::: Butler Financial Services, Inc

What a fascinating mix of conflicting data and behavior in the world economy and world markets! Commodities remain in a long-term bull trend. This is inflationary. Bond yields on US Treasuries have been falling. This asserts deflation and recession. Then, after 18 months of rebellious behavior, the US dollar has resumed its long-term bearish trend, in light of an abundance of economic and market driven factors. Finally, add in a low yield environment in the bond market. For, while it is true that 4.4% on the 10yr treasury is better than yields from several years ago ('03 in particular), and yields on shorter treasuries are much better (around 5% from recent 1-2% levels), nevertheless, investors at home and abroad need more yield. Interestingly, they need more yield for diverging reasons.

Even so, amid all these zigs and zags of data and slices of insight into Darkness & Light, the Equity markets have performed very nicely in 2006. But with 2% US GDP growth likely in the coming year: what is an investor to do?

In the summer we at Butler Financial ignored “the heavens” (the swirling macro-economic views) and upped our exposure to the equity markets, stock by stock, sector by sector: where—to our delight and surprise--we kept finding quality companies at excellent prices (as in “cheap” relative to fair value and charts). Examples of this include Dell, New York Times, Peabody Energy, and the ETF for the Canadian Bourse (ticker: EWC). Of the companies mentioned, we primarily bought them based on price, not a deep rooted love of Dell PC’s or publishing, for example. Price, naturally, is one of the best managers of risk.

Stocks remain the place to be & US bonds are generally to be avoided: this is based on two factors, one market driven and one macro-economic driven. The market-driven force, as mentioned above, is that bonds offer neither American nor International investors sufficient yield. The American investor needs yield to retire and to supplement his/her income. 4.4% doesn’t do it for all except the mega-wealthy (starting at 10M networth). For the International investor, there is the matter of a weakening dollar, which will impact overall total return. As well, foreign bankers continue to hold large quantities of dollars; even if they don’t sell them, it would appear that they will be disinclined to buy more.

Our macro-economic “working hypothesis” is that the US can have tepid economic growth of 2% GDP and the world economy nevertheless can perk along. And this is not just a story of China, India, Brazil and Russia: include Old Europe, where we are seeing an notable uptick in manufacturing and industrial expansion. Concurrently, the mature European markets (inflammatory cartoons notwithstanding) are poised to do brisk business with the emerging Muslim economies (Egypt, North Africa, etc.), and have a compelling relationship with China. Labor and pension issues in Europe are at least coming back into balance, though they remain tricky. Don’t be surprised to see several years of world economic growth driven by emerging nations building “consumer infrastructure” and increasing consumer spending. America, for better and for worse, may not matter as much as many believed.

The demand for hard assets of all stripes will remain intact, in our humble view, as these emerging consumer economies spend their money. Hence, where possible, we like to overweight portfolios with energy, gold, industrial metals, food, water and select international real estate, and we think some of the European and Asian companies (alongside some US companies) will do well because of this trend. Attention will be paid to price and proper points of entry.

Previously, we have written about our concern over the long term decline of the US dollar.** The bear trend means opportunity, insofar as we’d like to accordingly overweight our investments (stocks, in particular): we think it prudent to diversify not only across sectors and countries, but also by currency. An good example is one of our core holdings: EWC, which is an “index-type” investment (ETF-exchange traded fund), tracking the Canadian bourse. We like the Canadian economy and markets for many reasons, and one of them is currency. Another is hard assets and commodities—lots of them. Another is Canada’s “stock” in the “good will” department in the world political stage. And, last but not least, there is integrity to the Canadian financial markets; and, though not perfect (i.e. secession & Quebec), it is a relatively stable political environment.

The last three years of low volatility in the equity markets have been “cool”, but one should not be mistaken: even with 2006’s nice run up, domestic equities have generally returned a couple of percentage points lower return than the 9-10% equity returns of the past 75 years. The conspicuous point regarding volatility is this: things have become complacent. Fear is good in markets, just the way violent winds prune the trees in Fall and Spring. Complacency means that folks have a tendency to stop being disciplined, stop paying attention to price. Certainly, macro economic factors, particularly the soft domestic real estate market and the US dollar, will be impactful here.

Which brings us to that Glorious Greenback: what about the dollar, anyway? Robert Schiller, behavioral finance economist at Yale, notes that markets, like many areas in life, get into “self-fulfilling loops” or cycles; and once you’re in them, be they mania or depression, it gets awfully hard to get out. The US Dollar appears on the verge of just such a cycle, of the negative sort, and this would not be good (though arguably necessary).

Why? Let us count two (2) ways and identify how they could prove trouble. US federal budget deficit and current account deficit. Our federal budget deficit is currently negative 2.3% of GDP. Simply put, this means the government is spending more than it is taking in. To finance this, the United States Treasury sells various government-backed bonds, of which the 10 year is central. For the past several years, the cost of financing this debt (“the interest rate/yield”) has been held down, because there has been demand for these bonds. Notable, more than half of bonds purchased have been by foreign bankers and investors.

Now were these foreign bankers to stop purchasing such bonds, demand would necessarily slacken and the market place would adjust by driving up yields/rates. Of course, such increased yields are good for the buyer of such bonds and bad for the issuer of the bonds. In the case of the US government, the cost of financing its budget deficit would go up: that is decidedly inflationary.

Were the US dollar to go down for any reason, that would add pressure to yields as well, because foreign investors would demand more yield to cover the losses experienced by owning a currency that is declining in value. Of course, many foreign bankers and investors already possess a lot of US dollars (our current account deficit was negative 850 Billion for the prior 12 months), and if they lost confidence in the Greenback, this could represent a long painful road of systematic dollar sales by foreign investors, and that could be very painful.

The point here is that it is likely to see the US Dollar enter into a “self fulfilling loop”, wherein bad news begets further bad news, and the way out of the pain of the bad news is to create more pain and bad news: sell dollars, desist from buying further dollars, and so on. What could add further obstacle is a weakening US consumer market, which would take away foreign bankers’ incentives to “invest in” US bonds and keep local currencies cheap to protect exports to the US.

This is all THEORY, which we can’t eat and which is ever up for debate. We present this, however, as one of the looming major themes, that could play out in the world economy and markets over the next several years; and, in fact, we believe that in the past couple months we have seen resumption of such a trend.

In sum, then, we think: buckle your seat belts, equities are still the place to be but things are going get volatile (in keeping with their traditional risk profile); pay attention to price, don’t be greedy. And, while we at home may be feeling a bit of economic pain, other parts of the world economy should continue to prosper, and this is just and good, and most definitely we aim to participate in that prosperity.

Best regards,

Mark Butler David Stein

Sources: The Economist 12/2/06 Issue (various); John Murphy (internal note on US/Europe markets & economy: 12/1/06); Robert Schiller, Irrational Exuberance.


12.09.2006 \| BFS, Inc. Client Note... With or Without US - 2007 Yr End, Yr Fwd Note on Markets & Economy What a fascinating mix of conflicting data and behavior in the world economy and world markets! Commodities remain in a long-term bull trend. This is inflationary. Bond yields on US Treasuries have been falling. This asserts deflation and recession. Then, after 18 months of rebellious behavior, the US dollar has resumed its long-term bearish trend, in light of an abundance of economic and market driven factors. Finally, add in a low yield environment in the bond market. For, while it is true that 4.4% on the 10yr treasury is better than yields from several years ago ('03 in particular), and yields on shorter treasuries are much better (around 5% from recent 1-2% levels), nevertheless, investors at home and abroad need more yield. Interestingly, they need more yield for diverging reasons. Even so, amid all these zigs and zags of data and slices of insight into Darkness & Light, the Equity markets have performed very nicely in 2006. But with 2% US GDP growth likely in the coming year: what is an investor to do? In the summer we at Butler Financial ignored “the heavens” (the swirling macro-economic views) and upped our exposure to the equity markets, stock by stock, sector by sector: where—to our delight and surprise--we kept finding quality companies at excellent prices (as in “cheap” relative to fair value and charts). Examples of this include Dell, New York Times, Peabody Energy, and the ETF for the Canadian Bourse (ticker: EWC). Of the companies mentioned, we primarily bought them based on price, not a deep rooted love of Dell PC’s or publishing, for example. Price, naturally, is one of the best managers of risk. So now we look ahead, to 2007 and 2008, and believe several things: 1) stocks remain the place to be – albeit in a global stock market 2) over-weightings to International and Hard Assets remain 3) the US bond market is to be avoided 4) past three years of low to no volatility in equity markets ends 5) it’s all about the dollar 6) keep an eye on alternative investments impacting markets Stocks remain the place to be & US bonds are generally to be avoided: this is based on two factors, one market driven and one macro-economic driven. The market-driven force, as mentioned above, is that bonds offer neither American nor International investors sufficient yield. The American investor needs yield to retire and to supplement his/her income. 4.4% doesn’t do it for all except the mega-wealthy (starting at 10M networth). For the International investor, there is the matter of a weakening dollar, which will impact overall total return. As well, foreign bankers continue to hold large quantities of dollars; even if they don’t sell them, it would appear that they will be disinclined to buy more. Our macro-economic “working hypothesis” is that the US can have tepid economic growth of 2% GDP and the world economy nevertheless can perk along. And this is not just a story of China, India, Brazil and Russia: include Old Europe, where we are seeing an notable uptick in manufacturing and industrial expansion. Concurrently, the mature European markets (inflammatory cartoons notwithstanding) are poised to do brisk business with the emerging Muslim economies (Egypt, North Africa, etc.), and have a compelling relationship with China. Labor and pension issues in Europe are at least coming back into balance, though they remain tricky. Don’t be surprised to see several years of world economic growth driven by emerging nations building “consumer infrastructure” and increasing consumer spending. America, for better and for worse, may not matter as much as many believed. The demand for hard assets of all stripes will remain intact, in our humble view, as these emerging consumer economies spend their money. Hence, where possible, we like to overweight portfolios with energy, gold, industrial metals, food, water and select international real estate, and we think some of the European and Asian companies (alongside some US companies) will do well because of this trend. Attention will be paid to price and proper points of entry. Previously, we have written about our concern over the long term decline of the US dollar.** The bear trend means opportunity, insofar as we’d like to accordingly overweight our investments (stocks, in particular): we think it prudent to diversify not only across sectors and countries, but also by currency. An good example is one of our core holdings: EWC, which is an “index-type” investment (ETF-exchange traded fund), tracking the Canadian bourse. We like the Canadian economy and markets for many reasons, and one of them is currency. Another is hard assets and commodities—lots of them. Another is Canada’s “stock” in the “good will” department in the world political stage. And, last but not least, there is integrity to the Canadian financial markets; and, though not perfect (i.e. secession & Quebec), it is a relatively stable political environment. The last three years of low volatility in the equity markets have been “cool”, but one should not be mistaken: even with 2006’s nice run up, domestic equities have generally returned a couple of percentage points lower return than the 9-10% equity returns of the past 75 years. The conspicuous point regarding volatility is this: things have become complacent. Fear is good in markets, just the way violent winds prune the trees in Fall and Spring. Complacency means that folks have a tendency to stop being disciplined, stop paying attention to price. Certainly, macro economic factors, particularly the soft domestic real estate market and the US dollar, will be impactful here. Which brings us to that Glorious Greenback: what about the dollar, anyway? Robert Schiller, behavioral finance economist at Yale, notes that markets, like many areas in life, get into “self-fulfilling loops” or cycles; and once you’re in them, be they mania or depression, it gets awfully hard to get out. The US Dollar appears on the verge of just such a cycle, of the negative sort, and this would not be good (though arguably necessary). Why? Let us count two (2) ways and identify how they could prove trouble. US federal budget deficit and current account deficit. Our federal budget deficit is currently negative 2.3% of GDP. Simply put, this means the government is spending more than it is taking in. To finance this, the United States Treasury sells various government-backed bonds, of which the 10 year is central. For the past several years, the cost of financing this debt (“the interest rate/yield”) has been held down, because there has been demand for these bonds. Notable, more than half of bonds purchased have been by foreign bankers and investors. Now were these foreign bankers to stop purchasing such bonds, demand would necessarily slacken and the market place would adjust by driving up yields/rates. Of course, such increased yields are good for the buyer of such bonds and bad for the issuer of the bonds. In the case of the US government, the cost of financing its budget deficit would go up: that is decidedly inflationary. Were the US dollar to go down for any reason, that would add pressure to yields as well, because foreign investors would demand more yield to cover the losses experienced by owning a currency that is declining in value. Of course, many foreign bankers and investors already possess a lot of US dollars (our current account deficit was negative 850 Billion for the prior 12 months), and if they lost confidence in the Greenback, this could represent a long painful road of systematic dollar sales by foreign investors, and that could be very painful. The point here is that it is likely to see the US Dollar enter into a “self fulfilling loop”, wherein bad news begets further bad news, and the way out of the pain of the bad news is to create more pain and bad news: sell dollars, desist from buying further dollars, and so on. What could add further obstacle is a weakening US consumer market, which would take away foreign bankers’ incentives to “invest in” US bonds and keep local currencies cheap to protect exports to the US. This is all THEORY, which we can’t eat and which is ever up for debate. We present this, however, as one of the looming major themes, that could play out in the world economy and markets over the next several years; and, in fact, we believe that in the past couple months we have seen resumption of such a trend. In sum, then, we think: buckle your seat belts, equities are still the place to be but things are going get volatile (in keeping with their traditional risk profile); pay attention to price, don’t be greedy. And, while we at home may be feeling a bit of economic pain, other parts of the world economy should continue to prosper, and this is just and good, and most definitely we aim to participate in that prosperity. May 2007 be good to you and yours, Best regards, Mark Butler David Stein Sources: The Economist 12/2/06 Issue (various); John Murphy (internal note on US/Europe markets & economy: 12/1/06); Robert Schiller, Irrational Exuberance.

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