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 IHA Monthly  February 2011 
In This Issue
Market Commentary
January 2011 Asset Class Returns
Cash Alternatives
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History Speaks
Nilometer In ancient Egypt, fortune and wealth were determined by the extent of the annual Nile floods. A good flood year meant that there would be plenty of water in the Nile and its tributaries and an ample growing season. Small floods resulted in famine and starvation. Think Joseph's biblical warning of seven  fat years to be followed by seven lean years. The ancient Egyptians developed Nilometers in order to gauge the level of the flood. They were typically columns or steps submerged into the river that had markings indicating the current extent of the flood. The Nilometer in the picture was built in the 9th Century A.D. but there are others in Egypt that date back to the time of the Pyramids.

Market Commentary

U.S. and developed markets had a strong January, building on the strength they have shown since September. That's the good news. Conversely, emerging markets were hit by the dual (and interrelated) fears of political instability and rising commodity inflation. The uprising in Egypt has certainly demonstrated the fat-tails of emerging market investing. The threat to Hosni Mubarak's 30 year reign began with a series of self-immolations, starting with an unknown street vendor in Tunisia. As we mentioned in the previous newsletter, throughout history the price of food is closely correlated with political stability. Rising prices for food and other commodities are a major factor in the unrest across Northern Africa. The U.N.'s measure of international food prices has risen more than 28% year over year. The result has been a divergence in market performance over the last three months with U.S. and most developed nations up over 5% while many emerging markets are in negative territory. The chart below shows the performance of the Brazilian, Chinese and Indian markets (in local currency terms) since November: 
 Emerging Weakness

In terms of markets, rising commodity costs drive fears of inflation. There have already been a series of interest rate hikes in the Asia-Pacific region. The UK central bank meets this week with consumer prices in England haven risen nearly 4% year over year despite laggard economic performance. If the commodity inflation story continues, central banks around the world will be forced to raise rates much earlier than anticipated.

In our last newsletter we focused on three areas of risk to markets in 2011: Emerging markets' commodity dangers, structural hurdles to U.S. recovery, and European  debt issues. In the U.S., problems in the labor and housing markets persist even as the stock market continues to climb. Home prices have remained stagnant  and while the January jobs report showed a lower unemployment rate the rate of job creation is still far below what is required. In Europe, the debt crisis has been limited to Greece and Ireland thus far. In truth, we have been surprised by this as it seemed Europe would have been the first of the three factors to crack. Europe is muddling through and in case you have been distracted by Christina Aguilera's lyric malfunction you may not have realized that Portugal managed to get off a bond offering this week.

At this stage we see the best case scenario as a continued mild recovery in the U.S. and Europe while emerging markets contend with the double-edged sword of commodity inflation. This scenario lays out further gains in the stock markets of the developed world with more volatile returns from the less developed nations. It would also imply low or even negative returns from fixed income as rates rise to more normal, pre-crisis levels. However, we still believe there is a significant possibility of shocks to the system as we highlighted last month. In that scenario you will see a flight back to the perceived quality of fixed income and away from the risk assets that have dominated returns over the last two years.

 

Asset Class Returns

January 2011 - Monthly and 52 week returns for major asset classes. Performance information is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.
 

AssetReturns.2011.01.31

Developed nations' stock markets continued their strong run although therewas some pull back in smaller capitalization equities. Commodity prices continue to rise and are now up 26% in just the last 5 months. That increase, and the unrest in Egypt, set back emerging markets for the month. While fixed income managed to avoid losses for the month, the gains in that area remain quite modest. 

 


Financial Planning Highlight 
Cash Alternatives
 

Today we review a situation we frequently encounter: a client looking for direction regarding a substantial cash holding either from a recent bonus payment, an inheritance, or simply an accumulation of savings. The client wants to know what to do with it, "Where's the best place to put this cash?". We answer that question below and we also cover the biggest mistake investors make when examing cash alternatives.

As we open this discussion, it's important to keep in mind three primary considerations: liquidity, preservation of capital, and yield. Generally speaking, an investment provides two of these elements at the expense of the third. In deciding the vehicle to put cash into first determine which of the two factors are most important to you:

 

Liquidity à The ability to turn an investment into cash immediately or in the very near future.

Preservation of Capital à Assurance that the value of the investment cannot go below initial balance.

Yield à The return, or expected return, of the investment.

 

With these three factors in mind, here we list some common cash alternatives followed by their '2 out of 3 ain't bad' characteristics in parenthesis:

Savings/Checking Account (Liquidity, Preservation of Capital)

Certificate of Deposit (Preservation of Capital, Yield)

Money Market Fund (Liquidity, Yield)

US Treasuries (Liquidity, Yield or Preservation of Capital depending on duration)

Short-Term Bond Fund (Liquidity, Yield)

Here are some real-life examples: If you are looking to buy a house with the cash, liquidity and preservation of capital are tantamount. Liquidity in case the dream house presents itself and you need immediate access to the cash; preservation of capital so you are aware of your position in regards to a down payment. In that case a simple, boring savings account will make the most sense. If the cash is designated for an emergency fund in the event of job loss, then liquidity is less of an issue. In that scenario, CDs are ideal (perhaps ladder a few CD's so they mature throughout the year). In a scenario where you can afford some risk to the principal, a money market fund will offer a higher yield than traditional savings account. Although they are billed as completely safe investments (they always keep a nominal value of $1.00), money market funds do take some investment risk. The Reserve Primary Fund "broke the buck" in 2008 because of investments in Lehman Brothers and a suddenly very illiquid commercial paper market. Investors eventually got back 98 cents on the dollar but only after a long delay. If you have with no defined plan for the cash (a good problem for sure) U.S. Treasuries and short-term bond funds are the likely place to store your money. These holdings offer yield and liquidity but face market risk. In times of rising rates, their market price can go down but over the medium term they tend to retain their value and return some yield.

The biggest mistake when examining cash alternatives is to   s t r e t c h   for yield. There is a long history of investments that have promised safety of principal and liquidity while sporting relatively high yields. Overwhelmingly those managers are investing your short term money in longer term securities and expose you to potential losses in the event they have to quickly exit those positions. Examples from recent years include the auction-rate securities scandal and Schwab's YieldPlus disaster. Rates are low right now and what follows is often the temptation to invest in a proportedly safe and liquid product that offers a high yield - that magical investment. There is no such product, remember the '2 out of 3' maxim. For more information on this topic we urge you to read this Jason Zweig article from the Wall Street Journal where he looks at the sordid history of these types of investments.

Finally, a quick note on FDIC protection. If you are going to keep meaningful sums of money in an account that is designed to guarentee preservation of capital, make sure the entire amount is insured. If your money is at a bank or another institution that offers FDIC protection the standard deposit insurance amount is $250,000 per depositer, per insured bank, for each account ownership category. It is possible to have have multiple accounts at a bank that have seperate protection but more commonly accounts are aggregated. If you think you might be going over the limit, open an account at a completely different bank. If your cash balance is going to be well in excess of the insurance limit there are ways to get FDIC protection for the entire amount such as through a CDARs account.  

 

 

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Mike and John InnerHarbor Advisors


Contact Info:
InnerHarbor Advisors, LLC
212-949-0494
j.omeara@inneradv.com and m.keating@inneradv.com

Website:
www.inneradv.com