Client Communications

Third Quarter, 2012

1. It was an Eventful Quarter

2. The Power of Central Banks

With stock market returns in the low-to-mid teens for the first nine months of the year, it seems safe to say that the more recent collective measures taken by the world’s central banks have overwhelmed all of the other negativity that is constantly presented in the media.  In the past 2 months both the Fed and the ECB have taken potentially game changing aggressive courses of action to reflate their economies.  It is well documented that investment markets are forward looking, and that expectations carry more weight than yesterday’s news.  So, what do markets see that the financial press, the media in general, and most everyone else is missing?  The theory which makes the most sense to us is that we are in the midst of a powerful, global reflationary effort on the part of governments around the world.  During the third quarter:

  1. The Federal Reserve began a third round of monetary stimulus, this time promising an open-ended program of purchasing $40 billion of mortgage backed securities every month, all but guaranteeing that mortgage rates will stay low and possibly decline further in the months ahead.  This effort is now occurring at the same time that the Fed continues to purchase (through year end) long term treasury bonds with the cash coming from the sale of short term treasuries out of its portfolio (a program known as Operation Twist).
  2. In a similar fashion, the ECB has announced a program of unlimited purchases of sovereign debt and bank debt from those countries which formally apply for such assistance.  This announcement helped to calm European debt markets and precipitated a dramatic upward move in European stock markets in a matter of just a few weeks. 
  3. China has announced a series of moves to spur infrastructure spending and bank lending during the third quarter, and has pumped substantial amounts of money into the banking system.

In years past, a common Wall Street piece of wisdom was “Don’t fight the Fed”.  Now, and looking ahead to 2013, that mantra might be modified to: “Don’t fight the world’s central banks”.

Fourth Quarter and Beyond

The expectation among Wall Street analysts is that corporate America will experience a 2-6% decline in year-over-year earnings beginning with this year’s third quarter to be followed by a further decline in the fourth quarter.  If this view proves correct it will be the first year-over-year earnings decline in three years, according to Factset Research.  Companies are actually starting to exhibit the effects of slowing global trade and reduced consumer and corporate spending.  In addition, many individual investors, clients of ours included, have assumed what we will call a “bunker mentality” given “fiscal cliff” fears, a lack of implementable solutions to our growing budget deficits, and of course, the European mess.

A growth slowdown however is not necessarily the precursor to an economic catastrophe.  In fact, the International Monetary Fund, in its latest global economic assessment, is calling for 3% global GDP growth in 2013.  Three percent growth is not the same as a recession with all of its negative implications.

Unfortunately there are signs that the anemic economic recovery since the recession ended in early 2009, may portend the onset of a prolonged period of slow economic growth.  Our research reveals that growth in consumer spending, which constitutes approximately 70% of GDP during the past decade, has lagged significantly in this recovery, relative to all other economic recoveries with the exception of the 1929 economic cycle.  This fact is one of the considerations taken into account by the Federal Reserve in its strategy to keep downward pressure on interest rates through 2015.   The Fed did not randomly choose mid 2015 as the ending point of its reflationary effort.  Instead, that is the timeframe it believes is required, given the current slow recovery rate, for the economy to absorb all the slack in the system. 

A variety of factors are contributing to our present slow-growth phenomenon including:

  1. A very deep sense of uncertainty on the part of individuals and businesses about the future of the economy relative to that type of feeling during the past 30 years. Politicians bear a significant responsibility for this malaise given their increasingly polarized and uncompromising behavior (see following chart).
  2. The elimination of the consumer wealth effect resulting from two decades of rising home prices.  In its place, most consumers have experienced rising levels of debt relative to net worth since the housing bubble burst.  Wealth creation has morphed into wealth erosion until very recently when this trend appeared to be reversing.
  3. (*) The early stages of what appears to be a permanent increase in the unemployment rate as robotics take over a growing array of increasingly sophisticated job functions previously undertaken by humans.
  4. (*)  The demographic tidal wave of ageing baby boomers whose spending needs, in areas other than health, decline with the passage of time.

    Even if this analysis proves to be 100% prescient of future rates of economic growth it will nevertheless be impossible to translate this wisdom into a predictable future rate of return for the stock market.  Instead, experienced portfolio managers can only focus on the riskiness of markets based upon 1) metrics such as P/E levels and dividend yields, and 2) the rate of change in variables such as inflation which tend to shock the economic system.

*These last two factors are particularly disconcerting because they are not political in their origin, nor are they reversible.  To the contrary, both factors can be expected to present a growing headwind to economic growth for decades to come.

Homer's THE ODYSSEY: Odysseus' 10-Year Journey Home

Scylla and Charybdis

The Odyssey is an example of one of the world’s great books, defined as one that speaks to us through the ages.  Books such as these maintain their relevance to our life experiences today by illustrating how others managed to navigate through their own lives’ obstacles in pursuit of their own ends. A wonderful example of this form of literature can be found in Homer’s masterpiece, The Odyssey, which traces the 10-year ordeal faced by Odysseus and his men as they attempt to return home to Ithaca after a 10-year siege of Troy.

At one point in his journey Odysseus must steer his ships through a narrow stretch of ocean threatened by a six-headed sea monster, Scylla, living in a cave on one shore and a periodic whirlpool created by Charybdis towards the other side.  The story is an apt metaphor for the perils found by investors in their own journeys toward their long-term financial goals:  risks always abound.  If you are unwilling to take a controlled level of risk, you cannot expect to achieve longer-term goals.  As Odysseus and his crew approach this narrow body of dangerous water, he exhorts his men to hue towards the Scylla side to avoid the whirlpool that will likely result in the destruction of his ships.  As bad luck would have it, Scylla emerges from her cave in the cliff above the water’s edge and each of her six heads devours one of Odysseus’ sailors.  Just as Odysseus frequently experiences losses among his men on his journey, so too in long-term investing, losing money on your portfolio from time to time is unavoidable.

For Odysseus there can be no abandoning his quest to return home.  Moving beyond the reach of Scylla, Odysseus’ ships nevertheless get caught in the vortex of Charybdis’ periodic whirlpools.  His ship is sucked down into the swirling waters but Odysseus grabs a branch from a fig tree growing on the side of the cliff and hangs there until Charybdis vomits up the remnants of the ship into the now calm waters, allowing him to ultimately resume his voyage, though with a much reduced crew.

Throughout his journey trouble constantly befalls Odysseus.  Many times he uses his intellect to make good decisions, but on other occasions he allows his emotions to overrule clear thinking leading to foolish risk taking, just like the rest of us, along our own journeys.  The Odyssey doesn’t offer us answers, but it does illustrate how a single-mindedness of purpose and a clear vision of an end goal can help get us through, or around, the obstacles which life constantly throws at us.

Performance Analysis by Risk Category


9-month Benchmark Index Return



Moderate Aggressive2






1. 65% MSCI ACWI; 20% Barclays U.S. Corporate; 15% Dow Jones-UBS Commodity
2. 55% MSCI ACWI; 35% Barclays U.S. Corporate; 10% Dow Jones-UBS Commodity
3. 45% MSCI ACWI; 45% Barclays U.S. Corporate; 10% Dow Jones-UBS Commodity
4. 35% MSCI ACWI; 55% Barclays U.S. Corporate; 10% Dow Jones-UBS Commodity

Index Returns:                                       3rd Qtr.           9 months
U.S. Treasury Bill return                          0.0%                   0.0%
MSCI All World Stock Index                    7.0%                 13.4%
U.S. Investment Grade Bond Index        3.8%                   8.7%
DJUBS Commodity Index                      9.7%                    5.6%
CPI (12 months through August, 2012)                            1.7%

Stocks remain attractively priced and many offer very attractive dividend yields, a good combination for acceptable returns for long-term investors.  Throughout the third quarter we continued to overweight U.S. equities verses non U.S. equities, given our safe-haven status, but towards the end of the quarter Mario Draghi’s new plan for Europe created a strong price surge for European equities.  Our expectation is that the Fed’s two current programs – Operation Twist and the unlimited purchase of mortgage-backed securities – will continue to favorably impact risk assets for the balance of the year, at least.

Fixed Income
In general, our domestic bond markets enjoyed a relatively uneventful third quarter.  Corporate bonds of all types generally outperformed treasury securities as investors became more relaxed about lowering crisis expectations.

At one point near the close of the quarter it began to look like interest rates were starting an upward trend precipitated by the ECB decision to purchase distressed bonds as discussed above and an announcement by China to significantly ramp up infrastructure spending.  As a result of these two events we sold most of our client’s longer-term treasury bond funds out of concern that interest rates may have seen their lows for the year and that an upward trend had begun.

Our current strategy is to maintain client portfolio holdings of what is known as “spread product”: bond funds and individual bonds that offer yields above those for treasuries.  These investments include mortgage backed securities funds, hi-yield bond funds, bank loan funds and various individual corporate bonds.

Simultaneous aggressive reflation efforts by the Fed, the ECB and other central banks are expected to push the price of gold higher during the next few years.  In addition, today’s negative real returns (after inflation) from treasuries out to 10-year maturities represent another incentive for gold ownership.  Finally, severe labor unrest in South Africa is causing mine closures across a variety of extractive industries which in turn has led to curtailing supplies and rising prices.  We are maintaining client gold ownership at between 5-7% of portfolio total value at this time.

Industrial and agricultural commodity funds benefited during the third quarter from a combination of central bank reflationary efforts and severe drought conditions at home and abroad.


Stock Talk

This section presents a brief introduction each quarter to a company that is widely-owned by SIMI clients.  Its purpose is to add a little color to a quarterly report that otherwise deals primarily with facts and figures.

Prosafe SE (, a Norwegian company, is the world’s leading owner and operator of semi-submersible “accommodation rigs” and is also the leading supplier of such rigs used in harsh environments like the North Sea and hurricane-prone regions in the Gulf of Mexico.  The company’s eleven rigs operate in waters around the world.  A twelfth harsh environment rig, now under construction, will be added to the fleet during the second quarter of 2014.  

Accommodation rigs are positioned alongside drilling rigs and provide a variety of services including living accommodations for between 300-800 rig employees, catering and medical facilities, firefighting equipment, offices, workshops, and recreation and storage space.  Employees move between the accommodation rig and the drilling rig by means of a telescopic gangway.

The majority of Prosafe’s operations are related to low risk maintenance and modification of rigs in producing fields.  A smaller portion of the company’s activities relate to rig commissioning and decommissioning activities.

Demand for accommodation rigs is expected to increase in future years as a growing number of new drill sites are located offshore around the world, frequently in harsh environments.  In addition, many offshore fields are taking advantage of technological advances in oil recovery techniques that either extend the life of existing wells or allow for further extension of field boundaries.  Prosafe believes that the market for its services will be “buoyant” over the coming years as a result of field life extensions, aging infrastructure, and new large discoveries.

It is Prosafe's policy to pay out approximately 75% of the previous year's net profit as a dividend to shareholders. This policy has led to a near 100% dividend increase over the past four years. Based upon the payout policy, the stock currently yields in excess of 6%.

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We leave you with this parting thought:

In times like these, it helps to remember that there have always been times like these.”
– Paul Harvey, syndicated radio commentator (1918-2009)

As always, we look forward to discussing with you any thoughts or questions you may have regarding the contents of this letter.

Sheffield Investment Management, Inc.