There Is A Tide - Patton Albertson & Miller...Winter 2012 n Act 4, Scene 3 of Shakespeare’s Julius...

Winter 2012

n Act 4, Scene 3 of Shakespeare’s Julius Caesar, Brutus makes an observation about

life to his ally Cassius which also applies to the investment world:

There is a tide in the affairs of men,Which, taken at the flood, leads to fortune;Omitted, all the voyage of their lifeIs bound in shallows and in miseries.

Brutus speaks in the context of planning a military campaign. Successful generals must understand the ebb and flow of military operations and commit their forces at the optimal time. Investors too must appreciate the inevitable fluctuations in financial markets and adapt accordingly.

2011 left most investors idling in the shallows, wondering why they even bothered to invest. After wild volatility, panic declines, and manic rallies, the benchmark S&P 500 index finished the year with a price gain of zero. Even including dividends the total return was a mere 2.11%. Over the past ten years the annualized return of the S&P 500 has been only 2.92%. Investors are wondering, “Where are those oft-touted 9-10% returns from owning stocks?”

We think the answer lies in stock market valuation. Before getting into that, however, let’s look at some financial history using a long term chart of the S&P 500 - (on right). It shows the index from 1872 to year end 2011. Although the overall trend of the index is upward, note the stair step configuration of the monthly data. Table 1 shows the four periods which had mostly sideways movement:

Table 1Secular Bear Markets

Period Length in Years 1880-1896 16 1900-1921 21 1965-1978 13 2000- 11+

For example, the S&P 500 first breached the 90 level in May 1965. In the spring of 1978, 13 years later, it was still trading within 5 points of that level although it had fluctuated between 60.96 and 121.74 over that time span. Buy-and-hold investors had only modest dividend returns to show for all that volatility. The net sideways movement masked three cyclical bull markets (1966-1968, 1970-1973,

and 1974-1976) and four cyclical bear markets (1966, 1968-1970, 1973-1974, and 1976-1978). See Table 3 for more details. By the late 1970’s many investors in frustration had given up stock investing all together.

Market historians call these long, low cumulative return periods “secular bear markets”. Invariably secular bear markets begin from high stock market valuation levels as measured by the market’s price-to-earnings (P/E) ratio. Secular bear markets end at below average P/E ratios. Table 2 shows data going back to 1900:

Table 2Valuation Extremes

Price-to-Earnings Ratio Market Cycle Start End 1900-1921 23x 5x 1965-1978 23x 9x 2000- 42x #

# 12/31/2011 P/E ratio was 20.8x

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Insight & Outlook is published quarterly by Patton Albertson & Miller, LLC. The statements expressed in this newsletter are the opinions of Patton Albertson & Miller, LLC and do not represent specific investment recommendations or results.

IThere Is A Tide

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Bill MillerPatton Albertson & Miller, LLC

18 Years

22 Years

16 Years

2000 -‐ ????

mean profitable stock market opportunities will be absent. Consider Table 3 showing details of the secular bear market which frustrated buy-and-hold investors in the 1960s and 1970s:

Table 3Cycles in Secular Bear Markets

Cycle Period % Returns Bear 1966 -25 Bull 1966-1968 +51 Bear 1968-1970 -37 Bull 1970-1973 +77 Bear 1973-1974 -50 Bull 1974-1976 +78 Bear 1976-1978 -20

Does the volatility look familiar? The cyclical bull markets were certainly worth participating in assuming an investor could avoid large drawdowns during the subsequent bear markets. All secular bear markets eventually come to an end. When the last one did, the great secular bull market of the 1980s and 1990s began. That bullish tide surged for a generation during which the S&P 500 increased from about 101 to over 1550, a factor of 14 times. That’s the kind of action that “leads on to fortune”.

We wish we could predict when the stock market will extricate itself from the doldrums. All we can say is that, based on history, the tide must turn someday.

Bill Miller

11 Years +

13 Years

21 Years16 Years

ast quarter we highlighted that municipal bonds had not experienced the large wave of defaults that some analysts had predicted for 2011.

This quarter we want to review the much larger market for United States Treasury securities. Last August the credit rating firm, Standard & Poor’s, reduced the U. S. government’s credit rating to AA+ from its top grade of AAA. In addition it classified the financial outlook as “Negative”. This downgrade represented the first time in our history that the U. S. has not been rated AAA by every domestic ratings agency. S&P’s action followed acrimonious Congressional debate and a last minute agreement with the White House to increase the country’s $14 trillion debt ceiling in several steps to $16.4 trillion. That agreement enabled the government to keep borrowing until the end of 2012 and narrowly averted a default.

In July, S&P had warned that it would reduce the nation’s credit rating in the absence of a “credible” plan (at least $4 trillion in size) to lower deficits over 10 years. The debt ceiling law that Congress passed in August, however, only had slightly over $2 trillion in savings, many of which were questionable. The new law purported to cut nearly $1 trillion over 10 years, not by identifying specific spending cuts or budget savings, but instead by capping the amount of money Congress could spend in annual appropriation bills over the next 10 years.

In addition, the law created the infamous “Super Committee,” made up of 6 Democrats and 6 Republicans, and assigned it the task of identifying another $1.5 trillion of budget savings by November 23. The full Congress would then have 30 days to vote on the committee’s proposal. The law also had a fallback provision. If the Super Committee could not come up with the required savings, then automatic cuts totaling $1.2 trillion in defense and domestic programs would kick in, but conveniently not until 2013.

Moody’ Investors Service and Fitch Ratings, the other major ratings agencies, affirmed their AAA credit ratings after passage of the debt ceiling bill, although Moody’s assigned a “Negative” credit outlook. Both agencies, however, said that downgrades were possible if lawmakers failed to enact credible debt reduction measures. On the other hand, Standard & Poor’s appeared to lose patience with Washington. It stated that “…in our opinion…the fiscal plan that Congress and the Administration recently agreed to falls short of what would be necessary to stabilize the government’s medium-term debt dynamics. More broadly, the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”

Well not surprisingly, the Super Committee failed to agree on a plan to reduce the budget deficit by the November 23 deadline. Their inability to do so will now trigger the automatic cuts. A market strategist in London wrote that the Super Committee’s failure “…does little for the credibility of the U.S. political system.” The three ratings agencies were also critical of the Super Committee’s failure to come up with specific cuts, but there were no downgrades. Fitch did revise its long term rating outlook, however, to “Negative” from “Stable.” Fitch’s view, consistent with S&P’s and Moody’s, is that “…fiscal projections envisage federal debt held by the public exceeding 90% of GDP and debt interest consuming more than 20% of tax revenues by the end of the decade would no longer be consistent with the U.S. retaining its AAA status despite its underlying strengths.” Moody’s cautioned that any undoing of the automatic cuts next year also would be a negative.

Surprisingly, the actual credit rating reduction by Standard and Poor’s and the moves by Moody’s and Fitch to characterize the outlook as “Negative” did little to harm the market for U.S. Treasury securities. For instance, the yield on the Treasury 10 year note, a benchmark for everything from corporate bonds to mortgages, ended the year below 2% for the first time in 50 years. And at the short end of the maturity spectrum, the Treasury just sold four week Treasury Bills at zero percent (0.0%). As a side comment, these low interest rates help keep the deficit down, but at the risk of removing any sense of urgency to fix our budget problems.

The main influences driving Treasury rates down are 1) the serious sovereign debt problems in Europe and 2) Federal Reserve policy. While the U.S. has serious budget problems, our problems seem less severe than those of the weak countries in the Euro zone such as Greece (rated Ca by Moody’s and CC by S & P, both “speculative” ratings), Italy( A2,BBB+), and Spain (A1,AA-). Ten year bonds issued by these countries are currently trading around 29%, 7%, and 5.50% respectively. This has resulted in a

massive flight to quality which favors the bonds of the U.S., Germany, and the United Kingdom. Bill Gross, manager of the world’s largest bond fund at PIMCO, quipped that the U.S. Treasury is “…the cleanest shirt in the dirty laundry pile.”

The other major influence keeping our rates down is current Federal Reserve policy. The Fed remains concerned about the slow pace of the economic recovery. Recent speeches by various Fed Governors and District Presidents point to further Fed easing in the form of significant additional purchases (“Quantitative Easing” or “QE3”) of long term Treasury securities and perhaps mortgage backed securities backed by Fannie Mae and Freddie Mac. Details might be released at the next Federal Open Market committee meeting on January 25. Recall that the Fed has already said that it intends to keep short term rates close to zero at least through mid-2013.

Perhaps the current preoccupation with the struggling Euro Zone countries and the Fed’s focus on growth and housing will buy the U.S. some time to get through the 2012 election. Hopefully by 2013, there will be less political gridlock and more real progress in solving our budget problems. If not, then the United States might be next on the front pages. We have weathered the storm for now, but the winds are still blowing.

Charlie McAnally

LWeathering the Downgrade

Charlie McAnallyPatton Albertson & Miller, LLC

his colorful image has since taken hold in the

blogosphere, with Occupy Wall Street protestors sporting squid costumes, hats, and puppets. Yes, Goldman alumni wield tremendous financial and political influence worldwide.

But is the firm really that scary? Perhaps the answer depends on the motivations of Goldman alumni

such as former U.S. Treasury Secretary Henry Paulson, former Citigroup Chairman Robert Rubin, former Merrill Lynch CEO John Thain, former AIG Chairman & CEO Ed Liddy, and former New York Fed Chairman Stephen Friedman. All played prominent roles in the great Wall Street bailout of 2008. Did their Goldman roots influence their responses to the financial crisis? Did public officials such as Treasury Secretary Paulson put the nation’s interest first?

The Independent, a left-leaning British tabloid, suggests that Goldman Sachs’ strategy is “… to create such a deep exchange of people and ideas and money that it is impossible to tell the difference between the public interest and the Goldman Sachs interest”. The paper raises the same question for Europe today where the list of officials with Goldman ties includes European Central Bank Chairman Mario Draghi, Greek Prime Minister Lucas Papademos, and Italian Prime Minister Mario Monti, among others.

Also focusing attention on the practices of Goldman alumni is the scandal surrounding the recent collapse of MF Global, headed by Jon Corzine (former CEO of Goldman Sachs, U.S. Senator, and Governor of New Jersey). MF Global’s unexpected failure in October 2011 revealed an estimated $1.2 billion shortfall in customer accounts, prompting civil and criminal investigations. Mr. Corzine denied any wrongdoing. While details are still forthcoming, according to the news agency Thomson Reuters, “MF Global’s bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up

The Vampire Squid?

in MF’s dying hours, but were instead appropriated as part of a mass Wall Street manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds ...”

It is unclear at this point whether any illegal activity occurred at MF Global. We do know its clients signed agreements permitting MF Global to use customer securities as collateral for its own borrowings. The technical term for this is rehypothecation. Through its London subsidiary (the British have much more lenient rules regarding rehypothecation than the U.S. or Continental Europe), MF Global was able to use customer collateral to acquire a $6.3 billion position in European sovereign debt. That “bet” was more than five times the book value of MF Global itself. Furthermore, MF Global structured the transaction so it was off the balance sheet and therefore opaque to even the most diligent investors.

If the firm had purchased the debt of Germany or Finland, perhaps it would still be in existence. Jon Corzine, however, invested in the higher yielding debt of troubled countries such as Spain, Portugal, Italy, and Ireland. When the most recent Eurozone bond crisis hit in October, MF Global was unable to survive. Unfortunately for Corzine and his clients, with just $40 billion in assets and a mere $1 billion in shareholder equity, MF Global was not “too big to fail.”

Our concern is that much larger firms such as Goldman Sachs ($980 billion in reported assets, $70 billion in shareholder equity) are engaged in similar practices of leveraging customer securities, often with “off-balance sheet” accounting. The International Monetary Fund estimated that $2.45 trillion ($2,450 billion) of customer collateral had been leveraged into $5.8 trillion of investments at the world’s 14 largest securities dealers as of the end of 2010. The interdependence of American and European financial institutions may be much tighter than their financial statements reveal.

We’ve known all along that Wall Street was populated with sharks. It appears now we must also include vampire squids. Dangerous waters indeed.

John Healy

Numerous ways exist to calculate P/E ratios, and Wall Street often fails to distinguish them properly. We use “reported ten year earnings adjusted for inflation”. This is the methodology popularized by Yale’s Professor Robert Shiller in his excellent book, Irrational Exuberance. The Shiller P/E ratio has averaged 16.4x reported ten year earnings since 1872. Note the ending price-to-earnings ratios in Table 2. The S&P 500’s current P/E ratio of 20.8x is well above those levels, but the 1921 and 1978 ratios reflected unusual monetary conditions. 1921 had 10.7% deflation while 1978 had 7.6% inflation. Financial history demonstrates that very low P/E ratios are seen when price changes are abnormally large in either direction.

Fortunately, investors today perceive inflation to be relatively low and stable. This suggests the secular bear market could end at a price-to-earnings ratio meaningfully higher than the P/E’s seen in 1921 or 1978 provided inflation or deflation don’t get out of control. A

There Is A Tide continued from page 1On January 3rd Patton Albertson &

Miller welcomed Keith Jaworski as the newest member of our investment services team in Atlanta. Keith has over 28 years of experience in the investment services field; most recently as the Managing Director and Portfolio Manager for Falcon Partners, LP a long-short hedge fund located in Atlanta. Prior to Falcon Partners, Keith was the Director of Research for CAZ Investments, a Houston, Texas-based wealth management firm and multi-family office. Keith is a graduate of Carnegie-Mellon University in Pittsburgh, Pennsylvania and he holds the CFA designation from the CFA Institute. Keith is married and lives in Alpharetta, Georgia with his wife, Karen, and their two sons, Zach (18) and Kyle (15).

Welcome Keith Jaworski!

John HealyPatton Albertson & Miller, LLC

In 2010, Matt Taibbi, contributing editor at Rolling Stone Magazine wrote,

The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its funnel into anything that smells like money.

price-to-earnings ratio of 13x to 14x might mark the next secular bear market low.

There are two ways to get there. The most dramatic and least likely is a sudden stock market crash that takes the S&P 500 from 1290 to 820 where it would be trading at about 13.5x its reported ten year trailing earning as of December 2011. The other way is for the market to continue its sideways movement with periodic cyclical bull and bear markets until earnings “catch up.” As our review of financial history has shown, this is the usual way to resolve market overvaluation.

We are now entering the twelfth year of this secular bear market. The three prior episodes had an average duration of about 16 years. So we might have another few years of challenging markets ahead of us before the next great secular bull market begins. That doesn’t

All of us at Patton Albertson & Miller welcome Keith to the team!