-George Washington, letter to Henry Lee, October 31, 1786.

Holland & Hollande

We tend to gloss over the Founding Fathers’ fear of the masses in the hagiography of early American democracy.  By and large, the Fathers were middle-to-upper class property owners and professionals quite concerned with direct, unchecked democracy as they built America’s framework in the shadow of the French Revolution’s terrifying mob rule.  Alexander Hamilton allegedly said, “your people, sir, your people is a great beast,” one of his many little gems in favor of a wealthy minority holding the bridle of the majority.  But the push-pull of how much government is “for” the people and “by” the people is nothing unique to the American experiment.  I remember spending a whole semester in middle school on the “Spring of Nations” revolutions of 1848, the sui generis pan-European collapse of traditional authority.  Lately, we’ve spent a lot of time in the shop talking about that string of rebellions as some historians argue those few years of chaos wove patterns to dominate Europe for the next century; against the backdrop of a continental economic slowdown, food prices spiraled through poor harvests and population pressures while nationalism surged among minorities, all coinciding with dissatisfaction in the youth class.  There were also asset bubbles bursting in the railway, iron and coal industries best illustrated by the British Panic of 1847 that continued to feed increasing tensions between middle and working classes.  This all culminated in a series of violent demonstrations against monarchy.  Does any of this sound somewhat familiar?

Of course, the danger of studying history lies in assuming a similar set of events creates an identical result.  That rarely happens and, plainly, unequivocally, we are not stating Europe is devolving into chaos.  However, there’s enough to worry about in the political arena to give an observer pause and we as investors concern.  France has perhaps bought into a set of unattainable promises in Francois Hollande’s socialist program; in a rejection of immediate, German-style austerity his leftist French Socialist Party campaigned and won on public and education spending and a reverse of the departed Nicolas Sarkozy’s increase in retirement age.  Frankly, pun intended, this is fiscally impossible, and perhaps the silver lining is Mssr. Hollande will become more centrist by default.  Yet, these promises are still indicative of the sublime mood of disbelief present in Europe’s masses in regards to their financial condition.  If there is further good news to be wrung from the change in French leadership it will be Hollande’s pledge to reevaluate the European Union’s (“EU”) fiscal pact with an eye toward fiscal as well as monetary agreement.

A complete lack of commonality regarding budgetary policy seems to be stoking the extreme ends of European politics.  In late April, Holland’s Prime Minister Mark Rutte handed in his resignation after failing to find consensus on budgetary reform.  The Dutch (not the Danish, I still get confused) government has been extremely critical of free-spending EU members but found itself under internal attack from the Far Right Party led by Mr. Euroskeptic himself, Geert Wilders, who vehemently denied any adherence to external rules.  England’s Tory government continues to see the continent’s monetary union as a non-starter.  Italy’s recently elected Mario Monti appears to be learning on the job without any definitive path.  Troubled Spain’s Mariano Rajoy’s conservative People’s Party stokes Spanish nationalism above international entanglement; fiddling while Spanish industrial output appears to be burning.  And Greece…poor Greece…Golden Dawn’s surprisingly strong electoral showing is about as hard-right fascist a party as Europe has seen in the modern day spotlight.  Greek fringe entrants eroded enough support from the two major parties that another round of elections looks certain.  I think it’s safe to say the European Central Bank’s Jorg Asmussen was tasked with delivering a not-so-subtle message with this quotation:  “It must be clear to Greece that there is no alternative to the agreed upon restructuring program if it wants to remain a euro zone member.”  In public communications, that’s about as blunt as it gets.  So blunt that German Chancellor Angela Merkel had to play “good cop” the following day and assured Greece it was still welcome at the EU ice cream socials.

Generally speaking, the social network of Europe is broad and dense; income and value-added taxes are high but unemployment and retirement benefits are staggeringly good and early retirement is the norm.  On an anecdotal basis, my 11-year old son has a friend whose family has recently moved here from France and his mother will have her job waiting for five years in Paris while she follows her husband to America.  This amazes me, as I’m not sure I’d be employed if I took five days without checking into the office.  Government spending, again in general, has hovered in the 40% to 60% of gross domestic product range with markedly lower tax revenues.  This breeds deficits, so the pragmatist in me thinks calls for “austerity” are a logical conclusion to fiscal imbalances.  Instead, this movement is skewing the power balances within EU member states as the perceived reordering of the social network has empowered the political fringes.  When people are faced with an unpalatable choice they grasp for the extreme; Europe right now is personal psychology writ large.

All of this nation-state political mumbo jumbo is a shame, because corporations doing business in these troubled states are doing well.  Really.

With more than two-third’s of the S&P 500 companies reporting quarterly results we’ve seen 67% beat earnings expectations and 65% outpace revenue expectations.  There have been nice earnings upsides to the Materials and Consumer Discretionary sectors while revenue growth has been strong in the Health Care and Technology sectors.  The average company within the S&P 500 has grown earnings by 14.1%, on a year-on-year basis.  Admittedly, analyst expectations had been lowered to almost laughably low bars but equity and risk markets, generally speaking, anticipated the outperformance and raced out to healthy gains in the first quarter.  So healthy that despite negative performance in April and the first week of May, the S&P 500 was still up over 9% year-to-date, with the developed market MSCI EAFE index up nearly 7% and the MSCI Emerging Markets index up over 11% in the same time frame.

But, you can only focus on trees like earnings and positive hiring and firing trends for so long when the forest is burning:  The attention is on Europe.  As market observers, we’ll say almost any corporate and U.S. economic data over the next several months will be trumped by European news flow and the concern we are headed for a dreaded “Lehman Moment,” and the announcement of a major banking or sovereign meltdown.  Given the state of affairs as we publish, we’ll go out on a limb and prognosticate for posterity that this summer will see the exit of Greece from the European Union.  Politically and economically, this appears to be the road we are travelling and a logical outcome.  So although any analysis should strongly consider this, the actual breaking news will most likely be a source of major market volatility and a television talking head fiesta.  Despite the extremely decent profit picture in the corporate space and a domestic economy that is churning its way through tepid but still positive data, we have taken some steps to lower the risk in our portfolios because:  1) Again, we think the Greek situation will come to a headline boiling point this summer even though actual disengagement from the EU will most likely take years and, 2) despite the decent corporate news, equities aren’t screamingly cheap – long term, inflation-adjusted ratios are still trending above their mean, for instance – and even with record forward earnings forecast for 2013, next year’s earnings ratio at 12x is fair but not a screaming buy signal with the possibility of the U.S. sliding back into recession if Europe boils over.

The above is our immediate political and fundamental framework and hence we’ve begun to trim back our traditional, long-only exposures.  We felt the financial and energy sectors were the most at risk for European fallout and any slowdown in the global expansion hypothesis.  To mitigate, we sold our active dividend value manager that naturally focused on financials and energy and our energy sector exchange-traded fund.  We used those proceeds to purchase a market-neutral fund that hedges long-only individual stock exposure with individual stock short exposure and writes calls for premium income collection.

Combined with our existing market neutral manager our portfolios now feature two market neutral funds and a currency fund with a negative correlation to the S&P 500 index.  In conjunction with our cash holdings we believe these moves have lowered the potential volatility of our portfolios heading into summer.  We also used the cash from our sales to purchase an active global Utilities manager.  Our analysis led us to the sector for decent valuations and an attractive yield relative to underlying debt.  This was a trade designed to lower clients’ portfolios overall beta to the broad S&P 500 market, thinking very much in line with our market neutral purchase above.  Overall, we’ve tried to skew the structure of the portfolio to active management over the last several months to theoretically provide some relative outperformance in negative markets.  The climate for active equity management as a whole has been grim over the last eighteen or so months but we see a trend reducing equity-to-equity correlations so the theory is that stock pickers can enter a sweet spot.

On the fixed income side, we’ve continued on the path of short-to-intermediate durations and zero U.S. treasury exposure.  It’s pretty obvious when you look at our performance how this works on a month-to-month basis.  We underperform when investors flee risk or a third round of Fed-lead Quantitative Easing leads off the CNBC morning chatter and treasuries rally and the long-end of the curve dips.  We also run the risk in our short-to-intermediate stance that demand for yield will cause underperformance as in the tax-exempt market in the first quarter; despite the low level of absolute returns investors extended to long maturities.  To reiterate our pointedly stubborn stance:  The 10-year treasury is the baseline for all fixed income and at levels at or below 2% we feel this is the most overvalued liquid asset we can find.  As investors, we are and should be willing to trade short-term underperformance for long-term results, mainly protection of principal and the ability to reinvest at more attractive rates.  We also believe there are more attractive opportunities in niche income spaces such as MLP’s and overseas, with sovereign and corporate debt in the emerging nations and their cleaner balance sheets.  We also feel equities are the better relative asset class vs. fixed income for a ten-year forward time frame, and shift our allocations at the margins accordingly.  If our allocations seem routine to our long time readers that’s because they are, and we’ll continue to tweak things at the margins for current events but we won’t endanger the long-term financial goals of our clients by ignoring rational financial principles.

In case you were wondering how the 1848 revolutions turned out; France got itself a Bonaparte nephew and a Second Empire.  The German states took their first stab at a unified parliament, but wound up in failure as a power play between Prussia and Austria.  The Danish (not the Dutch) started down the path to democracy, and the Dutch (not the Danish) followed.  Switzerland took the opportunity to begin modeling itself after the United States and everyone took the wars and revolutions as a chance to flee to the actual United States setting off one of the world’s great immigration booms, including a brewer from Germany who used a small inheritance to open a brewers’ supply store in St. Louis, proving that from chaos could come an entirely new set of opportunities.  We’ll continue to look for these opportunities while navigating the headline turmoil.  Thank you, as always, for your continued trust in Capital Formation Group.  Please contact us at any time with any questions or concerns.

-William Shakespeare, “The Tempest”

“(They got me) starin’ at the world through my rearview”

-2Pac, “Starin’ Through My Rear View”

FIRE BURN AND CALDRON BUBBLE

In the fall of 2004 I had a co-worker, a tax manager, hand in his resignation to leave New England for Las Vegas, where he had maintained a vacation home for several years.   He was getting out of the private client game for good, off to semi-retirement and a try in the real estate market as a broker. At the time, this didn’t strike many of us as a daft enterprise for a youngish man; the Las Vegas Case-Shiller Home Price Index had just booked its fourth consecutive month of more than 50% annual price increases. Sure, some of us quietly mentioned that upon descent to McCarran there appeared to be unlimited surrounding land for Sin City to branch out and cause some oversupply problems, but that’s only because none of us realized most of the land around Vegas was owned by the federal government and the Southern Nevada Public Land Management Act had set up fairly rigid protocols for its disposition.   So, Vegas had a finite land supply, desert heat, celebrity buzz, no state income tax and the adult playground and thought-to-be-recession proof Strip, because, after all, when times got tough people still gambled; all in all, not a terrible mix. We wished him well at the goodbye party and went back to work.

Of course, you know how this turned out; since January 2007 every single month of that same Las Vegas Case-Shiller index has booked a negative annual change, with a crescendo of negative -33.11% (!) in December 2008. Can you imagine losing a third of your home’s value in one year? That happened. It turns out gambling is by no means recession-proof as lack of job does equal lack of ante and Vegas had and has no other industry to pick up the slack. Nevada, Arizona, California, Florida, all of the “sand” states, followed the same hyperbolic trend of real estate assets surging beyond all normal measures of fair value, like income-to-debt, and then plummeting back through the entry bids of most recent buyers; the prototypical “bubble and bust.” Bubbling asset values always go higher and crash lower than you think possible.

Why discuss old news? Because the Barclay’s 20+-year Treasury Index rallied +34.0% in 2011 to drop the 30-year government long bond yield near 2.90% at year’s end. Think about that for a second; with the year-over-year Consumer Price Index averaging 3.0% in 2011, and the 1946-2011 CPI average at 3.9%, annualized, you have to have an incredibly pessimistic view of the American future to effectively lock in a zero rate of return in a 2011 inflation scenario and a 1% loss at the post-World War II average inflation rate for thirty more years. To our eyes, U.S. treasury debt is the present equivalent of a just-off-the-Strip condo.   Of course, as we’re in the hyperbolic bubble phase this doesn’t mean treasury debt can’t appreciate to even further extremes in the event of, say, a complete debt death spiral in Europe. Also, the more extreme the crisis the more people will seek longer-dated safe assets. The aforementioned 20+-year index was trailed by the Barclay’s 7-10-year Treasury index up +15.6% and the Barclay’s 3-7-year Treasury index up +8.3%. We reason when the government debt bubble bursts the assets will unravel in similar tiered fashion, lead by an exit from the longest dated debt with the most painful losses.

The trouble with our treasury paradigm is timing; rates have stayed far lower, far longer than we ever could have imagined coming out of the ’08 chaos. Given our worldview, we’ve zero-weighted treasuries over the last four years and have even shorted treasuries off and on as things hit our perceived extremes, sometimes to great gain, sometimes to painful loss. It’s clear to us now the reversal of treasury yields is one of those frustrating financial ideas which will work at some point – and work brilliantly – but probably will bankrupt many along the way (just ask Japanese bond traders). In a surprise January 25th announcement, Federal Reserve Chairman Ben Bernanke pledged to maintain the short end of the treasury curve at effectively zero percent until 2014. Meanwhile, with the short end anchored by the Fed, longer dated treasuries are weighed down by sovereigns, pensions, insurance companies and large institutional players seeking risk-free yield; the irony of the search for yield forcing down yields and defeating the purpose. The old saw of “don’t fight the Fed” rings loudly in our ears so we won’t short treasuries any time in the near future but it also goes against our valuation principles to buy what we consider to be a clearly overvalued asset. Hence, in times like 2011 when treasuries surge, and the 10-year yield goes from 3.30% to 1.88% in the face of all reason, we won’t participate and will likely underperform in our fixed income mandate. Being sure of the upward direction of treasury rates, and sovereign rates as a whole, but having no good ideas on timing, we’ll maintain our worldview by owning intermediate duration debt, investment-grade corporate bonds, emerging market debt, MLP’s and the like. We must exercise caution though, as there is no way to achieve meaningful yield in fixed income without risk; Proctor & Gamble 10-year bonds just issued with a 2.3% coupon and top-rated 10-year municipal bonds yield in the 1.8% range. With a poor risk-return tradeoff domestically, we’ll stay shorter in duration than most indices and continue to seek international opportunities and niche spaces. Some years, like 2011, won’t have relatively pretty performance, but the long-term picture will pay off.

Fairly obvious to understand, though, why nervous investors might buy treasuries, and somewhat astonishing U.S. equities could eek out even modest gains given a broad sketch of 2011: Japanese tsunamis, Mid-East upheaval, Occupy Wall Street, U.S. government shutdowns, an aimless, ongoing war, much of southern Europe pushed to the brink of debt default and even the death of Steve Jobs seems like a deadly laundry list in even the best economic climes. As we continue to bounce along the bottom of tepid growth the world could have easily rolled over into global recession as confidence and optimism eroded. Working from the thread of our real estate intro, U.S. mortgage originations fell from $3 trillion in 2006 to $1.3 trillion in 2011. The negatives in the world are easy to come by, so why didn’t risk assets crumble?

As we go to print, 66% of S&P 500 companies had beat Q4 2011 earnings’ estimates and the index stands at a historically moderate ratio of 13.9 times earnings and a dividend yield just peeking north of 2%. Profit margins may be at or near all-time highs but don’t seem to be compressing in the near future. This isn’t screaming buy territory like March of 2009, but when you pair reasonable stock fundamentals and negative real fixed income yields with the broad trend of positive U.S. data including GDP, employment, manufacturing and confidence, all you need is the absence of cataclysmic news on the global front to catch rising bids. And Greece’s impending bankruptcy and our forecast of a decade-long workout like Argentina with multiple exchange offers and tender rounds would not be a newsworthy event in our estimation. Market prices have signaled Greece is a non-functioning financial entity for quite some time. Portugal, likewise, is an immaterial concern in the pan-European economic scope. What we do watch closely for is signs of stress in Italy and Spain; the two economies scale and depth of debt markets could overwhelm European Central Bank efforts if they were to spiral out of control.   Our belief has always been that Europe (read: Germany) has invested too much financial and political capital to allow the European Union to fail and this crisis would ultimately lead to increased fiscal and monetary ties as opposed to the union’s dissolution.   It’s our projection the ECB will allow Greece and Portugal to have somewhat disorderly defaults but will draw the line at Italy and Spain; as investors I think we have underestimated exactly how scarred global governing bodies are by the events in 2008 and how terrified they are of bringing the world economy to the brink again. They will literally do anything within their power to stop that seizure from occurring again. So far the markets appear to be agreeing with our worldview, as Italian 10-year yields have declined from their catastrophe-levels of 7.5% in late November of 2011 to the mid-5% range in early February. This is the backdrop of the risk asset rally we’ve seen since last year’s late summer panic; the global economy may be uninspiring, but it’s positive in spite of everything and the center of Europe’s economy will hold.

However, our optimism does not mean we’ve thrown caution to the wind and spent the cash hoard we built up through the end of last year’s 3rd quarter on broad, beta assets. We tried to have very targeted ideas as our cash levels come down into single-digit percentages. Tapping global turmoil we’ve made our first currency investment with a John Hancock feeder vehicle for First Quadrant management. Continuing global themes, we’ve picked up a pan-Asian dividend manager in Matthews and an emerging debt manager in MFS. Following positive forecasts from resource companies and commodity-consuming nations we selected a natural resources manager and the fundamental upward trend in U.S. data allowed us to hire a mid-cap U.S. equities manager. Further out on the risk curve, we also made a small investment in a European value manager to take advantage of some of last year’s massive sell-off across European bourses. We also hedged some of this long equity exposure with our first market neutral, publicly traded, open-end mutual fund.

To complete the story of my Vegas-bound coworker: He is not a straw man, but a real person I knew named George. After a few months of eastward-bound emails full of financial windfall and optimism, the communication stream dwindled and then stopped in late ’06. A couple of calls from people in the office went unreturned and even his e-mail address stopped functioning.   Finally, in mid-’07, another co-worker received an email from George. He had moved on to Los Angeles and back into the financial industry. Prosperity in the desert had been a mirage and a bursting bubble scatters so many of its participants to the winds. Historically, on average, the length of time an asset class takes to heal from an irrational top is much longer than its euphoric rise in value phase; the pain lasts longer than the pleasure. We’re in about Year 31 of the bond bull market. Let’s just say I hope George isn’t investing his savings in treasury bonds. As always, we deeply thank you for your continued support and relationship with Capital Formation Group. If at any point time you have questions or concerns please don’t hesitate to contact a member of our team.

-Blondie (Clint Eastwood) in The Good, the Bad and the Ugly (indirectly speaking to Greece)

Usually we start quarterlies with fluff, puff and bits of historical wonder (I even had an entire Halloween-themed letter penned as we waited until the end of October to get something more concrete out of Europe), but there’s too much going on right now for wordsmithing; we want to directly address how we see the market and what we’re doing so let’s get to the central question: How confused is the world when investors get back fifty cents on the dollar…and euphoria breaks out? Unfortunately that’s the scenario, as Greek lenders feared the Armageddon ending of disorderly default and total loss; facing with zero, any return seems preferable. News has French President Nicolas Sarkozy busily conferring with President Hu Jintao for China’s support in a European rescue fund and even Japan, beleaguered by decades-old deflation and natural disasters, stands poised ready to join once details materialize. Markets have temporarily gotten the heavily hoped for outcome of stability – or, at least, non-disaster – and October showed it: U.S. stocks posted the biggest monthly rally since 1987, with a roughly 12% monthly gain as we go to print, flying in the face of the doom and gloom of impending European implosion at the end of September. As our client and mentor, Tom Troy, always taught, “markets like to deliver lessons causing the most pain, to the most participants.” As of Monday, October 24th, 23% of mutual funds had underperformed their indices by more than five hundred basis points, proving the wisdom of Tom’s advice, and paving the way for a furious fund flow into equities by managers desperate to catch their benchmarks and a general “melt up” of the market. We went so far as to take some of the cash we’d begun to hoard since early August and purchased the biggest “bang for the buck” in a 2.5% position in the high beta MSCI Emerging Market exchange-traded basket of equities. Global emerging markets, in our opinion, have a valuation range compared to developed markets not seen for some time after the late summer sell-off. Summing it all up, we have European resolve, deep-pocketed international support, surging markets and plenty of dry powder for a rally tailwind. So why didn’t we do more? Keep reading.

In the short term, the simple fact Greece won’t outright default within six months is the removal of the type of chaos-inducing macro overhang that impairs sustainable rallies in risk markets. From late July through September fear of the domino effect of Greek default, world-wide capital raises by financial entities holding Greek debt, Italy and Spain forced into unsustainable borrowing rates by investors de-risking, and the general halt of smoothly functioning capital markets panicked global markets. With all of these very valid fears present and no resolution in sight, the S&P 500 bottomed on October 3rd at 1099 and marched straight up to 1278 in the next twenty-four days. We suspect global investors, faced with a 1.75% nominal return on U.S. treasury 10-year debt and a most recent year-over-year Consumer Price Index increase of 3.9%, decided Europe would muddle through some sort of resolution knowing full well the potentially irrevocable damage a second Fall ’08 could cause. The numbers also helped: Global prospective price-to-earnings, price-to-book, enterprise value-to-total assets – all the maths investors look for – provided an attractive jump-to point in equities. Excluding March ‘09, many valuation metrics were at lows not seen since ’03. Long story-short, it’s no mystery how a rally could occur and it wouldn’t surprise anyone for the sheer relief of not living the European nightmare before Christmas to power the markets into territory making those valuations not so sweet. But when the exultation ends…

As currently constructed, the world of investing is binary, oscillating from no-risk to risk, treasuries to everything else. Correlations among large cap stocks hit late-1920’s levels in September. It seems clear to our trading desk that high frequency participants at the margins of price action – and all prices are made at the margins – increasingly view the world as a collection of asset classes easily accessible through basket trading programs or products such as exchange-traded funds. When volatility peaks in times of turmoil these marginal price makers move assets in bundles of classes; equities, commodities and risky fixed assets out, and safe havens like treasuries, German bunds, gold and Swiss francs in. It would seem investors, to use a general term, are far less concerned with the academic benefits of diversified assets than the absolute total loss of a portfolio. Why?

We all witnessed as close to a systemic meltdown in ’08 as we think the world can bear and we have seen first hand how hidden bits of information from seemingly disparate entities are covertly interrelated. Hence, chain reactions across a multitude of asset classes can start from relatively isolated industries, with the notable exception that the press and populace now believe the financial industry to be the center of the entire web. So, when the bulge bracket banks continue a spate of earnings that are of poor quality or outright negative, investors will continue to look for macro risk issues that exaggerate the enormous trading ranges we now see. Financial volatility forces emotional and often irrational indecision-making upon investors and can lead to data points like the recent collapse in consumer confidence and forces a reconsideration of the multiple of earnings/sales/book an investor is willing to pay for what is essentially an “analyze and hope” asset in equities. For example, if fifteen years ago a fifteen times earnings multiple was considered averagely inexpensive for the S&P 500 in that investing world of unlimited growth and budget surplus, that same multiple begins to look very expensive in today’s world of low growth and overhanging debt. As markets re-rate multiple ranges and wrestle with volatility and the uneasy fact 2012 earnings estimates are turning decidedly bearish, huge trading swings are not only possible but probable and even logical. We feel this bound, jarring trading range is the fate of the markets for at least a few more years as we deal with sovereign debt and demographic issues.

And because of these huge price swings in assets and high correlations, we’ve been searching for something with low or negative correlation to both equities and treasuries and a bit more quantitatively based than our usual investment spec; we’ve long been interested in currencies as an asset class form our market thesis that currency pricing driven by at-the-margin trading is driving asset pricing, inverting the traditional model of asset valuations driving currency demand. We like this theory but the currency trading space is traditionally dominated by hedge funds and very large institutions with appropriately large barriers to entry. Fortunately, a well-respected currency manager, First Quadrant, has partnered with the John Hancock mutual fund company to create an open-ended, cost-effective and liquid feeder vehicle. Seeing the opportunity we had been waiting for, we instituted a 2.5% position in September. It’s a bullish bet on continued volatility, a case we continue to support.

What else is there to dampen this rosy October glow? Well, the Federal Reserve proved during the month how ineffective it’s remaining tools are by announcing Operation Twist on September 21st; a decades old re-hash of taking short maturing money and purchasing long maturity debt to effectively “twist” the long end of the curve down and make big capital acquisitions like mortgages more affordable. On the day of the announcement the U.S. 30-year bond stood at 2.99% and after all the central bank machinations, ended last Friday at 3.35%, the exact opposite effect. In truth, the only immediate solution both the U.S. Federal Reserve and the European Central Bank have is to issue more debt on top of the debt already owed and hope the emerging economies continue to lend…and the market is on to this game. This inability of central banks to tame the bond market, combined with at least a guarantee of mildly inflationary resource pricing from the spiraling demands of emerging economies and their need to eventually seek a higher rate of return on their lending is the central tenet to our zero U.S. treasury exposure and outright short of the long end of the curve through a liquid exchange-traded fund. However, this is a long-term thesis that may take years to develop and during high periods of instability the binary nature of the market will swing to risk-off and treasuries will perform very well, driving prices down to a 1.75% 10-year price in early October. During these periods, we will not perform well in the taxable fixed income space as short treasury exposure and spread-based fixed income is almost a virtual certainty to suffer, but over the long haul, if our forecast is correct, we should significantly outperform a treasury-only portfolio.

But, equities are volatile, treasuries are overvalued, the world is highly correlated…if you are masochist enough to read through any of our last couple of years of sermons we’ve beaten these themes to death; there’s nothing new so much as the specific observation that the underlying contagion of excessive sovereign debt continues to spread, and short-term haircuts to Greek bond holders is only a Band-Aid for a gunshot wound. We mentioned two quarters ago that Italy is the third-largest bond market in the world. Throughout the October euphoria Italian benchmark 10-year bonds continued to creep into unsustainable funding rates and trade at an excessive premium to German debt. Much like the origins of the Greek meltdown, two countries cannot share the same currency at markedly different funding rates, as the two are designed to offset one another. When this relationship breaks down financial instability will surely follow and the continued financial instability of Europe, minus headline-snatching temporarily bailouts, is the real elephant in the room that keeps our cash levels above 10%. Europe taken as a whole is the world’s largest economy and because we do not understand the entire global systemic effects of continued instability in the world’s largest economy we keep our cash levels high for a very simple reason: Wide trading ranges force marked dislocation in assets and we want the ability to take advantage of opportunities without requiring the sale of other assets that may be negatively impacted by those same dislocations. That’s a very fancy way of writing when times get crazy, we like to have a bit of cash on hand.

We continue to work on some interesting ideas for this type of macro market that we’ll outline in the year-end wrap up letter. The unnerving volatility and focus on globe-spanning events is a relatively new phenomenon for investors and we’ve been concentrating on modifying our analysis toolkit to help ground us through the news flow. Because of the frequency of market-shaking headlines we’ve begun expressing relatively weekly thoughts and you can follow our links to writing and conference calls on www.capitalformationgroup.com. As always, thank you for the continued trust in us during these most tumultuous of times. Please never hesitate to contact anyone on the team for questions and feedback.

Against the backdrop of uncertainty in Europe, the MSCI All-Country World Index has had its roughest stretch since ’08, down near 18% for the quarter. During this time, between the ECB and Federal Reserve, central bankers have bought bonds, banned short selling, pegged 0% rates, provided unlimited funding and tried to twist the yield curve flatter. Bottom line: As long as investors are concerned Greece’s debt issues can spiral into Italy and Spain risk assets will suffer.

Given fears of global recession and financial contagion, U.S. sovereign debt and the dollar continue their surge to little surprise. The oft-forgotten corollary to dollar strength is commodity weakness, as most commodities are traded internationally in dollars, so it is logical gold, copper and oil – to name a few headline natural resources – have fallen sharply in the past few weeks.

Investors are understandably on hold for more risk, but in our opinion the fundamental valuation of general equity indices has entered extremely interesting levels. Price/earnings, price/sales, book value, dividend yield…no matter the metric, equities are about as cheap as they’ve been in the better part of two decades. Can they get cheaper in the event of more European chaos? Yes. But the margin for error is getting larger and that should be a source of great comfort for stock buyers.

We love historical trivia here at CFG but it is melancholy to report a once-proud company like Eastman Kodak is sinking into a footnote. As we go to hit send share prices are near $00.67; this was an $80 stock in the mid-’90′s. It’s a bittersweet reminder that technology is the least forgiving of sectors.

Album of the Week: Nevermind by Nirvana; celebrating the 20th anniversary release on September 24th, you might just have to be a Gen X-er to appreciate what it meant to us…and that just made me sound like my parents.

CFG has special ties to CHB. John Williams’ son spent months there as an infant while he received treatment. Jonathan, born 13 weeks premature weighing 2 lbs, 5 oz almost 30 years ago was given continual, life saving care in the hospital’s neo-natal care unit for about 2 months. “Jonathan is one of those miracles we celebrate in this event,” says John. Nate Armitage has been receiving treatment and undergoing surgery for Crohn’s Disease at CHB since he was 15. His doctor, Dr. Samuel Nurko is being honored at the Gala for the quality of care he provides. “My family and I owe an awful lot to Dr. Nurko. Over the last 15 years he has played a vital and significant role in my life and I feel blessed to be one of his patients,” says Nate.

As a member of the Latino Council for CHB, Marcel Quiroga has been one of the Gala Chairs since the beginning. “Doing this aligns perfectly with my values. Personally, I can’t be grateful enough for having two beautiful, healthy kids. It is an honor and it is humbling to be a small part of something that gives life and health to children and hope to their parents,” says Marcel. CFG has also been supporting Milagros Para Ninos since the first Gala in 2010.

For more information about the gala please visit http://giving.childrenshospital.org/netcommunity/page.aspx?pid=2072 or contact andres.trevino@chtrust.org