When I  sat down a month ago to write this communication, it was intended to be the first quarterly communication to connect with our valued clients about topics relevant to your wealth, health and happiness. After about 80+ hours of research and editing over 4 weeks and listening to repeated expressions of concern over how much time I've been pouring into a "newsletter" (thank you for caring, Janet), it has morphed into a discussion of various important subjects and a market forecast of sorts. Subsequent newsletters will be much shorter and address a broader array of topics, and perhaps we can find a better format in the meantime. When all is said and done, substance is always more important than form. Thank you for taking the time to read "Views from the Crow's Nest," and please feel free to forward it to anyone you believe would benefit from the information.

  

Thank You. Before diving into the primary content, I want to reiterate my gratitude toward your family for trusting our team through one of the most trying times that today's investors have EVER experienced.  You have our full commitment to do everything within our talented team's power  to protect and grow your family's wealth as we move forward through more economic and financial market challenges.You have our word on that.  

Over the last 15 months we've witnessed key events that mark the beginning of a new era in history: the first wave of a financial market meltdown, a fragile partial recovery, the election of Barack Obama, open criticism of the Federal Reserve, the beginning of competing paper currency devaluations around the world, and now the Copenhagen Conference. This Conference is likely to result in significant changes in governance of climate-related issues globally and I'm not certain that history will look upon the results with the same enthusiasm as the current mainstream media does. Time will tell. 

Independent Thinking is one of the critical ingredients in the recipe for producing better results than The Herd - the investing masses who conform to "group market think." Understanding the risks and opportunities lurking around the corner is essential to preserving and growing your family's financial wealth. As explained below, I believe that your financial situation is now much more secure than ever before, despite the fact that I am genuinely pessimistic about the economy and markets for 2010 and possibly 2011.

Re-licensing. By January 1st our re-licensing process should be completed. We'll be working through "Financial Advice Inc." (FAI), a local Managing General Agency (MGA) in the insurance field. Re-licensing for IWM became necessary under a new set of financial regulations which very recently came into force. Your family's accounts are still managed by the same licensed Portfolio Managers and still held at the same financial institutions. FAI is the conduit through which our compensation flows, and changes nothing else. 

Room for more Families. Thanks to our newly streamlined business processes, we've experienced a natural expansion of our capacity to serve new Client Families, in addition to our ongoing commitment to serve all members of your family. Introductions from our current Clients are the most effective way to grow our Client Family and to that end we're working on various tools to help make that easy for you to do. We'll provide more details in future communications, and ask that you keep your ears open over the holidays for signs that family, friends or colleagues may be less than completely satisfied with their current investment advisor.

The Markets.  Over the last 15 months investors have experienced some of the worst market volatility in the last 40 years, with a fragile recovery off the March 2009 lows. Anyone who knows me well is aware that I'm optimistic by nature; however, my professional obligation is to "call it as I see it," even if what I think is not particularly positive or rosy. I believe the last 9 months are a Bear Market Rally, not the beginning of a new Bull Market. Based on the collective wisdom of our 6 independent daily and weekly research sources, I believe that the levels of most equity markets  are irrationally high, and thus in a very fragile state...and that the long-term government bond markets- about 40 times larger than global equity markets- are in worse shape. Please understand that I would love to be completely wrong and watch your accounts grow steadily without big downturns for several years, but I fear I'm correct. My pessimistic opinion of general market conditions is distinctly different than my outlook for your portfolio, as explained below.

 

Pick your Letter, or should it be a musical instrument? As far as I can tell, the general market "recovery" since March 2009 is predicated on an erroneous assumption, specifically that the underlying economy is in a genuine recovery; I  DO NOT BELIEVE WE ARE EXPERIENCING A TRUE ECONOMIC RECOVERY. In our lifetimes, we've become accustomed to "V-shaped" market recoveries from normal cyclical economic expansions and contractions, but this isn't a normal situation. I think the best we can hope for in the U.S. is a "W-shaped" economic recovery which would mean at least one more major equity market downturn.

 

Here's a very condensed list of reasons for this opinion:

1. • The current level of U.S. markets are pricing in about a 25% growth in corporate profits based on a 5% increase in real GDP for 2010. Consensus economic forecasts are predicting a 2.2% GDP growth rate. Their market is already priced for perfection.
   

1. • The apparent recovery in US consumer spending and residential real estate transactions is directly related to government stimulus via "Cash for Clunkers" and tax credits for new home buyers. For the first time since the end of World War II, U.S. consumers are actually reducing their household debt, i.e. reigning in unsustainable lifestyles. This is smart for families, but 70% of US GDP is consumer spending.
   

1. • Unemployment figures -including underemployment - in the U.S. are closer to 17%, less flattering than the headline number of 10%. Jobs in the private sector are still shrinking, except for temporary workers.
   

1. • Many State, County and Municipal governments are borrowing furiously from the Federal government to pay their current bills and do not know how or if they will pay it back. California is the worst State example and "The Governator" can't fix it. Municipalities and counties can declare bankruptcy, and many are getting close.
   

1. • There are now 552 "Zombie Banks" in the U.S. which are effectively bankrupt but haven't been allowed to officially fail by virtue of a "temporary" rule change that permits banks to state the value of their many toxic assets at their original value, not their current much lower market value. There are credible forecasts that as many as 1000 more banks will fail in the next two years.
   

1. • There is at least one more round of major residential mortgage resets still to come (Option Adjustable Rate Mortgages), likely leading to another wave of foreclosures and falling home prices. Sub-prime defaults were just the start, and the Federal Housing Administration could become the country's largest landlord, renting foreclosed houses back to mortgage defaulters.
   

1. • U.S. commercial real estate has its own challenges. A significant % (some estimate over 50%) of properties have negative equity, declining occupancy and lease renewal rates. Small businesses continue to cut costs to remain viable, including leasing less space. Collectively, there are about $2 Trillion of commercial mortages that need to be re-financed in the next 24 months. This could get nasty for credit markets.
   

1. • The Congress, Whitehouse, US Treasury and the Federal Reserve are all convinced that the way to fix their economy is to nationalize companies deemed "too big to fail," print more money backed by nothing more than governments' ability to tax, run even larger deficits, increase the government's role in "job creation" and act like things are fine. This is like pumping gas on a fire and telling the public that you're helping to put it out. Increases in money supply always lead to inflation, though it may take some time for this to develop while current excess productive capacity is absorbed. In the meantime there are hints of deflation, which makes sense considering falling house prices and unemployment. Stagflation is also a very real possibility: increasing nominal prices without real economic growth. It's happened before and CAN happen again. This makes long term government bonds quite possibly the most speculative asset class out there.  
   

1. • Paper currencies around the world are engaged in a de-valuations race to remain competitive in global trade. This is one of the primary reasons for the recent run-up in the price of gold, silver and other tangible investments - investors are seeking assets with intrinsic value, safe from the printing presses of governments worldwide. This is a direct result of fractional-reserve banking, fiat currencies, and secretive central banking systems...but this structure is unlikely to change, so we have to navigate markets while understanding their role.
   

1. • Public officials are still trying to characterize this as a "Recession" while numerous private sector pundits are openly labelling this as "The Second Great Depression" and "The Greater Depression." Semantics aside,  there are early signs of civil unrest , including taxpayer revolts and other signs of "desperate behaviour"  developing stateside. "Tent cities" are starting to form in some southern states, populated by the displaced - the unemployed and former home owners. According to the US Federal Government's own data, 1 out of 8 American children are on Food Stamps. This is a very serious situation.
   

 

An Accordion-shaped market? "Those who fail to learn the lessons of history are doomed to repeat them." Two decades ago, Japan experienced real estate and equity market bubbles, followed by devastating crashes and since then almost twenty years of "net neutral" markets. Their equity and real estate markets are still 75% below their peak levels of 1989. The folks in Washington are using very similar tactics to those employed in Japan following their crash, but they're telling us that these tactics will work differently in the U.S. Time will tell if the same actions will produce different results. Active management can still make you money by "range trading" in a sideways market, while buy and hold investment strategies produce neutral net results at best. That's why we call it "buy, hold and suffer."

 

So why are markets going up? Simply put, investor behaviour is rarely rational or logical. The markets probably over-shot to the downside in October and November 2008 and March 2009, and are essentially over-shooting to the upside right now, fuelled by excess liquidity in the banking system - provided by taxpayer-funded bail-outs -that is finding its way into riskier assets. Equity markets are being held up at their current levels by a combination of government stimulus, corporate earnings of U.S.-based companies with international operations that look better when converted into falling Greenbacks, and cheerleading from the mainstream financial media. This is drawing in more and more unsophisticated retail investors who are ignoring the economic facts. The only people with shorter memories than voters are the investing masses.  

What will change the current upward trend? The list of potential catalysts for a trend change include more sovereign debt downgrades, another major war (Pakistan or Iran?), increases in taxation, or political events like "cap and trade" on CO-2 emissions, an assassination or another terrorist attack...or something completely unforeseen and unpredictable. Hopefully it will be something more subtle like investors waking up and smelling the over-valuations in equity markets. Ultimately,  we won't know until it happens. Market charts show some early indications of a genuinely weakening trend, but nothing major yet, and December is traditionally a very positive month for equities. Ride the tide while it rises.

 

When will the Markets start dropping and by how much? Only time will reveal the exact tipping point and the full magnitude of a downturn. Our various research sources suggest the correction/crash could start some time between tomorrow and the last quarter of 2010.Estimates of 2010 U.S. market drops range from 15 to 35%, and every other market will be affected, including Canada. This could be rather devastating, especially for those who continue to trust the proponents of the buy and hold investment philosophy. Investment risk results from holding falling assets, so don't hold them when they're plummeting.

The Big Picture is NOT your Picture. I've painted a pretty awful picture using a short list of the negative data on the U.S. economy and market valuations, and I'm openly anticipating a significant market drop some time in the next six or nine months.

So why am I not concerned about your portfolio?

Firstly, if all our research sources are wrong, and investors indefinitely ignore the shaky economic fundamentals and push markets higher, your portfolio is mostly invested and will benefit from the rising tide. 

Secondly, if we turn out to be correct and the markets get ugly in 2010, the Portfolio Managers  will raise cash by exiting the positions that are falling as soon as a downward trend is recognized, and then wait patiently on the sidelines to preserve your capital from further declines. Keeping assets in cash allows the Portfolio Manager to nimbly re-enter the markets (with tight stops, of course) when their sophisticated array of market indicators show a major buying opportunity. Again, I would prefer to be wrong about this, and have all these challenges smoothly resolve themselves.

Easier said than done. Active portfolio management is extremely challenging to do in real time, and is exactly why we have dedicated full-time Portfolio Managers navigating markets for you. Being a Portfolio Manager is a unique and highly specialized discipline and in some ways it's a thankless job because there are always "Monday Morning Quarterbacks" who criticize with the benefit of hindsight. Pulling the trigger in real time with large amounts of client capital is very different from practice accounts or speculating with small amounts of "fun money." TIMING IS EVERYTHING.

Realistic Expectations.  Active management is NOT about perfection: selling at the very top or buying at the very bottom. The most successful active managers in the world very humbly admit that hitting the top or the bottom is a function of luck. Getting close to tops and bottoms consistently over time is a function of lots of hard work, the ability to correctly filter and integrate huge amounts of constantly changing data, and a genuine humility that allows them to quickly admit when the market shows them they're wrong. It's about using all the tools at the Manager's disposal to preserve your capital in falling markets, and then selectively exposing portions of your capital to the markets when the risk/reward balance seems to be tipped in your favor. By avoiding most of the worst periods of downward volatility, an active Portfolio Manager can afford to expose your capital to less risk when a recovery starts and still deliver a solid rate of return. 

Please click here for an overview of my Investment Philosophy.

General advice for families. As my clients you know that we focus on synthesizing the technical aspects of wealth management with your family's Life Goals, i.e. our advice is highly personalized. Given the nature of the current circumstances, I will depart from tradition and also offer some broader advice in hopes that it may help someone you know. As always, personal circumstances are an important part of the decision-making process here.

 

If you are invested in equity markets, be prepared to exit these positions when you are no longer comfortable with the risk of a market decline. Having philosophical discussions about holding through the next downturn but doing nothing to ensure you exit the markets could result in significant harm to your financial health. You can't change the past, but you can and should make a personal commitment to not ride the markets down this time.

Find a way to have "brakes" installed in your portfolio. This means "Stop Loss Orders" of one kind or another. If you're invested in mutual funds you have to do this manually, i.e. in writing. I was mutual funds licensed for over 14 years, so feel free to contact the writer for exact procedures on doing this.

Don't put any more cash into the market unless you have Stop Loss Orders in place!

Reduce your personal debt as rapidly as possible while interest rates are still low. Start with non-tax deductible debt with the highest rate and then work your way down to lower rate debt. Reduce your lifestyle spending if that's what it takes to eliminate your debt as soon as possible. Then attack the tax-deductible debts, again starting with the higher rate loans.

Consider selling some of your investment real estate...and yes I know this is controversial. Canada is NOT immune to the contagion of falling real estate values. If you insist on holding investment properties, lock in your variable rate mortgages, even if it results in break-even cash flow. You may also want to consider re-financing to the maximum allowed and investing your equity in liquid securities WITH REAL RISK CONTROLS to take advantage of future volatility. This allows you to diversify outside of real estate while still holding it.

If you have variable rate long term debt (e.g. a mortgage), lock in your interest rate for a 5 to 10 year period. This will increase your current payments, but will provide certainty for your family when interest rates start to escalate.

If you are debt free and not yet retired, increase your savings rate to take advantage of the significant buying opportunities that will present themselves during market volatility...even if it means reigning in some of your discretionary spending. You can't buy investment bargains unless you have cash, and you can always spend your investment profits in the future.

If you are retired and drawing more from your investment portfolio than you absolutely need to, reduce the withdrawals and leave more in your portfolio to ride out the storm and enhance your overall net worth. You can always spend more in the future when your accounts have increased.

 

Thank you for investing the time to read through this lengthy missive and please forward to anyone you feel might benefit from the information.

 

Cheers,

 

Andrew H. Ruhland, CFP, CSA

Wealth Management Advisor

Integrated Wealth Management Inc.