During the last five months of 2011, wild gyrations became common in the equity markets. The S&P 500 plunged almost 13% in early August, and then rallied over 8% to close the month, only to fall another 10% in September. Then in October, stocks rose a remarkable 17% from trough to peak. The spectacular rallies and corrections continued in November with the S&P 500 falling 7.5% and then rising an equal amount in the span of four trading days.

While this period of heightened stock-market volatility has been particularly acute, elevated volatility has been with us since the financial crisis began. There are many ways to measure stock-market volatility. Some investors prefer to look at the VIX Index, which uses put options to measure the implied level of volatility in the market. A more intuitive measure is the percentage of trading days the S&P 500 moved by more than 2%. Since the financial crisis began in late 2007, the percentage of days when the S&P gained or lost more than 2% has been almost five times the post–World War II average. In 2011, approximately 14% of trading days resulted in a 2% or greater move in the index. And for the final three months of 2011, the figure was a Depression-era 32%.

Why have markets been so volatile? There are many possible explanations. But in our view, the primary driver is the ongoing tension between a global economy trying to cure structural imbalances and actions by policy makers intended to prevent or slow this corrective process.

In past letters, I have discussed the structural headwinds the world’s largest economies face over coming years. The sources of these headwinds are many and varied, but a common thread across the world’s largest economies is the misallocation of capital.

When capital is misallocated, either by force or by monetary persuasion, an unsustainable boom is created, which inevitably leads to a painful bust. The real-estate bubble is the most recent example of capital misallocation in the U.S. Years of easy money, low interest rates, and a central bank focused on levitating asset markets contributed to an atmosphere of excessive risk taking by lenders, borrowers, and investors. Lenders made no- and low-documentation loans to folk with no ability, or in some cases willingness, to repay those loans. Investors and borrowers essentially made leveraged bets on home prices, using leverage of as much as 33 to 1. The underlying assumption of all market participants was that the downside risk was limited. If home prices started to drop or the economy slowed, the Fed would flood the system with liquidity.

When the housing bubble finally burst, the Federal Reserve did indeed flood the system with liquidity, but the damage was too great for Fed Chairman Ben Bernanke to contain. Some of the nation’s largest lenders collapsed, speculators were crushed, and foreclosures surged. Home prices are down more than 30% from their peak. Home equity has evaporated for some and collapsed for many more. According to Core Logic, 22% of all properties with a mortgage are underwater, and an additional 5% have an equity cushion of less than 5%.

The market is still correcting the widespread misallocation of capital built up over a decade or more. Market participants are searching for a bottom in housing and consumption and the stock market, but policy makers are doing everything in their power to prevent or delay this inevitable result. Despite the failings and risks presented by the Federal Reserve’s unconventional monetary policy, Mr. Bernanke presses on.

In the 38 months that have passed since Lehman Brothers failed, the Fed has been on hold (not easing or threatening to ease) in only six of those months. The Fed’s liquidity injections haven’t helped the labor market or prevented housing prices from falling.                  

But they have distorted financial markets, increased volatility, decimated the income of many retired investors, and created a dangerous dependency on 0% interest rates.

In the aforementioned six months that the Fed has been on hold, the average stock-market return was -2.02%, with only two out of the six months resulting in gains. This is a policy-driven market. When the Fed stops supporting asset prices, risk falls out of favor. When the Fed injects liquidity, investors bid up the prices of risky assets. This risk-on, risk-off environment has created a great deal of volatility.

But the policy-driven market is not limited to the United States. Financial markets have reacted violently to every statement and rumor about a possible solution to the euro-area debt crisis. As in the U.S., economic forces in the euro area are trying to right years’ worth of capital misallocation, and policy makers are trying to prevent or slow the process.

The euro experiment created a common currency and monetary policy for a diverse group of countries, but left each country to run its own fiscal policy. Profligate spenders such as Greece and Italy were able to borrow at Germany’s much lower interest rates. The euro area’s peripheral countries temporarily “papered over” the deficit in their competitiveness with Germany by going on a borrowing binge. In Spain and Ireland, too much capital was invested in real estate, and bubbles resulted. In Greece and Italy, government largesse was the result. Historically, countries such as Italy and Greece could improve competitiveness via inflation and currency devaluation, but now they are tied to the euro, those channels are closed. In a fixed-currency regime, the only way to improve long-term competitiveness is through politically intolerable wage and price deflation. But with debt levels now at unsustainable levels, the jig is up for the euro area’s periphery. Debt defaults, fiscal union, and painful wage deflation are the remedy to create a sustainable currency union, but these solutions are easier said than done.

In financial markets, the euro-area policy makers’ attempts to prevent a collapse of the common currency have caused elevated volatility. When rumors that a lasting solution to the debt crisis emerge, risky assets rally, but when those rumors are squashed, risky assets tumble.

High-frequency trading has also heightened volatility in the stock market over recent years. U.S. equity markets have changed drastically over the last 5–10 years. Gone are the days when the NYSE and its specialists dominated stock-market trading. Today, as many as 50 different venues in the U.S. trade equities. Now, almost all stock trades are done electronically. The NYSE specialists who were once obligated to make an orderly market during periods of market stress have been effectively replaced by high-frequency trading firms (HFTs).

HFTs are opportunistic traders that operate with little capital, hold small inventory positions, and are under no obligation to make an orderly market during periods of stress. These firms use sophisticated ultrahigh-speed programs to predict stock prices milliseconds into the future. The most successful HFTs are not the firms with the best insights into a company but those with the fastest programs, located closest to the exchange’s servers. HFTs don’t use fundamental analysis to make trading decisions. Instead these firms use information in order books, past stock returns, cross-stock correlations, and cross-asset correlation to make decisions.

While some might believe HFTs are benign market participants, just the opposite is true. High-frequency trading now accounts for 70% of U.S. stock-market volume—an astonishing statistic, to be sure. The purpose of financial markets is to efficiently allocate capital to its highest and best use, yet a majority of the daily trading in stocks is conducted by investors with no interest in the value of the companies they buy and sell. HFTs are interested only in the price of a stock over the next second or two.

HFT proponents will tell you high-frequency trading poses no risk to the broader market, and in fact increases liquidity and keeps transaction costs low. The counterargument is that HFT liquidity is transitory and shallow (large orders are hard to fill), and while HFTs have helped drive down bid-ask spreads on stocks, they are extracting those profits from investors in other ways (some of the strategies are discussed later).

Because HFTs are not under the same obligation as NYSE specialists to provide liquidity, they often pull back from the market during periods of stress, creating a liquidity vacuum, which can result in cascading prices. The so-called “Flash Crash” in 2010 was partly caused by several major HFTs stepping away from the market in order to limit risk. Here is what a joint CFTC-SEC report on the Flash Crash said about the structure of today’s stock market.

The Committee believes that the September 30, 2010 Report of the CFTC and SEC Staffs to our              Committee provides an excellent picture into the new dynamics of the electronic markets that now characterize trading in equity and related exchange traded derivatives. While these changes have increased competition and reduced transaction costs, they have also created market structure fragility in highly volatile periods. In the present environment, where high frequency and algorithmic trading predominate and where exchange competition has essentially eliminated rule-based market maker obligations, liquidity problems are an inherent difficulty that must be addressed. Indeed, even in the absence of extraordinary market events, limit order books can quickly empty and prices can crash simply due to the speed and numbers of orders flowing into the market and due to the ability to instantly cancel orders. Liquidity in a high-speed world is not a given: market design and market structure must ensure that liquidity provision arises continuously in a highly fragmented, highly interconnected trading environment.

More troubling than the transitory liquidity HFTs provide are some of the dubious strategies employed by these firms. Below are some examples of the strategies used by various HFTs—most are illegal but difficult for regulators to detect.

Front-running – Using computer algorithms to detect and trade ahead of institutional orders.

Quote stuffing – Submitting and then immediately cancelling trades in order to gain a few-  millisecond speed advantage over the competition. The computers of the HFT who submits the erroneous orders don’t have to process that information, whereas the competitors’ computers do.

Layering – Using hidden orders on one side of a trade and visible orders on another side of the trade to manipulate prices. For example, if a trader wants to buy a stock at $5.01, but the current bid is $5.02 and the asking price is $5.03, the HFT may put in an order that is hidden to buy at $5.01. It will then flood the market with orders to sell at a price higher than the current asking price, let’s say $5.05. Others will see the selling pressure and adjust their bid and ask prices lower, likely hitting the HFTs intended bid price of $5.01.

Spoofing – A trader may initiate the rapid-fire submission and cancellation of many orders, along with the execution of some trades to “spoof” the algorithms of other traders into buying or selling more aggressively, which can exacerbate market moves.

 My goal is not to suggest all high-frequency traders are unscrupulous or the practice should be banned (though I suspect few would actually miss it). But it seems to me high-frequency trading has become so vital to the proper functioning of today’s stock market that, at the very least, more oversight and disclosure should be required of these firms.

Even with the structural imbalances in the global economy and the potential for elevated volatility from high-frequency trading, we believe stocks could have a positive year in 2012. First, in the current low-interest-rate environment, many investors feel there is greater upside potential from stocks versus bonds. A bias toward stocks could help elevate share prices. Additionally, stocks tend to favor U.S. presidential election years. The election-year argument didn’t work out so well last time around, but in 2008 markets were in a bubble due to excessive leverage.

Even with the potential for a decent year in stocks, we do not favor abandoning our strategy for a globally diversified portfolio that includes corporate bonds. Short-term corporate bonds, which we currently favor, can greatly reduce volatility if misfortune or an unlikely event makes an appearance in 2012. Risks including the euro mess, the Middle East, and a less-than-robust U.S. economy are potential triggers for widespread market disruptions.

As most of us are all too aware, the stock market is an emotional and volatile place. Diversification is not about maximizing returns. Diversification is about reducing risk. A portfolio invested, by example, 50% in corporate bonds, 40% stocks, and 10% in gold and currencies should have much less downside volatility than a portfolio invested primarily in stocks.

Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Sincerely,

Matthew A. Young
President and Chief Executive Officer

P.S. The homepage of Younginvestments.com reads “Dividends and Interest. Cash Flow Is Our Focus.” For 2012, we continue to believe conservative retired and soon-to-be-retired investors are well advised to concentrate on the dividends and interest theme. A continuous stream of cash should provide comfort in an environment where stock volatility could remain high.

P.P.S. “Dividends are a bonus in up markets and provide comfort during slides. Over time, dividends have provided about 44% of the U.S. stock market’s annualized total return of 10%. And they are sure to remain an important component of returns if appreciation is hard to come by in coming years, as we expect. Thanks to dividends, you can make money even if the market essentially goes nowhere.” Kiplinger’s Personal Finance, January 2012

P.P.P.S. The fact that a company pays a dividend is only one criterion in our stock selection process. Beyond a cash payment, we seek high-quality companies, dominant in their industry, with high barriers to entry, strong balance sheets (in our opinion) and a manageable payout ratio. We believe that limiting our purchases to this type of company will allow our clients to sleep better at night and appreciate a continuous stream of cash payments during what should be an eventful 2012. The yield on our Retirement Compounders equity program is 5.1%.*

*Yield as of 1/23/2012

The information contained in this letter is for informational and educational purposes only. It is not intended nor should it be considered investment advice or a recommendation of securities. Please contact our office directly with any questions regarding items appearing in the letter.

Here is one problem facing investors: during August and September, the Dow Jones Industrial Average rose or fell by more than 1% on 29 days. By third quarter’s end, the Dow was down 12%, the largest quarterly percentage decline since the first quarter of 2009. This degree of volatility, which of course is great fodder for the media, can lead to knee-jerk decisions that send investment strategies off course.

 One reaction to the volatility is selling and going to cash. Hitting the mattresses and living to fight another day worked pretty well in the 1980s, when yields on one-year T-bills were often higher than 7%. And for much of the 1990s, one-year T-bills hovered around 5%. Today, nervous investors have unappealing options, including money markets essentially offering no yield or a 2% yield on 10-year U.S. Treasury notes. At these low rates and with overall inflation running at 3.9%, investors who move to cash are pretty much throwing in the towel and accepting a loss.

 Spooked investors who sold in September witnessed an October U-turn as the Dow quickly barreled ahead 6.6% in the first two weeks of October. The month finished at one of the biggest one-month gains since the early 1990s. Studies have been done illustrating how missing the best months of market returns can dampen investment returns. Investors who attempt to time the market run the risk of missing periods of exceptional returns just like we had in October.

 Now, investors who sold out in September must decide whether to sit in cash and accept inflation risk or get back into the market and accept the potential for continued volatility.

 It’s important for investors to understand their tolerance for risk. Risk varies for each investor. By example, volatility may not be the primary risk for the long-term investor. Instead, the long-term investor may be more concerned with the portfolio’s future purchasing power—in other words, keeping pace with inflation. This is definitely an issue for those who expect to be living for several decades.

 Over longer periods, stocks have historically outperformed both cash and bonds. Additionally, the longer-term stock investor has reduced risk of loss compared to a shorter-term investor. Historically, over a one year holding period, the chance of losing money in the stock market has been about 33%, over 5 years, 22% and over 10 years, 13% (based on historical S&P 500 returns excluding dividends from year-end 1930-2010). But when you go out over longer periods, especially over 20 years, the risk of loss is minimal.  

 Investors are living longer than before, and the rise in longevity means that retirees often face decades of investment decisions. More than likely, their main decision will be how to reduce portfolio volatility while having enough portfolio growth to keep pace with inflation. Most investors recognize the importance of an equity component to achieving their long-term investment goals.

 Balanced portfolios often are less volatile than all-stock portfolios. Balanced portfolios feature a mix of both bonds and stocks. Historically, when stocks do poorly, bonds perform relatively well. And when bonds do poorly, stocks can help pick up the slack. This teeter-totter effect can help smooth out the volatility and reduce dramatic swings in portfolio values.

 We currently suggest a portfolio featuring a mix of bonds, dividend-paying stocks, gold, and foreign currencies. Many clients at Richard C. Young & Co., Ltd., have at least 50% dedicated to bonds with approximately 40% in dividend-paying stocks and ETFs and 10% in gold and currencies (50-40-10).

 A 50-40-10 mix can offer at least two benefits. The first is that a balanced portfolio with 40% invested in stocks should experience much less volatility than an all-stock index. During dramatic stock-market declines, a balanced portfolio should not take as wild a ride. (The flip side is that when the stock market soars, a balanced portfolio will often lag by comparison.)

 The second benefit is that approximately 90% of the portfolio invests in securities paying interest or dividends. This regular stream of cash can help offset the negative impact of inflation. Such a portfolio has appeal to the longer-term investor concerned with inflation risk.

As I wrote in last month’s letter, the Federal Reserve’s August decision to hold short-term interest rates near zero for another two years pushed already low interest rates down even further. Yields on short- to intermediate-term Treasury securities are now under 1%. Investors looking for a 2% return in Treasury securities must now buy 10-year maturities. And those income seekers hoping to maintain the purchasing power of their money in full-faith-and-credit-pledge U.S. Treasuries are out of luck. The highest-yielding Treasury security, the 30-year T-bond, yields only 3.17%, compared to an inflation rate of 3.9%.

 The Federal Reserve’s confiscatory monetary policy has greatly complicated the task of clipping bond coupons. Federal Reserve Chairman Ben Bernanke is seemingly unconcerned with the potentially devastating consequences of his repressive interest-rate policy.

The Fed is forcing investors who are the least equipped to shoulder risk into speculative investments. You either take the Fed’s bait by risking portfolio-decimating losses or sit in cash and lose purchasing power. We of course are resisting the Fed’s misguided push to invest speculatively, but we aren’t sitting idle. To navigate the current low-interest-rate environment, we are investing selectively in high-yield bonds and taking a more active approach by using a roll-down strategy.

Concern about a recession in the U.S., a hard landing in China, and most notably, a sovereign-debt-induced financial crisis in the euro area has pushed high-yield bond prices down, and yields up. In early October, the yield on the Merrill Lynch High-Yield Master II Index rose to 10% and today sits at nearly 9%. Of course, high-yield bonds offer such juicy yields because they are issued by borrowers who are less creditworthy than those in the investment-grade bond market. But in our view, at current levels, investors are being compensated for the added risk.

One of the data points we use to assess the value in high-yield bonds is the default rate embedded in prices. A simple back-of-the-envelope calculation can show the default rate that is priced into high-yield bonds. To make the calculation, you need only two variables: the spread on high-yield bonds (yield advantage relative to Treasuries), and the loss rate on defaulted bonds. The spread on the Merrill Lynch High-Yield Master II Index is 7.5%. Historically, the loss rate on defaulted high-yield bonds has averaged about 60%. To find the market’s expectation of the default rate, we simply divide the spread, 7.5%, by the loss rate of 60%. The result of 12.5% is the default rate that would set the return of high-yield bonds equal to the return on comparable-maturity Treasury securities. In other words, if 12.5% of the bonds in the Merrill Lynch High-Yield Master II Index were to default, the return on high-yield bonds would equal the return on comparable-maturity Treasuries (assuming a 60% loss rate on defaulted bonds).

  How does a 12.5% default rate compare with history? According to Moody’s, the speculative-grade default rate has exceeded 12.5% only twice in the last 90 years—once during the Great Depression and a second time during the 2008 financial crisis. At current spreads, high-yield bonds are priced for calamity. Yet corporate fundamentals appear to be solid. Nonfinancial corporate debt to pretax income is at the low end of a three-decade range. Corporate profits and profit margins are at a record, and liquidity in the banking sector remains near record highs. We see limited downside risk and the opportunity for considerable upside.

 For some clients, we recently purchased a high-yield bond from Sunoco Inc. Sunoco is a leading oil-refining and marketing company. Sunoco sells fuel through more than 4,900 retail gas stations in 24 states that are supplied by Sunoco-owned refineries. Sunoco is also the general partner and has a 34% stake in Sunoco Logistics, a pipeline company. As of June 30, Sunoco had $1.4 billion in cash on hand, compared to $2.5 billion in debt. We purchased Sunoco’s 4.875% bonds due in October of 2014 at a yield of nearly 5%.

 A second adjustment we are making to portfolios to enhance yield is a roll-down strategy. A roll-down strategy seeks to profit from a steep and positively sloped yield curve (when long-term rates are higher than short-term rates). As a bond approaches maturity, its yield falls (assuming a positively sloped yield curve), potentially pushing up its price. With a roll-down strategy, an investor sells the bond after it rises in price and reinvests the proceeds in a longer-maturity bond.

 Let’s look at an example. Today, five-year Treasury securities yield 1.038% and four-year Treasury securities yield 0.73%. If an investor buys a five-year Treasury security today for $1,000, in one year the bond’s price will rise to $1,012 (assuming no change in interest rates) so that the bond’s yield falls to 0.73%—the yield on four-year Treasuries.

 Adding the $10.38 in annual interest the investor will collect,the value of the bond will be $1,022 ($10 in interest plus $1,012 in principal). That’s a 2.23% return—more than double the bond’s yield at purchase. Now, if the investor holds the bond to maturity, its price will eventually fall back to $1,000 and his return will equal the bond’s yield to maturity when purchased. But if the investor instead sells the bond at the end of year one, he can capture a capital gain and reinvest the proceeds in another five-year bond yielding 1.038%.

 A roll-down strategy works best when the yield curve is positively sloped and interest rates are likely to remain stable. Today the yield curve is steeply positive, and the Fed’s commitment to maintain its zero interest rate policy until mid-2013 is likely to keep a lid on short- to intermediate-term interest rates.

 As part of our roll-down strategy, we recently sold an AT&T bond due in 2013 at a price of $111.04 and yield of 1.29% and purchased an AT&T bond due in 2016 that was yielding 2.10% at a price of $103.67. We picked up 81 basis points in yield and for many portfolios captured a gain (above amortized cost).

 During the past decade ending September 2011, the S&P 500 generated a not-so-great annual return of 2.81%. For many investors, this experience highlights the unpredictable nature of the stock market, even over a 10-year period. It’s important to remember that stock markets do not run on a schedule. They are random and unpredictable.

 To cope with today’s speculative markets, we favor a defensive approach featuring a globally diversified portfolio of stocks and bonds. We emphasize companies that have strong balance sheets and operate in industries with high barriers to entry. And most importantly, we prefer securities that pay a steady stream of dividends or interest. Cash payments today and the promise of higher payments tomorrow are a comfort during periods of high volatility.

 Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

 Sincerely,

 Matthew A. Young
President and Chief Executive Officer

 P.S. An important feature of our equity strategy is to focus on companies we believe possess the ability and desire to raise dividends annually. Companies with annual dividend increases are usually confident about their future earnings. These companies tend to be stable businesses well positioned in their markets and able to perform throughout market cycles, making them good candidates for long-term growth.

 P.P.S. In October, the Conference Board Consumer Confidence Index plunged deep into recessionary territory. The index has only been lower twice in its more than four-decade history. Both episodes were associated with deep recessions. Why are consumers forecasting recession? Wasn’t October the best month in stocks in almost two decades? Maybe low consumer confidence has something to do with income. In the third quarter, real personal income excluding transfer payments fell for the first time since the recovery began. So we have millions who are scraping by with unemployment benefits, and those who are working are seeing their incomes fall. That doesn’t bode well for future economic growth.

Over recent years, we have advocated and pursued what we consider to be a defensive investment strategy. Our caution has centered on the troubling condition of the global economy. Today, the world’s largest economic players face powerful structural headwinds likely to constrain economic growth. Yet many economists, policymakers, and investors have operated with an optimistic outlook. We contend that problems exist and that many financial assets are not reflecting this reality.

According to the International Monetary Fund, the world’s four largest economies, in order of size, are the United States, the euro area, China, and Japan. In aggregate, these four countries generate almost 60% of the $69 trillion in global GDP. Most agree that without strong fundamentals in the “Big 4,” global economic growth will remain slow. Unfortunately, the fundamentals of the Big 4 are on shaky ground. I want to briefly describe some of the headwinds facing the world’s four largest economies.

The U.S. is riddled with problems, but debt is the nation’s biggest challenge. Over the last three decades, American households, businesses, and government borrowed too much. Debt growth outpaced economic growth by more than 100 percentage points. But debt can only grow faster than income for so long. There are limits to the amount of leverage a business, an individual, or a nation can service. In our view, the American economy has reached that limit. Deleveraging is now necessary.

Though you wouldn’t know it from looking at our debt-to-GDP chart above, the private sector has already started to deleverage. Household debt has fallen to .88X GDP from .98X GDP in 2009—the largest decline since records began over 50 years ago.

But if the private sector is deleveraging, why hasn’t total debt-to-GDP ratio fallen? Enter Washington.

Take a look at our next chart. Here we show the total amount of household and federal government debt. The drop in household debt has been more than offset by an increase in government debt. Policymakers have been reluctant to allow the economy to deleverage. But supplementing private-sector spending and borrowing with government debt and deficits only delays the inevitable. The status quo isn’t sustainable. The U.S. is borrowing almost 40 cents of every dollar it spends. On a $3.8 trillion budget, that adds about $1.5 trillion to the debt each year.

 To prevent a debt crisis in coming decades, the federal government needs to reduce the national debt. However, if large reductions occur, it is important to understand that austerity is bearish for growth (and the stock market) in the short run. Government spending and borrowing are artificially keeping the economy stronger than it otherwise would be. If the U.S. balanced its budget tomorrow, more than $1 trillion in spending would be taken out of a $15-trillion economy.

So the global economy’s lead horse is on the verge of a deleveraging process that is likely to hold back economic growth in the medium term. The world’s second-largest economy is the euro area. As you may know, the euro area is neck deep in a sovereign debt crisis. Greece has been given lifeline after lifeline because, like policymakers in the U.S., euro-area policymakers are reluctant to accept the inevitable.

Even after a modest restructuring plan that was recently approved by euro-area policymakers, Greece has too much debt. A default appears to be the only long-term solution in sight today. The same may be true of the euro area’s other peripheral economies. The E.U. is advising austerity for overly indebted euro-area nations, but austerity isn’t working.

In 2011, the Greek and Portuguese economies are expected to contract by 3% and 1.5%, respectively, while economic growth in Ireland and Spain won’t break 1%. Lower economic growth raises the debt burden.

The euro area’s problem is not so much overly indebted members as it is a structural flaw in the currency union’s design. Euro-area economies are a diverse bunch. There are mature economies such as Germany that average growth of less than 2% and emerging economies such as Estonia that average growth in excess of 5%. When policymakers apply the same monetary policy to vastly different economies, imbalances result.

If the euro is to avoid a breakup, we see only one option that would permanently resolve the instability that is plaguing the region—tighter integration. A fiscal union or political union in conjunction with labor-market reforms and greater labor mobility would increase the stability of the euro area and the viability of the common currency. The problem with greater integration is that the polls show the public set against it. Citizens don’t want to give up their sovereignty. The frugal Finns don’t want to bail out the profligate Greeks, and more importantly, the Germans want no part of a fiscal union or anything like it. In Germany, a majority of the public thinks the original rescue of Greece was a mistake. And 60% reject offering further assistance.

That doesn’t bode well for the future of the euro, or economic growth in the region. The threat of sovereign default or a euro breakup is likely to weigh on euro-area growth until the matter is permanently resolved.

If the U.S. and the euro area aren’t going to lead the global economy, can China save us? China is, after all, the world’s fastest-growing large nation. We don’t have high hopes for such a scenario. It is true that China’s economy may contribute to global growth, but if you’re looking for a structurally sound economy, China is not it. China’s economy has serious structural flaws—which we believe are more severe than those in the U.S. or the euro area.

Though it is not often mentioned by China bulls, it is important to remember that China is still a command-style economy. Command economies have a long history of failure. The most common shortcoming of command economies is their propensity to misallocate resources. China is no exception. The Communist Party’s management of the Chinese economy has resulted in massive misallocation of capital in the country. An intentionally undervalued currency, poor incentives for political leaders, and a government-controlled banking system are all to blame. There is a property and fixed-asset investment bubble that, according to one formerly bullish China expert, could produce a “major, major economic correction.” Investment bank Standard Chartered estimates that about 50% of China’s GDP is linked to the fate of its real-estate market. That’s a scary thought, especially since Chinese policymakers have been tightening monetary policy in an effort to slow inflation. A hard landing could be in store for China. And if it is, investors crafting portfolios on the hope that China will drive global economic growth are in for an unpleasant surprise.

That leaves Japan. With GDP of $5 trillion, Japan is the world’s fourth-largest economy. Is Japan any more structurally sound than the U.S., euro area, or China? Do two lost decades of economic growth, persistent deflation, a declining population, and a government debt-to-GDP ratio of 200% seem structurally sound to you? Japan’s excessive government debt is a disaster waiting to happen. The country has managed to avoid financial collapse up to this point because it has been able to finance itself with private-sector savings at sub-2% interest rates. But Japan’s population is aging, and as it ages, the country’s savings rate falls. By 2015, the household savings rate is expected to dip into negative territory. If Japan can’t finance itself domestically, external creditors will have to close the gap. What’s the problem with Japan turning to external creditors? The problem is the rate of interest. At today’s sub-2% borrowing rates, debt service eats up 20% of government revenues. If external creditors demand a yield more on par with yields on U.S. and euro-area bonds, Japan’s debt service costs could consume the country’s budget.

All in all, it is a pretty bleak picture for the global economy. The world’s four largest economies, accounting for almost 60% of GDP, face major structural headwinds that are likely to weigh on growth in the medium term. And without vibrant growth in the “Big 4,” global economic growth is likely to muddle along at a lackluster pace.

Until the structural headwinds subside or financial markets start pricing in the challenged outlook for the global economy (the latter is starting to happen), we will maintain our defensive approach.

Our defensive approach relies on several tactics. First, we focus on cash-generating securities. A predictable stream of interest and dividend payments not only can supplement spending needs but also provides a sense of comfort that appreciating markets are not the only fuel for portfolio growth. Second, we primarily invest in bonds and stocks of companies we believe to be higher quality. High-quality companies tend to stay in business and tend to continually make timely interest and dividends payouts.

Third, while we believe in a diversified portfolio, we do not wish to over-diversify. Long bonds, technology shares, and much of euro land are currently not welcome in a Young portfolio. Instead, we include favorites like short-term corporate bonds, utilities, consumer staples, pipelines, Canada, and Switzerland.

Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Sincerely,

Matthew A. Young
President and Chief Executive Officer

P.S. The Fed’s August decision to hold interest rates near zero for another two years has pushed short-term Treasury rates of varying maturities down to levels near zero. The five-year Treasury now yields less than 0.95%. We are adapting our fixed-income strategy to the current environment to enhance portfolio yield. We plan to rely more heavily on a roll-down strategy and high-yield bonds, which have become more attractive in the recent market sell-off. I’ll describe each strategy in more detail next month.

P.P.S. Most investors understand the concept of total return. Total return is calculated according to the following formula: capital gains + dividend yield = total return.
Total return could also include a third element, dividend growth. When you have dividend growth, your investment has a better chance to keep pace with inflation.Our Retirement Compounders equity portfolio invests in 32 dividend-paying securities, and a majority of the securities increase their dividend annually. Today, our Retirement Compounders program has a current yield around 5%.

P.P.P.S. As recently noted in SmartMoney magazine, a regular check isn’t the only way that a dividend-paying stock can benefit retirees. Recent research by Michael Goldstein, finance professor at Babson College, shows that dividend stocks as a group outperform nonpayers over time, in both up and down markets. Goldstein points out that dividend-paying companies tend to be more financially sound, which may account for the outperformance.

The information contained in this letter is for informational and educational purposes only. It is not intended nor should it be considered investment advice or a recommendation of securities. Please contact our office directly with any questions regarding items appearing in the letter.

During the seasonal months in Naples, Cato hosts seven invitation-only policy forums. The first forum, which I attended after meeting with Bob and Ed, focused on taming the federal budget. The inaugural Cato Naples briefing featured commentary on the budget from Chris Edwards, director of tax policy studies at Cato, and senior fellow Richard W. Rahn.

Mr. Edwards handed out a chart pack that allowed attendees to fully grasp the urgency of the message. In the chart “Federal Spending by Department,” the five largest annual expenditures are (1) defense at $761 billion, (2) Social Security at $742 billion, (3) Medicare at $488 billion, (4) Medicaid at $276 billion, and (5) net interest at $207 billion. Below the big five trailed a list of much smaller budget expenditures.

Congress has come up with a nifty scheme to deal with the budget crisis. In a nutshell, the idea is to nickel and dime the smaller budget expenditures and avoid the other five behemoths. It is clear to me, as it is apparently clear to the Cato analysts, that neither the administration nor Congress plans to address what appears to be a crisis. And here is the icing on the cake: net interest, which stands today at #5 on the spending list at $207 billion, is set on an uphill trajectory that will balloon it into the biggest, most bloated beast of all.

In a March 8 Washington Times article, Mr. Rahn wrote about the U.S. government’s serious overspending problem:

If the spending and the resulting deficits are not soon stopped, the U.S. economy will become dysfunctional, and our prosperity and freedoms will disappear. Despite the overwhelming evidence that the government is headed for a debt crisis, there are still a few economists who are saying: “Spend more.” Last week, one of the “spend more” crowd, Mark Zandi of Moody’s, made the absurd claim that the attempt by the Republicans to cut the budget by approximately $60 billion (or less than 2 percent of total federal spending) would result in 700,000 lost jobs. The Democrats and their media allies, of course, jumped on the opportunity Mr. Zandi gave them as their latest excuse not to reduce spending. Instead, they have proposed cutting the budget by one quarter of 1 percent.

On the monetary side, which Bob, Ed, and I also discussed, the Federal Reserve continues backing up the money truck. There has never been a more accommodative monetary policy in the 235-year history of the United States than there is today. The power of the 0% interest rates and the printing press cannot be overstated. Since the Fed first signaled to the market that round two of quantitative easing was likely, stocks have soared, with the S&P 500 climbing 22% and the speculative Nasdaq advancing 27%. Meanwhile, the dollar index has tumbled 9.1%. The CRB commodities index has gained 26%.

With commodities prices surging and inflation pressures heating up in certain sectors of the  economy, the financial press is loaded with articles offering advice on how to protect your portfolio from inflation. One of the more common recommendations is to buy Treasury inflationprotected securities (TIPS). This advice sounds reasonable. If you want to protect your portfolio from inflation, why not buy inflation-protected bonds?

In our view, buying TIPS today to protect your portfolio from inflation would be a mistake. It is not that we are averse to TIPS. In fact, we own a legacy position in TIPS for many of our clients. The problem with TIPS as an inflation hedge is one of price. TIPS yields today are far too low. By example, the yield on the Vanguard Inflation-Protected Securities fund is currently -0.05%. The last time we purchased TIPS for clients, yields were north of 3%.

If you aren’t familiar with TIPS, the yields I am quoting are real yields. TIPS earn a real yield plus compensation for the rate of inflation. So everything else equal, if inflation is 2% over the next 12 months, the Vanguard Inflation-Protected Securities fund should earn 1.95% (-0.05% in real yield plus 2% in inflation compensation).

The potential mistake in buying TIPS as an inflation hedge today is that investors cannot separate the inflation-protection component of TIPS from the real-yield component. Even in an inflationary environment, an adverse move in real yields could cause TIPS prices to plunge.

With real yields near historic lows, the probability of an adverse move in real rates is uncomfortably high. Take a look at my real 10-year Treasury yield chart. Here I am simply taking the historical nominal Treasury rate and subtracting the average inflation rate over the previous 10 years. Over the last five decades, the real 10-year Treasury yield has averaged 2.71%. Today, real yields are 0.99% as measured by 10-year TIPS. By historical standards, real yields are low. If real yields rose 1.70% to their historical average,  theoretically TIPS prices would plummet 14%.

Click the graph for a larger image

That -14% price change assumes an instantaneous rise in interest rates, but even if you use more conservative assumptions, the return implications still aren’t pretty. If you assume a three-year holding period, a 1.7% rise in real yields, and inflation of 4% annually, 10-year TIPS would return 1.15% annually for the next three years. That’s far below the assumed inflation rate of 4%
in my example.

Another sector of the fixed-income markets we continue to avoid is municipal bonds. We sold our clients’ muni-bond positions in 2009 and early 2010. Our concern was that states and municipalities were facing severe budget pressure that was likely to result in elevated muni defaults. The sales turned out to be timely. Since November of last year, muni bonds have sold off. My chart shows that the iShares National AMT-Free Municipal Bond Fund (MUB) fell 8.8% from October 31 to January 14. The fund has since recovered some of its losses but is still down 6.9% from its high.

Click the graph for a larger image

We continue to avoid munis for some of the same reasons we sold them in 2009 and 2010. State and municipal budgets are strained. In our view, more defaults are unavoidable. Will defaults reach into the hundreds of billions as some analysts are projecting? I don’t know, and neither does anybody else. State and municipal finances are famously opaque. Municipal financial statements, if you can even locate them, are filed with a long lag.

Historically, investors paid little attention to issuer financial statements. Most muni issuers bought AAA ratings by paying for  municipal bond insurance. But many of the muni-bond insurers went bust or were severely downgraded in the financial collapse. Insured AAA ratings are no longer prevalent in the muni market. The finances of underlying issuers must be evaluated. That’s no easy task when there are tens of thousands of different issuers.

What concerns us most about muni bonds is not so much the prospect of massive defaults. Rather, it is the potential for panic selling. According to Barron’s, 70% of the investor base in muni bonds is individual investors. The folk who own these bonds don’t analyze muni-bond credits full-time. If muni defaults start to pile up, panic selling may ensue. With long muni rates still below 5%, it could be a long way down before value buyers step in to stabilize prices. Who needs the potential volatility at such low yields?

Instead of buying TIPS and municipal bonds we currently favor a short-duration portfolio of GNMAs, individual corporate bonds, and bank loans. Bank loans are a new fixed-income sector we’ve added to many portfolios.

Bank loans are also referred to as floating-rate loans or leveraged loans. Bank loans are generally made to businesses with below-investment-grade ratings. They are most often secured by collateral of the borrower, such as receivables or inventories. Bank loans are the most senior security in a company’s capital structure, ranking ahead of even secured senior debt. That gives bank-loan investors first priority on assets in the event of default. Compared to similarly rated high-yield bonds, bank loans have historically had lower default rates and higher recovery rates. According to Moody’s, the long-term average recovery rate of bank loans is 70%, compared to 40% for high-yield bonds.

Bank loans are often issued at a spread of 250–300 basis points to three-month London Interbank Offered Rate (LIBOR). LIBOR is an interbank lending rate that is used as a benchmark for private-sector borrowing rates. The average maturity of bank loans is about four years, but because they are floating-rate instruments, bank loans have a duration of close to zero. When interest rates move up, bank-loan investors get a pay raise. In other words, bank loans have almost no interest-rate sensitivity, although there is credit risk. According to S&P, the current yield to maturity on bank loans is approximately 4.8%.

The total size of the bank-loan market is estimated at about $515 billion. Bank-loan investors include insurance companies, banks, hedge funds, and mutual funds. This is an institutional asset class. Bank loans aren’t securities individual investors can just go out and  purchase. You need large sums of capital and adequate support staff to deal with the legal and operational complications of managing a bank-loan portfolio.

To gain exposure to the bank-loan market, we are buying the Fidelity Floating Rate High Income Fund (FFRHX). FFRHX is a conservatively managed bank-loan fund. The fund manager tends to avoid the most speculative deals in the bank-loan market.

When you consider the current environment, bank loans can make sense. Banks are flush with liquidity. Companies that need to refinance maturing debt should. With risk appetite in the fixedincome markets on the rise, investors will be looking to pick up additional yield in lower-rated securities. An improving economy also points to higher interest rates. Since bank loans are
floating-rate instruments, they benefit from rising rates. The 30-day SEC yield on FFRHX is 2.65%. The yield is a bit lower than the average yield in bank loans both because investors must pay an expense ratio, and because the fund favors high-quality credits. The yield is still compelling when compared to a similar-duration three-month T-bill, which offers a yield of only 0.13%.

Given the wildly expansionary and unsustainable fiscal and monetary policies of the U.S. government, we believe the prudent investment course for conservative investors is a defensively constructed allocation. For fixed-income investing, we favor relatively higher-quality bonds with short- and intermediate-term maturities.

On the equity side, we are constructing a globally diversified portfolio featuring securities that pay out decent dividends rather than rely solely on capital appreciation. One of our favored domestic names has been Verizon, with its 5% dividend yield, which has increased in each of the last four years. Also, we have added Canada’s Peyto Exploration & Development to many client accounts. Peyto, a low-cost natural gas producer, owns a portfolio of natural gas reserves with an estimated life of 21 years. Peyto shares yield close to 4%.

Have a good month, and as always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Sincerely,
Matthew A. Young
President and Chief Executive Officer

P.S. We recently acquired bonds from Brazilian oil company Petroleo Brasileiro, or Petrobras. The energy giant, based on market cap, is the eighth-largest company in the world. By the end of this decade, some predict that Petrobras will pass ExxonMobil to become the largest publicly traded oil company in reserves and production. As CEO Sergio Gabrielli explains, “What we can say is that we have a lot of oil. We have an asset base in our own portfolio that, on an organic basis, can grow faster than anyone else.”

P.P.S. “Officially reported job growth is better in the last couple of months, but jeez, nonfarm payrolls today are at about the same level as May 2009. That’s almost two years with no net gain. And the rotten employment and new home sales readings come on the heels of a mega money-printing campaign at the Fed. What happens when the press shuts down this summer, when QE2 ends, and when the Bernanke-driven Free Money Truck exits the hood? It is an outrage that the Fed subsidizes Goldman Sachs, while Mr. and Mrs. Goldman, private citizens, hunkered down in a Boca retirement condo, are getting four basis points of T-bill interest on their retirement savings. Are Americans paying any attention to this appalling expropriation? No wonder gold and the Swiss franc are trading at record prices.” Dick Young, April 2011.

P.P.P.S. With the Swiss franc trading near record prices, we recently reduced our position in the currency. Historically, investors have viewed the franc as a safe-haven currency. But, with today’s sovereign debt problems in Europe and reckless money printing by the Fed, the franc has become a go-to currency to hedge against debasements. In our view, the franc has been overbought and over-owned by speculators. We continue to favor the franc on a long-term basis and will look to add to our position again in the future. For additional currency diversification, we have begun taking positions in Swedish holdings. I will profile Sweden and recent purchases next month.

The information contained in this letter is for informational and educational purposes only. It is not intended nor should it be considered investment advice or a recommendation of securities. Please contact our office directly with any questions regarding items appearing in the letter.