we still maintain that the timing of the ultimate resolution of these crises is highly uncertain, it looks increasingly likely that the resolution will have to involve large quantities of newly printed money.  Because such heavy printing could be ramped up at any time, we decided that it would be worth initiating gold exposure now in case such printing should begin very soon.  As indicated in last week’s post, we plan to build our position if gold prices correct further in the weeks, months or quarters ahead.

In the meantime, we wish our readers a merry Christmas and happy Hanukkah and a peaceful, relaxing holiday season.

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.

An aphorism passed down over centuries says that you should  always have enough gold to bribe the border guards.  In modern industrial societies, that concern  has rarely been the motivation for gold ownership.  In most time periods, only those labeled  “gold bugs” pay any attention to the investment merits of the precious  metal.  Periodically, however, some  political, economic or monetary condition gets gold’s price rising.  If it climbs far enough, publicity pushes  gold into the consciousness of those whose otherwise closest connection is  their jewelry box.

While I have never been counted in the “gold bug” camp, I  have counseled for several decades that holding some gold is a prudent insurance policy against any number of potential political, economic or monetary  disruptions.  Prior to this week,  however, we have not established long-term positions for clients in gold or  gold stocks.  This week we changed that practice.

With a nod to Reinhart and Rogoff’s comprehensive history of 800 years of financial crises, This Time Is Different, governments and central banks have for centuries resorted to money creation to cover up prior eras of overspending and overleveraging.  As our country faces its mother of all long-term debt crises, it appears virtually certain that our politicians and monetary gurus will eventually choose the easy way out– by way of the printing press.  The unconscionable inaction by the Congressional supercommittee charged with carving out a mere $1.2 trillion from the next decade’s projected deficits announces clearly that there is no real commitment to getting our budget under control.  Fiscal discipline won’t happen–if at all–until we demand term limits that would eliminate legislators’ need to bribe the electorate with near-term goodies in a seemingly perpetual bid for reelection.  Similarly, our august central bankers have demonstrated their utter disregard for the elderly retired and generations unborn. Their expansionary bailout attempts benefit primarily the current working generation, whose budgetary imprudence has constructed the bulk of our precariously tottering debt edifice.  Almost certainly the Fed will ultimately choose more money creation rather than accept the consequences of a decade and a half of dangerous central bank decisions.

The logical result of excessive money creation is the depreciation of the currency, which has led many analysts to forecast the decline of the U.S. dollar.  In fact, the U.S. dollar’s purchasing power has been systematically reduced throughout the nearly one-century life of the Federal Reserve.  Relative to a basket of foreign currencies, the dollar is worth far less than it was a decade or a quarter of a century ago, although it is above its 2008 low and about 10% above its May low in this most recent cycle.  The recent rise comes not from any dollar strengthening moves from our central bank, but from persistent weakening conditions in other major currencies.  And in the short run, that could continue.

Several asset categories demonstrate a negative correlation to the worth of the dollar.  Gold, especially with the wide acceptance of the GLD exchange-traded fund, is an extremely liquid and easily accessible investment choice.  Following the significant decline from GLD’s September price high, we began to build what could become a meaningful portfolio position in gold.

Above price levels that would be largely determined by jewelry demand, there is no sound way to value gold, notwithstanding the many authoritative-sounding analysts who grace the airwaves.  Most are short-term traders.  Rather, gold’s price is largely a reflection of investor fears and emotions.

The timing of factors that will stimulate investor fears and emotions is highly uncertain.  Europe appears to be on the brink of a regional recession with the possibility of a banking collapse.  Should Europe weaken markedly, it is likely that the rest of the world will follow in varying degrees.  Such a condition would be disinflationary–even deflationary–which would logically be negative for the price of gold.  On the other hand, such a condition would also logically prod central banks into action.  As the aforementioned Reinhart and Rogoff have pointed out in great detail, inflation is typically the method of choice to rescue economies from debt crises. There is little reason to expect this episode to vary from the historical norm.

Given the uncertainty of the coming sequence of events and their timing, we began to construct our position in GLD this week at two potential levels of support: the trendline in effect since January, then GLD’s 200-day moving average.  Given the current poor technical condition of gold, it was not surprising that prices broke through both levels.  Because most gold surprises for the past decade have been positive, we wanted to begin our holding with a small portion of a desired full position at these levels, in case central banks got itchy trigger fingers and began to print earlier than we have reason to expect.  Should such printing occur soon, we will likely see nice profits but on a relatively small position.  On the other hand, should gold experience a larger correction of its earlier substantial price advance, we plan to add to the position over the weeks, months or quarters ahead at price levels where gold has found support in the past.  Should the price decline last for a while, we will experience some loss of value on the small early positions, but we will build the potential for much larger gains from larger positions purchased at lower prices.

Whatever the near-term course of events, we anticipate that governments and central bankers will honor their genetic predisposition to avoid current pain without regard to longer-term economic dislocations.  In fact, I suspect they are actively oiling their printing presses today.

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.

After Wednesday, November 30^th’s massive 490-point rally in the Dow Jones Industrial Average, USA Today ran a lead story highlighting the ten biggest point gains ever.  The most recent advance was the seventh largest.  All ten have occurred in the last ten years.  While the USA Today story did not pretend to draw conclusions about future price movements, it clearly implied that such an advance was an indication of overdone fear in a context of many positive, underappreciated factors.

A quick look at the dates of the other nine biggest gains clarifies that most took place in major bear markets.  Eight of the prior nine took place after major market declines yet well above ultimate bear market bottoms.  Only the 497-point surge on March 23, 2009 occurred near the beginning of a new bull market.  In that instance, stock prices had bottomed just two weeks earlier, and the advance proved to be part of the initial surge in a market rally that carried for 26 months.  From the history of this century-to-date, therefore, the recent rise looks unlikely to mark the kickoff of an extended rally.

Leaning in a more bullish direction, however, is a study by Ned Davis Research, Inc., a highly reputable source of historical data.  Their December 6 report revealed that since 1950, there have been 37 instances of a 4% or better one-day advance in the Dow Jones Industrial Average.  In 33 of those instances, the market was higher 12 months later.  Those advances included most of the big gains that took place during the two giant bear markets that opened the twenty-first century.

The Ned Davis data showed that over the six-decade period of their study, such 4% one-day surges have typically initiated advances that grew roughly another 20% — more or less steadily over the subsequent 12 months.  That behavior clearly differs from eight of the most recent nine advances in the last decade, which saw major declines to ultimate bear market bottoms before beginning lasting recoveries.  Another important observation in the Ned Davis study was that preceding the 4% one-day surges, stock prices had on average been declining aggressively, by about 22% in the prior seven months and an even more aggressive 18% in the immediately prior three months.  In other words, stocks typically surged out of a significantly oversold condition.

What do these seemingly conflicting data suggest for the aftermath of our most recent stock market surge?  It is important to note that the November 30^th rally did not flow from a seriously oversold condition.  In fact, it began at a price level roughly 10% above where the index had traded about two and four months earlier.  This is markedly different from the typical advance profiled in the Ned Davis study and all nine of the biggest point-gaining days of this century.

If I had to choose between the precedents offered by price patterns in this century and those from the last half of the prior century, I would lean toward the most recent experience.  These observations took place in the era of egregiously overextended debt, which continues to provide the backdrop for today’s market.  That, I suggest, is the single most critical variable weighing on economic progress and equity prices.  If prices follow the recent precedent, they are likely to move significantly lower before beginning the next sustainable market advance.

While we are now in the seasonally strong month of December, interpretation of news from Europe will probably be the single biggest determinant of stock prices’ immediate path.

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.

The drama continues to play out.

Tuesday afternoon Standard & Poors downgraded 37 global banking giants–hardly a surprise. But when someone points out that the emperor is wearing no clothes, our markets reflexively decline, as they did in Tuesday night’s futures session. Just hours later the U.S. Federal Reserve, the European Central Bank and the central banks of England, Canada, Japan and Switzerland jointly agreed to cut the cost of borrowing U.S. dollars from 1% to just half that. Whether part of a coordinated move or not, the People’s Bank of China simultaneously announced a 50 basis point cut in that country’s Required Reserve Ratio for banks. The appearance of central bank solidarity quickly turned overnight futures from negative to strongly positive. That strength continued throughout Wednesday’s session with the Dow closing up a spectacular 490 points.

The financial press speculated that what prodded the central banks into their stimulative move was the prospect of an imminent collapse of a major bank, most likely French. Interviewed on TV Thursday, former Fed Governor Larry Lindsey admitted the likelihood of a major bank failure this month, but suggested the most probable stimulus to the central bank action to be S&P’s bank downgrades.

At least for one day the stock market celebrated this action as a big deal. One TV talking head characterized it as the banking authorities firing both barrels. On the other hand, it is not an immediate infusion of new money that can be put toward asset purchases. It is rather the expansion of a safety net should banks otherwise be unable to acquire U.S. dollars. One analyst aptly analogized it as putting foam on the runway to limit the damage of a crash.

At the very least, the move is encouraging because it provides clear evidence that cooperation is possible among the world’s largest central banks. At the same time, however, it underlines how severe the current crisis has become. The central banks acted because funding between banks has been freezing up, as it did in 2008, necessitating the greatest bailout in history. The S&P downgrades simply increased the distrust that banks have of their peers’ abilities to repay loans.

Whether or not this central bank action will provide meaningful assistance in calming the European storm is open to question. During the 2007-2009 banking crisis, similar swap line actions were taken four times, typically leading to dramatic stock market rallies. They ultimately failed, however, to promote the desired interbank confidence, which was only reestablished when the Fed provided broad guarantees. Such pledges would be politically improbable a second time around. Notwithstanding the stock market rallies precipitated by these liquidity-providing policy actions, all such gains were ultimately forfeited as the markets continued their plunge of more than 50% to their 2009 bottom.

Even if successful, these rescue actions are designed solely to solve emergency liquidity problems, not underlying solvency problems. And solvency is at the heart of the banking crisis. Bank of England Governor Mervyn King stated this week that the downward spiral facing banks looks like a systemic crisis. And the always insightful Martin Wolf, writing in Wednesday’s Financial Times, warns: “…that the eurozone has a choice between bad and calamitous alternatives. The bad alternative is radical policies to promote adjustment, while warding off a wave of sovereign debt restructurings (defaults), financial crises and a true depression. The calamitous alternative is that depression, along with a breakup of the (euro) project.”

As we have stated repeatedly, the ultimate resolution of this crisis is unknowable. A systemic collapse is possible with terribly severe potential consequences to worldwide asset prices. More hopefully, politicians and central bankers will craft a series of plans that will sufficiently boost investor confidence to keep asset prices afloat while the underlying debt problems are resolved, or where that is impossible, restructured. The latter alternative could lead to intermittent powerful rallies. Because the former alternative remains very possible, investors should weigh carefully how much exposure to risk they wish to assume. As recent market volatility demonstrates clearly, good or bad announcements can lead to precipitous moves in both stock and bond markets. In a truly dramatic resolution to the crisis, either positively or negatively, market prices could gap in either direction allowing no opportunity to get trade executions over a very broad price span.

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.

The equity markets had little to be thankful for during the U.S.’s holiday-shortened week.  The S&P 500 dropped by 4.7% through the normally bullish Thanksgiving week.  Other commonly watched indexes fell even more.  Not affected by our holiday, world markets likewise fell precipitously.

Expectations that Europe would cobble together a plan to prevent imminent economic collapse led to a spectacular October rally in stock markets around the world.  However, as persistent bickering among heads of state decreased confidence in that outcome, markets sagged throughout most of November.  Markets still go hour by hour waiting for a positive rumor from Europe.  A plausible plan to “kick the can down the road” will likely lead to a substantial rally, especially with markets as oversold as they are today.

Nonetheless, the longer-term picture is getting darker by the day.  Rating agencies downgraded sovereign bond ratings en masse last week.  Moody’s cut Hungary to junk levels and Fitch did the same for Portugal.  Belgium was downgraded.  S&P warned that it may cut Japan’s rating.  Fitch said that France’s triple-A was at risk.  Investors also downgraded bonds on their own, independent of the rating agencies.  The Italian ten-year bond reached 7.3%, and the two-year climbed over 8%.  There is no realistic prospect that Italy will be able to grow its way out of this debt morass with debt service burdens at such levels.  Even Germany, the financial engine of the Eurozone, saw its bond rates surge last week.  In just over two weeks, German ten-year rates climbed from 1.72% to 2.25%.  By way of comparison, the U.S. ten-year stayed at 1.96% over the same period. Fear is creeping in with respect to all of Europe.  And Europe is a giant piece of the world’s economic and market composite.

As I write this on Sunday evening, a report is circulating that the International Monetary Fund is preparing a $794 billion rescue package for Italy.  The rumor has overnight futures markets in rally mode.  With markets as oversold as they have become over the past few weeks, snap-back rallies could be powerful if it looks likely that some sort of rescue package will defer a near-term debt collapse.  On the other hand, long-term investors must remain conscious of the rapidly spreading deterioration of underlying fundamentals.  Massive debt problems don’t cure themselves.  Left to their natural outcomes, they unwind in a deflationary spiral.  Rarely through history, however, do governments and central banks allow natural outcomes.  More often than not, money printing becomes the defense of choice, resulting in a debt burden reduction through inflation.  In extreme situations, runaway inflation eliminates all debt but introduces economic chaos.  The last example of such an outcome for a major industrial country was in Germany in the 1920s.  In any inflationary environment, varying only by degrees, lenders (bondholders) are penalized and borrowers are rewarded.

Today’s investors are by rights in a serious quandary.  The financial system, at least in Europe, is in danger of collapse. Perhaps investors will believe in a rescue plan that will defer the pain for a few years, and equity prices may rise in celebration.  Holders of sovereign bonds in perceived safe-haven countries (the U.S., Germany and Canada, for example) may profit if a disinflationary or deflationary recession unfolds.  On the other hand, such bondholders may be beaten up badly if central banks resort to the printing press to alleviate the debt pressures.

Eventual outcomes will be politically determined.  Successful investors may succeed more by their ability to anticipate political outcomes than by a deep understanding of investment fundamentals.  In such an environment we rely on our underlying philosophical guideposts, which have stood us in good stead in this extremely dangerous century-to-date.  In a high-risk environment, reduce risk exposure.  Buy risk-bearing assets only when you can acquire them at extremely attractive valuation levels.  Never lose sight of the fact that there will always be another opportunity to make significant gains.  You will not be able to take advantage of that opportunity, however, if you lose a substantial amount of your assets when markets decline.

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.