Since the onset of the financial crisis, the Fed—alongside other foreign central banks—has been providing consistent and enormous amounts of liquidity to the economy. It has been hinting recently that it might stop doing so in a few months as long as certain conditions are realized in terms of growth, inflation and unemployment.

This has important repercussions and the lessons from history invite prudence and caution. Such reversals in the past have been very tricky to manage. Driving US interest rates higher has frequently resulted in a stronger US dollar, while gold, commodities, shares of high dividend stocks (REITS, utilities…), and emerging markets typically decline sharply. Emerging economies in particular have experienced noteworthy disruptions when US interest rates have moved significantly higher (Tequila crisis, Russia’s default…). The last 3 to 4 weeks have already seen some of these familiar patterns as markets anticipate this next move from the Fed.

We are not advocating market timing: you know our position on the subject. We believe we have prepared for this scenario for the past year or so by making the bond portion of your portfolio better able to withstand rising rates. We’ve also diversified in small increments into some investments that should be less volatile in order to weather the changing winds as markets around the world adjust. As usual, despite what we anticipate to be choppy waters, our message is to keep steady with your asset allocation.

Some Facts about US Jobs Being Shipped Overseas

Most Americans believe that US companies relocate their manufacturing plants overseas, and the jobs that go with them, solely to benefit from lower wages and weaker labor standards. However, most business people would tend to retort that these considerations are far from being the only reason to relocate manufacturing facilities. Other important factors include proximity to consumers, customers, or suppliers. The quality and skills of the workforce are important too, and so are taxes, political, and safety issues.

Some interesting data from the Bureau of Economic Analysis, a U.S. Government agency, seems to support a more nuanced picture: first, most investments from US based companies are directed to rich countries (75% in 2011) not low-wage countries (1.3% to China); Second, more than 90% of investment abroad is made to serve local markets—less than 10% of the products manufactured overseas by US based companies make it back to the US market.

Foreign companies reciprocate by creating jobs here in the US, a market that most can hardly ignore: 5.3 million Americans worked for foreign-based companies in 2011, and they earned 25% more than those who worked for the average American company. It appears that foreign companies are not chasing low wages either…

Private Business Opportunities… or Future Tax Write-Offs?

Our clients sometimes receive requests from friends, family members, or other solicitors to invest in a private business “opportunity.”  If you want us to review them on your behalf, feel free to involve Bristlecone (some of you have over the years). Tell the solicitor upfront that your financial adviser will be evaluating any business deal. The advantages are:

• It will take a burden off your shoulders, especially if you may have to say no to someone close;
• We can review the opportunity in the context of your overall financial situation and objectives;
• As financial analysts, we have experience in reviewing businesses and assessing returns on invested capital: we’ll ask tough questions.

We’ll review business plans and private offering documents from an investment point-of-view. If it’s a proposal where we can’t bring valuable insights, we’ll let you know right away.

Enjoy your summer!

Notwithstanding these risk factors, as we near the midway point of 2013, world stock markets are broadly higher.  In fact, U.S. equities lead virtually all developed markets with the exception of Japan, where extraordinary monetary stimulus measures from a newly-elected government have caused the Nikkei index to advance nearly 50% year-to-date (though it’s worth nothing, the Yen has also weakened 17% vs. the U.S. Dollar over the same period).

Why have stock markets done so well?  There is no single answer, but many factors likely contribute.  Central banks’ policy of “financial repression” has kept global interest rates low and forced many investors into riskier assets in search of return.  As we’ve noted previously, yields on so-called “junk bonds” hover near all-time lows.  Recently, Apple Computer completed a record $17 billion bond offering that was thrice over-subscribed despite offering a yield of only 2.45% on 10 year notes (slightly less than the dividend yield on the company’s stock).

Ironically, much of the proceeds from this offering will be used to repurchase AAPL shares (which have bucked the trend of the overall market, remaining about 36% below their September 2012 peak).  Apple had previously announced a $60 billion stock repurchase plan in April, responding to pressure from activist investors to distribute some of the company’s nearly $150 billion in cash.  Looking more broadly, large U.S. firms have increased stock repurchase authorizations 88% year-to-date versus the same period last year.

Meanwhile, the anticipated standoff over U.S. fiscal policy has been forestalled by a budget deficit which is shrinking more quickly than most expected.  Measures of economic activity continue to increase, leading some economists to increase their estimates for near-term U.S. GDP growth, an upward revision reflected in common stock prices.  Finally, reported margin debt (money borrowed to purchase stocks) is nearly back to the levels of the last cyclical peak in 2007, adding further fuel to the equity fire.

In other news, the annual “Woodstock of Capitalism” known as the Berkshire Hathaway shareholder’s meeting was held in Omaha on the first weekend in May.  The Motley Fool has compiled a helpful recap of the Q&A session with Berkshire CEO Warren Buffett and his Vice Chairman, Charlie Munger.

One final story which caught our attention last month was an investigative report from NPR’s “Planet Money” news desk, exploring the reasons behind a stealthy long-term rise in federal disability benefits over the past three decades.  Titled “Unfit For Work”, the piece is a lengthy but fascinating case study on the impact of financial incentives, and reaches some troubling conclusions about the state of the American workforce.

Before we go over recent market developments in more detail and how we are positioning your portfolios for the months ahead, we’d like to share a few thoughts on investment performance and how we pick managers for your portfolio (and ours).

For those eager to keep up with the Joneses, living in affluent areas such as Los Angeles can be challenging since one regularly runs into very wealthy people. The presumption, of course, is that such people must also be savvy investors, sometimes prompting outsiders to wonder whether rich people know something that they don’t.

A good illustration of this situation came up during a neighborhood gathering last summer.  A guest was boasting that, through a fund manager that he had found “thanks to a rich friend of his,” he had been earning close to 20% a year for the past 10 years. Needless to say, his audience was either skeptical or envious: the comparable performance for the broad stock market was about 4% a year over the same period.  The discussion hit closer to home when another guest later asked us whether Bristlecone also had access to managers that averaged 20%.

Although it won’t come as a surprise, the short answer is “no”. None of the equity managers that Bristlecone selected have outperformed the market by a factor of 5 times during the past decade. The long answer is the subject of this letter, for it helps understanding how we pick managers. Our goal is obviously to find managers that have the potential to outperform an appropriate benchmark, albeit on a risk-adjusted basis. For instance, we make adjustments for returns achieved with borrowed money. As most of you know, borrowing amplifies investment returns both on the upside and the downside.

The warning “Past performance is no guarantee of future results” is a required disclosure, yet how many investors pause to reflect on its meaning? It is probably the most important thing to understand: using past performance is not a reliable way to predict whether a manager will beat the market going forward. Despite the fact that there is a whole industry of consultants who analyze 3, 5, and 10-year performance track records, and use all sorts of statistical tools, the bottom line is that all of this work is nearly useless when it comes to determining whether past results were due to skill or luck (…)

Read the full commentary.

Early March brought a new all-time high for the Dow Jones Industrial Average index of large American companies. The closing value of 14,128 on March 5 topped the prior record high set in October 2007, nearly 5 ½ years ago. The S&P 500, a somewhat broader measure, is also within a few points of surpassing its all-time high of 1,565 (also in October 2007). Do these records mean anything significant for you? For the economy?

Yes – The stock market is an indirect and imperfect—but still useful—measure of economic health. More precisely, because stock prices mostly reflect expectations about the future, economists consider the stock market a leading indicator of broader economic health. The fact that the S&P 500 has rebounded 130% (!) since its crisis low 4 years ago is both a stark reminder of just how poor things looked at the depth of the crisis in early 2009 and also a yardstick of the broad improvement since then. Employment, housing, the banking sector – most if not all of the severely broken parts of the economy are much, much healthier today. The impact on individual investors is that many are now closer to being able to meet their retirement and other investment goals, which is a very good thing.

And No – By definition, the headlines don’t tell the whole story, and there’s a whole lot more to the story here. Should investors really be excited that the market is back where it was 5 ½ years ago? Or, for that matter, where it was 13 years ago at the end of the technology boom? Here are a few things to consider when reading the headlines.

• These benchmarks don’t take into account inflation, which is a very real cost for investors who rely on savings to fill in part of their budgets. For some context, to match the real spending power the S&P 500 had when it first crossed 1,500 in March 2000, it would have to be over 2,050 today  (in other words, it would take $1.35 to buy as much goods and services today as $1.00 would buy in 2000).
• On the other hand, the benchmarks don’t take into account dividends, either. Despite the headline S&P 500 level of 1,550 being flat with March 2000 and October 2007, total returns—including dividends—have been about 30% since then: still quite low, but better than nothing.

S&P 500 Price and Total Return with CPI

• The headlines focus on a single figure, the index level, or price. It is way more important to focus on value: what you get for what you pay. Stocks are not cheap today in absolute terms, but the corporate earnings and dividends are substantially higher than they were in 2000 and 2007, so it is fair to say you get more for what you pay today than at those prior points.
• Stocks of major US companies, and particularly the Dow 30, tend to dominate the headlines. For most of you, however, they don’t represent even a majority of your portfolio. Generally speaking, the US stock market has been one of the best performing markets so far in 2013. Global stocks are up, too, but only in the low- to mid-single digits. Emerging market stocks are down so far this year. Perhaps most significantly, because they do represent a major part of so many investor portfolios, large sectors of the bond market have delivered no return (some sectors are even down slightly) this year. A well-diversified portfolio will reflect all these contributors to performance.
• Federal Reserve stimulus, in the form of artificially low interest rates, has no doubt contributed to recent stock market performance. When savings and bonds offer virtually no return, stocks look relatively more attractive.

Understanding what’s going on in the markets and your portfolio requires a deeper understanding than the headlines provide, or that we can provide here. It’s okay for today’s record highs to bring a smile to your face; investors have been put through a lot over the last 15 years. Our goal is to help investors be successful by building portfolios based on a solid long-term plan and outlook that aren’t swayed too much by the highs and lows.

When meeting with prospective clients, we are regularly asked whether our clients’ portfolios are beating the stock market. People are often surprised to hear us answer that we work very hard at making sure that our clients don’t pay too much attention to the market.

Consider two hypothetical clients:  John, a 35 year old single man making $250,000 a year; and Mary, a retired widow living off her portfolio to complement her social security benefits. Why should either of them necessarily care about exceeding the performance of the same biggest 500 companies in the US?

A better approach is to look at the investor’s unique goals and circumstances. John is able to save about $50,000 a year, is not planning on having any children, and would like to retire at age 55. Based on the size of his current portfolio, some conservative assumptions for future returns and inflation, and John’s expected needs by the time he retires, we determine that a 6% average annual return over the next 20 years would allow him to build the necessary nest egg.  Consequently, does it make sense for John to be upset if his portfolio goes up 6% a year while the market returns 10% for the next 3 years? Or should he be delighted if the market ends up returning 5% while his portfolio earned the same 6%? Clearly, what should define success is whether his portfolio is achieving at least the 6% annual return necessary to retire. In other words, the most relevant benchmark for John here is not a market index, but an investment return objective of 6%.

We feel that people who try to measure their investment performance against the market, irrespective of their individual circumstances and goals, are setting themselves up for failure. First, it is unlikely that the stock market is a benchmark whose return and volatility is relevant to their needs. Second, fixating on stock market returns, particularly over short periods, leads to poor decision making. It is like navigating the seas with a manic depressive compass. One needs a steady and realistic road map to properly structure and measure one’s portfolio performance. Once the proper and achievable required rate of return is estimated, the objective should not be to exceed it by as much as possible, but to reach it while taking the lowest level of investment risk.  Remember that next time someone boasts about his market beating stock picks.

Should you worry about the bond market?

The back-up in yields and the drop in bond prices during January rekindled the fear that the bond market is headed for a crash. To a large extent, as this article from the Washington Post indicates, the fear is overblown. Nevertheless, we anticipate that the coming decade will provide very little real return to bond investors as rates are more likely to rise—and bond prices to fall—than to remain at today’s levels. For those of you who have been reading our newsletters, you know that we’ve been positioning the fixed income portion of your portfolio to be less sensitive to a rise in rates. The strategy relies largely on reducing the proportion allocated to funds that own corporate, municipal, and Treasury bonds with the longest maturities, while increasing the allocation to funds that invest in mortgages or bonds that pay variable rates.

We’ve also been diversifying outside of traditional fixed income securities; our latest addition is a variable perpetual note issued by Wells Fargo, a bank whose shares we’ve owned for a very long time in our Large Cap Value portfolios. The note is currently trading well over par and has a coupon of nearly 8%. We expect that it will be called at par once the call protection expires in about 5 years, and that consequently, the premium over par will gradually disappear. Netting the expected principal loss against the income received throughout our term of ownership, we expect the total return to our investors to be in excess of 4% annually, which compares favorably to a 5 year US Treasury bond currently yielding less than 1% per year.

Finally, we wanted to introduce Aimee Han to our clients. Aimee is a 2^nd year college student and was hired as our office assistant a few months ago to help us serve you better. We are glad to have her join Bristlecone. If you wish to say hi, her email is AHan@Bristlecone-VP.com and her extension is #6.

As part of the deal, the automatic spending cuts (“sequester”) which were scheduled to take effect on Jan 1^st were postponed for another two months.  As you might recall, the sequester was originally proposed during the last debt ceiling debate in the summer of 2011.  The logic behind it at the time was that, faced with the threat of draconian tax increases and spending cuts (which neither party wanted) lawmakers would have an incentive to forge a more reasonable long-term agreement. Eighteen months later, it is clear that such a threat is just barely sufficient to keep political opponents in the same room together.  Perhaps not coincidentally, the new sequester deadline is scheduled to arrive at around the same time that the Treasury Department expects to hit the currently authorized debt ceiling, setting the stage for another fiscal dogfight (and likely market volatility) just around the corner.

Read the full commentary.

Comedian David Letterman recently joked: “Everybody is talking about the fiscal cliff. And I’d be talking about the fiscal cliff too, if I knew what the hell it was.” The term “fiscal cliff” refers to an agreement reached about a year ago that was made as a compromise to reduce the growth in public debt: without legislative action, a number of laws will automatically come into effect in 2013. These measures will increase taxes  and cut spending resulting in a deficit reduction of about half in 2013.

• While reducing the deficit would normally be considered good policy, Ben Bernanke, the current Chairman of the Federal Reserve coined the term “cliff”, because he and other economists predict that these automatic measures will lead to a recession in 2013. Considering their track record at predicting the last recession, and all other potential dynamics involved, a more honest answer would be: nobody knows;
• Not often mentioned, some major federal programs such as Social Security and Medicaid are exempted from the automatic spending cuts. Due mostly to demographic factors– retiring baby boomers, lower birth rates, and longer life expectancy –  these two programs, with Medicare, account for the biggest reason why federal spending is expected to keep growing as a percentage of the size of the economy. The reality is that any serious attempt at reducing the causes of future deficits needs to include a review of these programs, particularly Medicare and Medicaid;
• Deficits are created when spending (outlays) exceeds revenues (tax receipts). The last time we had a balanced budget was at the end of the Clinton administration when outlays and revenues were both in the neighborhood of 18% to 20% of GDP. From the end of the Korean War through 2000, tax revenues hovered mostly between 18% and 20% of GDP, while spending fluctuated more wildly between 18% and 24% of GDP (see chart below. Source: OMB). Today, following the recession, tax receipts have fallen to 15% to 16%, while spending has surged to about 25%, a new post-war record;

  
  

• There are two primary reasons for tax receipts being lower today: the contraction in the economy and the famous Bush tax cuts. Recent estimates from both the White House and Congress show that as the economy recovers, tax receipts would creep back up to 18%-19% of GDP, even if the 2001 and 2003 tax cuts were made permanent. Importantly, expiration of the tax cuts for the rich (top 2% of wage earners) represent less than ½ % of GDP. Raising tax receipts to get back closer to 18% to 20% of GDP, without help from a  recovering economy, will require raising taxes for everyone, including the middle class;

• Historically, in the U.S., every major economic disruption has led to a new higher level of federal government spending as a percentage of GDP: the Civil War, World War I, the Great Depression, World War II, the Korean War and the Oil Crisis. Government programs that were implemented on a temporary basis remained, and the tax schemes created to fund them survived as well. The recent recession also led to a new peace-time record in federal spending. With the addition of a new health care program (Affordable Care Act or “Obama Care”), new taxes will come into effect, and bringing spending back down to previous levels of GDP will require cutting other expenditures in addition to letting stimulus spending expire.

After all the sound bites, partisan bickering and media hype, in order for our government to get serious about debt and deficit reduction, discussions will need to consider both taxation and spending levels going forward that do not hinder economic growth. The Clinton/Gingrich generation of politicians was able to balance the budget without crimping growth. Will the current crop rise to the challenge?  For the Republicans to accept an agreement, government spending will need to be capped at a lower level than current, i.e. closer to 20% than 25% of GDP. For the Democrats to accept an agreement, tax receipts will have to get closer to 20% than 15%. Much of the gap between the two positions could be bridged with robust economic growth, but it would be a mistake for both parties to keep kicking the can down the road and postpone tough decisions. Longer-term, it would result in the same predicament that some European countries are in today: an ever growing level of government expenditures and taxation, resulting in crippled economies.

What does it mean for you? The Tax Policy Center offers a tax calculator that allows users to input their own tax profile and see how they would fare under different scenarios, including the full fiscal cliff going into effect and various alternative proposals.

Financial markets will rise and fall in the next few weeks with positive or negative news about an agreement or lack thereof on how to solve the nation’s deficits. Your portfolios are designed to help you reach your long-term financial goals, based on your time horizon and risk tolerance. Our advice remains to keep your sights on the final destination and try not to be distracted by short-term fluctuations.

Now that the 2012 elections have concluded, investors are parsing the results and their implications for the economy and stock market.  In some respects, the elections clarified important fiscal questions; in most areas, much uncertainty remains.

To begin with, we should note that the presidential election result—in and of itself—tells us little about the future direction of stocks.  As we’ve discussed before, any important piece of legislation needs to find support in both houses of Congress, as well as the oval office.  While the Democrats won the White House and expanded their majority in the Senate, Republicans retained a substantial edge in the House of Representatives.  Political gridlock remains a likely scenario. 

One issue clarified by the election is that efforts to repeal the Patient Protection and Affordable Care Act (aka “Obamacare”) will be put on hold for at least another four years.  That being the case, it is worth revisiting some of the tax changes associated with this law that will go into effect on January 1^st.  The most significant of these is a pair of Medicare tax increases applying to households with adjusted gross income of $250k or more.  There is also a new cap on Flexible Spending Account (FSA) contributions, as well as a higher threshold for itemized deduction of medical expenses.

One issue the elections did not resolve is the looming confrontation over the so-called “Fiscal Cliff.”  As a reminder, when Congress and the President failed to reach a “grand bargain” for long-term deficit reduction during the debate over the debt ceiling in 2011, they essentially kicked the can down the road by agreeing to a set of automatic spending cuts (“sequestration”) to take effect on January 1^st, 2013 if both parties remain deadlocked on a deficit plan.  Complicating matters is that January 1^st also marks the date at which the Bush tax cuts (extended in 2010) are once again scheduled to expire.  Absent legislation in the next six weeks, marginal tax rates will rise across the board in 2013, and taxes on capital gains and other investment income will increase substantially as well.

Already, a broad coalition of business leaders is calling on Congress and the President to reach an agreement on tax and entitlement reform in order to head off a recession which would likely result from the combination of sequestration and tax increases.  Lloyd Blankfein, CEO of Goldman Sachs, wrote in an opinion piece for the Wall Street Journal: “The business community vigorously supports efforts to conclude a bipartisan fiscal accord.  I believe that tax increases, especially for the wealthiest, are appropriate, but only if they are joined by serious cuts in discretionary spending and entitlements.”

Normally at this time of year, we are counseling clients on ways to harvest unrealized losses so as to minimize their taxable investment income.  However, in the current political environment, it seems likely that taxes on dividends and long-term capital gains will increase next year.  In particular, investors with household income in excess of $250k per year may want to consider realizing long-term investment gains on highly appreciated stock before year-end, so as to qualify for the existing 15% rate on long-term capital gains.  As always, individual tax situations will vary.  We recommend consulting with your accountant.

The S&P 500, a broad gauge of US large company stocks, rose 6.4% in the quarter and is up 16.4% through the first nine months of the year. Generally, foreign stocks did as well or better than US stocks in the quarter, but are up somewhat less for the full year.

Read the full commentary

The outcome of the election has little effect on our investment outlook, because the US government and the American economic system have lots of checks and balances in place.  Our view and experience was supported in a recent article (Back to the Future: What’s at Stake for the Economy in the Obama-Romney Contest) by three professors at the University of Pennsylvania’s Wharton School. According to the authors, it is very unlikely that any candidate would win a clear majority that would allow him to pass all of his platform legislation. Additionally, other factors always weigh heavily on the economy and the stock market: the Federal Reserve, lobbying groups, businesses, foreign governments’ economic policies, etc.

Our bottom line advice is: stick to your financial plan. If the psychological pressure is too strong, make small incremental changes and revisit every 6 months or so to check if you still feel the same way. To paraphrase Warren Buffett: over time, it does not pay to bet against America… no matter who is President.

Besides not saving enough, making dramatic changes to their overall asset allocation in anticipation of a market rise or fall, so-called “market timing”, is one of the main reasons why investors fail to reach a financially secure retirement. One other reason is the increasing burden of sending their children to college.  In this useful article from Morningstar last August (Don’t Sabotage Your Retirement to Pay for College – Free registration may be required), the author reviews current financing options and makes some useful recommendations. The Wall Street Journal also pitched in on this subject with mistakes parents and students need to avoid when financing a college education (How Not to Blow it With Financial Aid – WSJ, Sept. 9).

Finally, if the kids are out of school, working, and you’ve saved enough to preserve your lifestyle during your golden years, congratulations! But before you hit the golf course or go trekking the Himalayas, and irrespective of the size of your net worth, this article (5 Estate Planning Tasks That You Shouldn’t Put Off – Morningstar, Aug. 20) is a useful reminder that there are some important steps that you can take to ensure that your final wishes will be carried out.

As usual, feel free to call us if you wonder how the recommendations in these articles apply to your situation, or if you need a referral for a CPA or estate planning attorney.