Market Commentary

Encounters with Uncertainty

July 2012

"I don't believe in accidents. There are only encounters in history. There are no accidents." – Pablo Picasso

We write during another uncertain summer. Corporate earnings and the economy are weakening here at home, as we thought they would, and Europe is now in full-blown recession. China is slowing. The feel-good market that anticipated a hot Facebook IPO has given way, for the third year running, to an uneasy summer full of questions about our financial future.

Domestic long-term fiscal issues are likely to remain unresolved until well after the Presidential elections this fall, even as an unprecedented amount of long-term U.S. government debt needs to be refinanced between 2013 and 2016. Europe's issues are far from resolved. As new headlines emerge from meeting after meeting in Europe, we see a lurching crisis that is likely to lead to a European-style federalism not previously seen. The LIBOR rate-setting scandal will engender yet more cynicism about cartel-like behavior by big financial institutions; esoteric as it seems, its impact is likely to be significant here in the U.S. Not surprisingly, the market is responding like a yo-yo.

In their excellent book This Time it's Different: Eight Centuries of Financial Folly, authors Carmen Reinhart and Ken Rogoff write that "What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it usually does."

Financial crises? Didn't we go through a crisis in 2008-2009? We think so, but during the last three years, we simply papered over the core issues in the crisis here and in Europe. The core issues in our view are too much private and public debt and not enough public and private accountability. We haven't really solved the problems that created the 2008-2009 crisis so much as we have kicked the can down the road so that we will have to solve the deeper problems on another, later day after we are forced by events to truly act. Like Picasso, in a world like this, we don't believe in accidents, but in encounters. Things are really shaping up for a series of potentially negative encounters over the coming period.

In this environment, as the managers at First Pacific Advisers (FPA) like to quip, we are focused not only on the return on capital but on the return OF capital. We think it's entirely likely that, as in mid-2007, risks that we can catalogue but that haven't yet impacted broad equity and bond market valuations could make the market quite treacherous in the coming one to two years (see our mid-2007 writing here: For this reason, while we understand that your portfolios have underperformed the U.S. stock market over the nearer term, we are emphasizing capital preservation somewhat more than stock market-like return at this point in time.

To wit, your U.S. and international bonds are short-term in orientation so that you'll be in a position to put short-term money to work at better long-term rates in the future. Your stocks are strong and solid businesses selected for financial strength and have been acquired cheaply - all of which we think will offer not only performance to the upside but some cushion should stock prices falter. Your managers continue to hold significant levels of cash, foreign currency-like investments, and gold-based investments. All in, you continue underinvested in stocks. We are adding selectively to gold-based positions in some client portfolios, depending on current weighting.

When will the market clear, providing a more broad-based opportunity to be more fully invested? We know this time will come. Just as success breeds failure in the financial markets, failure also contains the seeds of future success. We can't know the timing of the development of this opportunity, but studies of financial market history show that the opportunity does always develop.

We can see glimpses of the phenomena that will allow the market to clear, but their outline is not crisp. Baby boomers are showing signs of exhaustion with stocks, and over time they may sell collectively into a hole, creating significant value opportunity. Setting clear direction for our nation's fiscal policy will help – and Congress and the President will be forced to act more definitively to do so. An economy in which the babies of baby boomers finally engage in mass household formation and enter their peak consumption years will lift markets. Innovation will drive economic growth when it creates economic value. And, the upside of suffering yet another banking scandal is that one day we may get financial reform that discourages financial shenanigans and encourages responsibility and accountability at the highest as well as at the middle levels.

We can't know the timing of near term negative encounters - and good buying opportunities will take some time to develop. But develop they will, and as we see them unfolding, we will shift portfolios to take advantage of them.


This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

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