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April 25, 2013

Dear Clients and Friends:

This year marks the 30th anniversary of Vincent’s registration as an investment advisor and Fee-Only planner with the United States Securities & Exchange Commission and the Delaware Securities Division. It was a leap of faith in a vision that clients would appreciate a coordinated approach to financial advice, delivered using a method of compensation that was transparent and not tied to the sale of financial products. It is now safe to say they do, with public demand slowly but surely pushing the industry closer to the fiduciary model we adopted some thirty years ago.

Advisors and clients have been through a lot in the past thirty years. The United States experienced five periods of economic contraction and five periods of economic expansion. We saw Germany reunited and the Soviet Union dissolved. We lived through the widely held belief that Japan would supersede the United States as the world’s greatest economic power, only to see that country fall on harder times. Recently, we have seen countries like China, Russia, India and Brazil flex their economic muscles, with the U.S. losing some of its relative economic power.

Home buyers in January of 1983 faced mortgage rates of 13.4%, compared to about 3% today. In 1983, with the Dow Jones Industrial Average (DJIA) at 1,047, only 19% of U.S. households were invested in the stock market. Today, with the DJIA fluctuating at around 14,500, close to 60% of all households own shares of stock or stock mutual funds. It is interesting to compare the companies that were part of the DJIA in 1983 to its current components. The differences say a lot about how difficult it is for major corporations to stay dominant and relevant over that span in time. Companies remaining part of the index have been bolded below.

  Changes in the DJIA

 

 

Fortunately, most major trends in the economy happen gradually. For example, consumer buying and savings habits change slowly, employment gradually increases or decreases and a nation’s demographic identity changes incrementally. When things change gradually, we become accustomed to the trend and more accepting of it, sometimes to our own detriment.

It reminds us of the often referenced story of the frog and boiling water. If you attempt to place a frog in a pot of boiling water, the frog will immediately jump out. The dramatic temperature change startles the frog into action. Instead, if you place the frog in cool water and gradually turn up the heat, the frog will become complacent and remain in the pot. Sometimes it is not easy for us to recognize a significant economic trend because it is made up of incremental changes.

Movements in the financial markets, on the other hand, represent bets on the direction of those markets. Those bets can change dramatically from day to day, minute to minute, and now even nanosecond to nanosecond. It is important to note that while the bets on those markets can move very quickly and violently, the underlying assets upon which those markets are based tend to become more or less valuable gradually. Ultimately there is a link between price and value.

Think about the connection between the overall economy (value) and the stock market (price). Economist Roger Farmer uses the following example to explain their correlation, or apparent lack thereof. Think of two individuals, each holding the end of a rope. One represents the economy and the other represents the stock market. If the rope is tight, one individual (the economy) can pull the other individual (the market) along. More often than not, the rope is loose and the market’s movement and the economy do not appear to be directly correlated. The existence of the rope and its finite length, however, does result in limiting the disparity. The market cannot get too far ahead or too far behind the economy before one pulls the other along with it.

If we agree on the importance of being cognizant of significant trends, like the boiling water, and less concerned with the day to day, quarter to quarter changes in market prices, what significant trends do we now see in play?

Overall Debt Will Inhibit Future Growth

Debt is like a double-edged sword. Used wisely, it helps a person buy a car, a house, educate children, start a business, and leverage opportunities. Too much debt lessens the ability to save, limits flexibility, postpones the ability to start and house a family, and defers retirement.

On a national scale, the short-term build up of government debt in times of national stress, such as during wars or recessions, seems necessary. However, increasing the national debt requires higher levels of debt service, meaning fewer dollars are available for other worthy national priorities, like publicly funded research that could spawn advances in health care or private industry. The internet, a strong driver of commerce, had its roots in the need for government to improve communication between universities and defense research facilities in the 1960s.

A Strong U.S. Middle Class Remains in Danger

In order for this country to remain a desirable place to live, we need jobs that make that possible. There is a growing disconnect between the needs of employers and the skill and educational level of applicants. If we do not have a plan that unites our educational system with the needs of employers, there will be more "have-nots" than "haves". This could cause social unrest, put major stress on national governance, and limit U.S. growth. The decline of a strong middle class in the U.S. and "old" Europe stands in contrast to the growth of the middle class in emerging market countries.

The Financial Markets Need More Effective Regulatory Oversight

Banks considered too big to fail during the most recent financial crisis have only gotten bigger. Ineffective limitations on leveraged trading by these banks continue to expose the financial markets to major disruptions.

The compensation awarded to the hired heads of major corporations only grows more disproportionate to the compensation paid to the average employee in their service. Even if lower level employees are fairly paid, the excess compensation paid to high-level hired executives depletes funds that would otherwise be paid out to shareholders or reinvested in the business. This results in lower investment returns for individual investors. This is a trend that needs to be reversed.

U.S. Manufacturing on the Rise

As recently highlighted in a Time magazine cover story, more companies are finding that manufacturing in the U.S. is becoming competitive with outsourcing. The wage gap is closing and our engineering ingenuity continues to contribute to more productivity. It is too early to tell if this movement has legs, but it is encouraging.

U.S. Dependence on Foreign Energy is Falling

The use of advanced techniques to extract previously hard to reach oil and gas reserves has resulted in mini-booms across a broad section of the country. If the environmental concerns can be managed, these resources could go a long way to U.S. energy independence. Abundant energy is required to fuel industrial growth and the middle-class jobs that come with it.

The Impact on Investment Portfolio Design

The price for stability in a portfolio has never been higher. Throughout most of our lifetimes, investors could set aside "safe" money in CDs, money markets, or short-term Treasury securities, and earn a reasonable rate of return. Current rates are so low that after-tax and after-inflation rates of return from these investments are often negative, a high price for stability. We have chosen to use fixed income managers with the flexibility to allocate investments over a wide range of fixed income possibilities. When interest rates start to rise, we expect these managers to navigate the environment and limit, to some extent, downside risk.

On the equity side, we are using global managers who can allocate investments across many companies and countries. Doing so limits the downside risk of any one country’s market imploding and is consistent with the trend of more growth potential in countries outside of the U.S.

In our satellite space we continue to emphasize the unique investment qualities of the Ironclad Managed Risk Fund, first introduced in our February 2, 2012 newsletter. The manager’s goal is to deliver long-term results comparable to the S&P 500 with two-thirds of the volatility. His put option writing strategy for achieving these results was recently endorsed by Ben Inker, co-head of asset allocation at GMO, in his February 2013 newsletter to clients. Under a subheading of "More Sustainable Diversification", Mr. Inker writes:

 

"We at GMO do not believe the markets are efficiently priced today, nor are they particularly likely to be efficiently priced in future… So, if historically strong-returning diversifying assets deserve a certain amount of wariness with regard to their future correlations and returns, is there any kind of diversification you can get excited about? We believe there is…At a time like today, where many equities look to be significantly overvalued, the prospect of getting paid a "normal" equity risk premium for selling puts looks pretty attractive, and we have therefore added put selling as part of the equity portion of a number of our multi-asset portfolios." 

 

Cyber Security

Technology has played a major role in increasing productivity across the economic spectrum. Those of us brought up on paper records, actual stock certificates, and regular visits to the bank, have seen a dramatic shift to electronic transactions and recordkeeping. Advances in information technology have us placing more reliance on records and systems that lack an obvious physical presence. It is one thing to have cash or actual stock certificates in your hand and quite another to have most of your wealth in the form of electronic bits and bytes. Somehow pieces of paper, such as currency and certificates, seem more real than on-line screen shots.

Because so much wealth is managed on-line, criminals are following the money. If Willy Sutton, the famous bank robber, were alive today no doubt he would be surfing the web looking to hack into accounts to transfer wealth to his own electronic hideaway. On a national scale, cyber attacks have the ability to disrupt not only our financial system, but our power grids and water supplies. It does not take an army to create chaos in a country anymore, just a devious nerd or two.

What can we do to control these risks? Nationally, our government is aware of the risk and is allocating substantial resources to it. Individually, everyone needs to decide on the level of security they want when it comes to having ready access to food, water, and cash on hand.

The precautions are the same whether one is trying to protect against a man-made disaster like a cyber attack, or a natural disaster like a hurricane.

In order to prove your digital wealth, it is important to have evidence of your investments. Custodians, such as Fidelity, back up their records continuously. Our own records are backed up daily. Additional protection would be provided through your own copies of recent statements, either in physical or digital form. In addition, we recommend that you review all account withdrawal activity to confirm your authorization.

This is the new reality, but we did not get here overnight. Let’s be vigilant.

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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