Signs for Optimism. (Happy Birthday Bro.)

Following a strong start to 2009, equities had a disappointing showing last week, and given everyone’s painful 2008 memories, most investors were probably quick to conclude: “Oh no! here we go again”… But does this reaction make sense? As mentioned in the past, investment returns typically depend on four very important variables:

* Where do we stand on the valuation front? Buying overvalued assets can work in the short term during rising markets, but is hardly a long-term recipe for getting rich. The good news is that today, almost all assets (bar OECD government bonds) are at the very least fairly valued—and many remain very undervalued.

* Where do we stand on the sentiment front? When sentiment is buoyant, company managers are prone to over-reach, take on too much leverage, and jeopardize the long term health of their businesses. At the same time, as the past year has shown, buying assets alongside people who are over-extended can prove highly detrimental… in that forced selling hardly begets rising prices. The good news today is that a lot of the excess leverage has been wrung out of the system—there can hardly be any “weak hands” left. The bad news is that “strong hands” remain hard to identify.

* Where do we stand in the inflation cycle? Changes in prices are a key determinant to asset valuations. In a positive environment, prices remain stable, allowing companies to focus on their core businesses. When prices rise too fast, or decline precipitously, companies worry about their level of inventories, about the ability of their suppliers to continuing delivering, etc… Thus rapidly accelerating inflation, or collapsing prices, typically lead to serious contractions in P/Es (with inflation actually being worse for P/Es than deflation). The bad news today is that we are entering into an overtly deflationary phase, with consumer and producer prices collapsing in almost all major economies. The good news is that this trend may come to a halt sooner than most investors realize as a) central banks are pushing an unprecedented amount of money into the system, and b) the velocity of money, after an 18 month long pull-back, may finally be creeping back into positive territory.

* Where do we stand in the economic cycle? The three measures above combine to form the “P” in the P/E equation. But of course, valuations also depend on the “E”, and earnings are driven first and foremost by the economic cycle. And on this front, the news continues to remain bleak. Whether it be record job losses in the US, contracting retail sales in Germany, or shocking industrial production numbers out of France, there is little on which to hang one’s hat. In fact, the only piece of positive economic news we could rake up is the turnaround in the diffusion index of Asian leading indicators.

So where does all this leave us? On the positive side, most equity markets today are extremely undervalued and “weak hands” and other over-levered investors must have been shaken out by now. This good news is mitigated however by the fact that equity investors, having taken such a beating over the past year, now have little tolerance for pain of any kind. And with the visibility on both prices and economic growth still very limited, and unlikely to get better in the very near term, it is hard to think that equity markets will not remain choppy over the coming quarters. However, if investors do buy into the belief that the combination of an unprecedented monetary loosening, fiscal easing and low oil prices will help the US and Asian economies recover by the second half of 2009, then any significant dip in equity markets over the coming months should be seen as a buying opportunity.

(Courtessy of GaveKal Research)

Back To The Grind...

Ahhh the holidays. Nothing is better than to recharge the battery's and look into the New Year thoughtfully, aggressively, meaningfully, and maybe a bit timidly...

Most of the time, being a financial advisor ranks among the very best careers around. Once you’re over the hump of building an initial client base, few jobs offer the unique combination of being able to make a positive impact on so many lives, the freedom to take lots of time off and an above average income. (in some cases way above average)

And then there are periods like 2008. Your response to those market events was the ultimate measure of discipline and fortitude - as the old cliché goes, it’s periods like 2008 that separate winners from losers.

So now what? The value side of the market, like much of the bond market, is priced for a depression. The growth side of the market is priced for recession. With dividend and other income vehicles yielding in some cases 15% to 20%, and a possible ballooning of the Government fixed-income market(bonds, T-bills, etc.), it seems that applying appropriate risk and re-establishing a long equity position seems justified. (If you have not already done so.)

From their lows, most stocks recovered nicely in December. Yet again proving that accumulating during weakness beats buying into strength, and that market timing is not an intelligent practice. I won't go into company specifics, as you can just as easily open any finance paper and see the performance up till now. It is not industry/sector specific either, however...

Almost everybody, retail investors and institutional investors alike, invests with their eyes in the rear view mirror, favoring what has worked best in the past. But there is a very powerful pattern of mean-reversion in the markets. What has done spectacularly well often takes a rest or it takes a bear market to get back to normal. So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors. That goes for highly sophisticated institutional investors as well. This temptation to buy what has done well is the single greatest pitfall in investing, and it is the single reason that a disciplined approach to asset allocation can actually work very, very well.

Something to consider.

My Value As An Advisor...

To know what clients want, you need to first know what they really value in life. You need to know about their life objectives and their tolerance for various types of investment risk. Then you build a financial plan to give them the highest probability of reaching those objectives while remaining true to their values. I call this enhancing their wealth.

Here's one definition of wealth from Webster's Dictionary: "the things that are most important to you." So when I find out what wealth means for a client, I want to help them create an abundance of whatever that is. Will it be a specific amount of money? No, in fact, I have never had a client who ranked money as number one. What's most important to people are things like their families, friends, health, career, or even spirituality.

When a client engages me as their primary financial advisor, my mandate is clear: Design a plan to take the client from where they are today to where they would like to be. The plan needs to give them the highest probability of reaching their objectives. The plan must also give them more time to focus on what matters most to them.

In addition, as an advisory team, each year we will:

1. Recommend saving strategies. We go over how much they should save (or when retired how much they can spend). If things are tight, we will help find money in their budget to save what they need to. They know that we prefer never to suggest to someone that they need to reduce their lifestyle, unless they really must.

2. Control money management expenses. Performance we can't control, but expenses we can control. We'll never rebalance needlessly to trigger taxes, and that we may rebalance to soak up losses.

3. Reduce taxes. First we will look for deductions or credits. Next we'll look to incur minimal tax on the portfolio by adjusting type of income, as appropriate. Then we will look for any deferral opportunities, and lastly, look for any ways to have income taxed in the hands of the family member with the lowest possible income. It's amazing the many situations in which we can reduce taxes by thousands.

4. Anticipate cash flow requirements. We will make certain they have adequate liquidity to avoid liquidation at the wrong time.

5. Protect net worth. We will be certain that they are protected from an interruption of income as a result of disability or critical illness. It's important to make sure there are adequate funds to protect erosion of what they have accumulated.

6. Keep estate affairs organized. We will suggest any changes that need to be made as the life evolves.

It's quite easy to fall into the performance game... To be measured by ones ability to beat the uncertainties of the market at all times. Investment performance is obviously part of the financial planning equation, but it's the part that we least control. That isn't to say that this mitigates the need for us to use well-defined investment principles and processes, but lack of control of the markets is a constant... I ask myself: What is my value as an advisor worth? (Because I know clients will be asking the same question)

Thoughts on Future Inflation... (M.C.)

We are in the camp that, although what the Fed is doing is inflationary, it will not cause higher inflation for a while (perhaps at least a year or more). That is because commodity prices, earnings, jobs, consumer confidence and economic activity are all in the dumps with not much expectation of a dramatic improvement in the foreseeable future.

However, Alan Blinder, a professor of economics at Princeton and a former vice chairman of the Federal Reserve put it cogently:

“At some point, and without knowing the timing, the Fed is going to have to destroy all that money it is creating. Right now, the crisis is created by the huge demand by banks for hoarding cash. The Fed is providing cash, and the banks want to hoard it. When things start returning to normal, the banks will want to start lending it out. If that much money is left in the monetary base, it would be extremely inflationary.”

It's nothing to bet on yet but, if history is any proxy, the unprecedented stimulus efforts will at some point cause same unintended effects. A world inflation bubble might just be that unwanted love child.

Refreshing Idea's...

The market's going to be tough over the next number of quarters. But there are some incredible deals out there in both the Materials and Energy sectors. You're getting companies at single P/E multiples. I believe in Peak Oil, and when you can buy companies trading at half price sales, you want to buy them!

The small-cap cycles are typically 5 years in duration, and this is the 5Th year that small-caps have underperformed, which isn't surprising given the current credit crisis. In this environment, to succeed, you have to not follow the Index, cut your losers, and keep your winners.

Over all, what's happening now is both Deflation in paper assets and Inflation in real assets. To use Eric Sprott's example: "The price of a house is going down, because you can't borrow the money to buy the damn house! Because nobody wants to issue that piece of paper, because paper's not worth what it used to be..." (Our lovely "dual _flationary" environment)

Remember to stick to your convictions. There are periods where the market doesn't embrace your ideas... Unfortunately you have to wait for the market. You can't change the market. Nor shall we chase the market...

Ballooning Bond Yields... (Velocity of the USD)

Below is a recent ex script from Hong Kong's "GaveKal Daily" regarding the most repeated questions being asked by their global clients today. (An interesting piece I found most appropriate as we approach the end of 2008):

“I just don’t get it! The Fed is out there printing US$ as if paper and ink were about to run out, and yet the US$ surges, oil plummets, gold sucks wind and gold mining shares collapse and yields on long dated US government bonds reach levels that I had never thought I would see in my lifetime! How does this all add up? It makes no sense!” As we see it, there are three potential explanations to the above dilemma:

Option #1: As much as the Fed is printing, the velocity of money is collapsing even faster than the money supply is increasing. As such, the total amount of liquidity in the system is still shrinking, thereby bringing down prices (explaining the low bond yields and the low gold) and activity (low oil). Of course, this situation will not last forever and, once the banks get back on their feet (which admittedly may take some time), velocity will bounce back. At that point, the risk is that the excess liquidity provided by the Fed and other central banks will be multiplied aggressively and that we will move from a deflationary bust to an inflationary boom scenario very rapidly; it will then be very important for the world’s central banks to aggressively withdraw the liquidity that they provided or inflation will become a real economic problem.

Option #2: Looking to markets for any kind of confirmation of deep macro-economic trends today makes little sense as markets are still under heavy duress from forced selling in the riskier assets (i.e., oil, gold…) and forced buying of others (US$, US government bonds…). Indeed, how else could we explain that 3-month bond yields were actually negative earlier this week? If this is not a sign of a bond bubble, then what is? And as we all know, the late stage of a bubble is always characterized by “forced buying”; investors know that valuations make no sense but they are forced, either because of regulations, or simply to keep their jobs, to pile into an asset class. In early 2000, all the indexers and closet indexers had little choice but to buy Nokia, Cisco and JDSU. In the first half of this year, oil and commodities were driven higher by Chinese forced buying ahead of the Olympics (see our book A Roadmap for Troubling Times). And now, government bonds are being bought by banks, insurance companies and pension funds in an obvious attempt to “window dress” the books before the year-end. Thus, in the new year, once the need to “window dress” is behind us, we should expect capital to flow out of bonds and into riskier assets.

Option #3: Contrary to popular belief, the Fed actually has not been printing nearly as aggressively as everyone believes. Indeed, as we tried to show in our latest Quarterly Strategy Chart Book, borrowings from the Fed now exceed the total amount of bank reserves, and thus the reserve component of the monetary base is now entirely borrowed money. The monetary base itself is now a levered figure. Thus, non-borrowed reserves growth has been negative; Bernanke, the pre-eminent scholar of the Great Depression, who knew that the contraction of the monetary base was possibly the most significant policy blunder of the 1930s, sat back and let the unlevered monetary collapse by a third. Fortunately, however, that trend has recently been reversed with the Treasury injecting more than $150bn into commercial banks and taking equity stakes.

As we see it, these are the three possible explanations to the dilemma above. Now the interesting thing is that, whichever option you decide to go with, it will tell you that getting out of government bonds today is not only necessary, but could be urgent.

Something to ponder as you follow your path of due diligence...

Using Discipline in an Undisciplined Environment.

Courage is at the core of every great investor and genuine courage is rare.

Every market climate tests our investment conviction, today's environment is especially intimidating.

For an investor, challenging popular thought is never easy, but the fact is a number of solid companies with good fundamentals lie in the market wreckage.

Greed blinds us to danger while fear blinds us to new opportunities.

This occurs when logic loses out to emotion.

It is one of the principle reasons why it is so hard for investors to buy low and sell high.

Often, even when individuals plan strategically, they deviate from their plan when the market is too challenging or too tempting.

The elements of Investment Discipline:

- Don't chase performance - it can be hazardous to your wealth!

- Act Strategically, not emotionally. Build an investment plan

- Rebalance your portfolio regularly

- Stick to your plan even when your emotions tell you to do the opposite

- Seek experts when you do not have the tools, the time, or the experience to do it yourself.