Fourth Quarter GDP Breakdown

After three quarters in a row that averaged roughly 1.2%, the fourth quarter real GDP grew 2.8%, a bit below expectations of 3.0%.  Since the price deflator was up just .4% versus the estimate of 1.9%, nominal GDP (measure of growth not adjusted for inflation) was up 3.2% versus the estimate of 4.9%.

Personal consumption rose 2.0%; fixed investment rose 3.3%, helped by a 5.2% increase in equipment spending and residential construction rose by 10.9%. Government spending was a drag on GDP growth lead by a 12.5% decline in national defense spending.  State and Local government spending fell by 2.6%.  Inventories added roughly 2% to GDP growth, but final sales rose just .8% versus 3.2% in the third quarter.  This shows that inventory rebuild played a large part in the fourth quarter GDP increase.

Bottom line is the economic environment continues to be mixed, but positive.  We have to watch the European slowdown for potential impact on our domestic recovery.

Existing Home Sales Increase

The latest monthly data shows total existing-home sales rose 5.0 percent to a seasonally adjusted annual rate of 4.61 million in December from a downwardly revised 4.39 million in November, and are 3.6 percent higher than the 4.45 millionunit level in December 2010.

Total housing inventory at the end of December dropped 9.2 percent to 2.38 million existing homes available for sale, which represents a 6.2-month supply at the current sales pace, down from a 7.2-month supply in November.

This graph shows existing home sales, on a Seasonally Adjusted Annual Rate

(SAAR) basis since 1993.  Sales in December 2011 (4.61 million SAAR) were 5.0% higher than last month, and were 3.6% above the December 2010 rate. 

Expect the Unexpected

It is always interesting to see a tremendous amount of advice the New Year brings, an exercise which requires a considerable investment of time and attention by writers, despite the fact that markets tend to be indifferent to what month or year is on the on a calendar.  Our view of 2012 is that it will likely be marked by a continuation of the trends that were so obviously in place at the end of 2011 – mainly uncertainty.

The interesting thing about the latter portion of 2011 and now the start of 2012 is that it witnessed one of the clearest dispersion of returns in asset classes that we have seen in over a decade.  In addition, the US economy seems to be involved in a weak recovery as evidenced in the latest round of economic data.  Although this contradicts leading economic indicators which show the economy could be slowing down dramatically as we move through 2012.  We suspect that in this post crisis era economic recoveries which gain no real traction, such as the one we are in, will likely display a constant conflict in the data between recovery and possible recession, until one or the other becomes more obvious.

If at some point this year this recovery gains more momentum it will provoke a reconsideration of the Federal Reserve’s very accommodative stance.  This could be the greatest risk in 2012 simply because no one believes it.  We don’t believe the Fed will change its stance, mainly because this is an election year, but we want to be aware of the possibility of a surprise move.  We can follow the bond market for clues.  Right now bond investors don't expect rates to rise anytime soon.

Indeed the effect of the Federal Reserve’s promise not to raise rates prior to 2013 has been to encourage investors to take more risk than would otherwise be prudent and build portfolios around this premise.  However, we should be aware that the Fed has a dual mandate which concerns employment and inflation (not yet problematic but hardly non-existent).  We would imagine that if US economic data continues its recent path then pressure will grow within the divided FOMC to reconsider its accommodative stance.

As we head into 2012, we believe this could prove to be another interesting year.  In a world filled with uncertainty, one thing is probably certain – the markets have never experienced two flat years in a row.  This could be the year to expect the unexpected.

Happy Holidays!

We want to wish you and your family a very happy holiday season and a prosperous and healthy New Year!

Enjoy the year end review by the guys at Jib Jab - very funny!

Year End Tax Planning Tips

While there's not a lot of time left before the end of the year, there are things you can still do to reduce your tax liability.  A number of tax provisions end on December 31st of this year, so this will be your last chance to take advantage of them.

Tax Planning For Individuals The election to deduct either state and local income or sales taxes as itemized deductions expires this year. If you are contemplating buying a large item, such as a car, you may benefit by making the purchase in 2011. You can convert a traditional IRA to a Roth; this may make sense if you expect your 2011 income to be lower than in the future.   If you reached age 70 1/2 during 2011 you must begin taking a distribution from your traditional IRA by April 1, 2012.  If you wait until 2012 to withdraw it, you will need to take a second distribution during 2012.  It may be better for you to take that first distribution in 2011 and avoid doubling up in 2012. If you have a health savings account (HSA) you should consider making the maximum contribution you can, even if you need to withdraw it right away to pay for qualified medical expenses.  Since this is an "above the line" deduction, it has the added benefit of reducing your AGI, which could make you eligible for other tax benefits. Making charitable contributions not only helps others, but can save you taxes. The "American Opportunity Education Tax Credit" runs through 2012. To get the full $2,500 credit in 2011, you must pay at least $4,000 for qualifying expenses by December 31st.  If you have already paid this much, you may want to wait until 2012 to pay for the spring semester to be sure you are eligible for the credit next year.  This credit does have an income phase-out, so not everyone will qualify. If you need cash to pay for qualified education expenses, you should consider withdrawing the funds from your IRA.  While the amount will be subject to income taxes, you will avoid the 10% early distribution penalty.  Just be sure to pay the expenses in the same year that you take the distribution, otherwise the penalty will apply. The alternative minimum tax "patch" is scheduled to expire this year.  Those taxpayers who will be subject to the AMT in the future may find it advantageous to pay property and state income taxes in 2011 rather than waiting until 2012 when the taxes are due. The adoption credit was increased to $13,360 for 2011 and made refundable, meaning that you will benefit even if your federal income tax is not high enough to absorb the entire credit. However, you must finalize the adoption by December 31, 2011 to be eligible for the credit in 2011.  The credit will be reduced and no longer be refundable after this year.

 

Smartest Guys In The Room

Many believe bond traders understand the economy better than equity traders and therefore are considered the smartest guys in the room.  Large institutional bond investors pay very close attention to the economy and any factor that might affect interest rates.  Equity investors also recognize that changes in bond prices provide a good indication of what bond investors think of the economy.

Since the global bond market is more than twice the size of the world' stock markets, stock investors pay attention to what bond traders see.  Bond prices tend to rise and interest rates fall when there is greater perceived risk.   Many portfolio managers will move money from stocks to bonds if they see greater risk in the future. Transferring cash from stocks to bonds adds to the downward pressure on stock prices and upward pressure on bond prices.

Below is a chart of the 20-year US Treasury Bond Fund.  You can see in this chart that both the price of the bond fund and the trading volume moved higher in the first few weeks of August at the same time the Euro zone issues started to become more pronounced.  It will be important to watch Treasury bond prices in the future for clues.  If bonds continue to move higher in the coming weeks/months, bonds investors could be forecasting an economic slowdown or possible crisis in Europe.  Conversely, if bonds prices decline in the coming weeks/months, it could be a good indication that both an economic slowdown and Euro zone crisis are much less of a worry - at least in the near to intermediate term.

Home Equity Line of Credit as First Mortgage

With the Federal Reserve stating that interest rates are expected to remain low until 2013 and possibly longer, there is an opportunity available to homeowners with a higher rate first mortgage.  A homeowner could consider paying off their first mortgage (amortized loan) with a home equity line of credit (HELOC) or simple interest loan.  Over the life of the HELOC one may save thousands in mortgage interest and pay off the balance of the loan much sooner.

First it is important to understand a HELOC.  The term home equity line of credit is not interchangeable with the term "second mortgage." A "first" or "second" mortgage only refers to the loan's claim position, not its terms. HELOCs are often referred to as "second" mortgages because there is usually another mortgage against the property when they are taken out.  If one were to default, the lender in second position would not see any money until after the lender in first position had been repaid. However, it is possible to have a HELOC in first position if there is no other mortgage on your home when you open a HELOC or you use the HELOC to pay off your first mortgage.

Let's take a look at how a HELOC could work as a first mortgage.  For our example, let's take a $200,000 30-year conventional loan at a fixed interest rate of 5.50%.  For this loan the payment would be approximately $1,130 per month (roughly $900 interest and $230 principal in initial years).  Total interest paid over the 30 year life of the loan would be roughly $208,000; more than the original loan.  As we know, an amortized loan is mostly interest paid in the early years and mostly principal paid in the later years.  

Currently interest rates on HELOCs are 3.00% or less in some cases.  The interest rate of a HELOC is a simple interest calculation and is not amortized over a set period of time.  Therefore, each payment toward principal reduces the next month’s interest expense. The interest rate is variable so if interest rates rise, the interest charged will increase and vice versa.

For example, a $200,000 home equity line of credit at 3.00% would require a minimum interest payment of roughly $500 per month; almost half of the interest paid on the convential 30-year loan.  If one continues to make the same $1,130 payment each month toward a HELOC, which would result in a $630 payment to principal each month.  If we assume the interest rate stays at 3.00%, the loan could be paid off in roughly 19 years and total interest paid would be $65,000; much less than the total interest paid on the same convential loan.

Even if interest rates increased by .25% each year (HELOCs have variable interest rates), the loan could be paid off in approximately 23 years with total interest paid of roughly $143,000; still much less than the original total interest amount on a conventional mortgage.

While converting a first mortgage to a HELOC may not be the best option for everyone because of the variability of interest rates; in an environment of low, steady interest rates a HELOC could be a great opportunity to pay down a mortgage more quickly versus a coventional 30-year mortgage.  A HELOC is most attractive if a homeowner makes extra payments toward principal, which in turn reduces the monthly interest expense.   

Super Committee Update

Below is an LA times article which came out today regarding the latest on the "super committee."

"With time and compromise slipping out of reach, the congressional "super committee" may punt its toughest deficit decisions to next year rather than strike a deal that would enrage both parties' political bases heading into the 2012 election.  The Joint Select Committee on Deficit Reduction has until Nov. 23 to agree to a package that would reduce deficits by $1.5 trillion over the next decade.

Achieving that goal would require painful compromise — both parties would have to give up political weapons they have hoped to wield over the next year. But failure could roil the financial markets as the holiday shopping season begins and further trash the already record-low approval ratings for Congress.

In an effort to avoid stark failure, a fallback plan is emerging that would push tough decisions on taxes to next year, perhaps into a lame-duck session after the election, according to officials familiar with the panel's discussions.

Under this scenario, the two sides would agree now to a level of revenue from new taxes. They would direct the congressional tax-writing committees to revamp the tax code with fixed dates and goals. The object would be to generate new revenue while lowering corporate rates and keeping the top individual bracket no higher than the current 35%.

The move would allow the two sides to reach the outlines of the deal now, while deferring the most difficult issues until both see who wins the 2012 election. Currently, election politics makes an agreement difficult — each side has used the budget stalemate as a rallying cry and each believes it stands a chance of winning next November and thereby being able to strike a better deal.  If voters deliver a clear verdict in November, Congress might be in a better position to come to terms.

"By kicking it into next year you're basically saying you're going to have this litigated in the next election," said R. Bruce Josten, executive vice president for government affairs at the U.S. Chamber of Commerce.

Even a limited deal, however, as it is being envisioned by those close to the secretive panel, would require substantial political give on the tax and spending issues that have come to define the modern political parties.

Democrats would have to allow sizable cuts to Medicare, Medicaid and other cherished domestic programs, and Republicans would need to loosen their signature anti-tax stance. Any discussion of an overall increase in revenues would probably violate the "no new taxes" pledge that most Republican members of Congress have signed, although a deal might be able to fuzz up the line enough that Republicans would not have to acknowledge having done so.

In proposals that have been exchanged so far, Democrats offered a package that would be made up of equal parts spending cuts and new tax revenues — but would push the tax component to next year.

Under that plan, a new set of "triggers" would be put in place that would be designed to automatically force tax-law changes if Congress failed to act.

No changes in Medicare or other entitlement programs would take effect until the tax changes were adopted.

The proposal was rejected by Republicans, who said the Democrats' insistence on $1 trillion in new revenue was a level they could not accept. They also said the proposed triggers would not be strong enough incentive to reach a deal. The GOP's own proposal offered $250 billion in new tax revenues, along with lower rates.

A deal presumably would have to fall between those two amounts.

Just as in the summer, getting to yes will require substantial give — particularly on the ratio of taxes to spending cuts — that could prove out of reach in the current political climate.

A compromise would assuredly result in an uproar on the political left and right, signs of which have already emerged. AARP is running ads warning lawmakers not to dare cut Medicare or Social Security. Top conservatives have made it clear that compromise on new taxes would be politically unforgivable.

Alienating so many important constituencies just as the 2012 campaign season is underway would be a tall order, even if the result could be followed by a grand political bargain.  But with time running short, many in Congress are loath to walk away from the possibility of a history-making achievement. Never before, experts say, has one group of lawmakers been given as much power as the super committee wields. Any proposal the committee members agree to has a guarantee of an up or down vote in both houses of Congress, bypassing the Senate's ability to filibuster."

Risks Remain Elevated

Along with the news of an apparent final and comprehensive European solution last week was the the report that US GDP rose at an annual rate of 2.5% in the third quarter; higher than expected.  Unfortunately,  investors continued to follow the results of coincident and lagging indicators rather than leading indicators, so the positive GDP figure was taken as evidence that an oncoming economic downturn or slowdown was now "off the table."

We will emphasize that leading indicators are in fact leading evidence of the economy.  As we know, past performance is not indicative of future results.  For example, the ECRI Weekly Leading Index, which we discussed a few weeks ago, is continuing to point to a slowdown in growth.  Of course, it's not a perfect indicator by itself, but its leading properties are useful.  If you go back over the past few decades and look at the points where the index growth rate fell below zero, you'll find that weekly unemployment claims (a coincident indicator) were generally below the five-year average at that time and took 3 to 4 months before unemployment claims climbed over the long-term average.

So the tendency for investors to make predictions from data such as this current data can be dangerous.  It allows investors to be sucked in by temporary reprieves in periods where very negative conditions persist.  Despite the variability in short-term outcomes, and the tendency for the market to advance as the economy declines,  the overall implications are usually negative in terms of risk/reward.  

The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest that recession risks still remain, and combinations of such indicators provide a basis for concern.

For example, since the early 1960's, when the ECRI Weekly Leading Index growth rate has been below -5, the economy has already been in recession approximately 80% of the time.  If in addition, the S&P 500 Index was below its level of 6 months earlier, the economy was already in recession 87% of the time.  Interestingly, when the index was below -7, and the S&P 500 was below its level from 6 months earlier, the U.S economy has been in a recession within 6 months, 100% of the time.

Now, we certainly don't base our economic expectations solely on these data points, as a broad array of other economic data points are mixed at the current time; however we want to be very aware of the data and historical statistical evidence.  Therefore, we would view the sheer abandonment of a recession by the media, economists, as well as investors to be a bit misleading.  Wall Street economists will quickly point to the summer of 2010, when the ECRI's Weekly Leading Index dropped below -10 without a subsequent recession, thanks we believe to the brief stimulative effect produced by QE2.  Although the ECRI itself did not officially observe enough deterioration in its indicators to project a recession last summer.  As we know it is currently projecting a U.S. recession in 2012 based on its leading indicators.  To what degree is unknown at this time - it could be mild or more severe depending on outside shocks; or non-existent if the Federal Reserve steps in with another round of quantitative easing.

Given that nothing in economics is entirely certain, it's possible that this time will be different.  We have seen a lot of firsts over the past few years.  But that possibility is not one that has support in the data.  To avoid a recession, we have to hope for an outcome other than the one that has historically occurred 100% of the time; given the current indicators.  While we can't predict the future, it would seem prudent not to ignore this fact.

Quarterly Summary

The Federal Reserve's efforts to jump start the struggling U.S. economy dominated the quarter's headlines.  In early August, the Fed announced it would hold short-term interest rates near 0% until at least mid-2013.  The Fed's move accompanied a downbeat forecast in which it noted a depressed housing sector and deteriorating jobs market.  The Fed acted again in September when it announced plans to sell $400 billion in short-term Treasury bonds in its portfolio by June 2012 and buy longer-term debt, a move aimed at further driving down long-term borrowing costs.  The Fed also said it would maintain its investments in mortgage-backed debt at current levels, instead of paring its mortgage holdings as it has done over the past year, in an attempt to boost the ailing housing market.  On a more negative note, the central bank noted "significant downside risks to the economic outlook, including strains in global financial markets."

At the end of August, the Commerce Department reported the U.S. economy grew at a 1.3% pace in the second quarter of 2011.  However, other indicators continue to point to a sluggish economy.  Job creation stalled in August, when the unemployment rate was stuck at 9.1% for the second straight month.  Consumer confidence fell to multi year lows, as consumer worries about the weak jobs market and falling stock prices escalated.

Investor uncertainty has increased markedly in recent weeks, but we see reasons to be cautiously optimistic. We believe odds of an outright recession are around 50%, despite growing talk that the U.S. is sliding into another downturn; although the ECRI has officially called for a US recession in 2012.  A more probable scenario is a "stealth growth recession" characterized by extremely low economic growth and high unemployment.

The situation in Europe remains a bit troublesome, as economic growth is slowing across the Eurozone, loan losses continue to pile up, and the risks of a banking crisis are growing. A Greek default looks increasingly likely; it seems to be just a matter of when.  However, European policymakers appear to have finally grasped the gravity of the crisis, and we believe the odds are favorable that they will take sufficient action to prevent it from spreading.

While the news over the past several weeks has been fairly negative, the one thing missing from the constant cascade of worrying headlines is any hint of deterioration in US corporate earnings, at least at this point.  Earnings estimates will need to be watched carefully in the coming weeks/months for signs of a slowdown.  So far this month most earnings reports have come in better than expectations, which is a good sign for continued profitability by corporations.  S&P 500 earnings estimates for 2011 are still hovering around $98.00 (up slightly from the first quarter); with continued expectations for roughly $108.00 in 2012.