Quarterly Update

The market volatility which was missing back in the last quarter of  2010 into the first few months of 2011 came to visit in March as an unexpected earthquake and devastating tsunami in Japan, along with continued tensions and unrest in the Middle East sent global markets lower.  In just two and one half weeks, the S&P 500 lost 7%, while global markets declined even more.  In the subsequent two weeks the markets surprisingly recovered fueled by in-line or better than expected economic data.  The Federal Reserve continued its quantitative easing program increasing liquidity into the system; which has been finding its way into commodities; as the price of oil and soft commodities continued to rise during the quarter.

Amidst the natural disasters and geopolitical unrest, the S&P 500 ended the first quarter up 5.4%, excluding dividends.   Within the market, small caps outperformed large caps and the US Energy sector led with an impressive 16.8% rise amid political tensions in the Middle East.  Energy stocks have now gained almost 40% in the past year.  Developed markets outperformed emerging markets and Europe finished up 4.5%.  Fixed Income underperformed equities due to fears of inflation and rising interest rates.  Treasuries were basically flat, while high yield, (+3.9%), preferreds, (+3.6%), and TIPS , (+2.1%), did the best. 

The Federal Reserve Board continues a very aggressive monetary policy. At some point in 2011 this will likely change and recently there has been a growing minority of those on the board that QE2 should be halted on schedule at the end of June of this year.  With the exception of Thomas Hoenig, no calls for an actual interest rate hike have been made.  If the Federal Reserve does end QE2 on schedule (which it indicated it plans to do), it is possible the end to this policy could bring increased volatility to the markets as investors try to understand the implications to the economy moving forward; given the Fed has provided ongoing liquidity and support to the monetary system for well over 2 years and to the tune of almost $2 trillion.

Our current assessment is that the US stock market averages (based on S&P 500 index) are priced close to fair valuation given current earnings estimates and the possibility of future interest rate hikes, which lowers the amount investors are willing to pay for future corporate earnings.  Earnings estimates have remained steady over the past several weeks, despite the earthquake in Japan and issues in the Middle East.  As of April 1, 2011, earnings estimates were $97.00 for the full year ending December 2011, a 15.8% increase over final 2010 earnings of $83.77.   Applying a price-earnings ratio of 13 and 14 to expected earnings for 2011 translates into a value of 1261 (based on 13) and 1358 (based on 14) for the S&P 500.  The S&P 500 ended the first quarter at 1326, right in the range of fairly valued.  If expectations for higher interest rates don’t materialize, it is possible the markets could trade higher (higher price-earnings ratio) as investors will be willing to pay more for future corporate earnings.

Tax Saving Tips for 2011

The filing deadline for 2010 tax returns is upon us, with tax returns due this Monday April 18th.  In order to help you be better prepared for 2011, below is a list ot tax tips to help you maximize deductions and minimize taxes.  Please be sure to send us a copy of your 2010 tax returns for our records in order to assist us in tax planning for 2011.

1. Know the tax system - We know this is easy to say but far too many people do their taxes without fully knowing what they are doing.  Read the entire guide, read up on yearly 2011 changes and make sure you understand why you are putting a certain number in a box.  If you don't want to complete your return yourself, hire an accountant to file your return.  Mistakes can cost you money.
2. Use software - Software is great for helping you file your taxes efficiently online. The extra help and clear instructions give you a better chance of ticking the right boxes and inputting the right figures.
3. Claim the extra work expenses - If you work for someone else it is unlikely that you ever claim expenses. However you are entitled to some deductions and you can check with the IRS to see what is eligible. Examples may be expenses you have had to pay out of pocket while attending meetings or business trips.
4. Find out if you are eligible for any tax credits – There are lots of tax credits available with new ones every year. Read through the requirements and see if you qualify for any of them.
5. Give to charity – If you plan to make any donations remember these are tax deductible. If you want to save from donations without spending actual cash you can donate old goods to Goodwill or Salvation army and receive a tax deduction.  Just make sure to get a receipt.
6. Max out your 401k account – Maximizing contributions to your 401(k) will ensure that you maximize tax savings.  The maximum remains unchanged  at $16,500.
7. Check out health care deductions - There are lots of changes in health care deductions as a result of the Affordable Care Act Tax Provisions.  For instance, the cost of an over-the-counter medicine or drug cannot be reimbursed from a flexible spending account unless it’s for insulin or you have a prescription.
8. Keep track of mileage — The mileage allowance changes again in 2011 to 51 cents-per-mile for business miles driven; 19 cents-per-mile for medical or moving purposes, and 14-cents-per-mile for driving for charitable organizations.  Be sure to keep accurate records, seriously.  :)

 Have a wonderful weekend and be sure to contact us or your tax advisor if you have any questions.

Definition of Hedging

People sometimes ask me, “What exactly is a hedge fund? And what do they do that separates them from the other, more traditional investment companies?” According to Wikipedia, a hedge fund is defined as: “a private investment fund which may invest in a diverse range of assets and may employ a variety of investment strategies to maintain a hedged portfolio intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings.” Okay, but what does the “hedged” part mean? Here we will attempt to explain one of the most simple and basic strategies a hedge fund uses in order to “hedge” the fund from a downturn in the price of a stock.

Hedging is what an investor does in order to offset some of the risk on a certain investment or position within a portfolio. We will use a single stock position as an example. So, if you owned 100 shares of ABC stock and were afraid that its value might depreciate in the near term, you could employ a basic strategy designed to protect your investment in case that were to happen. In most cases, you’d pay a premium for this protection much like the premiums one pays for an insurance policy. It’s basically the same concept. Investors are able to buy this “coverage” simply through the use of option contracts. Options are contracts that allow investors to buy or sell a certain stock at a certain price within a certain period of time. Options to buy stock are known as calls and options to sell stock are known as puts. The price or premium for these contracts fluctuates based on the movement of the stock and the amount of time left on the calendar before the option expires. So when the price of a stock declines, put contracts typically appreciate while call contracts would typically depreciate. In getting back to the original example, if an investor thinks that the price of ABC stock is going down, a put contract, (option to sell) would work well here. Assuming the stock price depreciates, the put contract for that stock is actually going to appreciate and in result cover or offset some of the risk of owning the stock outright.

Now there are several types of option strategies that hedge fund managers can use, but this one here is probably the most basic and a good way to understand how these options are used to “hedge” a specific position. Now should the stock go in the other direction, (that being up), the value of that put contract is going to depreciate and possibly expire with little to no value. So in that scenario, the investor would lose on the principal paid for the owning the contract. However, they still own the stock and therefore would be getting appreciation for holding it. Therefore, owning the put option is the “hedge” against the stock.

The hedging activity by "smart money" or institutional investors is available to us via our friends at Sentimentrader. As you can see in the chart below, the "smart money" is currently hedging at a rate similar to that reached at various times in 2007. The higher the number above 1.00, the more hedging by institutions. After dramatically reducing hedging activity at the end of 2010, hedging activity has increased significantly since the beginning of this year. While the markets can obviously continue higher, this increased hedging activity by the "smart money" should be watched as it indicates a more cautious posture by large institutions; or at least a desire to "hedge" their bets.

Monetary Base Explodes Higher

The monetary base is defined as all currency in circulation outside of the central bank and Treasury including those deposits held by financial institutions (banks) at the central bank.

The chart below is a chart of the US monetary base. In simple terms, it charts how much money the Fed has pumped into the system. So it’s a kind of visual of when the Fed is really pouring money into the system.  Given the events of the past few years, we can assume when the monetary base explodes higher, the Fed is concerned about stability in the system and therefore pumps liquidity into circulation.

You can see that during the financial crisis the Fed didn't do much until the autumn of 2008 when it pumped nearly $1 trillion into the system - the first vertical spike.  Through various Federal Reserve programs the monetary base continued to grow during 2009.  Now, after the monetary base actually declined during much of 2010, it has recently jumped another $450 billion to roughly $2.45 trillion.  While some of this can be attributed to QE2, most of it is beyond QE2.

It could be the Federal Reserve just wants to keep liquidity in the system to be sure economic growth continues.  Or, it may be the Federal Reserve is worried about the stability of the system and is adding liquidity.  We will monitor this monetary expansion to see if it continues over the next few months.  Either way, going from less than $1 trillion in the monetary base to over $2.4 trillion in a little over 2 years is concerning and can't continue at this rate without consequences.  Stay tuned...