JR Snell Capital Management, LLC

I usually write a letter to clients that we include with the quarterly performance reports that all clients receive. I believe, in light of recent market movements that this quarter’s letter might be of interest to a broader range of folks. Please contact us if you have any questions or you wish to begin our free Roadmap Analysis to see if you’re on track to meet your financial goals.

Dear Client,

To say that the last three months have been dramatic is to REALLY say something because it comes on the heels of a heart-stopping stock market selloff followed by a mind-bending reaction rally… the likes of which haven’t been seen since Herbert Hoover was in office.

And who could forget that that it has been only about a decade since the stock market last showed us it’s “teeth”? It’s certainly been an era to feel like one could easily get “bitten” as an investor.

Of course recently, just at the point that it feels like we deserve to have some stock and bond market stability, we are again subjected to the kind of volatility extremes that have been cropping up more and more often the last few years. Have we been shown that we’re only living in the “eye of the financial storm” at the moment?

The first quarter of 2010 seemed to come and go quietly as we moved toward ever higher highs. I jotted a web site update in mid-May as I noted that I was feeling a certain level of complacency creeping back in to investor’s attitudes about the markets. Since then I’ve also been reminded by a client of a web site update from February of 2009 in which I wrote the following…

At present, I’m thinking that we’re probably looking at some serious deflation for a while and then a very muted, long term half recovery that could stretch out to a decade or so.

This leads me to a place where cash is king at the moment for most of our money.

Fortunately, these things usually unveil in slow motion. So slow in fact that people begin to dismiss their earlier premises and question their previous conclusions even though they are probably still correct.

Could it be just that simple? Could it be that many investors have dismissed their earlier correct assumptions because it is all taking so long? Is this “thing” so massive and lumbering that it can only unfold in “slow motion”?

During the second quarter, the buzz suddenly became about sovereign debt, which we’ve known for a while was going to become a problem one day soon. It appears that “one day soon” might be nearer than we thought and the market has been asking the question, “If the rescuers need rescuing, who is left to bail out whom?”

The tacit assumption has long been that China will provide some base level of support for the balance of the world via overwhelming demand for everything in the face of an otherwise global economic slowdown. However, there’s been recent chatter about a growing housing bubble in China and speculation that this might just be “the other shoe” to drop on an otherwise fragile global economy, bringing Round Two of the Global Financial Crisis with it.

But it hasn’t been just the stock and the bond markets that have been particularly quarrelsome the past few years. It’s been downright difficult, if not treacherous being an investor in any arena. For instance, real estate did something that it has never done before: It decreased in value. Conventional wisdom had it that despite the leverage routinely used by real estate investors, it was still considered a “safe” investment because real estate prices have never, ever gone down… not even during the Great Depression. The only safe bet now is that investors will never look at real estate investments the same way again.

Other types of investments have all experienced similar difficulties: Private loans, small business loans, real estate loans and partnerships, even previously assumed long time successes such as Bernie Madoff and a host of other Ponzi-schemers that have all been discovered to be “swimming naked” the moment the money tide went out.

So, while the financial turmoil of the past couple of years wipes out or changes much of the world’s conventional wisdom, it also performs a “cleansing” that presents new opportunities with new players in a new financial landscape.

All of the turmoil of the past few years will one day pass and the opportunities will be there for those of us who refuse to focus on the past. We need to keep our focus on keeping our minds open to the new and different opportunities that most certainly will present themselves in the future… while persevering through the “creative destruction” that we find ourselves in the midst of today.

Our Current Outlook

Bill Gross of PIMCO (Pacific Investment Management Co) speaks of an economic era that we are entering that he is calling the “new normal”. In recent papers he has been going into great detail as to the justification behind his theory, but basically “new normal” means an extended period of sub-par growth throughout world economies.

A favorite theory being embraced by what I believe might be the majority of investors is this theory that some day in the not too distant future we will be wrestling with some significant inflation pressures… possibly even a stagflation situation (stagnant economy, rising prices).

Over the past year or so, I’ve been inclined to side with those that anticipate inflation, but now I am beginning to modify my view of our future world. I’m beginning to consider the possibility that our current Keynesian monetary policy of flooding the economy with money MAY NOT lead to inflationary pressures. After watching unemployment not respond to unprecedented government spending, and housing not respond to historically low interest rates, I’m starting to see the US economy and perhaps the world economy as a “leaky bucket”: We continue to pour more and more into the bucket, but it is leaking out just as quickly (or even more quickly).

What is the “leak” in the bucket? I believe the “leak” is the process of deleveraging… up and down the line… from the smallest of consumers struggling to pay off their JC Penney charge card all the way up to the nation of Greece struggling to pay down their country’s debt.

Until the world deleverages, nations can pour as much money as they want into their respective economies and still not see net economic gains. They can throw it toward bailing out the banks, or homeowners, or other countries. At the end of the day it is just moving it from one side of someone’s balance sheet to the other side of someone else’s balance sheet.

The only solution is time. We need time as individuals and as nations to deleverage ourselves. I’ve expressed my thoughts to many of you that our financial issues are “generational”… meaning that it will take a generation for them to work themselves through. For example, our exit from the housing crisis could come as a result of enough people walking away from their mortgages… but it will only transfer the debt to the bank and then to the government as the bank is again bailed out and then ultimately on to you and me in the form of higher taxes or an extended slow-growth economy. Another way to exit the housing crisis is to wait for enough people to have paid down enough of their mortgages to again be “above water” allowing normalcy to return to the housing market. I’m assuming it is to be a combination of both… but the end result is the same: It will take time. This is my version of Bill Gross’s “new normal”.

While one set of opportunities has been winding down for the last few years, a new set of opportunities has yet to reveal itself. This leaves us in a bit of a “no man’s land” in the investment landscape. But again, to simply persevere and avoid chasing “old” opportunities will insure our ability to take advantage of our as yet unseen future.

Specifically

I anticipate that US Treasury securities will continue to be our baseline method providing the ability to persevere for the next who-knows-how-long. I believe that part of the new normal involves some moderate level of deflation for the foreseeable future, allowing your purchasing power to increase even without any real investment returns.

I expect that we will continue to see extended and significant moves up and down in the stock markets… probably quite similar to what we experienced between the end of 2007, down to the March of 2009 lows and then up to the April of 2010 highs. Our opportunities in the stock market will come by accepting that there is a disconnect between the stock market and the economy and by taking advantage of the volatility that we are sure to experience because of it.

Although the market may show little to no net increase over the next decade or two, I would expect that between positioning in and out of Treasuries as appropriate and positioning in and out of equities as appropriate, our clients will continue to persevere… and quite possibly prosper.

As always, I am honored to be your guide through these historical times. Please feel free to call or email if you have any questions or need any assistance.

Jeff Snell

Managing Member, JR Snell Capital Management, LLC

The latest market meltdown has gotten folks asking me about our performance as compared to the stock market (again). But I’ve always thought a little differently about comparing our management of client accounts against various indices. (The industry calls this “benchmarking”.)

I find it interesting that investors would want to compare whole portfolio returns to the stock market. It’s funny how consumers of financial products maintain this decision bias by wanting to compare all returns “against the market” to decide if they’re getting good advice or not.

I don’t think investors are necessarily to blame for this bias… I think our industry might have brainwashed people to think this way. After being subjected to the stream of advertisements on TV and in magazines comparing “this fund” and “that fund” against the market, what can we expect investors to do when looking for intelligent ways to discern between copius financial choices?

To get market returns… or a reasonable comparison between what you’re doing versus what the market has done, you have to accept “market risk”. Yet, what I know from innumerable conversations with real people who have real concerns, investors do not want to accept “market risk” for the entirety of their investments.

I think a better “benchmark” to judge portfolio performance would be to compare your performance to what you set out to do. I call this “Personal Benchmarking”. Once you’ve released your portfolio from the chains of relative performance and embraced the concept of absolute performance (Personal Benchmarking) all investment decisions become significantly easier to make and to manage.

If you’ve planned that you’ll need a certain average annual rate of return to make your retirement work, what relevance is the stock market to you personally? It’s one of the hardest concepts to get your head around… but it’s worth it when you do… kind of Zen-like if you will.

So, we try to use the stock market as simply a tool to help us to reach your objectives. To do this, we have to first define your objectives, then we have to have the courage to “walk away” from the market when necessary and to exploit it when possible. (Hint: Get this report.)

If you REALLY think about doing things this way, you are naturally going to under perform when the market is “hot” and “risky”… and you’re going to outperform (sometimes significantly) when the market craters. But then again, who cares? The goal isn’t to “beat the market”, the goal is to continue on a track to meet your personal objectives?

Looking back over the last couple of months worth of posts, I’m thinking that it might appear that I’m a little opaque as to what areas of what markets you should be focusing on.

I’m not, so I’ll clear things up before I go AWOL for the week. First, understand that anything can happen over the short-term. What we always work on here in our laboratory is more macro-type thoughts for overall “big picture” positioning for ourselves and our clients. That’s what this is about.

[Sidebar... I think I might have mentioned that we are all about the "return of thought" when managing investments... That is, come up with a prospective course that we believe things will take and position for it. A little more active than reactive, and certainly not passive.]

If there’s no magic bullet or secret formula to this investing thing, the elephant in the room says that those investors who wish to survive (and thrive) in tomorrow’s markets might have to think for themselves (gasp)… or (at the very least) think for themselves enough to know they should hire those people who think for themselves.  – From “How We’re Fixing It”

First, the average inflation rate for the last 100 years or so is about 3.0%. The TIPS market (Treasury Inflation-Protected Securities) is showing the breakeven inflation rate at 1.9%… significantly lower than the 3.0% average. Translation: The market says that economic stimulus and other Fed stimulators (very low interest rates) will not work as planned… Translation: Extended period of very slow or non-growth. Translation: Buy TIPS because the treasury structured them to provide downside protection against deflation (which, of course the Feds assumed would never happen)… and this is really one of the very, very few investments that I can think of that offers this.

We’ve been buying the individual bonds for clients and mixing it up between 7 and 14 year maturities. If you can’t buy the individual things, you can consider the ETF (TIP)… This ETF makes sense for smaller accounts, but they have some additional internal management fees which is why we shy away from them in larger accounts

Following this premise, it wouldn’t hurt to accumulate some longer treasuries… like in the 20 year (give or take 5) range. I hear people whining about only getting 4.20% on a 20 year treasury… but I think if a person accepts what might be the ”new normal”… 4.20% might not look that bad, in hindsight.

We’re not married to holding on to the things for 20 years though. If we were presented with some outsized gains on our treasuries over the next year or two, we wouldn’t be afraid to take the profits and find a new home for the proceeds.

Dividend-spewing, old-line, consumer staples stocks look tasty for a couple of long-term reasons. First, we can get between 3 and 4% on many of these stocks (i.e. HNZ) and their business model isn’t so sensitive to the economic cycle.

Don’t get me wrong… anything and everything will go in the tank if the economy falls off a cliff again (people will even go without ketchup if things get bad). But generally, if our extended-malaise scenario becomes fact, then these consumer staples companies will still be chugging along same as always.

Just be sure to do your homework and feel comfortable that the stocks you’re choosing have low debt and decent enough margins to keep coughing up the dividend if things stay marginal for a long time. Email us if you need some help in this area.

Technically, in the stock market we’re acting a little short-term “toppy”… meaning it’s not a good time to be going after your favorite growth stock. Long-term? At the moment, none of the classic, fundamental, long-term stock market indicators are suggesting that now is a good spot to become a new “buy-and-hold” type of investor. Sorry. Be patient.

The upside to the “new normal” is that we can afford to be patient in the stock market. These days, nothing is going to run away from us for very long. No matter what the economy does, we still believe in volatility. Since volatility is how we’ve always made our money in the stock market, we still believe that there is money to be made in stocks.

As far as the thoughts of chasing stocks for fear of being left behind? We’re content to let everyone else risk heartburn while we just pick at the turkey.

Remember when I wrote the “Market Timing for Dummies” thing? It was in December of 2008 and my little chart that I showed in the post indicated that, at that point we’d been out of the market for a year and we might be out of it a while longer too.

Click to enlarge

We’ll, we’ve been out of the market another 8-plus months since then. Guess what? While you weren’t paying attention, we slipped into a bull market! What? Yes, it’s true… here’s the chart from almost a year ago brought up to today’s date.

Before you defrost those little wieners-on-a-toothpick that you’ve been saving for this party, here’s what it means and what I’m doing about it and what I think you should do…

Ready? Here’s the answer: “ATTITUDE SHIFT”. Since 75% of all stock price movements are in the direction of the overall market, we can begin to think that price situations will begin to resolve in our favor now, instead of assuming that everything’s going to immediately go into the crapper the instant we buy it like the last almost two years. That’s an attitude shift.

Before buying anything, make sure the financials are right and good… and that the chart looks favorable… and that you’re only putting an appropriate amount of your dough in each situation… and that you protect yourself against too much loss. (I like 10%).

As the rally continues to mature and goes through a couple of “tests” and subsequently continues to keep the wheels on, you can add to successful positions, start adding additional positions, etc. etc…. all the while limiting your risks.

So, it’s an attitude shift to where you would begin the process of investing in stocks when they look right. Moving all at once to a fully invested position could end up being a mistake if things take a sudden turn for the worse.

I remind all that you cannot predict the future.

OK… The world is not coming to an end already…. Yes, we have problems… Yes, they are serious… and yes, they will take years (probably many) to resolve.

We have some massive deleveraging as a country and as individuals to work through. Deleveraging is painful, whether you are a nation or a household. As we pay down debt (individually and collectively), those funds have to come from somewhere… Maybe they come from curtailing our spending, maybe we curtail our investing and saving.

If you can think about what you would do personally if you find yourself having to “de-lever”, then you know exactly what is happening with our economy. You know why spending has evaporated, why no one is buying cars, or houses, or Rolexes right now.

You see, it’s not just that credit has tightened up, it has. But, I think we have to recognize that the demand for credit has evaporated as well. It’s for this reason that I believe that simply making credit more available will not solve our problem… We all have to de-lever… pay off debt, pay down mortgages, get off the credit cards, etc.

It doesn’t matter whether you personally find yourself in the position where you must de-lever. If you don’t, your neighbor probably does and the country definitely does… and this is what matters: There’s A LOT of it that is going on.

The solution? Time. Time for Americans to do what they’ve always done: Get up in the morning, work hard and pay our bills. We will take the kids to school and soccer practice and buy a house or a car if we need it.

And we’ll do this all the while and over and over and over until the problem solves itself. It will solve itself because it will all be done with a new attitude, one of frugality and a new conciousness of the difference between a WANT and a NEED.

Maybe we can learn the lessons that our ancestors learned during the Great Depression without having to plumb the same depths of despair.

Frankly, what we don’t need right now is the excessive hand-wringing and scare-tactic speeches that our President has been making as a ploy to get his package passed. And we don’t need the media hype and horror stories thrown at us every single day. We get it… the economy sucks.

What we do need to do is to stop, take a deep breath, relax and to look around. Most Americans are working, have good jobs and are not in trouble with their mortgages. Most Americans are already doing what needs to be done to get us out of this thing. We’re a lot more resilient and creative than ‘they’ think we are!