On paper things looked great for the markets as we wrapped up the 3rd quarter.  The S&P 500 was up 6.35%, foreign markets as measured by the MSCI EAFE rebounded and were up 6.92% and emerging markets were up 6.97%.  Even the bond market had a decent return as the Barclays US Aggregate Bond Market was up 1.58%.  Although we and our clients enjoy when the markets go up, there are times when you need to be on guard and now is one of those times.   We believe the underlying fundamentals that would normally drive a sustained bull market (like low unemployment, rising incomes and tame inflation) aren’t present, and the main reasons for the recent rise in the markets are from the steroidal pumping of money by the Federal Reserve and other central banks across the world.  Just like drinking a Frappuccino with a double shot of espresso and whipped cream can provide a short-term stimulating affect on the body, inevitably the sugar and caffeine high turns into a lingering drag and will slow you down.  Similarly, history shows that printing money can provide a short term economic high but the ultimate ramifications are long term hangover.

Stimulus – QE3
One of the objectives of the Federal Reserve’s (FED) Quantitative Easing (QE) is to push up asset prices by lowering yields and making it cheaper to borrow. The FED has created $2 trillion in its QE and “Twist” operations. While not notably successful in other objectives such as creating jobs and improving growth, stock prices have responded to the inflationary aspects of the program. That may be why the market has moved so well since March of 2009, the S&P 500 rising from the 750 area to 1475. And when each of the programs ended (for example in March 2010 and again in June 2011) stock prices peaked and pulled back lower. Quantitative easing version 3.0 (QE3) is due to push into markets.  The FED will generate about $1/2 trillion per year to be used to buy long bonds, while another $1/2 trillion will be generated with the continuation of Operation Twist, buying long bonds while selling short ones. The latest program is projected to result is $85 billion per month demand for long bonds about half comes from money creation.  This new program differs because it doesn’t have an end date, but rather will continue into the indefinite future until the FED in its almighty omnipotence deems it time to stop.  This money creation, in our view, has caused a level of false hope in the FED’s ability to control the markets.  Historically all countries that have tried this have failed.  The biggest similarity is Japan who has been attempting to spur on its economy through quantitative easing on and off for more than 20 years.  Consequently, Japan has been in a bear market for over 22 years since 1990, with both real estate prices and stock prices lower now than they were in 1990.

Corporate Profits – Top Line Growth vs. Bottom Line Growth
The bulls in the market will point out that corporate profits are at an all-time high and, generally speaking, they are right.  But, it should be noted that this isn’t because of the increased demand for companies products or services rather it’s because incomes have stayed nearly the same level for a decade and in some cases even gone down.  Labor costs, relatively speaking, have gone down while revenue (top-line) growth has been stagnant.  In a sustained bull market consumer spending is constantly increasing and creating increased demand for company products and services.  In the current bull market from 2009 until present consumers and companies are deleveraging and cutting spending.  Corporate profits have come from cutting labor and expenses rather than from increased demand which can have a negative effect.  It causes unemployment to increase and consumers to hoard, which has been the case over the last 4 years.

Update on Secular Bear
The chart below gives an update on the secular (long-term) bear market that we are in currently.  The price of the S&P 500 is still below the 2000 and 2007 all-time highs.  As you can see there is a channel formed by the two parallel horizontal lines.  The top of the channel is 1550 and the bottom of the channel is around 750. The current price of the S&P 500 is within 7% of its all-time high and top end of the channel.  This upper end of the channel known as resistance is a very difficult area to surpass.  Think of it as a ceiling that is difficult to break through.  I believe that the market will not make it above this level on this current try and will bounce off of that upper part of the channel and eventually head lower.  I’m not implying that the market crashes and goes back down to the lower end of the channel near the 750 area.  I do believe though that a significant correction is a high probability.  No one truly knows the future, but a successful investor puts the odds in his favor and with such limited upside potential compared to the large downside potential in the market, prudence would dictate that we stay defensively postured.

Fiscal Cliff
Federal Reserve Chairman, Ben Bernanke, recently coined the phrase “Fiscal Cliff” in one of his talks about the economy.  The Fiscal Cliff simply put, is the conundrum that the U.S. Government faces going into 2013 when the “Bush Tax Cuts” are set to expire, significant spending cuts are set to take place from the Budget Control Act of 2011 and the Affordable Care Act (“ObamaCare”) taxes are going to take effect.  Taxes are set to go up significantly for nearly everyone (not just the rich) and government spending will be sharply cut.  If the current laws slated for 2013 go into effect, the impact on the economy could be dramatic. While the combination of higher taxes and spending cuts would reduce the deficit by an estimated $560 billion, the CBO estimates that the policies set to go into effect would cut gross domestic product (GDP) by four percentage points in 2013, sending the economy into a recession. At the same time, it predicts unemployment would rise by almost a full percentage point, with a loss of about two million jobs.  This could cause a downward spiral effect to take place that could feed upon itself because when people lose their jobs they spend less and companies will not have as much demand for their products which will then cause them to lay more people off and so the downward spiral continues.
Source: (http://bonds.about.com/od/Issues-in-the-News/a/What-Is-The-Fiscal-Cliff.htm)

According to Rasmussen Reports (most experts agree that Rasmussen is the most accurate polling agency) on October 9th Romney and Obama are tied at 48% on a national poll.  The Electoral College Scoreboard shows that Obama is ahead 237 to Romney’s 181 for likely and safe states electoral count but there are 120 electoral points in a Toss-up of which Romney is showing a slight lead.  So as you can see the presidential election is literally anyone’s call.  The Senate Balance of Power looks to be nearly a tie with Democrats having a slight edge possibly ending up with 50-52 seats and Republicans ending up with 50-48 seats.  There is still a month to go and anything can happen before the election. One thing is certain about this election; as of right now, there is uncertainty about who is going to win and typically the stock market doesn’t like uncertainty.

Moving Forward
We live in unprecedented times where trillions of dollars have been created out of thin air and pumped into our economy in the attempt to get it growing again.  Although the U.S. stock market has had a decent run over the last few years, we believe this is a false hope.  Unemployment is still extremely high, the percentage of people that are working compared to the population is at a 30 year low and our GDP growth is just 1.3%.  We face some serious challenges ahead as we go into 2013, navigating and avoiding the “Fiscal Cliff” will be the biggest.  Although this outlook may seem gloomy, we do believe the American people are resilient and always seem to come together and find a way at the most difficult of times.  We believe once we make our way through these uncertainties over the next 3-6 months potentially a foundation will be built and we can have a secular period of sustained growth going forward.

Allgen’s current focus in the 4th Quarter and going forward into 2013 will be on preserving portfolio values by managing all of the above mentioned risks, holding higher levels of cash than normal, safe haven assets (positions that tend to go up if the market drops) and non-cyclical assets when appropriate in order to avoid major losses.  We are always searching for opportunities despite the challenges ahead, but there are times like now, where it is more important to focus on defense rather than taking high risks for low potential returns. As such, proper positioning and timing of when we switch from defense to offense should prove to be of great value for our client’s portfolios into the extended future.

Written by:
Jason Martin, CFP®, CMT
Chief Investment Officer
Allgen Financial Services, Inc.

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