Document 6514087

Dear Valued Clients and Friends I am not really sure how to even set up this week's commentary. I have tried to
provide a lot of big picture perspective this week, as well as a practical
understanding of what is going through my head every day (and night). There is a
little of info here on short term activity and perspective. I also am planning a
conference call soon to discuss the state of the market, and to get into a very
specific and actionable discussion about what I have been doing and where things
are going from here. I mentioned last week my time in Boston in private meetings
with the team I have significant amount of Fixed Income assets invested with. I met
this week with some of the leading analysts and economists in the country and had a
few of my major theses challenged. I am in town all of next week, and the week
following I will be in New York City for eight days, including over a dozen meetings
with portfolio managers, hedge funds, and major asset management firms covering
such asset classes as Emerging Markets, Dividend Equity, and High Yield Bond
(amongst others). I plan to communicate heavily with you about the illuminations
these meetings present. In the meantime, I hope this week's commentary brings a
calming and useful benefit to you!
So then was the sell-off of the last three days more about the Fed or
Europe?
In this case it absolutely was a combination, but I still believe the story is
primarily about Europe. I went to bed very late Thursday night with the futures
pointing to a 100 point increase in the Dow on Friday morning; I woke up Friday
morning at 4:00 am with the futures still pointing to a 100 point increase; shortly
thereafter Deutsche Bank issued a release that losses on Greek bonds could be more
than expected (7), and by 4:30 am the futures had moved from indicating a 100 point
increase to a 100 point decrease (a 200 point swing with nothing to explain it
besides the European bank issue). I am becoming more and more convinced that
the inevitability of Greek default is so firmly in the mind of most investors that
markets may actually just prefer to get it over with. This very unsettling issue
across the Atlantic is very likely to persist for several months.
In English: The European drama has been, and continues to be, the primary factor
driving the markets. It could be with us for several months.
---------Can you explain again why you don't just sell ALL stocks until this drama
goes away?
It is not my belief that the volatility of the stock exposure I do have is having any
real economic impact on my clients (though I certainly take the emotional and
psychological impact seriously). I do not have stocks in client portfolios where I
believe liquidations of stocks will be necessary to meet their cash flow needs. To the
extent that money is needed for income or spending needs or what have you, my
focus is on income generation from the investments we have (the dividends and
interest income our investments create). To the extent that clients have exposures
to stocks that are intended to grow in value, we maintain ample amounts of
exposure to other assets to allow those risk assets time for their inevitable periods of
volatility (like ones we are in now). So with that said, I believe clients can survive
the equity volatility very easily, and that I will severely hurt them if I try to exit the
markets entirely AFTER a 1,500 point drop. Of course, if I KNEW that the next move
in the markets was ANOTHER 1,500 point drop, it would make sense to try and sell.
But I do not know that, and neither does anyone else (though it certainly is
possible). What the last seven weeks show with incredible clarity is that we are in a
period of unbelievable volatility and that clients will do best to hold their quality
positions, to remain calm, and to trust the plan that is in place (and is being
actively managed for their benefit). I do not know if a recovery of stock prices is
coming in a week, a month, or six months, but I do know that the historical
precedent for not "selling all stocks" is overwhelming, especially in the content of a
diversified, high quality, tactically allocated portfolio.
---------But don't you just think it is obvious that we are going much lower? I can
just feel it...
I do not think it is obvious, but I do think it is possible. What I think is that energy
stocks have gotten hammered, and yet the fundamental thesis I believe in is very
much in place, so I want to patiently hold those energy stocks (which can go up by
much more than 20% and down by the same in quick periods of time). I believe the
financials have gotten beaten, and at this point need to just sit in the back room for
a while (I would agree that they may not come up for a while, but I also believe that
they may not have a lot more room for sell-off). But when someone says that "it
is obvious" everything is headed much lower, I think they are ignoring the
precedent of when has typically happened when Treasury bond rates have
gotten THIS LOW, and when the VIX has gotten THIS HIGH. I believe that the
embedded negativity in the question is understandable, but is not rational. It is a
by-product of incessant media doomsday-ism and also general human nature that in
seeing all of this negative activity it leads us to believe that it will necessarily
continue. History says otherwise.
---------What are the two biggest reasons to be bullish on stocks and what are the
two biggest reasons to be bearish?
The fact that investor sentiment is sooooooo bad is a huge reason for buying
equities, in my opinion (contrarianism 101). When the masses are selling, good
investors are buying. Secondly, robust corporate profits coupled with low earnings
multiples (valuation) is my other major source of optimism. Profits are the mother's
milk of stock investing, and I will never tire of saying it.
---------Okay, so sentiment and earnings are arguments for optimism. What are the
two major reasons to be cautious?
They are both macro, meaning they are "big picture" more than "bottom-up". One is
the volatile state of global financial markets as a result of the debt crisis in Europe.
Don't get me wrong - if Europe's banking system were to collapse, the world would
still march on. Self-interest is a powerful motivator. But the collateral damage of
various negative outcomes in Europe are a serious headwind right now, obviously.
The second reason to moderate my optimism is the fragile state of the U.S.
economy. I do not believe the housing market has been allowed to find its natural
bottom. I believe that policymakers have tried too hard to medicate the patient (the
patient this case being the U.S. economy), and now we really can not say when the
patient is taken off its medication (the medication in this case being the easiest
monetary policy in history). I believe that there is a crisis of confidence in the
general business community, with corporations preferring to hoard cash that yields
them 0% rather than invest in growth out of fear of the unknown (regulation,
expenses, taxes, etc.). The U.S. economy is the beneficiary of a simply unbelievable
growth engine. I do not take it lightly. In fact, in the long run, I have no doubt in
my mind that this will be the factor that pushes us into improved growth and
prosperity. But in the next year, or two years, the macro picture for the U.S. is not
known.
---------So, what forces will win out - the optimism created by sentiment and robust
earnings, or the pessimism created by the macro headwinds of Europe debt
and U.S. economic slowdown?
I don't know. If I told you I knew for sure, I would be lying. I will not ever lie to
you. I may be wrong at times, but I will not lie. In the short term I believe it is
impossible to calculate which side of this discussion will win out.
---------So if the winner of the battle between optimistic tailwinds and pessimistic
headwinds can not be known, what should an investor do?
Invest via a strategic asset allocation that takes into account volatility tolerance, risk
appetite, timeline, income need, and financial personality. Within the allocation,
overweight emerging markets where both of the aforementioned headwinds do not
have as perilous an effect. Be defensive in one's risk capital, seeking the protection
of stock dividends vs. the speculation of pure growth stocks. Be opportunistic but
prudent with your bond investing. Take risk with the capital you can afford to
take risk with, limiting yourself to an allocation that is within a comfort
zone for price volatility. Overweight alternative investments that may give you a
positive return on your money in numerous types of market environments. Use your
financial advisor as a PLANNER, and not just an investment selector, so that these
decisions can be made in the context of a prudent and customized plan for your
exact situation. I think that just about covers it for now. -)
In English: Investors with a portfolio that has been constructed to specifically meet
YOUR needs are going to do much better than clients trying to chase around various
investments. Be defensive, consider alternative investments, allow for adjustments
as conditions warrant, and do NOT allow emotions to damage performance.
---------What is the most interesting effect you see that the August market
problems had in the credit market?
New issuance of bonds has really been hit hard. Good quality corporate credits
averaged about $67 billion of new bond issuance through the first seven months of
the year. August saw just $47 billion come to market. In the high yield space the
drop-off was way more dramatic - $23 billion has been the average new issuance per
month, and yet only $1 billion came to market in August (1). These tightening credit
conditions are often a lagging indicator (showing bad things from yesterday) AND a
leading indicator (reflecting tough times and possibly defaults ahead). I am
watching carefully.
In English: There was a massive drop-off in August in the amount of new bond debt
issued by American corporations. This could be a mere indicator of bad conditions
last month, or it could be a sign of things to come. I am keeping my eye on it.
---------Why is the European situation so dire?
This first part is very easy to explain: The European banks have many times their
capital in sovereign debt. In France alone the banks are leveraged four times the
total GDP of France (2). $70 billion of Greek debt alone is on the balance sheets of
French banks (2). These figures have not been marked-to-market, so it is only an
accounting issue that is keeping these banks solvent. I believe some version of a
nationalization of many, many banks is on the horizon in Europe (some will
call it a TARPification). The ECB has not yet gone into the open market to get
dollars, and if it did the Euro would drop dramatically. So far the Fed and other
central banks are opening up liquidity lines for them. Our own central bank is afraid
of the Euro crashing against the dollar (yes, we are in a self-conscious policy of
promoting a weak dollar at the moment).
In English: The banks of Europe are the ones holding the bulk of the bad debt from
the EU member countries. The above paragraph gives some of the specifics as to
how severe it is. I believe that some form of nationalization of those banks is very
much at play.
---------You wrote a couple weeks back about the ten-year anniversary of the 9/11
terrorist attacks. What were the best (and worst) performing asset classes
in the ten years that followed the 9/11 attacks?
Silver was up 900%, and gold was up 568%. Oil increased 225%. The U.S. dollar
declined 34% over that period (which is directly correlated to the three figures that
precede this one). A 10-year treasury at 9/11 was yielding right around 5%, and as
we know it currently sits right around 2%. The S&P 500 was up 9.71% over that
entire period (less than 1% per year), with Energy being the biggest performer
(+128%) and Financials being the worse (-48%). One thing I would add when
people talk about the "lost decade" of the last ten years. Out of ten major
asset classes, NINE of them have a positive return in the last ten years.
Only ONE (the S&P 500) has a negative return (3).
---------What do you like as an income investment right now - Stocks, or Treasury
bonds?
The yield on the 10-year treasury is 1.78% here at the end of the week. The
dividend yield on the S&P 500 is 2.3% (3). It has only happened about 20 times in
the last sixty years, but in each 12-month period that it has happened the stock
market was up over 20% in the following 12 months (4). Now, my clients know that
I am not a believer of buying the entire S&P 500, and in fact favor stock portfolios
that have a far better dividend yield than 2.3%, but this illustrates just how
attractive the income aspect of stocks are right now, and along with that, I think the
growth potential is clearly in focus as well.
---------What is this week's factoid that is hard to determine if it is good news or
bad news?
The bad news is that we currently have $792 billion of revolving debt (in America).
This seems like an unfathomable number to me. The good news is that it was $972
billion just three years ago. So, $180 billion of revolving debt has been paid off
since the all-time high (good), but the current debt is still nearly $800 billion (bad)
(5).
---------What is one of the main reasons that few are talking about as to why you
believe the Euro will decline against the U.S. dollar over the next year?
I have written in the past couple of months as to what the structural problems are
with the Euro and the economic reasons for European policymakers allowing their
currency to depreciate as a partial way of dealing with their fiscal mess. But another
angle that warrants discussion is basic supply & demand: I believe that very wealthy
people throughout Europe are soon going to trade in their Euros in droves for the
safety of dollars, and when that happens, it puts us tremendous downside pressure
on the currency being traded in.
---------What are your personal predictions about global growth for the rest of
2011?
I should first say that my forecasts here are neither in line with my own firm's Global
Investment Committee (necessarily) or any other outside research or forecast. I am
basing this from my own analysis of data and general feeling about world affairs.
When it comes to forecasting things like GDP growth, neither myself nor any other
third party can do it perfectly - it is far more art than science. With that said, I
would be very surprised if the annualized pace for growth in the U.S. were
to exceed 1.5% for the rest of the year, which would mean we ended 2011 right
around 1% on the year (textbook definition of woefully anemic growth). Greece,
Ireland, and Portugal have had over two quarters of negative growth, meaning they
are in recession as we speak. However, the positive growth in Germany, The
Netherlands, and France may just be enough to keep the overall Euro zone in
technically positive territory (though even this assumes no massive shock to system
in next month, which is a big assumption). China's growth continues in the north of
7% range. Japan's economy should grow by 2-2.5% to complete the year, but even
that feels optimistic. Overall, 2011 global growth should finish the year right north
of 3%, with emerging markets helping to lift the anemic growth in Japan and the
United States as well as the negative growth in much of Europe.
---------What would you say is one of the better things you found out this week?
Well, there wasn't a lot, but one of the better pieces of information was that margin
debt plunged in August from $306 billion to $272 billion (the lowest level since
October of 2010) (6). The less long-leveraged positions in the market, the less
margin-call-driven-panic selling. So, it is good to see the margin debt in the
marketplace lower than it has been in nearly a year, but it still has a ways to go to
feel that margin risk is "really, really low" ...
In English: Margin borrowing is when a client uses the collateral of the stocks or
bonds they own to buy more of the same stocks and bonds. High margin balances
means there is a big risk for sell-off as that debt can be called by the financial
institution who has extended the money and therefore can result in forced selling
(pushing the prices of the stocks and bonds lower). When margin levels are low it is
generally a good indicator of a cheap market (but not always).
************
I have a lot more I want to say this week but I feel like I have gone on too long
already. I will roll the additional material I wanted to include today in next week's
commentary. Email me with any questions or comments. Have a wonderful
weekend. Family, church, and football will fill my weekend. And maybe a little
European research as well ... =( Here's to USC making it 12 in a row over the Sun
Devils!
With regards,
David L. Bahnsen, CFP®
Senior Vice President, Wealth Advisor
The Bahnsen Group at
Morgan Stanley Smith Barney
Senior Portfolio Manager
Senior Investment Management Consultant
800 Newport Center Drive, Ste 700
Newport Beach, CA
(949) 760-2482 ph
http://fa.morganstanleyindividual.com/thebahnsengroup/
No reference to any security herein should be taken as a solicitation. The opinions expressed herein are those of
David Bahnsen and are not necessarily shared by MorganStanleySmithBarney. Specific situations vary from case
to case and nothing contained in this email should be considered tailored advice. Orders must be taken verbally.
(1)
(2)
(3)
(4)
(5)
(6)
(7)
JP Morgan Asset Management, Market Insights: Weekly Market Recap, September 19, 2011
John Mauldin, Thoughts from the Frontline, September 17, 2011
First Trust, Bespoke Investment Group, Market Watch, Week of September 19, 2011
CNBC, Squack on the Street, September 19, 2011
Federal Reserve, By the Numbers, Sun Life Financial, September 19, 2011
New York Stock Exchange, Zerohedge, NYSE Margin Debt Plunges to Mid-2010 Levels, September 22, 2011
Bloomberg, Futures Swoon on European Bank Report, September 23, 2011
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