Newsletter_6

Q4 2012

We stated in a recent communication after our client survey that we are sending out a quarterly newsletter going forward. As the last several years have been a difficult investing period with many challenges for all investors and most asset classes, we definitely want to make sure that we help clients understand the Cornerstone approach and investment philosophy. We hope these newsletters will put performance in context of the general markets and maintain your confidence in our approach. Click here to view Newsletter in PDF format.

 

Market Overview

August was a fairly dull month across markets, but most investors were happy to see subdued market activity. Most equity and commodity markets reported historic low trading volumes indicating that investors are delaying decisions until later in the fall. “Risk on” assets such as stocks and commodities managed to move higher in August. Bonds were largely flat.

 

Policy makers returned to the spotlight this fall with the European Central Bank meeting early in September and announced a program that will intervene in the bond markets for struggling Eurozone nations that commit to fiscal reform. Now, even a month later, with no question that Spain needs a bailout, Spain has not yet committed to reform. While the program was a necessary step, it will only work if a country agrees to the required conditions.

 

The next week was the U.S. policy makers’ turn as Fed Chairman, Ben Bernanke, committed the Fed to quantitative easing (most call it printing money!) until unemployment significantly lowers. In essence, Ben put an unlimited easing policy in place by signaling that the policy would continue until the recovery was strongly in place. It appears that this means that controlling inflation has moved down the priority list and lowering unemployment is their top priority. While many may believe this is a good choice, it definitely has investment implications we’ll discuss below.

 

In the last few weeks, markets have fallen back as European debt fears have resurfaced with civil unrest, and U.S. economic data has come in below expectations. Here are a few key global themes that we are watching:

 

  • Economic data (in other words, headlines) will drive risky assets as investors gauge the effectiveness of the recent Fed activities. After a summer of falling correlations across asset classes, markets have started to once again move together with headlines. The upcoming unemployment reports will be an important catalyst.
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  • While ongoing Fed support may provide a support to stocks, the economy is still stalled with current GDP figures dropping below 2%.
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  • It appears the actions by European and U.S. leaders were fairly priced into the markets before the announcement dates as markets have only moved sideways since. This leads us to question, what will it take to keep markets buoyed going forward?
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  • The Eurozone bailout program may limit the biggest risk of Europe, its banks, but eyes will now turn to the U.S. as Americans face the fiscal cliff. If we go off the fiscal cliff, a recession is almost certain here in the U.S.
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Market Outlook

Below are a few bullet points from our outlook for the fall and year-end.

 

  • Ben Bernanke will continue to backstop the equity markets. The printing of easy money will continue, but it will be less effective than previous attempts at stimulating the economy.
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  • U.S. GDP will continue to stall below 2% into 2013 which means unemployment will not drop significantly.
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  • As we predicted, Bernanke stated he plans to keep interest rates low through 2015. Negative real returns for investors should bode well for hard assets such as precious metals and real estate.
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  • Currencies will play a bigger role as the Fed wants to weaken the dollar, but the crisis in Europe could keep the Dollar as a safe haven investment. A strong dollar will also have negative effects on U.S. companies because it will lower reported revenues fromforeign countries.
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  • Housing has bottomed in many areas which will be a positive for the economy. The housing sector has seen many improvements over the last six months. We expect a saucer recovery in most areas, but some areas that currently only have 1 or 2 month supply will recover much quicker.
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Investment Highlights

Using the above as our backdrop, below are a few thoughts on different asset classes that affect our current allocation strategies. In the current environment there are significant headwinds as well as potential catalysts we feel could improve the economy if Congress would act responsibly. We continue to maintain a diversified investment strategy that attempts to protect portfolios against the known and unknown risks facing investors.

 

Bonds - Although the upside of bonds has decreased substantially in the last year (how much lower can rates go, right?) many would argue it’s useless to fight the Fed. As one of our bond managers, Len Templeton, wrote, “What began as an emergency response by the Fed, has now become a standard monetary tool. This concerns us, because our studies show the Fed has been more effective in increasing inflation, than in creating economic follow-through.” For this reason, Len has started to use Treasury Inflation Protected Securities (TIPS) in some of his portfolios as he believes CPI, a measure of inflation, could increase in the short-term. Len still believes we are in a low interest rate period, but he would rather have the option on the CPI than hold bonds which yield less than the inflation rate of around 1.6%. In this environment, we also see the advantages of using managers which have the ability to go where the opportunities are. In many portfolios we have moved to a multi-sector bond fund which offers more of the flexibility the current environment demands, rather than a core bond fund.

 

High-yield Bonds - This asset class continues to be an outperformer in 2012. As companies have piles of cash sitting on their balance sheets, default risk remains low. This asset class has seen an increase in inflows, but continues to perform well. We see it as a good diversifier to stocks. If a client wants to take on more risk, but remain out of the stock market, high-yield we believe remains a good area.

 

Stocks - Stock mutual funds have seen over $117 billion withdrawn in the last 12 months. The continued flight from U.S. equities came as the market continued its summer melt-up. In August, investors poured over $36 billion into bond funds while pulling out $22 billion from U.S. stock mutual funds. Investors continue to fear the stockmarket. In 2012, the best investment in the stock market has been in index funds and ETFs. Managed and active funds have lagged considerably this year as “risk on” and “risk off” days have made managers cautious. This has caused our equity portfolios to lag this year, but we are still confident in the managers ability to perform over market cycles.

 

Real Estate Income - The multi-family sector of market has seen a lot of investor money come in to acquire assets. This bodes well as many clients have invested with Virtu over the last two years in the space. Virtu was able to sell one property this summer, and we hope that the continued recovery in this space will lead them to sell other properties that they managed during the downturn. Landsmith was also able to sell almost 60% of their portfolio of single-family homes in less than a year for about a 15% return as Phoenix market improved this year. However, we believe that the opportunity to buy in the multifamily sector is closing in many areas. We have recently begun a relationship with a group that will acquire properties in the commercial market, where we believe the next opportunity to buy from distressed sellers is. We still think real estate presents a great investment opportunity as well as diversification from the stock market. Specifically, we think the opportunity to generate cash flow favors this real estate sector in particular.

 

Real Estate Growth - As mentioned above, we believe the current opportunity with real estate is to acquire great properties that have existing cash flow with additional upside potential. However, we still believe that our investments in real estate acquired from distressed sellers the last few years will continue to perform. Residential real estate has seen good improvements over the last six months, with activity starting to pick up. This improvement should bode very well for clients invested with Landsmith and their finished lots as home builders start to acquire lots for future use. The lows interest rates maintained by the Fed should continue to help this sector. However, we know that one of the main headwinds lies in the difficulty for households getting approved for a loan. If banks would begin to loosen their credit, it could be a big catalyst for real estate.

 

Commodities/Managed Futures - Over the last twelve months these asset classes have been the biggest drag on clients’ portfolios. The “risk on”/”risk off” mentality of the markets is not conducive to great performance in managed futures which wants to follow trends whether up or down. However, history has shown that this is not an asset class that can be traded over a short period of time. The below chart shows historical growth of $1,000 from 2000 through 2010 for the managed futures asset class. As you can see managed futures was a great diversifier during the two prior recessions and performed fairly well during bull markets but did lag. In the end, it shows that consistent exposure to the asset class does lead to better performance and lower volatility. That is why we continue to maintain exposure to the asset class. Gold, other commodities and real estate have the potential to perform well for investors during a negative real return environment.

chart

As this is our first newsletter, we welcome your thoughts and feedback. We hope you found it valuable.

 

Disclosures: This commentary is submitted for the general information of Cornerstone Wealth Management, LLC clients and may not be distributed to other individuals. This commentary is not deemed to be investment advice and information contained herein may not be current. An investor should consider the investment objectives, risks, charges, and expenses of each investment carefully before investing. For more complete information, you may contact us at 858-676-1000. Past performance is no guarantee of future results. Individual performance may vary and investment performance numbers may not be audited.