Who’s on First?!

July, 2012
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

Years ago, Abbott and Costello performed a comedy routine called “Who’s on First.” There is a parody of this sketch making its way around the internet imagining what it would sound like if this famous duo discussed our current unemployment situation:

COSTELLO: I want to talk about the unemployment rate in America.

ABBOTT: Good Subject. Terrible Times. It’s about 8 percent.

COSTELLO: That many people are out of work?

ABBOTT: No, that’s 16 percent.

COSTELLO: You just said 8 percent.

ABBOTT: 8 percent unemployed.

COSTELLO: Right, 8 percent out of work.

ABBOTT: No, that’s 16 percent.

COSTELLO: Okay, so it’s 16 percent unemployed.

ABBOTT: No, that’s around 8 percent...

COSTELLO: Wait a minute. Is it 8 percent or 16 percent

ABBOTT: 8 percent are unemployed. 16 percent are out of work.

COSTELLO: If you are out of work aren’t you unemployed?

ABBOTT: No, you can’t count the “Out of Work” as unemployed. You have to look for work to be unemployed.

COSTELLO: But they are out of work!!!

ABBOTT: No, you miss my point.

COSTELLO: What point?

ABBOTT: Someone who doesn’t look for work can’t be counted with those who look for work. It wouldn’t be fair.

COSTELLO: To who?

ABBOTT: The unemployed.

COSTELLO: But they are all out of work.

ABBOTT: No, the unemployed are actively looking for work...Those who are out of work stopped looking. They gave up. And, if you give up, you are no longer in the ranks of the unemployed.

COSTELLO: So if you’re off the unemployment rolls; that would count as less unemployment?

ABBOTT: Unemployment would go down. Absolutely!

COSTELLO: The unemployment just goes down because you don’t look for work?

ABBOTT: Absolutely it goes down. That’s how you get to 8 percent. Otherwise it would be 16 percent. You don’t want to read about 16 percent unemployment do ya?

This humorous exchange makes light of the various ways of measuring how many people don’t have jobs. The official definition of “unemployed” according to the Bureau of Labor Statistics is someone who does not have a job who has actively looked for work in the past 4 weeks. If you include those who would like to work full time but have stopped looking, or are only working part time, obviously the figure grows dramatically. The bad news is that no matter how you look at it, the number of unemployed people is alarmingly large; the good news is that the numbers appear to be improving albeit very slowly.

This slow return to normal job growth is one of the factors weighing on the markets. For the quarter, each of the major stock market indexes were negative after a fairly strong first quarter. The unstable situation in Europe continues to dominate headlines as investors try to determine the extent to which the recession across the pond will impact our economy.

Index 2nd Qtr
2013
Return
1 Year Return 3 Year
Annualized Return
5 Year
Annualized Return
S&P 500 -2.8% 5.5% 16.4% 0.2%
Dow Jones Industrial Average -1.9% 6.6% 18.3% 2%
Nasdaq Composite -4.8% 7% 18.1% 3.4%
Russell 2000 -3.5% -2.1% 17.8% 0.5%
MSCI EAFE -7.1% -13.8% 6% -6.1%
Barclays US Aggregate Bond 2.1% 7.5% 6.9% 6.8%

In these uncertain times, many people are looking for a safe place to put their money. What are considered the safest investments – often referred to as “risk free” – are United States Treasury bonds. While these have extremely low risk from a credit standpoint, the ultra low interest rate environment in which we live presents some additional risks that investors should consider.

At the end of this past quarter, the rate on a 10 year Treasury bond was 1.67%. Let’s look at how much that 1.67% return actually means to you. The interest that you receive is subject to Federal Income tax according to your ordinary income tax bracket. For someone in the 25% bracket, that 1.67% now becomes 1.25%. Not only is your gain subject to income tax, but it also subject to the impact of inflation. Using the May 2012 CPI (Consumer Price Index) numbers of 2.3%, your real return has now become a NEGATIVE 1.05%. The investment that was supposed to be the safest has locked in a negative return.

This is yet another reason why we at Castle Investment Advisors® believe it is important for investors to have portfolios that are well diversified, containing a combination of stocks, bonds, and securities that are not dependent on either stocks or bonds to be successful (things like commodities, real estate, currencies, and others). All of these things combine to reduce the overall risk of a portfolio.

Looking to the second half of the year, we expect the markets will be reacting to the elections in the fall, the financial crisis in Europe, and the health of the U.S. economy. We will continue with our diversification theme and look for opportunities to make small adjustments as conditions warrant.

One of the elements that goes into building a diversified portfolio for some clients is the inclusion of individual stocks. Our research process for this asset class is typically focused on larger companies that are trading at a discount to their longer term valuations. A few of the details we examine are:

  • P/E, P/B, P/CF ratios (market price compared to the company’s earnings, book value, and cash flow) – both at a current level and compared to its historical levels
  • How much of its earnings is it using to pay its dividends
  • Profitability, both on its own and within its industry
  • Does its cash flow track reasonably with its revenues and earnings
  • How well has the stock held up when the market has fallen
  • Are company insiders buying or selling the stock
  • Are big institutions buying or selling the stock
  • Does the company have good prospects for the intermediate and long term
  • Is the company financially stable

Then we will put our research next to some other well respected firms to make sure that we haven’t overlooked something glaring. In future letters, we will talk about our research process for some other asset classes as well.

We wish you a safe and happy summer. Thanks to our clients for the opportunity to be involved in your lives.

Sincerely,
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.