Hello 2012!

If you extrapolate last year's lessons, diversification could be seen as the biggest threat to a portfolio. Traditional US Large Company Stocks and US Government Bonds sprinted past limping "diversifiers" such as international stocks, non-traditional bonds, and alternative investments. Over history, clients have generally benefited from diversification. But this pillar of investment discipline turned into a headwind last year.

For equity investors, flat domestic returns did not tell the whole story. Consider that the return of the S&P 500 index last year was 2.1% including dividends. US Companies took a roller coaster ride to get back to their starting point - disappointing summer news was eventually overcome by maintained slow growth and exceptional corporate profits.

Source: Morningstar, Inc.

For investors,

staying the course was a challenging proposition last year. The return landscape was even more challenging for portfolios with exposure to international markets. A natural disaster and nuclear situation in Japan first set things on edge followed by enduring concerns about debt which continues to engulf the Eurozone.

Bonds were king in 2011

with long bonds issued by the US government ruling the roost. Key interest rates found new lows (insert hyperlink to interest rate chart from RJ). This was helpful if you were in the position to refinance your mortgage and was also helpful from a portfolio perspective. However, those investors who anticipate a rate rise in the future and have positioned portfolios to attempt to minimize the risks did not fully participate in the boom for fixed income investments.

Our resident economist,

Angela Palacios, CFP ®, notes that unemployment has continued its downward trend since August and is currently at 8.5% nationally which is the lowest level in more than three years according to the United States Department of Labor, Bureau of labor Statistics. Retail, manufacturing, transportation and health care are a few of the sectors enjoying job growth. Based on initial claims so far this month it also looks like we will see another decline in the rate even though it is normally high in the first two months of the year with temporary holiday workers being laid off. This reduction in unemployment is a lagging indicator of the economy showing the pickup in economic growth even though it may be slow.

Short-term lessons don't always help investors focused on the long-term results. We still believe there are critical benefits to diversification and maintain portfolios with a variety of distinctive asset categories and strategies. Our process-driven investment strategy is also designed to avoid performance-chasing sirens in favor of disciplined investing.

Sincerely,

Melissa Joy, CFS

Partner, Director of Investments

Financial Advisor, RJFS

Inclusion of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks that's generally considered representative of the U.S. stock market. The Barclays Capital Aggregate Index measures changes in the fixed-rate debt issues rated investment grade or higher by Moody's Investors Service, Standard & Poor's, or Fitch Investor's Service, in that order. The Aggregate Index is comprised of the Government/Corporate, the Mortgage-Backed Securities and the Asset-Backed Securities indices. The Russell 2000 index is an unmanaged index of small cap securities which generally involve greater risks. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow”, is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal. Russell 1000: Measures the performance of the 1,000 largest companies in the Russell 3000 Index. MSCI EAFE (Europe, Australasia, Far East): A free-float adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. The EAFE consists of the country indices of 21 developed nations. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning, Inc. and not necessarily those of RJFS or Raymond James. Diversification does not assure a profit or protect against loss. Investments related to a specific sector, where companies engage in business related to a particular industry, are subject to fierce competition, the possibility of products and services being subject to rapid obsolescence, and limited diversification. Investing in emerging markets can be riskier than investing in well-established foreign markets. Investing involves risk and investors may incur a profit or a loss, including the loss of all principal.

U.S. Stocks - 1st Quarter 2012

Last year the S&P 500 – a bell-weather for American stocks – was statistically unchanged from a price perspective.  When you add in dividends, the index was up 2%.  You may be feeling a lot more bumps and bruises from the year in stocks than a flat 12-month return would indicate.  Markets had wild swings and Ron Griess of the Chart Store (Hat Tip ritholtz.com) reports that 2011 was the seventeenth most volatile year for the S&P 500 since 1928.  Perhaps not surprisingly, 2008 and 2009 were even more volatile.  All of this has presented a behavioral challenge for investors with the temptation to time the market or get off the bumpy ride.

As with anything, it is very difficult to predict volatility.  It’s best to plan, though, for more ups and downs.  Volatility seems to come in patches with 15 of the 17 most volatile years for the S&P coming between 1929 and 1939 or between 2000 and 2011.  Managing your investment behavior through allocation planning, regular rebalancing, or the advice of an investment professional is critical to help avoid paralysis or bad timing.

Returns of large US companies surged ahead of their smaller peers. While large company S&P returned 2%, the Russell 2000, a common index for small companies, was down 4%.  The Dow Jones Industrial Average, even bigger than the S&P as measured by market capitalization, returned 8%.  Still, smaller stocks have outpaced large stocks cumulatively since March 2009 (when using the same indexes).

Many have watched for large companies to outperform due to compelling valuations and diversified revenue sources.  This trend may continue with strong profit margins, cash on the books, and still interesting valuations relative to larger stocks.

Dividend-paying companies, especially those outside of the financial sector, rewarded their investors handsomely in 2011.   Dividends fulfilled their promise last year helping both the total return of companies as well as raising interest from investors for their companies themselves.

We still like dividends for reasons Angie Palacios, CFP® I explained in a recent blog post.  Dividend yields are attractive relative to interest that bonds pay across the world.  Furthermore, as more boomers retire and seek a more steady income stream (no small feat in a low-yield world), a strategy that includes dividends may remain attractive relative to their cash-hoarding peers. *Dividends are not guaranteed and must be authorized by a company’s board of directors.

International Markets - 1st Quarter 2012

International allocations are increasing portions of investment portfolios.  This isn’t a fluke.  International companies represent an increasing market cap of the world’s stock relative to the states.  Over the last 10 years, international investments almost doubled the returns of US investments (33.4% for the S&P 500 vs. 64.8% for the MSCI EAFE per JP Morgan Asset Management).  Blame for foreign investment woes were most strongly linked to a European debt debacle, Japan’s earthquake natural disaster, and concerns of slowing growth in China.

The world’s challenges are hard to ignore, especially in Europe.  Austerity is a big hurdle for economies to overcome.  Companies have been beat up along with their governments and we believe that longer term there may be compelling opportunities around the world.  The role of international investments in a diversified portfolio remains relevant today in our mind in spite of disappointing recent returns.

Please note that international investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Diversification does not assure a profit or protect against loss. Past performance does not guarantee future results. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions art hos of Center for Financial Planning, Inc. and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investments mentioned may not be suitable for all investors.

Bonds - 1st Quarter 2012

Source: Morningstar, Inc.

It seems like bonds are defying gravity at this point.  Entering last year at near record lows for yields, fixed income, as measured by the widely recognized BarCap Aggregate Bond Index, returned 7.8% vs. virtually flat returns for large-cap stocks as measured by the S&P 500. As bond returns continued to levitate, yields deflated to new record levels.  US debt was downgraded mid-year, but markets asserted a strong vote of confidence with double-digit returns for long treasury bonds.

Where to next? Past returns are not a predictor of future performance – that’s what we’re told to say by our compliance officers and in my mind, this disclaimer could not be more apropos. With interest rates telegraphed to remain low, the Fed may delay dreaded rising rates, but the ability to replicate the returns of 2011 will be a major surprise. Diversification away from a traditional mix of government bonds may help, depending on your situation.

Diversification - 1st Quarter 2012

Our recent blog post titled “Death of Diversification?” noted that 2011 was an exceptionally poor year for diversified investment positions. You may ask what we meant by diversified. For our purposes, we were referring to asset classes that are not US stocks as measured by the S&P 500 and US bonds as measured by the BarCap Aggregate Bond indexes. 

A similar, although altogether more painful time period was 2008 where all but the most risk-averse assets were in free-fall. Past performance does not predict future returns, but history has a funny way of rhyming. In 2009, as markets determined the world was not ending, diversified portfolios were richly rewarded.

January’s returns offer a peek into the behavior of markets coming out of a period where diversification has not worked.

In the chart above we compare US Stocks & US Bonds to common diversifiers. This illustrates (on an admittedly smaller scale) another inflection point for diversification where additional asset classes contributed positively to returns similar to the time period starting in March 2009.

The jury is out as to whether this period favoring diversification will sustain itself through 2012. At some point the diversification ship will right itself and reward investors that hang on with variety’s smoothing effect.

* Large Cap Stocks – S&P 500, International Stocks – MSCI EAFE NR USD, Small Cap Stocks – Russell 2000, Commodities – Morgan Stanley Commodity-Related, US Bonds – BarCap US Aggregate, Global Bonds – BarCap Global Aggregate, High Yield Bonds – BarCap Corporate High Yield.

Benefits of Process - 1st Quarter 2012

Investors are prone to periods of underperformance regardless of strategy. The response to underperformance is an important consideration for the investor's future success. Nobel Prize winning behavioral psychologist points to process:

"Organizations are better than individuals when it comes to avoiding errors, because they naturally think more slowly and have the power to impose orderly procedures." ~ Thinking, Fast and Slow, Daniel Kahneman, 2011.

At Center for Financial Planning, we have an investment committee dedicated to upholding the very processes that hedge us as investors from common pitfalls while maintaining customized financial planning solutions for each client's unique situation. There are checks and balances so that changes for investments don't occur willy-nilly. Parameters anticipating discussion of process change are documented within our written procedure. Please click here to read the full post at Money Centered.

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material.  Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.  Any opinions are those of Center for Financial Planning, Inc., and not necessarily those of RJFS or Raymond James.

Where in the World is Marilyn Gunther?

When you retire from Michigan, it seems like you have one of two choices. Florida or Arizona. So how did we Gunthers end up with a forwarding address of Wilmington, North Carolina?  And where the heck is Wilmington, North Carolina, for that matter?

Well, it’s in the southeastern corner of the state, a little more than an hour north of popular vacation destination Myrtle Beach.  Located on the Cape Fear River, the town is surrounded on the east with inter-coastal islands and beaches. With a population of 110,000, this port town is also a college town with a beautiful campus of the University of North Carolina at Wilmington (13,000 students) and a thriving Cape Fear Community College.

Home to a major Coast Guard Cutter, Wilmington also boasts the largest film studio outside of LA. It has a diversified economy with major facilities of Corning, Inc., General Electric and several drug research and development firms and during the last decade this area took part in the housing boom. Our climate is subtropical, sunny, and mild (think 50’s in January and 80-90 degrees in August). Trust me, Ron and I don’t have to twist any arms to get our family to come visit.

No, I didn’t take up a job with the Chamber of Commerce. And no, I’m not making a case for you to retire here too, however …

There’s a rich history too! Wilmington was the last port to close before Lee surrendered, ending the Civil War.  The town was left alone, relatively off the beaten path, and did not begin to flourish until the 1980’s when I-40 was built to bring Raleigh folks to the beaches.

For those of us who have been coming here for years, Wilmington was a well-kept secret.  The secret is out.  The beaches are pristine (a favorite of surfers), the restaurants great, the riverfront walkway fun, and the historic homes and gardens lovely.   The blend of college students, well-off young retirees, senior citizens and dock workers provide an interesting and often time colorful mix. We are not spit and polished — upon close inspection, you’ll find dirt under Wilmington’s fingernails. 

Talkin’ Tuna . . . A look at historical stock v. bond valuations

If the price of tuna doubled over a three-year period, you would expect consumption to plummet.  Even people who loved the “Chicken of the Sea” would look elsewhere for their protein.  But, come a sudden 30% to 50% markdown, buyers would flock back in to the store shelves.  That’s because, in every aspect of our economic life, our unconscious mantra is -- High Prices = bad.  Low prices = good.   And 2 for 1 is even better!

But when people walk through the magical door marked “investments”, something profoundly weird happens.  Suddenly (though still unconsciously), it is high prices = good.  Low prices = bad. 

So, I have searched through history for a measurement tool to provide more “meat” to the conversation than price alone can provide.  Today people are very uncertain.  Unemployment still looms over 9 percent for the 3^rd year, we have weak consumer confidence and many economists and investors predicted a double dip recession over the last year.

While these factors are certainly concerning, they are secondary or tertiary indicators. They influence the future, but do not predict it with much certainty. In the end, the stock market has, and always will be, about price compared to value.

American companies have finished 2011 with historically strong profits thanks to effective management, cost cutting and postponing some projects.  Add to that strong balance sheets and some strategists I listen to regularly (we’re talking people who have been at it for 40 years) have said that American companies are in the strongest position ever in their careers.

The recent fear last fall about the future of the US economy has caused a significant dislocation between the government bond market and S&P 500 earnings. US government debt has been bid up to record-low yields while S&P 500 earnings continue to increase. To illustrate the dislocation, we prepared the following charts.  Chart 1 gives a very long-term historical perspective and chart 2 zooms into modern day.

CHART #1 Source: Forbes.com

The earnings yield of the S&P 500 shows the percentage earned by the company for each dollar invested in the stock.

Money managers often compare the earnings yield of a broad market index (such as the S&P 500) to prevailing interest rates, such as the current 10-year Treasury yield. If the earnings yield is less than the rate of the 10-year Treasury yield, stocks as a whole may be considered overvalued. If the earnings yield is higher, stocks may be considered undervalued relative to bonds.

Economic theory suggests that investors in equities should demand an extra risk premium of several percentage points above prevailing lower risk rates (such as T-bills) in their earnings yield to compensate them for the higher risk of owning stocks over bonds and other asset classes. 

And investors typically purchase Treasury securities when they are worried about markets and the economy, which moves the yield on the note down (remember price and yields of bonds move inversely). 

Think about it for a moment, when the government reduces interest rates investors are forced to find their required income from some other place.  So they need to take on more risk.  The average retiree gets it because they live it, but many forget that institutions are also required to satisfy unfunded liabilities like pension payments and endowment returns. 

Take a closer look at both charts and you will also notice the date of the worst time to own stocks vs. bonds.  You can see the EYS dove to -5.7 below on October 9^th 1987.  That was 10 days before the worst stock market crash in modern history. So while this is not infallible by any stretch of our imagination, I think it has some validity to overweighting one asset class vs. another when it signals along with some other gauges. 

CHART #2 Source: Forbes.com

Chart #2 provides a closer viewpoint of our current spread.  I have heard indications by strategists of the spread approaching 8 in the last quarter.  A reading of 8 would be of historic proportions, because it has only happened 3 times in the last 140 years of stock market history.

1. Around the time of Francis Ferdinand Assassination 1914 (beginning of WWI).
2. Post WWII recession period 1946/48 when demand fell out of bed (since the war machine was being dismantled and yields on bonds were low but fear was still on the minds of investors). 

During the first two instances, just like now, there was a good reason for fear in the world and we went into two very ugly world wars.  However, in hindsight, they were very good points to enter the equity markets.  

In general, long-term investors were handsomely paid if they began to purchase and continued to purchase equity positions vs. bond positions when the Earnings Yield Spread was high.  That disparity between equity return expectations is one of the reasons The Center determined to stay fully invested in our equity exposure during the summer and fall of 2011.  So, the moral of the story is to buy tuna (or stocks, as the case may be) when it is being sold at a discount.  And if the price is considerably less than your other protein options and you like it…maybe buy a little more.  But for heaven sakes, it’s not time to give up tuna altogether!

Center Team Attends Invitation-only Raymond James Investment Conference

Angela Palacios, Melissa Joy, and Tim Wyman. The three headed to St. Petersburg, Florida January 25^th and 26^th to attend the Portfolio Manager Group investment conference. Top industry experts talked portfolio monitoring, analyzing risk in portfolios, and even about the current political environment’s impact on investments.

“It is very energizing spending time with a group of peers and sharing ideas,” Angela said of the conference. “It provides valuable insight into how to better serve our clients.  Also, it is always a great opportunity to hear from economists and money managers in person as this is key to our investment decision process.”

Melissa and Tim joined the experts at the podium, sharing The Center’s processes in the portfolio monitoring space. Tim explained the history of The Center’s Investment Process and Melissa detailed ten tips for monitoring investments for clients. The audience was particularly interested in learning about our Due Diligence Questionnaire, which is a pre-requisite for investment in our model portfolios. Our investment communication process and firm-wide investment strategy were also well-received.

The advisors at the conference are part of an ongoing Institute of Investment Management Consulting group (IIMC) that was formed last year.  The goal of the IIMC is to provide institutional quality education for investment management. 

Learning from peers and sharing with others puts our process to the test. By that standard, our trip was an overwhelming success. And, coming from Michigan, the weather wasn’t half bad either.