Lewis Wealth Management

Investment Management, Financial Planning, Consulting

Quarterly Newsletter (4th Quarter 2011)

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Please see our most recent newsletter that reflects upon 2011 and sets forth some investment strategies to help you navigate 2012.  The newsletter can be found at our web site.  www.LewisWM.com.

Written by Lewis Wealth Management

January 17, 2012 at 3:27 pm

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Newsletter – 3rd Quarter 2011

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Please see my new Newsletter summarizing the difficult 3rd quarter where we review the quarter the discuss strategies for moving forward.   www.lewiswm.com.

Written by Lewis Wealth Management

October 16, 2011 at 6:45 pm

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S&P Downgrade

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Please visit my website for my Special Edition Newsletter regarding the S&P Downgrade.  www.LewisWM.com

Written by Lewis Wealth Management

August 8, 2011 at 10:40 am

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Newsletter – 3rd Quarter 2010

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Executive Summary 

The third quarter of 2010 was a good one overall.  Both stocks and bonds are up year-to-date through September.  The outlook for the US economy remains mixed.  We are in an economic recovery, but it remains fragile.  The Fed is poised with another round of quantitative easing, but it can only go so far.  The national deficit remains a concern.  It must be managed and lowered over time.  If not, our future prospects for growth will be subdued. There are a lot of policy and tax issues that need resolution in Washington before the end of the year.  We all need to pay close attention, especially on the tax planning side.  The risk of policy error is heightened.  As investors, we are currently earning our risk premiums by staying disciplined during turbulent times.  This discipline should be rewarded in the long run.

Quarterly Investment Commentary

The US stock market had a solid third quarter.  The S&P 500 was up 11.29% for the quarter (up 3.89% for the year).  The US bond market, as measured by the Barclays Aggregate Bond Index, was up 2.48% for the quarter (7.94% for the year).  The markets in general continue to be a roller coaster, but equity markets have broken out of their previous range to the upside.

The Outlook for the US Economy

The National Bureau of Economic Research recently announced that the Great Recession officially ended in June 2009, marking the country’s longest and deepest recession since the 1930’s.  But why don’t we feel like celebrating?  It’s because there is still so much uncertainty about where our country is heading the next few years.  Economic historians would remind us that this is not an unusual state of mind during a recovery from a severe economic shock.  To be sure, there are reasons to be both bearish and bullish right now. 

The Bear Case

There are ongoing structural headwinds in our economy.  Consumers are in the long process of deleveraging.  Unemployment remains high.  Real GDP growth has decreased since the fourth quarter of 2009.  Credit is tight, and for small businesses, largely unavailable.  Housing markets are weak.  State and local governments (facing large budget deficits) are cutting back.  The federal budget deficit has ballooned.  There is tremendous uncertainty in Washington as the mid-term election approaches and there are many difficult policy issues to resolve before the end of the year.  As the baby boomers retire over the next 15 years, there will be challenges to our entitlement programs like Social Security and Medicare.

The Bull Case

We are in a recovery.  Industrial production and earnings have rebounded strongly.  Profitability is high (although due to aggressive cost cutting) and companies have very high levels of cash on their balance sheets. There has been a sharp rebound in merger and acquisition activity.  Emerging economies are showing strong signs of growth (which is good for investors and domestic multinational corporations).  Inflation and interest rates are low.  The personal savings rate rose to 6.1% in the second quarter (in the recent past, it was negative).

What’s the Fed Up To?

The Federal Reserve recently announced that it is ready to embark on a second round of “quantitative easing” (the so-called “QE2”).  Quantitative easing is the process the Fed uses to increase the money supply by buying securities, such as US treasury obligations, in the marketplace.  The seller of the security receives cash printed by the Fed, which increases the money supply.  The Fed’s objective is to increase the money supply thereby keeping interest rates low.  There are several consequences to this strategy: 1) the dollar will move lower relative to other foreign currencies (because of the relative increase in the supply of dollars); and 2) interest rates will remain low (good for borrowers, not so good for investors seeking yield).  The stock market is relying on QE2 if the recovery should falter, so we should keep our eye on the Fed.

There is a problem, however.  While the Fed continues to increase the money supply and its balance sheet, the velocity of money running through the economy (the money multiplier) remains low.  The Fed has less control over the multiplier.  Recall from our economics class that when new money flows into the economy, it multiplies.  For example, when new money is received by a bank (when it sells securities to the Fed, for example), it usually lends that money to businesses and consumers who will spend it on other things, and the recipients of those purchases will spend it on yet more things, and so on, and so on.  The problem is that banks have not increased lending.  Instead, they are building cash positions on their balance sheets.  Consider the following chart.  Until banks start lending, the Fed’s efforts to stimulate growth will have a muted effect on the overall economy.

What about the Deficit?

The US national deficit remains a serious concern.  Most respected economists believe that the Fed was forced to increase the size of its balance sheet to avoid a financial catastrophe and a second Great Depression.  The same can be said for the fiscal stimulus (of course, how the fiscal stimulus was spent will be the subject of endless dispute, some of which will be resolved by voters in the upcoming mid-term elections).  As you can see from the following chart, the debt burden has been radically shifted from the private to public sector; that is, when the private sector went underground in 2008, the public sector rushed in to fill the financial void as the lender of last resort.

But are these deficits sustainable?  The answer is no.  Consider the following chart that shows how many dollars of public debt it takes to create $1 of gross domestic product (GDP) (see the far right hand column).  Right now, it takes over $5 of public debt to create $1 of GDP.

Studies have shown that once a country reaches a point where its public debt is above 90% of its GDP, the underlying economic growth rate falls off substantially.  The US economy reached the tipping point this year.  The US federal debt is currently 93% of GDP.

Clearly, the US deficit must be carefully and prudently managed and reduced over time.  If not, we can expect below average economic growth in the US for the immediate future.  The US debt burden is easily financed at current low rates, but when those rates rise, the interest expense will follow accordingly.

The Political Angle

Regardless of the results of the upcoming mid-term elections, there is a lot of work to be done in Washington before the end of this year.  As you know, the Bush tax cuts expire on December 31.  If they do, tax rates will increase to prior levels on a variety of fronts.  In addition, Congress has neglected to fix to the estate tax situation.  If an agreement cannot be reached, the applicable exclusion amount will revert to $1 million with a top rate of 55%.  While a $1 million exclusion sounds like a lot of money, when you consider that life insurance and home equity may be included in the estate tax calculation, many more estates will be taxable.  Also, the AMT patch has not been passed.  This has the potential to sweep many more taxpayers into paying AMT.  We should all pay close attention to Washington after the mid-term election to see if the necessary compromises can be hammered out.  For sure, the risk of policy error is heightened. 

Recommendations

We all need to stay alert between now and the end of the year.  The recent rally in the stock market was welcome, but there are simply too many uncertainties to increase exposure to equities at the current time.  It is a good time to remain disciplined and focused on our asset allocations.  Having bonds and alternative investments (like commodities, real estate, and hedging strategies) will provide some downside protection in the event the stock market falters.

Speaking of bonds, trillions of dollars have flowed into bond funds as investors see that bonds have outperformed stocks on a rolling 20 year basis.  The only other time this occurred was briefly in the 1930’s.  It would not be wise to bet that the next twenty years will be the same as the last twenty.  This is a good reason to stick to your existing bond allocation and not increase it in an attempt to chase performance.  When equity markets improve, expect the herd to sell their bonds and start buying equities again.  This will put pressure on interest rates to rise, which will cause bond prices to fall.

On the financial planning side, we must be ready to react to what is going on (or not going on) in Washington.  I will send out another update before the end of the year when more is known about the outcome of the mid-term elections and the progress (if any) on the many outstanding tax and policy issues.  Finally, if we are in for a period of slow growth, we may need to revisit our financial plans and check our return assumptions.  This may be especially true if your investment horizon is short.

While there is a lot of uncertainty, history shows that investors who stay disciplined during turbulent times are ultimately rewarded.  We are all currently earning our risk premiums.  Keep that in mind.

If you have individual questions regarding your situation, please give me a call at (303) 500-0980. 

Thank you.  Austin Lewis

Sources of Information: Charles Schwab

This is an educational newsletter expressing an opinion only.  It cannot not be relied upon until your individual situation is taken into consideration by an experienced advisor.  This newsletter is not designed or intended to give you individual investment, tax or legal advice. I strongly recommend that you consult with you own financial/tax advisor and/or legal counsel for information and advice concerning your particular situation.  Past performance is not indicative of future results.

Written by Lewis Wealth Management

November 2, 2010 at 11:20 am

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Announcing our new website. Please check it out! www.LewisWM.com

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Written by Lewis Wealth Management

October 7, 2010 at 9:40 am

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Quarterly Letter – 2nd Quarter 2010

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Quarterly Investment Commentary

Executive Summary

The second quarter of 2010 was volatile.  Stocks are down year-to-date through June.  Domestic bonds were a bright spot.

There is an economic tug-of-war being waged in the markets.  On one side, economic indicators and company fundamentals are improving.  On the other, concerns remain about household and government debt and long-term economic strength.  This has stocks trading in a range, for now. 

Most economists agree that it is not likely that we are heading for a double dip recession.

We face economic challenges going forward.  These include high levels of government debt, an aging population, and a slow and choppy economic recovery.

To be a successful in this climate it will require us to have long-term discipline and patience.  Proper portfolio design can help overcome volatility and find opportunities in difficult markets. 

Changing course during periods of financial distress is generally not a good idea, but this is exactly what average investors tend to do.  This is why they dramatically underperform the market

Full Commentary

The equity market roller coaster returned in the second quarter.  Stocks were down in June, ending the first half of 2010 with losses across all equity markets. Year-to-date through the end of June, the S&P 500 was down 6.65% and the Vanguard Total International Stock Index was down 12%.  That being said, the stock market rallied sharply in the first two weeks of July.

As for the bond market, there was better news.  The Vanguard Total Bond Market Index Fund was up 5.3% year-to-date through June. Foreign bonds were mixed.

Meanwhile, government spending has jolted the economy back to life, but at a longer-term cost to the budget deficit. Further, entitlement spending (for Medicare and Social Security in particular) is projected to grow substantially in the years and decades ahead. The deficit will be difficult to fix without damaging a fragile economic recovery.

 The Economic Tug-of-War and Double Dips

 Recent volatility reflects the economic tug of war being waged in the markets.  On one side, economic indicators and company fundamentals are steadily improving.  On the other, concerns remain about household and government debt and the longer-term strength of the economic recovery.  The tension between these opposing forces has left the market uncertain about the future and stuck in a trading range, for now.

Looking at it another way, the leading economic indicators are rolling over, that is, they are no longer experiencing sharp gains and some of them have turned negative.  Consider the chart on the following page.

According to Charles Schwab’s Chief Investment Strategist, Liz Ann Sonders, the rolling over phenomena occurs when the economy shifts gears from recovery to sustained growth (see the exits from previous recessions marked in green below).  That transition is not always smooth.  Sonders believes that the recent pull back is typical after a powerful bull market recovery.  She does not believe we are heading for a double-dip recession, but rather a soft patch followed by a long, bumpy ride towards eventual expansion. 

 

 To be sure, many economists doubt that a double-dip recession is in store. One reason may be that we have just had three solid quarters of real growth in the gross domestic product. According to Yale economist Robert Schiller, when inflation-adjusted GDP has come out of a decline and posted three or four quarters of gains, it has never immediately begun to fall again — at least not since quarterly numbers began to be issued in 1947.

Unprecedented Volatility

Consider the recent swings in the S&P 500:

October 12, 2007, to March 6, 2009 (down 56%).

March 6, 2009, to April 23, 2010 (up 78%).

April 23, 2010, to June 30, 2010 (down 15%).

June 30, 2010, to July 14, 2010 (up 5%).

The amount of volatility in the stock market is truly remarkable.  As investors, it drives us crazy.  So, what do we do about volatility?  Please keep reading.

The Challenges We Face

Household and Government Debt

As you already know, there is too much debt in most of the developed world (the US, Europe and Japan, specifically), both at the household and government level.  The process of deleveraging (i.e. paying of those debts) takes a long time. 

 At the household level, the deleveraging process will keep a lid on consumer spending.  It will take another couple of years to work through all the foreclosures, thus hampering the residential real estate recovery.  The good news is that personal savings rates are on the rise for the first time in decades.

At the government level, the developed world must walk a tightrope as it deals with the pressing need to slow and ultimately reverse debt growth without also seriously harming economic growth rates.  Too much austerity too soon risks smothering an already fragile recovery.  But waiting too long to tackle rising debt levels digs a deeper hole and risks a lenders’ strike, which could result in government borrowers (and all others too) being forced to pay a much higher interest rate to finance their debt. 

 The Baby Boomers

 Whether we like it or not, baby boomers (including myself) are getting older.  We are starting to retire, and this presents several challenges. Savings rates will face downward pressure as more of the population moves from working and saving to retiring and depleting savings, and paying fewer taxes. More retirees also mean higher Social Security and Medicare expenses.  We will be fighting these headwinds for the foreseeable future.

A Slow Recovery

While the private sector gradually delevers, and we wait for the public sector to do the same, there is no denying that the US is experiencing an economic recovery, albeit a tepid one. There has been clear improvement from the depths of the recession. The economic cycle is, for now, a plus, but the big problems have not been resolved.

Three variables critical to improvement in private-sector consumption and a normal recovery—the labor markets, credit growth, and housing—remain weak. We are still down about eight million jobs from the peak and private sector job growth is barely positive – though that is an improvement from last year. Credit markets remain tight. And the housing outlook, which is critical to household financial strength and the banking sector, remains cloudy and appears to be slipping backward with an expiration of the homebuyer tax credit.

That being said, there are positives signs. The continued impact of massive federal stimulus (though this will wane later this year in the US), healthy corporate balance sheets and cash flow (after huge cuts to expenses), and a natural rebound in economic activity after a huge decline are also sources of strength in the US and global economy.

Europe and Japan face larger hills to climb.  Europe is experiencing very slow growth, southern Europe is uncompetitive and experiencing a sovereign debt crisis.  European economic policy is a challenge given a single monetary policy , but no political union.   Japan is even more demographically challenged than we are.

The emerging economies appear to be the bright spot.  They are in much better shape with stronger balance sheets, higher growth rates, younger populations, and slowly emerging consumer sectors. Their strength is an important source of support for the global recovery.

Thus, the recovery continues, but it is a slow and choppy one.

Investment Posture

Stocks

Investing in stocks requires long-term discipline and patience, especially now.  Is the risk of stocks still worth it in the long-run?  I ask myself this question almost every day, but my answer continues to remain, yes.  I believe that stocks still provide an important source of long-term growth in most portfolios, but only for a portion of your portfolio and when you have at least a five-year investment horizon.  My current allocation in equities (US, foreign, emerging, and private) ranges from 20% (for conservative portfolios) to 60% (for aggressive ones).  That being said, I routinely see portfolios with 80% or more invested in stocks, and many of those investors are within 10 years of retirement.  I believe that is too risky.  

Bonds

Bonds are not providing very high yields these days, but they have provided a steady source of return while the stock market remains volatile.  Since current interest rates cannot move much lower (and will probably be heading higher sometime in the future), it is important to focus on high quality and short duration fixed income investments.  Those investments will fare better in a rising interest rate environment.  I also believe there are opportunities in emerging markets local-currency bonds, albeit with higher volatility.  Finally, I believe that bond fund managers with the flexible mandates and the right expertise will continue to find good opportunities going forward.

Alternative Investments

Alternative investments that contain true, conservative hedging strategies still provide an opportunity to reduce portfolio volatility, especially if they are not correlated with the equity markets.  Interestingly, some strategies that were only available in expensive and illiquid private hedge funds are now available in public mutual funds with daily liquidity and improved transparency.  I believe that a mix of these strategies is helpful to manage volatility, but only to an extent.  Caution must be exercised here.  Alternative investments can be expensive, lack traditional transparency, illiquid (if they are private), difficult to understand, and rely heavily on volatile derivatives, options, and leverage strategies.

Perspective (and hopefully some wisdom)

 Although we hate to admit it, history does provide the best perspective.  We ignore history because somehow “this time is different,” but in reality, our country and our economy has experienced and survived repeated shocks, recessions (and one depression), terrorist attacks, and setbacks.  And in the midst of those events, we have managed to grow and thrive.

Thinking back to the severe recession in the early 1970’s, we were in the middle of the Arab oil embargo; there was high inflation and unemployment.  We were going to run out of oil in 20 years.  At the beginning of 1975, the S&P 500 stood at 68 (we are now at about 1075 as I write).  There was a lot of doomsday thinking.  In 1979, there was an infamous article that appeared in Business Week entitled the “The Death of Equities,” basically arguing that the previous 10 years of poor performance in the stock market meant that equity investing was over (sound familiar?).  Obviously, the article was wrong.  I also remember the budget deficits of the early 80’s and how our grandchildren and their children would be burdened forever with our government debt, only to see our deficit position strengthen substantially only 10 years later, long before those indebted great grandchildren were even born. 

Are the doomsday prognosticators of today also wrong?  Only time will tell, but history says that doomsday is not a likely scenario.

The best path forward is to stick to fundamentals.  We should revisit our investment philosophy and asset allocations.  We made these plans when our minds were clear and our goals in focus.  These plans provide us with discipline and focus when the path forward is unclear, or when we became anxious or euphoric. 

In the world of investment management, changing course in a crisis is generally not a good idea.  Back in the depths of the latest crisis, I rebalanced client portfolios by buying equities and resisting the temptation to run for the hills.  Of course, this was not easy, but it was the right thing to do.  And this strategy was validated as those portfolios have recovered.  Those that ran for the hills remain there – their portfolios unrecovered.

If there were ever a reason to remain steady in times of financial stress, consider the following study.

According to Morningstar, over the 20 years ending December 2008, the S&P 500 index averaged a gain of 8.4% a year. The average equity fund investor, however, gained only 1.9% a year over that time frame. Equity investors also underperformed over the prior three and five years.

For fixed income investors, the results were similar as the Barclays Capital US Aggregate Bond Index gained 7.4% a year for the past 20 years while the average fixed-income fund investor gained only 0.8% a year. Bond investors also underperformed the bond index over the prior three and five years.

Why?  It is because the average investor does not have an investment philosophy, let alone an asset allocation.  They jump into the market when it feels right (usually the peak of a cycle) and out of the market when things feel bad (usually the bottom of the cycle).  They change course frequently and usually at just the wrong times.  They follow their gut.  They chase returns.

 To avoid these mistakes, let’s stick to our asset allocations, rebalancing at the peaks and troughs.  If the facts dictate that a change to our investment philosophy is truly in order, that’s fine, consider the options.  But when “facts” only serve as a mask for our fear and anxiety, we should not be misled into changing course.

As always, I welcome questions about your individual situation.

Austin Lewis, JD, MBA, CFP

Lewis Wealth Management, LLC

26 W. Dry Creek Circle, Suite 510

Littleton, Colorado 80120

(303) 500-0980

austin@lewiswm.com

Sources of Information:  Advisor Intelligence, Charles Schwab, and Morningstar.

Written by Lewis Wealth Management

July 19, 2010 at 4:15 pm

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May 26, 2010 at 7:21 pm

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Market Perspective – May 26, 2010

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Dear Clients and Friends:

The stock market officially reached correction territory and there has been a lot of volatility, which is obviously a cause of concern. The market opened sharply lower yesterday and recovered. This morning the market opened sharply higher. I thought it would be helpful to put some context around what is happening in the markets.

The Euro-Zone.

The European Union has 27 countries, all with different political and economic systems, but tied together by treaty under one currency, the euro. Some countries came through the 2008 crisis better than others. In particular, Greece, Spain, Portugal, Ireland and Italy have not fared well. These countries are burdened by very high deficits and weak, inefficient, and in some cases corrupt economies.

Recently, Greece was having some difficulty rolling over its debt. When it went to the market to issue new debt, there were not enough interested buyers. Greece was on the brink of default.

Fortunately, the European Central Bank (ECB) and the International Monetary Fund (IMF) put together a financial rescue package in exchange for some very tough austerity measures that Greece must impose upon its economy. These austerity measures will be very painful and difficult to implement in the years ahead.

Spain seems to be the next economy in distress. Earlier this week, the Bank of Spain seized control of CajaSur, a savings bank controlled by the Roman Catholic Church. Cajas are savings banks that fall under the influence of regional Spanish politicians. Spain recently suffered its own housing bubble collapse and this exposed corrupt lending practices in the Cajas. As a result, Spain initiated a process to reform these banks and merge then into the larger commercial Spanish banking system. This seizure is seen as an acceleration of that process, which is a good thing.

The IMF recently sent a mission to Spain and it appears that the IMF will recommend a wide range of reforms for the Spanish economy (like Greece).

Here are the risks.

First, European banks hold a lot of sovereign debt (like the bonds of Greece and Spain). They will be financially weakened if there are any defaults and they will be unable or unwilling to continue to make loans – creating a credit crisis in Europe that could trigger a second recession on that continent. This could be similar to our credit crisis of 2008.

Second, if the European economy struggles that will hamper growth here at home as multi-national companies based in the US will do less business in Europe. That will have a downward drag on our markets.

Third, the markets are having a very difficult time pricing in these problems. Both Greece and Spain have defaulted on their debt before, and they also have very volatile political systems. But what makes this crisis unique is that they are now members of the EU – which is tied together under one currency. This makes it more difficult to predict what might happen. How far will the countries of the EU go to preserve the union? We just don’t know at this point and markets hate uncertainty. Don’t be surprised if more rocks are thrown on the streets of Athens and general strikes paralyze Madrid.

On the positive side.

The size of the current European crisis is much smaller than the problems our banks faced in 2008. Since our own credit crisis, the capitalization of our banks has improved substantially.
The European economies at the most risk (Greece, Spain, Portugal, Ireland, and Italy) are a relatively small part of the EU’s overall economic pie.

It is encouraging to see the ECU and the IMF vigorously defend the euro by creating a fund that can assist Greece and other struggling Euro-zone economies.

There is a lot of economic data pointing to recovery in the US, but headwinds and risks are still present.

Recommendation.

There will be continued volatility in the markets. The question is whether there are any facts present to trigger a substantial change in investment policy. I believe the answer to that question is no.

There is only one real strategy to deal with this type of volatility and that is to have some downside protection already in your portfolio (which all clients already hold). Your alternative is to try to time the market, which does not work and actually increases the risk to your overall portfolio and your financial plans.

While it is difficult to watch the headlines, keep in mind that we are long-term investors and only a portion of your portfolio is invested in the stock market, and there are other assets in the portfolio that are providing downside protection.

Regards,
Austin Lewis, JD, MBA, CFP®
Lewis Wealth Management

Caveat – This is an educational blog expressing an opinion only.  It cannot not be relied upon until your individual situation is taken into consideration by an experienced advisor.  This blog is not designed or intended to give you individual investment, tax or legal advice. I strongly recommend that you consult with you own financial/tax advisor and/or legal counsel for information and advice concerning your particular situation.

Written by Lewis Wealth Management

May 26, 2010 at 2:59 pm

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