As a parent of four children, I often say how  my children have “no fear.” It’s interesting  how children learn over time, typically by  trial and error. Of course once a child  figures out the last time a specific action  injured them, it is at that time, fear registers  and they rethink the action again.

Unfortunately, we don’t have the luxury of  trial and error in portfolio management.  However, we do have the historic data of all  the years of investing under different  economic conditions. Similar to the  reasoning of past experiences, we can  determine how best to proceed so that we  may preserve the integrity of our portfolios  under various conditions.

Investing can appear to be frustrating and  confusing when the world looks as it does  today. Often times we look at current  economic data but don’t take the necessary  “step back” to assess the real landscape prior  to making the next step. Perhaps the  information we will share in this news brief,  will help you to gain perspective of this  landscape. Late in January seemingly  insignificant demonstrations for leadership  change in Tunisia spread across northern  Africa into Cairo, Egypt. The 18-day  political insurrection in Egypt ended in the  ouster of President Hosni Mubarak from  power. Protesters carried the regime-change  demonstrations into Yemen and Bahrain but  when the citizens of Libya called for the  removal of Libyan leader Moammar  Gaddafi’s regime, an all out Civil War  began. Under the threat of massive  genocide, the US military as part of a  coalition, stepped in to enforce a no-fly zone  that seemed to include tanks and other  offensive weapons installations. In the  middle of all this, a massive 9.0 magnitude  earthquake hit off the coast of northern  Japan. As if the devastation from the  earthquake were not enough, it was  immediately followed by a massive tsunami  that resulted in waves 70 feet high hitting  the coastline of Japan with such incredible  force that it wiped out nearly everything for  miles inland, including a major nuclear  reactors’ cooling system. Recently, it was  announced that Japan’s nuclear accident is  on par with Chernobyl!

The Market Reaction

Commodity prices soared, especially oil  which hit $106 per barrel before settling  back. Businesses warned of lower earnings  due to the higher cost of energy. The stock  market fell nearly 7% in a matter of days  before recovering. Commodity prices also  recovered, as gold and silver as well as grains moved to new highs. Interestingly,  uranium prices did not recover as future  plans for nuclear reactor construction in the  country, once supposed to be a big part of  our future, were quickly set aside. Now, oil  drilling licenses are again being given to  drillers looking to increase domestic  production.

Where is the FEAR?

Global equity markets have shown positive  closes in spite of what is happening around  the world. Keep in mind Spain and Portugal  are experiencing significant fiscal problems  which continue to impact the Euro. Gold is  hitting new record highs…..Silver, tin, corn  and wheat are all moving higher. Corporate  bond spreads show the risk appetite that is  out there. Even the Euro Currency is off to  its best year since its inception twelve years  ago. The pound and Aussie currencies are  up as well.

Real Facts Worth Remembering 

• All of the monetary easing the Fed  has done is sitting on the balance  sheets of banks.
• Investor sentiment on stocks is  almost as bullish as it was in 2007.
• Energy and food now absorb 23% of  US wages and salary. This is a “Red  Flag” for the American consumers.
• Real average weekly earnings are  turning negative year over year  despite the job creation you are  hearing about.
• The economy may create some jobs,  however, it would take nearly five  years to get back to the pre-recession  peak in the employment-topopulation  ratio.
• Typically, at this stage in an  economic expansion, the level of  payrolls is at a new all time high.  This is not the case in the current  “recovery.”
• The US Economy has slowed to  2.0%-2.5% growth in Q1 from a near  4% increase in Q4; same pace looks  likely for Q2.
• Corporate balance sheets are strong  but the earnings outlook is not as  clear as it as been in past months.
• The US economy is going to feel  some major withdrawal symptoms in  the second half of the year as Fed easing ends and the government  stimulus begins to fade.

Home Prices Still Bottoming

• The S&P 500  Homebuilders are down 13% from  this year’s nearby peak.
• Unsold inventory of new homes has  expanded from 6.8 months’ supply in  December 2010 to 8.9 months  currently
• Both median and average prices for  new homes have sagged at over a  60% annual rate!
• It’s still taking over eight months for  homebuilders to close the deal on a  new home.
• There are over 3.7 million homes that are vacant and are for sale. This  is 30% above normal. In addition,  there are some 2 million homes that  are “distressed” or in the pipeline of  foreclosure properties.

Inflation/Deflation

• Inflation: is a rise in the general level of  prices of goods and services in an economy  over a period of time.
• Deflation is a decrease in the general price  level of goods and services.

The debate on inflation and deflation has  been quite lively on Wall Street and around  the world of finance. Nearly every media  appearance I have been involved with  centers around this debate. The below  missive is representative of the many recent  meetings we have had with our investment  team and portfolio managers:

The US Government has been issuing a  tremendous amount of debt and financing  our economic growth by having the one part  of the Government (The Federal Reserve)  buy it from another part of the Government  (The U.S. Treasury). They are  accomplishing this through banks (or other  intermediaries as the media states) so  essentially it looks better than just giving  enormous amounts of money to the  politically connected.

The Federal Reserve’s Quantitative easing  (QE1 and QE2) are slated to end at the end  of July, at which time the government will  be less able to finance itself internally.  While the Fed could choose to step in with  further Quantitative Easing, we find that  doubtful, at the very least not without  material weakness appearing in markets  first. The basic problem is that the US still  requires external funding, and it seems that  our creditors have become all too aware of  our money printing tendencies. At this level  of self-funding, we are already seeing dollar  revulsion, and any further action along those  lines will only make it worse. We cannot  totally self- fund without an accelerating  devaluation of the US dollar.

The Federal Reserve continues to print  money. Inventories have risen to high  levels. Gas prices in some areas are near  record highs. Even the CPI (consumer price  index) numbers have been showing high  inflation (close to 5%), while alternative,  free market measures show something closer  to 9%. In order to continue to keep this  credit bubble of “economic steroids,” we  will need even greater sums of money. To  get back to 2007 credit conditions we would  likely need over $2.5 Trillion. This would  likely create $5 gas and cause millions to  starve due to high food prices. It’s hard to  believe, but some market pundits want to reinflate  the last economic bubble.

We have yet to take the potent medicine and  solve our fiscal problems. Look at what has  happened and continues to happen to some  European countries… namely Spain,  Portugal and Greece. Interestingly, the  stock market is not likely to go down all that  much until the “punch bowl” of stimulus  begins to limit its servings. It’s likely by  June we will see this decreased flow of  easing, which may affect market values and  bring increased volatility.

It’s increasingly clear that credit creation  will still be coming from the Federal  Government, as even the hard-line budget  conservatives are only talking about minute  changes in deficit growth. It will come as a  likely increase in long term interest rates.  This potential increase in interest rates could  see stocks fall in the back half of 2011 as the  lack of direct government stimulation should  at least lead to deflation in the riskier assets  (stocks). It’s also worth noting that the Fed  intends to reduce their balance sheet in the  future. They cannot hold the US debt they  bought indefinitely, this will likely be an  additional headwind that the markets will  eventually have to contend with. The JJ  Burns and Company Investment  Management Team greatly questions how  much the Fed will “push” when they see the  markets go down even a little. The  medicine is difficult to stomach, however, it  is necessary.

Economically, America has spent the last 2  years “kicking the can” down the road, and  it seems like we’re having a harder time  doing any more kicking. Perhaps the  “kicker” may be higher interest rates. The  effect of higher interest rates in itself does  not spell disaster; however, the economic  sustainability going into 2012 could prove  daunting.

Portfolio Management Changes

For now inflation is in charge, so we have  been increasing commodities such as gold  and other hard assets inside our portfolios.  The added layers of diversification are  essential keys looking into 2012.  Alternatives Assets continue to become a  larger part of the overall asset allocation and  we see this area growing as it helps to  preserve capital and reduce volatility in the  portfolio. Most importantly, however, for  income based investors, we look toward  continued preservation of capital by  shortening bond maturities, adding bonds  whose coupons will step-up with interest  rate increases and, where appropriate, add  interest rate hedges to preserve principal  while maximizing income. Finally, high  quality stocks will continue to be a mainstay  of our portfolios, just in a smaller allocation  than average. As the economy ebbs and  flows, we anticipate market pull backs. We  will look to utilize these downturns to add  equities that are fairly priced, have long term  growth prospects and good management  teams.

We must have great resolve to understand  that we are far from solving the problems of  our economic system. We may see markets  rise on no clear fundamentals, or perhaps not  contracting on any levels of fear. What is  vitally important is to understand and  regularly revisit your own personal  investment goals over the long run and to  make certain your portfolio matches your  risk tolerance so you can “sleep at night.”

As spring flowers arise, we wish you the  blessed joys of a new season, health,  happiness and prosperity.

JJ Burns, CFP
President & CEO

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Disclosure: J.J. Burns & Company, LLC is a registered investment adviser with the U.S. Securities & Exchange Commission and maintains notice filings with the States of New York, Florida Pennsylvania, New Jersey, Connecticut, Georgia, Illinois, North Carolina, and California. J.J. Burns & Company, LLC only transacts business in states where it is properly registered, or excluded or exempted from registration. Follow-up and individualized responses to persons that involves either the effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, as the case may be, will not be made absent compliance with state investment adviser and investment adviser representative registration requirements, or an applicable exemption or exclusion.

All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.

The foregoing content reflects the opinions of J.J. Burns & Company, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct.

Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.

Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.