JANUARY 2012 QUARTERLY NEWSLETTER 2012: A YEAR OF MORE QUESTIONS THAN ANSWERS Executive Summary As we look back over 2011 from an investor’s perspective, our perception can be framed by one word: volatility. As we began to contemplate how to position our portfo- lios in 2012, we first needed to gain clarity regarding the factors contributing to last year’s market results. Our letter that follows will build on these main observations and ideas: The S&P 500 price performance was literally flat for 2011, after weathering a staggering 1% per day average fluctuation in the index and setting records for one day volatility. The factors that caused the volatility in 2011 have not faded away, and may have been exacerbated due to the continuing worldwide sovereign debt crisis. Austerity measures forced on Greece have already negatively impacted its JOEL FRAMSON & GDP, which desperately needs growth, not austerity, to become viable again. ERIC BRUCK, PRINCIPALS There is fear that Greece’s debt crisis may spread with Italy and Spain perhaps being next. In the US, political rhetoric is calling for austerity in the form of federal spend-Silver Oak Wealth Advisors, LLC ing cuts. What is good for a family is not necessarily good for the country. (see10866 Wilshire Blvd., Ste 1270 Paradox of Thrift, below) Los Angeles, CA 90024 We do not expect 2012 to be any less volatile than 2011, with the prospect of Phone: (310) 207-4800 either only modest stock market returns, or a strong possibility of negative re- Fax: (310) 943-0398 turns. www.SilverOakwa.com Our “Risk Controlled Asset Allocation” approach continues to minimize portfo- lio volatility and support stable performance. In this unstable world, we prefer to utilize a portfolio–building technique bor- rowed from Architectural Digest – find solid, stable building blocks to build the portfolio foundation which in 2012 will focus on income-oriented investments that may also produce appreciation.
Silver Oak Wealth Advisors, LLC — Quarterly Newsletter Page 2 2011: A YEAR OF UNPRECEDENTED VOLATILIT Y Rather than writing pages about how volatile our domestic stock market was in 2011, the picture below shows it well.There were many TV and print analysts at the begin- Looking back on 2011, the wild swings in the equityning of 2011 who forecasted where the markets markets established new records:would end up by year-end. Other than Adam Parker, In 2011, the total daily percentage move-head of equity trading at Morgan Stanley, who nailed it ments of the S&P 500 index added up to ato within about 1%, every analyst was overly optimis- staggering 260%, averaging about 1% pertic. (More about Parker later in this letter.) The S&P day. That is a lot of movement only to finish500 began the year at 1257. It ended the year at the year with an actual price return of 0%.1257, resulting in zero price appreciation. While his-tory will tell us that the 2011 return of the S&P 500 In the S&P 500, 85 companies fell 20% orwas 2.1%, that positive return was entirely due to divi- more in value, compared with 11 in 2010 anddend payments and not to any real growth in the in- 15 in 2009.dex. The Dow Jones Industrial Average alternatedDuring 2011 there were more days in which the stock between gains and losses of more than 400market volatility was more than 1% than ever before in points on four days for the first time ever inhistory. We know from behavioral finance that this is August. Daily share swings in August for thea cause of anxiety for investors. More importantly, we S&P 500 averaged 2.2%, the most for anyknow from our own clients that experiencing this type August since 1932.of volatility in their own portfolio would keep them up The S&P 500 index moved 1.3% a day sinceat night and make them worry more. For this specific April, compared with a 50-year average ofreason, in 2008we developed and continue to imple- 0.6%.ment our systematic methodology which we refer to as"Risk-Controlled Asset Allocation.”
Silver Oak Wealth Advisors, LLC — Quarterly Newsletter Page 3The key point for investors in our domestic stock mar- Keep in mind that ideally the performance of the stockkets is that during 2011, this record amount of volatility market is tied to the growth rate of the economy. Weyielded virtually no reward. Further, international mar- say ideally because there are numerous non-financialkets fared much worse with the Vanguard Total World factors that also influence the direction of the mar-Stock Index declining by -7.5%. By contrast, Silver kets. Our economy typically needs to grow at 3.5% toOaks decision to reduce exposure to stocks in general 4.5% in order to grow jobs and create opportunities forduring 2011 resulted in a visibly and viscerally the average citizen. In 2011, the average GDP growthsmoother ride over the course of the year. This re- rate was only 1.2% during the first three quarters andduced risk exposure resulted directly from our risk was 2.8% (before any future downward adjustment) inanalysis which concluded that stocks would not provide the fourth quarter. For the year, the annual growth ratesufficiently high returns to warrant the level of risk ex- was 1.7%, less than half the 2010 growth rate and theposure. worst rate since the Great Recession of 2008.STARVING AN ANOREXICIn fact, the rate of recovery from the Great Recession debt at both the sovereign level and the bankinghas been significantly slower than from any prior reces- level. In fact, not only has nothing been done to lessension. In the third year of an economic recovery from an the risks of “too big to fail” as observed during 2008,extremely severe recession, this sub-par performance but it is a fact that many of the big banks have grown tois very disturbing. Past recoveries, typically, have ex- be even larger since 2008.perienced growth rates 2-3 times what was actually The big picture that we continue to focus on is that theachieved during 2011. Certainly, the news media can global economy has accumulated and still is weightedpoint to any number of events to rationalize the results: down by too much debt. The underlying issues havenatural disasters (Japan), bad weather in the northeast not been solved, but have instead been compoundedkeeping shoppers at home, high gas prices, and the old by rolling bailouts and more debt which will restrainstandby, geopolitical strife in the Middle East. growth and make all economies and markets unusuallyWhile these reasons may have some element of truth susceptible to shocks.to them, we reject that they had a major impact on the Also of concern is the "austerity solution" that is beingnumbers. In our view, consistent with our thinking for imposed in Europe as a quid pro quo for bailouts. Tosome time, and supported by a number of credible the extent that this imposed austerity restricts Euro-studies (see Reinhart/Rogoff*, for example), the global pean GDP growth, the unintended consequences mayeconomic malaise has more to do with the unwinding include exacerbating a European recession that willof massive credit excesses of the past two decades have global consequences. Any time we are temptedthan it does with natural disasters or the cost of oil. to become more optimistic (and believe us – we wouldBusiness recessions typically end, on average, within like to be), our thoughts are tempered by the massiveeleven months. There was nothing typical about the amount of debt embedded in the system, the overly2008 recession. As opposed to typical business cycle simplistic rhetoric and the lack of political will to mean-recessions, the 2008 recession was a result of credit ingfully address the problem.expansion, which will require protracted deleveraging to Global financial markets have become addicted to easyresolve. Neither our domestic political process nor the money and government bailouts: rates have been low-European political process has come close to effec- ered, money printed en masse, and huge deficits cre-tively resolving the dangerously entrenched amount of ated. The message that is then crafted has been that
Silver Oak Wealth Advisors, LLC — Quarterly Newsletter Page 4sustainable growth will follow. The negative corollary to sound at the micro (individual) level is irrational and un-these bailouts is that certain institutions have not been productive for the community, or macro level. In effect,allowed to fail and those who knowingly took certain if the private sector is delevering and derisking, the pub-risks are no longer expected to take a loss when those lic sector is supposed to go in the exact opposite direc-risks go bad. The blatant unfairness that such a sys- tion and spend. Therefore, when a liquidity trap is oc-tem fosters gives rise to social classes; that is anath- curring, cutting federal spending is counterproductive.ema to our national psyche. Yet, it may now be seen to A look at Europe provides a good example, where thebe taking root. The prevailing bailout mentality is hav- Eurozone has suggested that Greece enact a severeing an effect on our market-driven economy. The sys- austerity plan to solve its debt crisis. Putting somebodytem of capitalism has succeeded over time because who is suffering from anorexia on a diet doesn’t make athe risk-takers, who have been encouraged to prosper lot of sense.and thereby grow the economy, have also bee n al-lowed to fail when the risks were unproductive. As re- In the U.S., there are encouraging signs from the variouscently stated by Kyle Bass, the well-respected investor reporting factions of our government in the first fewat Hayman Capital, “Capitalism without failure is like weeks of 2012. The equity markets have respondedChristianity without hell…it doesn’t work.” favorably to the headline news. However, even the early February positive employment statistics are being calledAnother economist who recently chimed in on the topic into question. Paul Biderman, President and CEO ofof the debt crisis is Paul McCulley, a former managing TrimTabs Investment Research, tracks daily tax with-director at PIMCO. McCulley points to the liquidity trap holding collections through the IRS data. Based onthat we are experiencing and the need for a specific set TrimTabs’ research, projected job growth should haveof policies as a solution. A liquidity trap is defined as come in at only around 50,000. Where the Bureau ofwhen the private sector is in a deleveraging mode, or a Labor Statistics came up with a number like 246,000 isde-risking mode, and is increasing its savings rate. Li- a worrisome question for Biderman. Time will tell.quidity is “trapped” in the process of people of payingdown debt or adding to savings, instead of being spent Therefore, as much as we would like to believe thaton goods and services. In such a mode, spending is signs like a slight lowering of the unemployment rate,not going to be revived by a reduction in interest rates recent liquidity measures implemented or promised bybecause there is no demand. Consumers do not care the ECB, and the current high level of optimism that haswhat the price of credit is, posits McCulley. They al- been driving the stock market higher this year are indi-ready have too much debt outstanding and are focused cia pointing to a financial world of less volatility, we areon paying down credit! This can be entirely rational for not prepared to risk a substantial portion of our client’san individual household and for an individual firm. capital on a bet that this will be the reality of 2012. There are still other areas to pursue respectableHowever, in the aggregate, it begets what McCulley re- returns, with far less demonstrable risk.fers to as the Paradox of Thrift. What is rational andTHE OUTLOOK FOR 2012If we have learned anything from the economic abyss performing sectors of the markets. When we refer to thethat we all faced in 2008 after the collapse of Lehman, markets in this context, we include not only the domes-it is that the world is a place of great financial tic and international equity markets, but also the bondrisks. Virtually no one has been able to forecast intelli- market which is influenced heavily by the direction ofgently the direction of the markets, much less the best interest rates, the commodity markets including
Silver Oak Wealth Advisors, LLC — Quarterly Newsletter Page 5precious metals, and all investments that are influ- function of the financial markets has been corruptedenced by the relative strength or weakness of the U.S. into what I’ve grown to view as a self-serving carnivaldollar. of speculation, where many participants are interested in nothing except getting the next rally going at publicWe do not expect 2012 to be any less volatile than expense, regardless of how badly market signals are2011. Headlines continue to drive the markets rather distorted, how recklessly capital is misallocated, orthan fundamentals. In our prior client letters, we even whether what they do has any positive effect onpointed out how the world’s reaction to pronounce- the economy or the country.”ments by European leaders impacted the mar-kets. The so-called “risk on” and “risk off” cycles of We often quote Mohamed El-Erian in our newslet-money pouring into or out of higher risk assets with ters. El-Erian is co-CEO of PIMCO and former head ofthe hope of making short-term profits hinges on the the International Monetary Fund (IMF). Toward thedaily pronouncements by the Federal Reserve, on end of 2011, El-Erian wrote about this quite changedstrategies announced by the European Central Bank, and unstable world with ideas as to how to manageand on debates between our politicians in Washington risk. Regarding this New Normal, as he dubs this busi-or their European counterparts, to name a few. ness cycle, he said, “Correlations across asset classes could change radically and therefore it is critical toThrough all of this, we do not believe that the world focus on risk factors (for example, equity, or currencyhas made sufficient headway in deleveraging, much risk) and consider their relationship across seeminglyless implementing sustainable strategies to create diverse assets.” In a most insightful comment, hegrowth. This year is a Presidential election year and said, “We also came to understand that diversificationfrom the rancor we’ve seen in Congress last year, we would be necessary, but not sufficient for risk man-do not expect any significant progress toward major agement.” (Bold font is ours.)initiatives. The Federal Reserve, officially a nonpoliti-cal agency, is caught between offering accommoda- We are strong proponents of controlling risk. As wetive policies to promote spending and which would are at Silver Oak, PIMCO is worried about additionallead to greater deficits, and those fiscally conservative extreme shocks to our economy that could send thevoices pushing for austerity and budget cutting, which stock market diving. While the highest probabilityfeeds directly into the paradox of thrift. While in the (PIMCOs "Base Case" outcome) is still one in whichlong-term we are absolutely concerned with our in- the U.S. maintains sluggish growth while the Europeancreasing debt burden, we are more persuaded by Union enters recession, PIMCO continues to worryMcCulley’s argument that in the near-term we could about another “fat tail” event on the downside. Whilechoke-off a fledgling recovery by prematurely cutting historically, the probability of such a catastrophic “fatoff the stimulus needed to grow the economy. tail” event is only 5%; PIMCO feels that the likelihood of another negative episode is more like a 20%-30%One source of our reading materials and research is probability.John Hussman, manager of the Hussman mutualfunds and known to be a conservative manager. He We utilize an analysis methodology developed by Pro-also believes that without continued deleveraging and fessor Robert Shiller to analyze the valuation of thewithout a focus on fundamentals, the economy cannot stock market. He developed a method which looks attruly grow. He recently wrote the following, the price-earnings ratio based on a 10-year normal-“Unfortunately, over the past 15 years or so, the basic ized PE ratio. The chart follows on the next page:
Silver Oak Wealth Advisors, LLC — Quarterly Newsletter Page 6The long-term PE ratio based on Shiller’s research is 2012 recession) recently had this to say about 2012’sat about 16. With the markets currently priced at forecasts, “To my fellow forecasters out there, I’d sayabout 22.5, there is evidence for us to believe that the they are roughly in two camps. There are those whomarkets are currently overpriced. Additionally, say the economy is firming and will continue to firmShiller’s Case-Shiller index of home prices still shows into next year. We reject that. There is nothing herethat home values will need to fall another 4%-5% over to suggest that at all. There is a larger camp that saysthe next year or two before reaching a fair current we are going to ‘muddle through’ with slow growth. Ivalue. would point out that has never happened. We never ‘muddle through.’ A market economy does not wantWe previously cited Adam Parker’s good fortune in to have a static state. It either accelerates or deceler-having correctly prognosticated the 2011 stock mar- ates.” Our view is that the more likely scenario is theket return. While we are always skeptical of anyone’s latter.ability to forecast the future, we thought we wouldshare with you his expectation for 2012 if for no other This, then, is what we are facing as we enter 2012reason than to test his ability to repeat. Parker ex- and continue proactively to adapt our investmentpects that the U.S. stock market will decline by 8% in strategy to weather any severe storm. The European2012. debt crisis continues to produce endless meetings and pronouncements of expected solutions, yet we haveThe economic consensus for 2012 calls for our econ- not yet seen a credible long-term solution to their sol-omy to grow at a 2-2.5% rate. This is what economists vency and competitiveness issues. With a low ex-have started calling “muddling-through.” The head pected growth rate at home, there is little cushion toeconomist at the Economic Cycle Research Institute withstand a probable major slowdown in Europe or a(ECRI), which has a pretty good track record of predict- significant deceleration in China.ing turning points (and, by the way, is calling for a
Silver Oak Wealth Advisors, LLC — Quarterly Newsletter Page 7CONCLUSION We understand that we have filled this 2011 year-end ment goals. Based on lower expected returns from as- client letter with quite a bit of information as we at- set classes that historically have had relatively high real tempt to share our observations and thinking with you returns, and avoiding those asset classes that continue It is no simple feat to have read this far and we apolo- to exhibit high volatility with expected returns not com- gize for weighing you down with all the complexity. mensurate with that risk, we will continue to focus on investments that will produce meaningful income. However, it is becoming a more and more complex world that we live in. Several years ago, we recom- Investments in our lower risk bucket are expected to be mended everyone read the then revolutionary Thomas stable income-producing building blocks that will still L. Friedman book, “The World Is Flat.” Today, that al- produce a good level of return. This is and has been the most seems like a trite title since the world economy solid foundation for our client portfolios. On the mar- has become so much more obviously inter- gins, we will take additional risk if we believe that there dependent. The book that we recommend for those of are rewards to be gained commensurate with the extra you who want to more fully understand how the world risk taken. has changed is, “This Time Is Different: Eight Centuries Our standing offer remains: a complementary analysis of of Financial Folly” by Reinhart & Rogoff. yours or a clients portfolio upon request designed to Amidst the backdrop of significant global financial assess the level of risk in the portfolio. headwinds and markets that are driven by headlines Please feel free to call us to discuss this letter or our and not by fundamentals, we will continue to focus on portfolio design approach in greater depth and visit our our “two-bucket” risk controlled asset allocation sys- website at www.silveroakwa.com. tem, as we build portfolios to meet long-term invest- Silver Oak Has a New Team Member! An Invitation to Women’s CirclePlease join us in welcoming the most recentaddition to the Silver Oak family, Kate Women’s Circle provides an opportunity for women to talk,Marten. Kate is taking over for Annie Hong as learn, and share about money.our new administrative associate. We will explore the powerful money questions with other women in aKate grew up in beautiful Santa Barbara, confidential and supportive environment. Lets talk to each otherCalifornia and later moved to Los Angeles to about what truly matters to us and learn the best from sharing ourattend UCLA where she earned a B.A. in His- own stories and experiences!tory. She minored in Film at the UCLA Schoolof Film and Television and traveled abroad to When: 5:15pm - 7:00 pmSiena, Italy in the summers to study Italian Last Tuesday of each monthlanguage and history. Where: 10866 Wilshire Blvd, Suite 1270. Los Angeles, CA 90024Kate will be the first voice you hear on thephone and the first face you see when you Refreshment will be served. Please RSVP at 310.207.4800 or email tovisit the Silver Oak office so we encourage email@example.com to take a moment to give her a warmwelcome to the team.