July, 2010
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

“Watchoo talkin’ bout Willis?!”
This oft-quoted catchphrase from the recently departed Gary Coleman character on the 80’s sitcom Diff’rent Strokes captures the feeling of many as they have tried to understand some of the headlines over the past few months. From the sovereign debt crisis in Europe, to the stock market dropping almost 1000 points in an hour, to the painful amount of time it has taken to stop oil from continuously gushing into the Gulf of Mexico, investors saw many things that challenged their comprehension and left them shaking their heads.

Market Performance
The economic optimism that characterized much of the first quarter of 2010 seemed to evaporate in the second. The S&P 500 lost 11.4% in the 3 month period and was down 6.7% for the first 6 months of the year. Market volatility had been on a steady decline since peaking in November of 2008, but spiked again during Q2, 2010.

Trouble Overseas
The sovereign debt crisis that began in Greece quickly spread to other countries including Portugal, Italy, Ireland, and Spain. The uncertainty over the depth and breadth of this problem increased the investment fear factor worldwide. To view a humorous video made by John Clarke and Bryan Dawe that attempts to explain the issue: http://www.abc.net.au/news/video/2010/05/20/2905304.htm. The European debt situation combined with a 10% drop in the price of oil did drive the U.S. dollar higher during the latest term.

Disaster at Home
Speaking of oil, the Deepwater Horizon rig explosion caused a massive oil spill forcing the Gulf region to brace for the reality that the area may be changed for decades. In addition to the obviously terrible environmental consequences, investors have growing concerns over additional repercussions, particularly as it relates to the amount of governmental involvement in the oil and other related industries.

Of course, this incident has made BP frequent fodder for late night comedians including this quip from Jimmy Kimmel:

  • “It’s Day 71 of the oil spill in the Gulf of Mexico. They just did a poll that says only 6 percent of Americans have a favorable view of BP, to which I say, 6 percent of Americans have a favorable view of BP? That’s 18 million people. Is it possible that 18 million Americans don’t know what the word favorable means?”

Rates Remain Low
The Federal Reserve has kept rates extremely low with indications that they will remain that way for an extended period of time. We will be watching for any signals of impending changes at future meetings, which occur in August, September, November, and December.

As a result, mortgage rates remain near all time lows, motivating existing home owners to refinance and giving a certain amount of impetus to those considering buying for the first time. Though, on the flip side of that, tax incentives for new buyers expired providing a headwind for the housing market. We encourage all of our clients and their family members to take advantage of the current environment and lock in these low rates. At the current rate of sales, there are 8 months of housing inventory, compared to historical average of about 5 months. The median house price saw an increase of 2.7% from this time last year, but is still 26% lower than its peak.

While positive if you are a borrower, low rates are a drag if you are looking for income from your money market fund, savings account, CD, and the like. This environment has also pushed municipal bond rates to 9-year lows. We continue to seek out conservative alternatives that provide decent income, rather than endure near zero percent returns on cash. This is a challenging risk/reward proposition that we are navigating delicately.

Slow Growth
The final Q1 GDP report came in at 2.7% growth while estimates are for the economy to have grown 3.3% in Q2, which would be equivalent to the historical average. Inflation remains tame at 2% - below its historical average of 3.4% while the personal savings rate of 4% is above its 10 year average of 2.8%.

While the NBER (National Bureau of Economic Research) has not officially set an end date to the recession that began in Dec. 2007, many have viewed it to have ended sometime in the latter part of 2009. While many elements have seen improvement, an area that continues to lag is employment. Private job creation for the past 2 months combined was 116,000 – the problem is we need to create 125,000 new jobs per month just to keep up with population growth.

Unemployment currently stands at 9.5% compared to 40-year average of 6.2%. This is a drop from 9.7% but the decrease is primarily due to the nearly 1 million people who have given up looking for work and hence have dropped out of the labor market.

The underemployment rate, which includes those who are part-time who would like to be full-time as well as those who are discouraged and have given up looking for work is estimated to be 16.5%.

Hoping for a false signal
While growth in many areas is encouraging, some signals show an increased possibility of re-entering another recession – called a double dip. The Weekly Leading Index (WLI) of the Economic Cycle Research Institute (ECRI) registered negative growth for the fourth consecutive week, coming in at -7.7. The rate of decline from the peak in October 2009 is unprecedented since the metric was first devised in 1967. The index has never dropped to the current level without the onset of a recession.

Industry Overview
As we look over the investment landscape of the major industries, we have a few observations:

  • Technology companies seem to be experiencing increased demand,
  • Government intervention is the theme for health care, energy, & financial sectors, and
  • Consumer companies face uncertainty due to the increased uncertainty of consumer trends.

What we are watching
Some of the specific economic areas that we have our eyes on as 2010 progresses:

  • Employment data
    • Significant improvement here will be the key indicator that the worst of the recession’s effects are behind us.
  • Fiscal Policy
    • There is significant uncertainty and concern regarding potential tax increases and spending cuts for 2011 and beyond as what are known as the Bush tax cuts expire at the end of this year.

So now what
We are, as always, continuing to allocate investment portfolios with each client’s individual situation in mind. Inside the boundaries of our long term view is the need to adjust portfolios in ways that circumstances indicate are prudent. Some of those adjustments currently include finding ways to increase the income production in accounts without adding to the overall risk level. As a result, we are evaluating the appropriateness of investments like preferred stock and foreign bonds – both in developed regions and emerging markets. We also believe that at some point interest rates will rise, and so we are examining floating rate bonds, as well as some inverse Treasury positions.

Laugh and Wonder
We all need to have those moments in our lives where we can sit back and laugh or just take time to marvel at things you see in nature. To that end, we present the following:

In closing, we would like to reiterate our thankfulness for the opportunity to partner with you on your financial journey. As always, we are happy to talk at any time.

Sincerely,
The Castle Investment Advisors®, LLC Investment Team

                    

Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.