What does this mean for our market?  It still means that there is much risk in the financial markets, even though at times it may appear to be calm.  The one thing most investors forget is that the market moves up like a tortoise, but down like a rabbit.  For example, when the Asian markets crashed in 1998 due to currency problems, the market fell much more severely and swifter than most pundits were espousing.  That same scenario could unfold in Europe.

A 20th Anniversary Thank You

An idea (THOR’s investment process) was hatched more than 20 years ago from many late night hours on a Radio Shack 286 computer.  Officially, THOR opened for business 20 years ago today on a shoe string budget and support from a loving family.  We have since grown to a family of nine employees and almost $300 million in assets under management.  We want to thank all of our clients for their support and the trust they have placed in us throughout the years.  We especially want to thank those that joined us shortly after our doors opened – John & Sue in Maryland, Lorraine in Chicago, Ted & Pia in Syracuse, Ron & Tanya in Indiana, Mary & Frank in South Carolina and those in Ohio – Geof, Mary & Jack, Donnie, Bob & Dianne, Mark & Kathy, Judy & Tom and Ollie.  We understand that we would not be around without the opportunity you gave us.  We look forward to the next 20+ years with a renewed focus on providing the best investment management and wealth services to you – our clients.  Thank you for a great 20 years!

Sincerely,

Your THOR Team

1) The French election this Sunday and run-off on May 6th.   Polls consistently show President Sarkozy losing to Francois Hollande.  The ramifications of this could be enormous.   Hollande espouses two main themes: increase spending by roughly 20% and raise taxes on those making more than a million Euros to 75%.  If Sarkozy loses, Merkel will be losing her number one friend in Europe.

2) Greece also has an election on May 6th.  This is important because the two Greek parties that signed off on the bailout promising to keep austerity measures in place are both doing poorly in the polls – Democracy 18.2% and PASOK 14.2%.  Greeks are angry with six years of austerity and the entire EU package may unravel with this election.

3) Spain is in trouble as bond rates have rocketed higher in the last few weeks.  The Spanish economy is as bad as Greece was two years ago.  Austerity and high unemployment is not a recipe for success.

The complacency in the markets over the past few months might once again be taken over by “Euro Crisis Fear”.   It’s Ground Hog Day in Euroland.

Sincerely,

Your THOR Team

The easy excuse for higher oil prices is unrest in the Middle East – especially in Iran.  Yes, the reduction in supply from Iran is putting a squeeze on prices, but there are other factors as well.   One of the biggest reasons is refineries are closing down because they are losing money.  Sunoco is closing its largest refinery on the east coast in July.  Valero is closing its refinery in Aruba.  In the Pacific Northwest, union workers at the Tasero Anacortes refinery in Washington rejected a new contract and are expected to strike in the weeks ahead.  The law of supply and demand will cause gas prices to rise as the supply of refined oil drops.  Any bad news from the Middle East will just compound the pain at the pump.

Sincerely,

Your THOR Team

Below is a chart of the VIX index over the past four years.   As you can see, volatility rises during periods of market uncertainty (peaking in October 2008, May 2010 and September 2011) as investors’ fears were heightened.  Once that fear subsides, the index falls.  The VIX currently is near the bottom end of its trading range over the last four years.  What does that mean?  It means that investors are not fearful about a stock market decline.  We believe, on the other hand, there are several significant issues that could spark the VIX off its bottom.  These sparks include rising interest rates, an Iran/Israel confrontation, the upcoming US elections and spiking oil prices to name a few.  With 2008-2009 still fresh in investors’ psyche, we believe that a rise in volatility will occur over the next several months.  Having an investment linked to the VIX is a prudent move to protect against any stock market losses when volatility spikes.

Sincerely,

Your THOR Team

The operation of the ECB has changed dramatically in the last year.  It is now run by an Italian – Mario Draghi – and has lost its sound German philosophy on money.  Does anyone remember how well Italian central bankers did in preserving the value of the Lira?  If you don’t, we can sum it up in one word – “disastrous”.  Last year, two of the ECB’s top leaders from Germany resigned because of concerns about debasing the Euro’s value.  Germans have been, and continue to be, staunch inflation hawks since the Weimer Republic printed money after World War I that sparked hyper-inflation.  The two individuals that left the ECB were former Bundesbank President Axel Weber and ECB Chief Economist Juergen Stark.  Since the loss of these two hawks, the ECB has gone on a printing spree – see the chart below.  With today’s action, the ECB’s assets have exploded to over 35% of GDP compared to just 20% less than 6 months ago – hmmmmmm, is this a coincidence that it happened right after Juergen Stark left in early September?

The ECB is trying to print the Euro out of its debt crisis.  This does not bode well for the value of the Euro.

Sincerely,
Your THOR Team

When investing, risk is always involved.  There is risk of loss of principal if an investment goes down in value.  There is risk that an income stream from an investment goes down – a dividend cut for example.  A risk exists if you are not invested and the markets rise.  There is risk that inflation will eat away at your principal value.  In today’s market, it is important to balance these risks.  Outlined below are the risks as we see them in the equity market, in the fixed income market and in cash.

Equity market

Macroeconomic risks (Very High): We believe the macroeconomic risks to the market are high at this time.  There are several reasons for this:  the ongoing European crisis, China’s financial system experiencing a shock (a great book on this is “Red Capitalism – The Fragile Financial Foundation of China’s Extraordinary Rise”) and the unrest in the Middle East – especially between Iran and Israel.   Any one of these events could cause a spark that brings equity prices down around the world.

Corporate earnings risk (High): Corporate earnings have rebounded nicely since 2008.  A big part of this rise is because labor output rose – see point A in the charts below.  This rise was created when companies laid off workers causing output per worker to rise and in turn causing earnings to rise.  This rise in earnings is usually temporary because workers get burned out after 18 months or so causing productivity to drop.  What concerns us most is that corporate earnings as a percent of GDP have never been this high in the last 50 years.  Every time this indicator has risen 8% or more, the stock market fell the following year.  We have seen a drop in productivity over the last few quarters while earnings continue to rise (point B).  We believe there will be continued pressure on earnings in the months ahead.  If there is, this pressure may cause a reduction in equity prices.

Drop in dividend payout risk (very low): We do not see a significant risk of companies cutting dividend payments.   Most companies have excess cash on hand and can withstand a financial shock.

Equity Conclusion: We believe that the macroeconomic risks and the risks to corporate earnings pose a significant risk to equity prices.  For these reasons, we continue to believe that a lower exposure to the stock market is warranted at this time.  We believe also that the greatest risk lies outside the US and in the Eurozone.  That is why we continue to maintain the lowest exposure THOR has ever had in international equity markets.

Fixed Income

Interest rate risk (very high): Fixed income (“bonds”) price movements are inversely related to interest rates.  In other words, if interest rates fall, bond prices rise.  If interest rates rise, bond prices fall.  Furthermore, the longer the time to maturity for a bond, the greater the risk of price fluctuation for that bond.  With interest rates at historical lows, we think there is a significant risk that interest rates will rise over the next 1-3 years.  As such, we want to buy bonds with shorter maturity dates rather than longer maturity dates – i.e., you would not want to buy 30-year Treasuries in this environment.

Credit Risk (moderate): Credit risk is the risk that the company or institution issuing the bonds defaults on the bonds.  There is real risk in the municipal bond market – especially in California and Illinois – and in European bond markets.   Most American-based companies are doing fine as we have seen corporate default rates drop significantly in the past couple of years.

Fixed Income Conclusion: As we believe the risk of interest rates rising is high and credit risk is moderate, we have balanced our fixed income portfolio between shorter-term bonds and high yield bonds.  We do not own any international bond funds at this time.

Cash

Inflation risk (moderate): There are two competing sides of the inflation debate: 1) the Federal Reserve printing more money; and 2) credit bubbles (like the 1930s) are extremely deflationary.  These competing interests are causing a massive tug-of-war at this time, but we believe the deflationary side is winning.  If the Euro does collapse, the dollar will rise and commodities will fall as they have been over the past few months.

Opportunity Risk (low): This is the risk of “missing out” on a major bull run in either stocks or bonds.  We don’t believe the most recent run in the market is sustainable because of the macroeconomic risks and the pressure on corporate earnings.

Cash Conclusion: We continue to hold cash because the risks in both the bond market and the stock market are high.  When that risk dissipates, we will redeploy that cash into higher returning investments.

The Federal Reserve last week surprised everyone by extending its “exceptionally” low interest rate environment until late 2014.   This is almost a year later than its previous forecast for interest rates.   With many economists saying the economy was improving over the last few months, we have to wonder why the Federal Reserve made this announcement.   At THOR, we think there are two reasons for this decision.  First, the economy is not as rosy as it appears.  Yesterday, the consumer confidence index fell and home prices slipped another 1.3% in November.  The economy also grew less than 2% last year which is well below the average growth rate for an economy rebounding from a recession.   Second, the Federal Reserve is keenly aware of what is happening in Europe.  We believe that the Fed is keeping rates low in order to assist Europe in keeping its rates low – it isn’t helping Portugal whose 5-year rates are now over 20%!  In a worst case scenario in Europe, if Greece and Portugal start a chain reaction that brings down the Euro, the US dollar will become the defacto currency for Europe.  One big question this announcement leaves in our minds is “Does the Federal Reserve know more about an upcoming crisis than they are telling us?”  In our opinion, the Federal Reserve is telling us that our economy has two more years before it starts to turn around.  Not the best sign for our economy.

Time to buy a home?

It was just a few years ago that investors in rental real estate were suffering because people were buying homes instead of renting.  People did this because of the ease in getting a mortgage.  Today, the opposite is true as the only real construction going on is in multi-family units – apartments.  Below is a chart that shows it is now cheaper to buy a home than to rent one.  We still believe that the fall in the housing market has a few months to run.  However, if you or your children are renting, you may want to consider buying a home.  We believe it could be a worthwhile investment over the next five to ten years.

Sincerely,
Your THOR Team

Dow Jones Industrial Average

• Post-election Year:      +4.7%
• Mid-term Year:             +2.3%
• Pre-election Year:        +11.0%
• Election Year:               +7.0%

The results seem compelling. However, our most recent Presidential cycle  did not follow this trend.

Dow Jones Industrial Average

• Post-Election Year (2009):   +18.82%
• Mid-term Year (2010):          +11.02%
• Pre-election Year (2011):     +5.53%
• Election Year (2008):            -33.84%

The results are opposite of what the Presidential election cycle would suggest would happen.  In fact, an investor would have generated a -30.1% return over the past 4 years if they only invested in the stock market during the pre-election and election year and stayed in cash for the final two years.  This is why we believe it is important to use more than one indicator when making investment decisions.  Keep in mind that the Dow was up 5% in 2011 when most stocks were down last year – the equally weighted Value Line Composite Index of over 1,700 stocks was down 11%.  The Dow is not necessarily a good indicator of the return for the overall market because it is weighted based on the share price of the stocks in the index.  This causes the return to be skewed towards the stocks with the highest share price.  IBM, with a share price of $179, has the largest weighting in the index of greater than 10%, while Bank of America’s weighting in the index is .40%.

EUROPE FOLLOW-UP

Last Friday, more European countries had their credit rating downgraded.  This caused the Euro to reach 16 month lows.  The situation in Europe has not improved from last year.  There is still significant risk to the global economy.   China is especially vulnerable since Europe is their largest trading partner.  The human tragedy that is now hitting Greece, will likely hit the other PIIG countries if Europe does not figure out a way to balance trade between countries.  The Euro is not just a financial crisis, but a social one as well.

Sincerely,

Your THOR Team

On the other hand, there is some bad news out there.  The industrial sector declined by .2% in November.  Our job market continues to grow slowly. This is a concern for the Federal Reserve and an issue it has been struggling with for a while now.  To help combat this problem, the Federal Reserve announced plans this past week to keep interest rates low at least through mid-2013.  Federal Reserve Chairman Ben Bernanke has also told the Senate that he has no plans to bail out Europe.  It is easy to have a mixed reaction to that statement.  On one hand, we should be satisfied that Bernanke does not want to entangle us in Europe’s problems.   On the other hand, it is uneasy to hear this believing that if Europe “unravels,” our economy will be affected as well.

Many experts believe that the euro-area economy will fall into a recession. Despite the EU leaders agreement last week to implement stricter controls over government spending and taxation and their pledge to hasten the start of the 500 billion euro bailout plan, substantial risk remains.  These moves temporally have eased the European credit markets.  The risk is still elevated as a large amount of refinancing of government debt still needs to take place in 2012.

Recession fears are not just coming as a result of policy issues, but from economic data as well.  The Purchasing Manufactures Index (“PMI”) is an index that measures whether a country is headed for a recession or an expansion.  If the index is below 50, then a country is believed to be moving toward a recession.  If the index is above 50, then a country is believed to be moving toward an expansion.  The most recent PMI reading for Germany was 48.1, for the euro-zone it was 47.9 and for China it was 49.

What does this all mean? To us it means uncertainty.  We have some economic data in the U.S. that is positive, but our job and real estate markets are not doing well.  We have Europe that does not seem to be tackling the real issues needed to solve their mess.  We believe that if Europe falls into a recession, our economy will be affected.

Where does that leave us? It gives us further comfort that the defensive position we have taken in your portfolio was the right decision.  What about the strength of the U.S.?  With the cash in your portfolios, we have the ability to take advantage of undervalued investments when we think the time is right.

All our best to you during this Holiday Season!!!

Sincerely,

Your THOR Team

The Federal Reserve’s action is its attempt to assist in stopping the runs on European banks and European money market funds. It took similar action in the United States in the fall of 2008. In September of 2008, the Federal Reserve created the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility. This facility provided funding to allow financial institutions to purchase asset-backed commercial paper from money market funds to prevent the money market funds from defaulting as a result of investors’ redemptions. This action helped to halt runs on money market funds in the United States. The markets reacted positively to this action in the short-term as the stock market rose over 6% on September 19th. Over the next six trading days, however, the market fell more than 11%. We believe the market reacted this way because the Federal Reserve’s action treated the symptoms and not the disease. In fact, the stock market continued to fall another 30% from mid-September through March of 2009. The market finally turned the corner once the problem with the financial stress was finally addressed.

Like the Federal Reserve’s actions in September of 2008, we believe central banks around the world are treating the symptoms of the disease and not the disease itself. We believe the disease needs to be fixed by political action. A large part of the solution to the United States financial crisis was changing the mark-to-market accounting rule. This rule, if you recall, forced financial companies to price assets well below their true market value. The rule change occurred within a week of the stock market’s bottom in March of 2009.

The crisis in Europe is more extensive and more complicated than our financial crisis. To fix the problem, in our opinion, there are basically two options: complete fiscal integration – United States of Europe – or a disbanding of the Euro. Other measures that have been taken to date have not been effective in solving the sovereign debt crisis. The first option would mean a loss of sovereignty and political power, likely create social unrest and require new treaties. The second option likely would cause major financial disruptions around the globe – including United States markets. Either solution adds risk to the financial markets. That is why, even with encouraging economic numbers in the United States, we believe it is prudent to continue to have a defensive weighting to your portfolios.

Sincerely,

Your THOR Team

Note: Please click on the two hyeprlinks in the above update to read a corresponding article addressing our point.