Sanders Market Report

Bulletin: 2010 Tax Law Changes
March 2010
As many of you may be aware, there is no estate tax this year.  However, there may be a retro-active law passed by Congress this year which would reinstate the estate tax.  We do know that if Congress does not act before the end of this year, the estate tax will be reintroduced on January 1, 2011 with a limited estate tax exemption amount of $1 million dollars.

What effect does the repeal of the estate tax for 2010 have upon my estate planning documents?

It is important to realize that many individuals may be impacted by the repeal of the estate tax and that their estate planning documents may need to be revised in order to avoid unintended consequences.  Depending on how the estate planning documents were drafted, these unintended consequences might include:

1) Unintentionally disinheriting the surviving spouse/partner.

2) Having the entire estate pass into a trust where the needs of the surviving spouse/partner are not superior to those of the children

3) Unintentionally leaving the entire estate to the surviving spouse and not protecting any assets from a future estate tax at the death of the surviving spouse.

Many individuals are not aware that with the elimination of the estate tax for 2010, there is no longer a “step-up” in basis for assets included in an estate.  When the estate tax was in force, assets were automatically “stepped-up” to fair market value at death.  For example, if a person owns $50 worth of stock in Coca Cola that was purchased for $10, then the stock’s basis would automatically be “stepped-up” to $50 at date of death.  There would be no capital gains tax if the stock were then sold for $50.  In 2010 there is no estate tax, but the property would be transferred to the beneficiary with the same $10 basis.  If the beneficiary were to sell the stock for $50, he or she would recognize a gain of $40 and owe capital gains tax. 

Each estate is allowed to increase the basis of assets within the estate by $1.3 million dollars, but not above fair market value.  In addition, each estate can further increase the basis by $3 million dollars if the assets pass outright to the surviving spouse or in trust for the benefit of the surviving spouse, but only if the trust meets certain conditions.  It is important to determine whether or not your estate planning documents adequately provide for this additional increase in basis.

Should you have questions about how the tax law changes effect your own estate planning documents, please feel free to call Duncan Moseley in our office to set an appointment.  Duncan was a practicing estate planning and tax attorney for over 10 years for high net worth individuals and will be happy to assist you. 

Bulletin: State of the Union
January 2010
January is typically the month in which the US President reflects upon the "State of the Union."  Since this time last year, the best thing that can be said about the economy in the last decade was that we did not see a repeat of the Great Depression.  The British, who use the term naught rather than zero, call this past decade the Naughties.  The name is rather appropriate for a decade characterized by market crashes, fraud and irrational exuberance.

The Naughties were the first decade since World War II with a net loss of jobs.  Private sector employment was 110 million in 1999 and stands at 108 million for the start of this year.  As if that were not bad enough, the US population grew 9.8% in the intervening period.  It will be anywhere from 5 to 10 years until we regain the jobs lost during this recession, with an offsetting positive of this country's productive and nimble workforce.  Nevertheless, in planning for the future we must seriously consider the possibility that problems in the labor market are structural and elevated unemployment, currently 10%, is here to stay.

Many remember a drumbeat of prognosticators saying stocks over the long term are the best performing asset class.  How did that claim hold up this past decade?  If one focuses on the stock market then the Naughties were clearly a lost decade. The S&P 500 shed 8%, and that includes dividend payments.  But it was not a lost decade for most other asset classes.  After years of super low interest rates and endless bailouts the best asset class in the past ten years was gold (up 270%).  Bonds, as measured by the JPMorgan US Aggregate Bond Index, also had stellar performance, up 90% for the decade.  It is ironic that the stereotypical "little old lady" portfolio would have significantly outperformed any growth portfolio.  The takeaway is that asset preservation strategies are critical in times of market uncertainty.

Hypocrisy was a key theme during the Naughties, with celebrities, prosecutors and politicians.  It is very fitting then that a period where the consensus was so strongly aligned with free markets and non-intervention saw unprecedented government involvement in the economy in 2009.  $14 trillion is the sum of every economic activity in the US in a year.  $12 trillion is the amount of assets the government guaranteed against default in 2009.  $2 trillion in appropriated and printed dollars is how much the government spent on stimulus and asset purchase programs in 2009.  This is to say nothing about the full and partial nationalizations of massive companies or the initiatives to overhaul healthcare.

To fund all this spending the US had to issue $1.5 trillion in new debt in 2009.  In a recent letter to shareholders, PIMCO's CIO Bill Gross noted that perhaps all but $300 billion of that debt was absorbed by the Federal Reserve as a part of various asset purchase programs.  In the coming decade the US will face deficits that will average $1 trillion a year.  If foreigners (mostly Chinese) are not willing and the Federal Reserve not able to absorb all that debt then it sets up an unwelcome set of options.  Either the deficit will be funded by domestic purchases of Treasuries on a scale not seen since World War II, or our government will be forced to make steep budget cuts that risk pushing citizens into yet another recession.

What price the government borrows money will have a profound impact on all asset classes in the coming decade.  Any number of seemingly unrelated events like China no longer buying the bulk of our debt, or entitlement costs spiraling out of control, or a dollar currency crash would all result in higher interest rates across our economy.  It is unlikely we would see inflation in the traditional sense.  Higher mortgage rates would push housing prices down but a lower dollar due to less demand for Treasuries would push up the price of oil.

The government faces a number of legislative challenges in 2010. First on the list is the healthcare debate, which will continue over from 2009. The debate is still very much in flux, though it appears likely some bill will be passed. A key concern is whether or not the bill will provide any meaningful change in the lives of most Americans, or will be another expensive measure adding to the already ballooning deficit. The second legislative challenge will be estate tax laws. Currently there is no estate tax in 2010, though Congress seems sure to apply any new laws retroactively to the start of 2010 to ensure no billionaires die and escape millions of dollars in tax.  Finally, we still await meaningful reform of Wall Street financial institutions -  it appears increasingly likely that self-dealing business will continue as usual.

A portfolio for the next decade incorporates some basic hedges.  Gold is the best hedge against a debased currency, which is a looming threat due to global money printing.  Inflation-indexed bonds similarly protect against an erosion of consumer purchasing power as most are indexed to CPI.  An allocation to fast-growing emerging markets incorporates the risks of investing abroad but would likely do well in an inflationary environment.  Taken together these investments provide protection if government spending proves unsustainable.

It is this government spending that causes us to conclude personal income tax rates will be higher than historically low rates at present no later than 2011.  Higher future taxes makes a Roth IRA conversion attractive for many, especially those that have a longer period of time before they will tap into their IRAs for retirement living expenses (when tax rates are sure to be higher). In 2010 alone there is no income limit in performing a Roth IRA conversion, so this option is open to all for the next twelve months. However, a key challenge for many will be coming up with the requisite cash tax payment on the amount converted to a Roth IRA.

Looking beyond one's portfolio it is key to consider that when it becomes more difficult for the government to service its debts due to rising interest costs and declining real income, the same could be true for individuals.  Deleveraging one's personal finances is a critical way to get ahead of any perils or pitfalls the economy will bring.  It comes as no surprise that consumer confidence remains low, although it is rising from awful levels found early in 2009.  As a nation, we are long removed from a time when academics were so sure of global stability they proclaimed a synchronized recovery.  The recovery is fragile, interdependencies are real, and we remain vigilant to deal with surprises that will continue in the coming decade.

Bulletin: Carry Trade in Fast-Moving Markets
September 2009
Let’s say you are taking a vacation in Europe.  You pack your bags, stop your mail, and change some U.S. Dollars for Euros.  If the Dollar weakens during your trip, then Euros will buy more Dollars than when you left.  This is the essence of a carry trade.  While it is one of the most sophisticated investments one can make, anyone who has ever exchanged one currency for another has done it. The carry of an asset is defined as the positive return of holding that asset while the cost of carry is what it costs to hold the asset.  A carry trade is a term that not only describes the asset held, but also the asset traded.  While almost any conceivable asset could be used in a carry trade, the focus here will be on currencies.

A currency carry trade involves selling what is known as the funding currency and buying an investment currency.  Most carry trades are leveraged, meaning the trader borrows the funding currency before selling it (a short sale).  Low interest rates for the funding currency are key.  In most cases the lower a country’s interest rates the cheaper it is to borrow that currency.  An ideal investment currency is from a country with high growth rates and high interest rates.  If all works well, there are two ways to profit: the interest rate differential and the investment currency appreciating relative to the funding currency.

A successfully executed carry trade can be exceedingly profitable.  However a leveraged carry trade can also become unprofitable very suddenly.  A trader caught off guard might be forced to unwind their position, which would involve buying back the funding currency they had previously sold short.  If several large carry trade positions are forced to unwind at once the result can be a dramatic increase in the price of the funding currency.

A brief look at recent history shows the fallout from a forced carry trade unwind can be devastating to world markets.  The Japanese Yen has traditionally been the funding currency of choice for carry trades.  At the height of the bubble years between 2005 and 2007, a preferred trade was to sell the Yen and buy the Dollar.  Investors started getting nervous in mid-2007 and began buying Yen and selling Dollars.  The timing coincided with the global peak in equities and the dollar sold off to record levels leading directly to $147 oil. 

In late August 2009 something dramatic happened.  Dollar LIBOR rates (a key rate used to calculate Dollar borrowing costs) fell below Yen LIBOR rates, making the Dollar cheaper to borrow than the Yen.  A Fed committed to indefinitely keeping interest rates at zero and printing money makes the Dollar an ideal funding currency.   

There are profound implications of a falling Dollar.  Over the past several months, stock market gains have been highly correlated with losses on the Dollar.  Over the short term a falling Dollar makes our exports more attractive, stimulates inflation in the economy, and boosts the profits of companies doing business overseas.  But dollar weakness is a double edged sword.  The S&P above its 2007 highs would mean little if it leads us back to expensive oil and $5/gasoline.

We see the Dollar carry trade as a new development.  The longer the carry trade continues and U.S. Dollars are sold short, the sharper the reversal when unexpected Dollar strength forces traders out their positions.  Unexpectedly strong economic growth, the Fed tightening monetary policy, or a major negative geopolitical event could force the unwinding of Dollar short positions.  There is wariness of a resulting spike in the dollar that could potentially destabilize world equity markets. 

It is almost impossible to answer the important question of when the carry trade will reverse, but it is possible to take advantage of the move while it lasts.  Energy, commodities, and international equities are poised to profit from short-term trades.  These sectors benefit most directly from a falling dollar. 

Carry trades often presage bubbles as cheap liquidity washes over markets.  This was seen with the Yen during Japan’s real estate bubble (1988), the Asian emerging markets bubble (1998) and the global financial bubble (2007).  With the Dollar now the funding currency of choice for the carry trade, bubbles can show up on any corner of the globe.  It is not suggested that individual investors participate in currency carry trades, yet the existence of a Dollar carry trade is a sign of macro forces at work.

Bulletin: The Great Recession is Not the Great Depression II
July 2009
The National Bureau of Economic Research has declared 12 recessions in the United States since the Great Depression.   According to the International Monetary Fund, the President, and every cable TV commentator, our current Great Recession is worse than all 11 preceding ones.  We are familiar with the iconic images and stories from the 1930s, but none bear much semblance to what we see around us.  As we approach one year since the global market crash, it is worth exploring ways in which the late summer of 2009 resembles the summer of 1930 to see how this comparison holds up.

The seminal event of the summer of 1930 was that the US was poised to strangle world trade with the Smoot-Hawley Tariff Act.  In 2009 our government is not so foolish as to be explicitly protectionist, yet protectionism is far from dead.  Global trade now is largely focused around China, who is very sensitive to global politics.  After British miner Rio Tinto scrapped months of negotiations with Aluminum Corporation of China in favor of a tie-up with Australian BHP Billiton, China’s semi-official response was to compare Rio Tinto to an unfaithful lover.  Annual contracts have been the cornerstone of the international iron ore trade for decades, but their future is tenuous as China has opted out this year.  Clouds are gathering over this trade issue, and where it ultimately will lead is not clear.

Despite the magnitude of the slowdown, excessive debt is a tie that binds the US inextricably to the 1930s.  Economist Richard Koo, the preeminent scholar on Japan’s “lost decade”, popularized the term “balance sheet recession” to describe this phenomenon and distinguish it from the typical business cycle downdrafts.  If easy money and asset bubbles propagate for too long, the massive profits they generate make institutions dependent on the same.  Holding inflated assets on a balance sheet affords the ability to borrow more money that is then plowed back into said inflated assets.  When the cycle is broken, mass deleveraging causes asset prices to fall precipitously.

A balance sheet recession can keep an economy down for a decade or more as the process of deleveraging is long and painful.  One way to mitigate the effects of a balance sheet recession is trade, since exports bring in money from outside the home economy that can be used to pay down debt.  On a positive note, the United States’ outsized trade deficit has been shrinking since last year.

The balance sheet recession will not stop being a drag on our economy until government, businesses, and individuals all reduce debt on their balance sheets.  Fortunately for present day Americans, personal savings have been increasing since the third quarter of 2008.  The $464 billion in personal savings the first quarter of 2009 provides a start toward deleveraging and absorbing new government debt.  By that crucial metric, we come out again ahead of where the country was in the summer of 1930.

Nevertheless, our previous recommendations to stay defensive still stand.  Balance sheet recessions are particularly brutal on equities.  When investing for clients we continue to favor companies with good cash flow and secure dividends.  Even if revenue is pressured, a company with a strong balance sheet is able to acquire other companies at attractive valuations.  Discrete bonds of high quality and short duration are good for providing stable returns while mitigating some of the inflation risk that is sure to come in the next few years.  For those who lack critical mass to invest in discrete bonds, a myriad of fixed income Exchange Traded Funds provide the potential to enhance yield with diversification. 

The future isn’t set.  Deleveraging our collective balance sheets will take years but this difficult task has started on a concerted global basis.  We can take solace in that the summer of 2009 seems far less treacherous than the summer of 1930.  It is too soon for the bear to hibernate and the bull to come out again, yet each passing day brings our economy one step closer to stability.  For portfolio investing purposes, caution is still the watch word.

Bulletin: Why Does China Matter To Americans?
May 2009
The government is taking on an increasingly important role in global issues, from the financial crisis to global warming.  It has a heavy hand in finance.  Accounting standards are weak through deliberate softening and regulators turning a blind eye to abuses.  Equity analysts cannot give much credence to reported results.  The real market mover is the government, and a tremendous amount of consideration is given to whether a company or industry is “favored” by politicians in the capital.  Debt markets are in complete disarray since a substantial chunk of lending is done at the government’s behest with very little regard for the ability of the debtor to pay.  Ultimately markets become less about price discovery and more a tool for the state to carry out policies deemed for the greater good. 
 
The government described above could be either the US or China with one key difference:  China is trying to move away from this model while the US is increasingly embracing it.  Two news items from May 19, 2009 show the contrast in full.  On that day the Fed expanded its TALF program (cheap non-recourse 20-1 leveraged loans) to include legacy (toxic) commercial real-estate loans of any duration.  Meanwhile the China Banking Regulatory Commission announced tighter lending standards for stimulus funds out of concern that funds were being misused.  The US is figuratively dropping money from helicopters while the Chinese appear to be taking care to consider where money is going. 
 
China has a three pronged approach to stimulate its economy.  Its intent is very similar to the US stimulus program, with the key difference being that few doubt they can pay for theirs in full.  China is spending massively on infrastructure projects, bank lending has been increased dramatically, and a full medical insurance program is being implemented that intends to cover 90% of the 1.3 billion population.  These efforts, if successful, have the potential to lift the rest of the world.  China is now supporting the OPEC and developing economies dependent on natural resource exports with its spending on commodities.  A Chinese national health care program provides incentives for its population to save less and consume more which would be a boon to countries exporting to China and anyone doing business there. 
 
While China is making very shrewd moves with regard to stimulus, it is being absolutely masterful in securing its currency a future on the world stage.  For one, China has set up currency swap lines with central banks across Asia to facilitate transactions clearing in Yuan instead of US Dollars. In another highly publicized move, Brazil and China are looking to conduct bilateral trade in the Brazilian Real and Chinese Yuan, thus avoiding the Dollar entirely.  Perhaps most importantly, China also announced they will be issuing Yuan-denominated bonds in Hong Kong.  This will have the effect of creating a liquid international market for Yuan trading and firmly cement Hong Kong as the Chinese center for international finance. 
 
One idea being discussed is to hand out foreign aid in Yuan.  This change would serve to earn goodwill toward China while broadening the international use of their currency.  Also, China, which is a repository of the world’s marginal manufacturing capacity, would have a place to send excess goods.  Unless demand returns ending the Great Recession, overcapacity globally, including China, will continue to pressure prices until more factories are closed or prices of goods are lowered. 
 
Nonetheless, the US Dollar still holds leadership.  It will be several years before there is a broad, liquid market for the Yuan to support international trade, as it is currently a controlled currency.  In the meantime, the US Dollar remains the primary currency for international settlements.   The Dollar’s intermediate future will be defined by the tension between an upward pressure from deflation and downward pressure from the Fed’s printing press.  The secular decline of the Dollar is exhibited when we have spent more bailing out AIG than all Apollo space missions and the Manhattan Project combined ($170 billion for AIG vs. $164 billion inflation adjusted combined for Apollo and the A-bomb). 
 
However things play out in the short and intermediate term, there is only one question that every investor in the world will one day ask themselves, and its implications should be at the front of our policymakers’ minds.  What are you more comfortable buying, a 30-year bond backed by the US government or a 30-year bond backed by the Chinese government? China is among the biggest buyers of US government debt, with $768 billion.  China’s ascendance cannot be ignored, and our recommendation is that every investor should strive to have at least one Chinese security or fund in their portfolio by year-end.

Bulletin: Bleak Days for Financial Markets
March 2009
“Bleak” is the word most seen in media headlines when describing the financial landscape, and is hitting investors emotionally, yet “brisk” rallies in a bear market are equally possible.  The question has been asked innumerable different ways amongst financial professionals, on TV, in the halls of power, and at dinner tables: when does the systemic chain reaction of this crisis end?  The answer is stated very plainly if it is honest: nobody knows.  While this painful process continues, risk management is the over-riding strategy to preserve hard-earned wealth.  The question of how the global economy has arrived at this point can best be described by a cycle called debt-deflation. 
 
Debt is at the heart of the world’s economic troubles, whether through taking on excessive debt or lending out too much without regard as to whether it could be reasonably paid back.  During a debt-deflation cycle it is as if everyone is trying to get rid of their debt at the same time.  The effect of too many sellers and not enough buyers drives down prices of assets.  Asset prices fall much faster than debt can be offloaded, and as a result the overall level of indebtedness actually increases.  Margin calls and debts coming due result in a spiral of forced liquidation of quality assets that drive prices down further.  Banks and consumers alike have strong incentives to accumulate liquid assets like cash and short-term government backed securities.  Money that would have been used for economic transactions benefitting the economy instead goes to paying off debts and saving.
 
The way to ride out this paradigm shift requires patience, as the market hates uncertainty.  A focus on reliable businesses with stable dividends can bring a level of stability to this picture, even with a growing tally of blue-chip companies cutting dividend pay-outs.  Innovative companies with strong balance sheets will survive and plant the seeds for future growth.  Cash comprises about 25% of clients’ portfolios, and gold continues to be held as a “safe haven.”  Short-term fixed income is being added to supplement income on historically low yields on cash.  Fixed income instruments of sound quality will remain in demand with higher bond prices translating to lower yields.  The stock market typically turns six months before the economy does, so expect 2009 to be challenging.
 
The debt-deflation cycle will eventually capitulate and run its course.  The “Great Recession” is expected to extend into 2010 and is pervasive in that two components of household net worth are declining simultaneously: financial assets and real estate.  Near-term, the dollar is likely to continue strengthening, not necessarily because other countries have confidence in the US, but because much of the world is paying off dollar-denominated debt.  In time, the dollar will be pressured and inflation will then become the chief concern.  Governments will continue to unveil programs and regulations, acting individually and in concert with other nations, having successes and failures along the way.  The sting and uncertainty of losing one’s job will be felt by more Americans.  As we go through a psychological adjustment, optimism will be crucial. 

January 2009
Fear in the air is palpable, yet it is worth remembering just how far we are from the Great Depression, when unemployment hit 25% in the US and 20% in Britain, and hunger was commonplace.  In 1930, Americans spent 25% of household income on food, while today we spend less than 10% on food.  However, we spend twice as much - - 21%- - on shelter.  We live in uncertain and historic times, and the scale and speed of economic decline is happening at an unprecedented rate.  Call it the "Great Recession”, which has become a synchronized global recession with trade figures to prove it. 

Governments throughout the world are making up for massive wealth destruction with stimulus funds to create future wealth.  In the past twelve months, the US will have spent almost $2 trillion on stimulus, yet there will be a six month to one year delay for the impact to flow through the economy.  Wall Street and Main Street will not see “insta-cures”, as the world economy will grow more slowly after a re-pricing of assets.  The world is in a "capital strike" where few want to buy because of fear and continued de-leveraging, and most are focusing on working off the debt that took decades to build up.

There is good news, too.  If investors merely focus on current negative headlines, the opportunity could be missed to buy assets at unprecedented values, assets that clients want to own over the next several years.  At the same time, a new legal standard for globalized financial activities, disclosure and transparency should help to mitigate the crisis.

From an investment standpoint, the style to thrive and navigate bear market rallies in 2009 is "Buy & Trade", in contrast to "Buy & Hold", which had worked well during a bull market.  In a sense, one "rents” sectors, rather than buys.   Consistent with this theme is that a risk management/asset preservation approach is more rewarding than profit potential for now. Covered call options protect existing common stock positions and add income.

It is more critical than ever to have an emergency stash of at least six months of future cash needs in the event you or your loved ones become a downsizing statistic.  It is still our expectation that 2009 will culminate with 10% unemployment.  At the current accelerating pace, another 3 million people may lose jobs through year-end, adding to the 11 million currently unemployed.  Companies are chopping payroll, slashing spending and reducing inventory, which could set the stage for a rebound later this year.

For the market to kick the bear mentality, investors' animal instincts must be re-stimulated with incentives to spend.  An example is low mortgage interest rates, currently being engineered by the government with targets as low as 4% for 30-year fixed non-jumbo mortgages.  The housing bubble is mostly behind us on the basis of affordability of renting vs. owning a home.  Nationwide, housing prices are expected to bottom in late 2009 after falling around 30% from their peak.  The recession will nearly be ending after two years (it started in December 2007), the longest recession in most people's memory.  History has often seen extreme sell-offs followed by explosive rallies, suggesting an opportunity in the spring.  It would not be unexpected to see another leg down in the market before recovery takes hold.  Due to the printing of money, there is a short-term bubble in US Treasuries, and gold will be a safe haven.

We are witnessing the US move to a more European version of capitalism, where the authorities are no longer just referees of the markets, they are also players in a scene of "economic shock and awe".  When governments intervene, taxpayers have an interest and as such, somebody in the capital structure is compromised, primarily common stockholders. It is imperative to follow government actions rather than ignore them.  However, the US is not strong enough to rescue the world economy on its own, and the nationalistic tendencies of nations must be closely watched.  In times of collapsing private spending, rescue efforts must be big enough to raise demand for US output as well as the surplus output of much of the rest of the world such as China.  We envision a land in which the wealthy don't feel compelled to retreat behind gated communities.

Hedge funds suffered their worst showing on record last year, with forced liquidations responsible for some of the most violent market gyrations.  The size of the industry has halved in the past year, and thousands more hedge funds are expected to die in 2009 as fewer dollars flow in and investors yank out what's left of their money.  Historically, Sanders Financial Management has not been an advocate of hedge funds for its clients due to lack of regulatory oversight, low liquidity and no transparency.  Since our firm's inception 15 years ago, custody of client assets have been separate from the asset management function, to ensure better protection.   2009 should be a more reasonable year for equities, and presents an opportunity, as well for those seeking new homes or businesses, as a tough economy weeds out poor performers and highlights value.

December 2008
The global financial markets in 2008 can be seen as an "annum horribilius", to quote Erasmus, and the 2009 economy will present many growing challenges.  This is a historic time with rapid fire litany of ugly news in every conceivable respect, of which the Bernard Madoff ponzi scheme disaster was the moral bottom.  Almost everything that has been predicted was proven wrong, and as a civilization, global imbalances have caused Americans to re-examine long-held assumptions about our standard of living and our institutions.   2008 marks the end of an era of global credit expansion based on the US dollar as the primary international reserve currency.  One of the only major bright spots this year has been the Beijing Olympics.  2008 was the year when long-held market beliefs and models were questioned, such as: a well-diversified portfolio of stocks and bonds will shield one from all risk; buying and holding quality stocks is the best long-term strategy; the regulators will protect individual investors from market abuses; if you save and minimize debt to manage investment risk you won't be adversely impacted; and a good education shields one from job loss. 
 
2009 will kick off a new administration and high hopes, yet not enough to stall the rise in unemployment to near 10% by year-end and the collapse of many national retail names.  Expect unprecedented trials of business figures and a high-profile executive to be sentenced to jail: Dick Fuld, former CEO of the now-defunct Lehman Brothers.  Housing prices will bottom in the second half of 2009 as the inventory of unsold homes declines, aided by lower mortgage rates; stock markets will get better once the bond markets thaw further, and Fed Chairman Ben Bernanke's policies of massive monetary stimulus will be vindicated, although gold will continue its rise.  China and India will regain their footing as the economic growth spots in the world order, not without civil unrest.  The key to wealth-building success in 2009 will be tactical in nature, along with willingness to pivot frequently including the use of covered call options as volatility continues at a high pitch.  Confidence will be slow to be restored, and indecision will linger.  While oil prices were manipulated by speculators in mid-2008 (and current low prices are like a tax cut for Americans), look for oil to return to $60/barrel in early 2009 and for a big infrastructure push to be made for alternative energy.
 
There is always a disposition in people's minds to think that existing conditions will be permanent.  Consistently declining equity prices are not the norm historically.  The stock market has recorded positive total returns in 71% of the 82 years since 1926.  A super-boom has just been completed that lasted more than 30 years, and assets of all types have been "marked down".  The flip side to this painful reality is that for those having cash or access to credit, next year will present opportunities to purchase financial and real assets at values not to be seen for another few decades.  Forced liquidations by institutional investors, mutual funds and hedge funds have been partly responsible for the market's violent moves to the downside.  The hedge fund industry is shrinking from $2 trillion to under $1 trillion.  Having less money invested in hedge funds is good long term because it means less volatility and less competition for investment ideas.  Almost half the gains of the next bull market will be reaped in the first six months, long before the recession is declared officially over in 2010.  Much has been made of the parallels between now and the nightmarish Great Depression of the 1930's.  Make no mistake, there are similarities, however, the current crisis is more akin to the 1973-74 recession, and an end is in sight.  Be patient - while there won't be a fast recovery, this too shall pass.

In this season of good will, we thank you for your business and association, and trust that you are blessed with the things that matter most in life:  the love and support of family and friends, the joy of giving, and good health.

Bulletin: Dislocated Financial System
December 1, 2008
The current financial crisis started small and has ballooned into something incredibly big and chilling, undermining the entire global financial system with increasing intensity.  The accompanying consumption plunge is without precedent in the modern era since WWII.  The positive aspect is a renewal of saving and investment for long-term prosperity.  Consumers are quickly abandoning an asset-based spending strategy and moving back to more prudent income-based lifestyles.  Equities have discounted a multi-quarter earnings shortfall due to the global recession, however, long-term earnings optimism is still inherent.  Many businesses and investors continue to wait and see what the government will do next, after a trillion dollars of bail outs have been approved.  Governments appear willing to lend as much as they must to prevent the financial crisis from becoming more harsh; financial system fragility is reversible with leadership and coordination.

There has been so much selling since mid-September that investor sentiment is close to turning around, and we may witness continued explosive bear market rallies of up to 10 percent.  We recommend slowly moving from high cash positions into equities and bonds.    Frantic federal spending is not stemming the rise of unemployment (now at 10 million), stoking consumer pessimism near all-time lows.  Consumer credit is much harder to come by today, although "Black Friday" (the day after Thanksgiving) showed slightly positive sales figures on highly discounted merchandise.  National home prices have fallen 16.6 percent in the last twelve months.  Households have benefited recently from falling gas prices, with oil under $50/barrel.

While we continue to recommend keeping double the normal allocation of cash for one's portfolio, global markets have been impacted by the US dislocation, and in the next quarter there will be screaming bargains internationally to begin rebuilding battered global positions.  Developing countries like China and India, while seeing their economies retract, are still projecting 7% GDP growth in 2009, among the highest in the world.  Even tiny Israel has adjusted its' 2009 GDP growth from 4.5% to 2.9%, still positive.  This is a tactical and opportunistic market, where one can capitalize on wide swings of volatility in either direction.  The Fed is expected to bring fed funds interest rates down to 0% from 1%, making safe-haven Treasuries appear over-priced.  Look to mis-priced corporate bonds, non-financial preferred stocks and TIPS (Treasury Inflation Protected Securities) as a place of value for income-seeking investors.

Despite an expected spate of negative economic reports, we anticipate the market will continue to trend flat or upward in the seven weeks leading up to the Presidential Inauguration on January 20, 2009.  It is defensive to keep a good portion of one's portfolio in dividend-paying securities, as insurance for interim downward moves.  There are some incomparable opportunities in dividend yielding stocks of companies that have stated they are maintaining dividend payouts.  Banks are not included in the previous statement, as their dividends are not secure until the financial crisis and government interventions are behind us and the dust settles.  It is anticipated that public works projects will come on-stream, not as extensive as FDR's New Deal, yet similar in spirit, to put Americans back to work.  Alternative energy should be a huge recipient of works projects, even with oil being lower for the time being, it is expected oil will rise again toward $100/barrel.  Intermediate-duration municipal bonds, especially pre-refunded, are a good place for funds in lieu of cash.  Gold continues to be a safe haven, and most clients own small allocations as a hedge against uncertainty.

The real economy is still declining, as businesses and households cut spending due to declining consumer confidence.  Credit conditions remain very tight, yet are showing signs of improvement.  Asset deflation is near a short-term bottom, although further testing of the lows are not out of the question.  Expect at least 100 more FDIC bank failures in the coming quarter, largely due to pressure from non-performing commercial real estate loans.  The causes of the financial crisis, starting in the last year or two, have been well documented.  The new Cabinet is a galvanized, high powered and multi-party group of appointees who will face unprecedented challenges as 2009 begins.  Until residential real estate stabilizes, we do not expect a critical recovery of the financial markets, and second half of 2009 should mark the bottom in real estate.  Expect to see scores of top Wall Street and European executives be prosecuted and go to jail, as world financial leaders of the G-20 continue to meet regularly and roll out sweeping regulations to increase transparency and disclosure in the world financial system, to mitigate massive dislocation from happening in the future.

Bulletin: Damage Control while Confidence Remains Fragile
October 30, 2008
The Federal Reserve’s 50 basis point cut yesterday in the Fed Funds rate is a precursor to future rate cuts down to 0%, just as Japan reached in the 1990's.  The rate cut barely made a ripple in the stock market, and the difference is that our crisis is global, not local, and the financial markets are moving at warp speed.  The source of the dislocation has been a lack of supervision of hedge funds and insurance instruments which has created spill over into the mainstream and a collapse of the western world's financial model as we know it.  The myriad of government facilities that are now beginning to kick in are themselves creating an increase in volatility due to uncertainty.   Depressed consumer spending and a negative wealth effect leads us to expect a five-quarter U.S. recession, which began in 3Q 2008.  Capital has been scarce for the past several months, causing businesses to slow expenditures which will result in a rise in job losses, and the unemployment rate going from 6.1% to 10% by late 2009.  For now, the best defense is to maintain low debt levels and ample cash, and to implement sector rotation into more traditional sectors (such as consumer staples and basic industries) and reduce international. 

We will continue to see strong rallies in the bear market, akin to "panic buying", that could retrace half the drop, yet don't expect recovery to be immediate.  The process of healing and balance is slowly coming back, as governments worldwide, central banks and agencies such as the IMF are redoubling coordinated efforts to contain the systemic dangers.  This gives us the opportunity to identify quality companies and securities with handsome dividends that have been sold off; equity markets typically rebound before a recession is over.  Many established equities have stable dividend yields not seen in years, and gold is looking appealing again as a hedge.  Diversification in the fixed income portfolio through a ladder of municipal bonds is advisable while historically cheap pricing exists.  In addition, non-financial preferred stocks are senior to common stocks and have attractive yields.  Like all crises, this one is a wake-up call, and the linkage between financial stability and the open-ended explosion of derivatives and structured products that was 10 times the size of world GDP must be understood and monitored.  The next administration will quickly tackle this monumental issue.

Bulletin: Global Credit Crisis Leads to Recession
October 9, 2008
The current global market meltdown is not about the fundamentals, and since it can no longer prevent spillover into the mainstream economy, anxiety is running high.  The economic environment in developed countries is pointing to a painful and protracted multi-year recession, accompanied by the highest stock market volatility levels since 1987.  Even the most experienced traders have not seen a situation such as this, where almost every asset class is pummeled daily, and investor sentiment is as bearish as ever.  The result is a "buyer's strike", or a panic born of a lack of confidence, vacuum of leadership and very little credit in the marketplace.

Trading patterns are abnormal while multi-billion dollar unregulated hedge funds are driving an indiscriminate mass-dumping of assets.  That said, on the basis of technical charts, the market is not quite oversold and price deflation will likely remain for an extended period.  The situation has clearly changed, as participants at every level are pulling back and not making transactions, leading to diminished retail activity and an inevitable cascade of increased unemployment in 2009 as households and businesses scramble to remain profitable. 

Where is the good news?   Yesterday, five Central banks in addition to the US joined in a unified action to cut interest rates, and today three more Central banks followed suit.  The TARP "rescue" facility passed by Congress last week is in the process of being implemented, and will have awesome reach to purchase toxic assets in reverse auctions and to take ownership stakes in banking institutions if warranted.

The healing process will eventually begin and the Dow is on the verge of a 1,000 point snap back rally.  The maximum point of pessimism is a good buying opportunity, although we are not yet prepared to call the bottom.  Not only are quality equities at bargain prices, debt securities are significantly mis-priced for strong future value and income potential.  It is prudent to keep double the amount of cash in portfolios as normally indicated, to cushion against the downside and to have cash available for liquidity needs. With a long-term time horizon, getting too heavily into cash at a low point in the market will miss the upside and fail to keep up with inflation.  Governments will urgently step in to get credit flowing again and usher in a new reality.

Bulletin: Addressing the Short-term Paradigm Shift
September 18, 2008
The US financial system is being redefined right before our eyes, and the violent shifts are painful to watch.  Compounding the pain, market manipulation is rampant by unfettered hedge funds who are executing "naked short" sales that the US SEC supposedly banned last month.  As with many panics, there is a herd mentality to "sell low", and professional investors resist the temptation to do this unless in cases of risk management and realizing profits.  The manipulation and speculation has also spread to the commodities market (oil, metals, agriculture) that were bid up sharply earlier this year and are now being "dumped" by the same players who are rushing to de-leverage.

Will there be an impact on Main Street flowing from Wall Street's rout?  It can't help but impact average Americans, as the availability of credit is momentarily drying up, thus causing corporations big and small to rein in expenses that ultimately lead to rising unemployment and decreasing consumer spending.  The US banking consolidation is long overdue, it is just happening in a wrenching way.  For those who have access to liquidity, the time has come to cut exposure to excess leverage and be debt-free in everything possible.  This paradigm applies to individuals as well as corporations, and it is prudent to focus on owning quality assets, some of which have gotten undervalued in a hurry.

While the government is reaching into its and taxpayers pockets to re-liquify the system and socialize losses while profits have been privatized, the best defense for clients is not to sell into weakness, to have excess cash, have as little debt as possible and to buy quality assets.  The direction of monetary policy is coordinated central bank actions (on interest rates and currencies) to stabilize global systems before putting the brightest heads together to craft domestic and global regulations that make sense in today's wired world without ham-stringing free enterprise.  I am proud to report that your advisor, Sanders Financial Management has no debt, and has not in its 15-year history.

In the long-run, the US will adjust to a new role as a great world economic power, albeit with a leaner balance sheet, yet in a role that must be shared with other emerging players whose standard of living will be rising while our standard of "living large" will be cut back to something more "normal", which still exceeds the vast majority of humans on earth.  Our share of world GDP has gone from around 50% after WWII to 25% today, still disproportionate to our 5% of the world's population.  Such statistics don't make people feel any better who worked their entire lives to save for a comfortable life for themselves and their family.  What is going on now is bigger than any one person, and is part of a seismic paradigm shift in the world economic and power structure.  Ordinary Americans are bearing the brunt of excess risk taken by big players in our lightly regulated system, and will right itself in due course by staying calm. 

Bulletin: Historic Turn in Modern Financial System
September 15, 2008
The team at Sanders Financial Management has been carefully monitoring the financial crisis, culminating in the bankruptcy of venerable Lehman Brothers this morning and the acquisition of Merrill Lynch by Bank of America yesterday.  A large increase in leverage among Wall Street firms (as well as among individuals) has been building over the last several years, and the current reversing process is called "de-leveraging".  In order to preserve the nation's credit rating, the US Treasury made the decision not to assist in another bail out following the Fannie Mae/Freddie Mac conservatorship last week and the Bear Stearns dissolution in March, while an unprecedented backstop has been opened by the Federal Reserve in their lending facilities to dull the crisis.  There is also a much needed focus on regulatory issues and a fundamental redesign of the financial landscape coming, in order to prevent the conditions that made the current turmoil possible.
 
For clients, your customized portfolios have been vigilantly managed such that cash is being kept higher than normal based upon your investment objective, volatile international securities are somewhat lower than objective, and financial stocks are at a minimum based upon their percentage of market averages.  With the Presidential election coming to a crescendo in eight weeks, there will be less uncertainty, that historically helps the market.  A large scale crisis resulting in a big failure such as happened yesterday could signal that the market is close to a cathartic bottom.  The economy still struggles with a recession hinging upon weakness in housing and commercial real estate, however, that is expected to bottom in mid-to-late 2009.

Once the crisis settles down, there will likely be a major infusion of new capital into the system from overseas sources flush with cash:  China, other Asian countries and the Middle East.  This is not entirely bad as the US is immutably a part of the global economy, and the US is still the major economy of the world with the most productive people, intellectual capital and a buoyant service sector.  The US dominates with a population of only 300 million, while the rest of the world houses nearly 6 billion people whose standard of living is nowhere close to ours.  As Americans, we have a lot to be thankful for, and have temporarily lost our edge.  As investors, stay the course, do not panic, and remember that out of crisis comes opportunity.

September 2008
Around the world, fixed income and equity markets are reflecting anxiety that slowing economies and tighter lending standards could create a feedback loop where one reinforces trends in the other.  Whether those fears are ultimately borne out in coming months or not, there is no question that markets are adjusting to a sea-change in how risk is measured and priced.

Credit spreads are the difference between the yield of a credit instrument and a “risk-free” interest rate.  Since the U.S. has never defaulted on its credit, the interest rate on Treasuries is the most often mentioned risk-free rate.   In most instances the interest paid above the risk-free rate reflects the risk investors perceive in a credit instrument.  If a lender believes they are taking a risk, they will charge more for taking on that risk (lend at a higher interest rate).

Most major drops in equity markets this past year came very shortly after sharp increases in credit spreads.  Both the buyout of Bear Stearns and the federal takeover of Fannie and Freddie were, among other things, direct responses to concern that credit spreads would spike to the point of forcing a tidal wave of defaults among financial institutions.  Understanding this facet of credit markets is key in understanding where we have been and where we are going.

The leading indicator in this case is the spread between LIBOR and the Federal Funds rate.  The London Interbank Offered Rate (LIBOR) is the interest rate at which banks lend money between each other on a London-based market encompassing more than 200 members across 60 countries.  On September 1, 2008, the three months forward Libor rate was at 2.81% whereas the Federal Funds target rate is at 2.00%, a spread of 81 basis points.  In previous years this spread was typically closer to 10 basis points (0.10%).  The crucial takeaway here is that banks have been cautious even when lending to other banks. 

In a world buffeted about by uncertainty, it is reasonable to presume that if banks are nervous about lending to each other they will be nervous about lending to individuals, businesses and governments.  The aforementioned feedback loop starts with banks lending less, or charging substantially more to lend.  Businesses and individuals, with less capital available, have to be much more restrictive and careful about where they spend their money.  Slower growth resulting from those collective actions creates a riskier environment for lending and banks restrict credit even further.  The Treasury and Federal Reserve have been working tirelessly to avoid a self-reinforcing cycle of tighter credit and slower growth with mixed success from August 2007 to today.  

The linchpin in all this is lending.  Lately there have been countless stories about banks having to raise capital or sell off assets at fire-sale prices.  Were the financial fallout limited to a company or bank taking the write down, one could call it capitalism and move on.   But a bank forced to write down their portfolio has less money to lend.  Whether it is the perception of risk reflected in higher credit spreads or the realization of risk through massive write downs, the effect is the same: it is more difficult for banks, companies and individuals to access credit.  In such an environment banks make less money, companies have trouble expanding and individuals consume less.

The credit conditions from the early 2000’s to 2007 were historically very loose.  Cheap capital funded not just the mortgage and real estate bubble but an overarching credit bubble.  In almost every way that money could be borrowed, too much was lent out at too low interest rates that underestimated risk.  Ken Lewis, CEO of the largest U.S. bank, Bank of America, warned in May 2007, “We are close to a time when we'll look back and say we did some stupid things. We need a little more sanity in a period when everyone feels invincible and thinks this is different.”

It may be a generation before we see credit as loose as it was in the mid-2000’s.  Investment strategies must incorporate this new reality.  Not knowing where the skeletons are, so to speak, has pushed some equities and sectors sharply lower, most notably financials.  Indeed, uncertainty almost always pushes markets lower than revelations of actual damaging events.  Equities unfairly punished for perceptions of risk will show outsized gains.  Banks will earn less and trade at lower price-to-earnings multiples than they did in 2007.  Corporations depending on lending to fund growth will not fare as well as companies with strong balance sheets.  And individuals, if not already consuming less, will increase their consumption of goods and services at slower rates than the early 2000’s.

July 2008
World financial markets have experienced unsettling times, led by the financial crisis in the deepest market in the world, the US.  A confluence of factors are weighing down the market, mainly the parabolic prices of oil, agriculture and commodities, which create the specter of inflation and consumer sentiment at the lowest point in 28 years.   The weak US dollar is exacerbating the negativity.  An estimated 88% of the world's commodities are traded in US$, so the falling dollar contributes to inflation on a worldwide basis.  Familiar factors continue to weigh on the market as housing is still in search of a bottom, the financial sector is braced for more write downs, and consumers of all classes cut back.  Nevertheless the world is awash with liquidity due to what many call “The Rise of the Rest” in developing countries like Brazil, Russia, India and China.

The oil crisis of the 1970’s was caused by supply shortages, yet the oil price spike today is driven by demand, particularly from Asia.  The world population is expected to be 9 billion in 2050, vs. 6.6 billion today, and 1 billion of that increase is projected from Asia.  Population growth and mass urbanization put considerable pressure on China's food and water supply and together lead to an insatiable thirst for energy.  Consider that almost 60 cities in China have populations above 1 million, vs. 9 cities of comparable size in the US!

A force called “demand destruction” is starting to work against oil’s relentless rise.  American drivers consume more oil than any group on the planet.  As Americans cut back on driving it exerts more downward pressure on the price of oil.  Only after the uncertainty of the November election is resolved is it likely that currency intervention will be implemented to strengthen the US$ consistent with the Treasury's rhetoric, and a believable energy policy will be crafted.  By year-end recess, expect Congress to define “oil speculators”, and to tighten regulations that currently allow only 5% margin requirements for crude oil trading.

June, 2008 was the worst June since the 1930's, and some fear-mongers have attempted to extrapolate and draw a parallel with the present financial crises.  The current unemployment rate recently rose from 5% to 5.5%, and may hit 6% by fall due to layoffs in stricken industries.  Historical insights show that unemployment hit a peak in 1935 at 24%, making present levels worrisome yet not enough to derail a highly productive, structurally well-positioned US economy.   Interest rates were also higher in the 1930’s than in the 2000’s.

The best way to stay defensive in uncertain times is to raise cash levels higher than normal in the short-term, while realizing that cash is eroded by inflation.   The duration of the slow-growth environment should be more apparent by next quarter, at which time cash can be deployed in equities to take advantage of an oversold market.  Within the fixed income space the risk-reward picture is growing more attractive.  While new credit is tight, a coordinated worldwide process is underway to structure banking regulations to create confidence in pricing.  With a careful eye on risk, one can find reasonable returns in high-grade corporate debt, municipal bonds, Treasury Inflation Protected Securities (TIPS), and preferred stocks.

Sectors in equity markets that are somewhat insulated from the US slowdown are: healthcare, consumer staples and telecom.  Until oil prices come down and the US$ is in a recovery, sectors to be largely avoided are housing, financials and retail.  Take profits in traditional integrated oil and mining stocks and shift into commercially-viable alternative energy sources such as solar, wind and nuclear.  The Federal Reserve has signaled that it will consider raising interest rates from the low 2% Fed Funds rate to stem inflationary pressures, however rates will be on hold while the economy remains fragile.  If not for the tax rebates sent to US consumers between May - July, 2008, the economy would be on pace for a negative annualized growth rate in GDP.

Since we are expecting higher interest rates and higher taxes in early 2009, investors should consider trimming over-concentrated positions of a single highly appreciated stock while taxes are low, or donating such shares to a charitable trust.  The oil price bubble is on track to burst before year-end, which will take pressure off businesses, consumers and the world economy.  Gold is no longer an attractive commodity as inflation expectations were built-in as of last year.   Classic advice holds true in uncertain times: stay the course with a well diversified portfolio of quality global stocks and bonds, seek out growth in emerging markets and value in mature markets, and be positioned defensively for the next upturn, which is on its way.

April 2008
A US recession is all but confirmed by a mound of economic statistics and anecdotal evidence.  With GE's disappointing earnings report on April 11, a proxy for the larger economy, there was no denying that economic malaise has spread beyond the financial sector, while Intel's forecast provided an upbeat assessment for tech.  With consumer sentiment at the lowest level since 1982, the contagion of a spending slump and tight credit markets on the American psyche are rippling throughout the economy.  Pile on global food inflation, historically high oil prices, reverberations of a housing downturn and further bank write-offs and failures, and our forecast for gradual recovery has shifted to the first quarter of 2009.  Over the past half-century, the US economy has been in recession only one-seventh of the time, so now is the time.  The key is to rationally behave in one's investment life to navigate the ups and downs.

The silver lining in all this gloom is that markets typically start moving back up four months before the end of a recession, and the US equity markets are not down as much as other parts of the developed world in Europe and Asia.  The pace of job losses in America has been mild compared with previous downturns, and the dynamism of emerging markets means that their economies, primarily in Asia, will continue to drive world growth and demand for raw materials, in spite of the spending slow down in developed economies.  Tax rebates in the 2nd half of 2008 will support spending, and if the economy continues to be fragile, a roll-back of Bush's tax cuts may be postponed.

Throughout the turmoil, there is a much-needed coordination among the financial ministers of the G7 developed countries, leaders of the International Monetary Fund, who are in the process of banding together.  Through the Basel Agreement, the inexorable movement is toward consistent regulatory standards in the banking system and the new off-balance sheet instruments and lax lending that flourished over the last five years and are now in the process of de-leveraging.  The ever-weakening US dollar could ultimately lead to currency intervention as early as 2008.  The Chinese Renminbi has appreciated 17% in the last year, and the Euro currency, approaching $1.60, whose economy is contracting, is overvalued against the dollar.  Due to inflationary pressures of a weak dollar and a rising Producer Price Index, the Fed can not go overboard in lowering short-term interest rates; the most recent round of rate reductions have not flowed through to the mortgage market, and foreclosures are accelerating. 

"Bubbles" have moved quickly from IT/technology in 1999-2000 to housing/real estate in 2006-07 to a developing commodities bubble in 2009-2010.  The equity markets are orderly compared to the bond market, yet the world is moving from low inflation to global inflation.  There is a tug of war between inflation and growth.  Investors will feel reassured that they can start taking risks again once confidence is restored.  In the meantime, sophisticated sovereign wealth funds from Asia and the Middle East are taking advantage of the confusion and purchasing trophy assets and corporations on the cheap with their massive foreign exchange reserves; a global re-allocation of resources is in progress.

In this climate, it is important to position portfolios defensively, including selling covered call options on appreciated equities as a hedge/additional income, as well as opportunistically buying index funds that short the broad market.  Select sectors such as tech and healthcare are under-valued, and the oil sector is fully-valued.  Small cap stocks had a poor year in 2007 and are now due for a rebound.  Long-term, alternative energy and agricultural commodities should be bright spots in portfolios.  Despite lower interest rates, cash is a safe haven that can temporarily be kept higher than normal.   International stocks, which have been volatile and taken an oversized hit in 2008, will be re-accumulated over several years up to 40% of portfolio weightings from a recommended 20% now.  Rather than grouping international stocks into a monolith, opportunities will be sought in pockets having a low base and huge prospects such as China, India, the Middle East and Africa.

Risk, and its' proper management, has been the major theme throughout this serious financial crisis.  Equity investors have never had more options than today in terms of where they can put their money, while liquidity abounds for prudent investors worldwide.  A clear understanding of the macroeconomic trends discussed above presents opportunities to capitalize, or at least to hedge against risks that are ever more apparent with each new write down.  Negative sentiment can often be a contrarian indicator; seasoned investors will enter arenas where others fear to tread, with a forecast of single digit returns in diversified portfolios by year-end.

March 2008
The March 7 employment report signaled two consecutive months of negative employment data, indicative that the US has probably been in a mild recession since February.  While exports are a bright spot in the economy, adding to GDP, retail sales are weak and consumer confidence is still falling due to continuing write downs from banks.  The typical recession lasts nine months, so by year-end the long term historical trend of stocks is to end up higher.  When combined with pre-election pump-priming as well as undervalued stock prices which will start to support battered stocks with bottom-fishing due to low PE's, we are optimistic that good buying opportunities are near.  In the mean while, we continue to sell covered call options on equity positions that have substantial gains as a hedge and income-producer against high ongoing market volatility, which is a familiar feature for this part of the economic cycle.

January 2008 Part II
Fear in the market is palpable, and rising on a global basis, culminating a near perfect storm beginning with the sub-prime mortgage mess.  When 42 of 43 world markets drop nearly double digits since yesterday (the US markets were closed for MLK Day), this is reflective of a crisis of confidence rather than a sudden deterioration in fundamental economic outlook.  The US is a healthy, albeit slowing, consumer-driven economy, comprising 25% of the world's GDP, with relatively low unemployment.  The fundamental growth outlook in Europe is good.  Foreign markets are not yet as "de-coupled" from the US economy as had been thought.  The torrid economic growth rates of emerging markets such as China and India, whose consumers seek a better life, are not going to evaporate due to the ripple of re-pricing credit risk.  The US Federal Reserve was expected to cut rates 50-75 basis points on or before January 30, as evidenced by the emergency 75 bp rate cut this morning, and to add liquidity again in March.  The Bank of England and European Central Bank are acting in a concerted effort of monetary policy to stimulate growth while temporarily de-emphasizing inflation-fighting tactics.

The media is blaring news of a bear market and impending recession on the heels of rising volatility.  By classic bear definitions, the US is close to down 20% from recent market highs, and the government won't know if we're in a recession until after the fact.  In terms of duration, the average recession since World War II has lasted about a year.  When the next recession ends, it is likely that the expansion that follows will be somewhere between parameters of two and ten years in length.  The stimulus package to be announced next week by Congress is not able on its own to reassure investors fearing recession.  Excesses must be wrung out of the financial system before it can improve.

A natural part of historical market cycles is to have expansions and contractions.  The market will "capitulate" in short order, after which opportunities to buy will surface based on relatively cheap valuations.  Once a slowdown starts, it is reflected in stock prices, and markets tend to respond favorably to the expected end of a recession before it occurs.  Global sovereign wealth funds will continue a trend of investing directly in US assets, partially mitigating recessionary forces.  

It is very important to avoid the tendency to panic; rather, look at the state of key economies and blue chip companies throughout the world.  Keep cash levels slightly above stated targets, continue to hedge and trim profitable positions, take tax losses and be willing to move opportunistically when warranted.   Continue to stay invested in global companies for diversification and future growth potential, seek defensive sectors such as healthcare, technology, energy and commodities, and remain invested in discrete bonds.  Volatility is high, and by the middle to end of this year, more normal levels and investment returns should resume.

January 2008 Part I
The United States is expected to enter into a mild recession in 2008, so what should an investor do?  Three strategies that Sanders Financial Management suggests are increasing international exposure, identifying large-cap defensive or “beaten down” stocks and exploring the agricultural and natural resources arenas.

One particular international play with potential is telecommunications.  Gone are the days when a person can “hide” from anyone they don’t want to talk to at that moment.  With the popularity of mobile phones and Blackberry devices, a person is accessible at almost anytime or anyplace.  Plus with the increase in international travel as companies increase their global footprints, the need for reliable communication becomes critical.

An investor can seek a wireless company that has exposure to multiple regions of the world, such as Europe, Asia, the Middle East, Africa and the United States. Offerings of both voice and data services is critical since data services are growing faster than that of voice, yet voice is normally a reliable income stream. Although it is important to provide service in multiple regions, the most critical factor is to be positioned well in fast growing areas, such as India and Africa, the “newest” of the emerging markets.  Another important region is Latin America where wire-line services are often not reliable or are almost nonexistent.  Pre-paid service, where the customer buys a mobile phone and then prepays for a set number of minutes, has been extremely successful in this region and increases the customer base.     

Although Sanders Financial Management places emphasis on international stock holdings, we believe that there are attractive large-cap domestic stocks that should also be considered given the current economic and financial environments. These include large consumer staples and “beaten down” retail related stocks.

One type of consumer staple stock that should be considered is a national drug store chain that offers branded and generic drugs and household goods. A well managed store of this type should be almost recession proof since the purchase of prescriptions and over the counter medicine is necessary regardless what turn the economy takes.  Although many large corporations have mail order drug operations, most small to mid-size businesses and individuals don’t have this option and rely on the “neighborhood” drugstore.  The ease of ordering refills with the same store makes the relationship somewhat inelastic.  In addition, many people picking up their medicine will also buy a few items, such as shampoo or greeting cards, while they are in the store and these types of items typically have higher margins associated with their purchase.

Another strategy is to identify well-run companies that have been “beaten down” but expected to return to increased profitability in a recovery.  Two types of companies come to mind, retail and package delivery.  Many well-run retail stores see profits reduced in an economic downturn although the company is still profitable.  Some, especially the chains that offer grocery type items as well as clothing, household items and beauty products, aren’t hurt as badly due to the diversity of products offered but can still be attractive purchases for a value investor.

Other retail stores, especially the higher-end, sometimes see profits fall dramatically since these types of stores usually sell discretionary products. However, when the economy recovers, discretionary purchases that were previously “put on hold” are now completed by consumers.  Package delivery companies are in a similar position.  Although the companies are still shipping packages during a recession, revenue is down because both businesses and consumers are forgoing extra purchases.  As the recession ebbs, purchases and shipments will increase.  Plus, more and more consumers are becoming comfortable purchasing over the internet, which entails a mode of shipping.

Another recession “play” is stocks in the materials sector.  One very successful portion of this sector is agricultural chemicals, which produce various types of seeds, among other products, that are sold to farmers worldwide.  Many of these seeds are made more resistant to insects, drought, etc., using various biotechnology processes that increase crop yield to produce larger and healthier crops to help feed the world’s increasing population, especially in China and India.  Another very important and profitable materials sub-sector is related to water.  It has been said that water is the “new oil” due to the limited supply of potable water compared to the world’s ever increasing population.  Water, like agricultural products, is a necessity that can’t be forgone in a recession, so companies providing these products are definitely at a distinct advantage.  

A recession isn’t a concern if an investor prepares her or himself properly.  With a few tweaks to a properly allocated portfolio, an investor should “weather the storm” with consistent returns.

October 2007
Financial advisors are always looking for the next smart investment.  The trend could be a formerly out of favor asset class, a move from “value” to “growth” style, or a new emerging market.

One such emerging market that warrants scrutiny is Africa, primarily South Africa, the financial backbone of the continent with a Gross Domestic Product (GDP) that comprises approximately 25% of the entire continent’s GDP.  South Africa is a leading world supplier of minerals and mineral products, supplying gold, platinum, coal and diamonds to over 80 countries.

How does the average American investor participate in the South African economy?   There is a sophisticated stock exchange in Johannesburg, JSE Limited, where stocks and bonds are traded.  However, a direct investment method is not convenient or cost effective due to currency and time zone issues.  There are currently three other options.

The basic method is investing in emerging market mutual funds focused on Africa, available since the mid 1990’s.   The investor is provided with diversified exposure to the continent, primarily South Africa.  Another way to gain a diversified exposure to Africa is through exchange traded funds (ETFs).  One new fund, SPDR S&P Emerging Middle East and Africa ETF (GAF), is designed to provide exposure to countries such as South Africa, Israel, Egypt and India, among others.  Another ETF, iShares MSCI South Africa Index (EZA), is more targeted and provides exposure only to South Africa.

For an investor who desires direct exposure to selected companies, American Depository Receipts (ADRs), are the investment vehicle of choice.  However, there are only a handful of African ADRs to chose from and most are gold mining companies so there would be little diversification opportunities.

For an investor who isn’t interested in investing in emerging markets but wants an aggressive investment, commodities are an option.  There are five broad categories of commodities: energy, metals, grains, livestock/meats and food/grains.

One of the more popular choices in which to invest over the last decade is oil since it is a product that is known by all, and crude oil inventories are denominated in US dollars.  The price of oil depends on supply and demand.  For instance, demand usually increases in the summer vacation driving season, or demand for heating oil might decrease during a mild winter.  However, oil prices can also increase due to expectations of an event, such as a hurricane in the Gulf of Mexico.

Metals are receiving global attention for a variety of reasons.  Arguably the most high profile metal is gold, which is often seen as a hedge against inflation and a “safe haven” during times of geopolitical uncertainty or dollar weakness.  Other commodities that have risen in importance are copper and aluminum due to the huge demand in building, especially in emerging economies, which is why their price is sensitive to infrastructure development.

Commodity exposure may be purchased via an investment in individual companies, such as oil companies or mining stocks, but the best option is to identify an ETF dedicated to a specific commodity, such as Streettracks Gold Shares.  A highly risky method of gaining commodity exposure is through the purchase of futures.  Although the initial investment might only be a few thousand dollars, if the market falls, the investor is required to invest additional funds.  This leverage makes investing in futures a high potential proposition, yet very speculative.

Another way to add diversification to a portfolio is to invest in real estate, and nowhere are we seeing more growth than in Asia, especially mainland China and India.  In both countries, with populations over 1 billion, large numbers of people are migrating from the rural areas to the cities for employment opportunities (urbanization) driving up the demand for new housing and increasing prices on existing properties.  In addition, due to the fast pace of economic growth, commercial space will remain tight leading to increased rents and new construction.     

To participate in the Asian housing market, the optimal investment vehicles would be either a Real Estate Investment Trust (REIT) or an ETF.  There are U.S.-based REIT companies that have added Asian exposure to their portfolios, such as large investors in industrial real estate.  A broadly based ETF investment option would be the SPDR DJ Wilshire International Real Estate ETF (RWX) which seeks to closely match the performance of the Dow Jones Wilshire Ex-US Real Estate Securities index.

It is important to remember that all investments contain some type of risk.  Even a conservative portfolio of US treasury bonds has the risk of not keeping up with inflation. However, by including diversified investments from around the world in a portfolio, an investor’s risk will be minimized and returns enhanced.

August 2007
In examining the recent market turmoil, it is instructive to look back in history for lessons and perspective.  At the start of the Great Depression on October 29, 1929, the Dow fell 23% in a single day, which was considerably more severe than the orderly but rapid downward 10% correction that has been taking place in the global stock markets over several weeks, culminating in a selling climax.  Following 1929, the US market didn't sustain its former levels until fifteen years later, when war spending put renewed activity into the economy.  "War bonds" were purchased with patriotic zeal by ordinary Americans during World War II, and financed 25% of the war effort without an extensive need for external borrowing.  Through this popular effort, Americans were also in a saving mode, as contrasted with the consumer, debt-driven mode of everyday Americans in today's easy money society.  In subsequent military conflicts such as Korea, Vietnam, Gulf War and the Iraq War, the government has not been able to do much domestic financing through re-named "Patriot bonds".

With the US current account deficit (in essence, imports exceeding exports) comprising 6% of GDP, it is ironic that 70% of China's $1.3 trillion reserves are invested in US Treasury securities; however, up to $200 billion are now earmarked for diversified, higher return investments such as private equity and hedge funds.  In fact, the Chinese market has been hitting new highs almost daily, while the US and European exchanges are off their summer highs.  There has been an inversion of world liquidity where emerging markets are lending money to the US!   Global financial markets are inextricably linked, and the value of the dollar could continue to be pressured against many major currencies as foreign investors have an effect on asset prices.  The linkage has turned into a double edged sword, as there has never been a time in history when the world economies are so prosperous, and yet when a financial crisis emerges it can spread like a contagion.  The holy grail in investment management has been diversification, yet many markets are now highly correlated thereby warranting the savvy investor to scan the world stage.

A "repricing of risk" has been widely reported in the popular business media and is inevitable, reflected by a slowing of private equity's ability to borrow at exceptionally good terms that barely reflected the risks involved.  Excesses of the past few years have come home to roost; look for more hedge funds to shake out in this dislocation.   There is an unwinding of an unsustainable amount of leverage and of financial engineering that had crept into the markets.   The world central banks have thrown $400 billion at the market to alleviate the short-term liquidity problem.  The mess has stemmed from the non-regulated part of the banking system, particularly non-bank mortgage brokers.  Last month the popular wisdom was that Asian markets weren't exposed to US sub-prime, however, it has now been disclosed that three Chinese banks and two German banks had bought US sub-prime paper in a globalization move for higher returns.  The Fed has begun to shift its bias from inflation to bracing for the possibility of a weakening economy, citing "downside risks to growth have increased appreciably".

The US market will have to re-test the lows of the late summer before it is able to rebuild beyond the Dow's 14,000 high hit in July.  Volatility, which is a measure of fear, is unprecedented and here to stay, at least through the autumn; there will be "snap-back" rallies before the market returns to equilibrium.  Corporate earnings seem healthy at present, although US GDP growth could be muted if the consumer tamps their spending when declining housing prices and collateral crunch leads to sagging consumer confidence.  While the rising home foreclosure rate is cause for concern, the lurking possibility of recession is not anticipated until 2008.  Will the Fed lower the discount rate at or before its September 18 meeting?  Don't count on it, as that would send a signal that the Fed has caved in to pressure from Wall Street, enabling a continuation of relentless risk-taking where bad assets can be sold with less of a loss.  The door is still open to a rate cut or two late in 2007, and individual investors are wise to hold at least 10% of portfolios in cash, stay well diversified globally with quality securities, save more and wait for buying opportunities.

Watching parents grow older can be an emotional drain on adult children.  It is especially difficult for baby boomers, many who find themselves in the position of supporting children at home or in college, while also taking care of aging parents.

May 2007
Watching parents grow older can be an emotional drain on adult children.  It is especially difficult for baby boomers, many who find themselves in the position of supporting children at home or in college, while also taking care of aging parents.

An estimated 16 million Americans find themselves "sandwiched" between two generations, struggling to raise their kids while caring for an aging loved one.  And that number is expected to skyrocket: In 25 years, there will be 60 million Americans between the ages of 66 and 84, many of them needing full- or part-time care.

While some people live their entire lives with little or no assistance from family and friends, most will need care in their elder years.  This month’s Sanders Market Report focuses on steps to help you care for your aging parents. 

What to do?

The first step to helping your parents involves just talking to them.  This should occur before your parents’ health has deteriorated.  Some parents will welcome the conversation.  Others may become defensive out of fear of becoming dependent or losing control, or they simply may be reluctant to burden you.

If your parents are open to discussions, explore the following topics with them:

Long-Term Care Insurance

Do they have it?  Long-term care insurance provides coverage for extended care in the home, an assisted-living center or a nursing home.  Many believe that Medicare pays for most of these costs, but it does not.  All too often, medical costs occurring later in life can deplete a lifetime’s worth of savings.  From a financial perspective, LTCI is asset protection for one’s heirs.  

Medicaid

If your parents or widowed parent have under $200,000 in assets, including a home, and have little or no retirement income other than social security, they may be a future candidate for Medicaid, a federal entitlement program administered by the states.

Eligibility requires, among other things, that the person have no more than $2,000 of “countable” assets (e.g. securities, cash, bank accounts, retirement accounts, and cash surrender value of life insurance policies)  in their name at the time of application.  Your elderly parent may consider gifting all assets to adult children if Medicaid coverage (e.g., nursing home care) is envisioned five years hence and no LTC Insurance policy is in place. Assets transferred within the last five years from the first date on which the person applied for Medicaid coverage are considered assets the applicant could have used to pay for care and will delay the start of Medicaid benefits.

Talk About Finances

It’s critical to talk to your parents about the provisions they’ve made for the future.  Are they able to pay their bills and taxes on their own or do they have a tax preparer?  Do they have sufficient retirement income?  Have they prepared an estate plan?  Do they have a living will, durable and medical powers of attorney? 

Be sure to learn the whereabouts of all their documents and get a list of policy numbers and the professionals and friends they rely on for advice and support.

Evaluate Their Living Situation

How can you tell when your parents are no longer able to live on their own?  Their inability to perform basic daily tasks is a key indicator.  Telling signs include forgetting appointments, not eating properly or having cooking mishaps (leaving the stove on), forgetting to pay bills, not taking medication properly, experiencing a fall or car accident.

If these signs sound familiar to you, it means your parent needs some kind of additional assistance and may no longer be able to stay in their home or drive a car.

If you’ve made the decision to have them move in with you, consider the following points:  Communicate your expectations in advance and be sure to make your parent feel a part of the household and share in some responsibilities; provide them with adequate privacy; involve your parent in the community; don’t neglect your own family when taking care of a parent.

Identify Additional Help

If you are unable to personally care for your parents, you may move them to an assisted living facility (possibly in your community) or nursing home if they require ongoing medical care.  A useful resource on nursing facilities is the state-by-state quality assessment survey of nursing homes published by the federal Health Care Finance Administration.  Every certified nursing facility is required to post its survey results. 

You may also consider hiring a geriatric care manager (GCM). Generally, while not inexpensive, these professionals are trained as nurses or social workers and have experience in geriatric issues and can work as a team with adult children. 

You can also seek out the services of a financial planner, attorney or CPA who has received specialized training in elder-care services and who can marshal resources from various disciplines. 

Take Care of Yourself

Taking care of an elderly parent can be very stressful, challenging and all consuming.  As a result, the caregiver’s health can deteriorate.  Do not neglect your own heath and be sure to get rest and exercise when you need it.  As appropriate, ask for help from friends, family members and other resources in the community.

April 2007
The typical American citizen outside the Washington, D.C. Beltway politicos, Wall Street moguls or the middle-America manufacturing workers who are losing jobs don’t think about the vast numbers of people in populous nations just waiting to adopt our unbelievably prosperous standard of living for their citizens. The typical American woman, other than aid workers or missionaries, doesn’t often think about how advanced and enlightened are the rights and opportunities available to our women, who are equals in decision making, especially as pertaining to economic freedom and independence that women in other parts of the world (except Scandinavia) just don’t enjoy. In past Sanders Market Reports, I’ve explored the exponential economic growth of India and China, and future reports will compare these two mega-powers with observations from my recent business trip to India, as well as implications for those of us on the other side of the world.

Women in developed countries will inherit 70% of all estates in the decade to come. Yes, you heard correctly. According to the Women in Higher Education website, this statistic will come about due to women’s longevity over men and women tending to marry men older than themselves. By 2010 women are expected to own half of the wealth in the United States. What are the implications of this for service businesses and organizations in the United States and abroad? How is this relevant to the Sanders Market Report, which has discussed the global economy and stock markets in prior editions?

Many American women, particularly younger ones, have no idea how privileged and fortunate we are to have vast opportunities. The fact that women can inherit so much wealth, poised to be transferred from the WWII “Greatest Generation” to the baby boomers, is undisputable. Those born before 1955 are considered “leading edge boomers”, and those born after 1955 are “younger boomers”. The “leading edge” females are on the verge of fully realizing their economic empowerment as well as political influence through sheer demographics. Some would identify three stages of women: age 25-35 where careers or families are forming, then 35-45 when wealth accumulation and networking is a winning strategy. Over age 45, economic independence and control over cash is a differentiation that has come to the attention of marketers and philanthropies. More American women and children are living in non-traditional families either due to divorce, death of a spouse or being single by choice.

American women own 6.2 million businesses, and women of color own 1.2 million of them. In the US these may be service-oriented business in consulting, information systems or financial services. The US is a relatively small country of 300 million people, whereas India has 1.1 billion people and China has even more. Only 48% of women in India are literate (meaning 52% are illiterate), the majority in rural villages or urban slums, in which the cycle is perpetuated and street kids are rag pickers, beggars, or worse yet, they disappear or are forced into the commercial sex trade. All these injustices go on in the US, yet the numbers pale in comparison to other countries that are shifting from agrarian to urban societies. For example, 700+ million people in India live on less than $2/day! The magnitude of these numbers are unfathomable until one visits India and is confronted with the stark contrast of a booming economy on the global stage alongside crushing mass poverty.

In many countries school is not an option for girls. In the US, half of all medical, law, and business school graduates are women, and women can borrow money in their own names and are afforded legal protections that are just beginning to be realized elsewhere. A growing industry in banking is microfinance, whereby poor women are granted loans of between $50 - $1,000 of which they must repay some portion daily at high interest rates. The microfinance groups are self-monitoring and locally run. The repayment rate of these loans is extremely high and incredibly brings women and children to self-sufficiency.

Women in our country have a voice, through growing economic power and clout, to impact key decisions and market movements. True, women are woefully under-represented on Boards of corporations, with their influence felt much more in academia and other “soft” disciplines rather than in the business realm. Unlike some European countries, where up to 40% of legislative seats are reserved for women, the US is just catching up with women’s representation. However, when studying history and looking at many major shifts of power or trends over the millennia, one can often decipher what happened when “following the money” and tracing the vested interests.

Geopolitical risk is an ever-present threat, especially as pertains to global hot spots such as Iran or Korea. The market volatility worldwide, which was low for over a year, has stepped up to more normal elevated levels. To protect against future unexpected downturns (the sudden large drop on February 27 was triggered by the Chinese talk of implementing a capital gains tax to dampen market speculation), it is recommended that the cash portion of portfolios be raised to the upper level of the range, say 10%-12%. Cash interest rates in the US and in Europe are at historically generous levels, so “waiting it out” with some cash is a good risk management strategy. Also, despite this year’s market pullback, mid-caps have a positive outlook due to a good earnings outlook and focus from buy-out firms. Large cap, defensive stocks have been popular to withstand a slowdown in consumer spending, and still offer some protection.

The greatest risk to the US market is housing and inflation. While labor force growth is positive, we see continued weakness in the housing market as sub-prime mortgage fallout is altering the landscape of the real estate business. A large number of adjustable rate loans converting to fixed, and this conversion to higher mortgage rates, along with an increase in gasoline prices in the summer, may add some pressure to the free-spending US consumer. The consumer has been the driving force of the US economy, which has held up better than many expected; however, if average home prices continue to drop this could further slow economic growth.

What is the antidote to the risk parameters above besides gradually raising the level of cash in portfolios and investing it for the next three months? Gold could be the biggest winner, which will increase due to currency premiums and reduce its risk as a commodity premium over the next two years. The dollar has stabilized and slowly halted its systemic slide against the European and Asian currencies, however that could change again depending upon the direction of US interest rates and the deficit. Every balanced portfolio should have at least 2% in a gold stock, a gold fund or an exchange traded fund, as “insurance” against a rise in inflation and a resumption of weakening US dollar. An era of cheap debt has caused private equity firms and hedge funds to make risky credit decisions that could lead to some notable defaults when the market shifts, as it inevitably will. The Fed is on hold with interest rates, yet could well raise once more in late 2007.

Regarding currencies, Japan continues as the developed country with the lowest interest rates around, just 0.5%. The “carry trade” is alive and well and fueling global liquidity, even after a brief “melt-down” in early March when speculators began unwinding positions. Japan is an attractive currency for worldwide private equity and other hot money to borrow (even the local Japanese consumer), then invest in assets elsewhere in the world such as Australia and New Zealand bonds which pay around 7 – 8%. The world is truly shrinking when home owners in Romania are obtaining low-interest mortgages funded through Yen borrowings; this works as long as the Yen stays weak! Most Americans do not speak a foreign language or think about foreign currency exchange rates, yet that puts us at a handicap to counterparts abroad.

March 2007
The last two weeks have seen particularly volatile market action, and since global markets are increasingly correlated, there can be a ripple effect throughout the world.  Some comments are warranted at this point.

The 3% US market drop in a single Tuesday two weeks ago on February 27, 2007 was ostensibly spurred by the Chinese market experiencing a one-day 9% drop on the heels of an announcement for stricter capitals gains taxes to dampen market speculation.

Given the excellent market performance worldwide in 2006, with the exception of Japan, traders were looking for a natural excuse to sell off, as markets can not psychologically go up in a straight line forever.  This mini-correction was expected.

Last week, I was interviewed on Bloomberg TV and predicted a “second leg down” in the market by early April after some relief rallies had occurred in early March.  I also stated the US housing market will bottom in 2008.  Yesterday, the second leg down happened, prompted by fears of sub-prime mortgage turmoil that could ripple through to the broader economy.  To date, the US stock market is 5% off highs achieved on February 20, not cause for undue concern.

The root of the volatility, in our opinion, is that for all of last year, there was very little volatility in the markets, due to extreme liquidity stemming from accommodative central bank stances throughout the world and underpricing of risk.

While housing has been slowing in the US, other areas of the economy continue to be healthy: GDP growth is trending between 2 – 3%, employment is tight in service sectors, unemployment is only 4.5%, and consumers continue spending.  The Fed’s biggest concern is inflation, as expressed by Fed Chairman Ben Bernanke in his testimony to Congress, which appears to be contained at slightly over 2%, showing that the economy is growing at a sustainable rate.

While the Bank of England, European Central Bank, the Bank of Japan and Reserve Bank of India have been gradually raising interest rates, and the Chinese have been raising reserve requirements, the US Fed has been on hold since pausing last summer after 17 rate increases.  The emerging markets such as China and India have been growing GDP at a break-neck pace of 9-10% per year, causing the central banks to use monetary policy to slow growth.

The increased volatility in world markets combined with the dampening of liquidity have been leading traders toward safe-haven assets such as US Treasuries, which have moved up the last few weeks along with a drop in yield.  The yield curve is still inverted, yet we are not looking for a recession this year or next as the economy is stable.  It is healthy for the market to be re-pricing risk to get rid of excesses due to deals that shouldn’t have been done in the first place.

Some analysts have been calling for the Fed to cut interest rates to boost the housing market, and there is even talk of a Congressional bail out proposal for sub-prime borrowers.  Neither scenario is likely, as the Fed is ever vigilant to curb inflationary tendencies in the economy, and will probably leave interest rates unchanged for the duration of 2007 or perhaps even raise rates 25 basis points in the second half of the year if wage increases continue to build. 

The Japanese “carry trade” has been a real factor roiling the markets the past two weeks, as positions got unwound.  It has been a big business for private equity and hedge funds, as well as private individuals, to borrow in Japanese Yen at 0.5% and turn around and invest it in other higher yielding currencies such as Australian/New Zealand dollars or to buy assets in other countries such as global real estate and companies.  As positions get unwound and Yen loans repaid, the Yen rises.

There is a certain amount of confusion in the market as no one knows for sure how extensive the Japanese carry trade is and how much risk is in the sub-prime mortgage market, stemming from loose lending standards in 2005-2006.  The aggressive lenders had sold packages of loans to private investors, investment banks and pension funds, so as these loans accelerate in default, the mortgage bond market and even financial stocks will feel the pressure.

What is clear is that the deterioration in US housing is acute and still unfolding, and will have an impact on slowing the US economy in 2007, especially in related sectors.  However, it is premature to over-react by selling off the market as a whole, and to assume the problems will directly impact foreign markets where the demographics and economic growth path is very different.  The US is still the most developed, liquid and advanced economy in the world.  

In time, by spring or summer, bargains will abound and we will recommend being buyers of equity in the US and in emerging markets.  A move toward increasing allocations of international securities is still highly desirable.  For now it is best to sit tight, watch and wait, let the market work out in an orderly fashion, selling covered call options where available as a defensive posture, and staying at the upper limits of one’s cash and fixed income allocation.

January 2007
The financial/economic theme for 2007 is the three C’s:  Commodities, Currency and China.  All three are interconnected.  Commodities encompass metals, gold and oil.  The focus of currencies, from a US perspective, is how they relate to the moderately weakening US dollar.  China is emblematic of the fast growing developing countries of the world, of which China is the largest economy and population.  China’s foreign exchange reserves broke records again, topping $1 trillion, making it not only the largest reserve in the world, but the first to enter 13 digits.  China is diversifying out of US $ instruments, and the Euro is replacing the US $ as a reserve currency.  Oil is now beginning to be priced in Euros.  There is a secular commodity bull run, due to insatiable demand from emerging economies globally.  The trend for oil prices is likely to be to the upside because political instability threatens supply, and Asian demand is going to double over time.  Gold should rally further on expectations that supply will decline, and because buyers of tangible assets don’t want to be so heavy in US dollars.

At the onset of 2007, the global growth outlook remains good, and international markets appear attractively valued.  Worldwide liquidity is plentiful and could be withdrawn, yet there is an incredible amount of passive capital sitting out there waiting for the first trend to emerge.  Where is all that flow of loose, investable capital going to go?  It will stay temporarily in cash and gold and primary real estate.  Oil prices have come down sharply (33%) from the record high of $77 on July 14, 2006, marking a serious correction and acting like an inflationary tax cut for consumers to spend.  However, by 2008, oil prices are going back to their highs.  The tightening cycles for interest rates are close to their end in developed markets like the US, although a rate hike or two is still expected throughout 2007 to stem the tide of inflation.

After a resounding successful year in the US stock market in 2006, the bullish market sentiment is too widespread, turning too many pessimists into optimists, therefore an equity pullback of 3 – 5% in first quarter is expected.   When 80% of forecasts have bullish consensus after four years of market increases and double-digit earnings growth, this is cause of concern that could drag on the market.  We’re in an unstable equilibrium with risk skewed 10-15% to the downside in equities with only 5 – 10% upside.  The world has been through a period of durable economic growth for three years, where every major economy has grown with no crises.  China’s economy is growing so rapidly that as a matter of policy the government is trying to put on the brakes, in part by halting the launch of new domestic equity funds amid concerns of an overheating stock market.  In search of commodities, the Chinese have a strong investment presence in Africa.  This could be an interesting story over the next 5-10 years.

Emerging markets in 2006 outperformed their developed counterparts for a fifth straight year, and we expect this trend to continue, with an allocation of up to 40% in international equities by year-end.  Half of that allocation can be in emerging markets for aggressive investors able to live with volatility swings.   Such fast growing economies include: China, India, Argentina, Brazil, Chile, Russia, Czech Republic, Poland, Singapore, Indonesia, Malaysia, Philippines, Taiwan, Hungary, South Africa and South Korea.   Consumers in these countries are becoming wealthy enough to propel economic growth even as demand for their exports slows.  Historically, their interest rates have fallen, except in the populous countries of China and India where the government is trying to slow the economy from growing at 9 – 10% with modest rate increases.

In summary, the weakening US dollar will continue to make overseas returns a more lucrative area for domestic investors.  We favor large, top-quality equities as there is little chance of a sell-off in this area.  Gold could approach $900/ounce and a scenario where oil could return to $70+/barrel is likely.  Plentiful liquidity and prolonged easy conditions in structured credit markets increases risk.  The US housing downturn looks contained, yet it is the biggest risk to 2007, which will dampen consumption, the largest driver of the world economy.  Yet developing nations are having enough internal growth due to demographics to continue growing even in the face of a much-anticipated US slowdown, and have become less dependent on the US, in addition to having booming real estate markets.  American investors should get in front of the curve and shift more of their financial assets out of US-dollar denominated assets and into the world’s growing economies.  Don’t be surprised if due to the weak US dollar, and growing currency reserves, our children and grandchildren find themselves working for Chinese (or Indian) companies based in the US one day.

October 2006
Is the US in a secular decline as the world's major economic powerhouse?  Some would say yes, a gradual decline has begun.  According to a study released on October 12 by the Chicago Council on Global Affairs, in partnership with the Asia Society, a majority of Americans, Chinese and Indians see the US losing its status as the world's unrivalled superpower within the next half century.  The Chinese see their country matching the US in terms of global influence within the next ten years.  Analysts have called this a landmark and complex study.  Whether one agrees with the conclusions of the study or not, the US, on the eve of achieving a population of 300 million people, must adjust itself to a world in which the views and perspectives of other, less powerful nations are taken seriously as a growing force.

The US is on track to complete a fourth year of a bull market with low double digit returns.  While it is historically unlikely this good fortune will extend into a fifth year, a scenario is likely with single digit market returns in 2007.  The Eurozone has been a surprise with double digit returns, particularly the new entrants into the EU such as Romania and other countries that were once a blip on the global radar.  Due to the single currency in most of Europe, there has been a sharp increase in merger and acquisition transactions, also making it an area of greater economic potential, despite the mature markets.  The Eurozone's GDP of $12 trillion is equivalent to that of the US, with China's GDP of $8 trillion coming up strong.  It is not hard to envision a scenario where in the next 5-10 years the GDP of China will reach that of the US.

By most measures, America's capital markets still dwarf London in terms of sheer size.  Yet behind the scenes, the Financial Times reports there are now many bankers who are quietly wondering if London could soon displace New York as the world's most dynamic financial center, at least in the higher margin businesses such as derivatives and global IPO's.  Some of the most lucrative mandates in investment banking these days are emanating from Eastern Europe and the Middle East, which are physically closer to London.  However, alongside the financial markets, the international real estate market is booming.  The twelve month return for global real estate as measured by EPRA/NAREIT index (excluding North America ) was 33.5%, which outpaced by double the Dow Jones Real Estate Securities Index for the same period.  It is not a coincidence that Donald Trump's organization is building a tower and huge complexes in such far flung countries as Dubai and Panama.

And how about oil's role in the world economic shifts?  The good news is that gasoline prices have continued to fall this autumn, which helps keep US consumers' spending relatively steady.  The massive decline in petroleum import prices leads to significant easing of inflationary pressures this quarter. The US is dependent on the Mideast for about 25% of the oil that we import.  The biggest exporter of oil to the US is Canada, a friendly neighbor, yet of the 8 or 10 countries that we buy oil from, there are only about three that are somewhat neutral toward the US.  This is a situation that leaves our country vulnerable to those who wish to harm us, and whose ever growing petrodollars keep our balance of payments in check by buying so many of our Treasury securities.  Most of the worlds' businesses go where the money is, and despite conflicted political feelings, want to gain lucrative contracts from countries that are awash in petrodollars, with trade sanctions nearly useless. 

US equity investors have shifted a record proportion of their funds into foreign markets this year as investors seek returns from overseas and emerging markets.  The highest percentage of international securities on record, 17%, is now held by domestic mutual funds, with 89% of new dollars going into funds investing in overseas companies.  This strong appetite for foreign equities has been bolstered by the declining value of the US dollar, which we expect to continue.  Federal Reserve Chairman Ben Bernanke warned recently in a speech to the Economics Club of Washington that entitlement programs such as Social Security and Medicare need to be overhauled before the massive wave of baby boomers retire.  Neither tax increases nor spending cuts alone will solve the difficult choices, so for now, the US Treasury wants foreigners to continue buying our country's debt.  This situation creates a vicious circle of economic abundance with dependence that cannot be sustained.

Take India, for example.  Economically, they are currently at a low base with a population of 1 billion+, so the economy is growing at a break neck pace.  In the worst slums of Mumbai, there is one toilet for every 1,500 inhabitants!  Think about the worst slum in Harlem or Bedford-Stuyvesant outside of New York City, and there is probably one toilet for every 15 residents.  Today, one third of the world's inhabitants is faced with a shortage of potable water necessary for survival.  The US is so economically affluent, that even our poorest residents live in relative comfort compared to the masses of the rest of the world.  With a satellite dish in many households in less developed countries, children outside the borders of the US see how we live and want the lifestyle, thus creating a dis-equilibrium of aspiration vs. reality.

The US isn't going to fall off its perch of global economic supremacy any time soon, however, with a shrinking globe brought about by instant communications (think satellites, cell phones, internet, etc.), Americans would do well to look outside themselves and see what is going on in the rest of the world to understand the forces shaping our economy.  Consider past ancient eras such as the Roman Empire, the great Chinese and Mayan dynasties, days in the 1400's when Spain and Portugal were world maritime powers, when Britain had colonies all over the world as recently as 60 years ago and then in the recent post-WWII era, how the US dominates world thought and commerce and even language.  Over the next two years, our recommendation is that clients double their international equity exposure from 15-20% to 30-40%, perhaps in some unexpected places.  The cycles of history tell us that nothing remains the same, and to profit in the world economy we must stay alert.

August 2006
Interest rates are trending higher globally in response to inflation, which is a real threat to the world economic expansion.  After 17 consecutive rates hikes, the Federal Reserve finally took a pause and left key interest rates unchanged for the first time in two years due to slightly better inflation news on core CPI.  Fed Chairman Bernanke doesn't want to slow the US economy too much, which has already decelerated from 5.6% in the first quarter to 2.5% in the second quarter.  The economy is showing signs of reacceleration, and the upward trend in unit labor costs suggests the Fed might resume hiking rates.

Productivity growth, which is still pretty good, is not offsetting rising labor costs as much as had been believed.  History shows that accelerating unit labor costs, if not contained, can fuel a sustained pickup in inflation, which is difficult for the Fed to reverse without substantial economic pain.  While the most recent report shows core inflation, outside of energy, under control, there is evidence that pressures on businesses to lift prices are coming from labor costs.  This acceleration in unit labor costs partly explains why consumer spending held up pretty well in July, yet, it is prudent to lighten up on consumer discretionary sector holdings in a slowing economy. 

While the Fed is trying to engineer a "soft landing" in 2007, a recession is entirely likely in 2008 if the Fed must actively tighten money again before the end of 2006 to curb inflationary pressures.  All tightening cycles except two in '83-'84 and '94-'95 have produced a recession within two years after they ended.  Fed Chairman Bernanke doesn't yet have the full confidence of the markets, although he is earning his spurs by slowing the US economy while keeping it strong.  The US remains a prime investment destination because of its transparency and the S&P 500 has posted at least 10% or better annual corporate earnings growth for over three years.  The third and fourth quarter earnings for the S&P 500 stocks are also expected to grow by at least 10%, and the market can move decisively upward after Labor Day when traders return.

The US dollar remains soft relative to the euro and other key currencies.  The Eurozone is slated for 3.7% GDP growth this year, outpacing the US, Britain and Japan.  Since the European Central Bank is willing to tighten rates to slow the economy, they will work to keep growth below an inflationary target level.   Nonetheless, Treasury yields have dropped considerably in the US since the Fed stopped hiking US rates on August 8.  The 10-year Treasury is now yielding under 5%, which is less than the 3-month T-bill of 5.10%.  Short-term CD’s are less attractive than just a month ago.  In a strange dichotomy, the inverted yield curve is posing the possibility that the Fed could lower key interest rates before year-end.

Energy continues to be toppy even though oil is perceived in the media to be heading to $100/barrel by early 2007.  The US consumes approximately 25% of the world's oil!  With the summer driving season nearing an end, the price of oil is heading down in the short term due to increasing inventories.  Since the price of oil shot up about two years ago, it has created ultimate increases in supply that hold down the price increases.  Russia is a huge oil exporter, so oil is fueling their economic growth.  As long as there are so many wild cards regarding crude oil production (Iran, Venezuela, Mexico), there could be a sudden supply shock, making it prudent to continue to hold selected energy stocks as a good defense. 

There is no doubt that housing is slowing, and we do not expect this downward trend to reverse in any meaningful way before 2008.  Housing permits fell 20% year over year July, with single-family starts leading the declines.  The National Association of Home Builder's measure of builder sentiment fell to a fifteen year low due to high levels of inventory and less customer traffic.  This will impact the broader economy through a negative wealth effect on the consumer.  The South, which was the best performer of the four census housing regions, accounts for 49.2 percent of nationwide housing starts.  Worldwide there has been a global housing boom that is also showing signs of slowing except in developing countries.

With corporate earnings strong and P/E ratios compressed to only 19.9 times current earnings and 15.4 times forecasted earnings, there is still upward potential in the US stock market, leading to a recommendation of only 5-10% cash.  Attractive rates for cash are available in the current climate.  Foreign economies remain strong as well, although with the same inflationary cautions as in the US, so we continue to recommend boosting the allocation to international equities of 15-20%, especially in the Eurozone.  The emerging markets are volatile, as seen in May-June 2006, so approach them gingerly, maintaining existing positions and buying on dips while trimming on rallies in Russia, China and Latin America.

May 2006
US interest rates are the story du jour, after the Fed boosted short-term rates to 5% in small stair-step increments for the 16th consecutive time in two years.  No one was surprised by the increase.  The Fed's default position appears to have shifted to one of not tightening unless the economic data are strong.  With the mortgage index down 28% below its year-ago level, the leading indicators are clear that the housing market will weaken due to the lagged effects of interest rate increases.  When combined with soaring gasoline prices that are causing consumers to spend less, it is rational to expect that the US economy is in the process of gradually cooling. 

The US dollar also began falling late last year, and since late April its drop has accelerated against a variety of major currencies.  Such a trend adds to inflationary pressure at home as imported goods become more expensive, which is one of the fears that is rattling the financial markets.  Interest rates and exchange rates are directly related, in a sensitive balancing act whereby a perceived decline in the dollar could serve to further drive up short-term US interest rates to 5.5% and make foreign investors leery of buying US assets.  From the government's standpoint, a weak dollar is the best hope for curbing the trade deficit, yet it is a double-edged sword if a plunge in dollar-denominated assets triggers a serious slowdown in the economy.  Given the dollar bearishness, it is hard for the greenback to sustain future strength.

Commodity prices are in a bubble-like stage now, with the vast majority being driven up not by supply/demand considerations but by hoarding and speculators.  It would be prudent to lighten up on any commodity positions such as aluminum, copper, crude oil, nickel, petroleum products, steel and zinc.  Without a meaningful correction in the commodity pits, psychology can play a big role in inflation.  Gold futures are also continuing to soar, indicating an expectation of stealth inflation in the published numbers as well as a hedge against global political crises such as Iran.   Our expectation is that gold will continue to rise this year.   In March, Congress raised the debt ceiling to $9 trillion to cover a new round of government spending.  This points to increased volatility in world financial markets brought on by speculative as well as political/economic factors. 

The trend to globalize and consolidate exchanges has also started to occur as NASDAQ grows its ownership stake in the London Stock Exchange (LSE) up to 24% and the NYSE is talking with companies like Euronext exchange and the LSE for possible acquisition.  The goal is to increase market share around the world to avoid being too heavily dependent on any one geographic region.  24-hour round-the-clock trading is only a few years off, and the Chicago Board of Trade is moving to such a model in summer for its flagship agricultural products.  The number of global exchanges will collapse down in the next decade, mirroring consolidation in the banking industry.  Companies must be global to compete effectively, in areas such as sourcing, manufacturing, sales and value added intangible services.

Another big stories that will not go away over the next two decades is elder care.  The pressures caused in developed countries by the demographics of baby boomers retiring, as well as cost pressures on the medical system in developed nations to care for the elderly will explode in importance.  The Medicare system will be forced into drastic changes much sooner than social security, and the U.K. is facing a similar crisis to the US in this regard.  Labor and capital will shift around the globe with the US transitioning into a largely service-based economy driven by intellectual property.  The gap between the haves and the have-nots will increase as knowledge workers earn 80% of the wealth of the US and laborers are more and more marginalized where unskilled labor is vastly cheaper in other countries.

A final critical issue that has been seeing increased media coverage is the avian flu and the possible repercussions should the virus mutate to human to human transmission.  What types of contingency plans are companies making if a pandemic does occur?  What securities and industries are the most vulnerable in the face of an emerging pandemic, and what are the industries that could see a bump up such as pharmaceutical companies?  Acting in our clients' best interests, scenarios have been modeled as to how the markets would react and what solutions would be implemented to protect assets.   Every serious company would do well to examine preparedness, even if avian flu turns into another "exercise without impact" like Y2K, better to practice risk management.  It is recommended to increase cash levels to 10% in retirement plans such as IRA's and 401K's to protect on the downside for an avian flu scare.

As often repeated in this column, a well-diversified portfolio will help investors to profit in good times and downturns.  Global economic growth paints a strong argument for raising the international component of one's portfolio from 10% to 20% by the beginning of 2007.  Have an allocation that includes a mix of stocks and bonds, yet be diligent to watch interest rate movements and keep fixed income investments relatively short in duration, with seven-year maturities the outer band.  As long as the US and Chinese "addiction to oil" continues to be a concern, alternative/clean energy sources will become a promising investment theme in the coming years as developments become more commercially viable.

March 2006
By basic measures, the US economy is doing well.  GDP is on track to continue averaging 3 - 4% increases and recent CPI data ex-energy indicate stable core prices that the Fed perceives as "inflation friendly".  The coming first-quarter 2006 earnings will represent the 16th quarter in a row of double-digit earnings guidance from corporate America.  Consumer spending continues to be solid, and the 4.8% unemployment rate is considered nearly Goldilocks-perfect in terms of alleviating any significant wage pressures.  Many businesses have chosen to absorb price increases and not pass them along to consumers, which is a positive sign.  First and foremost, the Fed wants a low and contained inflation rate.

In mid-March, the S&P index climbed above the 1,300 mark for the first time since May, 2001, and the Dow is within striking distance of a six-year high and breaking out of a trading range.  Indexes are hitting new records because earnings are strong, yet stock market volume is muted.  Sustainable rallies usually need increasing volume to be credible.  The tech-heavy Nasdaq composite is not leading the broad market, which may be a sign of short-term concern.  While technology normally enhances productivity, it depreciates quicker than ever, so needs to be replaced by businesses.  Telecom stocks have seen a recent spate of merger activity, warranting a surge in attention to this consolidating sector.

As long as the U.S. economy remains strong, and the dollar remains stable against the euro and yen, the secular trend of foreign interest in U.S. securities is likely to continue.  China, Japan and the Middle East now finance about $2.2 trillion of our nation's publicly held debt, which may be unsustainable.  The Senate recently voted to raise the federal debt ceiling to almost $9 trillion dollars to avoid the nation's first-ever default on its obligations.  Fed Chairman Bernanke is concerned about the deficit, given projected spending on commitments to Medicare and Social Security as baby boomers begin to retire.  Foreign countries with trade surpluses are reinvesting capital into the U.S, financing our budget and trade deficits.  It is a delicate dance, for if foreign capital migrates elsewhere, interest rates could rise, hurting stock and bond markets.

The much anticipated slow down in housing is now playing out due to a rise in both interest rates and home prices.  The U.S. is very dependent on foreign capital to keep interest rates low, particularly on U. S. Treasury bond yields.  Short-term interest rates have been raised 350 basis points from 1% to 4.5%, and it is likely that the Fed will tighten monetary policy by another two quarter-point moves, bringing the Fed funds rate to 5%.  This is still considered accommodative by historical standards.  Once the Fed stops raising interest rates, the "global savings glut" will be unleashed into the equity markets.

Forces of globalization have led to turbulent times, both geopolitically and economically, and uncertainty is here to stay.  Obscure foreign stock markets have outpaced domestic markets in 2005 by a wide margin due to their "discovery"; global stocks should comprise up to 15% of a well diversified portfolio going forward.  Energy stocks had a banner year in 2005, yet now appear "toppy" and profits should be taken.  The investment theme for 2006 is alternative energy.  Just two months ago President Bush declared the U.S. "addicted to oil", and strong economic growth in China and India has led to higher energy usage in those countries.  Brazil has become energy-independent due to the cultivation of ethanol products.

Due to the uneven equity environment, a third of one's portfolio stocks will likely attain most of one's investment gains, so diversification and a suitable asset allocation is paramount.  Given our reasonable optimism toward the economy and view that interest rates are nearly leveling, a 5% cash allocation is recommended.  Income/capital gain tax rates in the U.S. are lower than in the past forty years, so expect tax increases in the years ahead to address the deficit.  For investors who own large positions of a single stock, strongly consider tax-motivated selling in the next two years or donating a portion to charity.  With April 15 fast upon us, please accept a friendly reminder to make a 2005 IRA or Roth IRA contribution.

February 2006
US financial markets were off to a good start in January 2006 as market pundits believed economic data supported a balance between growth and inflation, which would point toward the Fed nearing the end of its monetary tightening policy.  New economic data indicates the Fed may continue to raise interest rates one or two more times to restrain inflation, as economic conditions continue to be impressive with GDP growing more than 3% and unemployment falling to 4.7%.  More than 2 million non-farm payroll jobs were added in the last year, and the Fed Governors forecast a “comfortable” 3.5% GDP rate. 

Ben Bernanke has replaced Alan Greenspan as Chairman of the Federal Reserve and expectations are that the Fed will stay on its present course.  With the US economy in a sustained expansion, resource utilization rising and cost pressures increasing, there exists risk that inflation might be to the upside of the Fed’s forecasts, which may lead to further firming of monetary policy.  During the past five years, the economy has largely been driven by consumer spending and housing appreciation, which is typical coming out of a recession.  Bernanke noted to Congress that even with the strong economy he expects the housing market to have a soft landing.  However, if the housing market cools further than expected it could pull down consumer spending and limit the economy’s ability to grow.

The US trade deficit set another record by reaching $725B in 2005, which has become a concern as the US continues to spend more than it produces.  It could take a decade to shrink the huge US trade deficit to more sustainable levels, said Bernanke.  The relevant question regarding the deficit revolves around whether traditional measures are telling the entire story.  Historic measures count tangible products like computers and barrels of oil, without accounting for intangibles such as R&D, training, and exports of knowledge that design and develop many of the products we import.  Education is an intangible that most see as an investment in one’s future, yet traditional measures record as consumption.

The shadow economy is made up of these value producing, but unmeasured, intangibles which are difficult to calculate.  Intangible investments continue to gain in importance as globalization and outsourcing lead to more emphasis in innovation and creativity.  It is this intellectual output that bolsters the US economy and will prove the cynics wrong about the true amount of the account deficit.  The US has long been a service dominated society, which is rapidly turning into a knowledge based society, and one that continues to be measured from a manufacturing point of view.  This is why we assert the US economy is and will do better than the numbers indicate and continue to recommend the US equity markets.  Diversification is not just between asset classes and investment styles, but geographic, and it is integral to minimizing risk in an investment portfolio.

Two countries that should be included in a well-diversified long-term portfolio are China and India.  As in all developing markets there is considerable risk, but these two countries are key beneficiaries of the US’s move toward a knowledge-based society.  China benefits from countries outsourcing the production of goods, while India benefits from trends in services outsourcing.  On a fundamental basis India has more experience with free markets, giving them a competitive advantage.  India is also open to doing business competitively, whereas China still operates with a tight network of business and social relationships.  India mitigates corruption with a free press, which is noticeably absent in China.  While fundamentals are important, valuation reflects India’s growth prospects: a P/E of 21 for the Sensex 30 Index versus a P/E of 15 for the Hong Kong Stock Exchange.

Despite fears about inflation, the Fed raising rates, housing slowing, and the current account deficit, the domestic economy continues to progress at a relatively stable pace.  This leads to a recommendation that investors remain fully invested (with 5% cash levels) in a diversified global portfolio of equity and intermediate fixed income.

January 2006
The US financial markets ended the year on a lackluster performance note with low single digit returns.  The exception was international markets where foreign stocks outpaced US stocks.  The Dow Jones World Index ex-US is up 20% since 12/31/04!  Due to a strong world economy, particularly in developing regions where ongoing reforms point to a trend of free-market capitalism, it is recommended to allocate up to 15% of one’s portfolio to international in 2006.  On the domestic side, only small and mid-cap US stocks of fast-growing companies have the likelihood of realizing double digit gains.

Corporate earnings continue to beat reported expectations, and they have been above average for 15 quarters (normal profit gains are 7%). The Dow Jones Industrial Average broke the 11,000 mark for the first time in 4 ½ years, along with buoyancy in the other market averages. While market optimism is typical at the beginning of a new year, if the stock market can maintain momentum through January, characterized by rising trading volumes, this could portend well for the year 2006. Additionally, a surge in corporate takeover and share repurchase activity is a positive indicator for stock returns ahead.

Concerns center on the speculative risk premium in oil due to geopolitical fears spurred by the health crisis of Israeli Prime Minister Ariel Sharon and Iran’s hawkish nuclear program.  The fear is that upward pressure on oil prices will contribute to broader inflation.  However, some economists believe that globalization will mitigate inflationary pressures, as more products and services are produced by low-cost economies. The heavy foreign demand for US Treasuries and TIPS (Treasury Inflation Protected Securities) are keeping long-term interest rates stubbornly low.  While China could start to reallocate some of its reserves away from dollars, it has as a vested interest in keeping the US economy out of a financial crisis so that we can continue buying Chinese goods.

The Fed has acted decisively to raise the short-term interest rate target from 1% to 4.25% over the last eighteen months.  The minutes from the Fed’s most recent policy-making meeting released in early January states that “… the number of additional firming steps required probably would not be large”.  This suggests that rates might be raised only one or two more times concurrent with January 31, Alan Greenspan’s last day and possibly the Fed’s final rate hike. The new Fed Chairman-elect, Dr. Ben Bernanke, is currently head of President Bush’s Council of Economic Advisors, and is expected to maintain the stability in global capital markets that have been enjoyed during the past two decades.

A slightly inverted yield curve developed on December 27, 2005, in which short-term yields are higher than long-term ones.  The current inversion is confined to a part of the curve between two and ten years. Historically, a full inversion could signify that the economy may slip into recession a year later, which has potential to be an issue in 2007. However, with the US population aging, demand will grow for the kind of bonds that can guarantee payments for future retirees, holding down long-term yields.  It is now “safe” to buy bonds out to a seven year maturity without major risk of principal loss.

The nature of domestic unemployment is a structural issue, with service industries at only 2% unemployment vs. 6% for production occupations.  Real disposable income has actually increased and will continue to bolster spending, keeping the economy humming.  Despite January’s increase in both chief executive and consumer confidence, a contrarian indicator, we strongly recommend that investors remain fully invested in a diversified global portfolio of equity and fixed income.

November 2005
Energy prices and hurricane shocks have hit the consumer confidence hard and deepened investor pessimism, yet the index appears to have bounced off the historic 25-year bottom. Slower consumer spending growth, which was already decelerating prior to Katrina, is the result of smaller gains in real disposable income due to higher inflation of energy prices. In China, however, a government commission is developing projects to reduce China's consumption of energy by implementing a series of energy saving practices.

All the major market indexes are trading at 6 ½ month lows, and there was heavy volume associated with the market's 4% sell-off in the first half of October. The relentless selling and bearish sentiment is a contrarian indicator that leads us to believe the stock market's condition is oversold, with many substantive stocks too attractive to ignore, now at levels well below their fair valuations.

Wall Street has tended to focus on a relatively mild core inflation report (up just 2% year-to-year), although the Fed is paying more attention to the potential of higher energy costs spilling over into the core CPI. When combined with the resiliency of the US economy, and the massive government deficit, the market has priced in at least two more Fed interest rate increases. There is also concern in the market, based on a report by the Presidential tax advisory panel, that taxes will eventually be raised to pay for spending, perhaps by capping deductible mortgage interest and tax deductions for health care.

However, the ultimate driver of equity markets is earnings, and third quarter earnings that are slated for release in the fourth quarter 2005 are expected to be strong. Several leading blue-chip companies are posting healthy, double-digit earnings growth figures (15-35%). Once the Fed signals an end to interest rate hikes, that will provide a major upward catalyst to the markets. There is also significant monetary liquidity floating around the world due to improving global income levels and cash sitting on the sidelines looking for a home. Capital inflows to the US have held up rather well over the past three years.

With President Bush's approval rating at 39% (the lowest level since he took office) and the impending replacement of Fed Chief Alan Greenspan (retiring in January), it may become more difficult to preserve tax breaks that are disproportionately benefiting wealthier Americans. The strong momentum for investment in residential real estate is slowing, so as inflation and interest rates rise, take advantage of opportunities to sell highly appreciated assets while capital gains tax rates are lower than in the past 40 years and interest rates are relatively moderate. Shift proceeds into taxable and tax-exempt bond portfolios to capitalize on increasing interest rates and have a buffer from volatile equity and energy markets. Continue to build holdings of global stocks that have outperformed the US market and will continue to do so due to economic growth abroad.

Harvest profits in the high-flying energy sector before it further falls back due to deteriorating market leadership, and be wary of the poor performing consumer discretionary and telecommunications sectors until consumer confidence rebounds. Corporate restructurings in important economies such as Japan and Germany will continue to support an increased allocation to foreign stocks. Exports have grown slightly faster than imports over the past year, which could help support the US GDP "on-trend" economic growth of at least 3%-3.5% over the next quarter or two. While it is our expectation that the broad stock market will end a year of flat returns in mid-to-high single digits, over the next 3-4 years the market could see 50% growth overall. This leads us to recommend keeping cash relatively low at 5-10% of portfolios and putting it to work.

September 2005
In the wake of Hurricane Katrina, the stock market has shown much resiliency. While a temporary slowdown in US economic growth is imminent in the fourth quarter, aggressive government spending on the reconstruction efforts should help mute the effects of the disaster and may even boost economic expansion over the long haul. Not surprisingly, new unemployment claims increased by 71,000 last week, due almost entirely to Katrina, with more claims likely to follow. Pre-Katrina unemployment was at 4.9%, which most labor experts believe is essentially full employment.

Government spending for Katrina-associated initiatives means more government debt. Combined with a tightening labor market this signals inflation. The bond market reacted to President Bush's rebuilding plan by lifting the 10-yr note to 4.28% last week from 4.21%. In addition, both key indicators of inflation, the consumer and producer price indexes, rose over 0.5% in August, before Katrina even hit. Given the ballooning deficit, it is unlikely that Congress will have the political will to push through a proposed elimination of the "death tax" to benefit high net worth individuals.

It is likely that the Fed will continue its measured pace of rate hikes despite concern over the economic aftermath of Katrina. There is the potential for 1-2 more increases before year-end. Nevertheless, the fear of an inverted yield curve (where long-term interest rates are lower than short-term rates) will likely keep the Fed from hiking the Fed Funds rate (currently 3.75%) too much higher. The Fed is also fully aware that seven of the last eight recessions were preceded by an inverted yield curve so they will most likely not allow this risk to happen.

Katrina also brought a temporary shock in oil prices, which rose to a high of $70 and have since tapered off to $67. To counteract the shock the International Energy Agency (IEA) made 60 million barrels available almost immediately, some of which came from the Strategic Petroleum Reserve. US demand for oil dropped 4% after Labor Day and is likely to decline further as the summer driving season has ended. New fears over Hurricane Rita's effect on the oil industry in the Gulf of Mexico have given high oil prices staying power.

In light of inflation concerns and fears of a weakening dollar, gold and gold stocks have continued to offer a strong hedge. Since Katrina struck, gold prices have risen nearly 8% to 17-year highs. It is recommended to maintain some gold stocks in one's portfolio.

Katrina also pushed consumer sentiment to 13-year lows - a likely response to higher prices at the gas pump. With demand dropping though, sentiment should rebound quickly. The oil and gas services industry should continue to be strong over the near-term from both continued exploration for the natural resources as well as from Katrina cleanup.

The international markets and particularly the emerging markets have outperformed the US stock market this year and their diversification value continues to make them a wise investment at present. Foreign stocks actually account for 50% of the world's total market capitalization. As a whole they have lower valuations than US stocks and pay higher dividends- 2.2% for the MSCI-EAFE Index vs 1.7% for the S&P 500. We continue to recommend a gradual increase in global holdings from 5% to 15% allocation.

The new Chairman of the SEC, Christopher Cox, backs implementation of a new rule for the regulation of the hedge fund industry, whereby hedge funds must register with the SEC. The industry has exploded in recent years, with assets nearing $1 trillion. The pending rules in 2006 will reduce the competitive advantage of hedge fund investments.

Third quarter US corporate earnings, which will be released in starting in October, look to be strong again. If so, it will mark the 12th straight quarter of double-digit earnings growth for the overall stock market. Compressed P/E ratios, earnings momentum, and continuing corporate buybacks should help bolster investor sentiment. If the Fed should pause momentarily from its tightening stance, the market seems poised for a strong rally to the end of the year. If the Fed continues to raise interest rates, the market will likely continue to move higher, although at a much slower pace, ending the year with single digit returns. It is recommended to lower the cash allocation to 5 - 10% of portfolios.

August 2005
July 2005 was the best month for the market averages all year, however August is living up to its reputation as a doldrums month. August has seen the S&P 500 and Nasdaq indexes reach 4-year highs, although the S&P 500 is just 80% of its all-time high from March, 2000, and today's Nasdaq is a mere 43% of its peak price before the bubble burst in 2000. This portends some room for tech stocks to continue their rebound when combined with an expected upturn in corporate IT spending.

Investors burned by the dot-com bust continue to favor tangible assets. Although condo and co-op sales represent only about 13% of the total existing home market, the attractiveness of condos as homes (especially in major cities) and the expectation of future cash flow have driven average condo prices above single-family home prices to $274,000 vs. $267,000, respectively. Even with interest rates rising at a measured pace, real estate is still becoming a larger part of individual investors' asset allocation.

Regarding the fed funds rate, the Fed's benchmark short-term interest rate, it has already climbed 2.50 points to 3.50% since June 2004, in a series of ten consecutive quarter point increases. There is a case for the Fed to continue to tighten rates, but only by a limited amount to 4.0% by the end of this year.

The prospect of an inverted yield curve (when short-term rates exceed long-term) will make the Fed leery of going too far with rate increases. The yield curve usually slopes upward, and nobody in the Fed wants to invert the yield curve which might create the risk of recession. Greenspan replacement concerns are a wild card that could spook the market as the end of his term as head of the Federal Reserve draws ever nearer.

Consumers are proving to be a lot more resilient toward high energy costs than many would have guessed, and the market is shrugging off substantial increases in oil prices. Employment costs appear to be in check with the growth in jobs clearly in services sector while maintaining productivity gains, and core CPI is up only 2% over the past twelve months. We are now moving into a range in which monetary policy may be seen as "neutral", which is the funds rate level that neither helps nor hurts economic growth.

Beijing's decision to allow the yuan to rise 2% against the dollar in July may be only the opening salvo of a carefully managed appreciation of the Chinese currency over the next couple of years. It also gives other Asian currencies breathing room to follow suit without losing trade competitiveness. Longer term, the yuan may catch on as a major world currency and a viable dollar alternative among Asian central banks in a way Japan's yen never did.

The recent string of better economic data out of the Eurozone certainly is welcome news. A sustainable economic expansion in the Eurozone, however, will require a pick up in domestic demand. From a valuation perspective, solid fundamentals combined with prospects for further weakening of the US dollar, suggest that international stocks remain attractive in both developed and emerging markets and their portfolio allocation should be increased.

Domestically, utility stocks, usually bought for safety and stability, have seen their indices double since the lows of October 2002, far outpacing the rest of the stock market. It has been the sector's sharpest rally since the 1950's. Therefore, do not expect further outsized gains. Utility stocks are fully valued even after factoring in the lower tax rates on dividend income. As we head toward the end of 2005, sectors we favor are technology, consumer goods, materials, energy and generic healthcare. Fixed income strategies are best pursued at the intermediate end of the curve. The Growth style of investing is reviving while the opportunity in Value stocks is subdued going forward.

June 2005
The last two months have been marked by a recovery of sorts in the US stock market, such that major market indices are nearly flat year-to-date. The market seems to be telling us that inflation is not a concern, otherwise the yield curve would not have flattened on the long end despite eight short-term interest rate hikes by the Fed; hedge funds' arbitrage of long vs. short-term bonds may be contributing to this. Long-term rates are down throughout the world, not just in the US, which has provided an engine for what has become a global housing boom. Be aware that interest-only mortgages are proliferating and are risky for consumers.

The US is in the ultimate sideways market, with a low volume and low volatility market marked by complacency due to a low number of bears since December. The market is likely to remain in a trading range at least until the end of July. Sell covered calls on equities owned to boost total returns, and start to take profits gradually on highflying sectors such as energy. Despite cash flow and corporate earnings being at record levels for some time, the stock market has been slow to realize it due to poor investor sentiment. In other words, companies are slow to invest their abundant cash or spend on hiring due to uncertainty stemming from an overhanging set of issues. Nonetheless, liberal spending levels are still having a favorable impact on the consumer discretionary sector, particularly luxury items.

It is widely expected that the Fed might be nearing the end of its credit tightening, with another quarter-point hike at its upcoming meeting on June 30. Greenspan has focused on the complex integration of global financial forces and the stepped up flow of capital worldwide. Net capital flows into the US are very strong, and will likely remain so as long as foreign investors have faith in the US economy. Compared to economic problems in the Eurozone and Japan, there exists an infrastructure in the US creating business opportunities far greater than in any other country in the world, except perhaps for China's raw growth. The Euro currency is down 6% against the dollar in the past month, which is good news for dollar stabilization. Regarding China, its consumption of major raw materials (such as oil and steel) now accounts for more than 20% of global demand. This enormous appetite has contributed to a rise in the prices of commodities.

Once the summer doldrums are over, we believe that the stock market is poised to make modest gains in the upcoming months and the bond market is expected to hold steady. We recommend hedging bets against an unreported upsurge in inflation by owning up to 5% of one's portfolios in gold proxies, and to start adding other Materials stocks that are rising with global demand. In recognition of an increasingly interdependent global economy, and the need for diversification, we are targeting 15% of portfolios allocated to global stocks and bonds by the end of 2006.

Last week, Paul Volker, well respected Fed Chairman from 25 years ago, expressed his belief that a global economic crisis is looming due to several main forces: consumption overload marked by high borrowing/deficits and lowest savings rates ever. The housing bubble is pronounced in certain regions which can increase fiscal imbalances and disturb the market. Lastly, most Americans have not saved adequately for retirement, and the stock market is facing large outflows when masses of baby boomers start to retire in the next decade and withdraw retirement funds. The availability of corporate pension plans is looking more insecure. While Volker's concerns are echoed by former Treasury Secretary Robert Rubin, Greenspan believes that there is something equivalent to an invisible hand which is continuously re-addressing market imbalances to reach equilibrium. Given the above, we believe that the probability of a full-blown market crisis is about 25%.

A balanced portfolio with 70% Equity and 30% Fixed Income/Cash Equivalents is still the wisest course to manage downside risk, unless you are retired and need more passive income to support your lifestyle. The message is to stay defensive with a heightened awareness of risk management, while continuing to maintain 10-15% in cash for safety and flexibility for future buying opportunities. Minimize debt as much as possible so that any bumps in the road can be weathered. Stay actively invested in the securities markets with an eye toward sector selection. Dispassionately assess the real estate mania, where the choice of geographic locale and timing will be a huge factor in success.

April 2005
Last week saw damaging action in the market through April 15, breaking key levels in the market averages in which bearish sentiment has been heightened due to concerns about job creation and consumer resilience in the face of pricey oil, rising interest rates, and inflationary pressures. For the year 2005, the Dow is down 6.4%, the S&P 500 is down 5.7% and the NASDAQ is down 12.3%.
The trend in economic growth remains solid, yet investors believe the market is succumbing to slower economic growth. Investor pessimism is a potentially good sign, since markets tend to turn at bearish extremes. The market is at lows not seen since October '04. A slowing economy also means interest rates may not rise as much as investors had feared, which would be good news for the market. The Fed has recently signaled that it will maintain a "measured" pace of interest rate increases. We are finding selective value in the market, as some large cap blue chip stocks have been battered and are now cheaper. Most first quarter profit reports are still due for release over the next three weeks, and could lead to a mid-to-late spring rally if financial results are positive. Productivity increases are slowing yet still a favorable trend, despite the slow down in foreign student enrollment, who typically boost US productivity through their employment.

Sectors in favor right now are the defensive utilities, consumer goods and energy, with REITs, technology and a gold hedge being neutral. Financial stocks should be approached cautiously due to rising interest rates and healthcare is beginning to rebound after large pharma drug recalls, although generic pharmaceuticals and medical devices show much promise. After energy prices have taken a breather this past quarter, we anticipate oil rising by year-end to $60 per barrel.

The dollar has moved largely sideways since the beginning of the year, yet it is anticipated the dollar decline will resume. The current account deficit is at record levels, and this has had a debilitating effect on the US economy and stock market. However, net capital inflows have been very strong over the past few months, and purchases of US securities by private foreign investors have accelerated. Foreign purchases of US corporate bonds have risen to the highest rate on record. Improved creditworthiness of US businesses, due to strength in US GDP growth over the past year, in conjunction with rising rates of return have made US corporate bonds very attractive to foreign investors. China has also begun making noises that it will adjust its exchange rate peg with the US dollar. This makes quality corporate bonds attractive for our clients.

Regarding real estate, there is a housing bubble developing in major Northeastern and West Coast cities as well as any waterfront areas in California, greater New York and anything in Florida and other parts of the east coast. What continues to drive real estate prices is the demographics of baby boomers buying second homes, the move to warmer climates as well as foreign investors taking advantage of the weak dollar to pick up land and spacious properties that are not available in home countries. There are opportunities to leverage multiple real estate holdings in relatively rapid turns, as prices will not deflate until interest rates move much higher. It makes sense to have the primary residence largely debt-free, as many high income tax payers lose mortgage interest deductions anyway, and home equity can be reasonably tapped to buy other highly appreciating assets.

In light of the above, it is our recommendation that cash portfolio levels remain at 10 - 15%, and that the international allocation gradually rise to 15%, as a currency hedge and to participate in faster economic growth in certain developing regions, particularly Asia. Take advantage of market weakness to pick up some cheap blue chip stocks. While the US economy is burdened with unprecedented debt and moderate inflation is trending upward, there is still no other financial market in the world that is more transparent, deep or developed as the US for investors in financial assets. Politically, peace is beginning to break out all over in the world's hot spots, so we wouldn't write off the US capital markets just yet.

January 2005
Now that the uncertainty of Iraqi elections has moved to a successful outcome, this could be the start of peace breaking out all over in 2005. We've used the recent market weakness in January to add to equity positions, while keeping the recommended portfolio cash allocation at 10-15%. Medium and small cap stocks are still the preferred vehicle, although some mega cap mergers will fuel the market this year as well.
Healthcare is very weak lately due to the Vioxx recall and more recently with the Celebrex issue. Expect short-term weakness from big pharma, yet we still like the long-term growth potential of sector due to the aging population. Short-term we tend to be more defensive going with diversified pharma, medical device companies and generics who will benefit from increasing number of patent expirations over the coming years.

We continue to see oil prices remaining high as tensions in the Middle East and the threat of terrorist attacks persist, as well as insufficient long-term energy supply for demands of growing global economies in Asia. Potential alternative sources of energy such as nuclear and natural gas can benefit certain utilities as the US tries to reduce its dependency on oil. Continue to be defensive with investments in the energy sector and gold.

The US is in a rising interest rate environment with risk of inflation although the Fed has done a nice job controlling this with measured rate increases and more transparency. Spreads on longer-term treasuries (10-yr notes) have not risen over the past 7 months despite the Fed increasing short-term rates by 1.25%. As a result, long-term treasury holders face more risk with less return over the near-term. While high-yield bonds performed well the last two years, we don't expect this to continue in the future. Overall, within the fixed income universe, we recommend a heavier allocation to inflation protected securities, shorter-term treasuries, and higher credit-quality corporate bonds.

November 2004
With the uncertainty of Presidential election behind, the US financial markets have rebounded nicely with the S&P 500 making an important technical breakout. Stocks are having difficulty making lasting progress in 2004, although inflation has remained surprisingly quiescent. Worker productivity continues higher and corporate profits remain strong, although earnings growth is decelerating.

Energy has been the best performing sector in 2004, which is expected to continue, and utilities have been positively defensive. Financials will continue to benefit from increased M&A activity, yet we are wary of large cap pharmaceuticals after the ripple effect from the Merck-Vioxx recall debacle. Emerging markets are outperforming their US counterparts' averages, so as the dollar falls we are boosting the weighting of non-US stocks and bonds from 5% to 10%. The US dollar is back to where it was in the early '90s trade weighted; yet the universal pessimism may be overdone. However, the mounting US deficit is clearly weakening the US dollar.

The US stock market is still a good place to be, at least through mid-2005. Investor sentiment is bullish, and the conviction in a longer-term recovery is good for small cap stocks. However, the extended bull market of 1982-2000 is long over, meaning that one can't exclusively follow a strategy of buying and holding any longer. From a trading perspective, it pays to be nimble in this market.

Regarding bonds, the Fed is widely expected to keep raising rates for months to come, gradually moving them up from last year's 45-year lows. Despite a resilience in Treasury bond prices in 2004, we continue to recommend underweighting bonds except for short duration and inflation-protected bonds, the letter was a top performing bond sector. High oil prices are draining some purchasing power, yet $10-20 of current oil prices is pure risk premium. Nonetheless, real oil prices are not as high as they were in the 1980's, when they hit a $90/gallon nominal equivalent price.

Real estate is still a bright spot, as investors have shifted a growing portion of their financial assets into real estate. Individuals are leveraging up their houses, still prompting talk of the ripple from a housing bubble, which we don't perceive as a large risk. REIT stocks have bounced way back from their April lows, so it is recommended to retain current holdings. Some big players are shifting toward commodities, and we are focusing on gold and oil as a way for individual investors to hedge their portfolios.

With year-end fast approaching, feel free to contact us with tax-related and asset allocation rebalancing questions. Even with historically low tax rates, December is a good time for making charitable donations or gifts of highly appreciated stocks. Permanent estate tax elimination, while rumored, may not have the votes to be legislated. Due to our outlook for the market, the recommended cash allocation is lowered to 10-15%.

September 2004
The summer ended with a whimper as trading volume remained unusually low and economic data softened. The first week of September brought some welcome relief to the market averages, which had spent most of the summer in negative territory. Stay the course with fundamentally sound companies having positive or growing cash flow.

With the Presidential election uncertainty continuing, to be resolved in a mere two months, hostilities in Iraq showing no signs of abatement, and high oil prices dragging the economy and consumer sentiment, conditions are uncertain and hard to measure. Such lack of resolution creates a drag on the financial markets.

The Fed meets on September 21 and is expected to raise interest rates by 25 basis points for the third time. Fixed income investments have made an impressive rebound since their big drop in April when the Fed signaled the first of two interest rate increases this year. As rates continue to rise, it could make equities less attractive on a risk-adjusted basis. Fixed income will still be attractive for retired investors as long as interest rate rises are gradual.

For the above reasons, plus no definable finishing points for global terrorism and the upward trend in US interest rates, we have raised the cash allocation recommendation to 20% from 15%. We recommend selling covered call options to protect appreciated equity positions, and lightening up on long-term fixed income investments in favor of short or intermediate maturities.
Common stocks are still a good investment, as businesses continue to invest and productivity is strong during a solid expansion in the US economy. Inflation remains tame, with the exception of energy prices that are partially being driven by speculators.

Given the huge US deficit, we are advising clients to expect tax rate increases irrespective to who wins the election. For those with discretionary transactions where capital gains can be taken this year, the 15% long-term federal capital gains tax rate looks like an exceedingly attractive opportunity. Employment taxes might increase significantly in 2005, to help keep the social security trust fund coffers full for the coming onslaught of baby-boomer retirements in the decade; this could dampen hiring.
June 2004

Interest rates have been the financial story of the last two months. While the Fed still hasn't raised short term rates off their 40-year lows, the market widely expects a 25 to 50 basis point increase this summer (most likely beginning at the next FOMC meeting 6/30/04). Strong growth in the economy and inflation concerns are the catalysts that have caused the Fed to signal an intent to raise rates gradually.

For retired investors living on a fixed income, this transitional period has been particularly difficult, as inflation will erode the value of bonds already held, even with no dividend impairment in sight. We recommend lightening up on long-term maturities and certain closed-end bond funds, and shifting into high dividend-paying equities.

Growth in corporate profits will increase M&A activity, thus helping financial and technology stocks. While utility stocks are not as growth oriented as other industries, they tend to pay high dividend yields. Select energy stocks also have good yields and continue to rise with the price of oil. To protect against uncertainty in the interest rate scenario, we continue to recommend a 15-20% asset allocation to cash.

If you or your parent(s) are affected by the impact of rising interest rates on your investment portfolio, please contact us for a strategic discussion. To help clients plan for their aging parents, many of whom live in a different city, Sanders International offers financial support services to give you and your loved ones peace of mind. We care about the challenges posed by demographic shifts and trends.

March 2004
The market correction we expected in December 2003 is occurring in March 2004. The market was due for a pullback after the healthy rebound in 2003 on all fronts except domestic job creation. Our recommended cash allocation has been reduced from 20% to 15% for most portfolios. The Dow and S&P 500 are back down near 10,000 and 1,000, respectively, which are good entry points for deploying some accumulated cash as the economic recovery continues.

With terrorism fears back in the forefront after the Madrid bombings, gold and precious metals should continue to be a safe haven investment. We continue to favor small and mid-cap stocks as offering more potential for growth and value than large companies. Corporate spending overall is finally strengthening, which is a positive sign for the economy and the market. Capital appears, at this stage of the business cycle, to be relatively cheap, as interest rates remain low. Businesses are poised to replace consumers in 2004 as primary drivers of the recovery. Inflation is under control except for energy prices, while wage increases are still tempered by the rise in productivity.

There are several key investment themes for the coming year: Media companies will benefit from increased ad spending due to the improving economy, Presidential election and Summer Olympics. Data processing and outsourced services will continue to benefit from corporations seeking cost control. Demand is increasing and growth is accelerating for global technology, including software. Biotech companies have innovative pipelines and are potential M&A targets. Diversified financials are experiencing positive earning momentum. India's economic boom is continuing due to service outsourcing while China valuations are beginning to be stretched relative to other emerging markets. US interest rates will maintain historic lows until 2005.

Our country is seeing some of the lowest Federal income and capital gains tax rates in sixty years, and certainly considerably lower than in most other developed countries. From an investment standpoint, if one has long term capital gains that you've been wanting to realize, 2004 is as good as it will get tax-wise. Due to the soaring government deficit, if the Republicans win a second Presidential term they'll likely have to raise taxes. Should the Democrats capture office, taxes will rise to reduce the deficit and cover social services such as healthcare. Either way, we recommend approaching today's low tax rates in an opportunistic manner. The Alternative Minimum Tax (AMT) will grab many unaware middle class Americans in the future and this will be disturbing to taxpayers.

January 2004
The markets ended 2003 on the upside with much flourish in December, more than I anticipated in the last President's Message. Despite orange terror alerts and the jobless recovery, all equity market indices are in a mini-bull market that I would consider over done. Given the number of stocks that are hitting all time highs on low volume, we continue to maintain a 20% recommended cash allocation, to manage risk when the inevitable dip comes.

While not a promising long-term investment for those with a growth objective, bonds are a good risk neutralizer to place some excess cash and earn ongoing yield. The Fed continues to signal an accommodative policy that is friendly to fixed income holders. At present we see good value in high yield bonds, intermediate term muni bonds and A-rated corporates.

Our position on gold hasn't changed since last year. Despite the run-up in price, we see gold as a good alternative investment in uncertain times for 2-4% of one's portfolio. We've been taking some profits on energy stocks that spurted higher in the past month or two. Dividend paying stocks still look attractive, including financials, healthcare and even slow growing utilities. Small and mid-caps have more fast growth potential than large caps, particularly in the technology and biotech sectors.

The consensus of U.S. economists is for a 4% growth in GDP in 2004; some are even forecasting 5%! Such growth is likely due to pent-up demand on the part of corporations and government, coupled with earnings improvement and expansion the past few years. The ever increasing productivity in the U.S. is keeping a damper on job growth, and coupled with the shift of blue and white collar jobs to Asia, we expect unemployment to stay at current elevated levels of 5-6%.

For those of you that are joining our dual 10th Anniversary celebrations in Atlanta and Florida this month, thank you! We appreciate your support and look forward to more good things to come as we help you make smart financial choices! We're also pleased to announce the addition of a new Advisory Board member, Elizabeth Noe, a Partner in the Corporate Legal department of Paul, Hastings, Janofsky & Walker, LLP. See Elizabeth's impressive bio on our website.

November 2003
The Dow is hovering at 9,625, almost exactly where it was at the time of our last message two months ago. Yet we've gone higher and now all indices are drawing back. We believe the market will continue to drift lower between now and year-end, and that gains should be harvested where possible. Capital gains tax rates are lower than they've been in a lifetime, so now is the best time to trim overly concentrated positions or take annual gains.

Gold is now up 50% this year, and as long as geopolitical uncertainty continues, gold will remain a safe haven. Due to our view of large-cap growth stocks being overvalued, as well as many mid-caps (witness the great number of stocks achieving 52-week highs in November), we're upping the recommended cash allocation to 25% for Growth portfolio objectives. Clients seeking Growth & Income are fine maintaining a 20% cash allocation due to their higher concentration of fixed income.

We are gratified by the overwhelming response to our comprehensive financial management service offering that was rolled out early this year. We'll be presenting various financial planning topics in a quarterly newsletter such as retirement planning, tax advantaged investing for children and grandchildren's education, insurance/risk management issues, debt management tips and philanthropic planning. We'll work as a team with you and your trusted attorney on estate planning topics. Pointer: don't overlook the importance of a Living Will or Durable Powers of Attorney for Healthcare.

Economically speaking, interest rates are due to rise from historic lows in mid-2004, although for now we're not overly concerned about the valuation of fixed income securities. The continuing morass in Iraq as well as the ballooning deficit point to the inevitability of rising tax rates in future years. It is too soon to call the 2004 Presidential election, although if the economy continues its gradual improvement and terrorism abroad becomes accepted as the new reality (not on U.S. soil), then Bush will probably win re-election, which will help affluent Americans. House passage of the first Medicare prescription drug benefit beginning in 2006 will bolster Bush's support among seniors.

September 2003
The summer is now drawing to a close with the Dow at a 15-month high at 9,645. Despite a jobless recovery, record deficits and a lingering crisis in Iraq compounded by looming crises in Iran and North Korea, the market continues to rise. The Nasdaq in particular and tech stocks have risen even more than other indices such as the S&P 500. Is the party over? Until we see more compelling valuation reasons to buy (besides jumping on a moving freight train) we'll remain cautious and buy securities that our analysis tells us are undervalued, such as many smaller cap stocks. We also find segments of the bond market somewhat undervalued at present such as munis and corporates.

The rapid growth in parts of Asia, such as China, cannot be ignored, just as the 40% rise in gold funds this past year cannot be ignored. We are recommending that clients participate in this continuing trend by having up to 5% of their financial assets allocated to gold and China.

We are thrilled to be coming upon our firm's 10 year Anniversary in the next few months. Stay tuned for more information as well as invitations to anniversary celebration events we are hosting in Atlanta on January 15, 2004 and in Boca Raton, Florida on January 18, 2004. We truly appreciate the relationship with all of our loyal clients as well as welcome new clients to the Sanders International "family". It is our privilege to be able to serve you.

July 2003
Now that the broad market averages have run up low double-digit returns in 2003, we are again raising our recommended cash allocations back to 20%. Given the persistent softness of the economy, particularly the "jobless recovery," we do not expect the market to end the year much higher than it is now. That would point to a defensive strategy seeking to preserve gains.

With the latest Fed rate cut of 25 basis points, interest rates are at a 45-year low. This has singly kept the residential real estate market incredibly buoyed to levels that will not be sustained once interest rates start rising again in 2004-2005. As long as US consumers are able to easily pull equity out of their homes, consumption is holding steady while business spending is lagging.

The sweeping federal tax cuts will benefit the pocketbooks of most Americans, except the poorest, and this fiscal stimulus should spur the economy in the first half of 2004. The ballooning federal deficit is a matter that is being swept under the rug for now, until the baby boomers start retiring and the US feels the crush of supporting increased retirement and healthcare needs. The new Congressional developments to overhaul Medicare show some future promise.

The sectors we favor are financial (due to low interest rates), healthcare (due to demographics and newly researched products), real estate (due to still-high dividends despite vacancies), well-rated preferred stocks (due to stable high dividends), selected defense stocks, and gold (as a hedge). In spite of the dividend tax cut, which has boosted the popularity of taxable dividend paying securities, intermediate tax-free municipal bonds are still looking like an attractive proposition.

May 2003
Our recommended asset allocation for cash is being reduced to 15% from 20% in recognition of the trailing off of the three-year bear market into a transitional period. The Dow keeps returning to a level of around 8,500, up 3%, while the Nasdaq has shown more robust gains in 2003, up 14%. A cautious amount of cash can be moved into equities to participate in the market rebound while corporate profits gradually improve.

Fixed-income investments are still relatively attractive in the near-term, both munis and taxable bonds. With the Fed holding the line on historically low interest rates, this mitigates interest rate risk and offers a steady, modest return although little upside. The fear of deflation could lead to one more interest rate intervention cut on the Fed Funds rate. Preferred stocks are still quite attractive.

Unemployment levels in the US are troublesome, with the ranks of jobless heads of household still growing, causing continued economic pressure. The promised $550 billion tax cut plan is unlikely to generate 1 million new jobs, while spiraling federal deficits puts the future generation behind the eight ball and trickles down to state and local governments that cut services and raise property taxes. Now that the Iraqi hostilities are behind us, however, the cost of winning the peace still weighs on the US.

The SARS epidemic is already causing economic contraction in Asia, while US manufacturers continue to move production offshore. At the same time, the dollar continues to weaken, which should help US exporters. The US economy and geopolitical situation is in a delicate balancing act, yet the market has proven resilient longer term. We are advising clients to stay committed to a long-term investment plan during troubled times.

March 2003
Now that the US has completed four days of its "coalition-based" war on Iraq, the outcome is still unclear. Investors have propelled the Dow to an 8.4% gain this past week, largely due to technical buying and an end to months of pre-war uncertainty. However, the images on TV, while uplifting for US psychology, are inflaming anger and passions in the Arab world, which will likely result in retaliatory action or another terrorist attack.

Our stance is to maintain a cautious, defensive posture in one's portfolios, selectively take gains while the market is up and hedge equities with covered call options before the US suffers a setback in the war leading to another sell-off. A cash position of 20-25% is still reasonable under the circumstances. While gold has dropped the past month, a small portion of portfolios should still be allocated there (2-5%) for diversification and hedge purposes. Interest rates will remain low, and new purchases of fixed income securities will be relatively safe yet not as profitable as in 2002.

Even when the Iraq war concludes, the US economy is not on solid footing, having suffered six months of business and consumer paralysis. While the residential housing market has held its value better than most other asset categories, the sector is leveling off. Individuals should resist the temptation to liquidate financial assets near the bottom to reinvest in real estate assets near a peak, unless it is for mortgage pay-offs, which we consider quite prudent.

January 2003
Our country is on the brink of either a war with Iraq and maybe North Korea or the hopeful exile of Saddam Hussein to another country. There are some eerie parallels with the Cuban missile crisis of the early 1960s, although the times and players are different. Either way, the market could be exposed to dramatic swings depending upon how long the conflict continues or how much loss of life ensues. No wonder why gold, traditionally a poor investment, did so well in 2002 as a safe haven; we expect gold's gains to continue in 2003.

The US economy, and the global economy ex-China, is stuck in its own weakness due to uncertainty, high unemployment, and slow capital spending. Yesterday's technology favorites are not necessarily going to work in the next economic cycle. The new themes for capital allocation will be security industries, defense forces, and energy generation build up. Healthcare remains a dominant theme due to ironclad balance sheets and because there is an aging population.

The proposed corporate dividend tax cut - $364 billion of the total $670 billion, ten-year tab - will likely not pass in its current form, if at all, because it is too expensive (the same price as a seniors' prescription benefit), impacts too narrow a segment of the population and will not provide immediate enough stimulus to kick-start the economy. The market may go down and test lows a couple more times before stabilizing and heading up for a modestly positive year. More details will be provided after the President's State of the Union address on January 28, 2003.

While inflation is tame, and deflationary fears are filtering into the public psyche, businesses have largely lost their pricing power. The lack of an inflation threat means the Fed will continue to have a free hand to react to any prolonged weakness in the economy. That said, interest rates will stay low this year and fixed income investments are still a conservative alternative in short to intermediate maturities. Closed-end bond funds trading at a discount can also be attractive.

We continue to recommend keeping a 20-25% cash cushion, we prefer dividend paying value stocks to growth stocks, and continue to sell covered call options as an equity hedge wherever possible.

November 2002
The market has made dramatic moves off its October 2002 lows and will likely continue to drift higher approaching year-end. However, the economy is not out of the woods yet and we would be remiss if we did not brace ourselves for future shocks. Consumer confidence is at a nine year low and uncertainty regarding war and terrorism is still holding back the financial markets. Corporate governance is also still evolving to a more regulated model with Board controls. The rising rate of mortgage foreclosures will likely put pressure on housing prices.

The bright spots are worker productivity, low interest rates, moderate inflation, and the prospect for further tax relief for investors on the 2003 horizon. Likely tax cuts include some sort of partial exemption on the taxation of dividends and an increase in the amount of capital losses that can be deducted from ordinary income (current limit of $3,000/year may rise to $10,000/year).

The big bombshell looming under the surface for next year is the under funding of pension obligations. Some industries have pension obligations that exceed the market value of their companies. The implication is that worker claims on future corporate earnings may crowd out the shareholder's interest. Such heavy unfunded obligations could easily depress share prices.

Tactically, we recommend keeping a 20-25% cash cushion, tend to prefer dividend paying stocks, and selling covered call options as an equity hedge. Now that the Fed has cut interest rates another 50 basis points, we are not buying bonds as aggressively as earlier this year due to interest rate risk. We are, however, holding on to quality fixed income and preferred stocks.

September 2002
The financial markets dislike uncertainty so the Dow will likely drift lower during October, which historically is a difficult month. We expect to see Dow 7200 before the market picks up somewhat prior to year-end. The typical erosion of equity portfolios by 25%+ this year is an ugly and painful picture for retirees and baby boomers alike.

Where can one hide in this market? A cash allocation of 25% is not unreasonable, for stability. Fixed income investments have been a bright spot while interest rates remain at a 40-year low. Minimizing or eliminating one's debt is a good way to reduce expenses while riding out the storm.

The impending Gulf War II will likely divert attention away from the struggling US economy by November. The economy will shift to a wartime economy for the duration, with different sectors growing than during the booming '90's. Healthcare companies will prosper in any type of economy due to demographics of an aging population.

When there is "blood in the streets" and the masses are running scared from equities, that will be the time for cool-headed investors to jump back in with cash they have been holding, most likely in mid-2003. It is unlikely that the Fed will raise rates any time soon, so for the time being fixed income is a relatively safe place to "park" cash.

The sectors that will emerge when equities pick up are defense-related manufacturing and technology, energy and fuel sources, financial services, and consumer non-durables. There has been much talk about gold, yet historically gold has not been a good long-term investment. Stay the course with a well-diversified, balanced portfolio. Monitor your stress levels to avoid allowing emotions to control investment decisions.