Testing Your Nerves
Weekly Market Commentary 6-17-13
Tim Phillips, CEO—Phillips & Company

Since the world misinterpreted the Federal Reserve Chairman's comments, we have seen a massive increase in volatility (also known as worry, anguish and second guessing by investors).

Volatility index

Prior to Bernanke’s comments, the Dow Jones moved 100+ points in a single day only 4 times since the beginning of the year[1].  Since his testimony, the Dow Jones has moved 100+ points 10 times—more than double the entire first part of 2013.[2]

I'm starting to see the worry within our clients and think it might be time to reaffirm some key concepts we have learned over many decades of collective experience at Phillips and Company. 

1) Your overall allocation, which is the amount you allocate to stocks and bonds, in addition to sector allocation (small cap, mid cap, etc.), determine most of your returns.[3]

2)  To suggest anyone can predict exactly what will happen in markets, let alone individual securities, is a "trap for fools", to borrow from my favorite poet Rudyard Kipling. 

Phillips & Company did a case study on timing.  If you were to time perfectly the buying and selling of asset classes over the last decade, you could take a small investment of $10,000 and turn it into $168,997. You can see below[1] that these returns are simply not realistic.

(Click here to download full slide "What if we actually could time the market?")

Seriously, do any of us believe someone would share with us their hidden gem of a tool to make money out of benevolence or a small fee, compared to what they can hoard for themselves?  I especially love the online brokerage firms touting their special trading tools that can make you money. Really?

3)  You can only shape the risks you take by using time. The longer time horizon you have for your investments, the less theoretical risk you take, as volatility can be smoothed out over time.  Take a look at the chart below.[5]

The challenge is to adjust those allocations as you get close to drawing down your investments. 

Why wealthy people get wealthier is in large part a matter of the time they allow their investments to work. They just don't need the money to maintain their daily living expenses or retirement.  The reason good foundations and endowments grow is that they have structural controls on their spending and allow multiple generations to grow the assets, looking past volatility.

4) Investors need to overcome the Sleep Well, Live Well Paradox. Your spending rate, inflation, fees and the time you have in the market will determine most of your allocation.

You can see from the table above[6] if you spend about 5% of your assets a year like most foundations, you will need to generate at least 8.20% returns to keep up with inflation and fees. A 70-30 allocation has historically produced these returns over the past 20 years, although a one-standard deviation event could cause returns to swing up or down by 10.70% in a given year.

Now, you’re talking about living with more volatility or losing some sleep. If you don't like the volatility, you will have to spend less.

I hope these rules of thumb can help as they guide us daily.  We have many more but perhaps these will calm nerves, stir a debate on your investment committee or dinner table about your timeframe, return requirements or simple ability to hold on. We certainly hope that we can engage you in this conversation with your financial advisor in the near future.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

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[1] “Recent Swings…”, Wall Street Journal, June 17, 2013

[2] Ibid.

There Is No Free Lunch: Correlations Abound
Weekly Market Commentary 6-10-13
Tim Phillips, CEO—Phillips & Company

Since the beginning of the year, the S&P 500 is up 16.2%, the Dow up 17.7% and the NASDAQ up 15.6%.[i]

Over the last several weeks, Wall Street has been having a capital debate with your wealth.  On one side, there were those that feared the end of Federal Reserve’s bond buying and intervention in our capital markets.  That side was selling. On the other side, there were those that felt the economy was too weak for the Fed to withdraw their stimulative efforts, and hence they were buying. 

With Friday's jobs report, the latter side won.  Last month, the economy added 175,000 jobs, but it’s important to note that 26,000 of those jobs were temporary help jobs. While it is good that those 26,000 people are now working, it is clearly a sign that employers do not have enough confidence yet to offer non-temporary positions.[ii]

On average, the US economy has added about 155,000 jobs per month for the last 3 months.  This is about the average when the Fed began their buying programs.  The economy needed help then as it does now.[iii]

What is worse is that corporate earnings growth is expected to be down substantially. Growth in Q2 2013 earnings over Q2 2012 is expected to be 2.59%, compared to 8.29% growth from Q2 2012 over Q2 2011—almost two-thirds less. Also, at the end of March, analysts expected 4.5% earnings growth from Q1 to Q2 2013 on S&P 500 companies—but now, that estimate has been revised down to 1.3%.[iv]

Source: FactSet Earnings Insight—June 7, 2013

Finally you can see continued weakness in commodity prices.  These tend to be predictive of future growth; if commodities are strong, it could be a sign that businesses and manufacturing are expanding, and hence need more raw materials like aluminum, copper, and so forth. The reverse is also true if the economy is shrinking. You can see from the chart below that commodity prices have been pulling back:

Source: Bloomberg LP

So, it seems bad news in our economy is good news for the market.  On Friday, when we received the modest news about jobs, the markets rallied over 200 points.  Bad news in the economy keeps the Fed pushing their agenda, and our capital markets moved up.  Before the jobs report, we saw many asset classes correlate: stocks, bonds, commodities—and this isn’t normal. Usually, US stocks and bonds have a negative correlation, meaning they move in opposite directions, but you can see below that last week (excluding Friday with the report), stocks and bond actually showed positive correlations:

Source: Bloomberg LP

I normally suggest the only free lunch in the long run is diversification.  Unfortunately, without our friends at the Fed, it seems like that free lunch is being challenged.  Remember, under extreme events, everything correlates, similar to what we experienced over the last few weeks.

Stay focused for the long run.  My expectation is for significant volatility in the short run, challenging most portfolios and investors.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

The Onion Has More Than One Layer: Crying or smiling will depend on your sensitivity
Weekly Market Commentary 6-3-13
Tim Phillips, CEO—Phillips & Company

As discussed in last week’s blog, policy errors are all around us.  The US equity markets have pulled back 1.44% since May 22, when the Federal Reserve Chairman suggested they might ease off on buying bonds in the open market if the economy improves.[i]

So why would equity prices drop if the economy improves?  It would seem logical if the economy improves, companies and consumers are doing much better and that should drive stock values higher not lower. 

While this is all true, what is also true is interest rates would have to rise to reflect the strength of our economy and act as a brake to inflation.  Generally this is done through monetary policy set by the Federal Reserve Bank.  As efficient as our capital markets are, participants (bond traders, mutual funds, pension plans, etc.) all anticipate changes well before the Fed can take action.  In this case, rates rise before monetary policy can be enacted.

Take a look at the 10 year Treasury market that measures real interest rates (TIPS).  It is important to note that what matters is real rates (those that adjust for inflation, as inflation erodes our buying power).

(Source: Federal Reserve)

You can see that quite a spike recently occurred.

So back to the question, why would equities drop when the economy improves and real interest rates rise?

The simple answer is higher interest rates lead to the following, in theory:

Note that I said all this could happen, in theory.  In practicality, stocks tend to rise during rising rate environments up until a point:

(Source: JP Morgan 2Q 2013 Guide to the Markets)

As you can see from the chart, stocks have historically risen with rates up until around a 5% rate on the 10 year Treasury.

Why? This is the speculative part.

• Rising rates don't always impact consumers immediately at lower rate levels. Take housing for example; if your house price rises faster than inflation, you might feel good and spend more in spite of a rise in interest rates.  By the way, housing prices have risen by 8.74% in the last two years.[iii]
• If you are collecting more interest income, you might spend more of it.
• If you are not paying that much in interest expense, a rise in interest rates might not impact you as much at lower rate levels. As you can see below, household debt service payments as a percent of disposable personal income are at multiyear lows:

• If companies can buy things with cash vs. borrow, or borrow at very low long term rates, a rise in interest rates might not impact them at lower rate levels. You can see below that corporate cash levels are at generational highs, and real interest rates for corporations are at generational lows.

(Source: Federal Reserve. Real interest rates for AAA corporations based on AAA bond yields deflated against the year over year change in CPI).

• US Government borrowing needs are dropping with a rise in taxes and a cut in spending, which reduces our debt services going forward—almost not worth mentioning but theoretically true. According to a Wall Street Journal article on May 15, the Congressional Budget Office is expecting the deficit to shrink to $642 billion, which is substantially smaller than the $1.087 trillion deficit last year.

My guess is market participants are once again only looking at the outer peel of the onion and reacting (selling) when it comes to stocks.  While this time could be different, we might just have some time to go before rising rates impact our consumer and economy.

Special note on bonds

None of this diminishes the notion that bond durations should be lowered in portfolios and that requires some active management on your part as well as ours.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[iii] “S&P/Case Shiller US National Index Levels Q1 2013 Not Seasonally Adjusted”, S&P Dow Jones Indices

On Wednesday, the Chairman of the Federal Reserve gave a very slight indication the Fed would consider adjusting the amount of bonds they buy on a monthly basis from $85 billion.(source: Bespoke, 5/24/13)  In that moment, the US Equity markets tanked.  We lost approximately $380 billion dollars in stock market valuation or 2.5% of GDP. (www.tradingandeconomics.com: United States GDP 5/28/13)

Bespoke, 5/24/13

Global markets also reacted negatively.

International Market Reactions

(The Telegraph 5/24/13)

While we can all prognosticate how and when the Fed will begin to cut back on their purchases of bonds (which are driving down fixed income yields and forcing investors into stocks); it should now be obvious investors don't trust the economy to function at any meaningful level without policy intervention.

The question prior to Wednesday was how much policy reliance were investors counting on versus a properly functioning economy and capital markets?  Answer:  Quite a bit.

Volatility jumped to its highs in the last 30 days as measured by the VIX.

www.marketwatch.com: VIX Index Chart 5/28/13

While Bernanke said nothing he has not said in the past and his formal comments reiterated the Fed stance to maintain the buying of bonds for a prolonged period of time, there are some very nervous investors. 

It does no good to speculate on investor jitters and concerns over a pull back.  Much of this thinking I put in the "market timing" category.  What is productive, is for you to again evaluate the time horizon as to when you begin needing your capital. 

If it's less than 5 years, start having a serious conversation with your advisor.  I use 5 years as a market cycle and you should be willing to withstand almost any volatility if you have time. 

If it's more than 5 years, take a hard look at your fixed income allocations.  Duration and where your fixed income falls on the yield curve will start to matter a whole lot.

We can now officially kick off the “Era of Policy Errors.”  It won't come on all at once but the "new normal" will require a deft hand with politicians and the Federal Reserve.  That's why I expect this period to be very volatile, nerve wracking and in the short run maddening.  Whether you are a pension account, a foundation or endowment, family or individual, it's critical to reassess your time horizon.  The only free lunch I can ever give you is the ability to shape risk with time when it comes to broad based public market equities. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO - Phillips & Company

Client Education
Planning For Health Care in Retirement
May 22, 2013

As part of our ongoing mission to help our clients make educated financial decisions, we are now releasing our latest client education presentation. This issue focuses on a topic that many of our clients brought to us as a concern, which is planning for health care expenses in retirement.

Click here to download presentation: "Planning for Health Care in Retirement"

You can also view our earlier client education presentations here:

• Individual Investor Behaviors
• Threats to Achieving Retirement Plans

With the uncertainty about rising health care costs and uncertainty over what may happen with health care benefits and insurance, planning for health care expenses should be a key component to any broad financial plan. I hope that you will find this presentation informative and that it will give you some issues to discuss with your financial advisor. You can also email me directly at tphillips@phillipsandco.com.

Tim Phillips, CEO—Phillips & Company

The Most Undervalued Asset Class? Can Cheap get Cheaper?
Weekly Market Commentary 5-20-13
Tim Phillips, CEO—Phillips & Company

It seems like nothing will stop the US equity markets from rallying.  I'm convinced Federal Reserve activity is creating distortions in market participant’s valuation perspective.  Equities in the US are getting more expensive.

PE Ratios as a Percent of 10 Year Average [1]

When you look at asset classes across the globe, you can see they are trading near their mean valuations.  It seems like coordinated central bank intervention has distorted global asset valuations.

PE Ratios as a Percent of 10 Year Average [2]

One asset class that appears to be below its mean by multiple measures is emerging market equities.

MSCI Emerging Markets Index [3]

In fact, emerging market equities are at a valuation similar to US equities back during the financial crisis.  The PE ratio on the MSCI Emerging Markets index is 12.65 currently, while the PE ratio on the S&P 500 on the market bottom of March 2009 was 10.29. [4]

It's to nobody’s surprise that the S&P 500’s PE ratio has expanded by 58.9% since the market bottom in March 2009 through today, leading to a total return on the index of 167.5% over that time. [5]

I think a similar opportunity presents itself in EM equities, but I am concerned about the Middle East/North Africa (MENA) countries. You can see below that Arabian Markets are trading at PE ratios significantly below their averages, much more so than just broad emerging markets:

Valuation Levels as a Percent of 5 Year Average [6]

In this case, it could be a situation where a cheap valuation gets even cheaper. MENA countries generally have one thing in common; they are large exporters of oil.  It seems like market participants have already priced in some significant economic disruption in these countries as domestic natural gas is discovered throughout the world. The current turmoil in Syria, ongoing concern in Egypt, and the risk of spillover is also a concern for the market.

While in general emerging market assets are cheap and I expect valuations to rise, in some regions “cheap” could be a true reflection of a shift in value, so cheap could get cheaper. Simply think of the 30 component stocks of the Dow Jones Industrial Average (DJIA) 50 years ago and realize that there are only 14 left in existence, and of that only 4 are still in the DJIA. [7] Investments that appear to be reliable can and sometimes do fall off of the map forever.

For example, 50 years ago, Bethlehem Steel was part of the DJIA. The world has changed, and in part due to inexpensive foreign competition, the company went bankrupt in 2001[8]. My concern is that the world is changing when it comes to energy production, and MENA countries are at risk.

I like emerging markets with growing middle classes, but I don't like declining markets that are in a fight for their survival. In those cases, cheap is never cheap enough.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

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[1] Bloomberg LP. 10 year average is trailing from May 2013.

[2] Ibid.

[3] Ibid.

A Chink in the Armor
Weekly Market Commentary 5-13-13
Tim Phillips, CEO—Phillips & Company

Amidst all the euphoria of a record stock market and plethora of earnings reports, it's easy to lose sight of how weak and cautious the consumer really is.  We have written in the past about the lack of wage growth in middle income families.

What's new this week is that we are seeing signs of the consumer beginning to perhaps pull in the reins on spending.  Consumer credit increased by only $8 billion in the month of March, compared to an $18.6 billion increase in the prior month.[1]

[4] Source: “Share of budget for higher ed shrinks”, October 2011, Minnesota’s Private Colleges

The Dividend Trump Card
Weekly CEO Commentary 5-6-2013
Tim Phillips, CEO—Phillips & Company

The most frequent question I'm being asked right now is, "Can this market continue to move higher?"  The short answer, in my opinion, is yes.  One basic rule of thumb on investing is anything can happen in the stock market and usually does.

As it relates to our current rally, the best answer is vested in good data.  For over a year now, we have seen stock valuations move much closer to their 10-year mean. Keep in mind that for something to have a mean, it must trade below and above that average for a period of time.

Source: Bloomberg LP

Historically, according to data compiled by Yale Economics Prof. Robert Shiller, earnings per share on US stocks grew at a 4.01% annualized rate between 1874 and 2012, and dividends per share grew at 3.46% over the same period.

Image source: Yale University website for Robert Schiller

Currently, the S&P 500 is posting a growth rate of 3.2% for companies that have reported Q1 2013 earnings so far, according to FactSet (May 3, 2013 article “Despite high negative EPS guidance, estimate cuts for Q2 on pace with recent averages”).

Image source: Yardeni Research article “Earnings, Revenues & Valuation: S&P 500 Sectors”, May 6, 2013

Clearly, companies are growing at a rate below mean averages.  However, a close look at dividends can help round out the picture from a fundamental perspective.  From a simple math standpoint if a company is growing its earnings at a certain rate and also growing its dividends at a certain rate, its value should grow (based upon a discounted cash flow model). 

According to the FactSet Dividend Quarterly (March 28, 2013), aggregate dividends per share (“DPS”) on the S&P 500 grew by 15.9% year-over-year at the end of Q4, and the number of companies  paying  a  dividend  over  the  trailing  twelve-month  period  (“TTM”)  hit  a  new,  thirteen-year high  of  405 companies (81%).

So while EPS growth is moderating, dividends per share growth is exploding. From an increasing valuation perspective, companies are doing very well once you factor in dividends.

What matters more, dividends per share or earnings per share growth?  Recent data might surprise you.

Image source: FactSet Dividend Quarterly, March 28, 2013

You can see from the data dividend growth rates were capable of overcoming some slow earnings growth rates. 

While current EPS growth rates look troubling, dividend growth rates look exceptionally strong and perhaps prove to be the trump card when determining stock market sustainability.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

The Consumer Did Its Job
Weekly CEO Commentary 4-29-13
Tim Phillips, CEO—Phillips & Company

The much anticipated report card on the US economy was released last week and I would grade it a C overall.  The US economy grew at an annualized pace of 2.5%.

The consumer represented almost 90% of the growth in GDP. They deserve an A+.  Business did its share, making up much of the rest of the growth through expanding inventories. Not surprising, government and net exports continued to represent a drag on the overall economy.

Source: Bureau of Economic Analysis

What We Know

Unfortunately, we know the consumer can't continue to represent this much a share of our national output.  Some kind of reversion to the mean is in store.  Much of consumer spending came from savings.  The US Savings rate dropped to 2.6%, which is the lowest level since 2007. 

Source: Bureau of Economic Analysis

We also know from earlier posts that businesses will find it harder to add to inventories as they are already at relatively high levels.

We certainly know there is significant fiscal drag in our economy.  Driven by tax increases and sequestration induced government spending cuts, we can see a drag of as much of 1.8% on GDP in the coming quarters.

So, what's left to keep the economy and markets going in the coming quarters before we get released from much of the fiscal drag in 2014?

Consumer credit is showing some signs of strength.  If the consumer can't spend their savings it looks like they are still willing to go to the credit card.

They are also making a little more money as personal disposable income recovered from a large drop in January.

The markets will soon start to anticipate better times ahead in 2014.  From my experience it could be as early as 6 months ahead or as late as several months.  It appears that investors have significantly more "present bias" and that could mean a sluggish summer before market participants look forward to 2014.  I also give my usual caution on accuracy and specificity on forecasts.

The summary of all this data looks as follows:

• Companies will want to shrink inventory before they rebuild delaying any significant movement in employment.
• Consumers will need to reload savings but can certainly continue to sustain a slightly elevated level of spending from a slight rebound in incomes, access to credit and a recovery in housing.
• Fiscal headwinds will continue throughout the rest of 2013.
• Market participants will look for sunnier times in 2014 so pull backs can be viewed as a normal reaction to an almost normal business cycle.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

The Fed: Do we trust them?
Weekly CEO Commentary 4-22-13
Tim Phillips, CEO—Phillips & Company

“Inflation, not if, when"- A noted Wall Street firm

Like you, all of us at Phillips and Company are very sad at the events that occurred this week in Boston.  Our hearts are broken for all the victims.

It made traveling to New York City a little more interesting than usual this week.  I had an opportunity to spend a couple days in the city meeting some of the finest minds on Wall Street.  (I say that with a healthy dose of skepticism in some cases). 

One firm that I admire posited, "Inflation, not if, when".  Good question.  Getting a feel for this answer can guide investors immensely when it comes to their overall allocation.

Here's the problem: I'm not sure it's a "when" question as much as it's an "if" question at this point in our cycle.  No question when you look at food prices, taxes,  health care, higher education—and don't forget grades—you see some serious inflation.

Source: gradeinflation.com

But, for the last 30 years, we have seen the rate of inflation trend downward.  Granted there are issues within the measurement.  Nonetheless, all things being equal, inflation has been an "if" question and not a "when” question.

Granted, there are issues within the measurement.  Nonetheless, all things being equal, inflation has been an "if" question and not a "when” question.

What are we facing now?

Noted professionals have been pounding the "When vs. If" paradigm for decades:

“Among the biggest worries have been higher import prices generated by the decline in the dollar’s value over the past year and increased wage demands from the nation’s workers. Even the trade bill pending in Congress and the new immigration law could add to the upward pressure on inflation, some economists said.” –Associated Press article from August 8, 1987

“Once inflation starts in the US, it usually is not interrupted until a recession.” –Allen Sinai, chief economist for Boston Co. Economic Advisers, quoted in January 20, 1988

Inflation, loosely defined, is a function of too many buyers vs. sellers, more dollars vs. more goods and services, and more demand than supply.

The challenge we face in our economy is from the demand side. 

First, look at wages as a percent of the economy (44 percent currently). Wages are not rising and in fact have been steadily falling. You can see this on the chart below:

Secondly, there are fewer workers who spend that 44 percent. The total rate of unemployed and underemployed Americans is 13.8 percent. Also, the labor force participation rate has been dropping since 2000, as you can see below:

Third, you can see a trend if you look at American demographics and aging.  Assuming older Americans 65 years and older consume less (eat less, go out less, need smaller homes, fewer cars), inflation gets a little harder to see.

Source: US Census Bureau

The one noted exception is health care.  While it might be inflationary for the government, because health care is a social cost, the government passes the cost increases along to producers in the form of higher taxes.  This is deflationary when it comes to producers having money to consume other goods and services.  

Changing paradigm

Structurally, we also face technological changes.  In the book "Nothing Like it in the World...." by Stephen Ambrose he noted the systemic economic shift brought on by the completion of the Transcontinental Railroad.  Travel costs dropped from $1,000 a person to $150.

More recently, we saw the same thing with the internet and telecommunications. In 1956, an international phone call on the original trans-Atlantic cable cost $12 for three minutes. Compare that to services now like Skype that let you call people or video conference globally for free using your existing internet connection.

No inflation there, because of new technology that lowered costs.

What this all means

While I know this time is no different than other times, I would not expect inflation to rear its ugly head in the coming couple of years.  Perhaps in 2015, which is how far out the Fed says it will maintain “exceptionally low levels” for interest rates.

Banks are still not lending and with the excess reserve interest rate and inflated FICO requirements, it looks like it could be a while before they pump the economy with their excess cash.

What I would do is trim duration risk, be patient with cash and work to squeeze more risk out of the portfolio through correlation diversification.

"If, not when" seems to be answered for us by the Fed for now at least.  The real question is: do we trust them?

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

2011, 2012, Now 2013?
Weekly CEO Commentary 4-15-13
Tim Phillips, CEO—Phillips & Company

Earnings season kicked off a quite start last week.  We had 33 of the S&P 500 companies report earnings so far, with 69.7% of them beating expectations (source: Bloomberg). So far, this looks good; however, things really get started in earnest this week with some key companies reporting: 

• Tuesday, April 16: Intel, Coca-Cola, Johnson & Johnson
• Wednesday, April 17: Bank of America, American Express
• Thursday, April 18: IBM, Microsoft, Verizon
• Friday: April 19: General Electric, McDonald’s

Unfortunately for the economy, we continue to see deterioration in economic reports.  As you can see from the following table, we are experiencing a rapid decline in economic indicators.

One important indicator is the Retail Sales report released last Friday.  Expectations were for retail sales to be flat month over month, but actual results showed that retail sales shrunk by 0.4% from February to March. Consumers appear to be cautious.

While I expect Q1 GDP to bounce back from near recessionary levels experienced in Q4 2012, I don't expect Q2 and Q3 this year to be strong for the US economy.  Much of my caution stems from the headwinds caused by the increase in payroll taxes and sequestration.  One impacts the consumer (70.7% of our GDP), and the other impacts Government Spending (22.3% of our GDP).

Another reason for my caution is in the large inventory buildup during Q1 2013.

While the inventory build was additive to GDP in Q1, it may not be helpful in Q2 and Q3 as consumers might be more cautious.  This will cause companies to replace inventories slower, adding to more economic headwinds.

I do believe our foundational economy is stronger in 2013 than the past two years, but I also believe that we might see a repeat of market activity post Q1:

The reason I would not bet too heavy against this market is the Federal Reserve’s vigilance in propping up this economy.  Perhaps a cautionary pull back will be short lived and viewed as an opportunity for investors to put cash to work.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

The Waiting Is Over
Weekly CEO Commentary 4-8-13
Tim Phillips, CEO—Phillips & Company

It's finally upon us: earnings season. To me this season is one of the most anticipated in many years.  Between the tax increases taking effect on January 1, and the sequestration cuts in government spending, the consequences are highly anticipated. 

• Is this recovery stalling? 
• Does the consumer have the financial strength to power through in light of tax increases? 
• What is the impact on spending cuts from the US Government?
• Ultimately, will companies hire more people?

We have for the first time in over a year ended an earnings period that is expected to be quite pessimistic. Between Q3 2011 and Q4 2011, the last period where we saw a significant earnings drop, the S&P 500 dropped -3.67 percent (source: Bloomberg). FactSet shows that analysts expect earnings to shrink slightly this quarter from Q4 2012.

Source: FactSet Earnings Insight

Guidance from companies, a much more reliable source, is also showing signs of extreme caution.  You can see from the chart below that negative guidance has been rising from December through now.

Source: FactSet Guidance

Guidance is particularly pessimistic in the consumer discretionary and health care sectors, as you can see below. Some sectors like energy and financials do not have enough companies issuing guidance yet to get a read on the sector.

Source: FactSet Guidance

The mood amongst professional investors is growing worrisome:

“On a scale of 1-10 measuring asset price ‘irrationality’, we are probably at a 6 and moving in an upward direction.” –Bill Gross, co-CIO of PIMCO from the PIMCO March 2013 Investment Outlook

“In the short-term, if the data are weakening - and I think investor expectations haven't really adjusted to that - there's a chance for the market to consolidate in the short-term.” –Thomas Lee, chief US equity strategist at JP Morgan

A drop in the markets is part of the consensus view in the short term. As we wrote last week, investor sentiment has remained cautious.

At the same time, we are seeing investors grow quite worried about their bond holdings.  The talking heads on TV are pitching the "bond bubble" notion (there is some truth to this).  Yet, bonds are the general safe haven for a falling equity market.

What do we do?

My strategy is to keep our foot on the brakes and the gas at the same time:  focusing on quality fundamentals in equity asset classes and shrinking the duration risk in bonds (click for a definition on duration).  While we will certainly miss some of the party on equities, we should reduce our risk on the downside.  I emphasize reduce risk—not eliminate it.  

I might regret saying this, but I'm glad the waiting is over and we can get on with it.  I want some answers to the questions I have.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Contrarian Viewpoint
Weekly CEO Commentary 4-1-13
Tim Phillips, CEO—Phillips & Company

It's quite common when markets achieve new highs to see lots of headlines, and typically the individual investor plows money into the market.  When the individual investor chases market returns, they typically get burned.  Contrarian investors and value investors are constantly on the watch for the emotional investor to buy things that are overvalued and sell things that are undervalued.  Greed and fear can take over for rational thinking. 

I know this seems counterintuitive and if investors were truly rational, you wouldn't see such mispricing in asset classes.

The question today, as we are at all-time highs on the S&P 500 and Dow Jones, is how much irrationality is in the market?  There are a few things you can look at besides pure valuations to get a sense of irrationality.

Contrarian indicators

The Investors Intelligence Bull and Bear indexes are surveys of investment newsletters, and if their recommendations are bullish or bearish.

Image source: “Stock Market Indicators: Fundamental, Sentiment & Technical” Yardeni Research

Investors Intelligence noted that in times of heavy bullish or heavy bearish recommendations, markets tend to do the opposite.

As another example, below is a chart by Avondale Asset Management of historic investor sentiment from the American Association of Institutional Investors (lots of people using discount brokerages), and how actual market performance has been during bullish and bearish levels of sentiment.

Image source: Avondale Asset Management

You can see from the chart that the individual investor is typically wrong.  When the individual investor is very bullish (right portion of chart), there is historically a 70% chance they will lose money.  Conversely, when they are extremely bearish, they historically have had only about a 15% chance of losing money, and in fact the average return was a positive 9.96%.

Just to prove how reliably wrong the individual investor tends to be, take a look at where sentiment stood during the last market bottom and also where it stood at the prior peak:

If you look at the table below, you can see we are nowhere near an extreme bullish sentiment by the individual investor.  

Perhaps because the last negative experience was so traumatic, investors are being cautious.  This bodes well for continued positive trends in the market, if you follow the contrarian models.

None of this is to say that it’s easy sailing ahead.  In my opinion, there are real world worries to consider:

• Stagnant European Union growth
• Flattening in US Corporate earnings growth
• A soft landing in China
• Federal Reserve monetary withdrawals
• Rising US interest rates
• US Government spending cuts

Perhaps that's why the individual investor is so cautious, and perhaps that's why valuations are in the fair range and not extremely overpriced.  Perhaps that's also why the market might move higher because the individual investor has not been in full chase mode. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Can it happen to us?
Weekly CEO Commentary 3-25-13
Tim Phillips, CEO—Phillips & Company

One of the nice things about managing money professionally is if you’re intellectually curious, it provides for ample opportunity to learn new things all the time.  Case in point: Cyprus.  I have heard the name of the country before, and that's about it.  I do enjoy seeing the Cypriotic (my term) experts roll forth with their infinite knowledge on something they probably knew nothing about.  That's an illness in our industry and a topic for later.

The real question for me and likely you as a saver with money in a bank is:  Could what happened in Cyprus happen to us?

What happened

The roots of the problem in Cyprus came down to some key points:

1) The financial sector is a large portion of the Cypriot economy, and a significant portion of the deposits aren’t domestic savers, but rather foreigners who sought to park cash overseas. CNN reports that “Nearly a third of the money in Cyprus' banks is Russian, and the country's 10% corporate tax -- half that of Russia's -- meant Russian firms had been using it as a tax haven since the early 1990s.”

Source: Central Bank of Cyprus

2) Cyprus was also damaged by the crisis in Greece. Cypriot banks held large positions in Greek debt, which ultimately turned out to be toxic assets.

3) Cyprus also has a great deal of political uncertainty. The country still suffers from the after-effects of a civil war in the 1970s, which has left an active UN Peacekeeping Force on the island to this day.

So in all likelihood what happened in Cyprus can't happen to us...exactly.

With the bailout agreed to, it looks like large savers will lose some of their deposits in the form of a tax, in exchange for continued EU support for the country. Originally, the terms were set to be a 6.75% levy on depositors under 100,000 Euros and 9.9% above that amount, but now the Cypriot government can adjust those figures (to try to spare small depositors) as long as they raise 5.8 billion Euros in total.

Larry Elliot, the economics editor at European newspaper The Guardian, also reports that, “The shakiest of the Cypriot banks – Laiki – will be closed. Deposits of more than €100,000 – amounting to €4.2bn in all – will be placed in a ‘bad bank’. That means savers will only get a fraction of their savings back and the deposits could, in theory, be lost entirely.”

Implications for US savers

Unfortunately, US savers have also lost money on cash savings during the 2008 financial crisis—something that was thought to be unthinkable before then.  Little known to the investing public was the “breaking of the buck” of the Reserve Primary Fund, a money market fund that in theory should stay at a value of $1 per share, but actually lost money for investors during the 2008 crisis—something that is not supposed to ever happen.

On another side of things, US savers are getting punished right now by extremely low interest rates. Over a 5 year period of time, who is better off: a Cypriot saver with a small haircut, or a US saver with near zero interest rates?

BankRate.com shows an average annual rate on a US 5-year CD is 1.34 percent. The European Central Bank does not keep data on 5-year fixed deposits (the European equivalent of a CD), but shows that a 1-year fixed deposit in Cyprus has a rate of 4.53 percent.

If a Cypriot saver loses 10 percent up front due to the tax, and assuming that they can roll their 1-year fixed deposit over at the 4.53 percent rate for five years, they would still break even with their capital loss and eventually outpace an American saver.

The government isn’t putting a tax on US deposits, but savers have been hurt nonetheless by minimal returns.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

After the Fall: The Rocky Road Upward
Weekly CEO Commentary 3-18-13
Tim Phillips, CEO—Phillips & Company

It's great to see equity markets at all-time highs.  It doesn't feel that long ago when we were working with clients to not jump off the cliff and give up on their equity strategy.  It feels good for markets to prove to us that they can and do revert to their mean, and in this case move from a crash low PE on the S&P 500 of 10.21 on March 6, 2009 (the market bottom), to where it stands now at 15.33—closer to long-term averages (source: Bloomberg).

So, what happens now becomes the paramount question.  When you look at the data from Rogoff and Reinhart in their seminal study of financial crises, you can see the economy is working its way through much of the traditional trouble. Below are measures from their report, which we have updated to current figures:

(source: Bloomberg, Calculated Risk, Federal Reserve)

The data shows major progress, more or less consistent with the time it takes to recover from past financial crises. 

One item that is getting tremendous amount of attention is housing, as it has a major impact on our overall economy by creating jobs and increasing household wealth. Total residential construction spending is on the rise, as you can see from the chart below.

From this chart, you can see we have added $74.8 billion in residential construction spending since spending bottomed in June 2009. You can also see improvements in private housing building permits.

All of this improvement in housing has improved our personal balance sheets. The chart below shows our balance sheets are $1.98 trillion better from housing alone, from its bottom in 2009 to the most recent quarter.

If you look at overall Net Worth things look even better, as it is reaching pre-recessionary highs.

All of this shows a picture that bodes well for jobs and the economy over the long run.

If we show you the same chart on total net worth on a percent change from a year ago, you would get a more cautious picture. 

You can see that growth in total net worth has been stalling from the prior year.  Add to this view the fiscal cuts that are well detailed by Mark Zandi at Moody's:

"Sequestration adds to the already-considerable fiscal drag on the economy, which will reach full force this spring and summer. The fiscal cliff deal that resulted in the American Taxpayer Relief Act, reached at the start of the year, raised taxes by almost $200 billion for calendar 2013, and will cut 0.8 percentage points from 2013 real GDP growth. Other congressional spending decisions, including the caps agreed to in the 2011 debt-ceiling agreement and appropriations for reconstruction after Hurricane Sandy, net a further 0.2 percentage point cut in real GDP this year. All told, federal fiscal policy will reduce real GDP in 2013 by almost 1.5 percentage points".

While we are working our way through the long and arduous process of recovery from a typical financial crisis (I emphasize financial as they are the worst type), we might have a hiccup or two along the way.

By no means do I suggest trying to time the market.  I have never seen the individual investor consistently do it profitably in my 27 years of investing.

Conclusion

I want to relate this to a personal experience. While traveling through the Himalayas of India last year in search of a rare fish, I was confronted with a terrifying series of rocky roads upward.  This economy and market feel about the same.  While upward is indeed the destination it will likely be very rocky going forward. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Where Do We Go From Here?
Weekly CEO Commentary 3-11-13
Tim Phillips, CEO—Phillips & Company

The Dow hit an all-time high of 14,397.07 on Friday. Bloomberg shows that since the market bottom on March 9, 2009, when the Dow was at 6,547.05, the market has rallied 146.33 percent. Year to date, the Dow is up 10.8 percent. On one hand, it’s comforting that we have come a long way since the depths of the financial crisis. On the other hand, hitting an all-time high is sometimes a cue to take a step back and make sure that the market has not gotten over-extended.

One of the tools that we use to value stocks and markets as a whole is called mean reversion. The idea is that performance of stocks and markets tend to converge to a long-term average, or a “mean.” If you flip a coin and get heads, it doesn’t necessarily mean that you will get tails on the next flip, but over the long run, you will probably get close to 50 percent heads and 50 percent tails. It’s a similar idea with markets; over enough time, high valuations will probably come down to average levels, and likewise low valuations will probably come back up to historic averages.

Where we are at now

Here is a table showing how much over or under P/E ratios from various markets are from their historic levels:

Compared to long-term averages, markets are still undervalued, with the most extreme example being Japan. What this all means is that some profit taking or a correction is possible, as markets have been rallying, but markets are still trading at valuation levels below historic averages.

We also looked at fixed income, by looking at the 10-Year Treasury data from the Federal Reserve, and seeing how its yield compares to historic averages.

It is clear that Treasury bonds yields are far below historic average levels, which is why we have been positioning out of long-term Treasuries and have been exploring other options in fixed income.

Important caveat

It’s worth noting a quote from Benjamin Graham: “It is absurd to think that the general public can ever make money out of market forecasts.” We do have to remember that mean reversion is simply a tool to help value markets, and it is not a crystal ball. This is why we have written previously that we look at forecasts, but we take them with a grain of salt. Using mean reversion and P/E ratios can be helpful for positioning or making tilts, but we do not make all in bets either in or out of the market.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

What's Next?
Weekly CEO Commentary 3-4-13
Tim Phillips, CEO—Phillips & Company

The world did not come to an end. As I traveled through security lines at airports this weekend, I saw absolutely no signs of long lines caused by cuts to government budgets, nor did the air traffic controllers have to leave their posts.

What I did see was people shopping, eating out and spending money.  From the looks of things, the Great American Ponzi Scheme, consumerism, is alive and well.  I have written several times that the essence of growth in our economy is largely driven by the US Consumer.  The formula is simple:

It's clear our current consumer is a little more cautious and consumes a little less, with the final outcome being fewer jobs created and not much support for wage inflation.

Fortunately for all of us, consumers can get their hands on money to spend through their savings.  That's exactly what we saw recently.

The Federal Reserve reported that the US Savings Rate dropped from 6.4% in December to 2.4% in January. This means that consumers deployed $513.5 billion from savings. This more than compensates for the $85 billion that is being cut from the federal budget.

It's also encouraging to see the US equity markets greeted the news with some support. Bloomberg shows that the S&P 500 is up 8.40% over the last three months.

• Is it possible global investors want a more responsible US fiscal policy?
• Perhaps the investor class cheered the fact that further tax increases might not be as easy to capture?
• It could also be a welcome indicator that the political class can focus on tax reform to help companies unlock the nearly $1.7 trillion in cash[1] sitting on their balance sheets.

I am comforted that there is plenty of dry powder in our system (corporate cash and personal savings/credit).  It's also comforting to see the Federal Reserve’s Flow of Funds showing that US homeowner’s equity improved by $387 billion from Q2 to Q3 2012 (most recent quarter available), largely due to a recovery in real estate prices.

On the other hand, I am also cautioned that there is a continued concern over slow growth that may be a precursor to a mild recession.

What I am working on with our investment staff is how to continue to optimize our equity allocations, and at the same time realign fixed income to reflect the transition phase we may be entering when it comes to interest rates.

Spending For Spending
Weekly CEO Commentary 2-25-13
Tim Phillips, CEO—Phillips & Company

It's apparent we are facing $85 billion in cuts to government spending.  As I mentioned in last week’s blog, there appears to be too wide of a gap for an immediate political solution.

So, can our economy sustain and grow without as much government?  If you listen to the President we are facing dire consequences if these cuts come to fruition:

 “Once these cuts take effect, thousands of teachers and educators will be laid off, and tens of thousands of parents will have to scramble to find child care for their kids. Air traffic controllers and airport security will see cutbacks, causing delays across the country.” –President Obama, weekly radio address, according to Real Clear Politics on February 23.

There is no question that many people who work in government or within its food chain will certainly feel some pain.

Putting the cuts in perspective

However dire the cuts might sound, these cuts are immensely survivable by our economy.  In fact, if we look at the period following WW2 when the government was withdrawing massive amounts of spending we see an entirely different picture. 

A September 2012 paper by Cecil Bohanon from Ball State University found that in 1944, the US Government was about 55% of GDP, and by 1947, government shrank to a more normal 16% of GDP.  This was a reduction of government spending by 75%. On the other hand, consumption rose by 22%, private investment rose by 223%, and housing exploded by 600%.

Similar to today's rhetoric, some very smart people predicted some doom and gloom. According to Bohanon’s paper, Gunnar Myrdal, who later became a Nobel Prize winner, forecasted an “epidemic of violence" by the amount of spending being withdrawn by the government after the war.  Oops!

Needless to say, we are not facing a human consumption explosion similar to that in 1947.  However, we really don't need one either.  We are talking about $85 billion in cuts, which is only 0.53% of today’s GDP of $15,829 billion.

Cash pile

When you look at consumer savings, they are sitting on massive amounts of cash—and have been adding to it.

The Federal Reserve reports that personal savings as of December was $805.2 billion, which is an increase of $412.3 billion since September. FactSet also reports that non-financial S&P 500 companies are holding on to $1.23 trillion of cash. Suffice to say, between households and corporations, there is a very large amount of cash on hand that can be spent.

While it might be time to brace for the impact of a policy induced recession, it might also be necessary to continue to keep our tilts toward growth.  Consumers might just surprise expectations and make up for what policy makers can’t: spending.

Will the cuts be hurtful? Sure. Is it as apocalyptic as the headlines suggest? Far from it.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Handicapping Sequestration
Weekly CEO Commentary 2-19-13
Tim Phillips, CEO—Phillips & Company

It simply amazes me how much we have to talk about government fiscal policy and the market moving forces it creates.  Just as a recap, the list of the times the US Government has been in a fiscal debate during these last two years is astonishing:

-December 2010: The Simpson-Bowles Deficit Reduction Committee report is released; the report is ultimately largely ignored
-May 2011: Bipartisan “Gang of Six” talks to raise debt ceiling begin to break down
-July 2011: The House passes a plan to raise the debt ceiling and reduce deficit; plan is immediately tabled in the Senate
-August 2011: A compromise debt ceiling plan is ultimately passed, and as part of this plan, Congress must pass a deficit reduction bill or $1.2 trillion in automatic cuts will take place—which came to be known as the “Fiscal cliff”
-December 2012: Congress attempts to pass a resolution to the “Fiscal cliff”, and ultimately postpones the issue until March

It’s no wonder why corporations are sitting on cash. Here are some stats on cash positions at major companies:

What's ironic is the President is asking Congress for $1 billion dollars for innovation programs recently. That figure is just 8/10ths of 1 percent of General Electric’s cash and short term investments.

How about this: the political class should create some stability in governmental fiscal and tax policy, and then perhaps GE and others will spend some of their massive cash stockpiles on innovation.  The best part is corporations need no congressional silliness to do this. 

The 120 billion dollar outcome

The sequestration in its current form will require cuts of $1.2 trillion over 10 years, split evenly between domestic discretionary spending and defense, according to CNN’s article “CNN Explains Sequestration” on February 19. This would be $120 billion per year. To put this number in perspective, US GDP from the Q4 Bureau of Economic Analysis report on January 30 was $15.8 billion.

A cut of $120 billion would cut US GDP by 0.75%, which is significant when we already had negative GDP growth for last quarter (discussed in our blog two weeks ago).

More Spending, Higher Taxes

I regrettably am handicapping sequestration as a 60% reality. Here's why based upon some basic facts:

Fact 1:  Most Republicans are sitting on very safe seats.  Nate Silver, the noted handicapper of political races, wrote a December 27 article in the New York Times titled, “As Swing Districts Dwindle, Can a Divided House Stand?” In it, he wrote that there are only 35 swing seats—down from 103 in 1992.

Fact 2:  Gerrymandering has created a very Republican bias in the House, and that is driven by the rural nature of their constituents.  While there were more votes for Democratic congressmen, they were mostly wasted votes in urban population centers.  Essentially, Democrats had lots of turnout in their fewer congressional seats vs. Republicans that had less turnout but in more seats.

The table below from the Washington Post shows this trend in actual bias with and without incumbency.    

Fact 3:  The most recent proposed solution to the sequestration cuts suggest a split between cutting spending by $55 billion and raising taxes by $55 billion, according to a recent plan titled the “American Family Economic Protection Act.”

Deduction 1:  Republicans in safe seats cannot vote for more spending and higher taxes.  It's not in their DNA, and they are certainly afraid of a primary challenge to their seat.  Basically, it's not in their incentive to do so.

Deduction 2:  If Republican's give on taxes now, they will not have anything to negotiate with on tax rate reform later in the year.  The President will have gotten more taxes and a little less spending, leaving Republicans scratching for something to negotiate a flatter tax system with.

Deduction 3:  There is little time to negotiate a major tax rate overhaul in this round leaving them with only two choices; sequestration cuts go through or they kick the can again.

My handicapping suggests a 60% likelihood of sequestration, and a 40% likelihood of kicking the can.

So what to do with your money 

The first thing is to realize the anticipated impact on GDP from the cuts will be -0.75%.  Second, and this is critical, GDP and stock market performance are not highly correlated, which we wrote about previously.  Finally, these cuts will have very little impact on emerging markets and developed economies outside the US.

I would suggest keeping a well-diversified portfolio with a decent exposure to global markets.  I would not run for the exit on most fixed income, with the exception of longer-term TIPS and US Treasuries.  In either sequestration scenario detailed above, a mild recession could be in the offering. 

Most importantly, continue to examine your need for funds from a timing perspective and be clear about the volatility you would face in your allocation during that time.  From there you can make some very educated decisions.  We would welcome the opportunity to run this analysis for you and I think it's the most important data point you can have.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Beating (Low) Expectations
Weekly Market Commentary 2-11-13
Tim Phillips, CEO—Phillips & Company

As we have written about previously, beyond the noise of headlines, what really drives stock prices is earnings. The S&P 500 has been approaching all-time highs, and as of last Friday, according to FactSet, 72% of S&P 500 companies reported better earnings than analyst estimates for Q4. Also, 67% of those companies had better sales than estimated.

Part of this, however, is because expectations for earnings and sales were set low to begin with. Since last summer, there have been more earnings estimates by analysts revised downward than upward.

Image source: Bespoke

Companies seem to be keeping investor expectations cautious for this quarter as well. FactSet reported that “63 companies have issued negative EPS guidance for Q1 2013, while 17 companies have issued positive EPS guidance.”

Image source: Bespoke

Cautious expectations are not without merit, as we did see negative GDP growth last quarter, and policy concerns remain.

Then again, continuing to have a low bar for expectations could set us up for another round of beating estimates for next quarter. It’s worth noticing that institutional investors don’t seem to be spooked by the low expectations; in fact, according to Thomson Reuters, money has been moving into equity funds at rates not seen since the year 2000. If the bar continues to be set low and if companies continue to leap over it, the market could continue to rally.

We remain with the view that the best approach is setting a long-term asset allocation, sticking with it, and tuning out some of the noise.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Policy Errors, Part II
Weekly CEO Commentary 2-4-13
Tim Phillips, CEO—Phillips & Company

It's official: the threat of massive cuts in spending with the fiscal cliff created a contraction in our economy.  According to the Financial Times, GDP as reported this last week contracted by 0.1%,  which is a drop from positive growth of 3.1% in Q3 to a drop in Q4.

Much of the drop resulted from a contraction in defense spending, which dropped by 22% or 1.3% of GDP, according to reports in the Financial Times and the Washington Post.  The Defense Department foretold steps they would have to take in preparation for sequestration, even if it were delayed. As early as February 2012, Defense Secretary Leon Panetta asked Congress to undo sequestration, saying, “There is very little margin for error in this budget.” Defense contractor Lockheed Martin announced layoffs in September, citing declining military spending as one of the reasons.

More recently, Ashton Carter, the Deputy Secretary of Defense, stated in a memo to the Department of Defense on January 10, 2013:

“The possibility of sequestration occurring as late as the beginning of the sixth month of the fiscal year creates significant additional uncertainty for the management of the Departments…I therefore authorize all Defense Components to begin implementing measures that will help mitigate our budget execution risks.”

The memo went on to outline hiring freezes, cuts in the Defense Department’s civilian workforce, and other measures.

What this means

It's critical to realize nothing actually happened from a policy standpoint. There were no mandatory cuts or congressional action–just simply the threat of massive cuts, which caused the Defense Department to scale back in preparation.

Generally when we wind down from a war, we collect on a "peace dividend", or cuts in defense spending, similar to the end of the Cold War. In the 1990's, the economy was growing at an average of 3.3% according to Bloomberg, so any cuts in defense spending after the Cold War were easily offset.

Today, it's an entirely different story.  While consumer spending expanded by 1.52% of GDP, it's not enough to help offset such a major impact on Defense.  We simply didn’t grow our economy fast enough to take massive cut's in any one component of GDP.

Source data: Bureau of Economic Analysis

Consider Q4 2012 to be Policy Error I.  Regrettably, we still face Policy Error II.  The "Political Class" kicked the can on sequestration until March 1. If we have a repeat of Q4 2012, that would be two quarters of contraction.  That would be the official definition of a recession. 

Market participants are clearly forecasting a resolution to this problem, as the S&P 500 is trading near all-time highs.  Let's hope they are right.  A 2% GDP growth economy is not enough to offset massive immediate cuts in consumption, government spending or business investment.  I would keep your foot on the gas and the brakes at the same time with your portfolio.  Don't give up on your fixed income allocations.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Measuring Sleepless Nights
Weekly CEO Commentary 1-28-13
Tim Phillips, CEO—Phillips & Company

I was recently asked by a client to explain what standard deviation is as it relates to investments and what's a good number.  Two things struck me about the questions.  One, it's a great question that merits an answer, and the other is a reminder to all professionals in my field, including me, to speak English and not complicate matters.

Most of you reading this will likely care very little about the standard deviation of your portfolio.  You outsource those issues to us and depend upon our background, experience and analytical ability to deal with such technical issues.

What I have learned though over the many years is that standard deviation impacts every investor in a very personal way.  Allow me to explain.

Standard deviation (which we will abbreviate as SD), when it relates to your portfolio, is a measure of how much your portfolio moves up and down from its average return. Basically, it is a measure of volatility.

As you can see from the table above, a sample 60% Equity/40% Fixed Income portfolio over a 10 year period has an average return of 6.62% with an annualized SD of 9.03%.  That means in any one year period given a 1 SD event, this portfolio could move up or down from its average by 9.03%, to -2.41% or 15.65%.

Unfortunately, this is not very real world.

What constitutes a 1 SD event?  That's a really hard question to answer as almost everything falls within a 1 SD event: earnings reports, economic releases, government interventions (tax policy and budget problems) interest rate movements—the list can go on.  You can see from the table below that 95.5% of the issues that impact a portfolio are within a 1 SD event.

Table: Percentage of standard deviation events by time period 

Source: CFA Institute. 

To add a bit more real world to this example, let's take a look at pretty big standard deviation periods.  According to the CFA Institute, "the largest positive [SD] event of all time occurred on 13 October 2008, when the S&P 500 surged upward 11% registering as an 11.82 [SD] event.” This was due to central banks coordinating easing policies to calm credit markets.  Meanwhile, the largest negative SD event was the famous 19 October 1987 crash, which was a whopping 20.98 SD event! (I have experienced both as a professional advisor as I am sure many of you have as an investor).

Table: Actual number of standard deviation events.

Source: CFA Institute.

Conclusion

In real world terms, standard deviation is a measurement tool that should be used by you to measure your threshold for pain, ability to withstand that pain, and time needed to survive it.  If you think you might lose sleep at night when your 60/40 portfolio drops by 1 SD or 9.03%, you might have to get used to sleeping less.  It's a fairly regular occurrence—but it also happens on the upside as well.

Of course, we spend considerable time trying to reduce the SD in a portfolio while minimizing the impact on the returns you could experience.  Pragmatically, it's really your ability to deal with the standard deviation/volatility that allows us to generate the returns you need.

That's why I always remind investors that sometimes going overly conservative and sleeping well today may not lead to living well tomorrow.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

American Consumerism
Weekly CEO Commentary 1-22-13
Tim Phillips, CEO—Phillips & Company

If the S&P 500 is any guide, the American Economy is back on track.  Reuters reported that we hit a five-year high on the index last week, and it also appears we will not have a nasty showdown over the debt limit in the coming weeks—all good news indeed.

The question that still looms large in my mind is will the American Consumer return to his or her normal ways?  When I mean normal, I am referring to borrowing and shopping.

So far, this post-recession recovery has been exceedingly muted.  According to Bloomberg, we are averaging about 2.25% in real GDP growth since the economy bottomed out in Q3 2009.  While that does not seem so bad, it actually is low when it comes to recession recoveries, which historically have been 3.0% in real terms, and 6.3% in nominal terms.

With 70.4% of our GDP driven by consumption, it's important to ask, has consumer behavior changed—and if so, when will it change back to normal?

Much of what drives consumerism in America is expectations.  Consumers that have positive expectations tend to spend more and save less.  The best indicator of consumer expectations is from The Conference Board that measures consumer confidence.  Unfortunately, consumer confidence dropped last month, and has yet to reach pre-recession levels, according to Bloomberg.

Even more troubling is consumers attitudes towards a return to normal. According to the latest COUNTRY Financial Security Index survey, just 27 percent think the old, pre-recession economy will return. Half of these Americans don’t expect to see it return until 2015 or later.

The survey went on to suggest that 35% of Americans are dealing with the "new normal" by cutting spending or downsizing—not exactly the news you want to hear if you’re betting on a quick recovery in consumption. 

According to the Senior Loan Officer Survey from the Federal Reserve, demand for consumer credit weakened a bit in the fourth quarter. A net 8.5% of banks reported stronger demand for credit card loans, compared with 11.1% last quarter. A net 16.9% of banks reported stronger demand for auto loans, compared with 33.3% in the third quarter. And, a net 4.8% of banks reported stronger demand for consumer loans excluding cards and autos, compared with 10% in the third quarter. While we do not want to go back to the extreme levels of debt that got us into the crisis, it is clear that consumer’s appetite to take on credit has weakened to some extent.

Housing

Before we write off American Consumerism as dead, we should test all of this negativity against the largest purchase a consumer makes: their home.  It appears home ownership, in spite of the trillions lost and millions of foreclosures, still appeals financially to the vast majority of Americans.

Attitudes and fear appear to be immovable objects when it comes to a return of the American Consumer.  I would not bet in the short run on the type of consumption habits that we saw in 2006 or 2007.  However, I would also not bet against the long range return of the consumer.  I would adjust my holdings to reflect those beliefs as we have done in many of our allocations. 

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Diversification Finally!
Weekly CEO Commentary 1-14-13
Tim Phillips, CEO—Phillips & Company 

For the last couple of years, investors that followed the easiest thing in finance, diversification, were not properly rewarded.  In fact, a heavy emphasis on US Large Cap stocks was a fairly rewarding experience.  From January 2009 to December 2011, the S&P 500 had an annualized return of 14.12 percent, according to Bloomberg.

For many wealth management firms and "Too Big To Fail" banks, this was a particularly rewarding experience.  Most of these institutions have a bias toward US Large Cap because it's easy to research and clients generally don't question what they know: large, familiar US companies.  Behavioral scientists call this a “home bias”.

Unfortunately, my concern is investors have become complacent with the previous wonderful US Large Cap returns.

This past week might have marked a return to rewarding diversification, where we saw the largest flow of funds into long-only equity funds since March 2000, according to Business Insider.  Bloomberg also reported that last week was the 18^th-consecutive week that emerging market stock funds showed inflows, showing that investors have been moving into asset classes aside from just US Large Cap.

Why diversification works

What makes diversification work is something called correlation: the way in which asset classes move in the same direction and to what degree. The highest possible correlation is 1, meaning the asset classes are moving in the exact same manner.  As investors, we want to see low correlations, meaning our portfolio isn’t as affected by a swing in one of our holdings.

In 2008, we saw correlations come together.  It's what you would expect when markets are under so much distress; investors sell everything and move to cash, so correlations tend to get closer to 1. Below is a table of correlations in 2008 from Bloomberg:

Now, here is another correlation table from Bloomberg for the second half of 2012.  When you compare the two, you can see asset classes are starting to decouple—hopefully rewarding diversification.

It's important to remember that in any given year, there will always be at least one asset class that outperforms a diverse portfolio.  For example, if you rolled the dice and invested heavily into real estate investment trusts in 2006, your portfolio would have easily beaten a diverse portfolio. REITs returned 35.1%, whereas a sample diverse portfolio only returned 15.2%, according to JP Morgan. Unfortunately, in the following year, REITs were the worst performing asset class with a drop of -15.7%, whereas diversifying across asset classes gave positive returns. Below is a table from JP Morgan illustrating this:

The "Free Lunch" of diversification comes in the form of reduced risk and smoother returns in the long run. Investors may have piled into US Large Cap equities because they are familiar—and because they have indeed performed well in the last few years—but our expectation is diversification will be rewarded over concentration going forward.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Precisely Inaccurate
Weekly CEO Commentary 1-7-13
Tim Phillips, CEO—Phillips & Company

This is the time of year when firms roll out their predictions for 2013.  Honestly, if they were so accurate they wouldn't need clients, nor would they share their information.  It would be too valuable.

However, firms understand one thing about investors; they love predictions.  I call it the "Prediction Addiction".  There is plenty of behavioral science research that supports this phenomenon, and mostly it comes down to our preference for certainty—even when it means inaccuracy.

Just take a look at the last year's market forecasts of top firms.  Remember that the S&P 500 closed at 1426.19 at the end of December 31, 2012, and GDP growth through Q3 2012 (the most recent set of data available) was 3.1%.  How accurate were these forecasters?

Perhaps the collective wisdom of all the firms, by looking at the average predictions among them, is the best relevant tool.  Regrettably though, when you look at last year’s average prediction among those eight firms, it was also inaccurate. The average among those firms was 1341—off by 85 points, or 6 percent. That may not seem like much, but keep in mind that the S&P 500 was up by 13.42 percent last year, according to Bloomberg. A miss of 6 percent is a miss of almost half of the S&P 500’s returns.

In light of this repetitively inaccurate exercise in forecasting, we thought we would simply publish others attempts at guessing where the market would end and how much GDP would grow this year.

The bottom line is very few of us will profit from these parlor tricks.  Making a very precise prediction may sound good; however, the more precise a prediction is, the less likely it is to be accurate.

Our predictions:

• Diversification will be rewarded this year as correlations among equity asset classes decouple.
• Emerging Markets finally have a recovery and outpace US equities, especially China and Russia.
• International Developed and Emerging Small Cap stocks will have the biggest risk to reward opportunities, especially Japan.
• Emerging Market Debt and International Developed Debt will offer better upside than US High Yield.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

All The Times I Thought I Should Sell: Panic
Weekly CEO Commentary 12-31-12
Tim Phillips, CEO—Phillips & Company 

As of this writing (Sunday Night) the Political Class in this country has failed to come to terms with over 500 billion in tax increases and spending cuts that will take place throughout 2013. This chart below from Goldman Sachs shows the projected impact of these measures on GDP next year.

According to Bloomberg, most Wall Street firms are forecasting GDP growth of 2.0 percent for next year, or approximately $316 billion based on the current GDP number of $15,811 billion.

As we wrote previously, Credit Suisse estimates a most-likely case drop in GDP growth by 1.5 percent from the fiscal cliff. It’s just simple math: if our baseline growth is only 2 percent, and if the impact from the fiscal cliff is 1.5 percent, that takes our economic growth down to almost zero.

So, one might think we would fall into a mild recession or a near zero growth economic environment.

As I have said in the past, I am hopeful something permanent will be resolved and allow the US economy to continue to slowly recover.  However, there is always a little part of me that thinks, sell.  It's only through 27 years of experience that has me fight that bias and reflect on all the times in the past I thought I should sell.

Here’s a table with some of the troubles I have seen in the past, and how much the market has risen since then:

As you can see, after each event, a recovery was forthcoming and those that would have sold and panicked would have paid dearly. In fact, some of the best performance came immediately after the market bottoms.

The rational things to do in times such as this are to assess your time horizon and reconfirm your targeted rate of return.  Be certain you know what you’re trying to achieve with your investments and if you are not clear, gain clarity and alignment with your advisor. 

Unfortunately, of all the times I thought I should sell, this one seems like the silliest.  The political class in this country has become tone deaf and has lost perspective on how much pain and suffering comes from their inaction.

As for specific actions, we continue to favor assets that pay a return while we wait.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Really?
Weekly CEO Commentary 12-24-12
Tim Phillips, CEO—Phillips & Company

While I was traveling through India in April I snapped the photo you see on the header of this blog.  I've looked at it several times over the course of this year and I finally figured out what his expression suggests: Really?!

I can only imagine that same look on his face if he considered what the political class is incapable of doing in our country: Solving our fiscal issues.

Consider the following numbers. The difference between the President and the Speaker on spending and revenue is only $200 billion. That's $200 billion over 10 years, or $20 billion a year.

Now consider that last week, we saw a spike in the Volatility Index—a measure of fear in the market—and we also saw consumer confidence fall to a five-month low. On the other hand, we also saw GDP growth revised up to 3.1 percent—not bad at all—and we saw a better than expected report on durable goods orders. There may be fear in the market, but the economy is showing signs of resilience.

If the political class cannot come to terms on a solution, we will face significant uncertainty, and that's not good for our economy. Let’s not ruin things over $20 billion per year.

If you consider a 1% drop in equity markets, as measured by the S&P Composite 1500 broad market index, that would be equal to $145.2 billion in equity stripped out of our asset base and economy.

A 5% drop would be $707.98 billion in equity.  When we are only talking about $20 billion in revenue and spending per year, the only thing one can say is, really?

Now consider how much we spent on stimulus ($819 billion) and how much Federal Reserve intervention was taken (over $2 trillion) to save our economy from ruins.  Again, reflect on the small difference that separates the two Parties and what their indifference can do to our economy.  Really?

This type of decision making process is what makes a third-world country risky to invest in.  Political risk should be left for others—not America.  Really?

I'm still hopeful we will see a resolution and continue to see our economy work its way back to a more prosperous growth footing.  Perhaps that's just hope.

After all, this is the season of hope.

Wishing you a very Merry Christmas and the Happiest of Holidays.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Don't Look Down: The GDP Growth Cliff
Weekly CEO Commentary 12-17-12
Tim Phillips, CEO—Phillips & Company

This week the Federal Reserve took another step in encouraging risk taking by shifting their communication policy.  They effectively went to a rules-based approach to managing interest rates.  In short they said as long as unemployment was above 6.5% and inflation was below 2.5%, we could expect near zero interest rates:

“…The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

-Federal Reserve press release on December 12, 2012

Couple this with their prior statement in September when they committed to keeping rates very low until 2015, and it's easy to conclude we are in for a slow growth economy.

Fortunately, we can now almost build a matrix or grid to calibrate interest rate expectations.  While the Fed gave themselves plenty of room to maneuver in their statements by suggesting other factors would be taken into consideration, it's quite clear we now have some specific rules of thumb to rely upon.

For example, if we added 150,000 jobs per month and keep the labor force participation at 63.6% of the population it would take roughly 3 ¼ years around 2016 to get us to the 6.5%.  In fact, I have included a link from the Federal Reserve Bank of Atlanta that will let you run your own scenarios.  

What happens if we change the participation rate?  After all, when the economy heats up more people will likely jump back into the labor market.  Take the 150,000 jobs per month and simply increase the participation rate to 65% and we are talking about 9 years to see interest rates rise and unemployment drop below 6.5%.

Behaviorally, you might think it's time to run for the exit on your equity investments—but once again, the counter-intuitive point might be better with finance. Historically, according to Goldman Sachs, there is little correlation between GDP growth and equity returns, Also, interestingly enough, the Goldman study suggests that the relationship between equity returns and GDP growth actually shows better returns during slower GDP growth. Here is a chart below from their study:

Further, when you look historically at different inflation and interest rate environments, we can see that with low and rising inflation, all asset classes showed positive returns, according to JP Morgan’s chart below:

While the Fed through their actions signaled we are actually well over the GDP Growth Cliff, it certainly does not suggest we should sell and hide.  Quite to the contrary, it might just suggest that we don't look down. 

Newtown

All of this seems trivial in the face of such a horrific event in the Sandy Hook village of Newtown, Connecticut.  Every one of us at Phillips & Company extend our deepest sympathy and heartfelt thoughts and prayers to all those suffering and grieving, especially our clients and colleagues in Connecticut.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

It's Never Quite What You Expect
Weekly CEO Commentary 12-10-12
Tim Phillips, CEO—Phillips & Company 

If you followed your instincts and sold out of your equity positions 3 weeks ago, you would have missed a 2.25% return.  Certainly you would have been reacting to your instincts that tell you the political class in this country will not resolve our fiscal issues without a messy fight.

Your instincts would have also told you the last time we saw such a fight—the summer of 2011 with the debt ceiling—our markets dropped precipitously. We saw a drop of 16.5% from May 18, when negotiations started to break down, to August 8, the Monday after the US credit rating got downgraded.

Your next thought might be to simply sell out and avoid a possible drop.  The problem is that now you’re in the slippery slope of market timing, and we all know where that leads.

The political class has been playing chicken with a very fragile economy, destroying the confidence of business and consumers, and the media has been painting a doom and gloom scenario. But, the reaction of market participants has been quite the opposite from what you would expect.  They have been buying.

Could it be the underlying economic data suggests something else is occurring?  When you look at the recent jobs report, you see a fairly stable picture of employment.  While the participation rate in the labor force is indeed down, companies are still hiring—albeit at a very slow and steady rate.  According to Dismal Scientist, US companies added 147,000 jobs in November, just enough to keep up with new entrants to the workforce.

Consumers are certainly willing to take on more credit to express their desire to spend.  Our recent report on Consumer Credit contained some interesting data.  

According to Dismal Scientist, Consumers borrowed 14.2 billion dollars in October with 3.4 coming from revolving credit (basically things you buy on your credit cards).  Overall this reflects a 6.2% increase on a YOY basis.  What is really impressive is the consumer is willing to make non-revolving purchases on things like homes and autos.  On a non-revolving basis, consumer credit expanded 7.1% on a YOY basis.

While this data reflects on behavior from two months ago, and I certainly expect a slowdown to some degree, it's not likely the consumer will shut down like we saw in the last recession.  Between a decent jobs report and consumers feeling confident enough to borrow, the de-leveraging trend we have seen in household balance sheets might be easing and allow for some economic tailwinds.  

Perhaps that is what market participants are seeing as they bid up stocks despite the incredible uncertainty surrounding the circus in Washington DC.

My recipe for working through the next several weeks is quite simple:  look past volatility, be ready to deploy any dry powder during a significant pull back in valuations, and don’t anchor your investment timeframe on political noise.

Of course, you could continue to buy in defensive sectors like consumer staples or healthcare, as well as income paying assets.  However, nothing is really safe from the circus in the short run.  It only takes one clown nowadays to make a circus and we have a wide variety of actors to choose from.

Panic and emotional reactions are not an investment strategy, and besides, we have all been fooled plenty of times as the markets never react quite the way we expect them to.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Stock Buybacks: Headline Investing or Looking Under the Hood?
Weekly CEO Commentary 12-3-12
Tim Phillips, CEO – Phillips & Company

Stock buybacks are expected to be on the rise, according to a report in the New York Times. We have already seen Starbucks, Procter & Gamble, and Chipotle announce buybacks, and ADT has announced both a buyback and a dividend. In the past, buybacks were generally viewed as a bullish sign, but there is more to the story. Here is what investors need to look out for to stay prudent.

Why do companies buy back stock?

As investors, the whole reason why we buy a piece of a company is to get a return on our investment. We can do this by either having the value of the stock increase in value, or we can get a return by the company paying a dividend. From a longer term perspective, if the economy is strong and there are lots of growth opportunities for the company, a way to increase value could be for the company to invest back into its own operations and grow the business further.

Clearly, we’re not in an economy where growth opportunities are abundant. But, corporations are sitting on record amounts of cash, so what do companies do to satisfy their investors?

When there aren’t many opportunities to re-invest into their own business, companies have two options. One of them we already discussed which is paying a dividend, but another option is for a company to buy back its own stock from the open market. Like any stock purchase, this puts an upward pressure on stock prices, which is good for investors.

But, there are some things that investors need to watch out for when it comes to stock buybacks.

The earnings management game

“Facts are stubborn, but statistics are more pliable.” –Mark Twain

Stock buybacks can create the illusion of growth when there really isn’t any. Let’s take an example of a fictitious company that has 10 shares of its stock outstanding, and the company makes $50 per year. This means the company has earnings per share of $5. Now, let’s say that one year later the company bought back two of its shares on the open market, and earnings stayed the same at $50. The company would now have earnings per share of $6.25.

That would make earnings per share look like it grew 25% in a year—seems pretty good in this economy!

But, let’s take a step back. Earnings didn’t really change at all; it was flat at $50 in both years. The only thing that changed was the number of shares on the market went from 10 to 8.

Earnings per share growth is one of the more common ways investors use to evaluate companies, but investors need to take this number in its appropriate context. If revenue growth or growth in operating cash flow is flat, but earnings per share growth is high, that might be a red flag that investors need to do some more research.

Real world data: Do buybacks actually work?

Some companies have had better success than others in giving shareholders value through stock buybacks. Fortuna Advisors and Institutional Investor magazine put together a study, where they ranked “the biggest spenders on buybacks among the members of the S&P 500 based on the two-year returns their repurchased generated.” Of the 253 companies they examined, the data shows quite a bit of disparity.

Here’s the return on investment over the last two years on the 10 best and 10 worst buybacks.

The real world data shows that buybacks have the potential to return value to shareholders, but they are by no means a cure-all if there is a more serious economic problem with the business.

The tax management game

We’re still waiting on the details of what will happen in the fiscal cliff negotiations. As we wrote about previously, one thing we do know for sure is that if nothing changes, the tax rates on dividends are set to go up significantly. The worst case on a dividend tax rate would be a maximum rate of 43.4%, and the worst case on a long-term capital gains rate would be 23.8%.

If this happens, investors may pressure companies to buy back stock rather than pay dividends, as the capital gains would be taxed at a lower rate.

Conclusion

With corporations sitting on large amounts of cash but not many opportunities for growth, expectations are that shareholder buybacks are going to be on the rise, and an increase in the tax rate on dividends could fuel this.

Even though the earnings per share growth would be manufactured from a buyback, I wouldn’t bet against irrational exuberance and investors chasing the headlines. When investors see 15% or 20% earnings per share growth rates, regardless of what the true cause was, we could see a round of speculative buying.

Investors need to be careful though. Buying back stock can, in theory, boost stock prices, but the actual results show there is a significant amount of variance in performance after buybacks.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

The All Consuming Fiscal Cliff
Weekly CEO Commentary 11-26-12
Tim Phillips, CEO – Phillips & Company

It's clear that Thanksgiving dinner could barely wrap up as the shopping began.  Stores opened as early as 8 PM on Thursday to get a jump on the most important tradition Americans share: consumption!

CNN reported that shopping was up 9 percent on Black Friday alone and up 13 percent over the whole four-day weekend compared to last year. Also, they reported that Internet sales were up 26 percent over last year and set a new record by breaking above $1 billion. Clearly, the US consumer doesn’t seem swayed by the uncertainty around the threat of higher taxes. 

I had a fulsome discussion with Jon Talisman, a leading expert on tax policy from the Washington DC based Capitol Tax Partners. It might be helpful to consider the impact on consumption from some of his thoughts. After all, 70%+ of our economy is based upon our willingness to shop. 

As you can see from his bio, he has clearly spent time with those that are in control of the outcomes on taxes in the coming years.  Here is a link to our first in a series of 4 conversations that will take place over the next several weeks, in MP3 format.

The good news

People at specific income levels consume a certain percentage of their income. As you can see in the chart below, those in the lowest levels consume more than 1.6 times their income, generally through government transfer payments to them. Those at the very highest income level consume about 9% of their income.

For our purposes, it's not necessary to calculate which quintile consumes the most in aggregate dollars, but rather to examine the income impact for those in each quintile based upon some proposed tax scenarios.

First, let's look on the chart below at the income impact from an idea to cap overall deductions to $50,000.

For those in the lowest quintiles, the tax impact is negligible.  For those earning, $100,000 the impact is still negligible.  While the impact on the top quintile is more pronounced at almost a 1% drop in after tax income (that's about $21,000 in additional taxes that won't go to their consumption), this is also a group that only consumes about 54% of their incomes—not a small amount, but not enough to drop us off a consumption cliff either.

Those earning over $7 million would see a drop in after tax income of 2.4%, or $194,000 on average. What decision would a person making over $7 million make regarding their consumption? Probably nothing different.

Here is a chart giving a look at the projected impact of a tighter cap of $25,000 on itemized deductions.  Again, there is nothing that suggests a shut down the great American tradition on spending and consumption.

Given the fear in the market, if the ultimate solution is a cap on deductions, we could see an upside surprise to low expectations on consumption.  The hard data suggests we just wouldn't see the impacts being talked about under that scenario.  Don't get me wrong: no one wants to pay higher taxes and I'm not supporting that as a position.  I'm simply trying to determine if we will fall off a consumption cliff if certain tax measures are implemented.

Based upon income levels associated with consumption and tax increases, it doesn't appear to pose a threat to our American tradition.

The bad news

However, if we do not have a definitive agreement and we were to fall off the fiscal slope, consumption would indeed take a hit.  When you consider all that is going to expire—the Social Security payroll tax cut, the lower income tax rates from the Bush tax cuts, the lower tax rates on dividends, the “patch” on the Alternative Minimum Tax—you can see how consumption would be impacted across the board.

Below is a graph showing the percentage change in federal tax rates if everything in the fiscal cliff hits.

Conclusion

It's clear that policy makers know what is at stake.  If they implement a cap on deductions or something similar, we wouldn’t get a major negative shock on consumption.  If we get no agreement and taxes go up on everyone, then there will be pain felt across the spectrum. The problem with playing chicken on policy is the small chance of something big and bad happening. 

What investors can do:

• Look past volatility in the short run.
• Recalibrate your time horizon in the markets. Don't have assets that you will need in the short term exposed to excess volatility.
• Calculate your future liabilities and determine if your current portfolio is meeting those or taking too much risk.
• Email your representatives in Congress and demand that they solve this game of policy chicken.

While the fiscal cliff seems scary enough, it's really the consumption cliff that we need to avoid.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Fear or Rationality
Weekly CEO Commentary 11-19-12
Tim Phillips, CEO – Phillips & Company

With the markets down 3.7% in the last three weeks, it's easy to think investors are fearful.  Or, they could also be rationally pricing in some legitimate issues.

Let's take the fear side first.  It's easy to be fearful of the fiscal cliff, as it has significant economic importance to future growth.  According to Credit Suisse, the most likely case after negotiations are finished is a -1.5% drag on GDP growth.

It's also important to consider these cuts not as a cliff, but perhaps something much more gradual.  As you can see from the graph from Goldman Sachs below, the economic impact is expected to come over the course of the year. As for reasons to sell assets immediately, that would fall on the massive increase in capital gains taxes as well as increased tax on dividend and interest.

However, both parties agree that one critical component of any deal cannot be policies that hurt growth in our economy.  According to MarketWatch, President Obama has been in conversations with business leaders to try to mitigate the impact of the fiscal cliff, including names such as Jamie Dimon (JP Morgan), Tim Cook (Apple), and Jim McNerney (Boeing).

Representative Tom Price, the chairman of the Republican Policy Committee, also spoke on CNN’s State of the Union on November 18, saying “We want a real solution, which means increasing tax revenue through pro-growth policies.”

Certainly it is plausible that investors are selling from fear of the unknown.  But, for investors that are collecting some very large yields from investments bought cheaply, selling is much harder to do.   For example, if you bought GE at its price of $7.60 on March 2, 2009 you would be receiving an annual dividend yield of 8.9% with today’s quarterly dividend of 17 cents per share. To put that 8.9% in perspective, buying GE today has a current dividend yield of only 3.3%.  It’s hard to sell something that gets you generous cash flows, when you would have to re-invest in much lower yields today.

Rationally, there could be more to this pullback than fear of the unknown.  As we mentioned in a past blog, earnings matter most when it comes to driving stock performance.

With earnings season wrapping up soon, we now have a clear picture of what's going on.

According to Bespoke, more analysts are now revising earnings expectations downward and more companies are lowering guidance than this time last year. More troubling, however, is that 58% of S&P 500 companies missed expectations on sales last quarter. 

You can see from this data that overall, earnings and revenue growth are showing some deterioration.  But, there is a bright spot in retail. As we wrote about in a previous blog, the American consumer has been surprisingly resilient.  According to FactSet, estimated Q4 earnings growth is expected to be high in apparel retail, stemming from “Black Friday” and holiday shopping.

I believe this might be a small earnings recession that you would see in any business cycle. 

It might just be magnified as we are in a slow growing economy—but one that could erupt with growth if we could eliminate the fear that is plaguing investors and consumers.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

The Emotional Cliff: Jumping is not a Strategy
Weekly CEO Commentary 11-12-12
Tim Phillips, CEO – Phillips & Company

Before I get into my market commentary, I want to take a minute to extend a thank you to all of our veterans and active duty military personnel for all of the grueling hard work and sacrifices that they make for our country. We hope everyone deployed overseas comes home safe and can enjoy a little down time for the holidays.

Investing after the election

It seems that the investor class is taking the election results very hard.  As Phillips and Company serves literally thousands of business owners and employees with defined contribution accounts, we have a decent view on attitudes. It's clear that investors are worried and perhaps fearful.

The election results could have a significant impact on personal income taxes, as well as taxes on dividends and interest.  After all, it was perfectly clear that taxes were going to change for upper income earners no matter who won.

Tax rates[1]

Before we all jump off the emotional cliff, let's just step back for a moment and evaluate a few of issues.

What's in your control - Expectations

First, when you invest, you should be looking to meet an overall objective.  In my opinion, the number one objective is to meet some kind of expected rate of return.  That target rate should be set by your future needs or liabilities, and your target rate should not change with election results. However, if you want to lower your expected rate of return, you could spend less today to have more tomorrow.  If you want to spend more tomorrow, you can take more risk and increase your expected rate of return.

You can see nothing political drives your expected rate of return, and whether or not you meet that expectation is another matter.

How serious are we about debt?

Second, while the consensus opinion might suggest tax rates are going up, I want to advance another perspective.  It's possible rates might not change at all.  In fact, we might see rates lowered.

“Let's extend middle class tax cuts right now. Let's do that right now. That one step would give millions of families, 98% of Americans, 97% of small businesses, the certainty that they need going into the new year.” –President Barack Obama on November 10.[2]

“It’s clear that there are a lot of special-interest loopholes in the tax code, both corporate and personal. It’s also clear that there are all kinds of deductions, some of which make sense; others don’t. And by lowering rates and cleaning up the tax code, we know that we’re going to get a lot more economic growth.” –House Speaker John Boehner, November 9.[3]

You can see both party leaders are thinking along the same lines. Perhaps deductions might be trimmed, but actual rates could be lower. Or, perhaps spending cuts might not happen as fast in order to keep tax rates on dividends low.  We will see how serious politicians are about cutting spending in the face of certain higher taxes. 

No one questions the fact that for our country to resolve our fiscal issues, it's not income or debt alone that will do it.  Growth is really the only big solution. Clinton era tax rates worked in the face of a massive technology boom not seen since the transcontinental railroad, with an average GDP growth rate of 3.8% from 1993 to 2000.[4]

It's also clear we are not facing the growth rates Clinton era economies experienced.  I would not be surprised to see much less rhetoric about spending cuts, in exchange for some compromise on tax rates and deduction caps. 

Don't bet against stability

Third, I often site John Maynard Keynes when he says: “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain.” Keynes wrote in his book The General Theory of Employment, Interest and Money about the importance of investors having certainty of what kind of fiscal policy to expect.

If we get some answers from Washington about policy—regardless of the answer, but as long as it clears up uncertainty and confusion—I think a couple of things happen:

            A)  US corporations that are sitting on historic levels of corporate cash would begin to invest in expansion.  Corporations are currently sitting on $392 billion in cash, and the average over the last 20 years is only $193 billion. If that extra $199 billion gets deployed, that could add 1.3% to GDP.

            B)  Banks are sitting on $1.4 trillion in funds above and beyond their reserve requirements. Normally, banks keep as little excess reserves as possible, as banks want to make money by lending.

Clearly, the supply of loanable funds is ample. The problem at the moment is a lack of demand, and lack of banks willing to take risk.

Keep in mind that banks can lend at 10x the amount of reserves, so a $1.4 trillion reserve amount could lead to $14 trillion in lending over the years to come.  I would not want to bet too much against the American Consumer to tap into this source of "consumption cash" when they get the urge.  Just take a simple formula of as little as $500 billion in additional loans for consumption or capital investment.  With current US GDP at $15.1 trillion, an extra $500 billion would add 3.3% in GDP growth.

A special note on inflation control:

One common concern I hear is all of this liquidity can cause inflation.  On its own, there is no question it can.  However, a little known piece of the Emergency Economic Stabilization Act of 2008 (the TARP “bank bailout” law) now allows the Federal Reserve to pay interest on bank deposits held at the Fed.

What this means is that the Fed can get another measure of control over the flow of this capital. For example, if the Fed wants to hit the brakes on inflation, they could raise the interest rates on deposits held at the Fed, and banks will be more likely to park their cash, rather than making loans. With a natural productive capacity of 3% growth a year without too much inflation, we now have a standard. The boom years of the 1990s gave us 3.8% annual GDP growth with an average inflation of only 2.6%--in line with historical averages.[5]

Conclusion

While I have been warning against some massive volatility in weeks to come, there are just too many strong factors that suggest a run to cover approach.  Unless you can lower your lifestyle in the future and change your expected rate of return you need, allocation will matter the most in meeting your lifestyle and planning needs.  Jumping off the cliff is not a strategy.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Alex Cook, Associate – Phillips & Company

Does It Matter
Weekly CEO Commentary 11-5-2012
Tim Phillips, CEO – Phillips and Company

Of all the times to not be political, now is one of the best.  In what looks like a very close election and polls suggesting an evenly divided country, I am sure emotions are running very high.  Out of respect for our equally divided and diverse client base, I think its best I focus on what we all are:  The Investor Class.

If you have a 401(k) with your company and we provide advice, you’re part of the Investor Class.  If you’re a CEO and we manage your wealth, you’re part of the Investor Class.  If you sit on one of the many committees for the foundations or endowments we advise, you’re part of the Investor Class.

The most important thing to the Investor Class is the macro environment in which we operate.  The overall economy is slowly improving.  We added 184,000 private sector jobs in October which was spread across several sectors according to the BLS:

• Construction
• Manufacturing
• Retail
• Professional and Business Services
• Leisure and Hospitality

Especially helpful were those jobs added in construction and manufacturing, 17,000 and 13,000 respectively.

US GDP grew at an annualized rate of 2% in the last quarter according to the BEA. By all measures, this will not create enough jobs to dramatically reduce the 7.9% unemployment rate; however, it will keep us from slipping into a recession.  

In fact, at the current rate of new jobs (184,000) it will take almost 4 years to see the unemployment rate drop to 5.5%.  Don't take my word for it; the Federal Reserve has a pretty nice calculator to help figure it out. 

Unfortunately, trying to forecast the future based on historical data is a bit like driving while looking in the rear view mirror.  As we have discussed in past posts, earnings are what really drive equity performance and in our current case, earnings are coming in very weak. 

According to FactSet, the S&P 500 blended earnings growth for the third quarter this year is -0.5%. If this number remains negative it will mark the end of the eleven-quarter streak of earnings growth for the index.

There’s plenty to drive the retail investor crazy with concern.  In fact, it's just the thing short-term money does: go crazy and run for the exits.  You can see from the chart below, institutional investors have been adding equities while the retail investor has been selling.  No wonder the S&P 500 is up over 125% since the March 2009 lows, when you saw the retail investor run for the exit.  

Below is a chart of the S&P 500 after Presidential Elections provided by Calculated Risk and as you can see, it would be futile to make a prediction using this type of short-term data. If you even look at slightly longer data than one or two days – perhaps something as long as 3 months – you can see elections matter, but how much?

As part of the Investor Class, we might face some short term pain.  We might face the median outcome of all elections which is 3.6% until the end of the year.   We might face even more upside through the end of the year.  It's especially important to keep one simple fact in mind.  For as long as business and government co-existed in our country, business and government have both thrived. I believe businesses will continue to innovate and find ways to grow earnings and benefit the Investor Class. The one thing the Investor Class could really benefit from is a stable tax policy from whoever lives in the White House.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Managing Earnings and Expectations
Weekly CEO Commentary 10-29-12
Tim Phillips CEO, Phillips and Company

We are over two weeks into earnings season, and it looks like companies are doing two things: managing their earnings well, and also managing expectations well.

Through the end of last week, 245 companies of the S&P 500 have reported earnings, and 71% have beaten earnings estimates. According to FactSet, over the past 4 quarters, 70% of the S&P 500 companies have beaten earnings estimates, making this quarter fairly in line with prior earnings seasons.

You can see from the chart below from FactSet, when it comes to setting investor expectations, only 64 companies in the S&P 500 have issued guidance for the next quarter and 48 of them have been below EPS estimates. It's clear that corporate offices are feeling nervous as they give guidance about future earnings that are much lower than expected.

When you review a few earnings releases from some of the largest companies, they are consistently citing global growth in emerging and developed economies as a major concern.

“You know, clearly we have – we saw a softening in the consumer segments. We talked about that when we did the pre-announcement about a month ago, and the surprise there was that China, which had been very strong, turned weak on us…” –Intel (Oct. 16, FactSet)

“Service orders of $2 billion were down 1%, also driven by Europe, down 12%...” – GE (Oct. 19,  FactSet)

“Sales in China remained weak in the third quarter and below the third quarter of 2011…While we have reduced production in China substantially, we have not seen an improvement in sales yet, and, as a result, the inventory reduction in China is slower than we had expected.”  Caterpillar (Oct. 22, FactSet)

There still appears to be a lot of uncertainty in this final quarter of the year which could lead to some turbulence in the markets:

• Uncertainty about earnings
• Uncertainty about Presidential election outcomes
• Uncertainty about Fiscal Cliff issues

However, we have seen uncertain and turbulence times in the past.  At the turn of the century you could have seen a list of worries like this:

• Bombing at the BBC Television Centre March – 2001
• Collapse of the dot-com bubble – March 2001
• Early 2000s recession – March 2001 – November 2001
• September 11 Attacks – September of 2001
• Anthrax Attacks – September 2001
• The Enron Scandal – October 2001
• Argentina Default – December 2001
• Passover Massacre in Netanya, Israel – March 2002
• WorldCom Accounting Scandal – July of 2002

When you look at what the markets have done since then, you can see our economic engine continues to run.  

I suspect companies are just being prudent in managing expectations for earnings, and I suspect we should be prudent in managing your expectations for returns in the short term.  On the other hand, low expectations can lead to large outperformance.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

For the third month in a row, retail sales numbers were stronger than expected according to the US Census Bureau. Perhaps the consumer is doing better than most give credit. This week I want to dive a little deeper into the consumer, because 70% of our economy is consumption, which drives corporate earnings.

Every category was up for the month with the exception of “Miscellaneous” (this category includes stores with unique characteristics like florists, used merchandise stores and pet supply stores).

To be fair, food and gas inflation has led to some of the gain. However, when you look at savings, revolving credit and personal income – factors that drive spending – they appear to confirm this positive trend.

First, consumers are willing to spend down their savings as the personal savings rate has dropped from 4.4% earlier this year to 3.7% in August. Either they are getting more confident in the economy or they are desperate and have no choice.  

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Second, revolving credit has been increasing. This year alone consumers have added almost 10 billion in revolving credit.  That's enough to add almost 1/10th of 1% to GDP growth.  Not bad for all the fear we hear about the American Consumer.

Lastly, personal incomes have been stagnant for at least 20 years, and all the while consumers have found ways to continue to spend.  While there is much debate over how to lift personal incomes, the data suggests we continue to consume in-spite of our slow growing wages.

It seems like we’re at a critical juncture in our forecast.  If you simply look at all the good news about the consumer you could put more growth into your portfolio, meaning commodities, growth stocks versus value stocks, and technology stocks over dividend payers.

On the other hand consumer spending is closely tied to confidence in the economy:

• Consumers will spend savings down only to a minimal level based upon their confidence in the economy
• Consumers will only spend so much on credit based upon their confidence in the economy
• Consumers personal income will only increase based upon businesses confidence in the consumer

As you can see, this can be a bit of a vicious trap.  In the case of a marginally confident consumer, a continued defensive approach might be warranted. 

In either case, it appears the consumer is quietly spending and perhaps will continue to do so.  This would be a big surprise to the consensus thinkers and could put a floor in for any market pull back we might be seeing right now.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Q4 2012 Look Ahead: Look Beyond 66 Days
Weekly CEO Commentary 10-15-12
Tim Phillips, CEO – Phillips and Company

Every quarter for the last several years, I have presented a “Look Ahead” for the coming quarter during my committee meetings with institutional clients. I have summarized the presentation below, and provided a link to follow along with the full presentation.

Click here to access full Phillips & Company Q4 Look Ahead

Many have called this a “jobless recovery” because it has been almost five years since it began, and we have only recovered half of the 9.8 million jobs lost. However, when you compare the loss of employment to other financial crises, it’s not that unusual. In fact, it’s actually been one of the smallest losses of employment during a financial crisis.

It’s clear the Federal Reserve’s use of unconventional monetary tools has helped in lifting asset prices. With the Federal Reserve’s latest round of quantitative easing having an unlimited time horizon there is no reason to believe it will end anytime soon.  The question is now, “Will it ever lead to job creation?”

The Federal Reserve can use all the monetary tools it wants, but at the end of the day, earnings drive prices. Despite the day-to-day volatility you see in the news, earnings are what matter over the long run when you are investing in equities.

This is concerning because corporate earnings for the S&P 500 are expected to shrink by 2.7% this quarter. It would mark the end of an 11 quarter streak of earnings growth for the S&P 500. Further, expectations for next quarter might be too optimistic with a growth rate near double digits.

If we go over the fiscal cliff in 2013, the economy is expected to contract by 2.9% in the first half of the year according the CBO. We don’t see that as the most likely outcome, and based on the performance of defense stocks (mentioned last week), the market doesn’t either.

Overall the outlook for 2013 is similar to this year: low growth, low inflation, and continued high unemployment.

Now before you consider selling everything you own, buying gold and burying it in your back yard, it's important to consider how and when returns are generated. It’s not from timing the market and it’s not always when the coast is clear according to a study by Michael Cembalest at JP Morgan. To summarize his study, if you invested $100 and only stayed invested when times were good as defined by:

• Attractive Valuations: Market P/E of 17 or less
• Not in a Recession: Unemployment below 6% and manufacturing expanding
• Stable Inflation: Inflation below 4% 

You would generate an annualized return of about 5.67% since 1980 and 5.36% since 1948. However, if you stayed invested no matter what, you would generate an annualized return of 7.50% since 1980 and 7.01% since 1948. Almost 200bps of additional annualized return by simply staying invested.

There are signs of stress as we look ahead this quarter, but it’s important for you to put this in the context of the time horizon of your portfolio. If you’re a foundation, endowment, or pension then you can probably look past short term volatility as you have a perpetual investment mandate. If you’re an individual or family then you need to consistently be recalibrating your portfolio to account for the changes in your investment time horizon and liquidity needs. Generating returns involves taking risks and time is a key component in shaping those risks.

Of course, if you think the world will end in 66 days with the Mayan Calendar on December 21, 2012 then you might want to sell everything anyway and have fun with the money.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company

Alex Cook, Associate – Phillips & Company

Part Time Confusion
Weekly CEO Commentary 10-8-12
Tim Phillips, CEO – Phillips and Company

In September, the unemployment dropped to 7.8% from 8.1%, according the Bureau of Labor Statistics report last Friday. With such a dramatic drop in the unemployment rate, you would assume more Americans are getting back to work at a much faster pace than anticipated.

The reality is we only added 114,000 jobs last month. Most economists suggest we need to add at least 200,000 per month just to keep up with new entrants into the workforce. The disparity between the net new jobs number and the dramatic drop in the unemployment rate has led a number of people, including famed former CEO of GE Jack Welch, to suggest some kind of conspiracy theory about the government manipulating the numbers.

Breaking down the BLS Report

While it would be easy to leave it to the conspiracy theorists, I’m not buying their stories. Instead, let’s take a deeper look at the report from the BLS to see if we can determine what is really going on.

First, we need to realize the report is comprised of two separate surveys. One is a survey of households, and results from this survey said we added 873,000 jobs. This is the data used for the unemployment percentage calculation. The other is a survey of establishments (business), and the results from this survey said we added only 114,000 jobs. This is the data used for the net new jobs numbers. These two surveys usually give us close to the same number, however right now they are clearly suggesting two different economies.

Second, this is not the first time the two surveys have shown such a divergence. In the graph below you can see the new jobs added based on each survey (household survey in green, and establishment survey in brown) going back to the beginning of the millennium. In the recovery from the early 2000s recession we saw similar spikes in the household survey suggesting a stronger recovery than the establishment survey.

So what drove this divergence in the household survey this time? It appears to have come from people getting part time employment due to economic reasons. In other words, they got part time work but really wanted full time work. Looking back at the data during the recovery from the early 2000s recession, you can also see a rise in the number of people claiming “Part Time Employment for Economic Reasons”   

This is better than Americans not working at all, but it's not necessarily the outcome we want for sustainable economic growth.

Digging deeper into the establishment survey, we did see other troubling signs. Manufacturers and Good’s Producers shed 16,000 and 10,000 jobs respectively. Some might consider the fact that government added 10,000 jobs as a positive sign, but if we are facing deep cuts to government, I don’t believe this segment can be counted on for much more.

Some concluded from this report that the coast is getting clearer, some see more clouds on the horizons and a few are still fitting it into their most recent conspiracy theory. The bottom line is we still have a tough fiscal debate coming up at the end of the year –and the last time Congress failed to act, equities sold off, volatility spiked and the United States’ credit was downgraded. 

Based upon the 50 billion dollar cuts to defense spending in 2013 if Congress fails to act and the fact that defense stocks have hardly dropped…

...one should be wary of gaining any comfort from the part time confusion in the employment numbers.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

The Real Meaning of Retail
Weekly CEO Commentary 10-1-12
Tim Phillips, CEO – Phillips and Company

If you look at the chart below from the Federal Reserve, the dramatic peaks in the non-seasonally adjusted retail sales (green line) paint a clear picture, ‘tis the season for retail. This week we will preview how the numbers are looking.

As we’ve discussed before, consumption represents approximately 70% of our GDP. A crucial component of this number is retail sales.

According to the US Census, retail sales were up 0.6% in July and 0.9% in August, and if you just look at the financial headlines from the last two months, the trend seems favorable. But, once you get past the headlines, some troubling trends emerge:

• July retail sales were actually revised down from a 0.8% increase to 0.6% increase.
• August retail sales only increased by 0.3% when you exclude spending on gasoline.

Looking at the big picture, retail sales are still up compared to last year. However, the rate of increase has slowed down since last July. We have seen similar slowdowns before, and unfortunately they came before the last two recessions.

Lastly, real final sales have stalled out at 2.0%, a rate associated with prior recessions when you look at the graph below from the Federal Reserve.

Turning to the consumer, they continue to spend down their savings leaving a little less “dry powder” to spending this retail season.

Combining this slow down with the uncertainty of an election year and a fiscal cliff, where the typical middle-income household would face a tax increase of about $2,000 according the Tax Policy Center, you can start to get a strained view of this retail season.

The very word ‘retail’ comes to us from the art of tailoring, where apparel is “cut off, clipped, or pared down.”  What’s troubling me is that based on the data above, this year’s retail season could be more “cut off, clipped, or pared down” than we want.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Wealth Does Not Equal Consumption: How Long Can This Last?
Weekly CEO Commentary 9-24-12
Tim Phillips, CEO – Phillips and Company

It's abundantly clear that Chairman Bernanke has been hard at work, and his actions have now had a positive impact on investors.

As we have written in the past, the only thing monetary intervention might be creating is a bit of the wealth effect. Based upon the chart above, those that have investments should be feeling wealthier since the Federal Reserve began quantitative easing.

Further, those with homes might be feeling less poor with a recent upturn in housing prices according to the Case-Shiller Composite Indices.

Unfortunately, the end goal of all of this monetary intervention is to stimulate end demand (consumption) and create job growth, not increase asset prices. The consequences of all of this market distortion will be felt most likely in some outlying years, 2016 and beyond.

As for creating job growth today, unemployment appears to remain stubbornly above 8% and weekly initial unemployment claims have been moving sideways most of the year according to the Bureau of Labor Statistics.

In order to create job growth, we need to focus on addressing real concerns that affect businesses. A recent NFIB (National Federation of Independent Businesses) survey clearly shows small business wants more demand (Poor Sales-20) much more than they want lower interest rates (Fin. & Interest Rates-3). 

In addition, a recent survey by Duke University showed 43% of CEOs are most concerned about consumer demand while only 15% are worried about interest rates.

What you might notice, besides the disparity between consumer demand and interest rates, is how much concern there is over high government regulations, red tape and federal government policies.

Unfortunately, no matter how good it feels to investors today, no matter how misguided recent Fed policy might appear, and no matter what CEO's say, we might be in for a long haul.

Carmen Reinhart and Kenneth Rogoff wrote one of the best history books on financial crises called This Time Is Different. In a recent paper titled, Public Debt Overhangs: Advanced-Economy Episodes Since 1800, they looked at countries since 1800 with 90% public debt to GDP for 5 years or longer, which now includes the United States.  Their study concluded:

• The average duration of the debt overhang is 23 years.
• The debt slows down economic growth and losing even 1 percentage point per year from the growth rate will produced a substantial decline in output.
• The average annual growth rate is 1.2 percentage points lower in periods of high debt (90% debt/GDP ratio).

It's not clear what causes high debt countries to find themselves in their high debt situation.  The reasons include war, excessive borrowing for social programs, and simulative efforts to avoid depressions, to name a few.  It is clear, however, that the time it takes to resolve these behaviors massively distorts markets.

The good news in all of this is that stock markets are not entirely correlated to US or World GDP in the short run. So, perhaps we can grow our wealth at the same time people consume less.  I have a funny feeling this can't last long though.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

The Kitchen Sink
Weekly CEO Commentary 9-17-12
Tim Phillips, CEO – Phillips and Company

Last week the Federal Reserve announced additional steps to try to support a stronger economic recovery according to their press release on September 13, 2012. Here's what they are going to do: 

• Purchase $40 billion of mortgage debt every month (Quantitative Easing 3)
• Continue to extend the average maturity of its holdings (Operation Twist)
• Extend forward guidance from late-2014 to mid-2015

The Federal Reserve is throwing everything but and the kitchen sink at this economy.  In addition to extending their forward guidance the Federal Reserve tied these actions to the labor market:

"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability"

What was a bit more concerning in the statement was their comment regarding inflation:

"The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective."

Running so dangerously close to the red line of deflation for a prolonged period in the future is certainly a risk to investors and savers.  From the data below we have been in a prolonged period of declining inflation.

While too much inflation is a bad thing, deflation is the worst possible outcome for savers and investors because it can lead to a vicious spiral. Lower prices lead to lower production, which leads to lower wages, which leads to lower consumption (GDP), which then leads to further decreases in prices.

Now that the Fed has pushed most of us to take more risk to generate limited returns, we should see inflation in asset prices—specifically in homes and more immediately in stocks. I think Howard Marks said it best in his latest letter to his investors:

Today’s low interest rates, engineered by the central banks, mean that investors are consigned to doing business in a low-return world. Interest rates near zero on T-bills, and yields of 1-3% on Treasury notes and bonds, set the base from which the prospective returns on investments entailing risk are established. And because that floor is so low today, even with healthy risk premiums added, the absolute prospective return on many investments isn’t nearly what it is was in the past.

Unfortunately we still have a fiscal policy to contend with in the form of a Fiscal Cliff. 

I am reading Bob Woodward's new book, "The Price of Politics".  It's a revealing narrative on how our political leaders were negotiating fiscal policy.  I ran across a statement that caused some lost sleep.  This was a quote from the President during his negotiations on that last extension of the Bush Era tax package:

"I’m drawing a line in the sand after this,” Obama promised, trying to rally the group. This was his final compromise on taxes. “Let’s protect the fragile economy. Come the next round when these things expire, I’m holding. Not happening again.”

It's clear that the Fiscal Cliff will not be an easy negotiation and compromise looks less likely based upon what was reported in this book.

The Federal Reserve is throwing the kitchen sink at the economy making investors take on additional risk in order to achieve a similar level of returns; however, the uncertainty surrounding the upcoming elections and fiscal policy could still hold returns back despite taking on additional risk.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

A Housing Head Fake?
Weekly CEO Commentary 9-10-12
Tim Phillips, Phillips and Company

Last Friday's jobs report almost guaranteed additional monetary intervention by the Federal Reserve to come this week at the end of their meeting on the 13^th. As I mentioned in last week’s blog, that could be a catalyst for a sell off. After all, we are still staring down a weak economy, right?

Well, not so fast. Besides the data we presented last week on the underlying strength in our economy, the housing market has been showing signs of life as well. Let's run through the numbers:

• In July, private residential construction spending decreased 1.6% from June, but it’s 19% higher than a year ago according to the US Department of Commerce.

• In July, existing home sales increased by 2.3%, and it’s 10.4% higher than a year ago according to the National Association of Realtors.

• The median price of homes sold rose 9.4% from a year ago and had its sharpest increase since 2006 according to the National Association of Realtors.

• In July, housing inventory decreased 23% from a year ago. This is the 17^th consecutive month for a year-over-year decrease according to the National Association of Realtors.

• In August, homebuilder confidence climbed to the highest level in more than five years according to the National Association of Home Builders/Wells Fargo Builder Confidence Index.

• New Residential Construction is running at 746,000 annualized units. Housing starts in July are also up nearly 22% compared with July 2011 and on pace to be up about 20% for the year from 2011 according to the Census Bureau.

• New single-family home sales for July came in at 372,000, a rise of 3.6%. Single-family home sales are now up 25.3% over the year. Sales rebounded to their fastest pace since May according to the Commerce Department.

Finally, looking at publicly traded home builders certainly suggest things have improved. The S&P Homebuilder Index, a basket of home building companies, is up 44.15% for the year.

Where’s the Beef?

Unfortunately, we are still missing the economic growth and job creation normally associated with a housing recovery.

In 2005, housing represented 6.1% of GDP when you factor in the construction as well as the associated spending that comes when we buy homes. It now only represents 2.7% of GDP According to the National Association of Home Builders. Clearly, an improvement in housing and its associated components would be very beneficial to our economy.

If the housing industry reached its historical average, it could add almost 3 million jobs and economic growth could double. (Remember more jobs = higher wages = higher consumption = higher GDP = more jobs) according to the Bipartisan Policy Center.

Will this trickle into the rest of the economy or is the recent data just an industry head fake fooling new homeowners?

I can’t be certain either way, but I am seeing more underlying positive trends in the US economy than last year as the US is beginning to lead the world out of this global recession. Certainly a recovery in the housing market would continue to benefit the United States by creating more jobs, higher wages, and drive more consumption.

That’s why our portfolios are overweight US equities, but we still maintain a global asset allocation. Housing head fake? We will soon find out.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

"Snatching Defeat from the Jaws of Victory"
Weekly CEO Commentary 9-4-12
Tim Phillips, CEO – Phillips and Company

Leave it to Lincoln to come up with another great quip that is very fitting to our current monetary agenda.  Allegedly, Lincoln used this phrase when he was referring to the ill-fated General Ambrose Burnside, shortly after a military defeat and subsequent sacking of said general by Lincoln.

Before we get to the Defeat Snatching component of my assessment, let's review the Jaws of Victory side of the equation.

Jaws of Victory

There are some fairly positive signs bubbling up in our economy.  It's almost hard to imagine saying that in the wake of so much uncertainty.

In fact, a host of economic indicators are pointing in a positive direction.  If you take a look at the chart below you can see key economic factors, like employment, are improving.  What's ironic is this is a chart from our friends at the ECRI (Economic Cycle Research Institute), the guys that are calling for a recession.  While they may still be right, the current data is not trending their way.

Secondly, earnings estimates have seen some improvement in the last several weeks.  I turn to our source at Bespoke to help make the point.  While estimates are still negative, analysts are getting more constructive on their outlook. In fact, they are getting more constructive in almost all sectors.

Snatching Defeat

Last Friday, The Federal Reserve concluded their seminal "Jackson Hole" meeting with Chairman Bernanke delivering his much anticipated closing remarks.  He strongly suggested non-traditional monetary tools were effective and would be strongly considered in the future.

“the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions”

One interesting and perhaps overlooked event during the meeting was a presentation by noted Stanford economist Edward P. Lazear.  He wrote a paper that suggested our current unemployment issues were not structural but cyclical. He went on to suggest much of our high unemployment might be strongly explained by "mismatch" in the labor force both within industries and between industries.  Basically, people need time to get retrained and relocated from shrinking skill sets and industries to those growing and needed.  One compelling point he made was: 

"First, the unemployment rate was 4.4% in the spring of 2007 and rose to

10.0% by October of 2009.  Thus, in a little over two years, unemployment rates went up by over5 ½ percentage points.  Most structural changes do not occur so rapidly."

The bottom line is the Federal Reserve is not mandated to handle structural employment problems but cyclical ones. So, Lazear essentially provided the rationalization for further monetary intervention.

The bad news is that most market participants are expecting intervention to occur—which may actually create a sell off when it happens with traders taking profits on “buying the rumor.”  Conversely, if the economy heats up and there is no intervention, market participants could be disappointed–also leading to a sell off.  That's what happens when government intervention distortions a market based economy.

Ultimately though: if the fundamental economic data improves and we get a Federal Reserve induced sell off, then snatching defeat from the jaws of victory could be a great buying opportunity.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Personal Profits and Corporate Profits
Weekly CEO Commentary 8-27-12
Tim Phillips, Phillips and Company

Corporate profits as a percentage of GDP are at all-time highs, and according to the Federal Reserve, these profits currently represent approximately 11% of GDP. That partially explains why equity markets continue to push higher despite the slow global growth.

On an absolute basis, corporate profits are also at an all-time high, according to the Federal Reserve.

It's amazing how strong corporate profits have been as we come out of this recession (if you believe we are really out of this recession).

These record corporate profits have enabled US companies to hoard a record amount of cash on their balance sheets. Reports vary on the exact number but it’s safe to say it’s somewhere north of 2 trillion dollars according to the Federal Reserve.

On the opposite side of the prosperity coin is the US worker.  In spite of what we hear from politicians about who is making more money and who is not, it appears most households are making less than they have in the past.

It's not hard to draw causality between US companies earning record profits and the worker (read: US Consumer) making less: companies cut wages, lay off workers, don’t replace vacant positions, utilize technology, outsource jobs, and resist costly fixed wage programs touted by labor unions.  

The good news in all of this is, at some point, companies should start to invest their cash. If companies invested just half of their cash into our economy in the form of new plants, equipment, technology, and hiring more people, then the US GDP could grow by over 6%!

The trick is getting companies to invest that money. To me it appears there is a showdown between policy makers and corporations with the worker (read: US Consumer) caught in the middle.  In order to get companies to invest and consumers to spend, policy makers need to produce a stable tax policy. Don't take my word for it, Keynes wrote about this in his book on "The General Theory of Employment, Interest Rate and Money” published in 1936.

Companies and people are so closely tied together—more so now than in the past.  Without the willingness of companies to invest, regrettably, I think the US Consumer won't have sustained, consistent, and stable income to consume at the level we have grown accustomed to.

Investment Outlook

With any sign of stable policy, companies might just start to spend and hire.  The challenge is to be invested well ahead of these policy changes because much of those market gains can occur in brief bursts.

The painful part of this showdown is it will likely create some significant volatility and test your patience and nerves as an investor.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Divergence
Weekly Market Commentary 8-20-12
Tim Phillips, CEO – Phillips and Company

The definition of divergence:

Di·ver·gence (diˈvərjəns) Noun: A difference or conflict in opinions.                              

On the one hand, we have the Dow Jones Industrial Average approaching five year highs:

Chart provided by Google Finance

On the other hand, we have the Bureau of Labor Statistics saying 44 out of the 50 states are reporting higher unemployment in July, including New York and New Jersey at unemployment peaks not seen since the beginning of the recession.

So what gives? How can the market be approaching pre-recessionary highs while unemployment is still rising? Is the unemployment data showing signs the economy is losing steam again? Perhaps the market is betting this unemployment data will force the Fed to bail out the economy again.

In my opinion they are both right, for now. For the last two years, economic data has been weak in August, coincidently right before the Federal Reserve’s annual meeting in Jackson Hole, Wyoming.

August 2011*:

• S&P Downgrades USA AAA Credit Rating
• Consumer Sentiment in US falls to three-decade low
• Manufacturing PMI indices weaken from US to China

August 2010*:

• 500K Initial jobless claims – highest reading since November 2009.
• Retails Sales (Ex. Autos & Gas) down 0.1%
• US Existing Home Sales fall to their lowest reading since 2000.

Now cut to the current environment:

• Companies reported weaker revenues
• Unemployment numbers are not improving

Given this weak economic data, the market participants have been trained to anticipate action from the Federal Reserve providing two decent rallies in the equity markets.

On November 3, 2010 The Federal Reserve announced QE2 purchases through June 30, 2011 and in that time frame the S&P 500 rallied 11.72% according to Bloomberg.

On September 21, 2011 The Federal Reserved announced “Operation Twist” and the S&P 500 rallied 18.14% through June 20, 2012 where the Federal Reserved announced they would be extending “Operation Twist” through the end of the year according to Bloomberg.

As economic data began to show weakness in June, the markets began to rally on hopes of additional action from the Federal Reserve. Since June 1, the S&P 500 is up 11.50% according to Bloomberg.

Unfortunately, when market participants anticipate an event, usually there is a hard sell off once the event occurs. We have all seen this with earnings announcements and I believe we could see this with another dose of quantitative easing.  Studies show actual events are less fulfilling than the anticipation of those events. I believe an economist won a Nobel Prize for a theory on this (more on him in a future post).

Needless to say diverging perspectives can create winners and losers.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Adam Gulledge, Associate – Phillips & Company

*2010 and 2011 August headline data provided by Bespoke Investment Group

Over the next six months, the dominant macroeconomic event we will deal with is the Fiscal Cliff. Now that the Republican candidate has picked his Vice President, the debate and potential outcomes are much clearer.

As a brief refresher, the Fiscal Cliff is what will occur this January because of Congress failing to act on a permanent solution to our growing debt crisis, in addition to the upcoming tax increases and spending cuts.

According to an analysis by JP Morgan’s economist Michael Feroli:

“In all, the tax increases and spending cuts make up about 3.5% of GDP.”

Below is a table breaking down all of the increases in taxes and cuts in spending, with the Bush tax cuts making up about half of that.

While I have a personal political judgment about all of this, the economic impact on growth is clearly negative if this all occurred in one year.

Before we discuss Romney’s Vice President nominee, Paul Ryan, I want to point out another trend to help focus the picture on this Fiscal Cliff.  There are several Republican Senatorial Candidates that align with the Tea Party making significant headway on their elections.

• Todd Akin - Missouri
• Josh Mandel - Ohio
• Ted Cruz - Texas
• Richard Mourdock - Indiana
• Wisconsin has two in a tough primary battle election tomorrow

On top of these there are 61 current Members of the House of Representatives that align themselves with the fiscally conservative group.

Now to address Paul Ryan, according to his latest plan, he does not want to eliminate the Fiscal Cliff; he just wants to reshape the cliff. Buried on the last page of his plan in Appendix II, he shows how he would reshape the cuts being imposed on government through the sequestration in the Budget Control Act. Clearly, the future has cut's in it. 

With the Ryan selection, this election just went from blaming the President about our current economic malaise to a much broader debate on the size and scope of government.  (By the way with only 3% undecided, this election looks like a "ginning up the base" election).

If Obama keeps his job, the only bargaining tool Republicans will have will be the mandatory sequestration cuts including the cuts to Medicare and Medicaid.  Certainly with 61 congressman and a few senators being elected as fiscal conservatives, anything less than a delay on everything other than cuts will not do.

If Romney and Ryan are elected, it's hard to see how they can propose anything other than cuts to current spending, and the Democrat's only real bargaining power will be in their holding onto the Senate.  They will not go easily without tax increases and some of the Fiscal Cliff being implemented.  Especially cuts to the defense budget.

The bottom line is it now looks likely some sequestration will likely occur.  Perhaps a delay might be negotiated by Romney but certainly cuts will be in store for whoever is elected. 

Keep in mind, it will only take about 150 billion in annual cuts to shrink GDP by 1%.  Again, let me emphasize, I am making no political judgment, just simply a mathematical one.  Short term pain looks likely and that will manifest itself in our equity markets with more volatility.

The fiscal cliff got a little closer in the window and to me looks more like an exclamation point than a question mark.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Confusion Confirmed
Weekly Market Commentary 8-6-12
Tim Phillips, CEO – Phillips and Company

The S&P 500 appeared to have another decent week ending up 0.36%. However, this is misleading because all of those gains came on Friday, whereas the market was actually down during the other four days of the week. This includes the initial knee-jerk reaction lower on the Federal Reserve’s decision to not take additional actions on quantitative easing. If you recall, each time the Fed has taken monetary actions in the last few years, the markets have rallied.

We are now past halfway through earnings season, and if you look at just the bottom line earnings numbers, it appears to be in line with the last few quarters. But, those earnings are coming from much lower top line revenue numbers. In order to maintain quality earnings growth, companies must continue to grow revenue.

As you can see, the percentage of companies beating earnings estimates for the last few quarters have been consistent—around 60% according to Bespoke Investment Group. Unfortunately, the percentage of companies beating revenue estimates have been trending lower and are now at levels last seen in 2009. Once again, the headline number is slightly misleading and confusing.

Then on Friday, we saw what appeared to be some pretty strong jobs data.  The economy added 163,000 jobs in July, which was much more than the expected 100,000.  The Dow Jones Industrial Average rallied over 200 points on Friday. However, once you look beyond the headline number, there were some fairly concerning data that makes the headline number a little confusing.

According to the Bureau of Labor Statistics:

• The unemployment rate rose to 8.3%, and the labor force participation rate declined to 63.7%.
• June employment numbers were revised down from 80,000 to 64,000
• U-6, the number of workers that are under-employed (an alternative measure of labor underutilization) including part workers increased to 15.0%

Lastly, according to Bill McBride of Calculated Risk:

The economy has added 1.06 million jobs over the first seven months of the year (1.12 million private sector jobs). At this pace, the economy would add around 1.9 million private sector jobs in 2012; less than the 2.1 million added in 2011. Also, at this pace of payroll job growth, the unemployment rate will probably still be above 8% at the end of the year.

What this all means

So if the earnings data and employment data is fairly negative at the core, then why have the markets rallied? The answer is not intuitive but it does confirm what's driving our markets to three-month highs. Basically, this weak economic data continues to leave the door open for further Federal Reserve policy action.  Based upon the first chart above, this type of activity has a strong correlation to positive market returns.

Unfortunately, this is not a long term solution; we need the fundamentals of our economy (employment) and companies (revenue growth) to drive equity prices higher in the long run. As we saw last week, speculating is a very small part of long run returns.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

 Research supported by:
Adam Gulledge, Associate – Phillips & Company

The Bureau of Economic Analysis has officially confirmed that the economy has downshifted from 4.1% growth to 1.5% growth in the first half of the year. The Dow Jones Industrial Average rallied almost 200 points on Friday in hopes that the Fed will act to address this downfall.

Based on this news, I see a few scenarios that could happen for the remainder of the year:

1)     The economy continues to “muddle through” with weak growth rates but does not slip into a recession, and the Fed does nothing. In order for the economy to have negative GDP growth, consumer spending would have to drop by approximately 166 billion dollars. This is probably unlikely because consumers have plenty of revolving credit and savings to fuel buying. On the other hand, we also know consumer spending isn’t growing because wages aren’t growing. Under this scenario, the market reaction would likely be negative as many participants have already priced in additional action by the Federal Reserve.

2)    Our economy slips into a recession, the Federal Reserve can act forcefully, and the market reacts positively because of the wealth effect.  I have written about the wealth effect and what the Fed can and can't do before here. Remember, the wealth effect is an economic term, referring to an increase (decrease) in spending that accompanies an increase (decrease) in perceived wealth. Some studies suggest a $1 increase in equity values raises consumption by 5 to 15 cents—not a bad thing for the Fed to bet on when they have fairly limited tools.

3)    The economy turns on a dime back up to 4.1% GDP growth. Overall I don’t think this outcome is very likely, but here are some catalysts to spur business and consumer spending:

• Stable fiscal and tax policy
• More jobs
• Improved consumer confidence, enough to take on more debt
• Return to growth in the Euro Zone
• Emerging market economies return to 8%+ growth

If we were to speculate, I think the most likely scenarios are one or two. The good news for us is we don’t need to pick one, because speculation doesn’t matter in the long run. At times speculation can make for good conversations, but it never makes for good investment advice.

As you can see from the table below from John C. Bogle, CEO of the Vanguard Group, the market had an average return of 10.4% over the 20^th century, and 9.8% of the return was driven by dividends and earnings growth. Only 0.6% of the return was driven from speculating.

You can also note, earnings growth contributed positively to market returns in every decade except the 1930s, and was fairly consistent throughout the 20^th century. This compared to speculative returns which were much more volatile and less consistent.

This doesn’t mean the events over the next six months aren’t important and shouldn’t be discussed with your advisor, it means you shouldn’t base your entire portfolio strategy on your expectations for the next 6 months, especially if these are retirement assets and you don’t plan on retiring anytime soon.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

We just crossed the half way mark for the year, and that means two things: earning season is getting under way in earnest, and we are a little over half way through the 2012 baseball season.

As expected, earnings have been weaker than usual, specifically on the revenue side. According to Bespoke this could be the lowest revenue beat rate since the first quarter of 2009!

If revenues continue to be weak this earnings season, then corporate profit margins are likely going to be weaker than prior quarters.

Based on the economic data over the last few months, a number of financial firms have lowered their Q2 2012 GDP growth projections for the United States from 2.3% to 1.8% according to Bloomberg.

What really counts now is not the number of companies beating

earnings estimates, or even the downward revisions to the GDP numbers. What really counts is your reaction to the upcoming potential volatility – even more so than your advisors reaction. Allow me to illustrate my point.

The famous LA Dodger’s pitcher, Sandy Koufax, started his career out fairly inauspicious. He was simply too strong, too fast, and too wild with his pitching for any catcher to handle. Then in 1961, a second string catcher for the Dodgers, Norm Sherry, told him to slow down to maintain better control. Take a look at Koufax’s stats before and after 1961 when Norm gave him those words of wisdom:

Also note, almost his entire career highlights and awards came after 1961:

• 7× All-Star (1961, 1961², 1962, 1963, 1964, 1965, 1966)
• 4× World Series champion (1955, 1959, 1963, 1965)
• 3× Cy Young Award (1963, 1965, 1966)
• NL MVP (1963)
• 2× World Series MVP (1963, 1965)
• 2× Babe Ruth Award (1963, 1965)
• 3× Triple Crown (1963, 1965, 1966)
• Hutch Award (1966)
• Pitched four no-hitters
• Pitched a perfect game on September 9, 1965
• Los Angeles Dodgers #32 retired
• Major League Baseball All-Century Team
• Major League Baseball All-Time Team

Like a baseball pitcher, an investment advisor can only be as good as his catcher, his client. Of course, if you have a bad pitcher (read: advisor) no catcher (read: client) will ever make them better.  However, if you have a good advisor you can certainly make them better and improve your own results.

Jerry Maguire said it best, “Help me, help you.”

Nothing could be truer for pitchers and catchers, as well as advisors and clients. A study by Watson Wyatt show investors can increase their returns by at least 1-2% per year when they function at highly efficient levels with their advisor.

As we enter what could be another volatile period, your advisor should be throwing you some pitches (read: ideas) on how to reduce risk while not giving up too much return.  It's entirely up to you if you want to catch the pitch.

If your advisor is not having these conversations with you, then that's on them.  Any good advisor that’s worth their weight should be constantly reviewing the risk-reward tradeoffs in these volatile markets with their clients.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

In a recent presentation by David Rosenberg I was reminded of something that was often talked about prior to the Great Recession, which is the upcoming retirement of the baby boomers.

Let me start by putting the Baby Boomer generation in context:

• At the beginning of 2011, 10,000 baby boomers will reach age 65 every day for the next 19 years according to the Pew Research Center
• Baby Boomers have earned $3.7 trillion, twice as much as the generation before it according to McKinsey & Company
• Baby Boomers control over 80% of personal financial assets according to Investors Insight
• Baby Boomers account for over 50% of total US consumption (70% of US GDP) and 80% of all leisure travel also according to Investors Insight

The Baby Boomer Generation has been able to remodel society as it passes through it simply because of its sheer size.

Below is a killer chart from David Rosenberg’s presentation:

What's fascinating about this chart is not the data itself.  We all knew a retirement boom or labor shortage was fast approaching by 2007.  We all read many books and articles on the investment implications or such a demographic shift.  In fact, many were planning on high cost, low return vehicles to trap you in and then take advantage of you when capital was distributed back.

Then the Great Recession took place and we forgot about this massive demographic shift. As this “pig in the python” continues to pass through, it will continue to have strong implications on social policy, spending habits, and entitlements just to name a few.

Today, most surveys suggest that baby boomers are putting off retirement due to the amount of wealth that was destroyed during the 2008 Financial Crisis. In fact, I’m sure many of you reading this are feeling the same way.

Now it appears that we are at least on the other side of the Great Recession, I want to highlight a few of my long term thoughts on the investment capital of the Baby Boomers as they move out of the work force and into retirement over the next couple of decades.

1)  More money will move into institutionally run vehicles, 401(K)'s, annuity contracts, insurance schemes and other blind pools. According to a study by Xia Chen at Sauder School of Business, in the 1950’s, institutions owned approximately 7% of US equities; in the 2000’s, ownership increased to 51%.

2)  More money will drive toward income seeking investments, as people place a premium on safety and certainty, despite not keeping up with long term financial needs. 

Between the housing meltdown, flash crash, banking scandals, and political ineptitude, investors have grown wary of core institutions that provided us with confidence.  Who really trusts their banker or elected official right now?

3) Below, you can see how money continues to pour into bonds funds over the last few years. The more of a consensus around an asset class, like we have seen in bonds, the more likely something else will happen.

With this in mind, I’m not suggesting to sell all your bond funds. They are an important part of a well-diversified asset allocation and over concentrating in one asset class will likely lead to sub-par performance. Instead, we are focusing on tilting specific asset classes to take advantage of global macroeconomic trends.

Don’t let the Great Recession be the Great Distraction from the real shift in society that we all know is coming.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

The economic data over the last few weeks continued to confirm what we had suspected for quite some time. This is an “L” shaped economic recovery that has made traditional static asset allocation difficult. When we first started writing this blog in the fall of 2010, we discussed the dynamics of a slow growth economy and investment themes that would fit this macroeconomic environment.

If you look at jobs, you can see how slow the growth has been from the BLS data:

Same for GDP according to the BEA:

Housing prices tell the same story from Standard and Poor’s:

Given this type of a macro environment, we listed a handful of investments themes at the bottom of that post in 2010, including:

• Looking for yield, yield, yield
• US Mega Cap Companies with large cash balances paying dividends

After Friday’s dismal jobs report it appears our forecasts for a slow growth economy are continuing to play out. Unfortunately, we see very little on the horizon to shift our view.

We all know the list of worries our market must climb:

• European recession
• Slowing across the BRIC countries and other emerging economies
• Corporate earnings growth rolling over in the US
• Jobs
• Political grid lock and polarization
• The fiscal cliff

The Importance of Getting Paid

So, what are some of the ways an investor can get paid today while maintaining the long term benefits of a broadly diversified asset allocation?

• High quality companies with stable cash flows
• Lower volatility and “boring” equities
• Companies with a sustainable and strong dividend
• High yield fixed income
• Covered call strategies
• Long/Short funds with a strong track record.

These ideas aren’t for everyone, and every portfolio. They should be viewed with the appropriate time horizon perspective, and risk tolerance levels. We want to continue to remind investors that opportunities for returns must be viewed in the context of your time horizon and future needs.

I do see one political scenario that could lead to a strong rally in our markets. I would like to preface it by saying this is not a consensus view and you won’t find many in my profession sticking their necks out with this scenario. With that said, here it is:

It's possible the economic headwinds will blow strong enough in the coming months for the President to try and trump Republicans by proposing his own economic legislation well before the election.

It could be an extension of tax cuts, or a deferral of federal sequestration on the cuts that would take place in January.  It could even be something as simple as an extension on the tax rates for dividends and interest.  By simply proposing one or all of these ideas, it would force the Republican's hands into action for fear of looking like obstructionists while "Rome Burns".  This could stimulate a nice market rally. 

While I wouldn't bet too much on this scenario, as it is certainly wishful thinking, it's worthy of consideration.  If all else fails, the Fed has made it very clear they are still willing to throw in the kitchen sink to bail out the markets again. In the short run, the mantra, “don’t fight the Fed,” reigns true.

In the meantime, why not get paid with dividends to wait through the significant market volatility.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Last week, the news headlines were dominated by two main events. Here in the United States, the Supreme Court (SCOTUS) upheld the Patient Protection and Affordable Care Act (PPACA), informally referred to as, “Obamacare.” Over in Europe, the EU Summit announced a new plan to support and recapitalize their banks, similar to the Troubled Asset Relief Program (TARP) we had at the end of 2008. We will certainly write more on these in the weeks to come. 

What got very little media coverage this week was some economic data that could be instructive for us as we begin the second half of 2012. If you recall, we have been covering the ECRI’s forecast for the United States to slip into a recession around July. Well…

According to the Bureau of Economic Analysis, the consumer increased their savings from 3.7% of their disposable income in April to 3.9% in May. Increases in the Personal Savings Rate usually indicate consumers are less confident about their future earnings and more uncertain about their future cash flows.

The consumer has also been spending less throughout the first half of the year. As you can see from the table below from the BEA, Personal Consumption Expenditures have been fairly flat since February. You might also remember from a few weeks ago that personal income is slowing too.

Clearly, the consumer is acting spooked. On the surface, most prognosticators will point to Europe as the main cause of this uncertainty. They may be right in their call, but only partially.

Corporations are also concerned. According to Moody’s, there was a large buildup of inventories in Q4 last year and Q1 this year. Unfortunately, weak consumer spending means companies are still sitting on this inventory. Without a rapid drop in inventories in Q2, we can’t expect companies to come to the rescue until Q3.

Finally, based on the numbers from BEA, we have seen a spike in corporate profits. 

Following the dramatic fall off in profits during the last recession, corporate profits have sky rocketed to all-time highs. However, this growth in corporate profits might have peaked at the beginning of the year when corporate profits fell 0.3% in the first quarter according to the BEA’s third first quarter estimate of GDP.

It’s now or never for the ECRI’s recession prediction and looking at the data right now we believe it is too close to call. Unfortunately we likely won’t know if they are right or wrong until the end of the year because it takes at least two quarters to determine if we are in a recession or not.

With all this uncertainty, the good news is that the SCOTUS decision on healthcare and Europe's plan on how to recapitalize their banks creates more clarity on what global growth will look like, and less uncertainty could lead to more market rallies going forward.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Adam Gulledge, Associate – Phillips & Company

This week, the Federal Reserve made a widely expected move to extend Operation Twist (the buying of long-term government bonds and selling of short term government bonds). This program is intended to lower long term interest rates and help make financial conditions more accommodative. Along with extending Operation Twist, the Federal Reserve also lowered their expectations for GDP growth to 1.9% - 2.4%, down about half a percent from April according to the Economic Projections of the Federal Reserve Board Members, release on June 20th. Clearly, the Fed still sees weakness in our economy and they don’t want to be the cause of more pain and suffering by tightening the money supply too early.

The Fed sees something our policy makers (aka politicians) don't see or refuse to acknowledge yet.   We are now, for the first time in a long time, a country that must pick winners and losers.  Allow me to explain.

Generally countries take on debt to finance their needs when the economy slows down, and they depend upon a growing economy to "bail" themselves out when the debt comes due down the road. It’s a win-win because we can increase spending and lower taxes in recessions, and then pay back the debt during economic expansions and smooth out the overall economic cycles. This meant people got their benefits, taxpayers paid lower taxes and the economy recovered quicker.

This is how President Reagan was able to triple the nominal debt level from 900 billion to 2.8 trillion, but only increase the debt to GDP ratio from 26% to 41%. The growth in GDP and tax receipts were able to offset some of the increase in spending and taxes cut elsewhere.

The key to this type of fiscal approach is that the long run GDP growth must exceed the long run deficit spending. Unfortunately, as you can see from the chart below our deficit spending has far outstripped our GDP growth over the last 10 years. 

Because of this, our total debt has now eclipsed 100% of our annual GDP according to the IMF and the interest on our debt now represents 6% of our total government spending for 2011 according to the CBO.

We could be at the end of this, “win-win era.”

The Fed gets that our economy has been used to having it all, but the political class has not. In order to keep the “win-win” dream alive we will likely need to borrow massive amounts because our financial picture is not the same as it was in the 80’s.

If we are at the end of the “win-win” era that means we must pick winners and losers. With persistently low GDP growth over the last 10 years, we are now faced with choices:

• Pensions for public sector employees or tax cuts?
• Food stamps for the poor or defense spending?
• Unemployment benefits for the jobless or Pell Grants for those that want to go to college?

Unfortunately, we are likely at a paradigm shift and about to realize we are now a “win-lose” society that will need to make choices.  Perhaps, the Fed realizes we are simply not ready to make those choices and their only response is to keep rates low to give the political class more time to figure out who wins and loses.

As for portfolio considerations, whether you have an aggressive allocation with an 80-20 blend of equity and fixed income or a very conservative mix, we are continuing to take into account the slow GDP growth environment when we are designing our portfolios while we wait for the political class to wake up.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

As a professional investor and advisor, I have had the dubious privilege to write - on a few occasions now - some basic lessons about investing during critical times.  Over my 25+ years of experience (and mistakes), the last five take the prize for being the most critical.

When investors look at the current “wall of worries” we have to climb, it takes every ounce of will power not to hit the panic button:

• According to the Bureau of Labor Statistics, 12.7 million people are unemployed in the United States.
• Purchasing power is eroding as US wages are growing slower than inflation according a to recent report by Bespoke Investment Group.
• US GDP growth is being revised downward.
• A $750 billion fiscal cliff at the end of the year could deduct 3% to 5% from our GDP according to economist’s forecasts.
• The European Monetary Union is under threat of breaking up.
• European countries like Spain and Greece are sitting on unemployment of 24.1% and 21.7%, according to Eurostat.
• China, India and Brazil are slowing down.
• The Middle East is still brewing with instability.

Okay, I think we get the point. Given these critical times, these are the lessons I’ve learned, and reflect upon to help guide our clients and my own investments.

In the long run, much of the current noise will be discounted and there will be a reversion to the mean.

• In the long run, the value of an asset (stock, real estate, commodities, etc.) is driven much more by its underlying cash flows (earnings growth and dividends), than emotion (speculation).
• According to the Vanguard Group, over the last 100 years the stock market has produced an average annual return of 9.6%.
• Earnings growth of 5.0%, dividend yield of 4.5% and speculative return of only 0.10%.

The old saying, "Don't just stand there, do something" does not always apply.  Sometimes the best thing is, "Don't do something, just stand there.”

This is especially hard for active decision makers and investors. During the trough of our markets in 2009 I had the privilege of working with some great investment committees.  One such committee took the advice to “just stand there” and resisted their gut instinct to, “do something.” They were richly rewarded.

I also witnessed a CIO from a major institution feel the need to, “do something”. He moved 5% of the portfolio into cash near the bottom of the trough, and then reinvested the money only nine months later. He lost 273 basis points in performance to the S&P 500 and likely will not make up the difference for years to come. 

Sleep well money today does not mean live well money tomorrow.

You need risk to generate returns.  It's that simple.  The questions you constantly have to ask yourself are also simple:

• When exactly is, “tomorrow”, when will I need to draw on my account? For example, 1 year from now or 10 years from now?
• What are the associated expected rates of return during that time frame I can expect?
• How much sleep am I willing to lose riding through the risk I need to get to tomorrow?
• How much volatility can I tolerate?

One of the reasons endowments and foundations do much better than the average investor is because they have an unlimited time horizon. This infinite time horizon allows them to look past the type of events we are facing now. It's fairly simple math, however it’s not simple to do through a rational and objective lens. If your advisor can't help you think through this, it might be time for a new advisor.

In general, when your emotions take over, your investment returns suffer.  I can almost predict the exact bottom of markets based on when I start getting panic phone calls from clients.  "Sell everything, I give up" is a common directive. I still have a fax from a client that gave such a directive in 2002. The fax was on Friday, October 4^th 2002. The market bottomed Wednesday October 9^th 2002, a mere five days later. This decision cost the investor 101% in gains he could have had as the market rallied over the next five years.

In the end, these lessons won’t necessarily make you rich overnight through investing, but hopefully they will help you stress less about your investments in the short term. If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Most days in Oregon, all we expect to see are clouds and rain, it doesn't matter if it is December or July.  In fact, I can’t really remember a 4th of July without clouds and some rain.  I know we have had them, but it's just that I've grown to expect clouds and rain.

That's why when we see sunshine, blue skies, and all the green trees, it’s always a welcome surprise even in the middle of August. Mother Nature has a way of managing our weather expectations here in Oregon.

Not unlike Oregon weather, our economy and broad markets have most of us expecting some pretty gray clouds—and not for bad reason with Europe's banking and fiscal debt crisis. On top of this is our own fiscal crisis as well as a slowdown in China, India, and other countries.

Like Oregon weather, no one really has a perfect macro picture of what to predict in the future for the markets.  In fact, you might find it a bit of a surprise to see companies beating estimates set by the “sell-side” analysts, and there’s a big reason why these surprises sometimes happen. Sell-side analysts have an incentive to follow along with the Wall Street consensus when it comes to making estimates. If one of them makes a dissenting call and turns out to be wrong, that could mean lost revenue from fewer research subscriptions or fewer trades routed through that analyst’s trading department. If they go along with the pack and the overall Wall Street consensus is wrong, then they can simply say, “Well, everyone else was wrong also!”

So, analyst’s estimates tend not to differ too much from the overall consensus—so when a surprise happens, markets can move.

This is a Bloomberg graph of analyst estimates for the quarterly earnings on S&P 500 companies (orange line) versus actual quarterly earnings (white line) for the period of June 2011 to June 2012. As you can see, estimates often do not get revised until there is a big swing either up or down—after the surprise has already happened.

Conclusion

Considering a 7.07% pullback in the S&P 500 (Bloomberg) since the start of the quarter, there are two possibilities: either the broad markets are forecasting some tough times ahead--which is very possible--or this is an overreaction and companies are earning stronger numbers than the low expectations set by the Wall Street crowd.

It is impossible to predict with 100 percent certainty. That's why we see the markets move in very brief bursts, and if you miss just a few days you could miss all the advantage. As we have written before in our July 5, 2011 blog post, missing only a handful of the best days of the market (which often occur immediately after the worst days) can have a very significant impact on performance.

Most of those bursts come when expectations are very low and a surprise positive catalyst, causes a rush to get in.

Tim Phillips – CEO, Phillips & Company

Research supported by Alex Cook – Associate Investment Advisor

If you watch TV or shop at a convenience store, you have certainly seen 5 Hour Energy drinks. This two ounce shot promises to give you a quick, and temporary, energy boost with no side effects. It’s like a sugar high, without the sugar. This energy shot has become so popular the founder, Manoj Bhargava, was recently added to the Forbes World’s Billionaire List. It appears that we like our sugar highs. Unfortunately, our economy might need another one soon.

At the end of September the Economic Cycle Research Institute (ECRI) made a very lonely call. They predicted the US economy was tipping into a new recession. We highlighted this lonely call at the end of last year and the beginning of this year.

After last week where 18 of the 21 economic indicators released were weaker than expected, their call looks more right than wrong. What’s especially concerning about their call is that they have accurately called the last three recessions without any false alarms in between.

The most troubling things about last week’s economic data were the downward revisions to the GDP and employment numbers. The Bureau of Economic Analysis revised the first quarter GDP from 2.2% to a paltry 1.9%. Followed by the employment report from the Bureau of Labor where we only grew jobs by 69,000 in May and April was revised down from 155,000 to just 77,000.

With that said, it’s important to remember that 70% of our GDP is based on consumption. This consumption is driven by income, and we saw Gross Domestic Income (GDI) grow by 2.7% last quarter, up from 2.6% in the prior quarter. For those who don’t remember what GDI is, it’s just another way to measure economic activity. In theory, GDP and GDI should be equal. Money spent (GDP) by one person (or company), is income (GDI) for another person (or company). However, in practice they differ wildly because they are calculated with different inputs.¹

Last week we highlighted the consumer’s ability and willingness to consume, despite weak income growth. We can spend our income, our savings and our credit (specifically, revolving credit primarily used for short term financing).

 

Recently, Real Personal Income growth has slowed.

 

However, in the absence of income growth the US consumer has been willing to spend down their savings over the last several months, possibly due to growing confidence in the stability of their income.

 

It appears the consumer is also done deleveraging for the time being, and feels confident enough to spend borrowed money.

A couple of other mitigating factors before we all pull our money out of the market and stuff it into our mattresses:

• Based on data from Bloomberg markets are already down approximately 10% from their April highs.  Once again, the efficiency of large numbers suggests our markets were forecasting a slowdown and not simply a 3-5% routine correction after a strong rally.
• Further, we believe that Ben Bernanke will do everything he can to prevent a deflationary scenario. So far the Federal Reserve’s liquidity programs (QE1, QE2, and Operation Twist) have led to significant market rallies.

The economy might be heading for a recession, but the consumer’s balance sheet remains in a much better position to deal with the uncertainty. The consumer might be strong enough to keep the economy limping along.

While I'm not certain these “5 Hour Energy” interventions do much in the long run to fix a normal part of the business cycle, it might be enough of a sugar high to keep the consumer confident and spending.

As for us, we will continue to look for opportunities to make tactical moves along this part of the market cycle. If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

^{1GDP vs GDI: A tale of two (wildly different) economic indicators} by Brad Plumer 5/31/12 The Washington Post, Wonkblog.

Developing an ability to look at counterfactual information is one of the hardest things for a professional investor to do. Today, it's fairly easy to look at the world and see some pretty bad news:

• China is slowing - The government lowered its target growth rate to 7.5%
• India is caught in a vicious cycle of a weak currency and high inflation
• Europe is imploding - Of the 17 countries in the European Union, 12 governments have been voted out of office or collapsed in the last two years
• US corporate earnings are being revised downward – Analysts have revised down EPS estimates for five straight weeks.

All of this is not very good news.  In fact, I could continue to look and find many more confirming data points.

This is because of a well-studied psychological behavior called confirmation bias.  It's a tendency of people to favor information that confirms their beliefs or hypotheses. First observed by Thucydides, in the History of the Peloponnesian War wrote,

"It is a habit of mankind ... to use sovereign reason to thrust aside what they do not fancy."  

Thucydides has been dubbed the father of scientific history because he ignored the Gods in 5th Century BC and focused his work on pure data gathering, standards of evidence, as well as cause and effect.

It's clear we, at Phillips and Company, have a bias toward a slowing global economy.  In many of our portfolios we are holding near zero exposure to Europe.  However, as professional investors it's also incumbent upon us to fight this human bias and look at the other side of our opinion. We must fight our desire and our natural psychological tendencies to seek confirmation of our opinions.

So here's, The Good News:

• US Household debt ratio has reached levels last seen in 1987, implying that the US consumer is in a better position today to consume than at any time in the last 30 years

• Personal income growth for the US Consumer is trending higher for the year

• The US Savings rate is still historically strong at 3.8% - Another bullet for the consumer to help prop up the economy
• In Europe, Germany managed to grow their economy by 0.5% from the previous quarter
• China’s target of 7.5% GDP growth is more of a floor than a ceiling target. They have a habit of surpassing them
• In India, The Reserve Bank is acting proactively by increasing liquidity through interest rate cuts and reducing the bank reserve requirements

After a healthy look at The Good News, it's still hard to change our opinion that the global economy is slowing.  Frankly, it would be easier to blame the Gods but it would be a shame to waste all the good work of Thucydides some 2,600 years ago.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

How can a country with 11 million people and 300 billion in GDP take down the world?  Since Greece's troubles reared its ugly head, European and Asian markets are down 9-15% for the month. The US has fared slightly better, but still down 7% month-to-date.

Greece has defaulted 5 times since 1800, this would be the 6^th time in about 200 years. It seems inconceivable that a country with less than half a percent of the global GDP can rattle the global economy.

Well, let me attempt to try to outline the process for how "A butterfly can create a hurricane" as suggested by mathematician Edward Lorenz.

1. Greece effectively lied their way into the EU with the help of Goldman Sachs.

2. Once Greece got into the EU they gave up their currency, the drachma, for the more stable currency, the euro.

3. A more stable currency led to lower interest rates, enabling them to borrow hundreds of billions of dollars from the European Banks and the ECB to fund their massive socialist agenda.

4. This put their economy on an unsustainable path. As long as they had access to low interest rates they could continue to rollover and service debt.

5. Once the global recession began, Greece’s already weak economy got even worse.

6. No one in the private sector wanted to lend to Greece once it was apparent they had no way to pay back the money they borrowed or even make the interest payments.

7. Greece had to resort to public funding from the IMF and the ECB. However, they could only get these funds if they agreed to certain austerity conditions.

8. The government of Greece agreed to these terms last year and they continued to receive funding from the IMF and the ECB.

9. Earlier this month, the Greek Government that had initially agreed to the austerity conditions has been voted out by their citizens. It’s no surprise that the Greek people don’t want to adhere to austerity measures put in place by other countries.

10. One year later, Greece and the European Union are right back where they started. Greece still needs money, and the EU still has no formal way for any country to leave the European Union. This is where the Butterfly begins to create the hurricane.

11. If somehow Greece is to be the first country to leave the EU; then the likely first step would be to print new currency. This would involve converting all of the current euros back to drachmas. They would need to set a conversion rate to do this conversion. Then the currency markets would likely devalue the newly minted drachmas by 40-50%+.

12. This would convert all of the debts owed by the Greek Government into the newly minted, and near worthless, drachmas. Greece would effectively print enough drachmas to pay off all of their debt and pay for continuing basic services.

13. The European banks, the IMF and the ECB would have to accept the near worthless drachmas as payment leading to massive write downs and losses.

14. The European banks would then begin selling off the debts of other troubled countries (Italy, Spain, Portugal, etc.) to mitigate these types of losses going forward.

15. The weakness of these banks would certainly choke off lending to legitimate companies in Europe and Emerging Markets.  Remember, most emerging market debt comes from European banks.

16. In order for the European banks and the ECB to maintain lending, they would likely need to increase liquidity, either through lowering interest rates, or printing more euros. Increased liquidity, could ultimately lead to massive inflation across the European Union.

17. If the ECB doesn’t increase liquidity, Greece defaults, and European banks begin to pull capital from other peripheral countries, the severity of the Eurozone’s recession could escalate quickly. 

Greece will hope to leverage this Butterfly Effect scenario, and force the European Union to renegotiate the terms and conditions for getting more funding without a plan to pay it back. The European Union and its banks will probably want to buy as much time as possible in order to prepare their balance sheets for Greece to exit the EU.

Once again it appears the Butterfly Effect will be in full swing, leading to the Kick the Can corollary.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

Myron F. Weiner wrote an article in the Journal of Medical Economics entitled, “Don’t Waste a Crisis — Your Patient’s or Your Own.”  While many people want to take credit for this quote, its exact form can be traced back to Mr. Weiner. It simply means, you should take advantage of a patient’s critical health condition by using it to bring about a change in their behavior.  I know the last time I was sick I promised myself to change some behavior that would improve my health.

I am hopeful this quote will come into play before the end of 2012 or very early 2013 to address the coming, “Taxmageddon” crisis. As it stands today, the Bush Tax cuts will expire at the end of 2012 and tax rates are expected to increase substantially for everyone on January 1^st, 2013.

These will have a major effect on the dividend and interest payments you receive from your investments. The table below illustrates the impact of the change in tax rates on a hypothetical investment that yields $10,000 annually. 

If the tax rates we currently enjoy expire, we would need our gross yield to go from $10,000 to $14,120 (36% tax bracket) and $15,020 (39.6% tax bracket) respectively, to maintain the same after-tax return in 2013. The only way for yields to increase is for prices to fall.

In this hypothetical situation, prices would have to fall by 29% to provide someone in the 36% tax bracket with the equivalent after tax yield. That’s assuming we are efficient evaluators of returns and completely optimize our expected rates of return. This is a fairly big assumption, but none the less, wiping out 29%+ of the assets for American’s is a crisis.

That's why I believe we will see one of three things happen before the end of Q1 2013:

1. A complete extension of the Bush tax cuts (not well liked by the current administration).
2. A partial extension of the Bush tax cuts on those under $250,000 in income (not well liked by Republicans in the house).
3. Another game of chicken and brinkmanship, similar to what we saw with the debt ceiling circus of last summer when we were stripped of our AAA credit rating.  Ultimately leading to another full, but temporary extension.

Any scenario suggests we should continue to look for cash flows out of equity positions and take some reasonable risks when buying debt.  We should prepare for more volatility in the capital markets and continue to expect our economy to improve at only a very modest pace as we kick the can down the road.  Remember, anytime you have uncertainty with tax policy, decision makers tend to postpone big decisions unless they are absolutely necessary. 

American consumerism is based on the absolutely unnecessary – and an uncertain tax policy could hurt.

I've often said, “It only takes one clown to make a circus.” So what happens when you have 536 clowns and 311 million spectators that want to consume?  You have a crisis and my bet is the circus clowns will be forced to make a pragmatic decision.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Weekly Market Commentary 5-7-12

Even before February 1^st when Facebook filed with the SEC to go public, investors have wanted to get their hands on Facebook. It now appears that investors will get the opportunity on May 18^th. We normally don’t highlight specific companies or IPOs; however, given that this will be the largest American tech IPO, and it’s a company almost everyone is familiar with from a user standpoint, we wanted to discuss the company from an investor standpoint.

Valuation: High

This is arguably the most anticipated tech IPO since Google, and that means if you want in on May 18^th, you’re going to have to pay up. It doesn’t matter what valuation metric you use though; they all point to a very high valuation. Two popular valuation metrics are the price to earnings ratio (P/E ), and price to sales ratio (P/S). Facebook has a P/E of 99 and a P/S of 24.

Compared to other tech giants these ratios are pretty high:

Google is probably Facebook’s biggest competitor for online advertising revenue dollars and their valuation metrics are much more in line with traditional valuation levels. Apple is also a tech company that most investors are familiar with and is currently experiencing record growth. Last quarter Apple blew away earnings estimates with 94% growth in earnings yet still trades at a much more reasonable valuation.

Slowing Ad Revenue

If you’re a user, then you know it’s free to create an account on Facebook and you’ve probably seen the ads on the side of the website. These ads are where Facebook makes a majority of its revenues. It sells ad space on its website to other businesses that are targeted to you based on the information you filled out on your profile and things you “like”. In theory, the more information you provide, and the more active users, the more valuable Facebook becomes.

At the end of April, Facebook released its financial performance for last quarter and it was a surprise to most Wall Street analysts:

• Facebook had its first ever quarterly revenue decline in both Ad Revenue and Payments/Facebook Credits
• Facebook’s year-over-year quarterly revenue growth rates have fallen sharply to 44%

Facebook attributed this decline to seasonal advertising trends but no matter how you slice it, the growth isn’t what most Wall Street analysts were expecting.

IPO Price versus Actual Price

Facebook officially announced they anticipate the initial public offering price will be between $28 and $35 per share. Most investors unfortunately will likely be paying much more to get their hands on shares of Facebook on May 18^th.

This price range represents the range in which Facebook will be selling shares to large institutional investors and other top clients of the investment banks. This is the actual initial public offering and this usually takes place the day before they are listed on the exchange.

Once they are listed on the exchange the following day, the shares are then traded among other investors in the secondary market. Most investors will have to buy shares in the secondary market where prices are dictated by market forces such as supply and demand, not Facebook.

For example, the same thing happened last year with LinkedIn’s IPO. The day before it was listed, LinkedIn and the investment banks sold shares to institutions and top clients at $45 a share. However, the following day when you and I could buy them on the secondary market the price was anywhere between $80 and $120 a share! Double, almost triple the so called, “IPO price.” Since demand to own a piece of Facebook appears pretty high, I think it would be highly unlikely for most investors to get shares at the “IPO price.”

Some investors will buy Facebook no matter what, updating their Facebook statuses on May 18^th as proud shareholders of Facebook. However, if you look at it from an investor standpoint, you might be buying in at an intermediate term high.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Adam Gulledge, Associate – Phillips & Company

Tim Phillips, CEO – Phillips and Company

On Friday the BEA released US GDP numbers for the first quarter of this year. Unfortunately, GDP grew by only 2.2%, slower than last quarter’s growth of 3%. So the economy is slowing, but before we dig into the numbers it’s important to remember that GDP growth is not correlated to equity market returns.

When you compare the GDP numbers from this quarter to last quarter, the difference was the fact that the massive inventory rebuild we highlighted in the 4^th quarter numbers did not continue into the 1^st quarter of this year. It's also clear that the Government will continue to be a drag on GDP numbers. As you can see, the government sector continued to shrink for the sixth consecutive quarter.

With that said, there are still several positives:

• Consumer spending contributed 2 percentage points to first quarter growth, the most since 4^th quarter of 2010
• Residential construction increased at 19.1%, the fastest in almost two years
• Cars sold last quarter at the fastest pace in four years

Going forward, the real challenge is to assess the likely outcomes in the next few quarters. We know that approximately 70% of our GDP is made up of consumption, and if we assume the consumer remains on track, that will provide a strong foundation for some moderate GDP growth. Working off that foundation, it’s also possible for companies to go through another inventory rebuild cycle this year. After all, companies are sitting on a tremendous amount of cash and can accelerate spending at any time.

Unfortunately, in the most likely scenario, we believe that companies will continue to be cautious in light of continued uncertain tax policy driven by the Affordable Care Act (ACA). Beginning in 2013, the ACA will increase the Hospital Insurance portion of the payroll tax from 2.9% to 3.8% for high income individuals.

To add further uncertainty around tax policy, you have the extension of the Bush Tax Cuts coming to an end this year, meaning personal taxes on income, interest and capital gains could go up for nearly all US taxpayers. If market participants start discounting both of these policy issues, we could see much more chop associated with this election. As you can see, there is a lot at stake when it comes to tax policy and this election. A recent study at the University of Iowa highlights how economic volatility increases during political campaigns. According to the study, “In general, more mature democracies saw increased market volatility in the six months prior to an election.”

All that being said, it's also likely that as we move into the 2nd half of earnings season, we will continue to see some more adjustments to earnings beating expectations, and corporate officers guiding revenue and earnings lower in the coming quarters.  Although there will be growth, it likely won’t look as good as it did a few weeks ago when we started this earnings season. The earnings beat rate have come down to 65.6% from last week’s 72%.

So at the end of the day, the confirmation of a slowdown appears to be upon us, and it's clearly being reflected in the amount of volatility we are now experiencing in our equity markets.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Our markets have had a tremendous run during the first quarter of 2012. The P/E multiple on the S&P 500 has expanded to 14 from 13.2 since the beginning of the year and earnings for the first quarter are coming in very strong. According to Bespoke, as of 4/20/12, 72% of the companies that have reported earnings have beaten estimates. This would be the second highest beat rate since 2000! There are still plenty of companies left to report earnings but it’s definitely a strong start.

In fact, if you ignored the rest of the world, one might think everything is not so gloomy. Unfortunately, we cannot; because our economy and stock market are deeply connected to what the global economy is doing.  We all know the markets do not go up in a straight line, and given this tremendous run, it probably wouldn’t take much negative news to cast a shadow on our markets making them extremely accident prone.

After returning from several weeks in India, the one conclusion I can make is that India, and much of the rest of the world, is in a slowdown. In fact, just shortly after returning the Reserve Bank of India cut interest rates by 50bps. They are also experiencing a real estate bubble similar to ours.

That is a picture I took of a New Delhi condo ghost town  similar to ones you could find in Miami, Vegas or even Portland, Oregon a year or so ago.  Literally thousands of condos, partially constructed, sitting empty.

China is in some type of “landing,” soft or hard, but neither is good for global growth.  a recent research paper highlighted the importance of China in the global economy; estimating variation in China’s output has three times the effect on Latin America today compared to the mid-1990s. Earlier this month, China surprised us with the largest trade deficit on record. This deficit is likely driven by declining exports to Europe and rising bills for commodities like oil.

The only bright spot in Asia is Japan. They are looking better with an anticipated 2% GDP growth in 2012 but it will be driven mostly by reconstruction spending.

The biggest concern is Europe. Euro-region debt has risen to 87.2% of GDP, the highest point since the start of the Euro. Spanish Treasury rates are flirting with 6% and many view 7% as the point where government borrowing costs become unsustainable. The European Central Bank (ECB) has already cut rates to a record low of 1% and provided over $1 trillion dollars in liquidity to the European banks. Europe is far from out of the woods.

After weeks of travel my perspective suggests some very specific actions:

• Continue to rebalance and maintain slight overweight in lower risk and lower volatile equities in the US.
• High yield US corporate credit continues to be a good risk-reward trade off with favorable valuations and opportunities.
• Look to average into emerging markets to dampen the potential volatility in the coming months. 

While the US economy is in much better shape this Q2 than Q2 of 2010 or 2011, the markets are reflecting that strength; making them extremely accident prone to some well anticipated but not well discounted shocks in the rest of the world.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

Weekly Market Commentary 4-16-12

The markets have had a great start to the year. The S&P 500 was up 12.6% for the first quarter, making it the best first quarter since 1998. Now the focus will be on company earnings with the first quarter earnings season getting underway.

As of Friday only 24 companies have reported, but the numbers and responses have been overall positive. According to Bespoke, the average one day change in the price of the stocks that have reported earnings was 2.54% and 75% of companies beat earnings. If you remember from some of our prior market commentary, this is on the high end for earnings beat rate.

We believe companies are continuing to beat earnings expectations for two main reasons, record high profit margins, and fairly low expectations.

Corporate Profits

US corporate profit margins are the highest they have ever been in post-war history. The graph below provided by a recent white paper by GMO shows the breakdown of what is currently driving these record profits.

As you can see, corporate profits have historically been driven by Net Investments (buying real assets), but lately it’s been driven more by the Governments fiscal deficit. Government savings contributes positively to corporate profit margins because they have a negative savings rate (a double negative is a positive). This negative savings rate is good for corporate profits right now, but probably not sustainable in the long run because it increases the deficit. If we expect these record profits to continue we need more people consuming more goods.

Once again consumption appears to be the key. If we continue to have an improving macro economy and the consumer’s animal spirits come out, these higher profit margins could be here to stay. The flip side is for these record profit margins to revert back to the mean. If their propensity to consume isn’t big enough, then I would expect these profit margins to fall back towards the mean over the next few years.

Analysts Expectations

Analysts have been bringing down expectations for this quarters earning growth since the beginning of the fourth quarter last year.  Initially it was 8%, then fell to 3% at the beginning of the year and as of last Friday it stood at 0.0%. If you take out Apple earnings growth rate for the S&P 500, then the earnings growth rate drops to -1.5% for the quarter.

With 0% earnings growth you might be wondering how the stock market just had its best first quarter in over a decade. We believe the answer is the fact that the market is a forward looking indicator. According to FactSet analysts are calling for double-digit earnings growth in Q4 of this year and Q1 of next year as the economy continues to strengthen.

Despite what you might be hearing about economies abroad (a hard landing in China, and European Financial Crisis’s) U.S corporate earnings are still intact, at least for the moment. Whether we continue to have record profit margins or double digit earnings growth only time will tell. But with 3% GDP growth in the fourth quarter and recent upward revisions to the first quarter GDP estimates we can say that our economy is at least moving in the right direction.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Adam Gulledge, Associate Investment Advisor – Phillips & Company

Weekly Market Commentary 4-9-12

The market has rallied off of its lows from the third quarter of last year, but the jobs report last Friday is a reminder that the global economy still has room for improvement.

Economists were expecting 201,000 new jobs, and the actual result was only 120,000. The unemployment rate did drop by 0.1%, but an important statistic called the participation rate declined as well. The Bureau of Labor and Statistics only counts people as unemployed if they are actively looking for work; discouraged workers may be out of work, but they aren’t “statistically” unemployed. Bear that in mind when you hear investors getting overly optimistic because of a falling unemployment statistic, as the picture may be more complicated than it appears.

For some good news, the amount of jobless claims (new applications for unemployment benefits) has continued to trend downward, which is a good sign. The number of jobless claims is reported weekly every Thursday, and this can be a volatile figure, so the important measure to look at is the four-week moving average.

This figure is encouraging. If we saw a sudden spike in jobless claims, it could be a sign of another downturn, but that has not happened so far. March could have just been a bad month, as it broke three straight months of +200,000 new jobs, but it is a reminder that growth continues to be slow.

A problem is that employment has not recovered as fast as it did in prior recessions. According to our previous estimates, at a rate of 245,000 new jobs per month, it would still take around 34 months to get the unemployment rate below 5%. This graph from Calculated Risk gives a good visualization for the situation:

The big difference between recessions in the past and the recent financial crisis is the amount of deleveraging (paying off of debts) that needs to be done to get things back to normal. People cannot spend like they used to when they are still trying to pay off their mortgage or credit card, therefore companies are not as profitable and look to cut costs (i.e., lay people off), and hence hiring is slow.

Fortunately, prominent hedge fund manager Ray Dalio recently said in an interview that he believes the United States has done the best job at deleveraging, but problems remain overseas. Europe’s problem is coming from national governments being overextended on debt; a government can be a lender of last resort to industries in trouble, but when the government itself is becoming insolvent, then the problem doesn’t have an easy solution.

While unemployment has been improving marginally, investors need to be prudent and remember that there is still a long way to go. An important number to watch for more context will be the consumer sentiment report on Friday. Also, pay attention to any announcements from the Federal Reserve to see if they are reconsidering another round of monetary stimulus based on this lower than expected jobs report.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Alex Cook, Associate Investment Advisor – Phillips & Company

Tim Phillips, CEO – Phillips and Company

Since Jim O’Neill’s paper on the BRIC (Brazil, Russia, India, and China) economies in 2001, there has been a lot of emphasis on growing economic countries because of their rapid GDP growth and the potential for significant investment returns. Over the next few weeks I will be traveling around India to see for myself what the country has to offer the global economy and its investors.

That’s 4 less years of income and 4 more years of expenses!

As April 15^th rapidly approaches I hope you use this as a reminder to fund your IRA, increase your 401(k) contributions, or simply save a little bit extra this year for your retirement. Don’t wait till tomorrow to do something you know you need to do today. You’ll feel better today, live better tomorrow, and avoid taking unnecessary risks along the way.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

 Adam Gulledge, Associate – Phillips & Company

Last week the S&P 500 had its best weekly gain of the year and economic data continued to show signs of an improving economy (albeit slowly). While this was happening last week, you might have noticed something else that happened (I sure did). Wall Street got called out on its behavior.

Gregmith, now former employee of Goldman Sachs sent in his resignation letter titled, “Why I Am Leaving Goldman Sachs” to his employer and the NY Times. I hope you have a chance to click the link and read the letter in its entirety. In the letter, Smith basically suggests culture matters and the culture at Goldman Sachs was broken placing corporate outcomes ahead of their client outcomes. Here are a few quotes from his letter:

“To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money.”

“It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity?”

To show how out of touch they can be, take a look at the response by one Wall Street CEO:

Morgan Stanley Chief Executive Officer James Gorman said he told staff not to circulate a Goldman Sachs Group Inc. (GS) employee’s op-ed criticizing that firm and that it wasn’t fair for a newspaper to publish it. 

I believe this to be typical behavior of someone trying to circle the wagons. It makes me wonder what he is trying to protect and if this guy is totally “out to lunch” on how information flows.

Once I read the op-ed piece I immediately sent it out to our entire firm and now I'm sharing it with you. I’m doing this only because I want to make a bigger point about culture and not because I’m trying to win business from Goldman Sachs. So, besides being insulted and called a "muppet" (in England this is slang for idiot, which is where Greg Smith worked for a time) behind your back, why should you as an investor care about culture?

When firms place corporate outcomes as their Key Performance Indicators (KPIs) instead of client outcomes you can see how the system can be rigged. Performance based indicators that focus on the bottom line drives a culture of salesmanship over stewardship when it comes to your investments.  A study done in 2007 by Oxford University and Watson Wyatt Worldwide (a global consulting firm), found that investment governance can have a material impact on your investment returns. Investment governance is a part of stewardship and is therefore driven by culture. 

Admittedly, this has not always been the case for us at Phillips and Company. However, it is now what drives the ethos around how we live our work lives and has been so over the last several years.  We’ve recognized it is our leaders (especially me) that have to drive the right culture. A few years ago we wrote a piece for our clients that addressed what Greg Smith was talking about called, Let’s Talk About Trust. I hope you have a chance to take a peek at this as well.

Being a professional steward is no easy business. An article in Daedalus (the journal for the American Academy of Arts and Sciences) from summer of 2005 discussed the challenges of professionalism.  Here are a few quotes from that article:

"Fulfilling a profession’s mission at a high level of excellence requires not only analytical distance and freedom from personal bias, but also passionate engagement, personal commitment, and human concern.  And these qualities must not merely coexist; they must be kept in some kind of integrated balance."

"The pressures of many of today's workplaces create conditions under which it is difficult for individuals to pursue non-economic professional values.  And since these conditions show no sign of improving-indeed, they may well continue to get worse- we need to strengthen individuals’ ability to do good work under less than hospitable conditions."

"To be both masterful and mission-driven students need to learn… the right equilibrium between analytics and human connection…”

To me this captures the essence of what it means to be a good steward: Doing good work to the best of your ability.

I'm quite proud of the people here at Phillips and Company. Together they wrote our mission statement, determined our operating values and selected our client values around your feedback. We may not win every account and we may not get every investment thesis right, but I can say we stand grounded in putting stewardship over salesmanship. I can only hope my larger cohorts on Wall Street will realize culture matters and they too can be richly rewarded for having the right culture.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

Last week’s economic data was overall positive. The most notable piece of economic news last week was the Nonfarm Payrolls Report. Last month nonfarm payroll rose by 227,000 according to the Bureau of Labor Statistics (BLS). The BLS also revised up the nonfarm payroll numbers from December and January by 20,000 and 41,000 respectively. The unemployment rate remained unchanged at 8.3% which was most likely due to the increase in the participation rate from 63.7% in January to 63.9% in February.

We now have had three consecutive months with at least 200,000 jobs added. The average increase of jobs within those three months is close to 245,000 while averaging a participation rate of 63.87%. We did some quick math using those two averages along with the population growth rate to determine how long until we get unemployment back to 5%. After running the calculation, we determined it would take approximately 34 months to bring the unemployment rate back down to 5%. If you are interested, here is a nice calculator provided by the Federal Reserve Bank of Atlanta that allows you to try out different scenarios.

Generally speaking, when our economy is at or below 5% unemployment, our GDP tends to grow around 3-4% annually. In fact, you can see from the chart below we have had several periods in the last 50 years where our economy has grown at or above 4%.

Initially, this may comfort you as an investor because it’s logical to assume positive GDP growth correlates to positive stock market returns. However, there is a significant amount of data actually showing a slight negative correlation between GDP and stock market returns.

We get lulled into believing there is a positive correlation between GDP and stock market returns, specifically when discussing emerging markets. We hear about rapid GDP growth in the emerging markets and we think that a rising economy should translate into rising asset prices. This is not necessarily the case for a number of reasons:

• GDP is based on sales/revenue (top line); stock returns are based on corporate earnings (bottom line)
• The stock market is not the whole economy.
• Corporate earnings may be earned outside of its home country
• Estimating GDP is not an exact science
• Shareholders can be hurt by dilution
• Poor corporate governance can negatively impact share price performance

It appears many of us gain comfort in assuming that positive GDP growth will lead to positive returns for their investments, but it turns out to be actually quite the opposite. As you can see from the table directly above, there is a strong positive correlation between GDP growth and lagged equity returns. Thus equity markets appear to be a leading indicator of GDP Growth. Based on this data, we should be looking for favorable valuations in areas with sustainable growth and the potential to provide upside surprises.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

For the last four years I’ve believed that in order for the economy to improve, we must at least see an improvement in jobs and income. Depending on the lens you choose to look through, it appears we might be seeing just that.

Bloomberg reported the following about improving incomes:

 Wages and salaries in the third and fourth quarters grew a combined $197.3 billion, the most since the six months ended March 2007, according to revised Commerce Department figures released Feb. 29.

Certainly that is encouraging since wages underpin consumption. Another welcomed improvement was the increase in the savings rate to 4.6% in the prior 3 months from an initial estimate of 3.9%. This increase in savings could suggest two things (depending on the lens you choose to look through):

1)    It could be a sign that consumers are becoming more cautious in the short term; or

2)    Consumers are replenishing their savings and now they are more able to spend

On the jobs front we have seen a steady improvement. As of January, the unemployment rate has dropped to 8.3% from a peak of 10% back in October of 2009. Focusing on this lens, unemployment appears to be improving.

On the other hand, looking at unemployment through different “lenses” may not give you the same picture. As of January, the Bureau of Labor Statisitics U-6 Total unemployment which counts the number of people that are unemployed, underemployed and are discouraged and stopped looking (but still want to work) was reported to be at 15.1%. Looking at more of a participation lens, the participation rate was 63.7% well below the 66-67% rate that was normal over the last 20 years. However, when considering the participation rate you have to place some emphasis on a demographic lens which points to a number of people that do not want to find work or choose to retire.

To get a better picture, we need to break down the workforce participation rate by age to determine if the drop in the rate is from an aging population or discouraged job seekers.

Here is how Barclay's sees it:

"Of those who dropped out of the labor force since Q4 2007, only 34.5% are classified as wanting a job, and only 14.7% want a job and are of prime working age (ie, 25-54)…The fact that the majority of those who fall in the “no longer want a job” category are in the 55+ age bracket suggests a significant move into retirement. This is consistent with the rise in the proportion of the population receiving social security benefits for retired workers.”

Through this lens, it appears there are significant structural changes at work in our labor force that will not change as the economy improves. These changes could create a different optic when we look for cyclical trends.

In light of what appears to be an improving picture for both jobs and income the question arises, can the market continue to trend higher? The answer is, it depends.

If you look at valuations from a yield perspective then the answer could be yes.

The next question is do we trust our vision?  We have been "head faked" in April of 2010 and again around the same time in 2011.  There are plenty of things that can blur our vision: European financial crisis, expiring government programs, and US fiscal problems. Recent headlines about record high gas prices could also begin to cloud our vision. The rule of thumb among economists is that a 25-cent increase in gas knocks $25-$30 billion off consumer spending in a year and lowers economic growth by 0.2%.

Year to date, stock market volatility has been extremely low, it might begin to pick back up as we head into summer. Remember, volatility is trouble to some and a necessity for others to generate outstanding returns, but I guess that too is all in the eye of the beholder.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

Warren Buffett released his annual shareholder letter this week. Among the facts and ramblings was an interesting opinion on gold:

“…Gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.”

(You can find the letter in its entirety here)

Clearly, Warren prefers his gold to pay a dividend.

Also, this week noted investor John "5 Billion Dollar Man" Paulson told his clients that his own money comprises over half of his Gold Fund which has over $1.2 billion in assets. The main reason is because Paulson still believes we are going to see inflation which he feels will lead to appreciation in the precious metal.

Gold definitely has some divergent opinions surrounding its place as an asset class in a portfolio.

• Some view it as a hedge against inflation because the price of gold spikes during years of higher inflation.
• Some view it as a hedge against a weak dollar because there is a strong negative correlation between the US Dollar and the price of gold.
• Some view it as a “crisis commodity” because it tends to outperform other investments during periods of global tensions

Personally, I agree with Warren Buffet on this matter. I prefer assets that I can value from a cash flow perspective. 

What I can say about gold is the number of seminars, commercials, reality TV shows and pitch artists selling gold is astonishing. I can remember when seminars on Film Production Limited Partnerships were all the rage in the 1980's. Then in the 1990’s, the seminars were all about day trading. Facilities were literally set up for people to come in and hyper trade their own account. This was followed by seminars on how to use your IRA to buy Residential Real Estate in the 2000’s. We all know how, "The Devil Take the Hindmost" on these supposedly exciting and sure fire ways to make money.  Now, I await the calls from clients who say they want to pull some money out and try the latest techniques they learned in a seminar.

What's worse, rather than allocating responsibly and consistent with their time horizon many investors want to "double up to get even” during current economic strains. This leaves them exposed to chasing returns and in some cases scams (like this one in Florida).

I have a pretty solid idea of how this will end. The only question for me is, “when will it end?” I am often surprised at how long irrational players can hold on to irrational positions. Let's face it, if the technique pitched in these seminars produced the short term gains promised, then the pitch artist wouldn't need to hold seminars.  Unless, these pitch artists have an act of benevolence towards us “ordinary folks” that trumps their desire for personal gain.

I don’t have a crystal ball to see where the price of gold is headed. Indeed it could go higher if people believe there is someone else out there willing to buy it from them at a higher price.  What I do believe is the "seminar standard" might just actually crack the "gold standard.”

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

There has been a lot of talk about a slowdown in the Chinese economy.  A slowdown which could have possible broad based implications as China is the third largest global economy (behind the European Union and United States). 

Although, before we get deeper into what those implications might be, let’s look at some recent data from January on China:

• Exports and imports fell for the first time in two years.
• New lending was the lowest for that month in five years.
• Money supply grew the least in more than a decade.

Even with this data, China’s GDP is still projected to grow at 8.50% this year. That number is staggering compared to the United States’ expected GDP growth rate of merely 2.20%.  In fact, if both China and the United States continue to grow at their expected rates and maintain that as a constant growth rate over the next several years, China will surpass the U.S. in GDP by 2024.

Here’s the, “Ripley’s Believe It or Not” part: some Chinese economists have expressed that if China’s economy does grow by less than 8%, it would be consider a recession by the Chinese! They believe China needs to maintain an 8% growth rate to stay on course with current social pressures created by new entrants coming into the workforce and people migrating towards more urban areas for jobs.

Economists also suggest there could be dire consequences if China does experience an actual recession. Yesterday, in response to the soft economic data from January the Peoples Bank of China (PBoC) cut their banks’ reserve requirement ratio (RRR) by 50 basis points. The PBoC hopes this cut will spur additional borrowing and growth. The Central Bank first cut the RRR at the end of November and utilized additional open market operations in January to provide short-term cash for banks.

Xi Jinpeng, China’s soon to be leader, suggested there would be no hard landing for China. Based on recent actions, it seems China is taking a page from the American playbook on loose monetary policy.

Going forward, if you believe the “American style” monetary policy will cause the Chinese consumer to borrow, then China might still be a good bet and could continue to rally. Although, if you think China is a society in structural change and the Chinese will not consume, then it would be wise to underweight China in your holdings. Also, if you do believe the latter then you might want to take it a step further and hedge against possible global deflationary concerns too.

The good news is the American consumer seems poised to pick up some of the slack (keyword: “some”). With the American consumer continuing to deleverage, it is unsure how much slack in consumption we could actually pick up. Let's just hope the Chinese are more responsive to the “American style” monetary policy than we’ve been.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

Markets have been on a rip roaring rally these last few weeks.  The S&P 500 was up 4.48% in January and is up 6.98% YTD.  Under normal circumstances coming off a year like last year where returns seemed non-existent, one would expect a strong start.

After a solid jobs report in January and stronger than expected improvements in consumer credit, it can be easy for one to conclude we’re currently in the throes of an improving economy.

In fact, this is one of the few times individual investors and professionals are normally optimistic about the markets. However, if you looked at analyst expectations of future corporate earnings you would see an entirely different picture.

Wall Street analysts have been reducing earnings expectations in droves. The following is a chart by Bespoke showing the daily net change in analyst’s upgrades (downgrades). As you can see, there has yet to be a single day this year where there were more upgrades than downgrades.

Numbers did improve throughout this earnings season as we suspected. However, during this earnings season companies continue to still lower guidance and expectations.  

While this might suggest we’re about to face some headwinds in our rally (which wouldn’t surprise me given the YTD performance numbers), calling market tops and bottoms is nearly impossible. Credit Suisse has also taken noticed of the interesting contrast between analyst opinions and the YTD performance numbers. This anomaly can be seen in a research study they did which compared the changes in earnings estimates with actual stock market performance.  Below is a chart that summarizes their findings.

From this chart, it appears when earnings estimates are lower than they were at the start of the year, the equity markets tended to finish higher roughly 2 out of 3 times. This underlines one of our core investment philosophies: it’s not about timing the market; it’s about time in the market.  Markets can be “irrational” longer than a logical investor’s patients. 

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Adam Gulledge, Associate – Phillips & Company

Hatip: Bespoke Investment Group for Sentiment Chart, Analyst Upgrades/downgrades and Guidance data. 

Tim Phillips, CEO – Phillips and Company

Is Facebook worth it?  Without a doubt, this will be the biggest question we get asked as advisors over the coming weeks. So, could investing in Facebook once it becomes publically traded be the path to fortune or could it be another version of “accidental investing” like the recent commercials suggest? 

When Facebook does have its IPO, it is expected to be valued between $75 and $100 billion. On their S-1 filings with the SEC, Facebook had reported revenues of $3.7 billion and earned $1 billion in profit last year. Based on these numbers, Facebook would have a price-to-earnings ratio (P/E) of 75 to 100 and a price-to-sales ratio (P/S) of 20 to 27!

In comparison to other tech titans, Facebook’s valuation might be considered rich:

The difference between Facebook and the other tech titans is their growth rate. Facebook’s revenue grew by 88% in 2011, while Apple, Google, and General Electric’s revenue grew by 68%, 29%, and -1.5% respectively.

Facebook boasts that 1/8^th of the world population are currently active users. However, this may mean Facebook’s user growth could start slowing simply because everybody who might join Facebook has already done so. Looking at the ad revenue growth numbers in 2011, we see growth of 18% in Q4, 3% in Q3, 22% in Q2, and -3% in Q1!

So what's Facebook actually worth? I’ll let the market decide the final number. Personally, I think a $60 billion valuation would be more attractive. If I succumb to “accidental investing” I might gravitate towards the $75 billion valuation. If I do, then I’ll certainly be much more cautious as I over pay.

Jobs, but not Steve.

Just to keep with our Facebook theme, I took a look at how many people our comparative company’s employ:

• Google has approximately 32,000
• Apple has approximately 63,000
• Facebook has approximately 3,200
• GE has approximately 287,000

From this fragment of data, the new economy appears to make more value and less employment.

With that piece of antidotal evidence in mind, we did have a great job's report last Friday. Job growth was widespread with large gains in professional and business services, leisure and hospitality, and manufacturing.

• Professional services added 70,000 jobs.
• Manufacturers added 50,000
• Leisure/hospitality payrolls increased by 44,000.
• Retailers added 11,000

There is no other way to put this jobs number other than a possible sign of a stronger consumer. The only downside is the employment participation rate dropped to 63.7%, the lowest rate since the early 80’s.

If Facebook represents the next generation of companies, then new companies look more like wealth creators than job creators. With Facebook being valued at near levels with the likes of Boeing, Caterpillar, McDonalds, and Cisco, yet only creating a few thousand jobs; the real winner will be the wealth effect not the employment effect.

Perhaps it's time to put more inflation hedges into the portfolio and add more risk into your holdings.  Just don't be caught “accidentally investing.”

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

A few things happened this week that give significant clarity around the winners and losers in our economy this coming year.

Event 1: As expected, the Federal Reserve announced no change in interest rates. However, they did unexpectedly change their specific language for when rates could increase from “mid-2013” to “late-2014.” The Fed cited two specific reasons for the change: continued weakness  in our labor markets and a global slowdown (i.e. Europe). Clearly, they see more need for accommodative rates to support the fragile growth we have in our economy. 

Event 2:  US GDP Estimates were released for Q4 2011.  They showed the economy growing at an annual rate of 2.8% in Q4 of last year. Growth is always welcomed; however, when you look behind the headline numbers you see two interesting facts.  First, business’s rebuilt inventories to the tune of 1.9 percentage points of the 2.8% (that's BIG).  Second, the US Consumer grew spending by 2 percentage points (There were several categories that subtracted GDP therefore these two numbers won't add up).  Our conclusion, inventory rebuild cannot be depended upon to add to GDP in the coming quarters as businesses don’t just build blindly. Especially, as consumers still appear very cautious about spending.

% Change in Personal Consumption Expenditures

Change in Private Inventories

Event 3:  The President focused his State of the Union Address on rebuilding the United States’ manufacturing base.  We view this as a good thing because much of what we manufacture is exported and exports generally benefit from a weak dollar. Because of the Feds unexpected actions (event #1), we should continue to see a weaker dollar. The manufacturing sector can be a large employer and an improvement in this sector can help improve the labor markets.

Without revisiting our yearly forecasts the storyline of these three events is pretty clear: Continued slow growth ahead for the next year or so.

Given these events, as an investor I might consider a few things:

• Pushing fixed income maturities out a bit (from 3-5 years to 5-7 years)
• Look beyond dividend paying stocks and perhaps select some energy and agency issues that can enhance income.  Be careful as these can be tricky investments.
• Inflation is a customary risk with all this cheap money floating around and certain commodities are going to be attractive.  I don't necessarily believe inflation is a threat in the short run.  Most of this cheap money is still being used to repair balance sheets for business and consumers.  Without money chasing goods and services, employment dropping; inflation might be a delayed effect.

One thing seems certain; we could be in store for another average year.  As an investor and advisor, I would strongly look past just one years’ worth of numbers as they really are irrelevant.  I was recently reminded of that by economist Robert Shiller when he quipped, “I don’t know why people keep using one year earnings. That is the time it takes the earth to go around the sun. I don’t see any other significance.”

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Tim Phillips, CEO – Phillips and Company

For just once I would like a piece of economic data without strings attached.  I long for the olden days of the 1990's when everything just pointed up and you hardly had to think as an investor. Just steer the car in the right direction and it would go where good returns were a commodity and all the data was great.

Oh how I wish.......

Today, everything seems to have a cautionary note attached.  Take for example our recent jobs report.

The Bureau of Labor Statistics (BLS) reported the unemployment rate dropped to 8.5% in December, down from 8.7%.  This is the lowest reading in almost 3 years.  Subsequently, we saw an addition of over 212,000 jobs in the private sector.  

The cautionary tale is that within this data, there were roughly 42,000 jobs added in the courier and messenger industry which was most likely due to the seasonal upswing of the holidays.  When you normalize this out, you get closer to the 150,000 jobs number which is more in line with expectations. 

On the side of bad news, we saw many retailers post weaker than expected numbers. Companies like Target, Wal-Mart and J.C. Penny’s reported to either have missed or reduced earnings forecasts. However, certain retailers such as Macy’s and Zumiez (a specialty retailer) reflected some pretty strong numbers. Some attribute the weaker numbers as a result of mis-timing promotions and under stocking inventories.

Finally, we have two confusing messages on Leading Economic Indicators.  

The two charts above compares the Economic Cycle Research Institute (ECRI) Weekly Leading Index (WLI) to the Conference Board’s (CB) Leading Economic Indicators (LEI) over the span of many decades. From the data you can see that for most of the WLI and LEI’s history there is a reasonable degree of correlation. However, beginning in the spring of 2010 (only 6 months after the last recession) we see a major unexplained deviation between the two. 

Perhaps all the divergence in this data is due to a schizophrenic economy or possibly it’s a sign we might be at a pivot point from a macro perspective. Or maybe, this is just the "new normal" and if that’s the case, we'd better get used to it always being something.

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

Tim Phillips, CEO – Phillips and Company

The start of the year has me preparing for meetings with endowment and foundation committees as well as strategic planning meetings for our firm. In general, I take a macro view on key themes that could impact investment outcomes and build those into my meeting preparations and strategic plans. Last week, I shared my wild guess as to the outcome for the S&P 500 by year end 2012.

The base case for economic forecasting is as follows (provided by Bloomberg):

• 2.10% Real US GDP Growth
• 8.70% US Unemployment
• 2.10% US Inflation
• 2.28% Real Global GDP Growth

Using that as my starting point, here are my key themes for this year’s base case:

US Economics

As you can see, the consensus estimates are a bit muted. My guess is there’s a 25% chance of an upside surprise driven by two main factors, foreclosures and consumer spending. First, foreclosures should begin to help clear the system and housing prices could stabilize this year. Secondly, the consumer could feel confident enough to spend down savings a bit more despite the lackluster wage growth.

US Politics

You can hardly mention consumer confidence without commenting on the state of politics in America. Contrary to popular opinion, I don't see public policy playing as large a role in 2012 as it did in 2011. In my opinion, there are only two big events that will play out this year in public policy:

• An extension of the payroll tax cuts beyond 2 months
• The Supreme Court’s ruling on ObamaCare.

The payroll tax is likely going to get extended without much of a fight as Republicans basically conceded that ground in December. The President will also make a public affairs debate over two key provisions in ObamaCare that are wildly popular: child health care and health care for people with pre-existing conditions.

Any other major debates will probably wait until after the election. The President wants to paint Congress (read Republicans) as a “do nothing congress” so it may be in his best interest to propose nothing. On the other hand, many in Congress want to paint the President as ineffective at getting things done, so it may be in their interest to propose nothing as well. We'll have to see who wins this stalemate in the coming November. As for markets, a year without big policy considerations might be helpful.

Europe

European Union countries may likely slip into a recession if they are not in one already. This on its own is already baked into the base case scenario and would certainly be a drag on Global GDP growth as the European Union is the largest economy in the world. Underweighting Europe has always been our mantra for years. However, there could be a low probability of an upside surprise if the recession is mild and the EU finds more ways to stabilize their currency and banks. Although, if a series of defaults occur outside of Greece, we could see a large drop in global equity markets.

What's a bit more troubling than the impact on our GDP is the impact on emerging markets.

Emerging Markets

While there is plenty of opportunity in emerging markets this coming year, one significant drag on that possibility is Europe. What most people don't realize is that the EU banks have been very large lenders to emerging market countries.

Since EU banks don't seem to want to issue new stock at cheap prices, they will most likely pull back on lending both at home and abroad. This is potentially bad as the EU banks are large players in both US and emerging market lending. I'm cautiously optimistic the emerging markets will provide positive returns this year.

US Markets

While my base case calls for the S&P 500 to close at $1,339, I do see a few areas of potential upside. One may be to continue concentrating on high dividend paying stocks, although this is hardly a fresh perspective. I continue to focus on high yield and distressed corporate bonds for those that can appreciate the risks. Additionally, I favor mid-cap stocks over small cap stocks this year. Large corporations have record levels of free cash flow and net income that I believe could be used to acquire smaller companies in the mid-cap sector.

To summarize, many global risks have been built into the base case outlook and there certainly could be some great upside surprises this coming year making the base case look very conservative. On the downside, a European Union breakup and defaults would crush Europe, damage Emerging Markets and have a strong negative impact on our markets. No portfolio would be exempt from this shock, but I consider this scenario highly unlikely.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

It's that time of year when everyone in my business tries, in earnest, to predict the markets for next year. I've spoken to some of these professionals and my takeaway is that they (still) tend to believe in their prognosticating skills.

In my profession, I’ve come to observe that the more “precise” you are, the more people are apt to find comfort in believing you. People seem to believe if you make very precise statements it must mean you are very confident and therefore it has to be accurate. Unfortunately, in my profession the opposite tends to be true when it comes to forecasting. The more precise the forecast, the more inaccurate the forecast tends to be.

The best example of this in 2011 was Meredith Whitney’s very bold, very precise, and very inaccurate prediction for the municipal bond market made last December 19th, on an episode of 60 Minutes where she said:

“There’s not a doubt in my mind that you will see a spate of municipal bond defaults... You could see 50 sizeable defaults, 50 to 100 sizeable defaults, more. This will amount to hundreds of billions of dollars worth of defaults”

Then later in the same interview in regards to rating agencies and their relationship to the municipal market:

“When individual investors look to people that are supposed to know better, they’re told – they’re patted on the head and told it’s not something you need to worry, about when it will be something to worry about within the next 12 months”

This prediction was heard around the world. She made the cover of magazines, and multiple TV appearances. It appears being precise is better for business than being accurate.

Since her prediction on Dec 19^th, 2010 the municipal market has returned 10.5% as of Dec 16^th according the Merrill Lynch Municipal Master Index. That beats U.S. Treasuries, stocks, corporate bonds and commodities. The municipal bond market was arguably the best performing asset class of 2011.

In keeping with the parlor trick theme, I will make my stab at outcomes for 2012.  Here it goes:

For 2012, I predict the S&P 500 earnings will be $103/share with an earnings multiple of 13. This would make a year-end target of $1,339.00 on the S&P 500, an increase from $1,265.33 which was seen at the close this past Friday, December 23^rd.

I see a very nice move in the equity markets in early Q1 driven by continued rebuilding of inventory.  Q2 will be a bit tougher as we have continued slack in housing and the peak of foreclosures take hold.  The second half of 2012 will be election driven and perhaps a choppy but rising market.

Europe will be the market to watch and certainly those that overweight their portfolio now could be richly rewarded, but I will not be one of them. Even if they solve their currency and debt problems, they still have a culture of leisure that I predict will keep them in recession or near a recession for a longer period of time.

Of course, a European disaster would spell an extreme event of perhaps 25%+ downside.  The actual GDP impact would most likely be small, however, I believe the equity markets would react swiftly and forcefully.

Asia (China) growth will slow slightly but much of that appears to have been discounted in 2011 as the Hang Seng Index and the Shanghai composite are down -19.13% and -22.86% year to date respectively. While many might run from Asia, I believe they have taken the brunt of the slowdown.

Ok, those are my best guesses.  I like parlor tricks so I played along; however, in the long run I tend to depend on solid allocations with specific tilts to take advantage of opportunities. The predicting is fun and if I'm right I'll be sure to let you know.  If I'm wrong and there is a high probability of that, then I will hope you are too busy to notice.  After all, this is a core concept for those in the parlor trick business.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Have a happy and safe New Years.

Tim Phillips, CEO – Phillips & Company

While Europe has been grabbing all the headlines winning our "Grim Reaper" award, there has been one country quietly accumulating some momentum, the United States. The U.S. has been posting some fairly positive numbers so far for the month of December. As you can see from the chart, we’re about evenly split between indicators that have beaten expectations and those that have not.

Most important are the weekly claims numbers that may suggest we are seeing a slight improvement in job growth. The data above shows that initial jobless claims have been significantly better than expectations for the past two weeks in a row.

Even with retail sales missing estimates, a breakdown of the 13 components show an interesting trend; consumer cyclical sectors all beat estimates while staples generally underperformed.

The Market may already be taking notice of our situation and acting accordingly. The U.S. dollar has recently strengthened against other currencies (especially the Euro) and coincidentally we’re seeing gold continuing to sell off. There has also been a lot of talk about gold breaking below its 200 day moving average of around $1,690 which is a bearish technical pattern. On Friday, the spot price of gold closed at $1,599/oz, down 15.89% from its high of $1,900/oz on September 5^th of this year.

With a 2011-2012 federal budget signed into law, we can move that debate off the table. Up next, we have payroll tax cuts and unemployment insurance and a two month extension would be counterproductive.  Who is going to run out and spend their two months of benefits if they think it will be their last? We believe a good resolution to this debate could support another 1% of GDP growth next year.

Finally, with the holiday fast approaching I want to thank all of you on behalf of everyone at Phillips and Company for your trust and confidence.  This has indeed been a volatile year that has been taxing for individuals and institutions.  We hope this holiday provides you with some time with family, friends and some moments of joy and happiness.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Happy Holidays and Merry Christmas!

Tim Phillips, CEO – Phillips & Company

Hat tip to Bespoke Investment Group for the Economic Data

Last week, we touched on a report from the Economic Cycle Research Institute (ECRI) that calls for the United States to enter a recession in 2012. This deserves further examination for two reasons. First, it’s a significant outlier from other 2012 GDP forecasts. Second, they’ve correctly called three recessions without any false alarms in-between.

The ECRI’s call is based on a number of leading indices which a key piece is their view on the United States Gross Domestic Income (GDI). GDI is similar to GDP conceptually in that it adds up a set of economic components. GDI is different from GDP in that it adds up economic components from the other side of the equation. In other words, GDP gauges the economy from the expenditure side, while GDI gauges the economy from the income side. In theory, the two should be equal but are usually not because in practice they are calculated in different ways. Where GDP is the sum of consumption, investments, government spending and net exports; GDI is calculated based on employee wages, corporate profits, and tax revenues. Looking at our economy based on income is fairly intuitive as income drives consumption and 70% of our economy is driven by consumption.

According to the ECRI the last reading on GDI was 0.30%. This is much lower than GDP which came in at 2.0% down from the initial reading of 2.5%. The ECRI goes on to explain that when you have a two quarter annualized GDI growth rate of 2% or lower, you reach a recessionary stall speed. The last reading was 0.28% and has been trending down steadily.

Looking past the troubling GDI data there are still a couple of interesting data points on what consumers are doing with their income.

First, according to the Bureau of Economic Analysis, income increased faster than spending and the savings rate increased slightly:

Personal saving --  (disposable personal income) DPI less personal outlays -- was $400.2 billion in October, compared with $376.9 billion in September. Personal saving as a percentage of disposable personal income was 3.5 percent in October, compared with 3.3 percent in September.

The savings rate ticked up in October, however, the trend still appears to be going lower. Consumers appear to be feeling more confident because they are more willing to spend down savings in order to consume.

Second, consumers have been using more revolving and non-revolving credit in the last couple of months to increase consumption.

As for companies, they are sitting on $2.11 trillion in cash. When you put this in terms of the total assets on their balance sheet – cash on the sidelines – it’s at a 30 year high. After all, many non-financial companies were frozen out of the debt and overnight lending markets by banks which almost collapsed their businesses.  However, there will come a point when they deploy this cash for higher returns.

Last but not least, corporations have had another banner quarter of record earnings which we did discuss last week.

So while the GDI data suggests gross income for our country is down, the consumer is still finding ways to consume.  Maybe it's just in our behavior to consume and we can't help ourselves.  Perhaps our consumption is unsustainable and we will fall back into a recession.  No one really knows what next year holds and the best bet is to tailor your investment strategy based upon shaping risk with time and allocating accordingly.

I for one wouldn’t want to bet against the consumer demonstrating unsustainable habits because history has shown how resilient the US consumer can be to spending at an unsustainable rate

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Hat tip to Calculated Risk for the savings graph, and Ritholitz and Arbor Research for the “cash on the sidelines” graph

Over the last two weeks we've looked at the European Debt Crisis and the potential impact on US exports if Europe falls into a recession (What’s All the Fuss?). We also covered the challenges many European countries face on budget agreements as a consequence of each country’s relatively unique social programs (The Cost of Leisure Part 2). It seems to me there is a lot of emotional noise; perhaps it’s time to step back and look at issues a little closer to home.

The official start of the 2012 presidential election campaign season is just 30 days away with the Iowa caucus on January 3, 2012. That means the political class has just one more chance to get something done and as a result, it appears we’ll have an extension of the employee payroll tax cut and unemployment benefits. These extensions will likely be funded with “kick the can down the road” funding mechanisms which will lead to cutting expenses sometime in the future.

Economic data was pretty mixed last week. Probably the biggest headline surprise was the drop in the unemployment rate to 8.6% down from 9.0%. Unfortunately, it was largely due to the decline in the Labor Force Participation Rate which fell well below the 66% to 67% rate that has been the norm over the last 20 years. On the positive side, October and September hiring numbers were revised up to 100,000 from 80,000 and 210,000 from 158,000 respectively.

Overall, our economy is still at a very fragile point and we’ve pointed out how a simple quarter of a percentage point can be the difference between expansion and contraction for our economy today. The Economic Cycle Research Institute (ECRI) still expects the US economy to tip into a new recession in 2012 despite what our policy makers do (you can read a summary and the full report here). The bottom line is, ECRI is basically saying, “If you think this is a bad economy, you haven’t seen anything yet.”

Companies continue to beat earnings expectations at pre-recessionary rates however we saw a big drop in the revenue beat rate. At the end of the US corporate earnings are near record highs thanks to improving margins.

Abroad, European Union Leaders meet for their next big summit in Brussels this Friday. We expect the leaders to continue to agree on being more connected through budget agreements and determined to save the EU and the Euro. However, anything can happen and the markets are growing impatient. On the other side of the Americas, we saw China unexpectedly cut required reserves by 50 bps.

Looking across the board, I think in the near term the upsurge and downsides are a toss-up and we need to continue to dig deeper to find the right allocation path. Remember without the uncertainty, the opportunities to generate returns would prove to be difficult and underline how critical it is to shape the risk by using time well.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

As we discussed earlier this month, a recession seems almost inevitable and the impact on US GDP growth is negligible. In fact, this morning the Organization for Economic Cooperation and Development warned that Europe risks a severe recession if they can’t halt the sell-off in the Eurozone sovereign debt market. What we did not discuss last week was a potential full blown collapse of the Euro.

What would happen if the 27 country European Union dissolved over a failure to come to terms with member country debt? After extensive searching, I’ve realized I cannot find a single paper written by the International Monetary Fund (IMF) or the European Union (EU) outlining a contingency plan to dissolve the EU and the Euro. Likely, any plan could be catastrophic if leaked and probably not worth the risk of writing. Perhaps this indicates a failure of the EU is not conceivable by the parties.

Before we can address what would happen if the EU fails we should review what's holding the countries back from agreeing on a solution.  In simple terms, Germans don't want to pay for Italian leisure at the expense of their own and each country has their own social programs (some much more generous than others).

Countries with these generous social programs need their economy and GDP to grow fast enough to cover the costs. When their economy doesn’t grow fast enough, they must borrow to keep their promises. Currently, it appears to be seen as political suicide for a Leader of an EU member country to decide to cover the debts of a “lazier” EU member country. So what are some possible solutions?

Eurobonds are still out of the question because it puts the burden of generous social programs onto the stronger economies. Hypothetically speaking, if Eurobonds are issued at 4.5% then any member country that was paying more than 4.5% would benefit and any member country that was paying less than 4.5% would be disadvantaged. Germany doesn’t want to backstop Italian summer vacations.

Reworking the EU treaty to stipulate more fiscal controls would certainly be a good place to start if everyone was going to share pain.  However, convincing sovereign nations to give up fiscal control is not an overnight process. Getting the 27 members to agree on specific changes to the EU treaty would take more time than they have.

The International Monetary Fund (IMF) could provide a rescue package or credit line to troubled EU members. This option would keep the EU together and buy additional time to revise the EU Treaty. The catch is who funds the IMF. Approximately 17% of the IMF’s funds come from the United States. Instead of Germany paying for Italian summer vacations it will be you and me.

There is also a possibility it may be too late for any solution. What if it all failed? The truth is the largest economy in the world would spend several years trying to figure out how to re-trench and grow again.  The geo-political consequences would be significant and we would all face a really ugly "new normal".

We are working diligently to continue to rebalance away from Europe without giving up opportunities to profit. With markets moving so quickly in both directions it’s a non-stop effort to determine the "best" next moves. While Europe slides into a recession and perhaps a depression we will continue to work hard, just like you. I sure hope Europe enjoys their leisure now, because one day the cost might be too much to bear. That's how conflict really starts.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

As of this writing on Sunday, the Joint Select Committee on Deficit Reduction, i.e. the Supercommittee, is poised to admit defeat.  Once again, Washington is gridlocked and if the markets react like they did during the summer’s debt extension debate there’s potential for another round of market volatility.

Even though “across the board cuts” won’t start until 2013, I have concerns today with how our macro-economy and GDP will be affected if our debt problems balloon to an impasse like those of Europe and Greece. 

For example, if our GDP grows at an annualized rate of 2% each year from 2011, then the first round of cuts in 2013 would amount to 0.44% of GDP.

These year-over-year spending cuts would have a significant impact on GDP particularly since we are already experiencing anemic growth.  To make matters worse, if you include the 0.25% hit to GPD from our import/export relationship with the European Union, then our economy could face close to a 0.75% hit to GDP in 2013.

The markets care about this a great deal. Right now, there seems to be a tremendous focus on companies that receive substantial government funding like healthcare and defense spending. Looking at healthcare and more specifically the home healthcare and assisted living sectors, anticipated cuts to Medicare appear to have already been priced as seen in the YTD performance of the following healthcare companies:

Smaller defense and aerospace companies whose revenue relies greatly on significant government contracts could also come under pressure if these “across the board” cuts actually happen. While the S&P 500 is only down 4.80% since August 2nd (when Obama signed the Budget Control Act of 2011), there is potential for more negative markets.

With all this doom and gloom, let’s look at the bright side for a moment.  It is likely many market participants have already discounted what they always knew: that partisan politicians can never get anything done and provide us a tremendous buying opportunity in light of expected GDP growth.

Let's see who shows up for the big announcement and who really cares. We certainly do.

Have a happy and joyous Thanks giving!

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

By now, I think it’s safe to say investors have been sufficiently tortured by what’s happening in the European economy.  The moment Greece moved off the headlines, Italy took center stage. Once the media gets tired of Italy and the markets adjust, they will probably move on to the next victim country.

What’s not talked about is how this may directly impact the US economy and our GDP.

First, the European Union is the largest Economy in the world. The European Union combined with the United States represents almost 50% of the entire World’s GDP. 

Clearly Europe matters, the question is, how much does Europe matter? Over the last 12 months we have exported approximately $324 billion dollars to the European Union in goods and services. We also import more from Europe than we export; therefore we have a negative trade balance which subtracts from our total GDP. This negative gap could grow significantly if we continue to import goods from Europe and we are not able to increase our export goods. 

As a quick rule of thumb, every $140 billion in economic activity is 1% of our GDP (1% of $14 trillion is $140 billion).  With that in mind, a 10% drop in exports to the European Union would be a decline of $32.4 billion in US GDP (about ¼ of 1% of our GDP). Under normal economic conditions that wouldn’t mean much.  However, under current circumstances 1/4 of 1% means something. 

Last week, we highlighted the Federal Reserve’s economic forecast where they slashed their 2011 United States GDP growth from a range of 3.3%-3.7% down to 2%-2.5%. Under current circumstances, a 0.25% drop in GDP would be 10% of our growth. 

The International Monetary Fund has trimmed its European growth forecasts to 1.4% and I believe the markets are expecting a European Recession. It's not hard to imagine their economy slipping into negative growth if there are no bold policy considerations for bailing out irresponsible, socialistic member countries of the European Union.  As I have said several times in presentations, this is the price for leisure.

I believe most of the bad news is already built into our markets, which is good news to me. Looking at export numbers year to year, exports to Europe peaked in 2008, fell steeply in 2009 and rebounded in 2010. Year to Date, 2011 looks to be better than 2010, but not quite as good as 2008 leaving more upside for US exports to the European Union in 2012.

When we get all the nasty headlines about Europe try to look past the emotion and perhaps we won't lose export ground as much as some pundits believe.  If this is indeed the case we could see a nice upside surprise to our markets.  Now that would be something to fuss over!

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Last week, we discussed the details of the Bureau of Economic Analysis’ (BEA) advance estimate of US real GDP for the third quarter. Sticking with the GDP theme, later that week the Federal Reserve came out with their fourth and final GDP and unemployment projections for the year.

GDP and unemployment projections have moved in the wrong directions since the beginning of the year. The November projection for 2011 GDP is expected to be 1.6% to 1.7%. This is much lower compared to their projection of 3.4% to 3.9% at the beginning of the year. Based on these new projections the Fed does not expect a 3.0% or greater change of real GDP until 2013!

As for the unemployment projections, the Fed still expects 9.0% to 9.1% for 2011 and does not expect to see unemployment under 8% until sometime in 2013.

According to an analysis by Bill McBride, author of the economics blog Calculated Risk: 

If we continue to see sluggish growth with 125,000 payroll jobs added per month (the pace this year), it will take an additional 52 months just to get back to the pre-recession level of payroll employment.

If job growth picks up a little - say to 200,000 payroll jobs per month - it will take an additional 33 months to get back to the pre-recession level.

Based on those numbers, unemployment won’t return to the pre-recession level until somewhere between July 2014 (blue line) and February 2016 (red line). McBride also notes that these projections do not include population growth and new entrants into the workforce.

While these numbers might be slightly depressing, it’s important to realize they are moving in the right direction, albeit slowly. GDP numbers continue to stay positive and we continue to have positive net jobs added per month. For now it looks like the US will avoid a “double dip” recession and continue its slow growth trend. In fact, Merrill Lynch and Goldman Sachs raised their Q4 GDP forecasts on the heels of the BEA numbers last week citing the same reasons we did previously, improved domestic demand and increased consumer spending.

It’s important to protect your portfolio from downside fluctuations, but it’s equally as important to not get caught flatfooted and miss a potential year-end rally. Historically, November and December are two of the best months of the year for US equities. 

Between the European Debt Crisis and our own fiscal problems there are plenty of downside catalysts, but if the consumer decides to spend more than expected this holiday season we could continue to see positive surprises in consumption and GDP.

If you have questions or comments please let us know as we always appreciate all your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

“Average Monthly % Change for the Dow Jones Industrial Average” provided by Bespoke Investment Group

You hear a lot about “risk on” and “risk off” by the media to describe the day-to-day short term volatility. For example, in the third quarter the S&P 500 fell 13.87%, clearly a “risk off” quarter. Then in October, as of Friday the 28^th the S&P had increased by 13.74%, clearly a “risk on” month. At the end of all this, the S&P was actually up by 3.87% so far for the year.

The last four months have been a roller coaster ride but it’s important to maintain an intermediate and long term perspective in order to invest in the right areas. With that in mind, we took a deeper look at the advanced real GDP numbers. According to the BEA and based on the advanced estimate numbers, the US Economy increased by 2.5% in the third quarter. This number was in line with consensus and better than the first two quarters of the year.

Looking deeper into the GDP numbers, you can see that third quarter was clearly a “consumption on” quarter when compared to second quarter:

I would say this is better than another “inventory rebuild” quarter, but we are still not out of the woods until we see wage inflation. “Consumption on” is much better than “consumption off”, but we need to make sure it’s sustainable consumption.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Hat tip to the Dismal Scientist for the spending graph

We have now entered the final quarter of the year and Alcoa kicked off the final earnings season after the bell on October 11^th. As we hit the home stretch we wanted to look back and compare the S&P 500 forecast from the beginning of the year, to current S&P 500 forecasts. Back in January, the average forecast for the S&P 500 2011 year end was 1384. As of October 17^th the average forecast is approximately 100 points lower at 1282. What happened?

To understand what happened, first we need to understand how they come up with year-end forecasts for the S&P 500. It’s basically two things: forecasted Earnings Per Share (EPS) and a forecasted multiple.  The EPS is based on the aggregated forecasted EPS from all the companies that make up the S&P 500 index. The forecasted multiple is based on the estimated level of certainty and predictability of those earnings. When there appears to be more certainty, multiples go up and when there appears to be less, multiples go down.

Earnings have been fairly good for the year and this earnings season appears to be shaping up similarly to the last two quarters; possibly a little better. The percentage of companies that have beaten earnings estimates so far is higher than the last two quarters (this is based on the companies that have reported as of October 21^st). 

Taking a look at the first variable EPS, the average 2011 EPS forecast for the S&P 500 was $92.75 at the beginning of the year. As of October 17^th the average 2011 EPS forecast for the S&P 500 is actually up $3.60 to $96.35. This underscores the fact that companies are continuing to meet and beat earnings estimates throughout the year. Clearly, this part of the formula is not bringing down the forecasts for the S&P 500.

The other variable in the S&P 500 year-end forecast is the multiple. The mean year-end forecast at the beginning of the year implied a year-end S&P 500 multiple of 14.9. The most recent year-end forecast now implies a year-end S&P 500 multiple of 13.3.

This contraction in the multiple is highly likely due to the increase in global uncertainty. In the United States, you still have the fiscal uncertainty and political silliness surrounding the “Super Committee.” The Committee’s deadline is November 23^rd to come up with a proposal and congress is supposed to vote on the Committee’s budget proposal on December 23^rd. In Europe, you have a grocery list of monetary and fiscal issues that are creating uncertainty in the Eurozone and the future of the Euro. German Chancellor Angela Merkel and French President Nicolas Sarkozy are supposed to make a big announcement on Wednesday regarding “a broad agreement” regarding these uncertainties. Lastly, in China you have talks about slowing GDP growth, and a real estate market bubble that could lead to a “hard landing.”

The bottom line is corporations are driving good earnings with a back drop of global political uncertainty. It used to be you could count on the corporations and the CEOs to do something that would create a circus. For example, Koslowsky at Tyco buying $6,000 shower curtains paid for by shareholders.  Now it seems like the politicians are the clowns under the tent.

This circus show might be hard to watch right now, but my guess is corporate earnings and opportunities through innovation will win out over rhetorical fights, political gridlock and self-interest. In my opinion, the best way to take advantage of this current environment is to continue to invest prudently, be patient, and align investments with time horizons.

To leave you on a hypothetical high note; if we were to take todays projected S&P year-end EPS ($96.35) and multiply it by the first quarter’s year-end multiple (14.9). You would get a year-end target of 1435 for the S&P 500 and a 14.5% rally between today and the end of the year.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Lately everyone I talk to from small business owners to “the men on the street” are words of doom and gloom. They all express significant doubts about the global economy and think a recession is all but guaranteed at this point.

• Consumer confidence is near a 30 year low, last seen during the “Great Recession.”
• Congress’ approval rating is at an all-time low – 13%
• Presidential approval rating remains at term-low – 41%

Overall, the mood of the country is awful and the people are targeting Wall St. and K St. for their general malaise.

Despite all of the negativity in the air, the US economy is still posting some signs of growth. To be clear, the signs suggest very slow growth, but growth none-the-less. If you look at the last few weeks of economic indicators most of them have been above expectations. For example, retail sales in September rose 1.1% from last month and 7.9% from the same month last year. Retail sales are now 4.5% above the pre-recession peak.

There seems to clearly be a divergence between the mood of our country and its economic indicators. This phenomenon can happen for a couple of reasons.

The first is that indicators have not caught up to our mood. This is usually the case when only lagging indicators are above expectations. However, we have seen some leading, lagging and coinciding indicators come in above expectations over the last few weeks.

The second is a straight forward but less obvious psychological explanation. Over the course of my 25 year career in money management I’ve made a few observations about human behavior. One observation is people tend to weigh recent events more than prior events.

I believe this is the reason for the divergence between our mood and our economic indicators. We just went through a very traumatic financial crisis that most people have yet to fully recover from. Now, we have a similar situation potentially developing in Europe and those feelings from our own financial crisis might be bubbling up again.

You might be a bit skeptical of my behavioral observation and dismiss it as anecdotal; however, this is actually a well-known cognitive memory bias. It’s called the Peak-End Rule and it’s related to the Recency Effect. This bias was discovered by Daniel Kahneman, an Israeli-American psychologist and Nobel laureate.

Despite the “okay news” from the economic indicators, we are still projecting our fears forward judging our past experiences almost entirely on how they were at their peak and that wasn’t pretty. This is not to say that we aren’t in or heading towards another recession, but I’m suggesting we should be mindful of our human biases and avoid letting them lead us to bad decisions.

A few weeks ago we talked about getting paid for volatility and we continue to look for good investment opportunities that can pay the rent. Including high yield corporate bonds, high dividend US large cap equities and preferred equities.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

The equity markets performed well last week after a historic late day rally on Tuesday. However the prevailing mood of business and consumers are of significant caution and concern. 

At the end of the day 70% of our economy is based on consumption. If people aren’t buying, then businesses can’t be hiring. If business aren’t hiring, then people can’t be buying. So which needs to come first in this “chicken or the egg” dilemma? We believe the consumer needs to come first and then businesses will follow. Keynes described this predicament in 1936 as spontaneous optimism.

In a recession, government spending can help spur spontaneous optimism.  However, it appears to have had little effect on our economy over the last three years. Outside of government spending Keynes would probably advocate for two additional solutions: a stable tax policy and a regulatory environment that allows businesses and consumers to make longer term plans. With the house and the senate controlled by different parties and a political polarization above 90% this doesn’t look likely.

M&A and IPO activity can be indicators of spontaneous optimism for businesses. Both of these events can inject more liquidity into our economy and suggest optimism from buyers. M&A activity has been fairly stagnant over the last few quarters and ventured-back IPO activity is at the lowest level in seven quarters according to Thomson Reuters and the National Venture Capital Association (NVCA). 

For consumers, an expansion of credit and willingness to borrow can be early signs of spontaneous optimism. Unfortunately, according to the Federal Reserve, consumer credit decreased at an annual rate of 4.5% in August. This was first decrease in in consumer credit in nine months.

None of these look very optimistic. However, as W. Somerset Maugham (the best paid author of the 1930’s) said, “When things are at their worst, I find something always happens.” He probably knew a thing or two about spontaneous optimism.

If you have additional feedback we encourage you to get in touch with us via  Twitter, Facebook, or Email me directly.

Last month, European physicists announced that they may have put a serious dent in Albert Einstein’s theory of relativity when they suggested it might be possible for something to travel faster than the speed of light. With relativity on the mind and a trove of economic data released last week, we decided to look at the actual numbers relative to what people were expecting. Surprisingly, most indicators actually beat expectations.

Overall 14 out of 18 reports were better than expectations. This included new home sales, durable goods, GDP, jobless claims and personal consumption.

This doesn’t have the same ground breaking implications that the European physicists’ findings do about relativity and it doesn’t mean we are not slipping into or not already in a recession. It does imply though, that there may be some pretty negative expectations already built in.

After the sizeable decline in July the market was relatively directionless and range bound for the remainder of the third quarter. Emotions seem to be ruling the day and a directionless market can still churn stomachs. The average daily change in the index for the last 40 days of the quarter was +/- 1.9%!

Continuing with the theme of relativity, we looked at how the market performs on average during different quarters of the year. 

The third quarter is historically the worst quarter of the year (this year being no exception so far) and the fourth quarter is historically the best quarter of the year. Relative to the other quarters of the year, the best quarter is still yet to come.

If we have already built in negative economic expectations and people are fearful due to the volatility, then a few economic surprises and little consistency this quarter could go a long way in providing a nice return backdrop for the fourth quarter, relatively speaking of course.

If you have additional feedback we encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Hat tip to the Bespoke Investment Group for the charts and tables. 

Investor and consumer sentiment are near all-time lows and the instinctive thing to do is to follow the crowd and run for the exit. 

Behaviorally speaking I call this, “risk as emotion versus risk as fact”.  Humans tend to view risk through an emotional lens.  When we see things that may be threatening to us we have a fight-or-flight response.  This is a good response for staying alive in a hostile world, but usually not a good response when it comes to investing. When things get bad (sentiment and prices are low) we sell and conversely when things are great (sentiment and prices are high) we buy.  Therefore you get the paradigm of buying high and selling low with the typical individual investor.

The good news is we can use sentiment as a contrarian indicator. When things get bad (sentiment and prices are low) and the individual investor is so dour, generally it can be a good time to buy. The real question in my mind is, “what is it time to buy?”

Right now global economic issues are driving the major moves in the markets. The prevailing global economic issues are Europe’s capital flow concerns and the United States’ fiscal policy concerns. Both issues are not likely to be resolved anytime soon.

According to the International Monetary Fund, The European Union is the largest economy in the world. It will take a coordinated effort by all the Eurozone members, led by Germany and France, to get the capital flowing in the region. These efforts will also take time to work their way through the Eurozone financial system and the global financial system.

As for the United States, the political class doesn’t want to solve our fiscal problem overnight even if stable fiscal policy is what’s wanted and needed. Both sides seem to want to kick the can down the road until elections because fiscal (tax and spending) policies are big ballot items.

If there is going to be continued uncertainty in the world’s two largest economies, then volatility should continue as well. My strong belief is investors should be paid for taking risks. Simply buying stocks and holding during volatile times doesn’t mean you’ll get paid. Based on my belief I’d like propose a tweak to that approach. Look at investments that pay you to hold on during volatile times.  If companies can "pay the rent" (dividends or interest) to be in your portfolio, then it can be easier to look past the volatility in price and easier to resist your fight-or-flight instinct of buying high and selling low.  Below is a table of asset classes which have been “paying the rent:”

Once we see some certainty in fiscal policy for our country and capital flows for Europe we can make a tilt toward growth.  In the interim, let's get paid for dealing with the volatility.

Once again, if you haven’t had a chance to fill out our survey we encourage you to do so. The outcome will lead us to developing a better experience for you and perhaps better outcomes for your wealth. If you have additional feedback we also encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

Tim Phillips, CEO – Phillips & Company

tphillips@phillipsandco.com

Research provided by:

Adam Gulledge, Associate – Phillips & Company

Focusing on one side of the balance sheet for consumers and corporations from a big picture standpoint you have: debt (liabilities) and net worth (equity). Adding up government, business and consumer debt, we are sitting at a nominal record of $36.5 trillion in debt. Looking specifically at the consumer debt numbers, we are in slightly better shape than we were in 2009 but still significantly above our historical average debt level relative to GDP:

• Current Total Household Debt (6/30/11): 66% of GDP
• Total Household Debt in early 2009: 76% of GDP
• Historical Average Total Household Debt: 37% of GDP

According to the Federal Reserve’s Flow of Funds data, total US consumer debt is down from the $13.93 trillion peak at the end of second quarter of 2008 to $13.30 trillion at the end of the second quarter of 2011. That’s a decrease of only $630 billion over three years, or only 210 billion a year.

So far this is not a pretty picture; let’s look at the other part.

On the other side of the balance sheet picture is net worth.US consumer’s net worth is down from the $65.9 trillion peak in 2007 to $58.5 trillion at the end of the second quarter this year. That’s a decrease of $7.4 trillion dollars. If consumers are only paying off $210 billion a year in debt (assuming everything else is equal) it would take roughly 35 years for household net worth to reach the 2007 peak of $65.9 trillion dollars.

The consumer balance sheet is not a pretty picture. Even though it appears to be heading in the right direction, it has a long way to go. The consumer needs to continue to repair their balance sheet and this means the consumer will have less of a desire to speculate, consume, and invest.

Based on this scenario it would be nearly impossible to get the net worth of the consumer back to the 2007 peak without somehow putting more dollars in the consumers’ pockets. This is one thing I think Washington DC understands which is why we are seeing so many discussions around fiscal policy. However, Washington also understands adding to our government debt is not a widely acceptable solution and leaves us in a consumption paradox.

Until we get to earnings season we will unfortunately only have a few economic data points and a public fist fight on policy. You can be certain the coming weeks will continue to be very volatile in our equity markets as the policy debates rage on in Washington. None of this will ease concerns in the markets.

However, if you can look past this short term phase of political silliness and focus on maximizing returns it might be wise to capture some attractive yields in the market. We’re focusing on high quality dividend growth and high dividend paying companies on the equities side, and bonds just below investment grade that still have an attractive higher yield. Frankly, as long as we select companies that can continue to pay the rent (dividends or interest payments) price fluctuations are less meaningful in the short run.

Once again, if you haven’t had a chance to fill out our survey we encourage you to do so. The outcome will lead us to developing a better experience for you and perhaps better outcomes for your wealth. If you have additional feedback we also encourage you to get in touch with us via Twitter, Facebook, or Email me directly.

I'm from the Government and I'm here to help.

Tim Phillips, CEO – Phillips & Company

We heard that message loud and clear last week.  Bernanke gave a speech to reiterate the FED still has plenty of tools at their disposal and Obama gave a speech to a joint session of Congress discussing his plans to create more jobs in our country.

The day after their speeches the markets fell 2+%.  Either the market doesn’t believe these guys anymore or the market believes the problems in Europe outweigh any government help at home.

If we strip away the emotional reaction to the speeches and look at the facts, here is my assessment.

People elected to office are there to govern, make public policy and do things that try to improve our "lot" in life.  Unfortunately, sometimes they can do more harm than good.  My point is politicians –Democrat and Republicans– don't like to sit and do nothing even if doing nothing might be the right thing to do.  So I suspect congress will take action.

If they act on the Obama plan- this will pump about 450 billion dollars into our economy over the next year and some economists suggest (Mark Zandi – Chief Economist of Moody’s Analytics) we will add 1.9 million jobs. According to Zandi the net impact of all this could be a 2% bump to next year.

If investors begin to believe the old saying, “We’re from the government and we’re here to help” and the political class will actually get something done, then we might see some kind of lift in equity markets.

This week we have retail sales numbers coming out and consensus is for 0.2% M/M increase. Based on the consumer data I highlighted in last week’s commentary, I expect this number to come out above consensus. We are also coming to the close of the third quarter and I suspect earnings will be slightly better than expected. Until then, it should be an interesting next few weeks.

Last week, we started collecting some additional feedback to gain a deeper appreciation for the values you look for in a firm and its employees. If you haven’t gotten a chance to fill it out, we encourage you to do so. The outcome should lead us to developing a better experience for you and perhaps better outcomes for your wealth.

Click here to take the quick survey!

We would like to honor those who lost their lives and loved ones on September 11, 2001. I was visiting the World Trade Center just one month before September 11^th and I will never forget the faces of those I met and spent the smallest sliver of time with.

Tim Phillips, CEO – Phillips & Company

@PHCO Advisors

facebook.com/phillipsandco

Research provided by:

Adam Gulledge, Associate – Phillips & Company

Risk vs. Return in Low Growth Economy

Tim Phillips, CEO – Phillips & Company

There is plenty of economic data to look at every week, but between Ben Bernanke’s speech in Jackson Hole and the September FOMC meeting there are three major economic data points:

• August employment (9-2-11)
• Retail sales (9-14-11)
• CPI (9-15-11)

Last week we had the first of the three come out and it suggests the recovery has hit a significant soft patch.

Looking at some of the other economic data consumers actually spent more than expected and saved less despite this recent soft patch.

According to a paper by Reinhardt & Rogoff titled, The Aftermath of Financial Crises, the average unemployment rises for almost 5 years with an increase in the unemployment rate of about 7 percentage points. If we use the date the National Bureau of Economic Research says the recession began, which is December of 2007 then that means we could have elevated levels of unemployment until December of 2012 (15 months away).

If we still have 15 months of elevated unemployment and a deleveraging consumer it could be hard to generate historical returns without assuming more risk. For example lower risk 10 year treasuries used to yield 3-4% and higher risk emerging market equities (based on the MSCI Emerging Market Index) used to return in the mid-teens.

In today’s slow growth and lower interest rate environment 10 year treasuries are now yielding less than 2% and emerging markets equity returns are flat to negative. We are being forced to accept either more risk or live with less return.

This is where blending asset classes to compose the right risk and return profile comes into play.

As you can see from the graphic above, based on historical data when you increase your diversification you can generate a higher return and lower standard deviation over time. Maximizing the power of diversification can be an easy way to increase your return and lower your standard deviation in this current environment with more risk and less return.

We are approaching the one year mark for our weekly market commentary and we have received plenty of feedback along the way. We wanted to take that feedback to the next level to try a gain a deeper appreciation for the values you look for in a firm and its employees. Below is a link to a quick online survey, the outcome of this work should lead to us developing a better experience for you and perhaps better outcomes for your wealth.

Please click here to take our survey

Tim Phillips, CEO – Phillips & Company

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Research provided by:

Adam Gulledge, Associate – Phillips & Company

Uncle Ben is Not Afraid Why Should We Be?

Tim Phillips, CEO – Phillips & Company 

Last week everyone was focused on Ben Bernanke’s speech in Jackson Hole, where last year he outlined QE2. As we expected earlier this summer, he didn’t announce or outline “QE3.” He did however make some very key statements:

Ben confirmed that the Federal Reserve still has options:

“The Federal Reserve has a range of tools that could be used to provide additional monetary stimulus.”

“[The Committee] is prepared to employ its tools as appropriate to promote a stronger economic recovery…”

The economy is not in a deflationary (read recessionary) trap:

“Temporary factors… were part of the reason for the weak performance of the economy in the first half of 2011; accordingly, growth in the second half looks likely to improve as their influence recedes…”

Although we are not out of the woods yet:

“Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if--and I stress if--our country takes the necessary steps to secure that outcome.”

A fitting speech given that only 90 minutes before his speech, the Commerce Department lowered its estimate for the second quarter GDP growth down to 1.0 % compared to the initial estimate of 1.3%.

Value Opportunity or Value Trap?

Value Opportunity:

This morning Bloomberg noted that based on Friday’s close the S&P 500 is trading at 10.8x analysts’ forecast for profits in the next 12 months of $109.12 a share and that the five-decade average P/E of the S&P 500 is 16.4x. If companies meet analysts’ expectations ($109.12) and we see a revision back to the mean in the P/E ratio (16.4) then that would mean the S&P 500 would be at 1789.57. That is over 600 points higher on the S&P 500 than the close on Friday!

That may be wildly opportunistic given the current economic environment, but it definitely shows a margin of safety for value investors.

As of this morning the S&P 500 had a slightly higher yield than the 10 year Treasury bond. The last time this happened was in the fall of 2008.

Value Trap:

This potential opportunity could turn into a trap if consumer confidence continues to fade. We have been living in a skittish and frightened state for 3 years now with a “sell first and ask questions later” mentality.

Gallup’s Economic Confidence Index and the University of Michigan Consumer Sentiment Index (released the day of Bernanke’s speech) both fell to levels that were last seen early in 2009. Constantly living in a “sell first and ask questions later” mentality has made equity investing very challenging, but the opportunities tend to lie within the fear. If Ben does not see a deflationary (read recessionary) trap yet, perhaps, and that's a big perhaps, it's just the same fear we've been feeling in our economy for the last 3 years.

If you have questions or comments please let us know, we appreciate all of your responses every week!

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

Facebook.com/phillipsandco

Research Provided by:

Adam Gulledge, Associate – Phillips & Company

Cold Hard Facts

Tim Phillips, CEO – Phillips & Company

Last month I mentioned we might “face some pretty gut wrenching days ahead with tremendous market volatility.” That might have been an understatement with everything that has happened.

• Dysfunction in DC
• Weak economic data
• European bank problems
• Downward revision on economic forecasts

The real question is on many investor’s minds is, now what?

If we could all retire comfortably with our cash on hand and live off of near 0% returns, then that would be fantastic.  Unfortunately, individual investors, pension plans, endowments, and foundations need better returns in order to meet their future obligations. That necessity for returns is why we invest in riskier assets like stocks and bonds.

Since investing is a necessity and market timing is a parlor trick, let’s look past the Wall of Worry and look at some of the cold hard facts (charts are courtesy of the Bespoke Investment Group)

1) Companies reported better earnings and revenue last quarter.  They also raised guidance going forward.

2) Wall Street strategists are still holding onto their return expectations according to Bloomberg. In general, I don’t hold out much faith in this cohort; however they do look at data more analytically and rationally than most.

3) This year is looking a lot like last year. Both peaked at the end of April and saw a very weak summer where the S&P 500 went negative for the year. Last year that weak summer was followed by a monster rally that started just after the Jackson Hole Fed Meeting. That same meeting is set to take place this week.

Last year the Jackson Hole Meeting was on August 27^th. Between August 27^th and the end of the year the market rallied 18.94%.

Not to sound too wildly optimistic, there is a real chance the consumer loses confidence in this recovery and in the policy makers. Durable goods numbers come out this week which might give us a good indication. While I’m not a pessimist by any measure we could see more downside if consumption data shows significant weakness. Lastly, when markets drop this much they tend to overcorrect to the upside before building a base.

Here are some simple tips to make sure you are prepared for either situation:

• Review statements to make sure you don't have any unknown risks.
• Continue to reflect on your time horizon for the use of your investments.  If you have time (3 to 5 years) equity markets can be reasonable places to invest.
• Build in hedges for deflation.  If a slowdown in global growth occurs, there will be a mad rush for higher fixed income returns. This is something we focused on with our clients.
• Stop, challenge and choose your path based upon cold hard facts.  Emotions are always tempting to follow unfortunately more often than not they lead to poor outcomes.

We appreciate all the feedback we get every week I look forward to your responses throughout the week

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

www.facebook.com/phillipsandco

Primary research done by

Adam Gulledge, Associate – Phillips & Company

"After a wild week on Wall Street the world is different"

Tim Phillips, CEO – Phillips & Company

This was the cover of Time Magazine just after the crash of 1987.  I remember being very new in the business and thinking, "Had the world fallen apart?" At the time, I also thought a “crash" was a once in a lifetime event.  It looks like I was wrong on both accounts.

People think things are different because today we have High Frequency Traders, algorithms and hedge funds, but I would argue similar schemes and large investors existed in 1987 as well. Despite our 2011 “wild week on wall street,” the S&P 500 closed down only 1.64%.

In my opinion this wild week was due to the increased probability of another recession and uncertainty in the European Banking System (note uncertainty not failure).  At the same time, retail sales data came out that seems to suggest the consumer is not in too bad of shape (as we suspected). Sales continued to grow for the 4^th month in a row including increased sales for electronics and appliances.

We believe if another recession happened it wouldn’t be a repeat of the Great Recession of 2008.  Cyclical industries like automotive and homebuilders are not coming off revenue bubbles and are still bouncing along the bottom.

We also know that investor confidence and consumer confidence can be a threat to push the consumer back into a cave.  This is one we’ll need to watch closely.

I see two possible scenarios:

• If the consumer does not nose dive then this market reaction is overdone and opportunities lie ahead
• If the consumer does nose dive then the market was right and market prices have already taken that into account.

In other words, possible good upside opportunity with limited downside

The interesting thing about allocating cash into your portfolio at this time is the potential outstanding return opportunities:

The downside to reacting to emotions is the poor returns you can achieve when you try to time the market too much (I am a firm believer in opportunistic cash at the risk of being wrong many times):

Besides the yield on the S&P 500 is currently better than that of treasuries:

After weeks like this it’s a good time to review your investment time horizon relative to your needs. For individuals, this means thinking about your retirement time frame and determining how much time and ability you have to ride out “wild weeks.” For foundations and endowments this means focusing on the big picture; thinking multi-generational and not in terms of “wild weeks.”

Over the last 25+ years I’ve been in the industry, the world has definitely changed. However, over the last 2000 years, our emotions have not. Humans have always been “fight or flight” animals and unfortunately it’s not a good quantitative analysis tool.

If you have questions or comments please let us know, and we always appreciate all your feedback

Tim Phillips, CEO – Phillips & Company

Research Provided:
Scott Edwards, Vice President of Wealth Strategies – Phillips & Company

Adam Gulledge, Associate – Phillips & Company

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More Questions Than Answers

Tim Phillips, CEO – Phillips & Company

As

I discussed in our blog post last week about Deficits, Defaults, and Downgrades, we believed a downgrade was inevitable, but thought it would come to fruition much further down the road. At this point, there are plenty more questions than answers, but here is my insight into this unprecedented downgrade.  Please remember there has never been a downgrade in United States History, so much of what I have to say should be taken in that context.

The likely short-run impact on US debt will be limited and muted. I suspect we will see effects to the magnitude of 25bp-50bp. Going from AAA to AA+ doesn’t mean much in terms of the government’s ability to pay. However, the negative outlook, if not removed and if other rating agencies follow suit, we may soon see much higher interest rates.

This situation is really more about prodding the political class to resolve the problems we all know exist in our country: entitlement spending, our debt, the deficit and tax policy.

There could be a significant impact on municipal debt with many downgrades to come. Any debt attached to federal spending or with US agency backing would likely see some deterioration.

Banking Sector

This sector was predominately sparred from the Fed, suggesting holding AA+ debt is the same as holding AAA debt. We shouldn’t see bankers running for the exits. Where would they run to anyway? France? Bermuda? New Zealand?

Corporate Sector

Insurance companies may have a tougher challenge to overcome based upon their charters, prospectuses and covenants. We’ll have to watch this sector closely. Companies in general might need to make some investment policy changes or dump their treasuries if they don’t have rating flexibility. This could pose a problem.

The Fed

As I have been suggesting, the Fed will likely enact some kind of easing policy to push banks into lending and stimulate the economy. This might become more challenging if the Fed attempts to buy the debt from the banks and issues new debt with a lower rating at the same old price. My guess is the banks are going to want better returns at some point in exchange for buying slightly worse debt. That in turn may cause banks to hold the debt with higher yields and not lend. So much for quantitative easing. Let’s see if the Fed can successfully navigate this situation.

Political Class

The real benefit is our politicians just got a cow prod up their you know what’s to resolve systemic problems with government spending habits. As they do this with the Budget Control Act which passed last week, we might actually see much more stability brought back to our markets once the committee makes its big cuts. This is to be done before Thanksgiving.

The Consumer

Assuming rates don’t jump through the roof, which I don’t expect to see in the near future, the consumer is not in too bad of shape.

• RevPar, the average price a consumer pays for a hotel room, is rising. This only occurs when rooms are being rented, suggesting a very good sign for consumer consumption and confidence.
• Furthermore, same store sales growth are rising 3-5%+.

My suggestion is to prepare for volatility and review debt holding in detail with your financial advisor. Also, if you have the time horizon to do so, make strategic investments in the coming months.

If the consumer is in as good of shape as the data suggests and this debt debacle is really about political posturing, then as Washington resolves these issues this could mark a historic buying opportunity.

This is speculation on my part and there are many more questions than answers at this point. Stay tuned to see how this all unfolds and what it might mean for you.

If you have any other questions about the downgrade feel free to contact me.

Tim Phillips, CEO – Phillips & Company

@PHCOAdvisors

http://www.facebook.com/phillipsandco

Primary Research done by:

Adam Gulledge, Associate – Phillips & Company

There is Only One Way

Tim Phillips, CEO – Phillips & Company

As we expected, it looks like the political class will get something done. As anticipated, The Debt Limit Deal also looks like it's heavily back loaded (much ado about nothing).  In fact, all the real cuts to spending will likely come under a different congress and perhaps a different President. Now that the "fiscal conservatism" charades are behind us, we can look at the one and only way to really cut deficits and our debt – GDP growth.

In the middle of the debt debate we received a pretty ugly report card on our economic activity.  According to the BEA, real GDP in Q2 grew only 1.3% compared to a consensus estimate of 1.9% and Q1 GDP was revised downward to a mere .40%. While the top line number looks weak some of the component parts look pretty good.

• Real nonresidential fixed investment increased by 6.3% in the second quarter, compared with an increase of 2.1% in the first.
• Real residential fixed investment increased 3.8%, in contrast to a decrease of 2.4%.
• Real exports increased by 6%.
• The change in real private inventories added 0.18 percentage points to the second quarter change in real GDP.

The one area of concern, and it's the biggest, is consumption (70+% of GDP).  This area had very anemic growth.  However, much of the drag came from autos and I attribute much of that to the events in Japan.

It looks like the automotive industry is ramping up for better supply and demand from the consumer, which should bode well for the strong second half of 2011.

As long as we can get our "sausage making" debate about the debt behind us soon and create stability for business, I believe they will begin to hire and continue to spend.  This should boost confidence with the consumer and allow them to free up their pocketbooks a bit.  With savings rates at 5.0% and corporations sitting on a mountain of cash there is plenty of fuel in the tank.

Once we get some stability from the political class, American businesses and consumers can do what they do best – innovate, create, invent, invest with the outcome being spending.

Remember, investing is anticipatory and requires us to look at past data and make intelligent guesses about the future.  I see a pivot, not a growth surge mind you, but a resumption of growth and employment and I'm a buyer (assuming our political class get its act together).

Thank you for your thoughts and comments, please keep them coming.

Tim Phillips, CEO - Phillips and Company

Twitter: @PHCOAdvisors

http://www.facebook.com/phillipsandco

Primary research done by Adam Gulledge, Associate – Phillips and Company