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On The Economy & Waiting For Breakeven

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
November 2, 2010

IN THIS ISSUE:

1.  A Look at the Latest Economic Reports

2.  Bernanke Setting Sail on the QE2

3.  US Dollar Falls in Value

4.  Waiting, Waiting, Waiting for Breakeven

5.  The Advantages of Alternative Investments

6.  Getting Started: How It All Works

The Latest Economic Reports

Last Friday, the Commerce Department released its first estimate of 3Q GDP showing that the economy expanded by 2.0% (annual rate) in the July-September quarter, as compared to 1.7% in the 2Q.  The increase primarily reflected positive contributions from personal consumption expenditures, private inventory investment, nonresidential fixed investment, federal government spending, and exports.  The report was right in line with expectations.

Keep in mind that this is the “advance” GDP report and it will be revised two more times in the next few weeks.  Here are the quarterly GDP reports since the recession officially began in the last half of 2008:

2Q 2008 +0.6   3Q 2009 +1.5%
3Q 2008 -4.0%   4Q 2009 +5.0%
4Q 2008 -6.8%   1Q 2010 +3.7%
1Q 2009 -4.9%   2Q 2010 +1.7%
2Q 2009 -0.7%   3Q 2010 +2.0%

Even with the modest improvement in the 3Q, this remains the slowest economic recovery since the Great Depression.  As I reported two weeks ago, the Blue Chip Economic Indicators’ consensus expects the economy will expand by only 2.5% in 2011.

But not all of the economic reports of late have been negative.  The Index of Leading Economic Indicators (LEI) rose 0.3% in September, the third consecutive monthly advance.  This suggests that the economy will perform slightly better in these last couple of months of the year.  The ISM manufacturing index rose better than expected to 56.9 in October.

Consumer confidence rebounded slightly more than was expected in October.  The Index rose to 50.2 from 48.6 in September.  The University of Michigan Consumer Sentiment Index was basically unchanged in October.  Retail sales rose 0.6% in September, following a gain of 0.7% in August.

There was also some encouraging news on the housing front recently.   Sales of existing homes rose more than expected in September to 4.53 million units, up from 4.12M in August.  New home sales were up more than expected in September to 307,000 units, up from 288K in August.  Housing starts also rose more than expected in September to 610,000 units, whereas the pre-report consensus expected a decline for the month.  Building permits, on the other hand, came in weaker than expected in September.

While there has been some welcome news in some segments of the economy, unemployment remains unacceptably high.  Weekly “initial claims” for unemployment benefits have been at or above 450,000 for months, although last Thursday’s report came in lower than expected at 434K.  There were 14.8 million Americans who were still unemployed at the end of September, along with another 6.1 million who have given up looking for work or are under-employed, who are no longer counted in the official unemployment rate.

In summary, most of the economic reports over the summer were disappointing and suggested that the economic recovery has lost some momentum as compared to the first half of the year.  But more recent reports suggest that we are probably not headed for a double dip recession, unless there are some negative surprises in the months just ahead.

Bernanke Set to Board the QE2

In an unusual move, Fed Chairman Ben Bernanke let it be known back in the summer that the Fed is considering additional “quantitative easing.”  You may recall that the Fed implemented quantitative easing in the last half of 2008 when it purchased over a trillion dollars worth of questionable securities in an effort to unfreeze the credit markets.  As the recession continued, the Fed bought another apprx. $300 billion in longer-term Treasury securities in 2009.

This time around, which is referred to as “QE2,” the Fed hinted it will buy up to another trillion dollars worth of long-term Treasury bonds.  The Fed underscored this commitment at its most recent Fed Open Market Committee (FOMC) meeting on September 21:

“The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation [QE2] if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”  [Emphasis added.]

Of course, the Fed has to print the money to make these purchases, which would be inflationary in better economic times.  Today, however, the Fed is worried that inflation is too low, as suggested in these words from the latest FOMC policy statement on September 21:

“Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”  [Emphasis added.]

This is very interesting.  We’ve long known that one of the Fed’s mandates is to keep inflation under control. What is not widely known, however, is that the Fed believes it also has a “mandate” to keep inflation from getting too low.  Given this perspective, it appears the Fed is more than willing to inject a lot more money into the economy via these huge purchases of Treasury bonds.

To our knowledge, the Fed has not begun these QE2 purchases yet.  In fact, the latest FOMC meeting began today, on Election Day no less.  It is widely believed that the FOMC will formally approve such Treasury bond purchases at this FOMC meeting, and that such an announcement will be made tomorrow (Nov. 3). 

That is speculation, of course, but most analysts expect the bond purchases to begin before the end of the year.  Likewise, analysts are anxious to see how much QE2 will come in the first round; most believe it will be at least $100 billion or more.

For the record, no one knows if this additional QE2 will stimulate the economy or not.  While the purchases will increase the money supply, that doesn’t necessarily mean that banks will increase lending or consumers will increase spending.  Several of my best sources believe the Fed is enacting QE2 simply to appear that it is doing “something.”

U.S. Dollar Falls in Value

Most forecasters believe that QE2 will be positive for the stock market.  I would argue that it has already been positive for stock prices.  The latest strong rally began about the same time that news of QE2 was leaking out of the Fed around mid-summer (see chart below).

News of QE2 was not good for the US dollar.  It has fallen apprx. 8% since the mid-summer level when we learned of the Fed’s latest plans.  The dollar is also under pressure because of our trillion-dollar deficits, the weak economy and near-zero short-term interest rates. 

Most forecasters expect the US dollar to continue to decline in the months ahead, and I wouldn’t disagree.  However, as we saw in 2008, the dollar spiked in value as a safe haven during the credit crisis.  As a result, I would advise leaving the currency trading to professionals.

Waiting, Waiting, Waiting for Breakeven

Since Halbert Wealth Management is a Registered Investment Advisor, we continually talk to prospective clients around the country.  There is one theme that we hear more than any other.  Most investors’ stock portfolios are still down from the peak in late 2007 – that is for those who stayed in.  Here, in so many words, is what we hear most from prospective clients:

 I know I need to change my investment strategy,
but I’m waiting until I get back to break-even. 

Unfortunately, that could be a very long time.  In fact, it has already been 19 months since the market low on March 9 last year, and the stock market is nowhere near back to breakeven.  Take a look at the chart of the Dow Jones over the last decade.

The market peaked on October 9, 2007 when the Dow hit 14,164.  It then proceeded to plunge all the way down to 6,547 in early March of 2009 – a loss of over 50% – for those following Wall Street’s “buy-and-hold” advice.     

And where are they now?  From the low on March 9, 2009 the Dow Jones has recovered apprx. 70% thanks to a meteoric rally until March of this year.  As this is written, the Dow Jones has finally crept above 11,000.  Yet it still has to rise another 3,000+ pointsto get back to the old high!  There’s no telling how long this may take, if at all.

Here’s a simple question: If you lose 50% and then make 50%, are you back to breakeven?  The answer is NO.  If you lose 50%, it takes a gain of 100% to get back to breakeven.  That’s why it is so important to avoid large losses in the first place.

Perhaps this is why legendary investor, Warren Buffett, has said, “The first rule of investment is don’t lose.  And the second rule of investment is don’t forget the first rule.”

In my investment management practice, one of our main goals is to avoid large portfolio losses.  I publish the following table often, but it can’t be repeated too frequently, in my opinion.  The breakeven table below illustrates just how devastating large losses are, and how difficult it is to recover from them:

Amount of Loss Incurred Return Required to Break Even
10% 11.1%
15% 17.7%
20% 25.0%
25% 33.3%
30% 42.9%
35% 53.9%
40% 66.7%
45% 81.8%
50% 100.0%
60% 150.0%
70% 233.3%

Note that if you lose 30%, you have to make almost 43% just to get back to breakeven.  Lose 50% and you have to make 100% just to get back to breakeven.  The table above should clearly illustrate to anyone reading this E-Letter why I believe that avoiding large losses is the most important objective of any worthwhile investment strategy.

Unfortunately, millions of investors bailed out during the severe bear market of 2008 and early 2009, and never got back in.  That’s because most investors are simply not emotionally built to lose half of their investments and remain invested.  They have not enjoyed the stock market rally since the bear market low in March of last year, and this same fear emotion won’t let them get back into the market.  I talk to folks in this very position frequently.

The Advantages of Alternative Investments

If you’ve read this E-Letter for long, you know I am not a big fan of Wall Street’s buy-and-hold mantra.  Instead, my firm searches the universe of professional money managers that use “alternative investment” strategies.  Numerous studies have shown the advantages of including alternative investment strategies in a diversified portfolio.  This is why many pension funds, foundations and wealthy individuals seek out these investments, but there’s no reason that you can’t participate in some of these same sophisticated strategies.

Unfortunately, the term “alternative” has been applied to a wide variety of investments, so let me be more specific.  We define alternative investments as those that use active management strategies in an effort to enhance performance, reduce volatility and provide additional portfolio diversification.

These strategies have the flexibility to move out of the market or “hedge” their long positions during bear markets.  Most stock brokers and mutual fund companies insist that “it’s impossible to time the market.”   But that’s just because they can’t

At my company, we have found numerous professional money managers that have been successfully timing the stock and bond markets for years.  Several have been doing it for a decade or more.  The key is how do you find these winners?

The answer is, you probably don’t.  At my company, we spend lots of money searching for successful active managers all across the country.  Just last week, for example, I flew two of my senior executives to Virginia to check out a money manager we’re considering recommending.  We always visit the manager’s place of business as a part of our thorough due diligence exercise.

Each of the managers we recommend has a time-tested system for spotting trends in the markets.  If the system signals that the next major trend is turning down, they can move out of the funds they own and into the safety of a money market until the trend turns up again.  In some cases, they use specialized “inverse” funds to hedge their long positions (so they don’t have to sell them).

Either way, the goal is to limit losses during downturns, while being invested during most of the uptrends in the market.  We have recommended money managers that specialize in stock mutual funds, while others invest in bond mutual funds.  We even have one very successful manager that invests only in convertible bonds that I wrote about in my October 12 E-Letter on retirement income.

Getting Started: How It All Works

Here’s how a new client relationship begins.  Typically, the new person has been referred to us by a friend or relative.  The first step is a phone conversation with one of my Investment Consultants (who are salaried, not on commission) to determine which of our recommended programs may be suitable for them.

Once the manager(s) has been determined, paperwork to open an account is sent to the new client.  The account(s) is in the new client’s name and is held at a major custodian (such as Fidelity, Rydex, TD Ameritrade, Trust Company of America, etc.).

The money manager(s) selected is given authority to buy and sell securities within the new client’s account.  There is 100% transparency with the activity in the account.  The custodians noted above all have online access to the account(s).  Likewise, the account(s) can be closed at any time – there are no lockups or required holding periods.

The manager(s) charges an annual management fee (usually 1.75 - 2.5%) which is deducted from the account, usually on a quarterly basis, and the client can see these fee transactions as well.  The manager then shares a portion of that fee with Halbert Wealth Management on an ongoing basis for referring the new client and for ongoing management of the relationship. (Note: all of the performance numbers we provide are NET of all fees and expenses.)

At my company, we track every program we recommend on a daily basis.  We can do that because I have my own money invested in every program we offer.  And we stay in close contact with all of the money managers we recommend.

Account minimums vary among the various money managers we recommend.  They range from as little as $25,000 to up to $200,000 in one case. 

By the way, it does NOT matter where you live.  We have clients in almost all 50 states, most of whom I have never met in person.  Most important, if you become a client, I will always take your phone call if you ask for me, or call you back promptly if I am on the phone or out of the office.  I am always happy to talk to a client!

Conclusions

If you lost a lot of money in the 2008-2009 bear market, maybe it’s time to consider the actively-managed investment programs I recommend that focus on limiting losses during bear markets and sizable downward corrections.  As always, past performance is no guarantee of future results.

If you know you need to change your investments but are waiting to get back to breakeven, that is probably a bad strategy, in my opinion.  The market may never get back to breakeven, or it could be a long time.  Think of it this way: The markets don’t know when or where you got in or out, and your investments don’t know what you paid for them.

If you know that you want an investment strategy that focuses on limiting losses – rather than Wall Street’s “buy-and-hope” approach, give us a call.  If you’re like most new clients, you will start out with only one account with one manager, but before long you’ll probably have several accounts – and be referring other people to us.

To learn more about the alternative investment strategies offered  by Halbert Wealth Management, you can contact us in one of the following ways:

Editor’s Note:  Last week I mentioned that a recording of the recent webinar featuring Wellesley Investment Advisors is now available on our website at the following link:

WellesleyWebinar Link

However, some of my readers have told us that they have not been able to download and view the webinar online due to computer constraints of one kind or another.  As a result, we now have the Wellesleywebinar recorded on DVD.  If you have had trouble viewing the online version of the webinar, please feel free to click on the following link and request your free copy of the Wellesley webinar DVD:

WellesleyOnline Request Form

As I noted last week, if you are worried that your bond portfolio will get hurt whenever interest rates start to rise, I highly encourage you to seriously consider Wellesley.

Wishing you profits,

Gary D. Halbert

 

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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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