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Year End 2008 Year End 2008 Year End 2008 EEEQUITYQUITYQUITY IIINCOMENCOMENCOME Portfolio Strategy UpdatePortfolio Strategy UpdatePortfolio Strategy Update Extraordinary Times Require Extraordinary Action to Protect Your Assets
T HERE’S NO DOUBT, 2008 was a year for the history books. Easily on par with other notable years like: 1929, 1933, 1941, 1945, 1963, 1968,
1973-75, 1981, 1987, 1994, and 2001. We don’t have to tell you why. Not withstanding the election of the first African-American President, most of what occurred in 2008 was not good. Some financial highlights for the year are tallied to the right. But again, if you’ve already seen a recent account statement, you already know pain-fully well what happened in 2008. So we won’t spend a lot of time sweating the details. Let’s just say that 2008 was a year we’d like to forget and leave it at that. But the overwhelmingly dismal returns for the financial markets don’t begin to tell the story of 2008. The collapse of the credit markets has rattled the inter-national financial system to its very core and has yet to regain its footing despite billions in federal loans, money, credit, federal and Treasury Department jaw-boning, and even the political wizardry of the new guy in the White House. That’s the message of this update: the economic road ahead is likely to be a bumpy one. What has us concerned is the fact that the financial system is in a virtual meltdown at the FRONT end of what is shaping up to be a long and protracted economic downturn. In the usual se-quence of events, the financial system fails at the END of
a long economic decline after slumping businesses and unemployed consumers have exhausted their financial resources and have no choice but to default on their debt. The banking crisis of 1933, for example, happened four years into the Great Depression. Such historical realities do not bode well for 2009 and beyond. More specifically, we figure we’re about a third of the way through a recession that began in December 2007. We also expect that the economic decline will be as bad as any in the post World War II period. Only when insolvent banks are shut down, others are recapi-talized, and debt levels in general are reduced will the conditions ease. Put it this way, we’ve just come off the greatest credit bubble in the history of mankind. A bub-ble that took more than 15 years to form. It’s going to take at least that long to unwind. The “unwinding” will take the economy and the financial markets to levels last reached in the early 1980s—single digit price-earnings ratios on depressed corporate earnings—at the bottom. And probably double digit unemployment.(1)
Between now and then, we can expect further downside risks in the stock market. With interest rates at record lows, they only have one direction to go, and that’s up! Making any long-term bond or bond fund an
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Helping You Navigate an Uncertain Investment World
Market 2008 Snapshot Core Bond Fund 7.8%
Physical Gold 6.0
Gold ETF 5.0
5-7 Year Corp Bonds 4.9
1-3 Year Treasury ETF 3.0
EIP Total Return* -18.0
Dow Transport -21.0
EIP "Equity Only” Return* -24.0
Dow Jones Industrials -33.0
Dow Utilities -34.0
High Yield Bonds -34.0
S&P 500 -38.0
Housing -38.0
NASDAQ -40.0
Emerging Markets ETF -55.0
Financial Sector ETF -55.0
Alternative Energy ETF -61.0 * Equity Income Portfolio Total return for 2008 and the return from the equity holdings “only.”
37 Years 34 Years 35 Years ? 30 Years
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1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035
1929 Stock Market Peak
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The highest on record!
“Inflation Adjusted” The Dow Jones Industrials Dollars: 1900 — 2008
Peak to Trough 18 Years?
Peak to Trough 15 Years
Peak to Trough 14 Years
1) If our economic forecast comes even close to realization, we think it’s a better than even money bet Obama is a one termer! Remember you heard it here first. One caveat: that’s assuming the Republican’s put up someone who can talk about economic growth policies and walk and chew gum at the same time, no sure thing, that.
Our Market Forecast 2000—2035
equally risky place to be—and that’s before fac-toring any defaults and a further erosion in the world credit markets. As we discuss in the feature, we do not be-lieve the “economic recovery plan,” being cobbled together by the new President and his collabora-tors in Congress is the fix for what ails the econ-omy. In fact, we believe it could very will make things worse by propping up shaky financial institutions rather than letting them die so healthy ones can prosper. The process is akin to thinning a forest of the dead trees so the healthy ones can thrive. We point to Japan’s experience with a similar ineffectual program over the last 20 years, as the ah, “model” we’re about to emulate. Our opposition to Obama’s “stimulus” plan is not partisan. We’re not reactively anti-Obama, it’s just that there’s no evidence to support a plan that is equivalent to the government handing out credit cards and encouraging everyone to go to the mall and spend their way to financial wealth. Yet, regrettably, the euphoria of Obama mania insures its passage. Obviously, such economic expectations implies risky times ahead for just about all finan-cial assets. So that leads us to the critical question; what the hell do we do about it? THE STOCK MARKET OUTLOOK The Train to Single digit P/E’s right on Time
A S VETERAN VIEWPOINT READERS KNOW, we’ve said the stock market’s been in a long-
term bear market since it peaked in 2000. The Standard & Poor’s 500 Index negative total an-nual return of 2.9% over the eight years since 2000 validates our contention. We also believe the current bear cycle will not end until P/E ratios
for the market as a whole reach single digits. Nothing we see changes that expectation. We’ve shown the chart at the bottom of page one of the Dow Jones Industrial Average adjusted for infla-tion a couple of times to give an estimate of a time line for reaching a P/E bottom. The section in red is our long-term expectation for the stock market. We used this chart for our long-term market forecast in 2000. The chart has been im-portant in building a long-term investment strat-egy. Given the average 15-18 year peak to trough ,the chart indicates a bottom somewhere between 2015 and 2020. That’s the good news. The bad news is stocks have a nasty tendency to linger at the bottom for an extended period of time. As much as ten years in some cases. EQUITY INCOME No Exception to the Rule The year of 2008 was notable to us here at Deschaine & Company because it was the first absolute down year in total return since we began the EQUITY INCOME Portfolio strategy in De-cember 2000. We take some comfort in that well worn phase: “it could have been worse.” And yes, by gum, it could have been a whole lot worse. For one, we could have taken the Chinese's lead and bought Blackstone at their initial public offering, ($31 a share now $4.50 as share) and watch our capital drop 86%. Fortunately, a modicum of ra-tional analysis prevailed and we managed to dodge that deadly bullet. We held about 30% of the EQUITY INCOME Portfolio and a similar percentage of client port-folios in money market funds to offer some princi-pal protection from what we saw coming in 2008. Our high cash position did mitigate losses to a negative 17.9% total return, while the stocks in the portfolio dropped 23.7%. Those numbers compare to the S&P 500 index which was down 38.5%, the
Dow Jones Industrial down 33.1% and the NASDAQ Composite index bringing up the rear at a 40.5% drop. We have to admit, we never thought we’d rave about being down 18%, but that’s the world we live for now. All told 2008 will be a year to remember or maybe to forget. Unfortunately, 2009 is shaping up to bring us a similar outcome. The Power of Dividends Cash Flow for Living and Reinvesting Not since the Standard & Poor’s began keeping track of dividends in 1956, have payouts been worse than they were in 2008’s fourth quarter. The devastating effects of the credit mess on banks and other financial companies pushed over-all dividend payouts down 30% for the year, while special dividends dropped 17% from last year. On an even more telling note, a total of 606 out of 7,000 companies reduced or eliminated their dividends in 2008, with half of the total in the fourth quarter. This compares to only 44 for all of 2007. Conversely, S&P reports that the yield on stocks paying a dividend has doubled over the last two years to 7.28%. But there are surely more dividend cuts on the way. We were not immune to the dreaded divi-dend cut in 2008. In fact, seven stocks in the EIP cut or eliminated their dividend last year trigger-ing our SELL signal. The cutters were: BAC, ALD, ACAS, AINV, TICC, ARCC, and C. Note, they’re all financial related businesses. Paradoxically, many of them raised their dividend in 2008. In ACAS’s case, right up to the time they announced they were eliminating it. As the credit crisis hit financial stocks particularly hard because they have to continually access the
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Page 2 Year End 2008 Equity Income Portfolio Strategy Update
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3-Month & 10-Year Treasury Monthly Yields April 1954 to December 2008
INTEREST RATE OUTLOOK Interest rates are at an all time low, in the case of short term Treasury Bills, near zero! Call us crazy but we’re betting the next move for rates is up! For our strategy for bonds see Long-term Interest Short ETF on page 4.
Deschaine & Company L.L.C. Page 3
EQUITY INCOME Portfolio Year End 2008 Update
T HE EQUITY INCOME Portfolio as of December 31, 2008 is shown to the left. The stocks highlighted in
green currently meet our investment criteria, however, as we’ve suggested in the commentary, any new stock pur-chases should be done with a great deal of trepidation and with the expectation that they could drop—possibly a lot—further. If you already own any of the stocks, with the excep-tion of the banks, we’d generally suggest holding them, as-suming, you’ve already got plenty of cash (money market funds) to protect your portfolio. As we indicated, our current asset allocation is 50% of the portfolio in the EIP stocks shown here. In case you can’t do math, that’s essentially a 1% position in each stock, with a tweak here and there depending on portfolio changes mandated by market reality. Some Other Suggestions to Help Protect Your Assets We offer the following suggestions on things you might do to help protect your assets during these difficult times. If you have any suggestions of your own, please pass them along and we’ll include them in future issues. • Make sure your bank is FDIC insured, not all are. • Consider selling bond mutual funds. With interest rates at
record lows, they have no place else to go but up. Having said that, the Fed recently announced they intend to keep rates low for as long as it takes, but their power to do so is finite. When their plan stops working, inflations will roar. Bond FUNDS have high fees and unlike individual bonds, they never mature, so when interest rates soar, bond funds be the first to get pummeled. Once under water, they may never come back. Also, it’s nearly impossible to know what assets they hold. Do your really want that risk right now? Interestingly, high yield bond funds are realizing a flood of new investor money seeking higher yields. Individuals poring money into a sector of the market is never a good sign. Remember, tech stock funds took in record amounts in 2000, do we have to tell you what happened next.
• Take an inventory of what is really important to you: do you really need two houses, and a several cars? You’d be surprised how liberating it can be to simplify.
• If you’re close to retirement consider, working a year or two more. The additional income and not taking any money out of retirement accounts can have a significant difference in your long-term financial health.
• You’re not alone. Everyone is faced with the new eco-nomic reality caused by the credit crisis. We’re here to help, either as a friend, a sounding board, or to take over the responsibility to watch your assets every day. All you have to do is call us at (618) 397-1002.
PUBLISHER: MARK J. DESCHAINE, EDITOR: JOHN H. DESCHAINE, CONTRIBUTING EDITOR: TOM O’HARA, COPY EDITOR: MARNIE E. DESCHAINE,TECHNICAL ADVISOR: JOSEPH M. DESCHAINE. VIEWPOINT is a complementary publication of Deschaine & Company, L.L.C. a registered investment advisor in Belleville, Illinois. This information has been prepared from sources deemed reliable, but its accuracy is not guaranteed. It should not be assumed that any securities discussed will be profitable or will equal past performance, or is it an offer to buy or sell any security mentioned. Deschaine & Company and/or one or more of its clients, employees, family or friends may have a position in the securities discussed herein. © 2009 All rights reserved. This issue was published on January 25, 2009. If you would like to receive a complementary copy quarterly, simply send us your address and the preferred method of delivery: by emailing us at [email protected] and we would be happy to add you to one of our mailing lists. Rest assured no one from Deschaine & Company will never contact you, unsolicited—honest. We simply don’t have the time or the desire to hassle people.
Name TickerCurrent
PriceDividend
Yield 3 Yr Div Grwth
Ret 2008
Yd to Target
Altria Group Inc. MO 16.99 10.00 2.65 (31.31) 51.80
Ameren Corporation AEE 34.92 7.27 ‐ (34.59) 52.70
Anglo Amern Plc Adr AAUK 9.65 4.36 ‐ (33.80) (13.90)
Arthur J. Gallagher & Co. AJG 24.15 5.25 7.43 12.71 36.16
Associated Banc‐Corp ASBC 16.44 7.36 7.70 (18.31) 77.06
B&G Foods, Inc. BGF 10.60 15.70 42.76 (37.08) 50.82
BB&T Corporation BBT 21.88 8.29 10.34 (4.31) 78.25
BP PLC ADR BP 42.76 7.60 15.16 (32.36) 101.63
Biovail Corp BVF 10.55 15.90 30.20 (18.65) 329.00
Bristol‐Myers Squibb BMY 21.88 5.54 0.89 (6.05) 24.30
Chevron Corporation CVX 72.47 3.43 13.89 (18.31) 14.68
Computer Programs & Systems CPSI 23.69 6.08 44.23 25.26 38.50
Consolidated Edison Company ED 41.33 5.68 0.88 (15.76) 20.32
CPFL Energy SA ADR CPL 39.52 12.64 ‐ (25.60) 136.30
Dominion Resources, Inc. D 36.39 4.43 3.94 (21.56) 25.30
ENI SpA ADR E 45.01 8.02 31.64 (30.49) 20.12
General Mills, Inc. GIS 60.84 2.80 8.18 9.49 150.10
GlaxoSmithKline PLC ADR GSK 34.90 5.92 5.38 (22.27) (7.00)
H.J. Heinz Company HNZ 37.25 4.40 10.06 (16.50) 47.16
Health Care REIT, Inc. HCN 41.20 6.48 ‐ 0.30 (20.57)
Integrys Energy Group, Inc. TEG 42.55 6.36 4.41 (12.18) 44.50
J.P. Morgan Chase & Co. JPM 26.95 5.50 2.86 (25.13) 46.10
Kraft Foods, Inc. KFT 29.58 3.79 10.54 (14.56) 55.60
Microchip Technology, Inc. MCHP 18.78 6.95 79.60 (34.88) 266.80
Microsoft Corporation MSFT 17.87 2.55 11.20 (44.39) (27.00)
Paychex, Inc. PAYX 25.34 4.87 33.01 (24.60) 132.50
Permian Basin Royalty Trust PBT 13.84 16.93 14.93 (4.77) 18.90
Pfizer Inc. PFE 15.27 8.29 20.51 (16.85) 113.50
Philip Morris International Inc PM 39.86 3.85 NA NA (23.90)
Pinnacle West Capital PNW 34.50 6.08 4.79 (19.44) 48.50
Plum Creek Timber Company PCL 32.79 5.03 5.76 (21.43) 20.90
Progress Energy, Inc. PGN 39.93 6.20 ‐ (12.93) 21.40
Realty Income Corporation O 20.79 7.76 7.86 (8.16) 29.60
Reynolds American, Inc. RAI 38.99 8.79 18.98 (34.70) 75.70
Southern Company SO 34.01 4.84 4.07 (0.03) 3.70
Southern Copper Corporation PCU 15.33 12.24 78.51 (50.38) 124.60
Standard Register Company SR 7.50 12.20 ‐ (14.32) 53.50
The Dow Chemical Company DOW 12.97 12.50 6.86 (59.25) 6.80
UIL Holdings Corporation UIL 27.33 6.23 ‐ (14.05) 83.70
Unilever PLC ADR UL 22.69 4.36 6.81 (36.30) (16.80)
United Online, Inc. UNTD 6.13 11.01 3.40 (45.08) 128.50
US Bancorp USB 15.22 11.12 16.79 (16.59) 656.90
Wayside Technology Group, Inc. WSTG 7.11 8.44 0.77 (16.78) 114.30
Wells Fargo Company WFC 20.53 6.13 8.26 1.88 38.90
Zenith National Insurance ZNT 32.12 7.59 36.29 (24.40) 104.40
Eaton Vance Enhanced Equity Income EOI 12.48 13.40 ‐ (28.79) 51.80
Eaton Vance Enhanced Equity Income II EOS 11.53 14.80 ‐ (30.20) 82.20
Totals/Averages 13.29 (20.16) 73.79
Equity Income Portfolio Year End 2008 Data
credit markets to operate their business. Often, if a bank stock price got ham-mered, it presented a buy-ing opportunity because even in slow economic times, banks have cash flow from interest and fees that can cover the dividend. As an investor, the smart thing to do was to use the opportunity to buy more shares. Not so in 2008. The credit envi-ronment in 2008 was so severe and changed so quickly that many banks had years of uninter-rupted dividends broken before being acquired or bailed out.
EQUITY INCOME Portfolio Strategy Review for 2009
It’s Not the Return on Your Money, it’s the Return of Your Money!
W E’RE GOING TO SKIP the usual detailed review of the EQUITY INCOME Portfolio and in its
place offer a more generic investment strat-egy including specific recommendations. We think such an approach will be more useful to more investors. Some of the assumptions we used in com-piling our recommendations are:
• The economy is in a protracted downturn that could last as long as five years.
• The credit down cycle that began in late 2007 will continue to unwind, causing deflationary pressures on prices and asset values short term.
• The economic stimulus will have little effect on economic growth, but will fuel an inflationary cycle over the long term.
• Interest rates will remain low until the credit cycle shows sign of a bottom, at which time inflationary pressures will push them higher.
• Stock prices are still 50% above their long-term bear market bottom.
• The financial sector remains the most vulnerable sector of the stock market.
• The economic slump will put many nor-mally safe dividends at risk.
Those are just a handful of the many assump-tions we considered when formulating the investment strategy for 2009 and beyond.
Portfolio Asset Allocation: In the most radical change in the EQUITY INCOME Port-folio’s asset allocation in its history, begin-ning February 1, 2009 portfolios asset struc-ture will be as follows: Equities: 50.0% Cash: 25.0% Short Financials ETF: 5.0% Short Dow 30 ETF: 5.0% Short Emerging Markets ETF: 5.0% Long-Term Interest Short EFT: 5.0% Gold Stock ETF: 5.0% Total Portfolio: 100.0% Let’s discuss our thinking for each asset class:
• Equities. We’ll continue to manage the 50% of the portfolio in equities just as we’ve done with the EIP over the last eight years. We will just focus on stocks we believe have the financial strength to maintain their current dividend. Any dividend growth we’ll just consider a bonus. Any purchases will be made with the full expec-tation that the stock will be 20 or 30% (or more) cheaper in the future. Which, now that we think of it, is the way all equity investing should be done.
• Cash. We will maintain 25% of the portfo-lio in money market funds. While short-term rates don’t offer much return, the cash cushion, just as it did in 2008, will help protect portfolio’s downside risk. Second, the cash will provide buying power as stocks get cheaper, as we are certain they will—eventually. And last, as interest rates rise for inflationary pressures, the cash allows us to benefit from rising rates.
• Short Financials ETF. The last ten years has brought investors what’s known as “Exchange Traded Funds.” Theses are baskets of stocks set up to achieve a specific investment objective. In the case of the Short Financial ETF, its a basket of large financial stocks designed to go up when the financial sector of the S&P 500 index goes down. Its what’s known as “shorting the market.” In ordinary times we would re-frain from making such bets, however like we said, “extraordinary times require extraor-dinary measures.” Under the current eco-
nomic circumstances, we think a modest 5% bet the shaky financial sector will drop fur-ther is a reasonable one. We’ll limit our downside with stop/losses on all shorts. • Short Dow 30 ETF. Bet-
ting the Dow stocks will drop, see above. Think GM.
• Short Emerging Markets ETF. With the world economy in a protracted slump, the still overvalued emerging markets are likely to fall further.
• Long-Term Interest Short EFT. This ETF and the Gold Stock ETF below are bets on inflation returning once the world gets a gander at the trillions in bonds our government will be issuing soon. That fact alone is likely to push interest rates, which in the case of the short-term treasury bill are currently close to ZERO, much higher from fears of rising inflation
• Gold Stock ETF. This is a basket of Gold mining stocks. Since few gold stocks pay much of a dividend, we can’t find any that meet our investment criteria. Besides, this offers us more diversification than we could do on our own.
There you have it. The most radical strategy change in EQUITY INCOME Portfolio history. A strategy designed to protect our assets in what we believe is the most difficult investment environ-ment in a generation. We’ll do our best to keep you apprised of our strategy in future issues. We always welcome your questions regard-ing our strategy or any other aspect of our invest-ment management services. As well, we’re happy to meet with you to discuss our strategy and offer our thoughts on it’s suitability, in whole or in part, for your personal circumstances. We would also be happy to review your existing portfolio or asset list. The portfolio re-view is always free and with no obligation. If you’d like us to do a review of your invest-ment portfolio. all you need to do is provide us with the ticker symbol and the number of shares or units, either as one list or listed by portfolio, you prefer and we’ll enter the information in our handy-dandy computer and provide you with a detailed review all your own. Free for nothing! Simply email the information to [email protected]. We keep all informa-tion provided to us in strict confidence. We see the next couple of years as challeng-ing ones. We want to do what we can to help you survive it with your wealth intact.
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Page 4 Deschaine & Company L.L.C.
2001 2002 2003 2004 2005 2006 2007 2008 Cumulative
Return Annualized
Return
EQUITIES “ONLY” 21.8 8.1 28.2 24.4 4.6 21.9 .2 ‐ 23.7 104.4 9.4 TOTAL RETURN 15.8 6.9 19.3 19.4 3.8 19.0 1.1 ‐ 17.9 77.8 7.5 S&P 500 INDEX ‐12.0 ‐21.9 28.5 10.7 4.9 15.6 5.5 ‐ 38.5 - 20.9 - 2.9
Equity Income Portfolio Annual % Returns
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