Investment Update - February '10

Mr. Hyde. Dr. Jekyll. Sanity, perhaps?


“We have spent considerable effort in developing the tools we will need to remove policy accommodation (relaxed monetary policy), and we are fully confident that at the appropriate time we will be able to do so effectively.” ~ Ben Bernanke, February 10, 2010


Summary:
The broad economic recession appears to have ended, and the economy motors forward, despite painfully high jobless numbers. Coming off both the hard economic pain and an irrational fear that helped propel the markets downward, the markets rebounded in sober fashion in 2009. Having avoided the cliff, and with the economy improving, corporate profits are seeing a predicted upswing. While concerns linger about future inflation due to high government debt and high unemployment rates keeping the consumer frightened, we see continued economic improvement and a reasonable probability of rising stock prices. While we see caution lights -- potentially increasing government sector layoffs, foreign government credit issues (i.e. Greece and Portugal), commercial real estate losses, US and geopolitical issues -- we remain mostly optimistic for the foreseeable future.
Read on….

 

Dear Investor –

At least once a year, we burden our clients with a painfully long newsletter/manifesto, and it’s usually this time of year. Figuring everyone has better things to do at the moment, I’ll keep this one on the briefer side. Frankly, we could have taken the last issue, and with a bit of cut-and-paste, presented it again here. Essentially all the positive economic aspects we were observing several months ago remain in place, with most having strengthened. Despite the news headline noise, the economy is, in fact, coming out of the “great recession” in the same inevitable manner it has come out of past recessions. The combined government stimulus actions along with natural economic forces have staved off what could have been a far deeper economic debacle. We are now witnessing the natural fits and starts of the recovery.

When Mr. Hyde brought the economy to a screeching halt in 2008, and with the equity and bond markets in freefall, the notion of a broad rebound, even for many more savvy investors was hard to fathom. Watching prices drop 50% or more, along with the uncertainty of the economy was something terribly painful to average investors, many of whom had their assets parked in 401k’s, IRAs and other retirement plans. Assuming those investors were lucky enough to leave their assets where they were, Dr. Jekyll’s 60% run-up that followed the crash brought them back perhaps to 2/3rd of where they were in October of 2007. For the many, however, that pulled their funds out of the markets at the market bottom, those poor folk are now way behind and pedaling furiously. And the “New Normal” – a phrase coined by PIMCO’s CEO and bond manager Bill Gross -- does not see great equity and bond gains for the foreseeable future. A great leveling has begun, sanity has perhaps returned, and recovery for many will be a challenge, for sure.

chart

 

Lessons Learned. Even still, had insurance giant AIG gone under back in October of ’08 in the middle of the financial meltdown, or had banks and governments not stepped in, financial life could have been far, far worse, and we might be looking at a very different future.

What have we learned, however? Lesson One: something much worse than the average stock broker is telling you that could, in fact, happen, can and did happen, and will probably happen again. After all, the one-hundred year flood still comes to pass, and even if it’s once in a hundred years, this could be your year. Lesson Two: yes, the economy and markets recover from all kinds of mischief, even really bad mischief. Lesson Three: vigilance rules – those with the know how and lack of emotion were able to get out when needed, and get back in when they should have.

 

Chicken Little Returns. With an “improving” economy all but a foregone conclusion, the world market pundits must now turn to three new points of obsession: inflation risk (and a weak dollar), government debt, and most of all, high unemployment – the latest media blitz-child. While the first two may be material in the future, right now they are not critically important, despite all the railings of the republican right. If there was ever a time to run a deficit, this is it. The government is not likely to dramatically raise interest rates, and there remains still very little wage pressure given the high unemployment and low commodity prices. Treasury yields remain low, and will probably remain fairly low for the next 6 months.

Addressing the second issue that leaped to the front of the line this past week - while government credit on the federal level remains high, and despite the budget challenges of Greece, Portugal, Italy, Dubai, and other nations, we don’t see national debt issues having long term impacts on the economy anytime soon. Aside from short shocks and a whole lot of hoopla about an impending default in Greece and others, these may be immediate triggers for corrections, but we don’t see these traumatizing the markets over the longer term.

 

Now you’re worried about jobs? So that leads us to unemployment. Few folks were rushing to Obama’s defense back in late ’08 and early ’09 when he was pressing for high labor subsidies to help lessen the blow to employment. Indeed, the Congressional compromise cut significantly from what could have been a far more equitable stimulus effort. While the most recent jobs data provided a mix of signals, monthly job losses, which plummeted to 780 thousand back in Jan ’09, are now close to 0. Yes, we’ve lost over 8 million jobs in this recession, yes our underemployment rate probably hovers close to 17%, but this, too will be turning around. Granted, it’s hard to find solace in a headline that points to a reduction in unemployment from 10% to 9.7%, but considering the economic pickle we were in just 18 short months ago, we’ve stopped the bleeding, and the healing can now begin.

Would we be in favor of a targeted job stimulus bill that focused jobs in new technologies, infrastructure, and education? Yes. Will it happen? Probably not in any significant fashion.

 

The Economic Upswing

With GDP growth around a 6% annual rate in the last quarter of 2009, the economy is clearly improving. Global economic growth for 2010 is predicted to hit approximately 4%, and many feel that here in the US we’ll be seeing something closer to 2.5%, but perhaps as high as 4%. These are not stupendous numbers, particularly so soon after a vicious recession, but they are positive nonetheless. Consumer spending, at least based upon current retail sales indicates a slow, but perceptible improvement. People are saving more, finally – this is a good thing! People are putting less on credit cards, finally. And many investors who have moved their funds to the sidelines, out of harm’s way, are now finally realizing the possibilities that they may outlive their investments.

Businesses, on the other hand, are starting to build up their inventories and have accumulated very high levels of cash. Manufacturing has come alive again. Housing permits are up dramatically, and housing inventories are down having been sold off over the last year at bargain prices. Corporate profitability across a broad range of sectors is returning. All the essential components of an improving and stabilizing economy are fitting into place.

Caution lights. The markets’ strong sell-off since January is indicative of both a normal profit taking breather – after all, the markets had risen over 60% since their March lows – and a sober appreciation of some of the deep systemic challenges we face here and abroad. Certainly, a big part of that run-up came off the very much predicted, and emotionally charged rebound; and that, of course, off the emotionally charged market crash in ’08 and March ‘09. This sobriety includes a collective gulp regarding the size of our national debt (over $1.5 trillion) and that of other nations (Greece, England), currency gyrations (between the dollar, the British pound, and the Euro), China’s decision to take a right foot off the economic gas pedal and assert some hubris diplomatically, and US’ unemployment levels. Add to this the extraordinary muck of the current US political scene in DC, and uncertainty remains.

Two economic areas remain worrisome. State and local municipal budgets remain under siege. With help from stimulus funds and the nature of the streams of property tax and state aid payments, municipalities were slow to cut budgets in 2008 and early 2009, and many jobs were saved. 2010 budgets, however, and budgets going forward are currently under tremendous pressure to be cut. If sales and income tax revenues pick up due to increased consumer spending, this potential shoe may not fall much further than it has, but it remains a real concern.

Another concern has to do with commercial real estate, often one of the last shoes to fall. With a global real estate bubble still in place in China and other Asian nations, and with limited credit available for commercial real estate lending and high vacancy rates, this economic area may continue to lag and pressure the markets. Defaults could impact regional and other commercial banks, and hold down a significant component of the construction industry as well. With the economy undergoing a broad recovery, however, with banks having cash to lend, and with businesses finding profitability and more able to pay rents, much of the edge of this sector could be softened.

Finally, the issue of a jobless recovery. As we observed in the ‘80s and even through the GW years, the economy may go through an expansion phase but leave the worker high and dry. Yes, the hue and cry around the excruciatingly high unemployment rate is being heard loud and clear. But workers are working harder and more productively than ever before, at unsustainable levels, and wages have been stagnant for years. In order to grow, we see businesses as having no choice but to rehire or hire anew. It may take some time – perhaps a few years -- to bring the unemployment rate down to healthier levels of 4-5%, but fall it will. But there is a significant difference between this recession and those prior – job losses here were much more significant and, as the old saying goes, what goes down must go up. In other words, the vicious drop in jobs could see an equally strong run-up in new hiring.

chart

A slowdown later this year? With the withdrawal of the stimulus dollars, with the possibility of federal reserve tightening of monetary policy and no longer purchasing mortgage backed securities, and with a slow improvement in employment and consumer spending, we see the possibility of a slowing economy in the latter half of the year. Still, we feel the Federal Reserve and Bernanke will be very careful in this regard, that fearing a massive congressional backlash and cognizant of the delicate nature of this recovery, will be very slow in raising rates or stemming liquidity. So while a slowdown is possible, we see the natural economic engine grinding forward at a more sustainable rate of economic growth with Fed support. Yes, a slowdown is conceivable, but we just don’t see the economy heading backwards again.

 

Systems Still Broken

With the world looking to the US for guidance, and with Congress and the Administration embroiled in a game of hot potato, little is getting done. Some might say “great – anything the US government gets their hands on turns foul anyway.” Unfortunately, from an international perspective, the appearance of the world’s largest economy locked in a struggle of self-paralysis, as the two parties undermine a presidential mandate -- this cannot give comfort to our economic partners abroad. What’s more, Wall Street is doing everything it can to add to the depth of the mud in Washington.

The nasty politics. The Obama administration finds itself in a very difficult position. Having committed to an open process while running for Congress, and seeking a “new way” of doing business in DC based on bi-partisanship, little has, in fact, been accomplished, and the administration and the democratic congress have left themselves open to a public-backlash-bloodbath come November. Wall Street, meanwhile, has engaged an army of lobbyists (those, at least, not completely tapped out by their health care assault) to gang-tackle any representative attempting serious financial reform. The investor protection bill recently passed by the House (HR4173) and soon to be taken up by the Senate, is being watered down as I write. If you doubt me, just read some of the recent tirades of Elizabeth Warren, TARP czar, who has vilified Wall Street’s unhealthy influence on US politics lately.

Referring to incumbent Republicans and Democrats, many Americans, yours truly included, will soon be calling for a pox on both their houses. The Republicans, seeking to tear down Obama at any cost, with close ties to Wall Street and philosophically opposed to regulation are massed against any change. The Congressional Democrats, ideologically in support of regulation but unfortunately reliant upon Wall Street contributions are quick to concede major reforms. Given the choice between abandoning their president and winning re-election, they’ll do the latter every time.

The political upshot is that there will likely emerge a very modest, hardly impactful job stimulus package, with some token benefit afforded small businesses. Dr. Paul K and I both feel the most effective approach, both economically and politically would be a simple across-the-board payroll tax cut, and this would, in one cut, benefit both the businessman and worker. But, alas, no one’s asking us to run the program.

A bit of government good news. Finally, and remarkably, the SEC is mandating that corporations make available to stockholders information regarding climate risks. Insurance companies, for example, will now be required to present potential impacts of hurricanes and other climactic events, so that analysts can better assess potential liabilities. In fact, the SEC has taken a rather strong turn in favor of corporate reporting and transparency, which bodes well with the general mainstream around ESG – environmental and social governance, something we have long been pressing for.

 

Outlook: Pretty Good

So, despite the political paralysis, we are left with a generally favorable outlook for both the economy and equity markets. With the markets up so steeply since March of ’09, and even despite this year’s pullback of nearly 10%, we expect continued “breathers” triggered by one issue or another to continue as the economy chugs forward. Market valuations – with the S&P trading at just off 18 times earnings, remains very reasonable, and possibly even “cheap” based on projected earnings in 2011. Aside from the employment issues, as we’ve said in prior newsletters, we see some of the headwinds as beneficial – helping to keep the economy from superheating and finding a healthier, more sustainable growth level. The massive deleveraging of financial and personal debt could be the healthiest thing we’ve done in years. Hopefully, it won’t be just a passing fancy.

For investors -- what now? We continue our generally optimistic perspective on the markets. Many investors have now returned to more normal asset allocations. With equities reasonably priced, we will continue to preserve these allocations. While some sectors may outperform, and fine-tuning is needed, for the near and intermediate term we see generally favorable conditions across a broad spectrum of sectors – including technology, exporters, and others -- despite modest, periodic corrections. Internationally, even as developed Europe experiences slow growth, and debt issues remain in Southern Europe, international growth, particularly in emerging markets looks promising.

However, we do see increasing pressure on bonds – both government and corporate – with the anticipation of a tightening of policy. Bond spreads between higher yield and high quality corporate bonds have continued to narrow with improved corporate profitability. Short term yields and money markets continue to remain extremely low with federal funds remaining at near zero interest rates. Offsetting this, at least for the moment, is the flight to the safety of the US as Europe and other nations continue to struggle with their debt. Even more than gold, the US dollar and treasuries remain the havens of choice in a flight for safety. All told, bond and fixed income investors, therefore, should remain vigilant regarding bond values, as these sectors could see considerable volatility going forward. Quality, dividend equity positions are becoming increasingly attractive as part of fixed income portfolios, offering competitive yields as well as a hedge against inflation.

Investors should also take this opportunity to take “stock” of their experiences over the past two years, which present an excellent opportunity to see how they experienced both the market fall and recovery process. There are lessons to be learned from each negative and positive experience, and the past two years can teach us much. With the benefit of this experience, investors should consider their future financial and income needs, and be mindful that risk aversion may impede their meeting their financial goals.

To all, enjoy the snow and the coming Spring. Of course, please feel free to call with any questions or thoughts.

Peace,
Ron Stein

Good Harvest Financial Group
631.423.6501
rstein@goodharv.com

 

Disclaimer: each investor has different needs. The information herein should not be used to direct investment decisions without assistance. No guarantees can be made or implied in the above information.