Close analysis of the national and global financial markets suggests that the U.S. economy will continue to experience tepid growth and manage to avoid a recession in 2012.

This past month marked an auspicious milestone for the U.S. Stock Market, which, as measured by the S&P 500, lost 7% in September. The S&P 500 index experienced five consecutive down months, which has happened only two other times since 1990. The stock market fell 14% for the third quarter and has helped drive consumer confidence to historic lows.

Consumer confidence took a hit in the third quarter for several reasons. Initially, it was the uncertainty created by the political fighting over the U.S. debt ceiling and the subsequent downgrade of our sovereign debt. This was coupled with the constant stream of news out of Europe, gradually revealing that Greece is, in fact, insolvent, and a default is inevitable. When you add a series of economic reports covering the second quarter that increased fears of a self-induced recession, we experienced panic selling and historic volatility.

As we enter into the fourth quarter, we face a world of extremes in both fear and valuations. We have no shortage of potential risks. Both stocks and bonds are trading at valuations that, in some cases, resemble valuations not seen since the 1950’s. The consumer is feeling as pessimistic today as they were at the depths of the credit crisis, a level we have not experienced since 1980. The Price Earnings Multiple (a measure of valuation for stocks) of the U.S. Stock Market was trading at 20% less at the end of third quarter than what has been typical in recessions, which begs the question, how much bad news is already reflected in the prices of stocks?

With all this uncertainty, U.S. consumers, so far, have not changed their behavior. As an example, vehicle sales increased from 12.2 million in July to 13 million in September (annualized). Heavy truck, chain store sales and durable goods orders all increased in the third quarter. Inventories and unemployment claims have not moved in a negative direction. The news in housing is awful but housing starts rebounded 15% in September. The U.S economy even managed to add jobs in September, measured by 103,000 new payrolls, a number lower than desirable but growing nonetheless. Despite all of this uncertainty, the economy has continued to grow in a painfully slow fashion, and we anticipate more of the same in 2012.

Recessions are typically induced by overcapacity, which leads to a contraction in the cyclical parts of our economy. Auto sales, inventories and housing starts are growing, but at such low levels, it would be difficult to send them lower. In addition, the consumer’s balance sheet has dramatically improved since the credit crisis, as evidenced by the average Equifax credit score and the historically low debt service ratio (debt payments as a percentage of disposable income). Savings rates have increased, and liabilities have generally decreased due to loan modifications and historically low interest rates. These considerations guide our baseline assumption that the U.S. economy will experience more of the same tepid growth and manage to avoid a recession in 2012. If our baseline assumption continues to unfold and fear starts to subside, valuations in the financial markets could move towards a more normal level, creating support for stocks and headwinds for bonds.

As usual, there are plenty of risks that can easily derail this fragile recovery. In Europe, the risk is not Greece defaulting, but rather the lack of cohesive leadership among the European Troika. They have failed to implement the measures needed to contain an orderly default that is necessary to calm the markets. In reality, Greece makes up only 3% of the European economy, and their aggregate debt could easily be absorbed by the stronger economies. The European Union has made a series of mistakes, first by mandating strict austerity measures on Greece, forcing the country into a deeper recession and ensuring an eventual default. We believe that they are slowly grasping the reality that they need to restructure the debt and then provide unlimited liquidly to back the other countries and banking system. They have promised to have a plan on Wednesday, October 26th, and we would not be surprised if the plan disappoints a world eagerly awaiting something of substance. Volatility will most likely continue as these countries slowly find a solution, but we believe patient investors with some exposure to Europe will ultimately be rewarded. The European stock market is trading at approximately eight times earnings and has a dividend yield of more than 5%. Our top four equity positions in Europe, Royal Dutch Shell, HSBC, Novartis and British Petroleum, have generated, on average, over $215 billion in revenue and $18 billion in net income over the last 12 months. These are extreme numbers and valuations that occur in a world of fear and uncertainty.

In the U.S., despite fears about the aggregate amount of our deficits, we do not believe our ability to service this debt is the biggest risk our nation’s economy faces. Our debt owed to the public as a percentage of GDP is approximately 65% today and is scheduled to increase slightly before leveling out under the current budget. These levels are manageable and much lower than our nation experienced following World War II. We believe the risk is the amount of fiscal austerity scheduled to hit our economy over the next 12 months with the phasing out of the Bush tax cuts. According to the U.S. Treasury, we are scheduled to lower our annual budget deficit from 8.5% to 6.2% of GDP in 2012. This large dose of fiscal austerity from tax increases could create a headwind for our economy.

Treasury bonds are extremely expensive, trading at levels we have not seen in over 50 years. While bonds have provided nice returns through these volatile times, we continue to believe the bull market in bonds is coming to an end and continue to be defensive against rising interest rates.

When faced with a world of extremes in fear, uncertainty and valuations, we believe maintaining a balanced portfolio through these volatile times will prove to be the winning strategy.

August 5, 2011

By: Trevor Callan

Turmoil in the stock market has the ability to create fear and cause investors to question their investment strategies.  Unfortunately, market corrections never happen when the financial news is positive.  With the Dow Jones Industrial Average down by more than 10% from its recent high, we are, by all measures, experiencing a major correction in the stock market.  The onset of a market correction, along with the barrage of media coverage, can easily drive investors off course.  Maintaining a diversified investment strategy for an appropriate period of time is more important than ever during turbulent times.

The selling pressure in the stock market might not be over, but our message is resolute.  While we can’t forecast the direction of the stock market over the short term, we do believe that over a market cycle, the American economy will continue to prevail.  Diversification works and is our antidote for volatility.  While stocks have erased all of their gains for the year with this latest round of panic selling, our bond portfolios are up over 6% year to date.  Despite this sell off in the stock market, our diversified portfolios are up between 5% and 8% over the last 12 months through yesterday demonstrating the resiliency that comes with diversification (capital preservation to aggressive growth).

The fundamentals suggest the stock market is undervalued and the bond market is overvalued for investors with an appropriate time horizon on their portfolios.  Like past corrections, investors are assuming the selloff is predicting a deep recession to come, but we question this premise.

There is no doubt that the tone of U.S economic data deteriorated in recent weeks, indicating a softening in the pace of activity.  The uncertainty surrounding Europe’s debt crisis has added to the fear driving this volatility.  However, near-term effects of Japan-related supply-chain disruptions, severe weather and high oil prices in the first quarter may have created temporary distortions in some data.  Japanese production was down 15% in March but has rebounded 12% over the next three months which should start showing in economic data as companies restock inventories.  Conditions in several key areas have remained solid:

• Companies continue to exceed their earnings estimates and it looks like the second quarter will mark the most profitable quarter in U.S. history for corporations.

• Employers added 117,000 more jobs in July which was more than forecast and eased concerns the U.S. economy is turning over.  Initial jobless claims are at 400,000 down from 478,000 in the month of April.

• Car and truck sales were up 6.9% in July over June and chain-store sales were up 4.6% over the last 12 months in July.

• Although the U.S. Manufacturing Index was lower in July, it was the 24^th consecutive month of manufacturing growth.

• The Federal Reserve is still running a very accommodative monetary policy with the funds rate near zero which provides fuel for the economy.

Many worry about government spending and the most recent budget compromise.  While our politicians made plenty of mistakes and have created uncertainty in the financial markets, we believe we are finally at a turning point with our budget.  Government spending as a share of GDP is now scheduled to fall by about 2% of GDP over the next 10 years even without any further changes.

Over the last 19 years of managing marketable securities, we have seen markets like this and the outcome is always the same.  Changing course while the financial markets are in turmoil has never proven successful while holding a diversified portfolio for an appropriate period of time has always been the most profitable approach.

Trevor Callan

By: Trevor Callan
July 28th, 2011

As recently as two weeks ago, it seemed highly unlikely that Congress would be unable to pass legislation to avoid a default on our government’s obligations. The current dispute in Congress is focused on the timing of the next debt ceiling negotiations, which is more politically driven and much less to do with the ultimate austerity of our nation. Given the political objectives driving the negotiations, and the potential financial implications from the uncertainty of our sovereign, Congress seems to be playing with fire. We continue to expect a budget agreement and an increase in the debt ceiling, though it is becoming more likely this will occur after the current deadline of August 2nd. We now believe that the rating agencies might downgrade the U.S. to AA from its longstanding AAA rating. It is very difficult to model the financial impacts of such an impasse, but the following summarizes our current position.

Initial reactions to a downgrade may be dramatic, but we do not expect it will be as significant as many have predicted. The U.S Treasury Department may have enough cash to pay the government’s bills for days or even weeks if Congress fails to raise the debt limit, in part because tax revenue is coming in higher than forecast. August 2nd is the deadline date for the government’s ability to borrow, not the date when it runs out of money, which is ultimately what matters. The extra cash may help avoid a default and provide Congress the time necessary to finalize a budget plan.

History shows a mixed effect to the stock market when a nation’s debt rating is downgraded from AAA. Japanese equities fell 7% over six months following S&P’s downgrade in 2001, but this was a period of global stock market weakness. Australia (1987), Spain (2009), and Ireland (2009) all delivered positive six-month returns following their downgrades.

Equities already appear to be discounting a significant amount of risk, and a downgrade does not give markets new information about the underlying creditworthiness of the U.S. As of June 30th, prior to the better-than-expected earnings reports for second quarter earnings, the stock market was trading at only 12.4 times forward earnings. Historically, the stock market has traded at 16.4 times forward earnings. To put this in perspective, the market would need to rise by over 30% to trade at the average of 16.4 times earnings. The current equity risk premium is roughly two standard deviations above its average over the past 25 years (occurs less than 5% of the time over the last 25 years).

High-quality companies with dividend yields competitive with government bond yields would become more attractive relative to a slightly lower quality Treasury bond. Corporate balance sheets are very healthy, as cash as a percentage of assets has more than doubled over the past two decades.

The dollar will most likely continue to weaken, but we do not expect this to fundamentally reshape the importance of the dollar as the world’s currency. The surge of the Euro above 1.45 is also a result of the current confidence in the most recent attempts by the European Union to work through their debt crisis. Europe faces its own problems, so their currency does not provide an adequate alternative to the dollar, nor does any other currency at the present time.

We have been cautious in the bond market for some time, and the potential downgrade of the U.S. credit rating only reinforces our opinion. We expect pressure in the upcoming weeks on the U.S. Treasury bond but do not anticipate a sharp selloff. While other countries have lost their AAA rating, they have not held the significant role that the U.S. currently plays in the global financial markets, so the impact is difficult to model. AA rating is not “risk free,” but it still represents a very high quality asset and will most likely be high enough to retain the majority of money looking for conservative options.

The implications in the municipal markets have been muted to date. The ultimate implications will vary by credit based upon the reliance on federal payments. Credits like pre-refunded municipal bonds, which are secured by escrow accounts funded with state and local government bonds, will most likely be downgraded with the U.S. rating downgrade. Highly-rated general purpose state and local governments relying on federal aid for a large percentage of their budget will be subject to scrutiny by the rating agencies.

Although we are headed into uncharted territory with the current impasse in Washington, we believe our current process-driven, highly diversified approach to the financial markets is the best way to move through early August and beyond.

This article was published in the San Diego Business Journal on June 13th, 2011 – Link

FINANCE: Trust, Communication Are Vital Components

By Julie Gallant

Whether it’s in the form of new hires, expanded offices or increases in assets managed, large and small companies on the San Diego Business Journal’s Wealth Management Firms list are thriving.

Topping the list is Merrill Lynch Wealth Management, which increased its total assets managed from $1.4 trillion in 2009 to $1.5 trillion last year.

Regional Managing Director Joseph Holsinger said the staggering $100 billion increase is partly attributed to the recovery of the markets and the expansion of its service offerings in the form of loans or other access to capital made possible by its affiliation with Bank of America.

Another area of growth focus is expanding the number of financial advisers, with a particular emphasis on recruiting women seeking a second career and those candidates with military backgrounds, Holsinger said.

Tying in with Merrill Lynch’s expansion is innovation in the areas of training staff, developing teams to work with clients, fostering one-on-one relationships and investing in technology.

Thinking Ahead

“We like to think we’re always innovative,” said Holsinger.

New York-based Merrill Lynch has 15,000 financial advisers globally, with 43 offices in the Southwest region. Locally, its four offices are located in La Jolla, San Diego, University Towne Center and Rancho Bernardo.

Former Merrill Lynch employees who took the leap to start their own boutique firm in January 2007 make up Callan Capital, the No. 18 ranked firm on the Wealth Management Firms list. The six-employee, La Jolla-based firm is run by three brothers, Trevor, Tim and Ryan Callan. The bulk of client relations are handled by Trevor and Tim, with Trevor involved in asset management and Tim specializing in financial planning. Combined they work with 78 households and delve into a variety of estate planning analysis, tax minimization, life insurance and risk management services.

“It’s a very comprehensive, holistic service we provide,” said President Tim Callan, who has a decade of experience in the industry. Trevor has been in the field since 1994 and Ryan since 2002.

Accustomed to working with affluent clientele at Merrill’s Private Banking and Investment Group, the brothers carry over their expertise working with entrepreneurs exiting businesses and executives of publicly-traded companies. They set the minimum investment account at $2 million, and they charge a flat advisory fee for their services rather than commissions.

Their strategies seem to suit them, with steady growth in assets managed from $100 million at startup to $205.8 million in 2009, increasing to $323.9 million last year to roughly $350 million in assets under management currently, Tim Callan says. Last year Callan Capital raised close to $65 million in new client assets, according to Tim Callan, and the additional growth is attributed to market appreciation.

Tim Callan says that the firm has had a positive reaction from the negative publicity surrounding the credit crisis that hurt its largest competitors.

Favorable Opinion

“We were able to compete very well and continue to do so because of that,” he said, adding that small, intimate firms have been gaining favor.

“It’s a trend that’s been happening for quite some time. It started after the dot-com bubble. Independent firms started to gain market share. That’s why we started the company after Merrill — to get ahead of that trend.”

Callan Capital’s growth streak continues with the recent hiring of a business development director and the expansion of its offices from 1,500 square feet to about 3,000 square feet using available space next door on Prospect Street.

Further down the Wealth Management Firms list at No. 27 is Pacific Wealth Management LLC, which experienced a growth in total assets managed from $179.6 million in 2009 to $187.3 million last year.

Pacific Wealth Management, with six employees, follows a similar pattern to Callan Capital in that it provides fee-based asset management services to mostly high-net-worth families, primarily in the Southern California region. Offerings range from financial planning services to life insurance risk analysis. The minimum investment account ranges from $500,000 for an individual to $1 million for institutions.

Founded in 1998, the Carmel Valley area firm has established 240 client relationships. Pacific Wealth Management Managing Director James Kuntz says they focus on wealth preservation, and incorporate risk management as part of the plan.

“We measure and quantify risk in the market at any one time,” Kuntz said. “In 2008, we had already significantly reduced our stock market holdings because wealth preservation is our goal.”

Kuntz and Managing Director Mark Hill say they’re dedicated to client relationships and meet with them on a quarterly basis or as needed.

“Our clients appreciate that we put a lot of energy into high-touch service,” Kuntz said. “We communicate exceptionally well with clients and people appreciate that, especially when the market is going through the level of volatility it has in the last few years.”

Kuntz says the firm benefited from the financial crisis in some respects because they were effective at managing risks leading up to it; he also believes the appeal of the financial strength of big banks has faded. Kuntz says his firm provides a viable alternative to the big brokerage firms and is purposely keeping a stable group of four advisers.

“We probably will grow our firm over the next five years but not dramatically,” said Kuntz, whose business was relocated to its larger High Bluff Drive site from a nearby location about a year ago. “We’re just growing our client advisory base.”

By:  Tim Callan

The first quarter of 2011 was filled with political and economic uncertainty.  We saw the beginning of a political shift toward democracy in several countries in the Middle East, a civil war in Libya and a devastating 9.8 earthquake in Japan.  So how was it that in the face of all of this news the S&P 500 increased by 5.9% in the first quarter?

The market continued to climb because investors recognized the market was trading at a discount relative to earnings.  We have experienced exceptional earnings growth over the last two years, and Large Cap S&P 500 companies are close to record earnings set in 2007.  With the most recent Q4 earnings report of $21.92 per share, we believe it is likely that sometime in 2011, corporate earnings will surpass the previous record of $24.06 set in Q2 2007.  Large Cap US stocks begin the second quarter of this year trading at a 20% discount to the historical average price to earnings multiple.  However, small cap US stocks are trading at levels consistent with historical valuations.  As a result, we favor large-cap US stocks over small-cap US stocks, and we made shifts in our client portfolios in February to reflect this belief.

The US economy is well into an expansion phase.  During our most recent recession, $554 billion economic output was lost from October of 2007 to March 2009.  We are now 25 months into the recovery and gained $571 billion in economic output.  However, the expansion is slower than we would expect after a recession as large as we experienced, with fourth quarter GDP growth annualized at 3.1%.  Housing remains the biggest reason for the slow economic expansion.  With interest rates and housing prices declining, housing is now the most affordable it has been in over 30 years.  However, in the last five years home equity has declined from $13 trillion to $6 trillion.  While many Americans can afford the monthly payment of a new home, lending standards have tightened and many Americans cannot come up with the down payment.  As a result, the rental market is expanding dramatically, causing rental vacancies to decline and rent prices to increase.

Emerging markets experienced the mildest recessions and the shortest recoveries of the world economies.  They continue to adopt low interest rates and easy money policies despite the fact that inflation is creeping up in the developing world.  Increasing commodity prices have been the largest contributor to rising prices in emerging markets, and there is cause for concern for countries such as Russia, India, China and several in South America.  In addition, their valuations relative to the developed world are well above normal.  We have reduced our exposure to emerging markets due to valuation and inflation concerns.

Unemployment declined in the first quarter from 9.8% to 8.8%, which is back to levels seen in November 2010.  Nonfarm payroll employment increased by 216,000 jobs in March, bringing the number to 1.8 million jobs gained since the recovery began.  However, this remains a small fraction of the 8.8 million jobs lost during the recession.  If our economy continues to add an average of 200,000 jobs per month, it will take three years to reach full employment.  If we add jobs at typical recovery levels, it will take four years to reach full employment.

We continue to be cautious on the bond market, especially Treasury bonds.  The ten-year treasury yields 3.47%, which continues to hover around the lowest level in 30 years.  The rise in Treasury prices can be partly attributable to the Fed’s treasury purchasing program called Quantitative Easing.  The current Quantitative Easing program, known as QE2, is scheduled to end in late June.  In light of the improving economy, it is unlikely that the program will continue into another round of Quantitative Easing.  In addition, investors are beginning to have more appetite for riskier assets such as stocks.  Mutual Fund stock flows have exceeded bond flows each month since December of 2010.  This ended a pattern of bond flows exceeding stock flows, which began in the middle of 2007.  As this pattern continues, we believe it will put pressure on Treasury bond prices to decline and yields to increase.

We believe that bonds in general are expensive. However, some areas of the bond market are more attractive relative to Treasuries.  Municipal bonds yield an average of 2.4% spread over Treasury bonds, and, unlike a Treasury bond, municipal bonds provide investors with a tax-free yield.  In addition, state and local governments were forced to make big budget cuts and are now are in a surplus of tax receipts relative to expenditures.

High yield bonds also look attractive on a relative basis, paying investors about 5.2% yield over treasuries with default rates of .8%, which is well below the historical average default rate of 4.4%.

Going forward into 2011, we have nearly eliminated our exposure to treasury bonds and increased exposure to municipal, high yield and floating rate debt.  Within the stock market, we are overweighting large-cap US stocks over small cap and developed international countries over emerging markets.

By:  Trevor Callan

In May of 2009, Bill Gross, founder and co-chief investment officer of PIMCO gave a sobering assessment of market prospects during his luncheon keynote address at the 2009 Morningstar Investment Conference.  He coined the phrase a “New Normal” – predicting lower returns for the foreseeable future.

Turns out, the “New Normal” warning cry is not so new.  Warren G. Harding used a “return to normalcy” campaign message for his presidential run referring to the prosperous time before World War I.  New York Mayor Fiorello La Guardia is credited with saying “We must realize that this is not a temporary depression but a New Normal and adjust ourselves accordingly,” referring to the lackluster economy of the 1930s.  Despite these ominous warnings, most financial market panics have actually been followed by periods of economic prosperity, including the relatively recent 1987 stock market crash and the technology bubble.  All year long, the New Normal dominated the national headlines, and although the economy continues to grow very slowly, 2010 turned out to be the opposite of the “New Normal” for the financial markets:

US Large Cap Stocks (S&P 500)- 15.1%

Small Cap Stocks (Russell 2000)- 26.9%

International Stocks (EAFE)- 8.2%

Emerging Market Stocks (MSCI EME)-19.2%

High Yield Bonds (Barclays High Yield)- 15.1%

Bonds (Barclays Aggregate Index)- 6.5%

Commodities (UBS Commodity)- 16.7%

Continued Economic Growth

Over the last two years, we have been recovering, albeit slowly, from the trauma of the credit crisis.  Ironically, assuming the economic recovery started in July of 2009, we spent 18 months in a recession and 18 months in recovery as of December 31^st, 2010.  The economy, measured by the Gross Domestic Product (GDP) lost $554 billion in output during the recession and has recovered $469 billion in economic output through the third quarter of 2010.  This is hard to believe given the high unemployment rate and low consumer sentiment, but it looks like the economy, measured by the GDP will recover all of the economic output lost through the credit crisis by December 31^st of 2010 (final Q4 numbers have not been announced).  This is the basis for our 2011 theme transitioning from recovery to expansion.  While growth is significantly below what is normal in a recovery, a modest acceleration is expected 2011 given rising corporate profits, consumer sentiment and spending, private payrolls, capital goods orders, light vehicle sales, low interest rates, federal economic stimulus and a modest improvement in housing starts.

Employment

The credit crisis was particularly devastating for the US economy with over 8 million jobs lost throughout the recession.  Jobs continue to be a problem for the economy with only 1.1 million private payrolls added in 2010, which is well below what we would normally expect in an economic recovery and too low to bring down the unemployment rate.  If we are correct with modestly higher economic growth in 2011, unemployment should stubbornly drift lower, particularly in the second half of the year.  Lower unemployment should benefit consumer sentiment, which could benefit valuations in the stock market as more investors believe in the economic recovery and shift portfolios from bonds back into stocks.

Inflation

In November of 2010, the Federal Government announced a second round of a controversial form of economic stimulus called Quantitative Easing which many believe will lead to higher inflation.  Essentially, the government is committed to purchase another $600 billion of treasury bonds through June of 2011, which is designed to provide liquidity to the financial markets and to keep interest rates low.  We agree with the Federal Reserve’s benign view of core inflation in 2011.  With the world economies still operating well below their long term capacity, core inflation should be tame in the short term, providing the Federal Reserve the flexibility to continue its quantitative easing policy.  Long term, there is risk of inflation given the stimulus that has been added to the economy with the Quantitative Easing program.  The Fed will need to walk a fine line as they balance sustaining economic growth with the longer term risk of inflation.  In order to hedge against higher inflation and interest rates, floating rate fixed income will be added to portfolios in 2011.  We also have exposure to commodities through our alternative investment portfolios.

Caution on Bonds

We believe we have seen the end of the bull market in bonds.  The extension of the Bush tax cuts adds to the federal deficit, which will need to be financed through the issuance of treasury bonds.  The Federal Reserve has committed to purchase the entire net issuance of treasury bonds through June of 2011, which will provide plenty of demand for the debt.  When the economy shows signs of a more sustainable recovery, the Federal Reserve will need to end the Quantitative Easing program by stopping the purchases of these securities.  We anticipate this will cause a slow rise in interest rates over the next several years, which will hinder returns in bonds in the foreseeable future.  This is the basis of our cautious outlook on bonds, but we still recommend bonds as a hedge against unforeseen and unquantifiable risk.  Our strategy is to keep maturities relatively short to minimize pricing pressures associated with higher interest rates.  We also plan to add to “Floating Rate” bonds (coupons adjust higher with interest rates) as a hedge.  High yield bonds and bonds denominated in non-US dollar currencies are a key theme in 2010.  We continue to avoid long term bonds and treasury securities.

California

Critics have suggested the state will default on its debt payments.  We feel this criticism is not factual.

Debt service on California general obligation bonds is constitutionally protected, with bond payments required even when the state is operating without a budget.  Debt service has a second call on the general fund dollars, right behind education.  Under California law, making sure bond investors get their money is a higher priority than providing healthcare to kids, protecting the environment and providing for safe communities.  During the current fiscal year, general fund revenues are expected to total $89.4 billion.  Education spending under Proposition 98 will cost $36 billion, leaving $54.4 billion to pay debt service on bonds, which is 8 times the $6.6 billion the state will need.

Smaller municipalities are facing larger budget deficits with less flexibility to cut costs and raise revenue.  These smaller issuers could have a more difficult time covering their debt service, and we expect a rise in municipal defaults, so security selection will be critical.

Relative to treasuries, municipal bonds provide value given their yield premium.  In addition to California general obligation bonds, we continue to favor large, high quality essential revenue bonds as a way to generate stable, secure, tax-free income for our clients.

Stocks

In general, the fundamentals for higher stock prices seem to be in place in 2011: accelerating GDP growth (albeit slow), low interest rates and inflation, improved corporate balance sheets and earnings momentum.  Earnings are expected to continue growing in 2011 but at a slower speed than 2010.  Stocks are trading at lower multiples to forward earnings today than they were on January 1^st 2010.  Consumer sentiment has been slowly improving, which could lead to higher valuation multiples as investors become more comfortable.  We continue to favor the cyclical industries and industries that generate the majority of their revenue from overseas, where there is stronger demand for goods and services.   For our international stock portfolio, we continue to favor Asia (excluding-Japan), emerging markets and Canada given their strong economic growth and, in the case of Canada, high commodity prices.  We are relatively underweight European stocks (relative to the FTSE all world excluding US Index) because of their lack of fiscal austerity and because they are exporting their goods in Euro Dollars, which are high relative to competing currencies.  We are also relatively underweight Japan given their shrinking population and low dividend yields.

Alternative Investments

Our strategy is to always diversify our portfolios by including asset classes that provide a relatively low correlation of returns to stocks and bonds and other traditional investments.  Strategies such as managed futures (commodities, agriculture and currencies) and direct investment in real estate provide diversification and help minimize volatility in our portfolios.  In 2008, Callan Capital launched our Distressed Debt and Income Opportunity Fund as a vehicle to purchase loans that were in distress from banks, residential properties in foreclosure and select real estate assets.  The fund continues to pay a high quarterly income distribution while we build a portfolio of real estate at distressed prices.

Risks

Reversing the Quantitative Easing program continues to be the elephant in the room.  Although we believe that the Federal Reserve will be successful, they have a daunting task of removing excess liquidity from our economy and avoiding inflation.  This is the basis for our cautious outlook on bonds and why we are focused on higher yield fixed income strategies, which should help mitigate the degradation of bond values as rates rise.

Governments around the world continue to run very high structural deficits and the European Union is under pressure.  Although we believe a recovering worldwide economy will provide these governments with the fuel needed to correct their lack of fiscal austerity, this is sure to cause headline risk in 2011 and could turn into a currency crisis if not addressed.

Oil has been rising steadily and could continue with the economic growth forecast for the emerging markets.  A dramatic rise would create a serious headwind to our expansion forecast.

Other risks, which are always more problematic, are the risks that we can’t quantify or predict, such as geopolitical risk.  We continue to witness tension in the Koreas.   The Israelis and Palestinians continue to struggle for a peace agreement.  Iran seems to be as adamant about obtaining nuclear technology as Israel is opposed to the idea.  For these reasons and many we can’t predict, we continue to emphasize a diversified approach to the financial markets.  2010 was a great year for our clients and the Callan Capital model portfolios.

We look forward to working with you in 2011.

Sincerely,

Trevor Callan, CIMA

CEO

Equity markets had a strong 3^rd quarter with the S&P 500 up over 11%.  The quarter started with strong fears of a European debt crisis and a double dip recession.  Both of these fears subsided and the markets responded positively.

The National Bureau of Economic Research announced on September 20^th that the second largest recession in US history began December of 2007 and ended June 2009.  Economic growth since the recession ended has been anemic with annualized GDP growth rates of 5% in Q4 2009, 3.7% Q1 2010 and 1.6% in Q2 2010 with the national unemployment rate hovering around 9.6%.  The GDP growth rates are well below most economists’ expectations for a recession of this magnitude and prompted discussion of a possible double-dip recession.

We feel the likelihood of a double dip to be very low, and most economists agree.  Recessions are caused when the cyclical components of the economy fall sharply and quickly.  These components include automobile sales, changes in inventories, residential construction, and equipment sales.  All of these areas are at historically low levels and the likelihood of a significant decline is low.  For example, the latest report shows approximately 11.7 million cars being built annually.  This is well below the average of 14.6 million cars per year.  With 13 million cars going to the junkyard every year and 2 million additional drivers coming into the system, a substantial decline in sales seems unlikely.  However, the minimum GDP growth rate needed to reduce the unemployment rate is 3%.  While we anticipate GDP growth to pick up modestly in 2011, it will take many years for our economy to reach pre-recession unemployment rates.

The Fed has reacted to the slow growth by “Quantitative Easing”, where they expand their balance sheet and purchase assets such as Treasury Securities and Mortgage Backed securities.  The hope is by purchasing these assets and injecting liquidity into the system, it will allow consumers and companies to borrow, spend and invest more.  Since the crisis started, the Fed has increased its holdings in long term credit by over $1 trillion and injected this money into the system.  However, the results have had limited success.  Considering the lack of confidence in the economy and government policy, banks and corporations are sitting on record amounts of cash thwarting the Fed’s efforts.  The debate continues on whether to implement additional Quantitative Easing.  We feel that the results will be minimal until confidence builds and the money begins to filter through the system.

We sense that many areas of the bond market are overvalued.  Ten year treasuries ended the quarter with a yield of 2.53% or 1.58% after inflation.  Despite the low yields, bond mutual funds have attracted about $200 billion in new money year to date as compared to equity mutual funds which have lost about $20 billion in assets.  Investors have been shying away from stocks and purchasing bonds, pushing the price of bonds higher and yields lower.  Investors need to be cautious with their bond portfolios, remain relatively short on the maturity scale, diversify by adding high yield and foreign bonds, and be cautious on treasuries.

Stocks still look very attractively priced relative to bonds even after the 3^rd quarter rally.  Companies continue to beat analyst expectations and report strong quarterly performance.  The S&P 500 reported earnings of $20.9 per share in September which equates to an earnings yield of over 7%.  Stocks are trading at a forward price to earnings (P/E) multiple of 12.3x which is a significant discount to the average of 16.6x.  The P/E multiple is highly correlated to consumer sentiment.  Consumer sentiment is low due to high unemployment.  We will likely continue to see the market trade well below normal multiples until unemployment decreases and consumer sentiment increases.  However, earnings growth is on track to beat the previous record which was $24.06 set in June of 2007, within two years.

One of the biggest risks we see for economic recovery is a deadlock in extending the Bush tax cuts.  Most Republicans want to extend the cuts for everyone while most Democrats want the extension to expire on those making over $250,000 per year.  If the Republicans take control of the House and possibly the Senate, it could create a deadlock on extending the cuts.  If an agreement is not met and the tax cuts expire for everyone, it could be very problematic for this fragile recovery.

By TREVOR CALLAN, Callan Capital

Thursday, September 2, 2010

Just as investors were feeling good about the stabilizing economy and financial markets, the second quarter of 2010 reminded us that we live in a world full of risk. The BP oil spill combined with worries about a double dip recession, the European debt crisis and the uncertainty in Washington relating to fiscal austerity, health care, financial and tax reform have all increased the level of worry and volatility. Watching the evening news is enough to make the most seasoned investors question the structure of their portfolios.

The good news is that time, in general, diffuses volatility. According to a recent study in JPMorgan’s (NYSE: JPM) “Guide to the Markets,” from 1965-2009 a portfolio consisting half of stocks and half of bonds never experienced a decline over any five-year rolling period. That said, it is possible and even prudent to rebalance your portfolio from time to time in a measured fashion to take advantage of ever-changing market dynamics.

Caution on bonds

For example, in today’s market, bonds are trading at historically high levels and are vulnerable to price reductions. Historically, investors could rely on insurance and ratings agencies to provide comfort about the underlying safety of their bond portfolio. Today, many investors are holding municipal bonds purchased when insurance companies were still considered solvent. Those investors would be wise to have a financial adviser examine the underlying quality of their existing bond portfolio and not rely on the rating agencies alone.

Fear and uncertainty has caused investors to flock to safety, driving bond prices higher. Bonds are currently trading at levels that warrant caution in our opinion, because bonds that have long maturities are more susceptible to rising interest rates.

Fear and uncertainty have also kept stock prices from rising, and, given the trends in recent earnings, equities provide value for investors with a longer-term time horizon.

Higher equity earnings

Equity markets (stocks) continue to fluctuate under the influence of economic news, political uncertainty and fiscal austerity. But as the second-quarter earnings season progressed, it appears that the underlying fundamentals warrant higher prices, but fear over the direction of the economy has caused stocks to drift lower. Only a few months ago, the consensus earnings estimate for the 500 largest U.S. companies was $17.17 per share. Those 500 companies actually earned $19.41 per share, much higher than anticipated. Currently, the consensus estimate for the second quarter is $19.61, and so far the majority of companies have exceeded their estimates. Most people contribute the recent earnings growth exclusively to cost cutting (earnings grew 29 percent year over year), but U.S. companies have also experienced healthy revenue gains (8.7 percent year over year).

Portfolio strategy

The risks of a double-dip recession have increased lately, but we still feel that the most likely scenario for the U.S. economy is for a continued slow, painful and uneven recovery. Our equity portfolios have a slight emphasis on the cyclical parts of the economy and the sectors that derive a large percentage of their revenue from overseas sources. Currently, our international equity portfolio is focused on countries experiencing economic growth combined with prudent fiscal policies such as some the Asian and Emerging Markets (with the exception of Japan).

Prior to 2008, investors considered themselves diversified by owning a portfolio of just stocks and bonds. After 2008, we experienced an increase in correlation across a number of asset classes that historically provided diversification. So, investors may also consider alternative investments for diversification purposes. Examples including strategies that can go long or short, private real estate, distressed debt and consumer receivables. Adding Treasury Inflation Protection Securities (TIPS), commodities, precious metals and agriculture as an inflation hedge can also help balance a portfolio.

Our financial system is efficient over time and has a unique ability to flush out excesses that are occasionally created by irrational exuberance. This cleansing process, which is painful in the short term, is what sets the stage for continued and healthy growth in the financial markets and investment portfolios over the long term. Investment portfolio diversification is key and protects against unforeseeable risk, but prudent and consistent adjustments to capitalize on shifting market dynamics can maximize the performance of an investment portfolio.

With the increase in recent volatility, investors should question their temptation to exit asset classes that are meant to provide an inflation hedge over a longer-term time horizon. A 65-year-old today has a 16.1 percent chance to live to 95 and a 5.1 percent change to live past 100, according to the Centers for Disease Control and Prevention. Most people should be constructing their portfolios to meet the income needs over an appropriate time horizon.

Just when investors were feeling good about the stabilizing economy and financial markets, the second quarter of 2010 reminded us that we live in a world full of risk.  The BP oil spill combined with worries about a possible double dip recession; the European debt crisis; and the uncertainty out of Washington relating to fiscal austerity, health care, financial and tax reform have all increased the level of worry and volatility.  Watching the evening news is enough to make the most seasoned investor question the structure of their portfolios.

Caution about Bonds

Despite recent volatility, Callan Capital’s portfolios have experienced positive returns for the 12 months ending June 30^th 2010.  Fear and uncertainty has caused investors to flock to safety, driving bond prices higher.  Bonds are currently trading at levels that we feel warrant caution, because bonds that have long maturities are more susceptible to rising interest rates.  Fear and uncertainty have also kept stock prices from rising, and, given the trends in recent earnings, we feel equities provide value for investors with a longer term investment horizon.

Unlikely Double Dip Recession

With all the turbulent financial news, it is important to focus on the facts and separate what is probable from what is possible.  The financial markets have been influenced by what could possibly go wrong and very little by what probably will go right.

For instance, a double dip recession is possible but not probable.  Double dip recessions are very rare and have historically been very short in duration.  The United States has only experienced three double dip recessions in the past 110 years.

The last double-dip recession was caused by a very unique set of circumstances, including extreme government intervention that forced the economy into decline.  In 1980, President Carter imposed credit controls that were designed to slow excessive money and credit creation.  The ensuing credit crunch pushed the economy into a sharp but brief recession (six months).  After the short recession, we experienced a short recovery, which ended in 1981 when the Federal Reserve was forced to increase interest rates to 18% to stop inflation.  This shock to the recovery was enough to send the economy into another short and mild recession.

The double dip recessions of 1913 and 1918  were short and ended in powerful expansions.  Given the unique set of circumstances surrounding the 2008 credit crisis, it is possible that we could re-emerge into a recession, but it is not probable.

Higher Equity Earnings

Equity markets (stocks) continue to fluctuate under the influence of economic news, political uncertainty and fiscal austerity.  But as the earnings season progresses, it appears the underlying fundamentals warrant higher prices.  Only a few months ago the consensus earning estimate for the 500 largest U.S. companies was $17.17 per share.  Those 500 companies actually earned $19.41 per share, much higher than anticipated.  Currently, the consensus estimate for the second quarter is $19.61, and so far the majority of companies have exceeded their estimates.  Companies have reported strong earnings growth (29% year over year) and healthy revenue gains (8.7% year over year).

Callan Capital’s Strategy

Our portfolios are positioned to take advantage of a recovery through emphasis on the cyclical parts of the economy and the sectors that derive a large percentage of their revenue from overseas sources.  Our international equity portfolio is relatively light in Europe and heavy in Asia (with the exception of Japan) and the Emerging Markets (relative to the FTSE All World Ex US Index).

We continue to include Alternative Investments for diversification purposes.  For example, we are purchasing private real estate, distressed debt (from banks) and consumer receivables (copayment receivables from hospitals) in our Distressed Debt and Income Opportunity Fund.  Also included in our portfolio’s are Treasury Inflation Protection Securities (TIPS) and commodities, precious metals and agriculture as an inflation hedge.

Those who don’t know their history end up repeating it. Remembering how financial markets recovered in the past and examining how current fundamentals will likely impact the future can help investors resist the temptation to jump at every piece of news that is disseminated over the airwaves and in cyber space. Diversification is key, and Callan Capital continues to refine the components of our diverse investments in a calculated and studied manner.

The first quarter of 2010 was marked by another strong gain in the stock market. The Dow Jones Industrial Average posted its best first quarter performance since 1999. Investors who were waiting on the sidelines for the market to pull back suffered. This helps illustrate the dangers of trying to “time” the market.

The economy continued its recovery in the first quarter of 2010 with nearly every leading cyclical economic indicator showing signs of improvement. Vehicle sales, for example, closed the quarter at an annualized 11.8 million vehicles, up from the low in March of 2009 of 9 million. However, they are still off from their annual average of approximately 15 million. Several of the other major indicators including inventories, housing starts, and capital goods orders all showed improvement, but they are still not back to historical averages. So what does this all mean? The economy is in the beginning stages of a fragile economic recovery that we believe is sustainable.

Unemployment remained at 9.7% over the last several months. The unemployment rate is a lagging indicator so we would expect this to improve by the end of the year. However, we could see the rate rise before it falls, mainly due to the fact that over 2 million people left the labor force during the recession and stopped looking for work. When a worker leaves the labor force altogether, they are no longer counted in the unemployment rate. As the economy continues to improve, we may see some of these workers come back into the labor force and continue to drive unemployment higher as they begin looking for work. Total Non-Farm Payroll measures the net gain and loss of jobs. We hit a low in January of 2009 with 779,000 jobs lost in a single month. Since then, monthly job losses have consistently improved and in March 2010, 162,000 jobs were added for the month. Many of these new jobs were due to the hiring for short term positions relating to the federal census. Even with those jobs set aside, a clear trend of improving employment is taking shape.

The Obama administration passed a monumental healthcare bill in March. Political opinions aside, the bill will mean substantial changes going forward. The cost estimate over the next 10 years is $1 trillion, but the administration claims that it will lower the deficit by $240 billion by bringing in more tax revenue and cutting certain expenses. Medicare tax will be increased by 1% on earned income paid by the employee and a 3.9% increase will be added on unearned income such as capital gains. In addition, the doctor’s compensation will likely get reduced under the program. It is too early to tell if the healthcare bill will actually lower the deficit over the next 10 years due to the uncertainty of many of the assumptions made by the administration. As a result, we take this claim with a grain of salt and assume that this bill will add to the deficit over this time frame.

Health insurance companies traded higher on the news of the new bill despite the fact that they can no longer turn down coverage to someone with preexisting conditions. This was primarily due to the fact that an additional 30 million people will be forced to buy coverage or pay a penalty. We find the penalty (starting at $95 per person in 2014 and increasing to $695 in 2016) is not enough to encourage uninsured healthy people to buy a policy which would cost several times this amount. We feel that they’ll get a policy only if they get ill, and since insurance carriers must take anyone with preexisting conditions, this will add to their costs substantially. If this happens, the administration will be forced to increase the penalty to be more comparable to the cost of insurance. So while in its current form the bill bears this risk, it will likely be fixed in the years to come.

The federal balance sheet continues to get worse. In March of 2008, $5.3 trillion in debt was held by the public (excluding the debt the government owes itself). As of March of 2009, that number is now $8.3 trillion and projected to increase to between $18 – $20 trillion by 2020. The Fed raised $2 trillion with relative ease over the last two years because investors flocked to safety in treasuries. However, over the next 10 years, this will likely prove a very difficult task as the economy improves and investors seek higher returns on their investments. Treasury yields will be forced to climb in order to attract the necessary capital to fund the deficits. This scenario is common across the developed nations.

Individuals, municipalities and corporations have more attractive balance sheets by comparison. There is $14 trillion in personal debt among Americans and most of which has either been refinanced at historically low rates or in many cases defaulted. This has lead to increased savings rates and a decline in debt payments as a percentage of disposable income. Corporations have also benefited by decreasing expenses and capital expenditures translating into large increases in retained earnings. Unlike the federal government, municipalities were forced to reduce their labor force and reduce expenses. As a result, most municipalities have fairly strong balance sheets.

As we look for opportunities for 2010, we think equities remain attractive, but only in the context of a 5 year horizon or more. The S&P 500 is valued at a 14.1x price to forward earnings ratio compared to a historical 16.7x average even after a 73% rally. Corporate bonds remain attractive but the 30% + returns we saw in 2009 are not repeatable. Treasuries look overvalued given the scenario outlined above.