October 2011: Increasing Safety as Dark Clouds Gather

October 3, 2011

Summary: Asset Allocation Advisors took constructive measures last quarter to bolster the safety of client portfolios: stock investments were reduced and cash balances were increased.  These proactive steps were based on mounting evidence that economies worldwide are faltering and, more importantly, the increasing likelihood of a default on Greek government debt that could ignite a European banking crisis.

The Problem: Investors are being bombarded with worldwide political and economic uncertainty and confusion.  They ask, “What’s going on? What should I do as an investor?”

Background:  First, economies worldwide are faltering – economic growth is slowing, unemployment remains high, and businesses are hunkered down.  Second, compounding the problem, as Greece’s insolvency becomes more obvious the European financial community inches closer to a financial crisis.

Governments and central banks are flummoxed; the levers that successfully ended past recessions -- reducing interest rates and increasing government spending -- are not working.  Still, that hasn’t deterred governments here and abroad from using the same levers repeatedly, despite their dismal results.

“Insanity: doing the same thing over and over again and expecting different results.”  -- Albert Einstein

Prior post-war recessions were of a cyclical nature; the economy would overheat, inflation picked up, and the Federal Reserve hiked interest rates to slow the economy and dampen inflation.  When the desired effects of a slower economy and lower inflation took hold, the process was reversed; the Federal Reserve would lower interest rates to rekindle economic growth and repeat the cycle all over again.  However, today’s problems are not cyclical and, therefore, traditional cures for a cyclical slowdown won’t work.  As we said two and a half years ago in our Comments on the Financial Stability Plan introduced February 10, 2009, "…the root cause of today’s economic problems can be stated in the simplest of terms; there is simply too much debt and an inability to meet the payment obligations on that debt.”
Today’s problems originate from a 70-year expansion of private and government debt.  When individuals and nations run up their debts, spending more than their incomes, it temporarily allows them to live beyond their means.  However, as the amount of debt increases, so does the required payment of principal and interest, thereby consuming ever greater portions of their incomes.  Eventually, the debt burden reaches a breaking point -- even for governments -- and it must be dealt with.  Unless and until debt levels are reduced and become manageable (meaning interest and principal payments can realistically be met), today’s problems will not be resolved. Embarking on policies that create more debt in an effort to spark consumer spending is as effective as trying to lose weight while dieting on hamburgers, fries, and milkshakes.  It may be a “diet” but it will only make the situation worse!

Our government has tried bold, costly, even untested programs in an attempt to jumpstart our economy, yet failed to achieve the desired results. The latest, “Operation Twist,” is a program designed to reduce long-term interest rates -- rates that are already at the lowest levels in decades.  We expect this revived 1960’s program to also fail.  Think about it: With interest rates already at record low levels, is it reasonable to think that monetary policy seeking even lower interest rates will get the economy moving? The answer is “No.”  Individuals and businesses do not want to incur more debt at any interest rate.

On the fiscal side of the equation, another round of stimulus spending has been proposed under the guise of a “job creation program.”  Do we really need more government “stimulus” that delivers a fleeting benefit, but leaves additional long-term debt in its wake? Again, the answer is a resounding “No."

Today’s Pocket of Pain: Greece

Greece is the poster child for the consequences of unchecked deficit spending leading to unmanageable debt levels.  We believe a Greek default (euphemistically referred to as “restructuring”) is a certainty.  But the coming Greek default is only a symptom of the underlying problem: too much debt that is still growing, that cannot be serviced, and that cannot be repaid.

Bailout measures by the European Union (“EU”) will merely postpone the inevitable. The plan to bailout Greece by issuing more debt to buy existing bad debt does not resolve the root problem: too much debt and an inability to meet the payment obligations on that debt.  A debt problem cannot be resolved by issuing more debt! This plan serves only to “kick the can down the road,” buying time for the European financial community to prepare for a Greek default.

Instead, we believe bailout funds would be better used to shore up inadequately capitalized banks so they can weather the fallout from the Greek default.

Beware of Reassuring Politicians and Central Bankers

“The lady doth protest too much, methinks.” – William Shakespeare

We believe the inevitable outcome of a Greek default is already well known, despite the increasing frequency of denials from European politicians and finance ministers.  History shows that repeated and emphatic assertions from central banks and finance heads that the status quo will be maintained always precede their abrupt reversal.

What Should Investors Do?

A skeptical ear toward strong assertions from governments and finance heads serves cautious investors well.  We must listen, take heed, and act.  Regardless of today’s uncertainties and rumored government schemes and responses, we can thoughtfully and prudently position our investment capital.  And, that is what we have done: Asset Allocation Advisors took action to protect our investors in anticipation of events we view as inevitable. As your investment managers, we apply our judgment, knowledge, and experience, making proactive portfolio adjustments to further protect your capital.  Last quarter, we took steps to increase the safety of our clients’ portfolios by reducing stock investment allocations and increasing cash balances.

Asset Allocation Advisors acted upon the gathering dark clouds, in advance of the rains we foresee in the not-too-distant future. Perhaps we are months early; perhaps not. But, even if we are early, we prefer that to being a single day late in protecting your capital.

We review the investments in your managed portfolio on an ongoing basis.  We recommend that all investors do the same, especially investments owned outside of our ongoing management.  We advise that you assess how much risk exposure you have and ask yourself if your risk level is within a range you are comfortable with.  We can assist you with this.

The asset allocations of moderate client portfolios (mix of stocks, bonds, and cash) are at their most conservative levels in years.  Portfolio risk levels are correspondingly low.  Portfolio cash balances are very high at 35% (this includes money fund balances plus cash held within the mutual funds in client portfolios), compared to just 8% for our benchmark of moderate balanced mutual funds (Morningstar Moderate Allocation Category).  Stock allocations are only 40%, compared to 58% for the benchmark.  (Note: Three-fourths of our client accounts and our company pension plan embrace this “moderate” investment profile.) Nonetheless, if you personally desire a more conservative (or aggressive) portfolio allocation, please call us to further discuss your personal preferences and how we can adjust your portfolio accordingly.

Closing Thoughts…

Our mission is to take care of you and your money.  We cannot promise that we will prevail in each and every instance, but we can promise that we are steadfast in our commitment and unwavering in our resolve to navigate your portfolio proactively through these difficult and uncertain times.  Thank you for your continued support and for the trust and confidence you have placed in us.

Greg Schultz & Bruce Grenke
© 2011 Asset Allocation Advisors, Inc.