Investment Commentary, Q1 2011

Every quarter or so, our investment committee meets to review current market trends and expectations. Our most recent meeting conducted early in the second quarter has led to very few significant changes in our market outlook.

Cash as an asset class remains stale at best. Money Market yields remain in the 0-1% range[1], while yields on Treasury Bills and other short-term notes remain lackluster. The US Dollar remained surprisingly strong against rival developed market currencies through late 2010 in the face of the Fed’s expansionist monetary policy, but has experienced expected dramatic weakness during the first quarter of 2011. Over the long-term, currency fluctuations are neutral to a diversified portfolio; on the short-term hedges against a weak dollar include commodities and foreign-currency denominated fixed income securities.

Bond yields have remained compressed. The 10-year US Treasury Note is yielding just 3.42% as of 04/26/2011[2]. In November, the Wall Street Journal reported that for the first time home buyers enjoyed a 30-year mortgage rate lower than the yield on 30 year US Treasury Bonds! Meanwhile, municipal bond yields have exceeded taxable bond yields reflecting increased apprehension about municipalities’ abilities to repay their sometimes excessive debt loads. On a broader swath, bonds in aggregate have enjoyed 30 years of falling interest rates, which have boosted bond investors’ returns and in some ways skewed the average investor’s perception of the efficacy of bonds as a long-term investment vehicle. Currently, yields are at all-time lows while default risks are at all time highs. We do not feel that bond investors are being adequately compensated for taking on the additional default risks present in the market at this time. Although we do not expect dramatic rate increases anytime soon, we there has been murmuring about a potential rate increase at the next Fed meeting. We are still recommending clients stick to short-duration, high quality notes alongside a generous helping of Treasury Inflation Protection Securities to hedge against risk asset volatility.

Good values in stocks abound, although history indicates that domestic markets may be overvalued in spite of rosy earnings forecasts. On the one hand, the current earnings yield on stocks in the S&P 500 is about 6.6% (compare to the 10-Year Treasury at 3.42%) and current cost of a dollar of earnings (Price/Earnings ratio) stands at $15.01[3]. These would indicate shorter-term fair to attractive valuations. However, trailing 10-year P/Es stand on the high side at 23.84, compared to the historical mean of 16.40[4]. Based on our research, this would indicate a more intermediate to long-term overvaluation in equities. Thus, although we cannot forecast next year’s market returns, we do expect domestic market returns to be at or below historical averages over the next 8-12 years, and are recommending investors diversify into international and emerging market equities while focusing on core value and select tactical investment management strategies. We feel that in light of present conditions, indexing and passive strategies are unlikely to yield satisfactory returns for the foreseeable future.

While inflation risk plagues cash positions, default risk and low interest rates discourage bond investors, and equities may be overvalued, real estate presently remains attractive. Distressed sellers and erratic debt markets have created great value for prudent real estate managers. These have led to historically low prices, high capitalization rates, and in some instances below-replacement cost purchase prices. A securitized real estate research firm, Green Street Advisors, currently estimates that the traded real estate investment trust market to be trading at a 15.3% premium to net asset value[5], meaning that, in large measure, publicly traded REITS may be overpriced. New non-traded programs are beginning to emerge, allowing investors opportunity to invest in high quality real estate assets at today’s net asset value prices, creating potential value compared to the publicly-traded alternatives. We are encouraging our clients to consider expanding their real estate allocations based on attractive valuations and as a hedge against inflation risk.

Gold and silver have taken center stage in the commodities arena, and have experienced dramatic increases in price of late. Storefronts have popped up all around the Phoenix area advertising “We buy gold!” and “Cash for Gold!”. In fact, there have even been street-corner sign-wielders advertising for gold and silver dealers. The last time this author remembers such fanfare was in 2005-2006, but instead of spinning gold and silver advertisements, the corner advertisers were pushing homes. This timeframe turned out to be the peak of one of the greatest real estate bubbles in history. If we observe the fundamentals, gold is currently trading well above its long-term inflation-adjusted average price, indicating a severe over-valuation from long-term norms. We believe that reversion-to-the-mean is a vital investment concept, and that a purchase of gold today would be ill-advised.

Rather, purchasing a representative basket of commodities could potentially serve as a short-term inflation hedge when added to investors’ existing portfolios. There are various investment vehicles in the commodity sector that can potentially meet this objective when added to investors’ portfolios. Jim Rogers, former co-manager of the Quantum Fund with George Soros, has been an ardent proponent of commodities as an investment since about 1998. He has since created several commodities indexes that are available for tracking via some of these investment vehicles. We prefer utilizing these tools and Rogers’ indexes based on their balance and international orientation. Please contact us to set up a phone or in-person appointment to discuss if adding commodities to your portfolio could provide added diversification.

In summary, our we recommend clients assume only the amount of cash and bond positions they feel absolutely necessary to reduce overall portfolio volatility, while increasing exposure to equities and real estate to increase their hedge against both long-term and short-term inflation risk.

This information is provided for general purposes and is subject to change without notice. The information does not represent, warrant, or imply that services, strategies or methods of analysis offered can or will predict future results, identify market tops or bottoms or insulate investors from losses. Past performance is not a guarantee of future results investors should always seek individual financial advice based on their own personal circumstances before acting.

Best Wishes,

Jeremy S. Mitchell, CFP®
Financial Planner / Portfolio Strategist

[2] on 04/26/2011 , data courtesy of Robert Shiller, Yale Department of Economics
[3] Standard and Poor’s 500 Index Data dated 04/19/2011 2010 earnings of 83.77 with an index price of 1257.64 on 12/31/2010.
[4] , data courtesy of Robert Shiller, Yale Department of Economics
[5] Based on Green Street NAV estimates 3/2011, source

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