Thoughts and Strategy Around the Fiscal Cliff
By Trevor Callan
On December 31st, 2012, a significant amount of the federal income tax code is scheduled to expire, an event that has come to be known as the fiscal cliff. The 2001 and 2003 tax cuts enacted under President George Bush, a compromise on the estate tax, a patch in the Alternative Minimum Tax, the temporary 2% payroll tax, and the ?extenders? package of miscellaneous tax deductions are all scheduled to expire.
On January 1st, 2013, five taxes enacted as part of the Patient Protection and Affordable Care Act (Obamacare) also go into effect as well as $109 billion in spending reductions. The size and speed of these tax increases and spending decreases has many concerned that this could push our economy into a recession.
The fiscal cliff is the culmination of a decade of temporary tax and budget bills that have allowed our politicians to avoid solving key policy differences. The good news is our politicians can no longer afford to avoid good governance. Unfortunately, we believe that there are enough politicians on each side of the aisle who prefer going over the cliff (allowing these tax codes to expire) to strengthen their respective bargaining leverage next year. With only a few days remaining in session this year, there is an increasing chance that this sparring will continue into January, which could increase volatility in the financial markets as we move through the holidays. We believe this volatility will be short-lived because both sides of Congress cannot afford to let these budget talks extend for very long. It is not a matter of if there will be a compromise, but when this compromise will take place.
In 2010, President Obama created the bipartisan National Commission on Fiscal Responsibility and Reform. The committee, called ?Simpson Bowles? after co-chairs Alan Simpson (Republican) and Erskine Bowles (Democrat), created a template for fixing our country?s fiscal problem. Unfortunately, neither the President, who created the committee, nor Congress has provided broad-based support for their recommendations. The reason is simple: every organized constituency from AARP to the National Association of Realtors will find something wrong with a balanced solution because a balanced approach affects everyone. Although the Simpson-Bowles proposals were not adopted, they have recently resurfaced as a template for pushing toward a bipartisan solution. We had the opportunity to meet and listen to Simpson Bowles at a recent conference in Chicago and walked away encouraged with their basic message, but felt a modified version would serve as a better long-term solution. Although we favor cutting expenses, through streamlining inefficiencies within government, over raising taxes, we do not believe there is a way forward without a compromise. Their basic proposal serves as a good foundation for a compromise. Specifically, their plan incorporates simplifying the tax code, lowering marginal tax rates, widening the tax base, and increasing effective tax rates on upper-income individuals through the elimination of deductions. Their plan also addresses entitlement reform, which, they correctly pointed out, is unsustainable in its current form. Their proposal was to eliminate tax deductions and use the revenue to both reduce tax brackets and the ongoing deficit. Notably, as part of their proposal, preferential tax treatment for long-term capital gains, qualified dividends, and the Alternative Minimum Tax would be eliminated. As the Simpson Bowles proposal has gained momentum in the media, this has had an impact on the equity markets as investors rush to realize gains and question their preference for dividends. We feel both of these trends will correct as a long-term solution is negotiated.
The good news is the word is out. You cannot avoid hearing the constant barrage of doom and gloom coming from all sides of the financial sector. In our experience, investors are paid to take a contrarian view to that of the investing public, and it is difficult to find anyone optimistic on the financial markets, despite relatively positive news recently reported on the economy. Black Friday weekend spending was up 13% from a year ago. In September, the housing market posted the sixth straight monthly increase, and we are in a seasonably weak period. GDP was revised up to a 2.7% annualized rate in Q3, more than double Q2?s 1.3%.
Although our long-term views have not changed, we expect some volatility over the next several weeks as the negotiations play out. In October, we took steps to modestly lower the volatility in our portfolios in anticipation of these negotiations. Specifically, we decided to take defensive positions within our bond portfolios by reducing our exposure to high-yield, convertible bonds and preferred stock, which typically move in line with equities and added exposure to emerging market bonds and residential mortgage backed securities (RMBS). We believe our portfolio of high-quality equities, with a bias toward dividends and an emphasis on diversification, will continue to provide our clients with the right balance between reducing volatility and providing attractive returns when Congress finally compromises and finds a long-term solution to our budget woes.
December 19, 2012 tcallan Uncategorized Comments OffOpportunities, Risks and the Fiscal Cliff
By: Tim Callan
This has been a great year for risk assets such as stocks and mediocre for low risk assets such as treasury bonds and cash. The S&P 500 is up 16% through the third quarter while the Barclays aggregate bond index is up only 4%. Since the bull market in stocks started in in March 2009, the S&P 500 is up over 112%. Despite the market approaching previous highs set in 2007, most investors favor bonds over stocks. Investors have added $1.2 trillion to bond funds and bond ETF?s since 2007 versus $200 billion into stock funds, despite the strong market performance. The current yield on 10-year treasuries is a mere 1.65% through the third quarter and -0.27% real yield after inflation. In addition, approximately $10 trillion sits in cash throughout the U.S. economy earning almost nothing. So why aren?t investors adding to stocks over low risk assets like bonds and cash?
Economic uncertainty remains the primary driver behind investors? low aptitude for risk. The economy is growing at a pace of about 1.3% as of the second quarter, which is well below the historical average of 2.5%. In addition, the European debt crisis, high unemployment, the fiscal cliff, the presidential election, future tax rates, and other variables continue to create uncertainty. What investors are ignoring, however, is the fact that even ?low-risk? assets present risk.
The 10-year Treasury bond, for example, has climbed under a 30 year bull market. Yields peaked in 1981 at 15.81%! Since then, bond prices have increased and yields have declined steadily to less than 2%, where they sit today. While increases in interest rates don?t seem likely in the near future, they are inevitable long-term. For every 1% increase in 10-year interest rates, investors can expect the value of their 10-year Treasury bond investments to decline by 9.1%. We believe proper diversification in fixed income and short maturities will reduce but not eliminate this risk.
Cash and CDs are asset classes of choice among the risk averse. For every $100,000 invested in a 6-month CD, an investor is earning $440 for the year. After inflation, cash loses purchasing power of nearly 2% per year. Despite this lackluster return on investment, $10 trillion is sitting in cash money funds, including CDs, surpasses the total mortgage debt in the entire United States.
The Federal Reserve has been keeping both short and long-term interest rates at low levels in hopes of getting banks to lend and investors to start taking more risk. This has yet to happen, and all the money sitting in cash and bond funds will be added fuel for future stock price appreciation.
Despite the bull market in stocks over the last 5 years, stocks remain at very attractive valuations. The consensus earning estimate for the S&P 500 over the next 12 months is $111 per share, which represents a forward price to earnings ratio of 12.9 times. This is a 20% discount to the historical average multiple of 16.2 times earnings. In other words, stocks would have to increase by 20% to reach the average multiple on earnings. While, we don?t expect the multiples to go back to the historical average short term, the current valuation discounts lend themselves to long-term stock price appreciation. Historically, stocks trading at current valuations have never been negative 5 years later. In fact, the average return after 5 years has been 13% annually.
The pending fiscal cliff remains the biggest short-term risk to economic growth and stock market returns. If nothing is done by congress over the next two months, $400 billion in tax increases will go in effect with the expiration of the Bush tax cuts, payroll tax cuts, unemployment benefits and the 3.8% increase due to the Patient Protection and Affordable Care Act, commonly called Obamacare. In addition, approximately $200 billion of spending cuts go into effect, mostly in the area of defense, which would hit our local economy particularly hard in San Diego.
All of the tax increases and spending cuts would target the current deficit, which is on track to hit $1.2 trillion in 2012 or 7.3% of gross domestic product. The fiscal cliff would drive deficits down to 2% of GDP in 2 years. While that would be great for deficit reduction, it would likely drive our economy back into another recession by reducing $600 billion of economic demand immediately. Our national debt remains a concern long term, but it would be more advantageous short term to lower deficits gradually. Both political parties recognize this dilemma, and a more gradual solution will likely prevail. However, time is running out, and we will likely see Congress and the newly elected President scrambling down to the last minute.
At Callan Capital, we believe investors will be rewarded for taking more risk over the long term. However, we still hold bonds and cash to help reduce potential declines short term. In addition, we have been defensive in our bond holdings by being diversified, avoiding treasuries and keeping maturities short.
November 21, 2012 tcallan Quarterly Newsletter, Tim Comments OffCallan Capital Q3 2012 Newsletter
Read Between the (Head)Lines
By: Trevor Callan
The elephant in the room right now is fiscal austerity, and not just for the U.S. As U.S. policy makers grapple with impending tax hikes and budget cuts, European leaders are scrambling to save the Euro. Headline-driven investor behavior is nothing new, but cooler heads will look past the panic-laced headlines as they position their investment portfolios for the remainder of 2012 and 2013.
US Economy
As we anticipated in our prior updates, the U.S. economy has continued to experience tepid growth and has managed to avoid a recession in 2012. Our nation?s economy marked its 12th consecutive quarter of growth but expanded at a slower pace. Housing shows signs of improving, with the Case Shiller, FHFA Purchase Only and Average Existing Home indexes all moving higher. As of June 30th we have added 4.3 million jobs since the great recession, but the growth in payrolls has been a disappointment and not strong enough to move unemployment down in a meaningful way.
Risks
As usual, plenty of risks need to be addressed in the design of our portfolios. If no action is taken in Washington to extend current law (Bush era tax cuts), 2013 will begin with a $400 billion tax increase and a $100 billion per year spending cut, which could send us into another recession. As we approach this well-anticipated fiscal cliff, the U.S. economy is growing slowly at 1.5%-2.0%. Both sides of the political aisle are flexing their muscles as we head into the election, signaling gridlock. We feel neither party will ultimately want to take responsibility for a fiscal cliff dive and that this will lead to a compromise, providing relief to investor fear and reduce some of the uncertainty in the financial markets.
Europe continues to fight to save their monetary union. Greece is struggling to satisfy the troika on budget cuts and other reforms promised as part of their bailout arrangement. The process of saving the Euro has proven to be and will continue to be slow and uneven. Jose Manuel Barroso, the head of the European Commission, recently warned Antonis Samaras, the Greek prime minister, that Greece has only a couple of weeks to persuade its creditors that it can put economic reforms back on track. Mario Monti, Italy?s prime minister, noted serious concerns about the possibility that Sicily would default. In the face of this uncertainty, the Europeans have shifted their rhetoric towards creating a fiscal union in addition to their monetary union, which is what is needed to solve the crisis. Mario Draghis, president of the European Central Bank, pledged last week to do whatever is necessary to save the euro, saying, ?And believe me, it will be enough.? This statement is important because it speaks to the little known fact that despite the rhetoric and the messy political process, the ECB controls the printing press and theoretically has access to unlimited Euro Dollars.
Although the European region will continue to be a source of uncertainty and volatility, we favor the region?s equity markets for long term investors. Our European equity position, which includes over 400 of the world?s largest companies, provides a dividend yield of more than 4% and is trading at deep discounts to historical averages. Europe has been and will continue to be a case of three steps forward, two steps back, but the overall fear should slowly dissipate, reversing some of the pressure on the financial markets.
Portfolio Strategy
Stocks and bonds continue to trade at valuations that, in some cases, resemble those not seen since the 1950?s. This is clearly reflected in the Price Earnings Multiple (a valuation measure for stocks) of the U.S. Stock Market, which is trading at a lower multiple than what has been typical in past recessions. This is extraordinary given the fact that we have experienced 12 consecutive quarters of economic growth. Investors are so fearful of the unknown that many are actually purchasing 10 year U.S. treasury bonds with a negative real yield (net of inflation). If we use the earnings yield as a valuation measure (earnings divided by price), the stock market is cheaper today than the week following the Lehman Brothers bankruptcy, September 11th, the stock market crash in 1987 and the Cuban Missile Crisis. This leads us to believe that the remainder of 2012 will be directed more by emotions and headlines and less on fundamentals. This creates an enormous opportunity for investors with a longer term time horizon. As an example, when Mario Draghi pledged to defend the euro this week, investors exhaled and stock markets around the world skyrocketed in euphoria. This begs the question of how much bad news could be priced into the financial markets. If the news is slightly less dire, we should see relief and a move toward more normal valuations, creating a headwind for bonds and support for stocks and residential real estate.
Our antidote during these uncertain times is to focus on diversification and dividends. We continue to focus on yield across our fixed income and equity portfolio, which has proven to be a good strategy in 2012. Standard and Poors expects dividends to set a record this year as companies distribute their record cash surpluses. We expect to continue to see companies repurchase their stock, increase dividends and make acquisitions which provide support for equities. We feel interest rates will eventually rise as central banks reverse their bond purchase programs and fear subsides, creating a headwind for fixed income. With this in mind, we continue to position our fixed income portfolios defensively against interest rate exposure.
July 31, 2012 tcallan Quarterly Newsletter, Trevor Comments OffCallan Capital Q2 2012 Newsletter
By: Tim Callan
We are off to a great start in 2012 with the S&P up over 10% in the first quarter giving back only about 2.5% during the month of April. The S&P is up 108% (120% if you include dividends) since it bottomed in March 2009.
Opportunities
During this period, many investors have remained on the sidelines fearing volatility. Currently, $9.9 trillion of investor funds sits in savings accounts, money market funds, certificates of deposits etc., earning near zero return. To put that in perspective, total mortgage debt outstanding in America is $9.8 trillion. We are now within 10% of the market highs set in 2007, and many investors fear that the current rally is over. A pull back after such a significant gain would be normal. However, fundamentals suggest the market still has room to grow long term. Large U.S. companies have never been more profitable than they are now, and they have never hoarded so much cash either. The forward price to earnings multiple is 13 times, which represents a 17% discount to the valuation at the peak of 2007 and a 50% discount to the valuation at the peak of 2000.
As companies continue to hoard cash, they experience increased pressure from investors to return it to the shareholders through either share buybacks or increasing dividends. For the S&P 500, buybacks are up from $50 billion in 2009 to $120 billion in 2011 and dividends have increased from $80 billion in 2010 to over $140 billion in 2011. We expect 2012 to set a new record for dividends and buybacks with growth of over 20%.
Economic Growth and Employment
The economy continues to grow, albeit slowly. The fourth quarter gross domestic product increased 3% on an annualized basis and we expect between 2.5% – 3% growth for 2012. We continue to see job growth around 200,000 jobs per month, (excluding March which came in at 120,000 jobs) and we stand at an 8.2% unemployment rate. At the current rate of job growth, we likely won?t see full employment until 2016.
Unemployment varies drastically by education level. The unemployment rate for those without a high school degree is 13%, while those with college degrees have an unemployment rate of 4.2%. Many individuals start college and for various reasons, mainly financial, never finish. There?s not a big difference between those with high school diplomas and some college experience versus those with high school degrees and no college experience, 7.3% versus 8.3% respectively. As a result, it?s more important than ever that parents plan for continuing education for their children.
Risks
The 4th quarter of 2011 saw significant fears of another global recession stemming from the European debt crisis. However, those fears have subsided. The ECB injected over $2 trillion into the banking system in the 4th quarter preventing another Lehman style disaster in the region. As a result, we expect the European recession to be milder that we previously thought for the major economies of France and Germany. However, risks still remain especially in the peripheral countries of Greece, Italy, Spain and Portugal as they fight to keep their borrowing costs under control.
Other risks are still in play. A tremendous amount of political pressure exists to cut the mounting U.S. deficits by a large amount in a short period of time. If nothing is done by the end of the year, $500 billion in austerity measures will take effect in 2013 which, if legislation doesn?t change, would push the economy into recession. For example, the Bush tax cuts are set to expire at the end of this year causing tax increases across the board. In addition, part of the debt ceiling limit increase agreement reached in July 2011 creates $1.2 trillion in spending cuts over 10 years starting in 2013. The best way to reduce the deficit is gradually rather than immediately. Congress will likely come to an agreement to change this after the presidential election.
The other risks we see pertain to oil prices. Oil is now trading at $104 per barrel up from $45 after the crash in 2008. Oil currently represents a 3.2% drag to our GDP growth. For every 30% increase in oil, it reduces our GDP growth by 1%. We do see risks with Iran, which provides about 4.9% of the worlds oil supply. The U.S. is increasing sanctions on Iran effectively cutting the supply of the market and putting upward pressure on prices. The world economy can withstand a 4.9% cut and continue to grow. However, Iran has threatened to shut down the Strait of Hormuz where 18% of the world?s oil travels. They don?t have the military capabilities to do this for a long period of time but they can certainly cause havoc in the oil markets if they attempt to do so.
Despite the current market rally and risks, we continue to think that riskier assets, i.e. stocks, will outperform risk-free assets, i.e. treasury bonds and we continue to position our portfolios to reflect this.
May 1, 2012 tcallan Quarterly Newsletter, Tim Comments OffCallan Capital Q1 2012 Newsletter
By: Tim and Trevor Callan
2011
The year 2011 started with promise as the US economy was gaining momentum. Gross Domestic Product (GDP) was growing at about a 3% rate, and the unemployment rate was dropping from its peak of 10% as we were adding about 150,000 jobs per month. Stocks started the year relatively inexpensive, trading about 13 times forward earnings, while treasury bonds looked extremely expensive, with the ten year bond yielding 3.3%.
In hindsight, 2011 was a year full of unexpected events. The year started with the Arab spring, which drove oil prices from$90 per barrel to $111 per barrel. This was followed by a Tsunami in Japan, which derailed global manufacturing for months. Volatility spiked in the 3rd quarter as a result of a political deadlock over the debt ceiling and discussions about a potential U.S. default. A downgrade of the U.S. Treasury followed in conjunction with a revival of the European Debt Crisis. This confluence of events created fears of a second recession and a near bear market in equities, with a decline of roughly 18% in only three months.
During this global uncertainty corporate profits grew by more than most analysts expected. The 500 largest companies in the United States (S&P 500) grew their earnings from $22.60 per share in the first quarter of 2011 to a record of $25.29 per share in the third quarter (a growth of over 14%), and the fourth quarter results are expected to be even higher. Despite this record surge in earnings, due to global unrest, stock prices did not see correlated returns and the S&P 500 closed within 3,000th of one percent of where it traded on January 1st. During this same time, the 10-year treasury became more expensive as it rallied and yield fell to 1.89%. As a result, we ended last year with stocks even more inexpensive and bonds even more expensive (on a relative basis).
2012 The Year Ahead
Close analysis of the national and global financial markets suggests that the U.S. economy will continue to experience tepid growth and manage to avoid a recession in 2012. It is likely Europe is in a recession, which we believe will last until mid-2012.
As we enter 2012, we face a world of extremes in both fear and valuations, and we feel the fear of future bad news may be already largely priced into the market, as investors are expecting more bad news to come. While there is no shortage of potential risks, both stocks and bonds are trading at valuations that, in some cases, resemble valuations not seen since the 1950?s. This is reflected in the Price Earnings Multiple (a measure of valuation for stocks) of the U.S. Stock Market, which was trading at 9% less than what has been typical in recessions. Although consumer confidence has been improving as of late, the consumer feels almost as pessimistic today as when they were at the depths of the credit crisis, a confidence level we have not experienced since 1980.
US Outlook
Even with all this uncertainty, U.S. consumers have not changed their behavior. Vehicle sales increased from 12.2 million in July to 13.6 million in November (annualized). Heavy truck, chain store sales and durable goods orders all increased in the third quarter. Consumer sentiment is still low, but it has been improving. The unemployment rate has fallen to 8.5%, with 200,000 new jobs added in December. The news in housing is poor, but housing starts rebounded 15% in September and continued to rise through November. Manufacturing is still low, but has been gaining momentum measured by both ISM Manufacturing Indices.
In the U.S., fears abound regarding our deficits, but we do not believe our ability to service this debt is the biggest risk our nation?s economy faces. As a percentage of GDP, our debt owed to the public is approximately 65% today and is scheduled to increase to 85% before leveling out under the current budget. These levels are high, but are manageable and much lower than we experienced following World War II.
We believe the risk to the economy over the short term is the amount of fiscal austerity scheduled over the next 12 months with the phasing out of the Bush tax cuts. According to the U.S. Treasury, we are scheduled to lower our annual budget deficit from 8.5% to 6.2% of GDP in 2012. This large dose of fiscal austerity from tax increases could create a headwind for our economy.
Despite these headwinds, we believe economic growth is sustainable. Recessions are typically induced by overcapacity, which leads to a contraction in the cyclical parts of our economy[J1] , and as we are currently operating in an already reduced capacity, a further contraction is unlikely. As a result, U.S. auto sales, inventories and housing starts are growing from their previously low numbers. In addition, the consumer?s balance sheet has dramatically improved, as evidenced by the average Equifax credit score and the historically low debt service ratio (debt payments as a percentage of disposable income). Savings rates have increased, and liabilities have generally decreased due to loan modifications and historically low interest rates.
These considerations guide our baseline assumption that the U.S. economy will experience more of the same tepid growth and manage to avoid a recession in 2012. If our baseline assumption continues to unfold and fear starts to subside, valuations in the financial markets will likely move towards a more normal level, creating support for stocks and headwinds for bonds.
Europe
As usual, there are plenty of risks that can easily derail a fragile recovery. The lack of cohesive leadership among the European Troika has caused tremendous confusion and uncertainty, and the financial markets reflect the chaotic environment. They have failed to implement the measures needed to contain an orderly default that is necessary to calm the markets. If current conditions persist, we feel that the European Financial Stability Facility (EFSF) and, ultimately, the European Central Bank (ECB) will step in.
While Greece is small enough for an orderly default, Italy is not, and a worsening financial condition would need to be addressed with unlimited financial firepower. Unfortunately, we feel the European leadership has missed the mark by touting the EFSF as the liquidity firewall that will keep the Greek crisis from spreading to Italy and others. The EFSF is undercapitalized, and although there are several plans for leveraging the funds to the trillion euros they predict will be needed, the details fall short of reality.
Ultimately, we believe the ECB will be the liquidity pool that will keep the European crisis from chaos even though Mario Draghi, the new President of the ECB, has made it clear that governments should not rely on ?external? help and that the ECB?s role is to manage the Euro and provide price stability, not serve as a lender of last resort to governments. Similar to the Federal Reserve in the United States, the ECB has the unique benefit of controlling the printing press. Conceptually, they can print an unlimited amount of Euro Dollars[J2] , and we believe they would step in as the ultimate nuclear option if needed, which would ultimately help stabilize the region if the financial condition should continue to deteriorate. Currently, the Stoxx 600 trades at approximately 10 times estimated profits, a discount of 16% to its average price earnings ratio over the past five years, according to Bloomberg, and though volatility will most likely continue as these countries slowly find a solution, we believe patient investors with some exposure to Europe will ultimately be rewarded.
Fixed Income
Treasury bonds are extremely expensive, trading at levels we have not seen in over 50 years. While bonds have provided nice returns through these volatile times, we continue to believe the bull market in bonds is coming to an end and continue to be defensive against rising interest rates. We have added floating rate senior bank loans and high yield bonds to our portfolios and shortened our maturities to hedge against higher interest rates.
2012 Strategy
Our antidote during these uncertain times is to focus on diversification and dividends. We believe the search for yield will be the greatest theme for the next few years. S&P expects dividend payments to set a new record in 2012 as companies manage their record cash balances. There are only three things companies can do with excess cash: re-purchase shares , make acquisitions and raise their dividend, all of which are positive for equities.
Dividend payers stand to benefit in coming decades as the baby boomers retire and search for yield, and we feel that building a rising stream of income within our portfolios will help mitigate volatility and help support prices over time as these income streams rise. We have, therefore, added the Dividend Aristocrat portfolio, which is a group of high dividend companies that have each raised their dividend for 25 consecutive years.
Lastly, as I write this report, we are celebrating our five year anniversary, and I would like to personally thank you for supporting our company. We appreciate the trust you have placed in us and look forward to 2012.
A World of Extremes
by Trevor Callan
Close analysis of the national and global financial markets suggests that the U.S. economy will continue to experience tepid growth and manage to avoid a recession in 2012.
This past month marked an auspicious milestone for the U.S. Stock Market, which, as measured by the S&P 500, lost 7% in September. The S&P 500 index experienced five consecutive down months, which has happened only two other times since 1990. The stock market fell 14% for the third quarter and has helped drive consumer confidence to historic lows.
Consumer confidence took a hit in the third quarter for several reasons. Initially, it was the uncertainty created by the political fighting over the U.S. debt ceiling and the subsequent downgrade of our sovereign debt. This was coupled with the constant stream of news out of Europe, gradually revealing that Greece is, in fact, insolvent, and a default is inevitable. When you add a series of economic reports covering the second quarter that increased fears of a self-induced recession, we experienced panic selling and historic volatility.
As we enter into the fourth quarter, we face a world of extremes in both fear and valuations. We have no shortage of potential risks. Both stocks and bonds are trading at valuations that, in some cases, resemble valuations not seen since the 1950?s. The consumer is feeling as pessimistic today as they were at the depths of the credit crisis, a level we have not experienced since 1980. The Price Earnings Multiple (a measure of valuation for stocks) of the U.S. Stock Market was trading at 20% less at the end of third quarter than what has been typical in recessions, which begs the question, how much bad news is already reflected in the prices of stocks?
With all this uncertainty, U.S. consumers, so far, have not changed their behavior. As an example, vehicle sales increased from 12.2 million in July to 13 million in September (annualized). Heavy truck, chain store sales and durable goods orders all increased in the third quarter. Inventories and unemployment claims have not moved in a negative direction. The news in housing is awful but housing starts rebounded 15% in September. The U.S economy even managed to add jobs in September, measured by 103,000 new payrolls, a number lower than desirable but growing nonetheless. Despite all of this uncertainty, the economy has continued to grow in a painfully slow fashion, and we anticipate more of the same in 2012.
Recessions are typically induced by overcapacity, which leads to a contraction in the cyclical parts of our economy. Auto sales, inventories and housing starts are growing, but at such low levels, it would be difficult to send them lower. In addition, the consumer?s balance sheet has dramatically improved since the credit crisis, as evidenced by the average Equifax credit score and the historically low debt service ratio (debt payments as a percentage of disposable income). Savings rates have increased, and liabilities have generally decreased due to loan modifications and historically low interest rates. These considerations guide our baseline assumption that the U.S. economy will experience more of the same tepid growth and manage to avoid a recession in 2012. If our baseline assumption continues to unfold and fear starts to subside, valuations in the financial markets could move towards a more normal level, creating support for stocks and headwinds for bonds.
As usual, there are plenty of risks that can easily derail this fragile recovery. In Europe, the risk is not Greece defaulting, but rather the lack of cohesive leadership among the European Troika. They have failed to implement the measures needed to contain an orderly default that is necessary to calm the markets. In reality, Greece makes up only 3% of the European economy, and their aggregate debt could easily be absorbed by the stronger economies. The European Union has made a series of mistakes, first by mandating strict austerity measures on Greece, forcing the country into a deeper recession and ensuring an eventual default. We believe that they are slowly grasping the reality that they need to restructure the debt and then provide unlimited liquidly to back the other countries and banking system. They have promised to have a plan on Wednesday, October 26th, and we would not be surprised if the plan disappoints a world eagerly awaiting something of substance. Volatility will most likely continue as these countries slowly find a solution, but we believe patient investors with some exposure to Europe will ultimately be rewarded. The European stock market is trading at approximately eight times earnings and has a dividend yield of more than 5%. Our top four equity positions in Europe, Royal Dutch Shell, HSBC, Novartis and British Petroleum, have generated, on average, over $215 billion in revenue and $18 billion in net income over the last 12 months. These are extreme numbers and valuations that occur in a world of fear and uncertainty.
In the U.S., despite fears about the aggregate amount of our deficits, we do not believe our ability to service this debt is the biggest risk our nation?s economy faces. Our debt owed to the public as a percentage of GDP is approximately 65% today and is scheduled to increase slightly before leveling out under the current budget. These levels are manageable and much lower than our nation experienced following World War II. We believe the risk is the amount of fiscal austerity scheduled to hit our economy over the next 12 months with the phasing out of the Bush tax cuts. According to the U.S. Treasury, we are scheduled to lower our annual budget deficit from 8.5% to 6.2% of GDP in 2012. This large dose of fiscal austerity from tax increases could create a headwind for our economy.
Treasury bonds are extremely expensive, trading at levels we have not seen in over 50 years. While bonds have provided nice returns through these volatile times, we continue to believe the bull market in bonds is coming to an end and continue to be defensive against rising interest rates.
When faced with a world of extremes in fear, uncertainty and valuations, we believe maintaining a balanced portfolio through these volatile times will prove to be the winning strategy.
October 26, 2011 tcallan Quarterly Newsletter, Trevor Comments OffDiversification – A Prescription for Volatility
Diversification - A Prescription for Volatility
August 5, 2011
By: Trevor Callan
Turmoil in the stock market has the ability to create fear and cause investors to question their investment strategies. Unfortunately, market corrections never happen when the financial news is positive. With the Dow Jones Industrial Average down by more than 10% from its recent high, we are, by all measures, experiencing a major correction in the stock market. The onset of a market correction, along with the barrage of media coverage, can easily drive investors off course. Maintaining a diversified investment strategy for an appropriate period of time is more important than ever during turbulent times.
The selling pressure in the stock market might not be over, but our message is resolute. While we can?t forecast the direction of the stock market over the short term, we do believe that over a market cycle, the American economy will continue to prevail. Diversification works and is our antidote for volatility. While stocks have erased all of their gains for the year with this latest round of panic selling, our bond portfolios are up over 6% year to date. Despite this sell off in the stock market, our diversified portfolios are up between 5% and 8% over the last 12 months through yesterday demonstrating the resiliency that comes with diversification (capital preservation to aggressive growth).
The fundamentals suggest the stock market is undervalued and the bond market is overvalued for investors with an appropriate time horizon on their portfolios. Like past corrections, investors are assuming the selloff is predicting a deep recession to come, but we question this premise.
There is no doubt that the tone of U.S economic data deteriorated in recent weeks, indicating a softening in the pace of activity. The uncertainty surrounding Europe?s debt crisis has added to the fear driving this volatility. However, near-term effects of Japan-related supply-chain disruptions, severe weather and high oil prices in the first quarter may have created temporary distortions in some data. Japanese production was down 15% in March but has rebounded 12% over the next three months which should start showing in economic data as companies restock inventories. Conditions in several key areas have remained solid:
- Companies continue to exceed their earnings estimates and it looks like the second quarter will mark the most profitable quarter in U.S. history for corporations.
- Employers added 117,000 more jobs in July which was more than forecast and eased concerns the U.S. economy is turning over. Initial jobless claims are at 400,000 down from 478,000 in the month of April.
- Car and truck sales were up 6.9% in July over June and chain-store sales were up 4.6% over the last 12 months in July.
- Although the U.S. Manufacturing Index was lower in July, it was the 24th consecutive month of manufacturing growth.
- The Federal Reserve is still running a very accommodative monetary policy with the funds rate near zero which provides fuel for the economy.
Many worry about government spending and the most recent budget compromise. While our politicians made plenty of mistakes and have created uncertainty in the financial markets, we believe we are finally at a turning point with our budget. Government spending as a share of GDP is now scheduled to fall by about 2% of GDP over the next 10 years even without any further changes.
Over the last 19 years of managing marketable securities, we have seen markets like this and the outcome is always the same. Changing course while the financial markets are in turmoil has never proven successful while holding a diversified portfolio for an appropriate period of time has always been the most profitable approach.
Trevor Callan
August 9, 2011 tcallan Trevor Tagged with Trevor Callan 2 comments
Playing With Fire – US Debt Ceiling
Playing With Fire
By: Trevor Callan
July 28th, 2011
As recently as two weeks ago, it seemed highly unlikely that Congress would be unable to pass legislation to avoid a default on our government?s obligations. The current dispute in Congress is focused on the timing of the next debt ceiling negotiations, which is more politically driven and much less to do with the ultimate austerity of our nation. Given the political objectives driving the negotiations, and the potential financial implications from the uncertainty of our sovereign, Congress seems to be playing with fire. We continue to expect a budget agreement and an increase in the debt ceiling, though it is becoming more likely this will occur after the current deadline of August 2nd. We now believe that the rating agencies might downgrade the U.S. to AA from its longstanding AAA rating. It is very difficult to model the financial impacts of such an impasse, but the following summarizes our current position.
Initial reactions to a downgrade may be dramatic, but we do not expect it will be as significant as many have predicted. The U.S Treasury Department may have enough cash to pay the government?s bills for days or even weeks if Congress fails to raise the debt limit, in part because tax revenue is coming in higher than forecast. August 2nd is the deadline date for the government?s ability to borrow, not the date when it runs out of money, which is ultimately what matters. The extra cash may help avoid a default and provide Congress the time necessary to finalize a budget plan.
History shows a mixed effect to the stock market when a nation?s debt rating is downgraded from AAA. Japanese equities fell 7% over six months following S&P?s downgrade in 2001, but this was a period of global stock market weakness. Australia (1987), Spain (2009), and Ireland (2009) all delivered positive six-month returns following their downgrades.
Equities already appear to be discounting a significant amount of risk, and a downgrade does not give markets new information about the underlying creditworthiness of the U.S. As of June 30th, prior to the better-than-expected earnings reports for second quarter earnings, the stock market was trading at only 12.4 times forward earnings. Historically, the stock market has traded at 16.4 times forward earnings. To put this in perspective, the market would need to rise by over 30% to trade at the average of 16.4 times earnings. The current equity risk premium is roughly two standard deviations above its average over the past 25 years (occurs less than 5% of the time over the last 25 years).
High-quality companies with dividend yields competitive with government bond yields would become more attractive relative to a slightly lower quality Treasury bond. Corporate balance sheets are very healthy, as cash as a percentage of assets has more than doubled over the past two decades.
The dollar will most likely continue to weaken, but we do not expect this to fundamentally reshape the importance of the dollar as the world?s currency. The surge of the Euro above 1.45 is also a result of the current confidence in the most recent attempts by the European Union to work through their debt crisis. Europe faces its own problems, so their currency does not provide an adequate alternative to the dollar, nor does any other currency at the present time.
We have been cautious in the bond market for some time, and the potential downgrade of the U.S. credit rating only reinforces our opinion. We expect pressure in the upcoming weeks on the U.S. Treasury bond but do not anticipate a sharp selloff. While other countries have lost their AAA rating, they have not held the significant role that the U.S. currently plays in the global financial markets, so the impact is difficult to model. AA rating is not ?risk free,? but it still represents a very high quality asset and will most likely be high enough to retain the majority of money looking for conservative options.
The implications in the municipal markets have been muted to date. The ultimate implications will vary by credit based upon the reliance on federal payments. Credits like pre-refunded municipal bonds, which are secured by escrow accounts funded with state and local government bonds, will most likely be downgraded with the U.S. rating downgrade. Highly-rated general purpose state and local governments relying on federal aid for a large percentage of their budget will be subject to scrutiny by the rating agencies.
Although we are headed into uncharted territory with the current impasse in Washington, we believe our current process-driven, highly diversified approach to the financial markets is the best way to move through early August and beyond.
July 29, 2011 tcallan Uncategorized Tagged with Debt Ceiling, Trevor Callan Comments OffService Is the Source of Success For Wealth Management Firms
This article was published in the San Diego Business Journal on June 13th, 2011 – Link
FINANCE: Trust, Communication Are Vital Components
Whether it?s in the form of new hires, expanded offices or increases in assets managed, large and small companies on the San Diego Business Journal?s Wealth Management Firms list are thriving.
Topping the list is Merrill Lynch Wealth Management, which increased its total assets managed from $1.4 trillion in 2009 to $1.5 trillion last year.
Regional Managing Director Joseph Holsinger said the staggering $100 billion increase is partly attributed to the recovery of the markets and the expansion of its service offerings in the form of loans or other access to capital made possible by its affiliation with Bank of America.
Another area of growth focus is expanding the number of financial advisers, with a particular emphasis on recruiting women seeking a second career and those candidates with military backgrounds, Holsinger said.
Tying in with Merrill Lynch?s expansion is innovation in the areas of training staff, developing teams to work with clients, fostering one-on-one relationships and investing in technology.
Thinking Ahead
?We like to think we?re always innovative,? said Holsinger.
New York-based Merrill Lynch has 15,000 financial advisers globally, with 43 offices in the Southwest region. Locally, its four offices are located in La Jolla, San Diego, University Towne Center and Rancho Bernardo.
Former Merrill Lynch employees who took the leap to start their own boutique firm in January 2007 make up Callan Capital, the No. 18 ranked firm on the Wealth Management Firms list. The six-employee, La Jolla-based firm is run by three brothers, Trevor, Tim and Ryan Callan. The bulk of client relations are handled by Trevor and Tim, with Trevor involved in asset management and Tim specializing in financial planning. Combined they work with 78 households and delve into a variety of estate planning analysis, tax minimization, life insurance and risk management services.
?It?s a very comprehensive, holistic service we provide,? said President Tim Callan, who has a decade of experience in the industry. Trevor has been in the field since 1994 and Ryan since 2002.
Accustomed to working with affluent clientele at Merrill?s Private Banking and Investment Group, the brothers carry over their expertise working with entrepreneurs exiting businesses and executives of publicly-traded companies. They set the minimum investment account at $2 million, and they charge a flat advisory fee for their services rather than commissions.
Their strategies seem to suit them, with steady growth in assets managed from $100 million at startup to $205.8 million in 2009, increasing to $323.9 million last year to roughly $350 million in assets under management currently, Tim Callan says. Last year Callan Capital raised close to $65 million in new client assets, according to Tim Callan, and the additional growth is attributed to market appreciation.
Tim Callan says that the firm has had a positive reaction from the negative publicity surrounding the credit crisis that hurt its largest competitors.
Favorable Opinion
?We were able to compete very well and continue to do so because of that,? he said, adding that small, intimate firms have been gaining favor.
?It?s a trend that?s been happening for quite some time. It started after the dot-com bubble. Independent firms started to gain market share. That?s why we started the company after Merrill ? to get ahead of that trend.?
Callan Capital?s growth streak continues with the recent hiring of a business development director and the expansion of its offices from 1,500 square feet to about 3,000 square feet using available space next door on Prospect Street.
Further down the Wealth Management Firms list at No. 27 is Pacific Wealth Management LLC, which experienced a growth in total assets managed from $179.6 million in 2009 to $187.3 million last year.
Pacific Wealth Management, with six employees, follows a similar pattern to Callan Capital in that it provides fee-based asset management services to mostly high-net-worth families, primarily in the Southern California region. Offerings range from financial planning services to life insurance risk analysis. The minimum investment account ranges from $500,000 for an individual to $1 million for institutions.
Founded in 1998, the Carmel Valley area firm has established 240 client relationships. Pacific Wealth Management Managing Director James Kuntz says they focus on wealth preservation, and incorporate risk management as part of the plan.
?We measure and quantify risk in the market at any one time,? Kuntz said. ?In 2008, we had already significantly reduced our stock market holdings because wealth preservation is our goal.?
Kuntz and Managing Director Mark Hill say they?re dedicated to client relationships and meet with them on a quarterly basis or as needed.
?Our clients appreciate that we put a lot of energy into high-touch service,? Kuntz said. ?We communicate exceptionally well with clients and people appreciate that, especially when the market is going through the level of volatility it has in the last few years.?
Kuntz says the firm benefited from the financial crisis in some respects because they were effective at managing risks leading up to it; he also believes the appeal of the financial strength of big banks has faded. Kuntz says his firm provides a viable alternative to the big brokerage firms and is purposely keeping a stable group of four advisers.
?We probably will grow our firm over the next five years but not dramatically,? said Kuntz, whose business was relocated to its larger High Bluff Drive site from a nearby location about a year ago. ?We?re just growing our client advisory base.?
June 14, 2011 tcallan Tim 1 commentEconomic Uncertainty, Earthquake in Japan, Democracy in the Middle East: Where Do We Go from Here?
This article was published in San Diego Newsroom on April 21st, 2011 – Link
By: Tim Callan
The first quarter of 2011 was filled with political and economic uncertainty. We saw the beginning of a political shift toward democracy in several countries in the Middle East, a civil war in Libya and a devastating 9.8 earthquake in Japan. So how was it that in the face of all of this news the S&P 500 increased by 5.9% in the first quarter?
The market continued to climb because investors recognized the market was trading at a discount relative to earnings. We have experienced exceptional earnings growth over the last two years, and Large Cap S&P 500 companies are close to record earnings set in 2007. With the most recent Q4 earnings report of $21.92 per share, we believe it is likely that sometime in 2011, corporate earnings will surpass the previous record of $24.06 set in Q2 2007. Large Cap US stocks begin the second quarter of this year trading at a 20% discount to the historical average price to earnings multiple. However, small cap US stocks are trading at levels consistent with historical valuations. As a result, we favor large-cap US stocks over small-cap US stocks, and we made shifts in our client portfolios in February to reflect this belief.
The US economy is well into an expansion phase. During our most recent recession, $554 billion economic output was lost from October of 2007 to March 2009. We are now 25 months into the recovery and gained $571 billion in economic output. However, the expansion is slower than we would expect after a recession as large as we experienced, with fourth quarter GDP growth annualized at 3.1%. Housing remains the biggest reason for the slow economic expansion. With interest rates and housing prices declining, housing is now the most affordable it has been in over 30 years. However, in the last five years home equity has declined from $13 trillion to $6 trillion. While many Americans can afford the monthly payment of a new home, lending standards have tightened and many Americans cannot come up with the down payment. As a result, the rental market is expanding dramatically, causing rental vacancies to decline and rent prices to increase.
Emerging markets experienced the mildest recessions and the shortest recoveries of the world economies. They continue to adopt low interest rates and easy money policies despite the fact that inflation is creeping up in the developing world. Increasing commodity prices have been the largest contributor to rising prices in emerging markets, and there is cause for concern for countries such as Russia, India, China and several in South America. In addition, their valuations relative to the developed world are well above normal. We have reduced our exposure to emerging markets due to valuation and inflation concerns.
Unemployment declined in the first quarter from 9.8% to 8.8%, which is back to levels seen in November 2010. Nonfarm payroll employment increased by 216,000 jobs in March, bringing the number to 1.8 million jobs gained since the recovery began. However, this remains a small fraction of the 8.8 million jobs lost during the recession. If our economy continues to add an average of 200,000 jobs per month, it will take three years to reach full employment. If we add jobs at typical recovery levels, it will take four years to reach full employment.
We continue to be cautious on the bond market, especially Treasury bonds. The ten-year treasury yields 3.47%, which continues to hover around the lowest level in 30 years. The rise in Treasury prices can be partly attributable to the Fed?s treasury purchasing program called Quantitative Easing. The current Quantitative Easing program, known as QE2, is scheduled to end in late June. In light of the improving economy, it is unlikely that the program will continue into another round of Quantitative Easing. In addition, investors are beginning to have more appetite for riskier assets such as stocks. Mutual Fund stock flows have exceeded bond flows each month since December of 2010. This ended a pattern of bond flows exceeding stock flows, which began in the middle of 2007. As this pattern continues, we believe it will put pressure on Treasury bond prices to decline and yields to increase.
We believe that bonds in general are expensive. However, some areas of the bond market are more attractive relative to Treasuries. Municipal bonds yield an average of 2.4% spread over Treasury bonds, and, unlike a Treasury bond, municipal bonds provide investors with a tax-free yield. In addition, state and local governments were forced to make big budget cuts and are now are in a surplus of tax receipts relative to expenditures.
High yield bonds also look attractive on a relative basis, paying investors about 5.2% yield over treasuries with default rates of .8%, which is well below the historical average default rate of 4.4%.
Going forward into 2011, we have nearly eliminated our exposure to treasury bonds and increased exposure to municipal, high yield and floating rate debt. Within the stock market, we are overweighting large-cap US stocks over small cap and developed international countries over emerging markets.
April 25, 2011 tcallan Quarterly Newsletter, Tim Comments Off