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October 26, 2011

Dear Clients and Friends:

The Economy

Advances in technology over the last couple of decades have been a major contributor to economic growth around the globe. The economies of nations once separated by seas and cultures have become more intertwined and in many ways dependent upon each other’s stability and progress. That is why Europe matters. It is why the stock market rises or falls with news of progress or lack of progress in a viable European solution.

The basic background is this. To facilitate trade and travel, several countries in Europe created a common currency, the Euro. The economies of those countries remained independent and thus established their own priorities in areas like social programs, thrift, and the role of debt.

While the financial crisis continues to impact virtually all economies around the world, certain countries in Europe are under severe stress. They include Greece, Italy, and Portugal, with Spain not far behind. Greece is in the spotlight now. With a shrinking economy and tax base it is unable to stay current on its debt. If Greece cannot meet its financial obligations, the holders of Greek debt will suffer. These holders include the central banks of other European countries, other European commercial banks, and financial institutions around the world. Similar to the scenario that threatened U. S. banks, if banks reflect the decreased value of Greek debt (an asset) on their balance sheets, their financial survival is threatened. Germany will need to decide if playing a significant role in saving the weaker economies in Europe, and the cost to do so, will be sufficiently offset by a stronger European consumer base in the future.

The current financial crisis was caused by a vicious cycle years in the making. One of the key elements that fueled the crisis is the fundamental way people access credit, using assets as collateral. The market value of the collateral can affect that amount one can borrow. This is best illustrated graphically.





Expands available credit

Decreased access to credit

Increases asset prices (collateral)

Reduces demand

Increases demand

Decreases asset prices (collateral)

Increased access to credit

Decreases available credit

Just as the leveraging cycle was years in the making, deleveraging (debt reduction) will also take years. In other words, investors will have to be patient for this process to unwind.

The government can play a significant role in speeding up the deleveraging process. What needs to happen is a coordinated global response on how to restructure debts at both the country level (Greece), institution level (banks), and household level. While lower rates can ease the pain, nothing short of principal write-downs and/or debt-to-equity conversions will be truly impactful. It is time governments globally acknowledged that we have a solvency problem, not a liquidity problem, and that extending credit more freely and at a cheaper cost will prove only modestly effective.

The abundance of employment opportunities is the signature characteristic of a healthy economy. It allows willing applicants to be easily absorbed into the work force and gives existing workers the confidence to consume and invest. High employment drives the establishment of households and families, further adding to economic momentum.

It is a somewhat eerie coincidence that one of the leaders of the technical revolution in the U. S., who recently passed away, was a man named Steven Jobs. His company, Apple, employs 46,600. He was the vision behind products people didn’t even know they needed – until they were invented. His entrepreneurial spirit will be missed, so will his ability to create jobs virtually out of thin air, or silicone chips.

We have listened to the words of existing and would be political leaders and find their proposals mostly weak and uninspiring. Are our leaders a reflection of Americans in general? As a nation are we more threatened by the world we live in, instead of being challenged by it? Are the problems we face today more imposing than the Revolutionary War, Civil War, Depression, world wars, the Soviet Union, social injustice, or polio? We think not.

Big problems call for bold initiatives. A very old and anonymous saying is "Necessity is the mother of invention." If the need is great, so must the effort be to fill it. We need job growth and plenty of it. How do we get it? Do we encourage additional federal spending on, say, updating and repairing our infrastructure? No one can argue that the need is there. We have excess capacity in manufacturing and labor. Instead of funding such an objective by adding to our national debt, and asking future generations to pay for it, perhaps we can reduce our role as the world’s police force and spend those dollars in the U.S.

We need to unleash more American ingenuity by smoothing the path for entrepreneurs. Their success will foster meaningful work for others. Every company started as an individual’s dream. We need bold plans to encourage calculated risk-taking. The government cannot solve this employment crisis; it can only temporarily ease its pain. Until we agree that private enterprise is the growth engine, we will be stuck in a stagnant economy where one person’s gains are another person’s losses.


Recently, the markets have exhibited "risk on" or risk off" characteristics across all asset classes. Depending on the most immediate news, "risk on" translates into an increase in prices in commodities, real estate, stocks, high yield bonds, increasing treasury yields, and narrowing of corporate spreads (i.e. the yield difference in corporate over treasuries). "Risk off" is just the opposite. This is a short-term phenomenon that makes diversification seem ineffective and meritless. Rest assured this is not the case on a longer-term basis.

Even though we have written about this in the past, it is still worth repeating. Heightened volatility from globalization and financial innovation (derivates) is here to stay.Furthermore, the build-up of debt in the developed world is going to be a drag on future growth, which, in combination with low bond yields, will put a damper on returns over the next decade. Bottom line, lower returns and higher volatility is, as Bill Gross coined it, "The New Normal."

We shouldn’t let volatility distract us from making good, long-term investment decisions. The following themes will continue to be expressed in client portfolios:

- Large multinational corporations and emerging market countries have healthier balance sheets compared to developed country debt, and pay higher interest.

- With the exception of large cap, high quality U.S. stocks, the U.S. market appears to be expensive, using a normalized P/E ratio.

- Profits will grow at the rate of GDP growth over the long-term (i.e. profits cannot continue to outpace GDP growth as cost cutting will reach its limits).

- Real interest rates (nominal interest less inflation) are negative but will move to the normal, or positive, differential over time.

- Emerging markets will become less dependent on exports, more domestic consumer-oriented, and therefore less dependent on the U.S. Also, emerging markets will continue to grow at rates far above developed countries.

- A rise in demand from the emerging market middle class and upper middle class will put upward long-term pressure on available natural resources.

- Opportunities will exist to invest in global companies with excellent fundamentals at prices made attractive as a result of being domiciled and associated with countries and regions under an economic cloud.

Specifically, this translates into:

- Fixed Income: holding emerging market, corporate and floating rate debt in favor of Treasuries. The caveat is that fear or Federal Reserve Bank (Fed) intervention can turn this strategy on its head in the near-term.

- Equities: holding a below average allocation to stocks based on higher valuations and lower prospective growth. Allocating to equities globally, with the exception of a higher amount to high quality large U.S. companies, and very little to the rest of the U.S. market (small and mid cap stocks). Again, this portfolio will underperform if the dollar rallies against other currencies in the near-term (fear driven).

- Satellites: maintaining exposure to tactically allocated funds that can nimbly capitalize on short-term market swings, hard assets, and funds that employ niche strategies to capture absolute return, despite what the market is delivering (up or down).

Funds that deserve special attention:

Rising Rate- The purpose of this fund is to neutralize the negative impact from rising interest rates to the fixed income portfolio by shorting long dated U.S. Treasuries. This fund will perform poorly when there is a flight to quality (fear is prevalent) and/or the Fed is intent on driving down long-term rates. In the most recent six month period, we have had both occur. Fundamentally, there is less value in U.S. government bonds than corporate and emerging market debt, but it may take some time before the market reflects this. One of the key factors will be the government’s ability to successfully reverse the deflationary forces resulting from the debt overhang.

Evermore Global Value - This fund has heavy exposure to Europe and invests in a concentrated portfolio of around 30 stocks. The market is penalizing anything that is attached to Europe, regardless of where a company’s customer base is located. The often-used phrase for this is "throwing the baby out with the bathwater." A company’s fundamentals will ultimately drive its stock price. However, in the near-term, whole markets "get painted with a broad brush." We have full confidence in this manager’s stock picking ability and expect this fund to deliver superior returns over time. In the near term, its European exposure has clearly hurt. Also, Evermore recently terminated their assistant fund manager, Jae Chung. This is a non-event to us as David Marcus, the lead manager, and majority owner, is the one we place our confidence in.

Ivy Global Natural Resources - This fund will consistently be the one of the most volatile holdings, requiring extreme patience. The fund invests in common stocks of companies tied to underlying natural resources and not the natural resources themselves. The volatility exists two-fold: 1) at the commodity level, and 2) at the individual company level. This is a combination play on currency devaluation as well as increased resource demand from the emerging markets over a long-term time frame. The threat of deflation and near-term "flight to quality" has clearly caused this fund to suffer, despite our optimism about its long-term prospective return.

Donations in Lieu of Holiday Gifts

As most of you know, it is a tradition of ours to deliver a gift basket to clients during the holiday season, as a sign of our gratitude for allowing us to be of service. Some clients, while expressing their appreciation, have requested that the value of their gift be donated to charity instead.

Last year we initiated a program that allowed clients the option of making a donation to select charities in lieu of their gift from us. We believe the program was well-received and we are happy to offer it again this year. In selecting this year’s list of qualified charities, we decided on a theme of helping those feeling the brunt of these most difficult times. While we can accept that the volatility in the stock market is stress-producing, it must pale in comparison to the stress individuals and families face day in and day out when their resources are depleted while experiencing underemployment or unemployment.

This year’s list is as follows:

The Ministry of Caring

This community-based nonprofit organization provides a network of social, health and support services for the poor, including the homeless and working poor, in greater Wilmington. Services comprise case management, emergency shelters, transitional and long-term residences, a residence for people with AIDS, dining rooms for the hungry, a job placement center, child care centers, an outreach center, medical and dental programs, and a distribution center.

Food Bank of Delaware

Founded in 1981, the Food Bank of Delaware provides food for the hungry in the entire state of Delaware and small parts of Maryland and Pennsylvania. They solicit, collect, purchase and store food from farmers, manufacturers, brokers, wholesalers, retailers, and others in the food industry for redistribution to nonprofit agencies that serve the hungry.

Friendship House

A non-profit Christian corporation committed to making a difference in the lives of the homeless people of New Castle County, Delaware through the traditional spiritual ministries of hospitality, education, empowerment and community. Friendship House resources are often sought by persons driven preliminary by their physical needs for food, clothing, housing, employment, bus fare, etc. Its ministry also provides caring and consistent supportive services once physical needs are met.

If you would like to participate in this program, please contact Lauren at our office before Wednesday, November 16th.

Year-End Tax Planning

We recently completed a review of all 2010 Roth IRA conversions to see if any should be recharacterized (reversed) before the filing deadline of October 17, 2011. If you were not notified at that time, in our opinion, there was no need to reverse your conversion and amend your returns.

Our advisors will soon be engaged in year-end tax planning. As part of this review, we will be calculating Required Minimum Distributions (RMDs) for clients with IRAs that have reached age 70 ½. Our review will include federal and state income tax withholding recommendations from these RMDs.

Please provide your most recent paystub. We cannot overemphasize the importance of responding to our requests for information as quickly as possible as year-end approaches. Providing you with the best possible service and the best possible recommendations requires a high level of timely cooperation.

We continue to work daily to earn your trust and confidence.

Best Regards,
Vincent A. Schiavi, CFP®, CPA/ PFS               Ravi P. Dattani, CFP®, CPA

President                                                       Vice-President




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