Bleeck Financial Management, Inc.

Summary

The S&P 500 index was up 2.7% for the six months ended June 30, 2016. The Vanguard Balanced index fund, which represents a portfolio of 60 percent stocks and 40 percent bonds was up 3.07%. With a less risky position of about 40% stocks and 60% fixed income our results were generally a little better. The difference was attributable to gains in individual stocks we owned.   July has seen the markets rally in spite of Brexit, Donald Trump, Hillary Clinton, Turkey, etc. As of today, July 22, the Vanguard Balanced index fund is up 5.5%. Our accounts have risen accordingly.

Individual Stocks                                       June 30, 2016             July 22, 2016

Aberdeen emerging country stocks               up 12.6%                    up 15.2%

Facebook                                                         up    1.9%                    up    9.0%

                IBM                                                                   up 10.8%                    up 16.9%

                Hewlett Packard                                              up    8.4%                    up 20.8%

                Emerging countries debt                               up   7.6%                    up    9.5%

                Google (Alphabet)                                      down    5.5%                    up      .9%

It’s not an easy task picking stocks. However, as I noted in my last letter, I believe it is necessary in the current environment because the overall stock market is expensive. This does not bode well for passive index funds that represent the entire market.

Lessons from Warren Buffett

I first became aware of Warren Buffett in the 1980’s. I bought the stock in his company, Berkshire Hathaway for about $7,000 per share (it now sells for $218,790). I sold it in the early1990s for about $65,000 per share because it became too big a position to maintain reasonable diversification.   Although Buffett has been tight lipped in regard to his holdings over the years, he has been anything but that when it comes to investment philosophy.   On the website of Berkshire Hathaway, you can read his “owner’s manual” for the company. I learned early on that his favorite stocks have a common theme – they enjoy what he calls a ‘franchise’ or what I call ‘almost a monopoly’.   That’s why I own stocks like Facebook and Google.

In November 1999, Warren Buffett wrote an article for Fortune Magazine in which he explained why he believed the stock market would not go up much over the next seventeen years and why it rose so much over the previous seventeen years (1982 – 1999). He noted that certain things have to happen in order for the market to go up:

Interest rates must fall further. This is what happened for the period beginning in 1982 and ending in 1999. With current interest rates at record lows all over the world this ingredient will be missing for the period ahead.
Corporate profitability in relation to GDP must rise.   After tax corporate profits have been coming in at a record pace over the last few years with gross profits at record highs as companies have cut expenses year after year. In the current year earnings have been disappointing as expenses are about as thin as they can be and labor costs are on the rise.
Valuations of stocks must rise. Current valuations are at very high levels historically with the price/earnings ratio of the S&P500 currently about 27. As the chart below illustrates it has only been higher three times before, in 1929, 1999 and 2006.

The move over to Charles Schwab Institutional has been sensational!   I am now able to move in and out of investment positions with very little cost. Additionally, I am able to make investments that were not available at Wells Fargo Advisors. This is extremely important when deploying cash without undue risk in a zero or negative interest rate environment.

Beginning June 30, 2016 the monthly statements from Charles Schwab are much more user friendly and provide plenty of detail on investments without being more difficult to read. Therefore, I will no longer be sending detailed quarterly reports (on Excel spreadsheets) but I will continue to send out quarterly summaries that illustrate changes in your accounts for the year to date.

   Very truly yours,

Robert M. Bleeck

For Bleeck Financial Management, Inc.

Second Quarter Results – June 30, 2015

Both the S&P 500 stock market average and Barclay’s Aggregate Bond Index were nearly unchanged for the six months ending June 30^th, 2015. Neither of these indexes take foreign stocks and bonds into account. International stocks were up 1.4% according to Lipper, a Thomson Reuters Company that keeps track of stock and bond indexes worldwide.

Actively managed funds did better than index funds for the first time in several years. According to the Wall Street Journal (July 6, 2015), “the average diversified U.S. stock mutual fund wheezed to a 0.03% return in the second quarter making the year to date rise 2.5%, virtually all of it from the first quarter.”

As I mentioned in my first quarter letter, I believe that some individual stocks and bonds are necessary along with passive funds (index funds) in order to thrive in the current economic and political environment.

Are bubbles being created again?

Most assets are very high priced. U.S. Stocks are expensive by almost any measure. They have been going up since 2009. Bonds and other fixed income items are extremely expensive after six years of Federal Reserve activity keeping interest rates near zero.

The search for earnings among investors has forced up the price of both residential and commercial real estate. In some areas such as San Francisco and Los Angeles, bidding wars are again common as they were in 2005-6.

The only items that are cheap are commodities such as oil and copper. Until there is a worldwide economic recovery, the price of most commodities will continue to lag. This is having a harsh economic effect on countries that depend on exporting commodities such as Russia, Canada, Australia, Brazil and others.

What about Greece and other European nations?

Whether Greece works out something with their lenders or not, I don’t think it will make much difference to the Greek economy. In an article in the New York Times last week, Paul Krugman wrote, “It’s depressing thinking about Greece these days, so let’s talk about something else, O.K? Let’s talk about Finland, which couldn’t be more different from the corrupt, irresponsible country to the south. It’s in the eighth year of a slump that has cut real gross domestic product per capita by 10% and shows no sign of ending. And Finland isn’t alone. It’s part of an arc of economic decline that extends across northern Europe through Denmark to the Netherlands. Why are there so many economic disasters in Europe? Actually, what’s striking at this point is how much the origin stories of European crises differ. Yes, the Greek government borrowed too much. But the Spanish government didn’t – Spain’s story is all about private

lending and a housing bubble. And Finland’s story doesn’t involve debt at all. It is, instead, about weak demand for forest products and the stumbles of Finnish manufacturing, in particular of its erstwhile national champion Nokia.”

Economic Stresses closer to home

Pension promises that have been made to public employees and medical costs of aging societies are outstripping most countries’ ability to pay. This will only get worse as the baby boomers continue to retire. Greece is just the tip of the iceberg. Last week the Governor of Puerto Rico said their debt is not payable. Illinois is drowning in debt and in Chicago it’s no secret that most of their debt comes from the city’s pensions, but health insurance and long-term debt are also a significant part of Chicago’s fiscal shortfall.

When Jerry Brown asked California voters to approve Proposition 30 in 2012 (“You have a moral obligation to vote for it”) it helped pay for more teachers but still hasn’t solved the public employee pension long term shortfall even as California now has the highest state taxes in the nation. There will be more and more pressure to raise taxes to pay for these obligations. With record low interest rates it has become harder for private and public pension plans to earn enough to pay retirees. If interest rates are raised just two or three percent, it would greatly increase the cost of paying the interest on the national debt and would have a negative effect on high priced stocks. Hence, I don’t believe Federal Reserve Chairwomen Janet Yellen will raise interest rates very much anytime soon.

Why the market will continue to rise

Jeremy Grantham Chief Investment Officer of Grantham Mayo van Otterloo (GMO), In a speech at the Morningstar Investment Conference on June 24^th, said, “Over 30 years ago 20% of senior management remuneration was attributed to stock options; today it has exploded to 80%. In order to dominate an industry from the 1960s through the 1980s, corporations sought market share. This was good for capital spending, job creation and wage growth, but it was terrible for profits. Since the 1980s, corporate management teams have chosen the much less risky path of stock buybacks to drive valuations and profitability.” He lamented that this is a high price to pay to make senior management rich, and the lack of capital spending is a drag on economic growth. Grantham believes we are moving towards bubble conditions in the stock market but there needs to be a trigger event before the bubble pops. “There will be no trigger until individuals pour into the market. That hasn’t happened yet,“ said Grantham who believes the markets will continue to rise at least up until the next election.

Last week I had the great experience of watching Ken Burn’s documentary “The Roosevelts”. For those of you who didn’t catch it, I highly recommend it. It covered the Roosevelt family from Teddy (TR), his niece Eleanor, and his cousin FDR. I learned a tremendous amount about the Great Depression and why FDR made the choices he did.

I was mesmerized by the similarity of the rhetoric of that time with today’s narrative. Many of the same arguments appear now as they did then. Examples are: (1) Should the government deal with the issue of inequality in our society and if so, how? (2) How big should the government’s role be in providing jobs? (3) What should the proper role for our government be in relation to globalization?

The Federal Reserve has continued to buy bonds and keep interest rates at record lows. This has boosted asset prices, especially stocks. However, it has not caused businesses to invest in creating more jobs as the Federal Reserve had hoped. The government jobs report is issued each week and tries to shine the best light it can on jobs created and the unemployment rate. However, the labor participation rate (shown above) illustrates that there are less people working as a percentage of available workers than before the Great Recession. The participationratemeasures the number of Americans employed or looking for a job as a share of the working-age population. It does not count discouraged workers and others no longer looking for a job.

The stock market is not cheap. As Gary Shilling points out in his article in Bloomberg Viewon October 2^nd, “A number of warning flags are flying today. Among them: 1. High-price-to-earnings ratios. These ratios aren’t at record levels, but they certainly are elevated. 2. Slow economic and corporate revenue growth. 3. Profit margins are at all time highs and have been on a plateau for a few years.”

For the quarter ended September 30, 2014 the Vanguard Balanced Index is up 5.1% for the year. As I have explained, the Vanguard Balanced index assumes a portfolio of 60% US stocks and 40% US bonds. The index is little changed from June 30^th. I believe that the Federal Reserve is determined to stay the course and try to maintain the markets on an upward bias by keeping interest rates unchanged for the foreseeable future. With the Federal Reserve stimulus coming to an end this month, many people are wondering when the Fed will begin to raise interest rates. I doubt if it will be anytime soon. In Janet Yellen’s own words from a speech on August 22, 2014 in Jackson Hole, Wyoming, “The Committee reaffirmed its view that it will likely be appropriate to maintain the current target range for the federal funds rate for a considerable timeafter our current asset purchase program ends.”

I will continue to hold broad based index funds of stocks and bonds as well as some individual stocks and bonds that I feel are likely to perform better than the more diversified funds. Our asset class allocation will continue to be a bit less than the 60/40 allocation in the Balanced Fund. In addition, we will continue to hold some other items outside the US.

From an article in the Financial Times yesterday, “Central banks around the world, including China’s, have shifted decisively into investing in equities [stocks] as low interest rates have hit their revenues, according to a global study of 400 public sector institutions.”

If Central banks are buying stocks then how can stock markets fail to keep rising? And if markets keep rising, how much risk should we take?

Although investing in the age of an aggressive Federal Reserve is a new experience for most people, I believe we are properly positioned at this time.

I confess: I am a market timer and a stock picker at heart. This investing style is not popular in the financial services community because of the belief that very few people can be successful at it over the long term. However, it worked very well for me throughout most of my career. I bought stocks I thought were cheap and held them, sometimes for many years. I avoided losses in 2000 and incurred only small losses in 2008 (less than 10%) by lightening up our stock allocation as I perceived the market to be overpriced. Because interest rates traded in a range of 4-6% for many years, there was always a place to put money when looking for safety during difficult times.

I have changed my opinion as to whether it is better to use passive index funds or active mutual funds or pick individual stocks outright. When the market is cheap it is best to use a passive index fund. When the market is expensive it is better to use an active mutual fund or individual stocks to some extent.

Everything changed in 2008. The Federal Reserve began the largest monetary stimulus in history. At first it was to save the banking system and the economy from collapsing and later to try to boost the economy. Although the economy is still lagging, the Federal Reserve’s actions have helped to raise the price of stocks to record levels. So far this year the market has languished and stands nearly unchanged. Bonds have been doing better than stocks this year. The Vanguard Balanced Index Fund (60/40% stocks/bonds) is up 1.78% year to date. Our accounts which are about 40/60% in favor of bonds are up about the same.

There is not much more that bonds can produce at current interest rate levels so stocks are going to have to carry the load if this year is going to show any substantial gains. Although stocks are not cheap I still believe we have to own them as long as the Federal Reserve continues it’s near zero rate interest rate policy.

The closing prices for the first quarter ending March 31 were mixed. The Dow Jones Industrial Average closed down

-0.7%, the S&P 500 Index closed up 1.3% and the Nasdaq Index closed up 0.5%. The Barclays Global Treasury Bond Index closed up 2.2%. As I explained in a recent letter, The Vanguard Balanced Index Fund is made up of 60% stocks and 40% bonds which is a little higher in favor of stocks than our asset allocation (40% stocks and 60% bonds). It closed up 1.84% for the first quarter.

Because interest rates are so low, it is doubtful that we can make more than 4% this year in bonds. That leaves the heavy lifting to stocks. Owning stocks will likely continue to be the best approach to having a profitable year. I believe that most stocks are expensive so it is hard to find any bargains. Because of this we will continue to move our stock allocation towards index funds. Janet Yellen, the Chief of the Federal Reserve has continued to state that she intends to keep interest rates near zero indefinitely because of the high unemployment and the sluggish economy.

As of the close of business last Friday, The Dow Jones Industrial Average was down 3.1% and the S&P 500 index was down 0.4% for the year. On the International side the Global Dow was down 2.3%. Bond fund indexes are up 1-2% for the year. Hence, a portfolio made up of half stocks and half bonds should be about unchanged for the year.

In my last market update I explained Modern Portfolio Theory. I stated that Modern Portfolio Theory keeps you in the stock market most of time and avoids trying to time the market. Another popular method of investing involves keeping 60% of funds in stocks and 40% in bonds almost all of the time. Slight adjustments should be made during unusual periods and bonds should take up a higher percentage as an investor gets older according to this theory. One of the most popular mutual funds that follow this model is The Vanguard Balanced Index Fund. As of the close last Friday it was it was up less than 1% for the year. This method will tend to mirror the overall market most of the time. However, that can mean being down as much as 22% for the year 2008 (bear market) and being up nearly 18% last year.

I thought it would be useful to keep track of this index and compare how we are doing in relation to it since our current position is somewhat similar. Currently, our accounts are doing about the same as the Vanguard Index. The difference is that we have a lower allocation of stocks (40-45%) and our bond position consists primarily of short-term corporate bonds. Under the current economic and political conditions I have no plans to change our allocation at this time.

When Federal Reserve Chairman Ben Bernanke announced that he would continue to buy more mortgages and treasury notes until the unemployment rate came down to 6.5%, I think his inferred message was, “I plan on keeping interest rates near zero so you had better keep buying riskier assets. If investors think that I’m going to stop printing money anytime soon, they are misinformed.” The result of this continued creation of money by the Federal Reserve has caused many assets to be very highly priced. John Hussman, Investment Strategist for the Hussman Mutual Funds, said [where/when], “I realize that there is a visceral urge to participate here, as well as a fear of missing out when the market is hitting new highs, but over the full market cycle, investing to achieve short-term comfort costs a fortune.”

There’s an old stock market adage that you don’t fight the Fed. In other words, when the Federal Reserve is printing money to lift the markets either go along with it by owning financial assets or get out of the way by sitting on the sidelines. Benjamin Graham once said, “Even the intelligent investor is likely to need considerable will power to keep from following the crowd.” It is important to remember that higher markets caused by the Federal Reserve usually end in tears. The Stock Market tech wreck in early 2000, the financial meltdown in 2008, and the Japanese market peak in late 1989 were all preceded by central bank money creation.

An article by Jason Zweig in the Wall Street Journal last week about diversification was so good and timely that I couldn’t have said it better myself:

“If you care about risk, not just return, you could be forgiven for just wanting to bury your money in your backyard. With bond prices near all-time highs and yields near record lows, the returns on many bonds are doomed to be negative after inflation. Since 2000, the U.S. stock market has fallen by more than 40% from top to bottom—twice—but still looks overvalued by some measures. Real-estate investment trusts are at their highest prices in five years. Gold has sextupled in price since 2000. The past decade also has shown that traditional diversification—parceling out your money across U.S. and international stocks and bonds, along with a variety of other assets—can leave investors exposed to the risk of severe losses.

“Thinking about diversification in a different way—what we might call "differsification"—might change your views entirely. Instead of spreading your bets to protect against a plunge in the U.S. stock market, you should regard your portfolio as a set of bets on basic economic conditions and create one bucket for each: expansion, recession, inflation and deflation.

“How does this approach differ from traditional diversification? Financial planners have long built portfolios based on historical correlations, or the extent to which various investments have moved up and down together in the past. The theory is that when stocks zig, bonds and other investments will zag; market declines in one asset will be buffered by rising values for others. Unfortunately, markets forget all about theory during a financial panic.”

In today’s financial environment, this thinking makes sense and I will attempt to keep the volatility as low as possible in our accounts. Sticking to basic “differsification” will give you peace of mind—and probably the last laugh.

Back in 2000, you could buy an ounce of gold for only $273. Now that same ounce of gold will cost nearly $1,700. The price of gold in terms of dollars has now risen thirteen years in a row. We maintain our position in gold as a hedge against inflation that will eventually show its face as a result of endless fiat money creation.

While there was a lot of hype about the fiscal cliff, in reality not much changed. For most, the Bush tax cuts will be extended. Only for the top earners, those making more than $450,000 for a married couple and $400,000 for a single person, will the top marginal tax rate increase from 35% to 39.6%.

To capitalize on the certainty of permanent rates, we will be proactive in our planning.

The market conditions that we face today with the financial problems that exist in the developed, overleveraged world will require extreme patience and realistic expectations in order to earn reasonable returns. Safety of capital continues to be our primary goal.

Six weeks have passed since the Federal Reserve Board (Fed) last met and launched QE3, its open-ended policy of buying $40 billion worth of mortgage securities each month. The Fed announced they would continue this until there was substantial improvement in the jobs market. The principle aim is to raise asset prices such as stocks and bonds hoping that increased wealth will make consumers feel better about the economy and want to spend more money and invest in higher risk items. Stocks initially jumped and the S&P500 Index set a post financial crisis peak of 1465 in mid-September. Stocks have fared poorly since then as consumers are still shy of opening their checkbooks or incurring more debt. As of today, the S&P500 average has sunk to 1412. While it is too early to measure the results of QE3, the dip will not surprise those who have doubts as to the Fed’s ability to lift the economy by pumping more money into the financial system.

Wall Street has long advocated the mantra, “Don’t fight the Fed”, but we might finally be testing the limits of the Federal Reserve Board’s policy.

All three people have the same problem: They need to earn more than is readily available in low risk investments.

You can only count on a return higher than 5.6% if you are able to earn more than 8% a year on stocks and/or interest rates will continue to fall from current levels. Both these possibilities seem unlikely to me. That’s why it’s so important to lower your expectations on investment returns for the foreseeable future.

If a country is having trouble because it cannot handle its sovereign debt, it has three choices:

First choice: Opt for austerity. By cutting expenses the country hopes to get its financial house in order by getting out of debt. This might be good advice for one family but if every family or an entire country cuts back on spending at the same time then the economy will get worse. This is what is happening in Europe right now.

Second choice: Default on the debt. This has been done many times in the past by small countries such as Greece and Argentina. However, when you default, it’s less likely that you will be able to borrow in the future. For countries like Great Britain or the United States, defaulting would be unthinkable. It would bring the whole financial system down because no country would be willing to trust any other country. Essentially, the world’s financial system would freeze. This almost happened in the fall of 2008 but was avoided because the World’s Central Banks flooded the banking system with money and guaranteed almost all financial instruments.

Third choice: Print money -- if you can get away with it. This is what is happening in the United States and to a lesser extent in Great Britain, China and Japan. Countries that are members of the European Union can’t do this because they no longer have their own currency, having traded it for the Euro. America can get away with printing money as long as other countries are willing to accept our paper dollars for their products. At some point our creditors may demand collateral (perhaps gold) or higher interest rates to compensate them for the higher risk. Until then we need to invest carefully and always with one eye on the value of the dollar.

The market conditions that we face today along with the financial problems that exist in the developed, overleveraged world will require extreme patience and realistic expectations in order to earn reasonable returns. Safety of capital will continue to be the primary goal.

Since March 31, most stock markets have fallen significantly. When this happens we have to ask ourselves whether we believe this is merely a correction in a bull market or the beginning of a bear market. After staging a big rally during the first quarter, the averages have lost most of that gain.

If we are entering a bear market, which I think we are, what does the stock market see ahead? Perhaps it is the “fiscal cliff” that has been discussed in the news lately. This represents the changes that will occur on January 1, 2013 if congress remains at an impasse. A payroll-tax holiday ends, which means a tax increase for workers of as much as 2% of wages. Income tax rates revert to pre-George Bush levels, rising not only for the rich but for nearly all taxpayers. Across-the-board cuts in domestic and, particularly, in defense spending are triggered. This will have the affect of removing a great deal of potential spending from an economic recovery that is already tentative.

After peaking at over $1,800 in November 2011, gold has dropped down to $ 1,560 recently. In his regular column The Short View for the Financial Times, James Mackintosh opined on Wednesday, May 16, that gold is not doing well as an investment lately. He states, “Gold could easily fall further. Only one thing is sure to save it: central banks stepping in to rescue economies and markets.” Does anyone doubt that they will do that as times become tougher?

Warren Buffett and his co-CEO Charlie Munger disparaged gold at the annual meeting of Berkshire Hathaway last week. Buffett compared the great difference in gains from buying one share of Berkshire Hathaway vs. buying one ounce of gold back in 1967. Charlie Munger recently said he clearly has some issues with gold. He said, “I think gold is a great thing to sew onto your garments if you’re a Jewish family in Vienna in 1939, but civilized people don’t buy gold, they invest in productive businesses.”

It is clear to me that Mr. Munger and Mr. Buffett do not understand the role of gold, both currently and historically. Since it’s unclear when you will need gold you need to own it beforeyou need it. The Chinese are currently the world’s leading buyer of gold.

Europe is struggling to come to terms with its debt problems. Consider the demographics. When there were a lot of people working and not too many disabled or retired people, generous benefits were promised by governments in Western Europe, Canada, Japan and the United States, among others. When social security was first established there were fifteen workers for each retiree. Now there are less than three. The fertility rate (the average number of children a woman would bear in her lifetime) is below replacement value in the United States, Canada, Japan and every country in Western Europe. The average age in these countries is rising every year. It is over 40 in most countries in Western Europe, 37 in the United States and 45 in Japan. As taxes rise and benefits are cut it will be harder to live in the west and economic growth will become more difficult to sustain. Investment opportunities will also shrink as money moves to the east where the growth is.

A presidential election year is always exciting. That, combined with the debt problems in Europe, the economic slowdown in China, the unwinding of the wars in Iraq and Afghanistan, the “fiscal cliff”, and our own weak economic recovery lead me to believe that this year will be exceptionally volatile and potentially profitable.

In my letter of last July I opined that I was perplexed by the market and quoted Robert Rhea, the great Dow theorist and trader of the 1930s, who said that he was perplexed regarding the market about 80% of the time. These remain uniquely interesting times.

U.S.stock markets wound up 2011 with generally modest gains and minor losses. The Dow Jones Industrial Average was up about 5%, the broad S&P500 index was unchanged and the technology heavy NASDAQ declined a few percent. Overseas things weren’t quite as sanguine. The British market was off 5.6%, Germany’s 14.7%, France’s 17% and China’s 22%. Furthermore, volatility was significant making it hard to take a long-term position. The old market adage “sell until you can sleep” seemed very apropos last year.

This year has started off like gangbusters with most averages up convincingly so far. Usually, the fourth year of a presidential cycle is an up year as the Fed pumps up the money supply to keep the economy rolling along and the incumbent in the White House. The difference this year is that the Federal Reserve has been pumping since late 2008. It has succeeded in getting the stock market to rebound but has not been so successful with the economy and the jobs market. Never fear, if things continue to deteriorate Federal Reserve Chief Bernanke may just revert to his oft quoted threat made before he was the chief: “If things get bad enough, we’ll just throw money out of helicopters”.

For the first time in my memory I am hearing very astute financial people questioning Keynesian Economic Theory -- just keep printing the money.

In his February Investment Outlook Bill Gross noted, “My intent really is to alert you to the significant costs that may be ahead for a global economy and financial marketplace still functioning under the assumption that cheap and abundant central bank credit is always a positive dynamic… Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.”

On February 6^th, Charles Schwab wrote in the Wall Street Journal, “We’re now in the 37^thmonth of central government manipulation of the free-market system through the Federal Reserve’s near zero interest rate policy… The Fed’s action, rather than helping, is having the perverse effect of destroying the confidence of businesses and individuals to invest and the willingness of banks to loan to anyone but those whose credit is so strong they don’t need the loans.”

In my view, when it comes to ordinary recessions that are cyclical in nature and come and go with the business cycle, monetary policies such as lowering interest rates may help shorten the recession although I doubt they have any long term effect on the cyclical nature of business. However, when it comes to recessions or depressions that are caused by accumulation of debt such as the Great Depression and the current deflationary depression in Japan, I don’t see how anyone can successfully argue that government action in the form of monetary stimulation and lower interest rates have ended these economic contractions any sooner. It didn’t work during the Great Depression and it hasn’t worked in Japan over the last 20 years. Paul Krugman and his pals say that is because the stimulus was not big enough. But they don’t really know for sure since the Great Depression didn’t end until World War II put everyone back to work. Japan is still struggling with their deflationary depression which began in 1989.

Mohammed A. El-Erian, CEO of Pimco, wrote an article in the Wall Street Journal on January 9^th, entitled “Investing in a Fat Tail World”, and explained that, “By pushing interest rates to very low levels, central banks are pushing investors out the risk spectrum…. Every year has elements of unpredictability, but what’s in play in 2012 goes far beyond the usual risk of policy slippages, unexpected election outcomes and geopolitical hotspots. This is also about the global economy losing important anchors…Fat tails – the technical term for the extremes of an outcome distribution – are risks for any global system that loses its anchors… Navigating such unpredictability requires investors to rely less on historical short cuts and, instead, spend more time decomposing assets classes into their constituent risk factors...In such a world, prudence is the name of the game, and patience will likely be rewarded. In doing so, investors should exploit the flexibility that comes with cash…Unpredictability yields both risks and opportunities, and the answer to it should never be paralysis. More than ever, investors in 2012 will be challenged to understand an unusual set of global dynamics and to position their portfolios accordingly. For many, this will translate into strategies that are generally defensive yet agile enough to also be offensive as opportunities emerge.”

Mr. El-Erian’s view is similar to my own. There is just too much uncertainty not to be diversified and liquid enough to move quickly as opportunities arise or dangers emerge. If you are interested in more risk and/or exposure please let me know and we can make adjustments to your account.

It has been quite a while since I have written to you but quite frankly, I just haven’t had a strong opinion about what has been happening in the financial markets or what is likely to transpire. Robert Rhea, the great Dow theorist and trader of the 1930s, once wrote that he was “perplexed” regarding the market about 80% of the time. Today, all you have to do any time you want an opinion is merely check the internet and you can get all the opinions you want. The problem is that most of them won’t be accurate.

Here’s how I see it. Before President Roosevelt was elected in 1932, the US economy expanded and contracted just as it does now. There were booms, busts, recessions, and depressions. There were inflationary and deflationary periods. The US was on the gold standard which maintained the value of the dollar in both good and bad times and limited the government’s ability to print money. In an effort to create more currency and stimulate the economy, President Roosevelt took the country off the gold standard, called in all the gold held by private citizens, and made it illegal for citizens to own gold. Although it might have been understandable why he would have done that during times as tough as the Great Depression, his move set a precedent for stimulation of the money supply every time the economy has fallen into recession since. The effect of this stimulation has devalued the dollar to a fraction of what it was worth when it was backed by gold. There are many economists and politicians who support this method of stimulation -- which we refer to as Keynesian theory named after British economist John Maynard Keynes --because they believe it is better than sitting and doing nothing. The problem is that Keynes’ theory is, in my opinion, still unproven. It didn’t lift us out of the Great Depression, WWII did; it hasn’t lifted the Japanese out of their 20+ years of deflation, 1989 to the present; and so far it hasn’t put people back to work during the post-2008 downturn.

After a long period of credit inflation like we had until 2008, the natural tendency is for the economy to enter a period of deflation in order to pay down or renege on debt. This used to be the norm before the Keynesian theory was adopted as the method used any time there was an economic downturn. Before that time, recessions and depressions would clean out failed businesses and bad loans and lay the groundwork for another period of economic growth. That is no longer acceptable to the public as politicians claim that we can just grow our way out of debt with more debt. Hence, the US Treasury and the Federal Reserve worked together to create TARP, QE1, and QE2. Our banking system and various government entities have taken on huge amounts of bad loans and our government has worked to save financial institutions that are supposedly “too big to fail”.

I’m in the minority with my view that monetary stimuli and the dollar’s devaluation are, in the long run, a mistake. The large amount of money being created by the Federal Reserve and other central banks around the world will affect our economic well-being. When John Maynard Keynes was asked what would ultimately happen he stated, “What’s the difference. In the long run we’re all dead.” Our kids and grandkids however, will inherit this mess.

Why are prices rising? World demand for raw materials is increasing with China leading the competitive charge. George Soros cites China’s consumption of the world’s commodities with the following exhibit. Bear in mind that this does not include consumption of other large emerging countries such as India, Brazil and Russia.

Source: Barclays Capital (2010), Credit Suisse (2010), Goldman Sachs, United States Geological Survey (2009), BP Statistical

Review of World Energy (2009), Food and Agriculture Organization of the United Nations (2008), International Monetary Fund (2010)

The combination of dollar devaluation as a result of monetary stimulus and rising demand for commodities is likely to keep driving up prices of everything we buy. Long-term rise in our cost of living is the greatest threat for most Americans. Our biggest challenge in the years ahead will be to maintain our standard of living. That will be no easy task as the US and Europe struggle to increase economic growth. After all, we’re no better off if the value of our investments goes up but the value of the dollar falls in relation to other currencies. Investors will have to be nimble and invest throughout the world often moving to different asset classes as environments change.

In 1913 Congress created the Federal Reserve Bank (FED). It has tried to manage financial downturns by injecting money into the banking system to stimulate the economy as it is presently doing with quantitative easing – known as QE1 and QE2. In the 1930s this became known as Keynesian economics named after the British economist John Maynard Keynes. Professor Keynes advocated that the government should step in and spend money when the private sector is unwilling or unable to do so.

Since the creation of the Federal Reserve Bank the dollar has lost 95% of its value. Over the last few decades the people who have been able to maintain their financial position and purchasing power have been the wealthiest individuals who own tangible assets such as real estate, stocks, businesses, commodities, etc. Those who have owned financial assets such as bank CDs, government and corporate bonds, money market funds, cash, etc. have watched their wealth evaporate due to constant inflation.

In the summer of 2008, as it became apparent that the US was about to enter a great recession, the US Treasury and the FED rushed to the rescue by spending billions to save big insolvent banks and other companies. Through various government programs they attempted to prop up the economy. When the FED creates all these dollars, these new dollars have to go somewhere. Often, they end up bidding up the price of tangible assets such as stocks, commodities, gold, art, collectables and other items that hope-fully will keep up with inflation.

Over the last decade, gold has been rising and the dollar has been falling. As the dollar continues to fall, items that consumers buy become more expensive as producers raise their prices to compensate for the loss they are taking by holding dollars. Declining purchasing power and rising prices of goods and services mean that our investment gains are not making us richer.

Furthermore, we must change our asset allocation to vehicles that are not denominated in dollars. Bill Gross, CEO of PIMCO and co-investment counsel of PIMCO’s Total Return Fund has stated recently that if he could only give one piece of advice to investors it would be exactly that: Buy things that are not denominated in dollars. This is no easy task since the Chinese have pegged their currency to the dollar. The Euro is no better than the dollar because the European Central Bank is printing billions of Euros. I believe we should think of gold and silver as alternative currencies rather than as commodities or collectables. Other items that are worth considering are currencies of countries that do not use the Euro such as Switzerland, Canada, and Australia; commodities such as rare earth metals and foods; and prime, well-located real estate in politically stable countries.

The stock market has had a big rally since March 2009. However, I believe that a lot of the rise is due to the Federal Reserve’s quantitative easing. John Maynard Keynes cautioned, “The market can remain irrational longer than you can remain solvent.” John Hussman (Hussman Funds) reminds us that Keynes’ quote is a favorite of speculators. “In my view, the more important quote for the present environment is from Benjamin Graham -- Speculators often prosper through ignorance: it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator in one of temporary profit and ultimate loss.”

This is not an easy time to be an investor. With short term interest rates hovering near zero and stock markets that are not cheap, investors must look to other less familiar items. Stock markets are rising in spite of being highly valued. However, as Marty Zweig used to say, “Don’t fight the FED.” We won’t – but we will proceed with caution.

Most of what I read is bullish and many writers are expecting an increase in equity (stock) prices or 20% of more over the next year. Investors Intelligence data shows a significant shift from the “correction” camp to the “bullish” camp among investment advisors, with 45.6% bulls and 24.4% bears. The more volatile American Association of Individual Investors poll shows an even wider skew, with 51.6% bulls and 21.6% bears. With the Federal Reserve announcing that it is planning to flood the banking system with billions of dollars after the election, investors jumped the gun, and the stock, bond and commodity markets rose substantially in September and October.

"Quantitative easing" is nothing new. It has been going on since the 1930s when the Roosevelt Administration opted for Keynesian stimulus whereby the government would spend money when the public wouldn’t or couldn’t. The Federal Reserve has a lot of confidence in the power of stimulus because it has lifted us out of economic recessions every time since World War II. However, like all medicine, it has side effects. Following are some of them.

1. Since the Federal Reserve was created in 1913, the dollar has lost 95% of its value. That’s another way of saying that we have been living with inflation as the dollar buys less and less each year.

2. Anyone who lived through the 1970s is familiar with a never-ending increase in the cost of living. That wouldn’t be so bad except the average worker's income has not kept up with these increased costs.

It is interesting that the Founding Fathers did not create a central bank. I believe that they were afraid that such a bank would do exactly what this one has done – print money that is not backed by anything tangible such as gold.

I understand that sometimes there is a need to borrow. In the case of emergencies such as war, natural disasters, or economic calamities the government has stepped in and rightly so. However, the Federal Reserve has a poor history of withdrawing money from the system after times have improved and Congress has seldom raised taxes to pay for necessary expenses. After all, legislators want to get reelected and raising taxes rarely helps them achieve that goal.

My asset allocation is currently 25-35% stocks, 50-55% short term fixed income, and the balance in cash or cash equivalents. Included in the stocks is gold which accounts for approximately 10% of total assets. The market may continue to go up, but sometimes discretion is the better part of valor. It is good to be brave, but it is also good to be careful; if you are careful, you will not get into situations that require you to be brave.. I believe this is one of those times.

To Stimulate or not to stimulate, that is the question.

The answer to this question may determine whether we continue to slog through the economic doldrums that have plagued us for the last two years or get the economy moving again at a faster clip so that we can create the jobs we need so desperately. As an old saying states: When your neighbor loses his job it is a recession; when you lose yours, it is a depression. The history of our nation is rife with examples of recessions and depressions. Most of us have lived through the recessions of 1974, 1982, 2002 and 2008. Some of my older clients and friends experienced the Great Depression.

If you are paying attention to the news lately you have seen articles that argue why we need more monetary stimulus from the government, and articles that argue why we need to stop the printing presses and begin to deal with the burgeoning deficit.

Pro stimulus people like Paul Krugman have been telling us that unless we increase the stimulus we are heading for a weaker economy and continued unemployment for years to come. In Krugman’s column in the New York Times on June 27 entitled “The Third Depression” he states, “We are now, I fear, in the early stages of a third depression. And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending. The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.”

Members of the deficit cutting crowd such as Alan Greenspan, a born-again conservative, stated in an editorial on June 18 in the Wall Street Journal, “An urgency to rein in budget deficits seems to be gaining some traction among American lawmakers. If so, it is none too soon. Perceptions of a large U.S. borrowing capacity are misleading. The U.S. government can create dollars at will to meet any obligation, and it will doubtless continue to do so. U.S. Treasuries are thus free of credit risk. But they are not free of interest rate risk. If Treasury net debt issuance were to double overnight, for example, newly issued Treasury securities would continue free of credit risk, but the Treasury would have to pay much higher interest rates to market its newly issued securities.”

Where does that leave us? What should the Fed do? Should they believe Paul Krugman and put the pedal to the metal and keep the printing presses running? Is deflation that much of a threat? Or should we begin to reign in with what appears to be a never ending growth in the national debt? What I find amazing is that on either side of this argument are people who are absolutely sure they’re right. I prefer to follow the markets to help me understand what is happening.

As investors, we are interested in what affect the choice to increase the stimulus or not will have on our investments. When money is injected into the economy along with lower interest rates it has the effect of either creating more business and therefore jobs, or it just pushes up asset prices. The stimulus seems to have pushed up asset prices as is often the case. If not for the stimulus, the stock market may have continued down from its March 2009 bottom or most likely not rallied as much as it has. Without another stimulus it is hard to make a case that the economy will do anything other than slog along at best and go into a double dip recession at worst. Without another stimulus, asset prices, which include stocks, will be on their own – they will have to rise by virtue of their earnings and not by excess liquidity looking for a place to land.

If the Federal Reserve cuts back and practices austerity more money will be removed from the economy as debts are repaid and even less money will be available for business and jobs. This will probably result in a weaker economy and possibly even more unemployment, especially at the state and local levels as they cut jobs in order to balance their budgets which are generally the law in most states. This is already happening across the country.

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