The first priority for what gets paid starts with the interest on our national debt which would take $207 billion.  The next priority would be military operations, which is budgeted at $965 billion.  The amount left over to fund all other U.S. government spending would be just shy of $1 trillion.  It would require a 60% cut across the board to all of the other federal programs in order to balance the budget.  This would affect every person who receives benefits from Social Security, Medicare and Medicaid, education, transportation and infrastructure, unemployment, low income housing, environmental services, national parks services, public safety, prison security and on and on.

Trying to predict what would happen if the politicians in Washington failed to reach an agreement is difficult.  However, because of the untenable nature of the spending cuts it doesn’t seem likely that a government shutdown would last long.  The last two times it occurred, it lasted a total of six days in 1995 and around three weeks in late 1995 to early 1996.

We believe that a deal will get done before a shutdown happens.  Our assessment of where things currently stand is that a deficit reduction package that both sides can come to an agreement on may not be possible by August 2^nd.  What can happen, however, is an agreement to punt the issue of making structural changes not only to spending but also our tax code (revenue) to the 2012 election.  The leadership in the Senate is working on a backup plan that would give the President the authority to raise the debt limit without a specific approval by Congress.  This would accomplish a short-term solution allowing more time for discussion of the two longer-term potential problems, health care costs and the appropriate level of tax revenues, to be addressed.

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Ofunato, Japan

The tragedy in Japan continues to be the top news story and warrants international support.  While the human aspect of this crisis continues to be devastating, we can’t discount the economic impact as well.  Well respected international fund family, First Eagle Funds, was heavily allocated to Japanese investments before the tsunami hit.  To find out how they are reacting to current events and their outlook for the future in Japan, please read their recent Manager Insights.

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Sunny or Stormy?

An easily forgotten truth of investing is when prices are high, skies are sunny and when prices are low it’s stormy.  In other words, successful long term investing involves turning cautious when things look good and aggressive when things look bad.  Sunny = Sell High, Stormy = Buy Low.

Best Time to Invest

Think back to last July when there was oil in the Gulf of Mexico and the TV and radio talking heads were all convinced we were going into another recession.  Did those mid-summer days feel like the best opportunity over the last year to invest?  Since then, skies have brightened considerably and stock prices have risen about 20%.

Fear = Opportunity

We don’t know which way the Middle East turmoil will resolve.  It could be positive or negative in the short run.  In the long run we don’t think it matters, revolutions and geopolitical turmoil is the norm rather than an exception.  Short term scares provide the opportunity to pick up stocks at low prices from those who are selling out of fear.

So if market conditions get worse, how are you likely to react?

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In Jeremy Grantham’s latest quarterly letter, he profiled a story about Sir Isaac Newton in which one of the most highly regarded intellects in human history was lucky enough to enter the South Sea stock bubble rather early.  He stayed in long enough to make some money and then, most likely feeling good about himself, sold his holdings at a nice profit.  After the stock continued to rapidly appreciate, his friends began to brag more and more about how rich they were becoming from investing in South Sea stock.  Kicking himself for having made such a foolish mistake by cashing out at such a paltry profit, Sir Isaac dumped much more than he had invested the first time into the stock.  Of course, this time the bubble was perilously close to the top and he made the fateful mistake of riding the bubble burst all the way down before selling out on three separate occasions with hardly anything left to show for his original investment.

Gravity in the Stock Market

There are several lessons in this story.

1. Don’t get carried away no matter what type of circumstances surround an investment.
2. Remember that even smart people get burned by stock bubbles.

For these reasons, we’ve designed our strategy to help fight these feelings.  The stock ranges we establish for each of our clients (and ourselves) act as a discipline, helping to control those visceral responses to booms and busts in the markets.  Making calls of where we should be at a given time within those ranges is a large part of our research process.  So the next time your emotions make you feel like you want to act, remember Mr. Newton’s experience. With a sound and solid investment strategy, you can fight these very human urges that are born out of the fear and greed that dominate the average investor’s decisions.

Reasons for Optimism

We are not even six months removed from a period when many economists were predicting we’d see a double-dip recession.  Bob Veres, author of Inside Information, wrote a piece back in September that discussed some important counter-points to the bearish prognostications that perpetuate the the wall of worry a bull market typically climbs.

If you’re feeling a bit gloomy about the economy and the markets, you have a lot of company these days.

All of this gloominess is leading investors to search for alternatives to corporate stocks–including gold and cash equivalents like CDs and Treasury bills.  One online blog is titled “Nine Adult Entertainment Stocks to Weather the Recession;” it recommends Playboy and several providers of “mature entertainment” in hotel rooms.

There’s only one problem with following the herd down this gloomy path, or stuffing your portfolio with gold and smut.  In the past, people have been least optimistic about stocks and the economy right before the economy recovered and the markets produced higher-than-average returns.  Business Week published its famous cover article entitled “The Death of Equities” in August of 1979, after the stock market had sustained serious losses and the long-term health of the U.S. economy was in doubt.  The article noted a massive flight of investors from the market–right before one of the longest and most powerful bull runs the market has ever seen, which would take the S&P 500 index from just over 95 in 1979 to more than 1469 over the next 21 years.

If you want an extreme view of gloom and doom, then consider this quote from Time Magazine:  “In a normal rebound, Americans would be witnessing a flurry of hiring, new investment and lending, and buoyant growth. But the U.S. economy remains almost comatose a full year and a half after the recession officially ended. Unemployment is still high; real wages are declining… The current slump already ranks as the longest period of sustained weakness since the Great Depression.”

Sounds pretty awful, right?  Except that this is a quote from Time’s September 28, 1992 issue, talking about the gloomy prospects for the economy coming out of the 1990-91 recession.  It reflected the mood of economists and the country at large–and, with the generous benefit of hindsight, we now know that this severe downer of an article was followed by a 16 year economic boom in the U.S. economy, without a single down year until 2008.  The S&P 500 ended calendar 1992 at just over 435, and climbed, with more ups than downs, to just over 1576 at the peak in 2007.

There are good reasons to be cautious in today’s economy and investment markets.  We don’t know what the markets are going to do tomorrow or next year.  But the good news is that everybody else doesn’t too.

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Separate Politics and Investing

When it comes to investing, emotions are probably the single biggest obstacle to success for most investors.  Since strong emotions often accompany politics, we feel it’s important to try and minimize politics when gathering our investment research and implementing investment strategies.

Given that there are plenty of examples of the economy and markets doing well and examples of it doing poorly with every combination of party control, we believe that the business cycle is simply much more powerful than politics.  Of course in countries like Cuba and Venezuela that is not the case, since the government controls so much, but this is the United States and we are one of the most market oriented nations in the world.

As for individual investors, we have noticed that efforts of all the political actors to motivate their base around the time of elections can be a particularly dangerous time for those whose political beliefs are strong.  For this group, it is probably even more beneficial that they have us, or a trusted professional third-party in place, to implement their investment strategy.

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Understand Your Risk

In today’s economic environment, safety is at a premium but bank account rates remain at historical lows.  This has persuaded many investors to look for higher yields with their safe money.  In some of these situations, they are finding products that are advertising a 7-9% return.

We found a real-world example described in this Bloomberg article that should make you think twice about higher-yielding “fixed” investments.  The article provides a clear picture of how stretching for yield in a bond investment can leave you wondering why you just took a 30% loss.

Many of these so called “safe, high-yielding” investments are made up of Structured Notes, Derivatives, and CMS curve notes.  As explained in the article, these are all complicated derivative type investments being pitched as safe alternatives to bond investments.  Many retirees now are being seduced into purchasing these products without fully understanding the risks involved.  Structured note sells alone are up 58% from last year as people look for ways to earn more than what they would earn in their bank account because of the rock bottom bank account rates.

Another area of these products to investigate is the increased fees being charged by those who sell them.  One of the products described in the write-up earned a fee of 5.1% in which half was used to compensate the brokers selling the convertible bond.  This is nearly 5 times the average expense ratio of your average mutual fund.

Make sure you ask questions about any investment you are considering and remember if it sounds too good to be true…it probably is.

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Riding the Roller Coaster

This is normal.  Many people simply cannot handle stock market volatility, which is why the people who DO have, historically, tended to make more, over multiple ups and downs, than the people who kept all their money stashed away in Treasury bonds.

The question is: is there better way to handle the inevitable anxiety that comes with buying stocks?

Psychologist Ken Haman, who now works at the investment firm AllianceBernstein, says that the key is to stay rational.  He points to studies of the human brain which shows that all of us actually have two brains.  One is the neocortex, where all of your higher thought processes take place.  Below the neocortex is a primitive brain which is about as smart as an alligator, and this lower brain happens to be where all of our survival instincts are housed.  Whenever you experience panic, the primitive brain immediately takes over and shuts down the neocortex–which allows you to respond instantly (rather than thoughtfully) on those many occasions when a saber-toothed tiger is running in your direction.

So when the markets have spent the past quarter giving up all the gains they generated in the first quarter, what do you do?  First, talk with somebody who actually listens to you about how you’re feeling.  Then start to engage your neocortex.  What do you imagine is going to happen in the future?  Then move to: is that what you think, or how it feels?

If you’re talking with a professional advisor, the advisor can guide you through this process, and then, when your neocortex is functioning again, you can look at some of the past market declines and see what happened next, or look at your financial situation and take stock of your progress toward your financial goals.

People who can handle the stock market roller coaster without getting sick seem to have an unfair advantage over everybody else in the investment world.  It seems to depend on which part of your brain is in control.

This is post written by Bob Veres.  He is the publisher of Inside Information, an industry leading publication for financial advisors.

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Making use of the Gym

Why do we do this?  Until recently, researchers had no idea what made us act so strangely.  But now, a few studies are helping explain how we make decisions, and the results are funny.

David Laibson, an economics professor at Harvard, has conducted research which suggests that people do fairly complex mental accounting whenever they make decisions, and count future rewards (or efforts) as half as important as present rewards or efforts.

How does this work?  Suppose you get up in the morning and face the decision of whether or not to go to the gym.  In your mind, the effort of putting on your sweats and driving the health club on any particular day can be given a hassle factor of 6.  The benefits (being more healthy and in better shape) can be assigned a benefits value of 8.  But the future benefit is discounted by half, so it has an effective weight, in your decision-making, of four.  Since 6 (the hassle) is greater than the benefit factor of 4 (eight divided by two), your mind decides to skip today’s workout.

In mathematical terms, Laibson says the decision to exercise today can be defined by the equation (-6) + (8/2) = -2.  The negative result means that the future benefits are not worth the immediate investment.

So why do people buy memberships in the gym in the first place?  Laibson offered an analysis of the PLAN (or resolution) to exercise, and the numbers come out very different.  The intention to go to the gym three times a week costs nothing.  The future effort of going to the gym (-6) will be discounted by half, and so will the benefits (+8).  Therefore the mental equation you use when you buy the gym membership be defined as 0 [the "cost" of planning to go to the gym three times a week] + (-6/2) + (8/2) = 1.

“Planning to go to the gym is a win,” Laibson explains, “chiefly because the planning itself costs nothing.

In a confirming bit of research, two of Laibson’s students surveyed health and fitness facilities in the Boston area and found that the average cost of a gym membership is $75 a month.  Because people swipe their membership cards into the machines as they enter, there are fairly detailed records of how often members actually go.  The researchers found that the average person goes to the health club four times a month, which means the average cost per visit is $19.

But…  Laibson’s students found that these health clubs typically offered a $10 “pay per visit” rate.  Clearly, the people who bought their memberships intended to go at least twice as often as they actually did.  The mental equation around planning produced a very different outcome from the mental equation around execution.

Is there a way to change this mental accounting?  Laibson suggested that you hire a coach who will hold you accountable–adding a hassle factor if you don’t go to the gym.  Or arrange to meet a friend there three days a week, adding the hassle factor of disappointing your friend if you don’t show up.  Or, if you want to do it more positively, promise yourself that you’ll reward yourself with a fruit smoothie after you exercise, adding something positive to the mental equation.

This article was written by Bob Veres.  He writes for several national publications and publishes a monthly newsletter titled “Inside Information.”  You can find more info about him here http://www.bobveres.com/.

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