April 2012: European Update - Problems Unresolved

Fast Start for 2012

The stock market soared in the first quarter, propelling account values higher.  Asset Allocation Advisors’ typical managed account gained more than +5.5% last quarter.  It was the best of both worlds: solid profits, but with conservatively positioned portfolios.

Outlook

Stocks are richly priced. We believe the best course now is to emphasize capital preservation in the short-term, as we have done, positioning to maximize your long-term profits when improved, low-risk opportunities arise.   Our portfolios are positioned conservatively and geared toward defense:  de-emphasizing stocks while emphasizing above-average reserves of cash and short-term bonds.

European Update: Problems Unresolved

The Problem: The world’s financial problems that erupted in 2008 are a result of over-indebtedness, that is, large and growing debt whose repayment is becoming questionable.  The problem has not been corrected.  Instead, band-aid “solutions” have been applied through various types of easy-money policies: Quantitative Easing in the U.S. and unlimited 1% loans from the European Central Bank (“ECB”) to individual European banks (the European back-door version of our Quantitative Easing).  These measures have temporarily enabled heavily indebted governments to continue to engage in deficit spending, thereby making the problem worse instead of better.

Greece: To no one’s surprise, Greece finally defaulted on its sovereign debt, forcing bondholders to accept a “restructuring” of debt that was equivalent to a write-down of about 73%.  Yet, after taking losses of 73%, the newly restructured debt is already trading at discounted prices.  Why? Investors have doubts that even the greatly reduced debt obligations can be met!  The problem – that Greece far outspends its revenues -- has not been resolved.  In fact, the more that austerity is forced on Greece (i.e., higher taxes and reduced government spending), the further their economy deteriorates, making it even harder to close the gap between spending and revenues.  

European Banks: The quality and worth of European banks assets, including bonds of faltering governments, has been deteriorating. This has weakened banks, causing short-term financing from private sources to evaporate. The European Central Bank intervened last December and again this past quarter providing temporary relief (commonly referred to as “kicking the can down the road”) but did not address the deep and growing economic ailments afflicting European governments and banks.  The ECB provided a virtually unlimited amount (the equivalent of $1.3 trillion) of 1% interest, three-year loans to European banks. (Who else would lend money to insolvent banks?) These loans have temporarily provided a reprieve from banks’ short-term financing difficulties.  This is a classic example of treating the symptom while the underlying problems created from a crushing burden of high and growing government indebtedness continue unabated.  The problems of European banking insolvencies and the deep and growing economic ailments in Greece, Portugal, Spain and Italy continue without resolution.

Conclusion

Our job is to do our very best to capture profits for you and protect your capital.  (We invest our company pension plan the same as our typical managed account.) We trust that you, too, share our commitment to both capital preservation as well as capturing profits. At present, an emphasis on capital preservation is the order of the day. We strongly believe that patient investors who embrace conservative portfolios now, with low allocations to stock and high allocations to cash and short-term bond reserves, will be well rewarded in the near future when superior investment opportunities present themselves. 

Thank you for your continued trust and the confidence you have placed in us. We welcome your questions and comments.  Thank you.  ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2012