FOMC new Strategy

Forwarded to me by my friend David Kotok

The New Communications Strategy of the Fed
January 24, 2012

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at  He may be reached at


Tomorrow the FOMC will embark upon its new communications strategy, by which it will release information on the interest-rate path, consistent with achieving its dual mandate of low inflation and low unemployment.  As always, the devil is in the details; and we will explore some of the gotchas that may result, depending upon which of the many possible scenarios they choose.  But first, it is important to correct a misperception being perpetuated in the press when they state that the FOMC will reveal its interest-rate “forecast(s).”  Since the FOMC sets the short-term Federal Funds target, its inflation, unemployment, and GDP forecasts are conditional upon the path its sets or that is assumed.  The FOMC is not “forecasting” the Federal Funds rate.  Each committee participant is instructed to assume the path consistent with the committee’s longer-run objectives and then provide forecasts of GDP, inflation, and unemployment.


So what are the possible options as to how the FOMC might choose to release the interest-rate information?  The options entail two different dimensions, involving the amount of detail provided and the frequency of the data released (i.e., quarterly, annually, etc.).


In terms of detail, the committee might choose to provide a consensus path, the individual paths assumed by each participant, and/or a fan chart, similar to those released by other central banks, like the Riksbank of Sweden.  The Riksbank provides the mean path and probability ranges around that path.  The analogy for the FOMC would be to provide the central tendency of the path and range, similarly to what it does now for GDP, inflation, and unemployment.


But right now, the FOMC only provides yearly forecasts for both GDP and inflation while unemployment rate is the rate expected to prevail at the end of the year.  If the frequency of those releases doesn’t change, then the FOMC could choose to provide the Funds rate assumed to be in place at the end of the forecast year, or it could provide the average over the year.  Neither one of these is likely to be particularly informative, nor would it avoid creating confusion in the market.  For example, the FOMC embarked upon a slow and steady path of increasing the Funds rate by 25 basis points for 18 consecutive meetings beginning in June 2003.  If in June the FOMC had provided data to the market suggesting that the Funds rate would be 125 basis points higher at year end and would at that same time be 325 basis points higher by the end of 2004 and 425 basis points higher by the end of 2006, it is likely that the performance of the economy and path for market rates would have been substantially different from what they turned out to be.  Clearly, if the market had been appraised of the likely path for policy, all the smart money would have shortened durations, the term structure would have flattened, and short-term rates would have risen more than long-term rates, which likely would have moved up sharply as well.  The shock to markets would have been huge.  Now, it isn’t likely that the FOMC would have had perfect foresight, as most of the models it employs assume about both market participants and policy makers, with respect to the path that was subsequently followed, so periodic changes would have surprised markets.  The end result would have been more volatility and uncertainty rather than useful information.


Two other points are critical.  First, there would have been lots of different ways to get to a 125-basis-point increase in rates by year-end 2004, and as far as market participants are concerned the path is critical.  For example, if markets had known that rates would move by only 25 basis points per meeting, they likely would have responded much differently than if rates had simply moved up in different increments and at meetings than at others.  Another source of uncertainty is likely to be introduced by the new policy, related to its conditional nature.  President Plosser, for example, has continually emphasized that the future path for the Federal Funds rate is conditional on realization of GDP, inflation, and unemployment levels.  Intermeeting upside or downside surprises, for example, might require a revision in the assumed path for rates, which might then call for either a deviation from the short-term path previously identified or an adjustment in the longer-term path with no change in the short-term policy. In this case the logical question for market participants to ponder is how much of a short-term deviation from the expected paths for inflation, unemployment, and/or GDP would be sufficient to cause the FOMC to revise policy and the policy path it assumed.


The less frequent the forecast revisions and the less detail provided about the intermeeting forecasts for the key variables of interest, the more uncertainty that is likely to prevail.  Since the FOMC does meet eight times a year, and twice within each quarter, it would seem logical to provide at least quarterly forecasts for the key variables, rather than simply annualized data.  Changing both the frequency of the forecasts and when they are provided would suggest that they should be updated at each FOMC meeting and released, with quarterly annualized estimates to match how GDP data are provided.


There has been the suggestion that the paths assumed by each participant might be released.  There are three issues here.  First, since only five reserve bank presidents vote, along with the current five governors (normally seven), it becomes critical to know, not the average path or the range of possible paths, but rather the paths of those actually voting.  Clearly, given the present make-up of the committee, not all would have the same set of policy assumptions nor the same reactions to deviations of key variables from the forecasts.  If individual forecasts are provided, then it is also important to be able to identify the assumed rate path with the projections for GDP, inflation, and employment.  Without that information, knowing the rate path is of little use.


One could go on and on and spin different scenarios and cite problems with the alternative disclosures the FOMC is about to make.  Whether the information provided will be useful or not, and whether it will reduce or add to uncertainty, remains to be seen.  One thing is for certain: Chairman Greenspan was always very cautious about changing how policy was revealed or modifying the FOMC’s communications; because he emphasized that, once done, the change could never be undone, so it had better be right.


Bob Eisenbeis, Chief Monetary Economist


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The Chilean Wonders

From my friend David Kotok

Report from Chile
January 18, 2012

There are no shortcuts to reach the Alto Puelo Lodge on the Rio Puelo in Chile.  You can travel from the Argentine side through Buenos Aires and Bariloche or from the Chilean side through Santiago and Puerto Montt.  Either way, the journey is long, but well worth it.


Due to the volcanic activity in Chile interfering with Argentine air travel, this trip was routed from the Chilean side.  That translated into four different flights: from Philadelphia to Miami, Miami to Santiago, Santiago to Puerto Montt, and the last leg, a charter flight across the Andes Mountains from Puerto Montt to Segundo Corral, a small village with an air strip located near the lodge.


This is my fifteenth visit to the Patagonian region.  Arriving at the Rio Puelo, I drink in the marvelous scenery and wonder at the natural beauty that has come to be so near and dear to my heart.


Pristine water and majestic mountains frame the Alto Puelo Lodge, which at maximum capacity accommodates eight guests.  The only lodge in the area, it is a family-owned and -operated business.  You can find additional information via the following links:; e-mail


With the sun shining brightly over the clear water, we decided to take a boat out and trek to the head of the lake.  There we encountered a large cloud of midges swarming and performing their summer ritual.  Beautiful, hungry rainbow trout were standing on their tails, gulping the midges in midair.  What a sight to behold.


In order to fish a midge hatch, you must pick a fly so small it is nearly impossible to see when it is on the water.  Because these are wild Patagonian trout, you need a long leader and you need to cast at a fair distance, approximately 50 to 60 feet.  The entire fly is 1/8”-1/4” long, including the eye, the shank of the hook, and the hook itself.  In order to get through the eye, you need a very fine leader.  In this case, I used a 7x tippet.  It is extremely thin and hard to see with these old eyes, let alone to tie a strong enough knot.


After several casts, we were able to land the midge imitation in the midst of the cloud.  A friendly rainbow trout, gulping his way through a feast of a thousand insects, happened to bite on the midge.  With a small tug to set the hook, the fun begins.  The water here is deep and clear, and with a fish like this one has to be extremely careful to not “horse” the fish in.  When the fish wants to run, you must concede.  With the very thin leader, any pressure can break it off.  After twenty minutes of many runs and much activity, we were able to get the rainbow trout into the net, take the fly out of his lip, thank him for the exercise, and release him back into the water.  These experiences on the Rio Puelo entirely vindicate my 36-hour journey.


The real powerhouse on the Rio Puelo is the brown trout.  These large demons of the deep turquoise waters are the trophy fish sought by all fly fishermen.

I asked Eric, our guide and owner of the Alto Puelo Lodge, which fly to use.  We discussed flies at length.  For some reason, as I looked around on this warm, sunny, clear day, I suggested, “If I were in the west, I would use a grasshopper.  Eric, have you seen any grasshoppers?”  Eric replied, “Yes!  Actually, that is a good idea!  I had not thought about that.”


We tied on a hopper, our backs against some rock ledges on Lago Puelo, the headwaters of the Rio Puelo.  On the third cast, a trout came to take a look.  He did not like what he saw.  Fifty yards down, against another rocky ledge, a second trout came and took it fast.  Unfortunately, this old fly fisherman missed the hook set.


The next rock ledge had a notch in the water line.  It was a dark, covered area underneath the ledge overhang.  These wild fish are very alert to anything not consistent to their habitat.  It was a perfect place for a wily, large brown to wait for its next meal.  Three false casts and then I was able to flip the grasshopper right into the dark shadow in the notch between the rocks.  It landed in the cleft that had taken four million years to form, and within seconds a brown took that fly and gulped it down.  A fast hook set, and off he went.  The first run out towards the deep part of the lake took me to the backing on the line.  A monster, he was hungry and strong from swimming in currents, and ready for battle.  The results are in the photo here:  After a wonderful, invigorating fight, this fish is released to swim again in Lago Puelo — until my next visit.


This remote Chilean valley is a fly fisherman’s dream.  There is such diversity of fishing here, from calm to windy lakes, to streams and deep rivers with flies rising and hatches.  In the midst of this unspoiled landscape sits the Alto Puelo Lodge, a wonderful, welcoming retreat where one can delve into a book or research paper.


Let’s turn to the economics in Chile.  Chile is a booming place, a South American success story.  Evidence of their success can be seen in their economic growth and lower unemployment rate.  When you look at Chile, no matter how you examine the data for flaws, you find a continually improving account.


The Chilean central bank has expressed concern over external events, which is why interest rates were surprisingly reduced during its last meeting.  It even explained that its concern originates from the crises in Europe, not from a domestic, anti-inflation central bank policy.


We like Chile; we like it as a destination, we like it as an investment, and we like it even more with each return visit.  I have asked my colleague Bill Witherell, Cumberland’s Chief Global Economist, to summarize our investment position.  In our Emerging Markets Model, the overall weight is 4.65%, which is much higher than the 1.52% weight in the Emerging Markets benchmark.  In the International model the weight is 2.025%, and in Global MAC it is 2.0%.  These compare with the 0.5% weight of Chile in the Vanguard world ex-US ETF.  It is important to note that Chile is not included in the EAFE benchmark index.  Chile’s stock market underperformed in 2011, -20% compared with -18.2% for EEM.  As of January 12, 2012, Chile is up 3.9% compared with 4.2% for EEM.



David R. Kotok, Chairman and Chief Investment Officer


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Around the Block

Shared with us by my friend,  Janice Dorn, M.D., Ph.D.

Illustration Copyright: Janice Dorn, M.D., Ph.D.  All rights reserved

He that lives upon hope will die fasting…Benjamin Franklin

A man had constant dizzy spells and searched everywhere to find a cure.

He told a close female friend about it, who advised, “Walk around the block four times on Sunday afternoon.”

The man followed the advice, and then complained to his friend, “I did what you said, but still feel dizzy.”

She replied.  “ Interesting.  It didn’t help my dizziness either!”

Moral:  Beware of foolish advice and most advice is foolish unless it comes from a person of great wisdom and even then—beware.

In trading and in life, it is critical to ask yourself:  What sources of information are guiding my actions?  Have I checked the facts, or am I simply relying on the word of this or that person? Have I applied common sense and my own study to this situation, or am I acting impulsively or instinctually?  Is my primitive rat brain really out to get me this time, or am I taking the higher road and using my frontal  brain areas to overcome fear and greed?  This is a recurring theme in my writing and coaching where I show you how your brain sees and reacts to trading signals and setups and what to do to put the odds of winning in your favour.

Among the most important questions for you to ask is:  What do you believe that is not true?   This must become a mantra for you if you are to succeed in trading because you are trading your beliefs against the beliefs of others. Constantly question your own belief system.  This leads you to question what others are saying. It forces you to turn down the noise and focus on the signal in the here and now.

Lazy thinking leads to lazy trading that leads to losses.  The incessant drumbeat of self-deception is magnified by the unending amount of misinformation and disinformation that bombards your senses during the trading day.  Be vigilant.  Question everything and everyone, including me.  There are no gurus except for you.   You, more than anyone else in the world, know your risk tolerance.  If a position is not working, it is not a good position. Get out. Cut losses.  If you see another opportunity in the same stock, have the courage to get right back in.  Don’t allow your rat brain to “dope-amine” you to the point where you deceive yourself by holding and hoping as losses mount— or are frozen in fear from taking even a small loss.

The schills of the financial markets are always hard at work to inundate and smother you with hype and deception.  Learn to see past these, and become alert to anything that sounds just too good to be true.  If it sounds too good to be true, it most likely is.  The tragedy of trading is that that even the most alert and rational among us can be fooled.  This is one reason why the search for trading truth is a lifetime journey that no one ever fully completes.

Hope is a good breakfast, but it is a bad supper…Francis Bacon
Thanks and Good Trading!

Janice Dorn, M.D., Ph.D.

Copyright and Illustration Copyright:  2006-2012, Janice Dorn, M.D., Ph.D.

China Update – Pt 2

From my friend David Kotok

China Update, Part 2
January 13, 2012

This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist.  He joined Cumberland after years of experience at the OECD in Paris.  His bio is found on Cumberland’s home page,  He can be reached at  

Developments in China have our attention as 2012 gets underway. David Kotok, in “China Update, Part 1,” wrote about some disturbing indications that China is tightening restrictions on the freedom of speech.  Last month I wrote in “Reassessing China Equities” about more positive indications in the economic policy sphere that suggested the slowdown in the Chinese economy will be moderate and brief and that Chinese stocks will likely regain their relative strength in the coming months, following their significant underperformance in 2011.

More recent data is confirming the redirection of policies towards stimulating the growth of the Chinese economy. The supply of loans from commercial banks in December, some Rmb640.50 billion, was considerably above the volume for November, Rmb562.2 billion.  The 13.6% growth in the M2 measure of the money supply in December was up from 12.7% in November. Also, fiscal spending is speeding up.

An upside surprise in the December Purchasing Managers Index (PMI) and better-than-expected export growth are leading to a scaling up of estimated GDP growth for the year 2011. We now expect the growth for 2011 to be reported as 9.2%. We are projecting 2012 growth at 8.8%, followed by a return to 9+% growth in 2013. The Chinese currency is likely to continue to strengthen at a controlled moderate pace of around 3% per annum.

Looking out further, to a not very distant future, the December 31 issue of the Economist reports on its analysis that by 2018 China’s GDP in US dollar terms, converted at market prices, will exceed that of the United States. Last year, only seven years earlier, US GDP was approximately twice that of China’s. Our own long-term economic scenario similarly projects 2019 as the year that China’s GDP eclipses that of the United States.

Already China leads the world in manufacturing and in purchases of cars. By 2019 China will have also become the world’s largest market for consumer and industrial products. On a per-capita basis the average American will still be much better off than the average Chinese in 2019. Nevertheless, China’s role in the global economy, already great, will become even more predominant. Japan revealed it understands this when last month it announced jointly with China an agreement for Japan to buy Chinese sovereign debt, despite the difficult past of these two countries.  While China’s capital market will still be 30% smaller than that of the US, it is expected to increase at more than twice the rate of the US market. The importance of such projections for international investors is evident.

We have written about the growing number of US-listed China ETFs, 19 equity ETFs at last count. There is now over $8 billion in China ETF assets, with a daily trading volume of over $900 million.  Chinese equities, as measured by the broad-based SPDR S&P China ETF, GXC, that we prefer for our portfolios, slumped by 8.4% over the December 1-19 period; but they have since trended upward, surpassing their December high by January 12.  As we anticipated, China has returned to outperforming the emerging markets benchmark. Over the past thirty days (through January 11), GXC has gained 1.7%, whereas the iShares MSCI Emerging Markets ETF is up only 0.3%. We have recently added to our China positions in our International, Emerging Market, and Global Multi-Asset Class portfolios.

Bill Witherell, Chief Global Economist

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About China

From my friend David Kotok

China Update Part 1
January 7, 2012

“I think this move is a sign of weakness and will only increase the likelihood that the winds of change from the Arab spring will reach China. The Chinese middle class, while enjoying their new wealth, will eventually demand the freedoms other middle classes expect and enjoy. Attempts to move the country in the direction of North Korea are bound to fail and hasten the regime’s end.”  – Bill Witherell, Chief Global Economist, Cumberland Advisors

Hidden in the clamor of Iowa caucuses and the forthcoming primaries to take place in New Hampshire and South Carolina, a news item slipped through nearly unobserved by the American media.  It is important and deserves some discussion.

A January 3rd official news release from China by Xinhua News Service described changes that will take place in Chinese television programming.  KGS NightWatch, one of the thought-provoking research sources on such significant but obscure news items, reproduced the text of the Xinhua release.  The English translation, according to NightWatch, reads as follows:

“A recently implemented rule has effectively curbed the ‘excessive entertainment’ trend as two-thirds of the entertainment programs on China’s 34 satellite channels have been cut, according to the country’s top broadcasting watchdog.  ‘The total number of entertainment shows airing during primetime every week has been reduced to 38 from 126 at the end of 2011, marking a 69 percent plunge as the new rule came into effect on Jan. 1,’ said a statement issued Tuesday (3 January) by the State Administration of Radio, Film and Television (SARFT).

“According to an SARFT directive last October, each of the country’s satellite channels would be limited to broadcasting two entertainment programs each week and a maximum of 90 minutes of content defined as entertainment every day during primetime — 7:30 p.m. to 10 p.m.  The directive also required channels to broadcast at least two hours of news programming. Between 6 p.m. and 11:30 p.m., they must each broadcast at least two 30-minute news programs.

“The restricted programs on the SARFT list include dating shows, talent contests, talk shows as well as emotional stories that were deemed ‘excessive entertainment’ and of ‘low taste.’  However, popular dating shows like ‘If You Are the One,’ produced by Jiangsu Satellite TV, and soap operas, such as ‘Li Yuan Chun,’ presented by Henan Satellite TV, will still be aired during weekend primetime hours, according to the statement.

“It said that the satellite channels have started to broadcast programs that promote traditional virtues and socialist core values.  The newly-added programs among the satellites’ revised broadcasting schedules are documentaries as well as cultural and educational programs, it added.  The SARFT believes that the move to cut entertainment programming is crucial in improving cultural services for the public by offering high quality programming.”

Source: Xinhua News Service, 3 January 2012, as reported by NightWatch

The NightWatch analysis is alarming.  They suggest that these changes portend “more restrictions on freedom of speech and social activity” in China.  They point out that China does not have guarantees of freedom of speech as it is a “Communist country,” and that American notions of what basic rights are cannot be effectively applied to China.

NightWatch continues to discuss these policy issues.  They emphasize how China is concerned with intrusions from Western culture and how the strength of those intrusions has reached a point where Chinese leaders must rein them back.

This is an interesting sequence of events, taking place in the world’s second largest economy.  It occurs in an economy where the government and central bank aspire to emerge as a world reserve currency.  It happens on the heels of a capital market transaction between Japan and China in which Japanese reserves will begin to be deployed in Chinese currency-denominated debt obligations.  It is also happening at a time when China’s activities around the world are influencing the demand for commodity prices and altering the behavior of numerous countries and regions.

At Cumberland, we discussed the Chinese news release and the implications for the markets in detail.  Of course, we do not know what is going to happen; but we do know that an official news release by China, citing Chinese leadership and translated into English, must be taken seriously.

One possibility is that China is heading towards a more restrictive and oppressive regime.  This essentially suggests that in response to the infiltration of the culture by Western ideas, Chinese leadership is pulling back and will tighten restrictions.  That leads to speculation that the Chinese citizenry will respond negatively.  Will we see more demonstrations?  Will we see civil unrest in China?  Is turmoil in China one of the possible surprises for 2012?

It appears that this time China has escaped the radar screen of Western media and markets.  That is very understandable.  Europe is focused on its internal turmoil and is the daily lead headline in American and certainly in European media.  At the same time, European countries such as France are going through political processes that add to the turmoil, as candidates who are more extreme advance their positions in threatening ways.  We see isolationism rising in France; we see isolationism articulated in the United States during our primary season.  Isolationism, military threats, and blustering cultural shocks – all are disconcerting to markets and to those who look at global enterprises and suggest that globalism, integration, and worldwide trade expansion will continue unabated.  That is the nature of the beast in 2012.

Cumberland will offer this update on China in two parts.  These opening comments call attention to the news release and invite readers to dig a little deeper into the evolution of the events in China, even as we are distracted by the American political process that tends to be an all-consuming media show.  Bill Witherell, my colleague and Cumberland’s Chief Global Economist, will follow with a second commentary.  In China Update Part 2, he will examine the markets in China, how we see them, how we structure our investment weightings, and how we are using ETFs in a diversified way to position in China.  He will also give his own outlook on the political developments in China and tell us where he believes things will go.

Our travel itinerary for January includes another lengthy plane ride.  In a week, we will leave for Chile, a fascinating country and one I have visited on numerous occasions.  Here is an example of conversion of a society from an extreme and harsh dictatorship to a functioning democracy with entrepreneurial spirit and a growing economic base.  The period of Allende morphed into the period of Pinochet.  During the Pinochet regime, the introduction of entrepreneurial and profit-sensitive individualism evolved in Chile.

This type of transition triggers a question.  Does it take a dictator to create the opening for democratic institutions and meaningful material economic advancement?  It seems as if that may be the case.  Strong regimes, led by those who see the need to move their countries towards opening up freedoms and expanding individual rights and entrepreneurial spirit, have evidenced their success in notable ways.  We saw this in Chile and in Singapore.  We started to see this in China, first under Deng Xiaoping.  China has been opening up since Deng’s initial effort.

The same strong regimes are also threatened by the very act of introducing freedoms and entrepreneurial spirit.  On the one hand, they fear the change; on the other hand, they recognize its inevitability.

Chile is an example of success.  The country is growing.  The economy has shown its resilience when faced with tragedies like tsunamis and volcanic eruptions.  Chile has a young, vibrant population.  It manages its debt well.  It has introduced social services in inventive ways.  It is a growing success story in economic terms.  Long-term financial-market benefits have come to Chilean investors.

When you visit Chile now, you see growing investment and trade relationships with Asia, even as the Chilean currency continues to be managed by the central bank in a relationship that compares it to the US dollar as a standard.  So, here we have Chile, in our American hemisphere, with growing trade and an economic interface with China, yet focused on continuing its evolutionary path as a Western democracy with entrepreneurial spirit.  Contrast that with the new China policy of “closing up” instead of “opening up.”

We will leave the second part of this update to Bill Witherell.  We will return from Chile after a week’s time.  We hope along the way a friendly trout will give this fisherman a pulse increase and rise for a dry fly on the Rio Puelo.  Barbless hooks will ensure that the trout will be released in case someone desires to visit in the future.

David R. Kotok, Chairman and Chief Investment Officer

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Coming back full circle

………………….as seen by my friend David

Sunrise 2012
January 2, 2012

Looking eastward from my 12th floor Sarasota condominium, one sees the cityscape and then a long view of South Florida’s flat landscape.  Greeting sunrise has become a habit.  The winter solstice season is best.


Fireball sun rises between buildings.  My gaze crosses the level expanse of Florida.  The dawn light brightens into yellows and oranges and reddish hues as the giant fireball prepares to peek above the morning ground fog that is prevalent this time of year.  Norah Jones’ sultry, seductively sweet “Sunrise, Sunrise” greets Fireball as I hit the play button.


The New Year’s balcony view puts Fireball in a special sandwich.  The bottom is the Florida landscape.  The top is a cloud layer.  As Fireball prepares to emerge, the band of light between landscape and clouds is the brightest orange in the spectrum.


7:19 AM. Fireball heard Norah Jones’ call as it slowly but steadily heaved itself up and filled space.  The spinning Earth tumbles forward to deliver the perfect moment.  Glorious Fireball shines forth.


The Earth spins on.  Fireball seems to rise behind the clouds and begins to disappear, masked by the gray mass.


Oh, how I wanted to reach out and help Fireball get up and through the clouds.  Imagine yourself watching this unfold; imagine extending your hand across the miles, reaching under Fireball and gently assisting its upward struggle.


Fireball was lost in the clouds.  The mammoth orange orb was history.  The narrow cleft between land and cloud radiated a residual, yet dimming, glow from Fireball’s opening appearance of 2012.


Sunrise 2012 greets us with questions.  Will it be a year of positive outcomes or a year with only brief, bright interludes sandwiched between gray, cloudy masses and misty, obscuring ground fogs?


Let’s reflect on that for a minute or two.


2011 started out like our rising sun metaphor.  The market rose, along with optimism about the US economy.  The market peaked on April 29.  Europe’s turmoil and uncertainty about the US recovery triggered a 5-month, 20%-down,  bear market.  The sell-off became serious, and in early August we witnessed a selling climax.  The climax was retested several times and a final low was established on October 3.  Since then the market has recovered robustly and broadened.  If you looked at the S&P 500 index on Jan. 1 and then took a trip to Mars, you would have missed the show.  You returned on December 31 and found the market at exactly the same level as when you departed.


Fed policy this year is likely to be benign.  Bernanke’s term is up in 2013, so the latter half of that year could witness changes.  That is then, and the present course of monetary policy seems to be set.  Furthermore, any shock that injected risk into the US economic recovery could and would be met with additional monetary stimulus.  In 2012, Bernanke has the majority support of the FOMC voting members.  We expect no change in Fed policy during 2012.


This bodes well for US markets.  Tight money can kill a stock market recovery.  Easy money rarely does.


US political risk is high.  The Iowa circus has put on display the dubious nature of some of the characters who aspire to be our next president.  So far, they have succeeded in raising the ratings of Obama.  Nevertheless, politics are fluid and volatility surrounding the election is to be expected.  Maybe the market transitions in 2012 will mirror 2011 as the political cycle and market cycle become congruent and mature in November?


We expect some early strength in US stocks.  We see the earnings rate for the S&P 500 at about an $100 run rate.  That puts the market at less than 13 times earnings.  Those earnings support a dividend yield higher than the riskless ten-year treasury yield.  The equity risk premium is very high.  US stocks look cheap by many measures.


Granted, the profit share of GDP is higher than the historical norm, but the real question is what will cause it to shrink.  It won’t shrink from labor-cost pressure when the unemployment rate is so high.  It won’t shrink from high financing costs when interest rates are so low.  Moreover, it won’t shrink from inflation pressures when inflation is benign.


In other words, the case for a bear market is weak as 2012 unfolds.  Could this change?  Of course.  Will it?  We do not know.  Shocks come from many sources.  They always do.


We enter 2012 fully invested in our US stock portfolios, using exchange-traded funds.  What happens as the year progresses remains to be seen.  We hold to an interim target of 1350-1400 for the S&P 500 index.  Our longer-term target is 2000 by the end of this decade.


And now, in this moment, we welcome the sunrise.


David R. Kotok, Chairman and Chief Investment Officer


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