message to clients on 8/5/11

Good morning.  The US stock markets fell more than 4% yesterday and have now reached the point of "correction", which is 10% down from recent highs.  A "bear market" is 20% down from recent highs.

Since 1962, there have been 25 corrections and nine of them have turned into bear markets.  That's not much different than a coin flip for those who are wondering if we should ride this out or seek shelter.

So, I am providing two items for you to read and consider.  One is attached, and the other is linked here:  http://latimesblogs.latimes.com/money_co/2011/08/stock-market-correction-bear-market-wall-street-birinyi.html

The linked article offers some perspective on market history, while the attached guest-blog by PIMCO's Mohamed El-Erian offers probably the best overview I've seen on the conditions that are fueling this market volatility.

MY ADVICE:  if you think the USA will go back into recession and a bear market will come with it, we should exit or put protections on our equity (stocks) positions; if you think this correction has more to do with the market being overbought, perhaps artificially-inflated by "quantitative easing" programs from the government, then it is okay to keep the equities allocation.

NOTE:  thanks to the nature of the Flex portfolios, most of my clients are holding much more net cash than would be normal; while we are "fully invested", the funds we're using are not, so the professional portfolio managers working for us have more "dry powder" than usual, either for safety if things keep going badly or for opportunities if the correction ends and markets stabilize or move up again.

As always, please let me know if you have any questions.  If you want to make a portfolio move, please call me or e-mail me.  If you do not hear from me within a few minutes, please don't hesitate to call Schwab's Signature Services Alliance team at (800) 515-2157.

Thank you.

--Gary


Garo Linck Partoyan
Financial Advisor
Potomac Wealth Strategies, LLC
(703) 746-8195
Garo.Partoyan@PotomacWealthStrategies.com
www.PotomacWealthStrategies.com

Bill Gross' Lets It All Hang Out--Radical Change of Approach Needed for USA

If you can get over the initial intellectual/emotional hurdle presented by this article--that college is, for many if not most, as it is currently working, not exactly part of the solution to our economic woes--you'll find a lot to chew on here.

Bill Gross is arguably the greatest money manager in modern history (he's "the bond king" and "the Warren Buffett of bonds"--and his PIMCO Total Return fund is the largest mutual fund on the planet and owns a tremendous market-beating track-record), and he has a global perspective that is almost uniquely astute and often pretty unconventional.  And he calls it like he sees it, whatever "it" is...

In short, he sees no way for private-sector market-based idealism--OR government-as-usual--to dig us out of this hole any time soon.  Time to think radically, perhaps.

We have created less than two-million jobs while the workforce has expanded by 15 million people in the past decade.  And while he doesn't say it here, there's a strong argument to be made that the 20mm+ jobs created in the previous decade were largely thanks to a largely false (over-leveraged, service-based instead of asset/manufacturing-based) economy...  think of the causes of the economic disaster that started in late-2007 and persists today.

Balancing the budget and re-jiggering the cost-curve of entitlements and healthcare programs are of course necessary, Gross says or implies, but will not be enough to close this employment gap, and neither will the education provided by Today's version of undergraduate college education.

Call to action, or crazy billionaire screaming?  Either way, I'm listening.

Tax Rate Cuts vs. Share of Tax Burden

Prior to Bush's income tax cuts, the top 20% paid 78% of the income taxes and the bottom 40% paid 2.8%.

After the cuts, it was 81% and 2.2%.

That is probably news to a lot of folks, and it goes along with what I calculated about whether or not tax cuts pay for themselves (see here for more info).

What Is "Rich"?

I just read a brief blog about Fidelity Investments' fourth annual Millionaires Survey.  In short, most millionaires don't "feel" like they are "rich".  That probably makes most non-millionaires a little resentful, and it inspires me to offer a walk-through of my way of analyzing this whole "rich" or "not rich" point of view.

Cut to the chase:  Think of "rich" as a function of wealth.  Think of wealth as "access to goods and services, necessary and merely desirable".  The higher your income, the richer you are.

If you're earning your income, your assets are not really the issue--you don't buy gas and food and pay the mortgage with stock certificates.  If you're not earning income and, instead, living off of your assets, then your assets are the area of focus when we're talking about who is rich.

Now, what's the cut-off between "rich" and "not rich"?  No one can say for sure, but let's say anyone in the top 20% of income.  Fair enough?

In one survey, I read that $92k per year puts a household in the top 20% income grouping.  If that's so, then I'd say family earning $92k or more is "rich".  Maybe not in Northern Virginia or Manhattan, but most certainly in Toledo or Amarillo.  Regional cost of living adjustments are a topic for another time...

Now, if a family is not working (retired, already rich, whatever), how much do they need in the bank to be "rich"?  Most financial planners use a withdrawal rate of 4% of nest egg for income (if and when short-term interest rates rise up from 0-1%, where they are now, that 4% will increase a few points).  That would mean it takes about $2,300,000 "in the bank" in order to be rich.  At least right now in this low-rate environment.

That's not including equity in one's home or income-earning assets.  But if someone has a rental property that delivers net income of $10k per year, then we'd only need $2,050,000 "in the bank" to produce the other $82k of income.

So, by this logic, it's a dynamic assessment.  What does "rich" mean?  Where is the line between rich and not rich?  What assumptions can we make about income-producing investments vis a vis prevailing interest rates?

Bottom line, you're probably "rich" if you have the ability, financially, to do all the necessary things in life with more ease and certainty than most other folks.  If you're earning a living, a high income can make you rich.  If you already have a relatively high net worth, you might be rich, as long as your real and investible assets produce enough income.

Insurance, Just In Case

I just learned that a friend's colleague, a young and healthy man, had a stroke today.  His wife is pregnant and they have a one year-old child also.  Prayers for them, and motivation for us.

Do you have enough of the right kind of Disability insurance and Life insurance?  Anything can happen, and if we have others depending on us for income, we can insure something is there if we die or if we are suddenly unable to earn a living.

My firm does not sell insurance, yet it is higher on my list of recommendations than saving and investing (things on which I earn my living).  Think about that, please, and then consider you own situation.

Thank you.

2011 Predictions: Three Different Scenarios

Here are three scenarios for 2011:

Worst...

• HOUSING DOUBLE-DIP of -20%, thanks to spike in foreclosures that were artificially on-hold 2010.
• BOND MARKETS TANK in the US and EuroZone, as over-indebted G20 countries struggle to sell bonds to pay for deficit spending and thus raise rates to attract buyers even though the economies are not strong enough yet to handle higher costs of capital.
• WAR IN KOREA, as S. Korea and USA become fed-up with N. Korea's aggressive antics.
• WAR IN IRAN, as Israel and USA strike preemptively at Iran's nuke facilities, fearing Iran getting "the bomb".
• CYBER-WAR BY CHINA disables critical systems of USA military and exposes its vulnerability.

Best...

• USA ECONOMY RECOVERS FASTER than expected, fueled by continued low interest rates thanks to relative strength compared to other developed-economy countries and by the accelerated roll-out of alternative fuels that reduce geopolitical heat and spur economic growth and hiring; taking advantage of this situation, the government embarks on massive infrastructure-rebuilding programs that create jobs and increase demand.
• USA STOCK MARKET BOOMS, going up 20+%, thanks to good economic/employment data and fueled by record amounts of cash in both corporate and personal coffers.
• IRAQ BECOMES MORE STABLE and the USA really does exit as planned.
• AFGHANISTAN IS BROUGHT UNDER CONTROL thanks to history-making counterinsurgency tactics, mastered in Iraq and modified for Afghanistan, are executed prudently and pecisely; Gen. Petraeus' status as a great leader is solidified.
• WEALTH GAP IN USA CLOSES while regulations and taxes remain limited; evidence provided for posterity that Keynesian pump-priming successfully, but temporarily, served the purpose of stopping the economic free-fall and re-igniting growth before more normal market forces take-over.

Likely...

• WEAK ECONOMIC RECOVER IN USA, but no double-dip recession or second housing-price collapse.
• COMMODITIES, DOLLAR, AND STOCKS all rise, signaling brighter future.
• UNEMPLOYMENT GOES TO 10% as new jobs are not being created fast enough.
• GOP CONGRESS OVERSHOOTS by trying to roll-back most of president Obama's agenda, costing some public opinion points for the Republicans.
• IRAQ INCREASES STABILITY and nurtures its new government, but US troops remain there and are still targeted for attacks by insurgents.
• AFGHANISTAN FLARES-UP as USA tries to maintain a non-kinetic posture and then overreacts to insurgents' attacks in ways that cost unnecessary civilian lives; "Obama's War" starts to look more like an actual war.
• CHINA ALLOWS ITS CURRENCY TO FLOAT as modernists want to be real global player and not be perceived as a manipulative economic bully.

RECOMMENDATIONS FOR YOUR PORTFOLIOS:

• Avoid long-dated bonds of developed-economy governments.
• Own high-quality stocks around the globe.
• Use global/flexible mutual funds and/or portfolio managers for most or all of your investments.
• Keep 5-15% in cash, in addition to whatever the global/flexible fund managers are doing--dry powder, so to speak, in case of emergency and/or opportunity.

GENERAL FINANCIAL RECOMMENDATIONS:

• Life insurance for your dependents
• Disability insurance for yourself and dependents
• Cash for rainy days
• Retirement savings next, before education and other savings (there's no work-study or SallieMae for retirement)
• Refinance your home and investment properties to lower rates, but don't extend your time-frame too much (if you have 18 years left on a mortgage at 7%, be careful about re-fi to 4.875% if you're then going to be right back at 30 years to go...)
• Give generously if you have extra, accept help gratefully if you need it.

What We Expect for 2011

I expect continued market volatility, for economic and political reasons.  This week's debt ceiling stuff is just part of the big picture that I think is already driving the ship.

Developed-market countries are laden with debt and suffering from declining, or no-better-than-anemic economies.  At some point, some major currencies could really devalue and the bond prices of the world's traditionally "best" economies could tank when the interest rates spike in the auction markets as they issue unprecedented amounts of new debt (via government-bond auctions) to fund their ongoing deficit spending.   The USA is not inherently exempt from this just because we're the greatest economic power in history.  Just ask the Romans and British about the notion of indefinite staying-power.

My best ideas for this year:

• opportunistic stock-picking (let's look at that--I like C, VCM, RIG, F, GM and some techies right now--seems they are under-valued and could skyrocket)
• opportunistic commodity bets (gold should go up, oil should go up, copper goes up especially if the USA recovers better than expected)
• global/emerging markets bond picking (as the Asian and other developing markets grow stronger, they can pay lower bond interest rates, boosting bond prices; and countries with rising rates, while posing risk to asset values, at least offer better income payments)
• dividend-paying stocks of high-quality, global companies are a great choice for income-oriented investors since quality bonds and cash alternatives are paying so little now

The big risk I fear, since all this macroeconomic knowledge is kinda baked into the cake, is China's efforts to slow down a bit to avoid the bad kind of inflation--if they over-do it and tank their economy, then it could lead to another global economic train-wreck and US bonds and dollar could go up suddenly.  This is unlikely, but staying nimble and diversified is nonetheless advisable.

 I still like my "Flex" portfolios for these reasons.  It is confidence-inspiring to have Dorsey Wright's Systematic Relative Strength strategy, Mssrs. Avery and Caldwell, and Mr. Cuggino running the opportunistic/unconventional stuff through their mutual funds, and all the more reason to have the Yacktmans and the Eveillard disciples picking our stocks, and Mssrs. Gross and Hasenstab picking our bonds.