As the markets opened we were greeted with the news that Standards and Poor had lowered its “outlook” to negative for our nation’s long-term debt, with a potential downgrade of our AAA rating a real possibility. 

 This event has several implications. First and foremost, it should send a message to all our elected leaders that the days of politics as usual must come to an end.  While there seems to be almost universal acknowledgement of the unsustainability of deficit spending and runaway national debt, little is being done to rein it in.  Such behavior is obviously disconcerting.  As citizens and patriotic Americans, we must all insist that in order for a candidate to get our vote, there must be a real commitment to serious fiscal reforms.

The market’s reaction to the news resulted in a hard selloff.  Ironically, history has shown us that, while both the equity and debt markets experience selling pressure with such news, the equity markets substantially underperform the debt markets. It seems a bit odd in that the potential downgrade is coming from the debt side, but such is life in the capital markets. 

The current market correction will most likely last somewhat longer than it would have without such news.  In the short-term, we seem to be falling under the guise of the adage “buy the rumor, sell the news”.  In other words, the markets had a nice run up to start the year in expectation (rumor) of good earnings reports.  With the news being reported, the markets are correcting (selling), with profits being taken.

It is our intent to take advantage of this corrective phase depending on the level of the correction.  We continue to believe the markets will finish 2011 with positive returns.  The main caveat to that is, however, the price of energy.  As investors have flocked to buy energy, it has obviously driven up the price of oil.  If prices continue to raise much above the $110 a barrel level, it will hurt the consumer, slow the economy and create a less attractive stock market.

With the recent tragedy in Japan, our thoughts and prayers go out to her people.  Obviously, the aftermath of such a tragic disaster not only brings immense personal suffering, but also ushers in a time of economic instability, uncertainly and concern.  In light of these events, we have received several calls and emails from clients regarding what impact the Japanese earthquakes would have on world markets, so we thought it would be timely to address the issue. 

Japan, like most countries in our post recession economy, has been struggling to regain its economic sea legs.  The recent natural disaster delivered a punch of historical proportions.  In our mind, the question becomes, “Will this disaster be a knockout blow or another setback before a painful recovery?”  We tend to believe it will be the latter, primarily because Japan is a nation of resilient, determined and efficient people.  We saw a similar situation in Japan after WWII, and following the 1995 Kobe earthquake.  In each circumstance, the people of Japan received it as an opportunity to rebuild, modernize and encourage growth of new economic activity.  We have no reason to believe this time will be any different.

As it applies to the US, the overall effects on our domestic economy should be somewhat limited.  U.S. exports to Japan are less than 5% of our total exports.  However, the issues in Japan will most likely cause supply disruptions for specific industries, such as auto and semiconductor.  In fact, GM has already started seeing the effects of this supply shortage and had to shut down production in several areas.  Thus, while it may not have an overwhelming effect on our economy, it does raise a red flag in several sectors for us to avoid. 

In the end, the issues in Japan are disconcerting, but on the investment side, we must keep our “eyes on the prize” and that prize is economic growth.  Our economy continues to improve, as evidenced by the recent round of corporate earnings and economic indicators such as manufacturing growth.  We have been communicating with you over the last several months that we were due for a correction as the markets were stretched.  We believe that such a corrective phase is now underway.  That said, our economy is continuing to improve and this should lead to higher markets later in the year. We expect this correction to give way to higher prices later in the year and we will attempt to use the volatility to our favor.

In our March 2008 client letter, we stated:

“In spite of all the difficult times, our economy has always cycled back to prosperity.  Economic cycles, such as our current slowdown are the inevitable and natural result of a free economic system.  Without the ebb and flow of commerce, there would be no opportunity for successful investing.  Our Delta accounts are well positioned to take advantage of what we believe could be a time of very favorable upscale opportunity.”  That was 3 years ago…

So… what has actually happened?  Well the good news is the markets have indeed cycled back and doubled from where they were in 2008.  The only other times in our market history when we have seen a run this substantial and this quick was once in 1937 and once in 1939.

So… where do we go from here?  We believe, we will trade higher in a longer-term sense.  But, discretion being the better part of valor, we feel it may be time to take a few chips off the table in the short-term.  The economy is showing signs of recovery and it appears that job creation has begun.  That said, we are seeing a few short-term headwinds emerge: 

Oil and food prices are on the rise raising the specter of inflation.  Raising inflation, of course, is something which could act as a catalyst for slower consumer spending and mire the economy.

Interest rates are rising which is bad news for bond holders.  If they continue on their current path, it could also represent another drag on business and consumers.  Understand in this context, rates are moving higher from historically low levels. Thus, we are not overly concerned in a long-term sense.  Higher rates will also further dampen any recovery in housing.

Our expectations at this time, point to a market which will soon start a corrective phase.  We remain bullish longer-term and think the next couple of years will be good ones in the markets. 

However, if inflation heats up and interest rates continue substantially higher, they will come to public light sooner rather than later, and will almost certainly act as the driver for a short-term correction.  As a result, we my start taking some profit and raising cash.

We were very pleased with our 2010 year-end account performances and are thankful for the opportunity to serve you.  Additional, we are thankful for the many expressions of appreciation received from our clients.   In both our conservative (income) and aggressive (growth) portfolios, we exceeded our benchmarks in most cases in spite of a challenging and hostile economic environment.   

 As we now look forward to a new year, our team is again poised to deliver both solid results and excellent service to our clients.  To that end, we always welcome the opportunity to assist you with any financial planning or investment questions you may have.  Please do not hesitate to use us as your professional resource.

 We thought it may be helpful with this month’s letter to provide some insight in answering some of the most asked questions we are getting from our clients to wit:

 1.     Will we finally see a “real” economic recovery?

Yes… what has made us so much more optimistic?  The biggest positive has been a sharp improvement in the economic data.  The change in real GDP appears to be on track for about a 5% (annualized) pace in the fourth quarter of 2010.  If it holds, it will be the best organic growth pace since at least 2006.

 2.     Will the housing market see meaningfully recovery?

No… in fact the housing market is the only major sector of the economy where the news is not getting better.  Actually, it has actually trended worse.  The primary reason for this is the still-large excess supply, as only about one-third of the distressed residential properties have been unwound and absorbed.

 3.     Will the trade deficit shrink substantially?

No… while the deficit is likely to narrow a bit, a meaningful improvement is unlikely.  While an improving economy will help, we don’t expect a significant drawdown until 2012 or 2013.

 4.     Will the unemployment rate fall?

Yes… but not to levels anywhere near historic “Full Employment” numbers in the 4-5% range.  However, the relationship ratio between changes in real GDP and changes in the unemployment rate remains as close as it has ever been which should translate into higher growth and thus higher employment.

 5.     Will interest rates continue higher?

Yes… we expect a moderate increase.  The domestic above-trend growth coupled with strong momentum in the emerging world should outweigh decline in core inflation and translate into gradual increase of interest rates.

 6.     Will state and local budget crisis derail recovery?

No… while this problem is unlikely to get better quickly, the gathering pace of the recovery should support the continuing rise of state and local taxes.

 So… as the journey continues into 2011, please accept our best wishes for a prosperous and healthy New Year.

As we anticipated, the markets emerged from their summer lull with an impressive fall run.  While we still have substantial economic headwinds to work through, it appears that the summer slowdown may have been a correction in an otherwise more positive macro-trend.

 In a longer-term sense, we are guardedly optimistic for the potential of the capital markets.  From a “bigger picture” view, we see several positives as we extrapolate the data:

 Businesses are producing about the same GDP as in 2007.  Currently, this is being achieved with 7.5 million fewer jobs, which obviously reduces production expenses.  If growth is sustained, some level of additional hiring will also come into the equation.

 Corporate profit margins have recovered to levels seen only in a couple of previous expansions.

 Markets have experienced a good solid rally.  In fact, a majority of the S&P 500 stocks are trading at 52-week highs.

 With our market view tilting to the positive, we are turning our attention to finding the next level of market leaders we can invest in or rotate into.  One of the areas we are getting excited about is the financial sector.  With financials making up 40% of the S&P 500 index, it’s our position that the markets cannot push higher in coming years without financials re-taking a dominant leadership role.  Further, it is a sector in which we are beginning to get more earnings clarity.  In the real short-term, the markets are overbought and may correct to start 2011.  That said, if they correct “nicely” we will more than likely establish positions in this group.

 With another year about to enter the history books, we extend our best to you and your loved ones.

We waited to write this until after the election.  Regardless of your political persuasion, there are several things we can glean from the recent election results.

 The FED will inject another $600B into the economy via QE2 (Quantitative Easing – round 2).  This wasn’t necessarily in doubt, but was cemented by the results.

 The majority of the Bush era tax cuts will most likely be reinstated, for at least a twelve to twenty-four month period.   

 In a long-term sense, further corporate regulatory reforms out of Congress, which inevitably impact business earnings, will be slowed or possibly stopped.

 Sectors like healthcare (primarily pharmaceuticals and bio-tech) and financial services (banks) will likely benefit from the election results.  Alternative energy stocks will probably see a more negative bias. 

 As we know, markets are forward looking.  We experienced a 13% gain in the S&P 500 during the months of September and October.  This represents the largest two-month gain since the bottom of the market in March 2009.  So, the logical question is, “Where do we go from here?”

 We related in the summer that many of our internal indicators, like the advance/decline line were very strong.  We felt this internal strength would pull the markets higher, which it did.  At this point, they continue to lead the markets and this is encouraging.

 QE2 will likely serve as a short-term catalyst for the economy.  But, it’s a band-aid and the economy is in dire need of corporate and consumer confidence to return to some type of historical norm.  In our estimation, the economy is suffering from a confidence problem, not a money problem.    

 With that, on behalf of our entire Delta Team, please accept my very best wishes for a most Happy Thanksgiving.