I spent the second week of May at the 64th annual conference of the CFA Institute. The venue this year was Edinburgh, Scotland and I was able to include a couple rounds of golf. It’s truly a wonder how one can experience rain, heat, sun, rain, strong winds and calm sunshine again… all in one round of golf. As usual, the conference provided a solid lineup of financial professionals from all over the globe. As solid as they may be, each has his/her own view of the global economy.

As you might expect, there were differing views on the future of the global economy, including the prospects for inflation… how much inflation, if any… and when? Prior to the end of the Cold War in 1989, one could make the case that the United States did not have a proper allocation of capital. We were spending money preparing for a military disaster that may or may not occur… and we were paying a relatively high price for labor. After the fall of the Berlin Wall, we began to allocate capital more productively. Technology allowed us to produce more with fewer employees, and U.S. manufacturers gained access to extremely cheap labor overseas… millions of laborers who were willing to work for a tiny fraction of what was being paid to workers in the U.S. The next twenty years saw manufacturing jobs in the U.S. decline as corporations opened facilities overseas. Not coincidentally, each recession since then has required more time for the economy to return to full employment. As you can see by the red line in the chart below, it might yet be a long time before this economy creates enough jobs to return to full employment.

Note that the previous recession is the brown line and took 47 months to return to full employment. The recession before that one is the black line and took 31 months to return to full employment. What does this have to do with inflation? Wage pressure is a major component of inflation. Workers are reluctant to demand higher compensation when they can be easily replaced. Without upward wage pressure, inflation is not likely to be sustainable long-term. I think we will eventually see the day when the cost of foreign labor has increased so much that manufacturing begins to return to the United States. However, that is not happening soon and there is nothing that is driving the cost of labor higher. Another component of inflation is the cost of housing. Do you need to be told that the value of your house has declined for the fourth year in a row? The S&P Case-Schiller index of home prices just announced that home prices fell to their lowest values since prior to the recession. Falling home prices and declining real estate values tend to be DE-flationary, not IN-flationary even though the price of housing is not included in the calculation for the Consumer Price Index. Yes, fuel prices have increased a lot. Food prices have increased a WHOLE lot. Gold can’t seem to find a ceiling (although silver banged its head really, really hard). Looks like inflation. Feels like inflation. But is it? It could be that what we have experienced for the past 18 months is something we are not going to experience in the next 18 months. Exploding commodity prices may have been the result of red-hot (pun intended) growth in China combined with “Quantitative Easing” (QE2). QE2 is the action taken by the Federal Reserve Bank to keep rates artificially low while pumping dollars into our financial system (a bit more complicated but that’s the short version). QE2 is scheduled to end this month and, although it may not be considered a success by some (unemployment is still 9% and home prices continue to fall), a case could be made that the economy would be even worse without QE2. Certainly those who implemented QE2 will make that claim and no doubt those attempting to be re-elected will cite how much worse things would be without the fiscal and monetary measures taken. The possibility of a QE3 is remote. Although the Federal Reserve Bank operates independently of the Administration, QE3 will likely be considered an unpopular strategy to a country already very concerned with our profligate debt and continuing deficits which add to the debt. Meanwhile China has been raising interest rates in an effort to slow growth and reduce inflation. Don’t be surprised to see declines in the prices of the same commodities that experienced huge price increases in the past year. As a matter of fact, several of the commodities which recently experienced spectacular price increases (Ben Bernanke refers to them as “transitory”), have seen sharp sell-offs in the past couple of months. Cotton, wheat, cocoa and coffee are all down over 10% from their peaks. Bottom line: there are many economic issues to be concerned about but inflation is not one of them… yet.

Meanwhile, Northern Africa and the Middle East have calmed somewhat and the tsunami in Japan has become old news. So who shows up back on the front page? Europe! Specifically Greece… although Portugal, Ireland and Spain are getting their share of negative press. We knew the problems had not been solved and were actually getting worse. It was simply a matter of time before they became front page news again. Greek bonds which mature in one year are trading today with a yield over 17%. At one point last month, they traded down so much that the yield was over 23%! Portugal and Ireland, with bonds trading to yield over 9% and almost 8% respectively, illustrate that investors have concerns about them as well. But Greece is in a class all by itself. It appears that a Greek default of some kind is a fait accompli. It should be noted that “default” can happen in one of five ways:

1. “We are not going to pay you another penny.” In other words, the country just decides to never pay back ANY of its outstanding debt. This doesn’t make the borrower very popular and future lenders, if they exist, will likely want to exact a very high rate of interest… just like credit card companies do to borrowers with a spotty record of making payments on time. Since the yield on Greek bonds has declined from 23% to 17%, it appears investors are not viewing a Greek default as one where the investor will get totally stiffed.
2. “We are going to pay you back but… it might take a little longer than we promised and we might not be able to pay back all of the debt.” This is called re-structuring. There’s even a new term called “re-profiling” the debt, but it is essentially the same thing as re-structuring.
3. Default on its citizens. The country can implement austerity measures on its people that renege on promises previously made to its citizens. In the U.S. an example of defaulting on our citizens would be telling us we cannot collect Social Security at age 65… that we will have to wait until age 66 or 67. Oh, wait… we already did that. I guess now we may have to increase the age for Medicare to age 67. This is a default strategy that is rife with political volatility. Politicians hate this one because it’s usually followed by the end of a political career.
4. Inflation. This is the one countries usually choose because the first three are too painful. Just inject more currency into the economy and hope the economy heats up. “Heating up” hasn’t happened in the U.S. (yet) because, despite all the new money, it just sits in the banks.
5. Devaluation. Kind of like #4 but this choice is not available to countries which do not have their own currency.

No one knows the extent of damage (economic, political and physical) that will be the result of a Greek default, but two countries (Portugal and Ireland) will be watching with more than just a passing interest. Will Greece have to temporarily close banks to prevent a run on the banks? Will Greece exit the Euro currency and return to operating with its own currency? Will Greece have to impose additional austerity measures on its citizens? And if so, will they have to institute martial law and establish a curfew? Stay tuned.

Meir Statman was one of the keynote speakers in Edinburgh. A professor of finance at Santa Clara University, Mr. Statman gave a presentation titled “What Investors Really Want, Lessons from Behavioral Finance.” Although I have heard him speak before, it is always helpful to be reminded of the types of investing errors that are easy to make. A couple of the more common errors are:

• Confirmation errors – looking for evidence that confirms our investment claims while overlooking (or ignoring) evidence that contradicts our investment claims.
• Herding errors – it is tempting to join a herd that appears to have “figured it out”… and the more people that join the herd, the more appealing it may become.

He used the example of becoming a client of Bernard Madoff. Over time, becoming a client of Madoff had the aura of belonging to an exclusive country club. There was a status associated with this “membership.” Another example of herding is making an investment because everyone else seems to be making money in that investment… like technology stocks in 2001 or real estate in 2006. Mr. Statman said that what investors want with their investments can be expressed in three needs:

• Utilitarian benefits – the most basic benefit. “I will always have enough money for food and shelter.”
• Expressive benefits – what my investments say about me “I am financially independent.”
• Emotional benefits – how my investments make me feel. “I have freedom from fear and I have hope for riches.”

As a portfolio manager, it is important, yet still difficult to remove emotions from investment decisions. Many investors, particularly mutual fund managers, are driven by short term performance. They are locked into a system that evaluates them on how they performed the past three months, the past six months or “year to date.” Having a longer time horizon and understanding behavioral finance helps us avoid short-term, knee jerk, emotional decisions.

As I am writing this the first day of June, the House voted yesterday 318-97 against raising the debt ceiling. GOP leaders have stated they will not vote to increase the debt ceiling unless it is linked to a deficit-reduction plan. This is all political posturing, particularly with a Presidential election approaching in 2012. Each party is desperately trying to make the other party look responsible for anything economically negative. They are meeting with the President today and will certainly work something out, because having the U.S. government cease operations is probably not in the best interest of either party. The stock market took a breather in May. The S&P 500 and the Dow Jones Industrial Average declined just over 1%. If you were invested in the S&P 500 since 12/31/99 (almost 11 ½ years), your annual return would be 1.06%. Some people would tell you that means the next 11 ½ years are going to be great years for investing in the stock market… that its average annual return for the past millennium is north of 8% and therefore it will eventually “regress to the mean”. The problem with that thinking is that the stock market might regress to the mean next year… or not until the year 2015. At Boyer & Corporon Wealth Management, we continue to have grave concerns about the global economy. Having said that, we don’t view the stock market (in general) to be expensive… neither do we find it particularly cheap. Bonds have rallied this past month. The 10-year Treasury is trading below 3% today and it is difficult to find good values in taxable fixed income without extending duration further than we would like. We continue to find decent value in tax-free bonds although they have rallied the past few months and are not nearly as attractive as earlier this year.

~Richard W. Boyer, CFP, CFA
Chief Investment Officer

This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

I spent the second week of May at the 64th annual conference of the CFA Institute. The venue this year was Edinburgh, Scotland and I was able to include a couple rounds of golf. It’s truly a wonder how one can experience rain, heat, sun, rain, strong winds and calm sunshine again… all in one round of golf. As usual, the conference provided a solid lineup of financial professionals from all over the globe. As solid as they may be, each has his/her own view of the global economy.

As you might expect, there were differing views on the future of the global economy, including the prospects for inflation… how much inflation, if any… and when? Prior to the end of the Cold War in 1989, one could make the case that the United States did not have a proper allocation of capital. We were spending money preparing for a military disaster that may or may not occur… and we were paying a relatively high price for labor. After the fall of the Berlin Wall, we began to allocate capital more productively. Technology allowed us to produce more with fewer employees, and U.S. manufacturers gained access to extremely cheap labor overseas… millions of laborers who were willing to work for a tiny fraction of what was being paid to workers in the U.S. The next twenty years saw manufacturing jobs in the U.S. decline as corporations opened facilities overseas. Not coincidentally, each recession since then has required more time for the economy to return to full employment. As you can see by the red line in the chart below, it might yet be a long time before this economy creates enough jobs to return to full employment.

Note that the previous recession is the brown line and took 47 months to return to full employment. The recession before that one is the black line and took 31 months to return to full employment. What does this have to do with inflation? Wage pressure is a major component of inflation. Workers are reluctant to demand higher compensation when they can be easily replaced. Without upward wage pressure, inflation is not likely to be sustainable long-term. I think we will eventually see the day when the cost of foreign labor has increased so much that manufacturing begins to return to the United States. However, that is not happening soon and there is nothing that is driving the cost of labor higher. Another component of inflation is the cost of housing. Do you need to be told that the value of your house has declined for the fourth year in a row? The S&P Case-Schiller index of home prices just announced that home prices fell to their lowest values since prior to the recession. Falling home prices and declining real estate values tend to be DE-flationary, not IN-flationary even though the price of housing is not included in the calculation for the Consumer Price Index. Yes, fuel prices have increased a lot. Food prices have increased a WHOLE lot. Gold can’t seem to find a ceiling (although silver banged its head really, really hard). Looks like inflation. Feels like inflation. But is it? It could be that what we have experienced for the past 18 months is something we are not going to experience in the next 18 months. Exploding commodity prices may have been the result of red-hot (pun intended) growth in China combined with “Quantitative Easing” (QE2). QE2 is the action taken by the Federal Reserve Bank to keep rates artificially low while pumping dollars into our financial system (a bit more complicated but that’s the short version). QE2 is scheduled to end this month and, although it may not be considered a success by some (unemployment is still 9% and home prices continue to fall), a case could be made that the economy would be even worse without QE2. Certainly those who implemented QE2 will make that claim and no doubt those attempting to be re-elected will cite how much worse things would be without the fiscal and monetary measures taken. The possibility of a QE3 is remote. Although the Federal Reserve Bank operates independently of the Administration, QE3 will likely be considered an unpopular strategy to a country already very concerned with our profligate debt and continuing deficits which add to the debt. Meanwhile China has been raising interest rates in an effort to slow growth and reduce inflation. Don’t be surprised to see declines in the prices of the same commodities that experienced huge price increases in the past year. As a matter of fact, several of the commodities which recently experienced spectacular price increases (Ben Bernanke refers to them as “transitory”), have seen sharp sell-offs in the past couple of months. Cotton, wheat, cocoa and coffee are all down over 10% from their peaks. Bottom line: there are many economic issues to be concerned about but inflation is not one of them… yet.

Meanwhile, Northern Africa and the Middle East have calmed somewhat and the tsunami in Japan has become old news. So who shows up back on the front page? Europe! Specifically Greece… although Portugal, Ireland and Spain are getting their share of negative press. We knew the problems had not been solved and were actually getting worse. It was simply a matter of time before they became front page news again. Greek bonds which mature in one year are trading today with a yield over 17%. At one point last month, they traded down so much that the yield was over 23%! Portugal and Ireland, with bonds trading to yield over 9% and almost 8% respectively, illustrate that investors have concerns about them as well. But Greece is in a class all by itself. It appears that a Greek default of some kind is a fait accompli. It should be noted that “default” can happen in one of five ways:

1. “We are not going to pay you another penny.” In other words, the country just decides to never pay back ANY of its outstanding debt. This doesn’t make the borrower very popular and future lenders, if they exist, will likely want to exact a very high rate of interest… just like credit card companies do to borrowers with a spotty record of making payments on time. Since the yield on Greek bonds has declined from 23% to 17%, it appears investors are not viewing a Greek default as one where the investor will get totally stiffed.
2. “We are going to pay you back but… it might take a little longer than we promised and we might not be able to pay back all of the debt.” This is called re-structuring. There’s even a new term called “re-profiling” the debt, but it is essentially the same thing as re-structuring.
3. Default on its citizens. The country can implement austerity measures on its people that renege on promises previously made to its citizens. In the U.S. an example of defaulting on our citizens would be telling us we cannot collect Social Security at age 65… that we will have to wait until age 66 or 67. Oh, wait… we already did that. I guess now we may have to increase the age for Medicare to age 67. This is a default strategy that is rife with political volatility. Politicians hate this one because it’s usually followed by the end of a political career.
4. Inflation. This is the one countries usually choose because the first three are too painful. Just inject more currency into the economy and hope the economy heats up. “Heating up” hasn’t happened in the U.S. (yet) because, despite all the new money, it just sits in the banks.
5. Devaluation. Kind of like #4 but this choice is not available to countries which do not have their own currency.

No one knows the extent of damage (economic, political and physical) that will be the result of a Greek default, but two countries (Portugal and Ireland) will be watching with more than just a passing interest. Will Greece have to temporarily close banks to prevent a run on the banks? Will Greece exit the Euro currency and return to operating with its own currency? Will Greece have to impose additional austerity measures on its citizens? And if so, will they have to institute martial law and establish a curfew? Stay tuned.

Meir Statman was one of the keynote speakers in Edinburgh. A professor of finance at Santa Clara University, Mr. Statman gave a presentation titled “What Investors Really Want, Lessons from Behavioral Finance.” Although I have heard him speak before, it is always helpful to be reminded of the types of investing errors that are easy to make. A couple of the more common errors are:

• Confirmation errors – looking for evidence that confirms our investment claims while overlooking (or ignoring) evidence that contradicts our investment claims.
• Herding errors – it is tempting to join a herd that appears to have “figured it out”… and the more people that join the herd, the more appealing it may become.

He used the example of becoming a client of Bernard Madoff. Over time, becoming a client of Madoff had the aura of belonging to an exclusive country club. There was a status associated with this “membership.” Another example of herding is making an investment because everyone else seems to be making money in that investment… like technology stocks in 2001 or real estate in 2006. Mr. Statman said that what investors want with their investments can be expressed in three needs:

• Utilitarian benefits – the most basic benefit. “I will always have enough money for food and shelter.”
• Expressive benefits – what my investments say about me “I am financially independent.”
• Emotional benefits – how my investments make me feel. “I have freedom from fear and I have hope for riches.”

As a portfolio manager, it is important, yet still difficult to remove emotions from investment decisions. Many investors, particularly mutual fund managers, are driven by short term performance. They are locked into a system that evaluates them on how they performed the past three months, the past six months or “year to date.” Having a longer time horizon and understanding behavioral finance helps us avoid short-term, knee jerk, emotional decisions.

As I am writing this the first day of June, the House voted yesterday 318-97 against raising the debt ceiling. GOP leaders have stated they will not vote to increase the debt ceiling unless it is linked to a deficit-reduction plan. This is all political posturing, particularly with a Presidential election approaching in 2012. Each party is desperately trying to make the other party look responsible for anything economically negative. They are meeting with the President today and will certainly work something out, because having the U.S. government cease operations is probably not in the best interest of either party. The stock market took a breather in May. The S&P 500 and the Dow Jones Industrial Average declined just over 1%. If you were invested in the S&P 500 since 12/31/99 (almost 11 ½ years), your annual return would be 1.06%. Some people would tell you that means the next 11 ½ years are going to be great years for investing in the stock market… that its average annual return for the past millennium is north of 8% and therefore it will eventually “regress to the mean”. The problem with that thinking is that the stock market might regress to the mean next year… or not until the year 2015. At Boyer & Corporon Wealth Management, we continue to have grave concerns about the global economy. Having said that, we don’t view the stock market (in general) to be expensive… neither do we find it particularly cheap. Bonds have rallied this past month. The 10-year Treasury is trading below 3% today and it is difficult to find good values in taxable fixed income without extending duration further than we would like. We continue to find decent value in tax-free bonds although they have rallied the past few months and are not nearly as attractive as earlier this year.

~Richard W. Boyer, CFP, CFA
Chief Investment Officer

This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.