One impediment to stronger growth is the debt burden the U.S. and other developed countries find themselves under. As annual budget deficits reach record amounts, overall government debt is piling up quickly.

The current fiscal predicament is not the making of the Great Recession alone. However, it did quickly bring longsimmering fiscal pressures to a boil. The U.S., like Japan and many developed economies in Europe, suffers from an aging population and rapidly rising healthcare costs. This situation has long been anticipated, but the financial crisis and economic contraction of the last several years accelerated the day of reckoning, as governments were forced to borrow and spend heavily to avoid even worse outcomes.

In the U.S., the federal government’s debt-to-GDP ratio has surged by some 30 percentage points in just the past four years. The current ratio of publicly traded debt to GDP is close to 65%, the highest since World War II and well above the approximate 40% average of the postwar period. This reflects the downward pressure the recession has had on tax revenues, due to higher unemployment and lower payroll tax collection, as well as increased government spending on unemployment insurance claims and other social-safety-net programs, and also the government’s multifaceted response to the financial crisis. Put another way, demands on the federal budget were soaring at the same time receipts were tumbling.

The total budgetary cost of the Great Recession is expected to ultimately top $2.35 trillion, equal to more than 15% of GDP. The cost to taxpayers was substantial but would have arguably been greater without the government’s aggressive policy response, as the economy would have almost surely suffered a depression.

With fiscal deficits projected for years, the question becomes: how much can the U.S. borrow before reaching a tipping point at which the size of the national debt becomes so large it undermines the economy?

The concept of fiscal space can be used to determine how close a government is to this point of no return. Fiscal space, a concept introduced by the International Monetary Fund (IMF), is defined as the difference between a nation’s sovereign debt-to-GDP ratio and the limit beyond which the nation will default unless policymakers take fiscal steps that are outside of anything they have done historically.

The amount of fiscal space, or the capacity to add additional debt, is affected by a country’s economic growth rate and the interest rate it pays on its sovereign debt. Not surprisingly, nations, like the U.S., that enjoy stronger GDP growth and lower interest rates have higher limits and more fiscal space than those that do not.

Analysis conducted by Moody’s Analytics suggests that U.S. still has some room to maneuver. In fact, Moody’s estimates that U.S. debt could increase by roughly 70% and 10-year Treasury yields could rise to nearly 9% (currently 2%) before incurring a serious fiscal problem. This is not to say that U.S. policymakers can be complacent. Given a budget deficit equal to 8.5% of GDP in fiscal 2011 and large deficits likely for a number of years even under the most optimistic assumptions, the borrowing capacity of the U.S. will shrink quickly. At the same time, it is neither necessary nor desirable to do too much too quickly. After all, nothing will push the U.S. to its debt limit faster than another recession.

It is easy to understand why investors are unnerved. Between April and October of last year, U.S. stocks dropped over 19%, the worst decline since 2008. At the same time, daily volatility intensified. During the third quarter, the S&P 500 moved 2.4% on average between its intraday low and high. The Dow Jones Industrial Average alternated between gains and losses exceeding 400 points on four straight days in August—the longest streak ever. With such dramatic swings, investors seemed to lose confidence that stocks were trading based on any fundamental measures or valuations. As a result, many opted for the relative safety of cash and bonds.

Similar to individual investors, hedge funds have also grown weary of stocks. As a group, hedge fund stock exposure is now only slightly greater than it was during the March 2009 low. In the spring of 2009, hedge funds were caught leaning the wrong way as the market bottomed, then quickly moved higher. We suspect late 2011 and 2012 could follow a similar pattern.

In terms of earnings and other valuation measures, stocks look very favorably valued. The S&P 500 currently trades at 13.5 times reported earnings, which is much less than the average P/E ratio of 16.4 since 1954. Overall, earnings for companies in the S&P 500 are expected to be up 7.5% in the final three months of 2011 versus the same period in 2010. And even if fourth quarter earnings (which are starting to be released now) prove disappointing, earnings for 2011 will still be more than 10% above 2010 earnings.

More importantly, based on consensus estimates, earnings are expected to rise again in 2012, reaching more than $105-per-share for the S&P 500. At current stock prices, this would mean a P/E ratio of only twelve. The last time stocks were that cheap on an earnings basis was in the mid-1980s. At that time, more than 25 years ago, 10-year Treasury yields were between 7%-9%. This compares to yields of less than 2% today. In other words, in the mid-1980s, Treasury bonds yielding in the high single digits were a very attractive, riskfree alternative to stocks. But today, stock earnings are being valued no more favorably than in the mid-1980s, even though the riskfree alternative to stocks today is yielding less than 2%.

In addition to earnings, other valuation measures paint a similarly favorable picture. For instance, the ratio of debt to assets, which measures the financial strength of companies, reached its best level since 2002. And, stock dividends continue to rise, with the yield on the S&P 500 now greater than 2%, which is also higher than the yield on the 10-year Treasury. It has been more than 50 years since the dividend yield on stocks has been above 10-year Treasury yields.

Today’s low-yield environment has investors wondering where to turn for attractive yields. Of course, higher yields come at the price of higher risk, but one higher-risk area which offers an attractive reward trade-off is high-yield bonds. Our preferred high yield bond investments currently offer yields better than 7.5%, which is net of any defaults within the portfolio, and much higher than other bond classes. Considering that inflation in the U.S. is below 2%, and that the U.S. economy is expected to keep growing, we believe high-yield bonds continue to offer attractive yields for long-term investors interested in income. In addition, due to their modest correlation with stocks (about 50%), high yield bonds can add meaningful diversification to portfolios, as well as potentially attractive returns.

Low expectations and attractive stock valuations, coupled with under-invested individuals and institutions, have created an environment in which the market could easily move higher. While we are not expecting a breakout year in terms of economic growth, we are expecting growth, and feel like the market still has some catching up to do from last year’s selloff. Furthermore, we expect 2012 will see lower volatility, making it easier for investors to return to stocks.

Lest we sound too optimistic, economic problems still abound. At this point, aggregate demand is still too weak to justify a strong resurgence of hiring. While it is likely that job growth will strengthen in the first half of 2012, the improvement will be gradual as uncertainties continue to undermine business confidence. Put another way, we expect firms will typically continue to hire only on an as-needed basis, and not make bold hiring moves in an attempt to spur company growth. As a result, the unemployment rate is expected to remain stubbornly above 8% through 2012.

Europe has now been pushed into recession by a lingering debt crisis. However, U.S. stock prices, in spite of dramatic volatility, are little changed since Europe’s problems surfaced nearly two years ago. It is easy to construct dark scenarios in which Europe loses the political will to hold the Euro zone together in its current form, and its economy enters a deep recession with significant spillover affects on the U.S. and other global economies. But this seems like a less likely outcome as Europe’s leaders are showing greater determination to work through the current issues.

In addition, the U.S. Federal Reserve and other global central banks have teamed together with the European Central Bank to provide funds to the stressed banking system. To the relief of financial markets, these powerful central banks seem to be signaling that they will not allow a major bank to fail from a lack of liquidity.

If policymakers successfully stabilize financial markets, Europe’s downturn is expected to be relatively mild, lasting only through the middle of 2012, with real GDP in the euro zone falling no more than 2%.

In late December, lawmakers passed a two-month extension of the payroll tax cut while continuing to negotiate a yearlong extension. Though both sides appear to agree on a yearlong cut in principal, reaching a final agreement was again bogged down in partisan wrangling.

Reaching an agreement to extend the 2-percentage point payroll tax rate reduction enacted for 2011, and the emergency unemployment insurance program, will have a meaningful impact on 2012 economic performance. Together they will be worth close to 0.9 percentage point on 2012 GDP, but would also cost taxpayers nearly $175 billion.

Given the lackluster economic recovery, it seems likely that policymakers will come to some agreement, because not extending the payroll tax reduction will prove to be even more costly if the economy slips back into recession.

With the heightened political and economic uncertainty,it is hard to see businesses expanding operations more aggressively through increasing investment or hiring anytime soon. Still, businesses have the financial wherewithal to do so—profits are strong and balance sheets are sturdy—but caution is still being practiced in the wake of the Great Recession, and events in Washington and Europe do little to bolster confidence.

Historically, economic recoveries have evolved into selfsustaining economic expansions when businesses decided to take a leap of faith and expand without knowing for sure whether demand justified the additional production.

The current business cycle appeared to be following a similar pattern early in 2011, as firms began to increase investment and hiring. But this was apparently short-circuited by a surge in commodity prices, the Japanese disaster, the spectacle in Washington over the debt ceiling, and the European debt crisis. How long it will take to get the business cycle back into gear isn’t yet apparent, but it is possible that business investment and hiring will remain sluggish until after the 2012 election.

With businesses expected to remain cautious, 2012 is unlikely to be a breakout year for the U.S. economy. That said, real GDP is expected to post respectable growth in the range of 2.5%-3.0%, while creating as many as two million new jobs. However, the unemployment rate is likely to remain above 8%.

With modest growth and stubbornly high unemployment, inflation and interest rates are expected to remain low. Core consumer price inflation will stay well below the Federal Reserve’s implicit 2% target, which should allow the Fed to easily continue its zero-interest rate policy.

 The U.S. Federal Reserve, European Central Bank, Bank of England, and the central banks of Japan, Canada, and Switzerland have joined forces in an effort to ease the financial strain caused by the European debt crisis.  In a joint statement, the central banks stated, “The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.”

 In other words, central banks from around the world are stepping forward to ensure that banks have access to credit, so that the European debt crisis doesn’t snowball into a global credit freeze like the one experienced during the financial crisis of 2008.  Before the announcement, banks were becoming unwilling to lend to one another due to the uncertainty around which banks were most at risk to potentially bad sovereign debt.  Today’s announcement goes a long way towards restoring the confidence of the global banking system and sends a clear signal that central banks from around the world are prepared to take steps to prevent the European debt crisis from becoming a global contagion. 

Read More:

http://www.nytimes.com/2011/12/01/business/central-banks-move-together-to-ease-debt-crisis.html?hp

http://www.npr.org/2011/11/30/142940118/worlds-central-banks-act-to-ease-market-strains

By Chris Isidore @ CNN Money Markets, November 17, 2011

Bill Miller, portfolio manager who beat the S&P for 15 straight years will remain Legg Mason chairman, but in April he will give up his role of managing Value Trust that made him famous.

Read More:   http://money.cnn.com/2011/11/17/markets/bill_miller/index.htm

This is an intriguing article about what Kahneman calls the “illusion of skill”—the ingrained belief that we have the ability to accurately predict an outcome, despite overwhelming evidence to the contrary. 

According to Kahneman, “people come up with coherent stories and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness.”

The article describes how this is painfully obvious when it comes to picking stocks, where individual investors have a strong tendency to shoot themselves in the foot, and even professional managers consistently underperform the market.  As Kahneman says:  “overconfident professionals sincerely believe they have expertise….You will have to struggle to remind yourself that they may be in the grip of an illusion.”

Kahneman’s “over confidence” assumption resonates with us at CCM and this is one of many compelling reasons why we utilize passive investments such as index and exchange – traded funds in client portfolios.

Click the link below to read the article:

http://www.nytimes.com/2011/10/23/magazine/dont-blink-the-hazards-of-confidence.html?pagewanted=1&_r=1&emc=eta1

The market’s steep decline was sparked by the Federal Reserve’s announcement yesterday that it would begin further quantitative easing measures aimed at lowering long-term interest rates to stimulate the flagging U.S. economy.  This move by The Fed was widely anticipated, as dour economic conditions are well known.  But in spite of being widely expected, the market sold off sharply in response.

The Fed’s actions and commentary, coupled with the expectation that further Fed action will soon be necessary, left little hope the economy can regain momentum in the near-term.  Consumer and business sentiment has collapsed.  Hiring is at a standstill.  Economic fears are once again gripping the country, and spending and growth are almost certain to suffer.  In other words, the U.S. and much of the developed world may have already entered into a new recession.

Fear is high, be greedy

During periods such as this, when all hope seems lost, and the stock market looks like a fool’s bet, keeping a long-term perspective is paramount to investment success.  So to offer a bit of long-term perspective, please consider the following:

• The S&P 500 closed today at 1,130, the Dow at 10,734.  Both of these indices finished the day at nearly the same level they were just six weeks ago.  This is notable simply because the market’s dramatic drops over the last several weeks lend to the perception that stocks just keep going down.  The reality is that the market has been making dramatic moves both up and down, with the net effect of moving sideways within a jarring 8%-9% trading range.
• Even after the most recent plunge, the total return on the S&P 500 is actually slightly positive over the last twelve months.  The perception of the market’s performance is much worse, due largely to the fact that the market was strongly trending higher before the selloff.
• The Dow Industrial Average is up over 60% from its bottom reached in the spring of 2009.
• The yield on the 10-yr Treasury stands at roughly 1.7%.  Put another way, a “risk-free,” 10-year investment in government bonds will yield an investor a return of less than 2% per year.  Alternatively, the Dow Industrials offer a dividend yield of 2.5%, the S&P 500 yields slightly better than 2%, and real estate investment trusts (REITs) yield nearly 3.5%.  Put in this context, the “safety” of government bonds may not seem so safe.
• The S&P 500 is at the same level it was in 1998—thirteen years ago.  However, valuations today, compared against the heady days of the internet bull market, are compelling, especially when bonds are paying so little.

It’s said that bear markets end with a whimper, not a bang.  That is, investors become so disenchanted with eroding portfolio values, and the stream of negative economic news, that they simply give up hope and exit the market.  Unfortunately for investor’s net worth, this is most likely to happen near a market bottom when confidence is at its low point.

As advisors, we have had the unenviable experience of seeing this type of psychology work against investors during the bear markets of the last decade.  In a declining market, even the most sensible investment strategy can seem misguided and it is human nature to want to change something that doesn’t appear to be working.  We encourage our clients to avoid this temptation, just as we did during the dark days of the financial crisis.  We don’t think now is the time to sell.

We don’t have a crystal ball, nor would we claim the market cannot drop further, but we do hold a strong conviction that stocks are now favorably valued compared to other investment options and that long-term investors who are able to ride through these painful, but inevitable patches of volatility will be handsomely rewarded down the road.

Colorado Capital Management serves a wide variety of clients—all with different needs.  And of our clients, widows make up a sizable portion.  Friends and associates refer widows to us because, first and foremost, they trust us.  But, for the recently widowed, it goes far beyond trust.

As investment advisors, we construct sensible investment strategies that provide steady income and support ongoing financial needs.  But we also help navigate the process of settling the estate, we will establish trust accounts as needed, we review insurance coverage, and also help widows think through monthly living expenses and other financial matters.  All of this is done at a thoughtful pace, and with an abundance of respect for what our new client must be going through. 

If Colorado Capital can help you or someone you know, please call us.  Initial consultations are always free and without obligation.

Since the stock market peaked in May, economic growth and the prospects for future growth have both been downgraded. Forecasts of higher job growth have failed to materialize and the unemployment rate remains chronically high at 9.2%-nearly three years after the financial crisis of 2008 and the start of the Great Recession.

There is a tremendous amount of concern and pessimism being expressed right now regarding public and private debt levels, European debt problems, unemployment, government spending (or cuts to it), depressed home prices, underwater homeowners, falling consumer confidence, lack of credit, stagnant wages, sluggish demand, and so on. Things aren’t great, and the market’s decline only reinforces the fear that our fragile economic recovery might now be unraveling.

We fully appreciate that stock prices may continue lower, and the risk of recession has certainly increased. However in spite of this, we view the market’s current decline as acknowledgment of a slower recovery, but not the start of a new recession.

And even if the economy does struggle more than expected, we are not at all convinced that selling stocks would be an appropriate strategy. To illustrate why, let’s compare two standard bond and stock investments: the 10-year U.S. Treasury bond and the S&P 500 stock index.

At today’s levels, an investor can lock-in a 2.5% return for ten years by buying a U.S. Treasury bond. The principal and interest are guaranteed by the full faith and credit of the U.S. government, which is the good news; however, the bad news is that the 2.5% will also be the investor’s maximum return. And, once you factor taxes and inflation, the investor’s 2.5% return could actually turn negative in real terms.

Conversely, the same investor could instead buy the S&P 500 index, which can be thought of as small pieces of ownership in America’s 500 largest companies. Companies like GE, Exxon, Apple, IBM, Microsoft, and Procter & Gamble. By investing in the S&P 500 index, our investor would earn a dividend slightly above 2%. Not quite as high as the 10-year Treasury, but in the same ballpark. Of course, the investor will also have to live with the appreciation or depreciation of the share prices. But, if the choice was between the two investments for the next ten years, we suspect the stock market, in spite of its volatility and all the problems facing the global economy, will best a 2.5% return, and probably by quite a bit.

Our advice to long-term investors is to continue to focus on the long term, even while the short-term might appear bleak.

We welcome the opportunity to talk specifically about your portfolio and how recent developments might affect you. Please don’t hesitate to call us. We always enjoy hearing from you.