August 12, 2011

This is the time of year when people go to amusement parks. Well, for the record, I do not ride roller coasters anymore, and I do not like the ride the markets are taking us on these days (weeks, months). 

Take a look at these numbers as of close of business on 8/10/2011 for the Dow:

• 8/10 Down 519.83 points or 4.62%
• Down 11 of last 14 trading days
• 3 consecutive days of 400+ point moves
• The Dow Jones Industrial Average dropped 1.17% (127 points) in the last 30 minutes of trading on 8/10
• Lowest close since 9/23/10
• Down 3444 points or 24.3% since its record close of 14,164 on 10/09/2007
• Year to date: down 7.41%
  

These are some of the questions and issues the markets are dealing with:

• A dysfunctional Congress
• A jobless and very slow recovery
• A possible double-dip recession
• A zero interest rate Federal Reserve policy for two more years
• Will the Congressional gang of 12 be able to agree on anything?
• What does the downgrading of our debt to AA+ really mean?
• What impact will the Euro sovereign debt crisis have in the U.S.?
• Can anything be done to help the unemployment and housing situations?

I have opinions on all of the above issues, but I want to finish this newsletter without writing a dissertation. In the next few paragraphs, I will make several observations and comments.

1. The credibility of all the rating agencies is suspect, and the U.S. government is not in any danger of defaulting on its debt.
2. Equity markets are much cheaper now than in 2008, and corporations are making record profits.
3. Geopolitical uncertainty and sovereign debt concerns, especially in the Euro-zone, will be with us for years. In fact, France is the latest country in the spotlight for a possible downgrade.
4. Resolving the debt crisis in Europe, as well as the U.S., will be a prolonged and very painful process to watch. But it will most likely be resolved.
5. At the moment we are not on the verge of another recession. But slow growth is the norm and the economy is very fragile.
6. The rating downgrade will hopefully serve as a “wake up call” to Congress and prompt them to act in a credible way to reduce our debt to GDP ratio and secure our financial future.
    

What should investors do now?

It’s a natural reaction to be concerned – but don’t panic. It is critically important to understand that we have a long term investment plan in place for all our clients. And we all know that markets don’t go up every day, or every month, or every year. What is most upsetting currently is the volatility, the magnitude of the swings, and the acceleration of the 24/7 news stories on TV (cable TV). For the last week, CNBC has been running “Markets in Turmoil”. Do we really need this sensationalization by the media? An abundance of information does not lead to better decisions. Much of this market behavior is based on fear and emotions. Let’s not succumb to this!


With respect to your portfolio, it is important to note that we have already been positioning our clients more conservatively over the last few years. We hold many investments specifically because of their stable behavior in volatile and uneven markets. Times like these can cause discomfort, however, your diversification helps mitigate the overall risk.

In summary we are in for a bumpy, up and down roller coaster ride (which I don’t like). But let’s stick with our long term plan which we laid out over many meetings, and not overreact emotionally to this volatile market.

If you have any questions or concerns about your portfolio or any of these issues, please call.

Turn off the TV and enjoy the rest of the Summer!

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

Unimpressed with U.S. deficit reduction plans, S&P delivers on its warning.

August 8, 2011

Unprecedented and unsettling. Standard & Poor’s issued a historic downgrade of U.S. debt on August 5, sensibly waiting until the market week had concluded to send a shock wave toward global investors. It reduced America’s long-term debt rating – which had been AAA since 1941 – to AA+.¹

S&P felt Congress did too little too late. The credit rating agency had threatened to lower the boom if Congress passed any deficit reduction plan smaller than $4 trillion in scope. The Budget Control Act of 2011 “falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,” an S&P statement noted. It also retained its “negative” credit outlook on the U.S.²

S&P is also skeptical that the federal government can collect more money from taxpayers. Its analysts do not think the Bush-era tax cuts will sunset at the end of 2012 “because the majority of Republicans in Congress continue to resist any measure that would raise revenues.”²

On August 5, S&P sovereign ratings committee chair John Chambers told Fox News that the new AA+ rating could be cut to AA within 6-24 months if the U.S. doesn’t arrange to slash $4 trillion from its deficit in the next decade. The implication: Congress better agree on more cuts by February.³

China’s comments. The world’s largest holder of U.S. debt issued a critique of Congress through Xinhua, its official news agency. The state commentary stressed that the U.S. has a “debt addiction” only curable via major cuts to defense spending and entitlement programs. It also said that the option of a “new, stable and secured global reserve currency” should be explored.⁴

The Treasury’s claim.Friday evening, the Treasury argued that S&P’s analysis contained an accounting error that unnecessarily added $2 trillion to its projection of U.S. debt. S&P admitted the error but stuck with the downgrade.¹

So what happens now?The early August global response aside, analysts are divided as to what the short-term impact might be for the American economy. Could it cripple the recovery, or just prove inconvenient to it?

Demand was big for Treasury notes even before the threatened downgrade and Treasuries still symbolize comparative safety to institutional investors, so an August selloff might be short-lived. If this turns out to be the case, the effect on interest rates might be less significant than feared.

In the opinion of JPMorgan Chase analysts, Treasury yields could increase by 60-70 basis points as a result of the downgrade, translating to $100 billion in added annual borrowing costs for America. Citing Federal Reserve research, these analysts think that an increase of 50 basis points in Treasury yields (0.5%) could take a 0.4% bite out of U.S. GDP.²

Could the Fed launch QE3*?The possibility exists, particularly if foreign investors ditch dollar assets. The Fed’s Open Market Committee will make an announcement on August 9, and few analysts expect another wave of bond buying – but it is an option.

When might the U.S. recapture its AAA rating?It might take years for that to happen. S&P has cited political gridlock on Capitol Hill as a major reason for the downgrade, and it doesn’t see that going away in upcoming months. On top of that, the U.S. economy expanded just 1.3% in the first half of 2011 - about half the pace needed to dispel the lingering effects of recession.⁵

Are mortgage rates going to go north?Maybe; maybe not. Rates on conventional mortgages have a direct relationship with 10-year Treasury yields. Recently, those yields have dramatically fallen. Interest rates on auto loans might see a spike, as those rates are pegged to 2-year notes and factors like the LIBOR rate. The hardest hit might come from credit card issuers. Credit card interest rates reflect the prime rate. Credit.com credit card advisor Beverly Blair Harzog told CNNMoney that she believed credit card firms could possibly jack up rates 1-5% as a result of jitters over the downgrade.⁶

Wall Street might sail through this.Does that sound far-fetched? Look at some historical examples. S&P downgraded Canada’s AAA credit rating in the spring of 1993, yet Canadian stocks gained 15% in 1994 and our northern neighbor had its AAA rating back by 1997. Moody’s Investors Service downgraded Japan in November 1998 and its stock market advanced more than 25% in the next 12 months. Italy, Canada, Ireland, Japan, Belgium and Spain have all suffered S&P downgrades from AAA, and most of these cuts had little sustained impact on government bond yields.^6,7

We are continuing to monitor the situation. Call if you have any questions.

* Quantitative Easing [round] 3

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

“When buying and selling are controlled by legislation, the first thing to be bought and sold are legislators.”

-      P.J. O’Rourke

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

Citations.

1 - nytimes.com/2011/08/06/business/us-debt-downgraded-by-sp.html [8/5/11]   

2 - bloomberg.com/news/2011-08-06/u-s-credit-rating-cut-by-s-p-for-first-time-on-deficit-reduction-accord.html[8/5/11]               

2 - bloomberg.com/news/2011-08-06/u-s-credit-rating-cut-by-s-p-for-first-time-on-deficit-reduction-accord.html[8/5/11]               

3 - foxbusiness.com/markets/2011/08/06/sp-us-faces-further-downgrade-beyond-double/ [8/6/11]

4 - nytimes.com/reuters/2011/08/06/world/asia/news-us-china-sp.htm [8/6/11]

5 - huffingtonpost.com/2011/07/29/gdp-us-q2-second-quarter-expectations_n_913032.html [7/29/11]

6 - money.cnn.com/2011/08/06/pf/sp_rating_money.moneymag/ [8/6/11]
7 - marketwatch.com/story/china-rips-us-on-debt-rating-downgrade-2011-08-06 [8/6/11]

 August 5, 2011

August 4: the Dow’s toughest day since December 2008.On his 50th birthday, President Obama watched Wall Street cast a no-confidence vote in the economy he had been assigned to turn around. The Dow Jones Industrial Average sank 512.76 and experienced a correction Thursday, with the S&P 500 (-60.27) and NASDAQ (-136.68) also down more than 10% from spring peaks.¹

Developments overseas generated anxiety on Wall Street.Citing “renewed tensions in some financial markets in the euro area”, the European Central Bank abruptly announced a bond-buying program Thursday, a distinct reaction to fears that Italy or Spain might need a bailout from the European Union. ECB president Jean-Claude Trichet stated that “downside risks may have intensified.” The ECB didn’t detail what debt securities it would buy or the amount of the purchases. Early indications hinted that the campaign would be modest. The ECB broadened the scope of its lending to Eurozone institutions at its benchmark interest rate this week in a move to aid feebler banks; the Bank of England kept its key interest rate at 1.5% and the ECB held its key rate at 0.5%. These firefighting moves did little: the FTSE 100, CAC 40 and DAX all dropped between 3.4%-3.9% on the day.^2,3

Japan’s central bank sold 1 trillion yen Thursday in an effort to weaken the currency while also announcing an increase in asset purchases. This move followed the Swiss National Bank’s Wednesday decision to reduce interest rates to near zero to try and weaken the Swiss franc, which had climbed 10% versus the euro in July. The dollar went 2.3% higher against the yen on the day.^4,5,6

Gold & oil posted losses on the firmer dollar.Gold slipped 0.43% Thursday to $1,656.20 per ounce; oil pulled back 5.77% to fall to $86.63 a barrel.⁷

Treasury prices rallied. The yield of the 10-year note went down 15 basis points (0.15%) to 2.48%, the biggest descent since June 2010; 2-year note yields fell to a new low of 0.26% on Thursday.⁸

Could we see a rally out of this position?Some market analysts thought a correction would take place this summer, with the major indices subsequently recovering in fall. Regardless of market reaction to Friday’s jobs report, stocks could rebound, even before the holiday season.

At a time when bullish sentiment is being severely strained, it is worth accentuating the positive. Bloomberg data indicates that 77% of S&P 500 firms have surpassed average profit forecasts of analysts in this earnings period. The S&P 500 was trading for 13.8x reported earnings on the day before the correction - the cheapest level in 13 months. Birinyi Associates data notes that the average bull market since 1962 has lasted about 49 months (the current one is about half as old). In the past 39 years, 25 corrections have occurred in bull markets, and just 9 have led to bear markets; on average, these corrections have lasted 118 days. That is history, not the near future. Yet while the future is ultimately unknown, we can recall that last year’s correction did not send Wall Street into a bear market.^9,10

We will send you additional information in the next few days. In the meantime, call us if you have any questions or concerns.

Stay cool and stay tuned!

Sincerely,

“When did the future switch from being a promise to being a threat?”

-      Chuck Palahniuk

 Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

Here are the particulars of the Budget Control Act of 2011.

August 4, 2011

The Budget Control Act of 2011 has become law – just in time to meet the August 2 Treasury deadline and reassure world financial markets. The framework of the new law is complex and shows that both Democrats and Republicans can claim some victories.

The federal deficit will be reduced by at least $2.1 trillion. That figure comes from the non-partisan Congressional Budget Office. The savings will be realized over a decade ... although it isn’t yet clear where the bulk of the cuts will be made.¹

• More than $900 billion will be saved through the first wave of cuts.
  
  
  • Discretionary spending on defense and non-defense programs will be reduced by $741 billion over a 10-year period. This includes a $350 billion cutback in defense spending at the Pentagon (a Democrat goal in the negotiations).
    
  • Another $156 billion in savings will emerge as a result of shrinking interest costs on the national debt.
    
  • Another $20 billion will be cut from education loan initiatives and through efforts to identify fraud and abuse in other mandatory federal programs. (Student loan funding will be reduced to $22 billion by 2021, but Pell Grant funding will increase by $5 billion by 2015.)^1,2
    

A bipartisan committee of 12 will have to recommend between $1.2 trillion and $1.5 trillion in additional federal budget cuts by November 23.

• This committee will likely propose cuts to Social Security, Medicare and Medicaid and perhaps further reductions to the defense budget. Its membership will be handpicked. House Minority Leader Nancy Pelosi (D-CA) and Senate Majority Leader Harry Reid (D-NV) each get to select three Democrats; House Speaker John Boehner (R-OH) and Senate Minority Leader Mitch McConnell (R-KY) each get to pick three Republicans.
  
• Congress has to vote on their recommendations by December 23. If the bill is defeated, then automatic budget cuts will kick in on January 2, 2013 - at least $1.2 trillion worth, divided almost evenly between defense and domestic spending. (Social Security, Medicaid, military pay and veteran’s benefits would be exempt; Medicare would not be, according to House Speaker Boehner.)
  
• In addition, a Congressional vote on a balanced budget amendment to the Constitution will occur before the end of 2012. An approved balanced budget amendment would have to be ratified by two-thirds of the states. (This was a key victory for Tea Party Republicans.)^2,3,4

The debt ceiling will be raised by up to $2.4 trillion. It will be raised incrementally from the current $14.3 trillion level, dependent on a series of triggers:

·         The first trigger: the bill’s passage. Congressional approval amounts to a formal declaration that the federal government is less than $100 billion away from hitting the debt cap. Now that the Budget Control Act of 2011 is law, President Obama is expected to immediately raise the debt limit by $400 billion.

·         The second trigger: the initial $400 billion increase. This move initiates another formal request to hike the debt ceiling by another $500 billion dependent on Congressional authorization. It is widely assumed that Congress will disapprove this request, with President Obama vetoing the disapproval and Congress failing to override the veto. The probable outcome: the debt limit rises by the desired additional $500 billion.

·         The third trigger: what Congress does by December 23. Here are the possibilities that could play out during the holiday season:

o   If Congress fails to pass the deficit-reduction bill generated by the bipartisan committee of 12, then President Obama can formally request another hike in the debt limit – a $1.2 trillion increase. Congress would likely reject this request, President Obama would use his veto power in response, and Congress would likely fail to override the veto.

o   If Congress passes the deficit-reduction bill, then President Obama gets automatic authority to raise the debt cap by an amount equivalent to the budget cuts defined in the new law.

o   Alternately, if Congress passes a balanced budget amendment and sends it to the states, President Obama immediately gains the authority to raise the federal debt limit by $1.5 trillion.³

Tax hikes for the rich? Not immediately. In a key Republican victory, the two-step bill does not include tax increases or new levies for those in the highest tax brackets. House Speaker Boehner said July 31 that the forthcoming 12-member committee could not approve tax hikes – it would be “impossible” under current federal budgeting rules. Yet with the expiration of the Bush-era tax cuts increasingly probable in 2013 and the possible elimination of some deductions and exemptions in the tax code to generate additional revenue, there is a good chance many Americans will pay out more to the IRS in the near future. The White House says $1 trillion could be saved alone by not extending the EGTRRA/JGTRRA cuts further.⁵

December isn’t that far away. Expect more drama on Capitol Hill as 2011 ends, with a chance of added volatility in our financial markets.

We are sure that the above information can be somewhat confusing and overwhelming. We are still digesting this bill, as you probably are as well. Stay tuned for our upcoming newsletters to hopefully shed some more light on this as it unfolds, and for our commentary and opinion on what this all means and how it will affect that markets.

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

“It is the duty of the patriot to protect his country from the government”

-          Thomas Paine

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.

Citations.

www.petemontoya.com

1 - money.cnn.com/2011/08/01/news/economy/debt_ceiling_deal_cbo/ [8/1/11] 

2 - npr.org/2011/08/01/138885258/congress-to-move-quickly-on-debt-spending-deal [8/1/11]           

3 - blogs.abcnews.com/politicalpunch/2011/07/debt-ceiling-framework-where-they-landed.html [7/31/11]      

4 - theatlantic.com/business/archive/2011/08/congress-needs-a-kinder-gentler-balanced-budget-amendment/242871/ [8/1/11]

5 - foxnews.com/politics/2011/08/01/tax-hikes-impossible-under-debt-deal-think-again/ [8/1/11]

July 29, 2011

As we approach the August 2^nd deadline, Congress continues to astound us with their incompetence and inaction. The latest Boehner bill wasn’t even brought to the House floor for a vote.

We still believe that the Federal government will be able to avoid default, but it will probably lose its AAA credit rating. 

We are going to lay out what we think is the most likely scenario:
                                                 

• • There will be some compromise to allow the debt ceiling to be increased.
  • The ceiling will only be increased by about a trillion dollars.
  • The whole issue will have to be revisited within 6 to 12 months.
  • There will be a downgrade of U.S. debt from AAA to AA.

Any action short of a $3 to 4 trillion bill will have enormous repercussions. We will discuss that in more depth in future articles.
 

Maybe we should just turn off the TVs, radios, and smartphones until next Tuesday, then hope we will wake up to a brighter day!

Stay cool and stay tuned!

Sincerely,

Edward J. Kohlhepp, CFP^®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP^®, MBA

To read our previous newsletters on the debt ceiling issue, click here http://www.kohlheppadvisors.com/pages/kohlheppUpdate.aspx?LinkID=109337&spid=94786 and scroll to the bottom to view our archived newsletters.

Please contact us whenever there are any changes to your financial situation, personal situation or investment objectives.