Steady. Steady.

 

 

Dear Investor –

 

For those of you not interested in all the sundry details, and seeking only a short, get-to-the-point commentary, we’ll begin by closing. We don’t mean to be flip by saying little has changed from our last newsletter -- things are much the same since July, just more so. The economic stimulus is stimulating both here and abroad, the economy is improving as credit has become more available, and inflation remains low. Housing is beginning to turn a slow, long corner, and unemployment continues to tick up, as expected. Stock prices, usually a leading indicator of the economy, are rising. All eyes will be on the Federal Reserve as it tries to deftly manage monetary policy and inflation. While we expect the markets to tip and tumble with profit taking, high unemployment and other mixed economic news, we expect a continued modest increase in equity and bond markets, along with an improving economy for the foreseeable future. For more…. Read on.

 

Off and Running

 

 

 

As we know from 2008 and much of the first half of 2009, the markets are prone to panic lurching. Yet aside from the wild travails of the early part of the year, the last few months have witnessed the continuing of the more rational trends discussed in our July newsletter as the economy is improving. The recent GDP 3.5% annualized growth figure for the third quarter, even if somewhat overblown by the government stimulus efforts, is not all fluff. It’s a simple fact: we are in better, much better shape than we were a short year ago. The recovery is likely to be spasmodic over time, but recovering it is. As we stated in the last newsletter, the recession is over, and the Wicked Witch is dead. What kind of ride the Good Witch will provide remains to be seen, and investors need to remain wary of the vitriol of the Wicked Witch’s evil, perhaps vengeful sister.

The equity markets have been riding the celebration very hard since March, up nearly 20% since the April rebound (after the March plunge). As is often observed after a severe market change, there is no logical explanation for the extreme sudden rise, let alone the extreme drop between March and April, and perhaps even over the last few months. It continues to amaze how the brightest Harvard and Stanford grads under stress continue to perceive and invest in reptilian fashion. Yet reason seems to be stepping forward again, finally, with the S&P equity indexes marching lately in a more orderly though largely upbeat fashion, with just enough healthy concern to march carefully.

Perceptions of Risk Changing. What’s important for all of us to keep in mind are our perceptions of risk. After experiencing the equivalent of a 100 year flood, most investors came away determined to either raise the financial new house on stilts or move away from the river altogether. The focus had shifted for many to a greater degree of capital preservation. What will be interesting to watch, however, is the extent to which these attitudes shift if the equity markets continue to rise over the next year or so. (We’re going to speak more to some of these “behavioral finance” issues down the road.) As one might expect, those people who are most unemotional in their investment decisions are those most likely to outperform in terms of rate of return of their portfolios over time. However, in 2008 most investors had a chance to see just how unemotional they were able to remain, and how much unpleasantness was experienced. And as we stand today, with most investors having regained nearly half of their losses since the October ’07 market high, all are encouraged to keep an eye out for their own changing attitudes going forward.

What is becoming clear, though, is that many investors are already starting to take a more relaxed attitude about risk as the economy and markets are rebounding. Like labor pain, the excruciating experience of 2008 is starting to recede from consciousness, allowing many investors to fret more about what they may be missing out on, versus what they might lose. Watch out for this remarkable phenomenon.

 

Current Economic Temperature: Warm

Looking at the economic picture, we see far more green lights than red. As stated before, Gross Domestic Product is on the upswing, even taking into consideration “cash for clunkers” and other temporary stimulus efforts, with GDP projections going forward of a modest 2.5%-2.9% through the end of 2010. Housing starts have bottomed and are starting to turn upwards in several areas, as are home prices for several months running. Consumer savings is up, inflation is low. Borrowing rates for good credit customers has come way down, which is helping all borrowers, from individuals, to municipalities and corporations. Inventory oversupply has been effectively wiped out, and now new orders are forcing companies to restock. Consumer personal spending is stable, and slightly increasing. What’s not to like?

Of course, the right wing naysayers and fundamental pessimists are looking for different observations. They focus on fears of massive inflation, of increasing dollar decline, horrible unemployment. The irrepressible Dr. Paul Kutasovic, begs to differ. He sees the economy as a loaded spring, with tremendous pent up demand and loads of cash on business balance sheets ready to be put to work. Yours truly takes a more muted view, but stands far closer to the good professor than the hard-wired pessimists.

In any case, reality keeps poking the inflation naysayers in the eye. Inflation remains at extremely low levels, and the Federal Reserve conservatively projects core inflation at a very low 1% over the next two years. With current industrial capacity at a scant 65% (the average is 80%), the short and mid term outlook for inflation is relatively benign.

The naysayers also point to the recent 3.5% GDP third quarter figure and cry foul – that this is all “smoke and mirrors” stimulus money. Of course, these are of very same tribe that claims the stimulus isn’t working at a;;. One might also remind them that over 60% of the stimulus dollars, according to many experts, hasn’t even kicked in yet, but many are perhaps too busy celebrating the election eve results to notice.

Internationally, economies appear to be improving, although unevenly. China and Australia are leading on clearly strong upswings, while other economies appear to be facing slower upward marches. The World Bank sees a strong rebound, but notes the “uneven” recovery in East Asian countries and other emerging economies and emphasizes the need for continued stimulus. IMF –

the International Monetary Fund – forecasts modest global growth of approximately 3% in 2010, but cautions that the recovery will be very delicate and uneven. Strengthening economies domestically and sustainably is crucial, according to the IMF, to a solid recovery. Makes sense.

 

The Dollar. Sure, the greenback has fallen versus other currencies. Putting our petty patriotism aside, we just don’t see that as an issue at the moment because it is a) healthy, b) actually acts as a boost to the part of the economy we need to grow (like exports and the making of things), and c) helps inhibit the things we need to rely on less (such as 60” televisions and other imports). Some day, in fact, the dollar may give way to the Euro, Yen, or Yuan as the currency of choice, but that day is still well down the road.

 

Finding balance. Ironically, while the rest of the world needs to increase their domestic and consumer spending, the US needs to reduce its reliance on spending and import-purchasing, and focus on important services (i.e. healthcare), industrial and technological production and exports. The US, and its emerging market economic spouses, are part of an economically dysfunctional relationship that is out of balance for all sides. Asia has become addicted to exporting cheap goods to the US for its revenue stream, and here, at home, Walmart Nation has to break its fix and pull the consumptive IV tubing. Economists and public policy experts globally are hoping that this “intervention and rehab” may be one of the truly positive consequences of this global financial fiasco.

Personal balance is also on the upswing. American consumers, historically with the lowest savings rates in the developed world, may also be making a paradigm shift. Part of the slow start of the stimulus efforts in 2008 was due to citizens doing the unpatriotic thing: instead of spending as their then President was imploring them to do, actually paying off debts and stashing money away. That squirrel-like behavior has continued. So while investors have dramatically improved their personal balance sheets (hopefully what will become a new behavior), at some point in time, probably very soon, new acorns will be needed for consumption.

 

If it’s broke, fix it. Meanwhile, with all the scandals, crashes and financial turmoil the last few years, Congress appears finally willing to do what it has neglected to do since – well, we can’t remember: protect the investor. Nothing like closing the barn door after the wolves have followed the chickens out. The Investor Protection Act, initially the brainchild of the new administration, is being taken up in earnest in the House, at this time. A variety of important consumer investor protections will be incorporated. At the same time, the Federal Reserve and Treasury are working on more long-term power sharing ideas to help tackle several major systems’ risk issues, while Congress whines about conceding power – a hollow whimper after such poor oversight of the SEC.

Stocks – the word is earnings. The price of stocks, usually, has some connection to reality. It’s a present value of the anticipated stream of earnings per share. Stocks plummeted last year and early this year as it became apparent that earnings were completely unpredictable, and if anything, darn low, particularly with nobody buying. Lo and behold, stock earnings are dramatically improved, not a particularly difficult thing to do given the fact that earnings projections were so artificially low in many cases – in many cases practically assuming bankruptcy. With the bar so low, it was inevitable that disappointment would be less. We’ve all pulled that stunt in anticipating a test score, yes? So stocks were probably artificially cheap in early March. Then the turnaround – the big rebound we saw from March thru May.

The other bit of news here is that stocks are historically a leading indicator of economic growth. The good stock figures are only partly a result of improving economic fundamentals. What’s more likely is that they are indicative of an improving economic environment going forward.

 

Going Forward…the Bad, the Good, and the not so Ugly

 

So, what are the potential party poopers here? Unemployment, the ultimate lagging indicator, always the last one on the bus, looms large. This is unfortunate, because so many real lives are painfully impacted -- over 7 million jobs have been lost since late 2007. We continue to expect real unemployment to top off between 10% and 11% (it’s currently at 10.2%). The shadow unemployment picture – those partially employed, underemployed, or out of the workforce altogether – add at least another 7% to 10% to that number. And of those still working, many are frightened about their job security. But as we’ve commented before, the rate of loss of jobs has dropped, and we’re starting to see businesses starting to rehire again. With unemployment rates this high, though, the politics for the mid-term elections next year for those currently in office may not be pretty. Indeed, if we’re still hanging above 10%, the term “blood bath” comes to mind.

 

Consumer spending remains a big “if” – not surprising given the high unemployment rate and lukewarm consumer confidence. Yes, people are saving more and, yes, we know that for a sustainable economy, consumer spending shouldn’t represent 70% of our GDP growth. It’s too much. As a society – and we’ve spoken about this more than we care to think – we are far too materialistic and acquisitive. Maybe, as alluded to over a year ago, this crisis may lead to some permanent shifts in our spending behavior and personal spending discipline. Optimistic thinking aside, the financial world will be goosed if retail sales don’t show a pattern of “healthy” growth as we move closer to the holiday buying season -- a disappointment in retail sales could plunk a real tomato in the economic cake. However, retail sales so far have been improving, and with all the saving over the last year or so, there is real pent up demand. Even some of the high-end retail sectors are showing strong upward trends. Expensive boat sales may never fully recover, but the lines at Starbucks are getting a lot longer these days.

 

Real Estate woes – a real threat. Another concern we’ve been discussing for some time has to do with the real estate markets – particularly commercial. Notice all the For Sale signs in the downtowns, the malls, the condos? All the proposed big box projects now tabled? Even good developments stopped dead in their tracks. With businesses struggling, rents are tumbling. Many leveraged real estate firms are not meeting the necessary cash flow to cover their real estate loans and are in danger of bankruptcy. Moreover, new loans have been very difficult to obtain for all but the best credit risks. The combination has been quite a double whammy for many commercial real estate operations.

The real estate distress doesn’t end at vacancy signs, closed up office buildings and failing malls; indeed, the pain impacts the financial markets – the REITs (real estate investment trusts) and other securities and investments that have purchased those real estate assets to provide investments to the gamut of stockholders. The investor victims here include regular investors, big pension plans, small retirement plans, mutual funds, what have you, so big and small investors alike could continue to see stress on the real estate positions in their portfolios.

Perhaps the biggest risk regarding these commercial loans is to regional banks, who have fronted many of the loans to these real estate ventures. With over $1.8 trillion of real estate on the books of US banks, and with much of that real estate under pressure, delinquencies could threaten the failure of numerous medium sized banks. So far there have been over 100 bank failures in 2009. The good news is that the Fed is getting on top of this (finally), and banks are less likely to jump to foreclosing actions with these more sophisticated loans. A watchful eye will need to be kept on this area, however.

Another shoe to drop: municipalities? With the enormous infusion of federal aid to states and then to municipalities over the last months, only now are municipalities going through the deep shedding of jobs and capital projects that are byproducts of the significant drop in retail sales, income and property tax revenues, and transportation tax and toll revenues. The cutbacks are intensifying, and should continue to do so. Wages are being compressed, retirees not replaced, school programs reduced or cut. The stimulus brilliantly delayed the inevitable so as to limit the initial job losses, but reality must set in. Needless to say, municipalities and municipal work forces will continue to be under extreme duress. For investors, credit downgrades and credit defaults could wreak havoc on muni portfolios as this next shoe falls. Yellow caution flag here.

On the bright side, however, the majority of municipalities are so far managing to maintain their credit strength. There have been relatively few defaults of municipal bond payments, and hopefully this trend will continue. So far, so good, but vigilance by municipal bondholders will be needed here.

 

Other potential problem areas

Remember when oil was over $140 per barrel? It wasn’t that long ago. The market pressures that precipitated that overpricing were based on demand projections stemming from growth in the emerging markets, notably China and India. China, however, having invested over $500 billion in its own stimulus efforts is roaring once again, and it will continue to gobble up natural resources at an ungodly rate. Should commodity prices – oil, gold, other metals and raw materials – as a result of this increased demand suddenly take off, it could put a dampener on growth here in the US, as input costs (the costs of production) would rise considerably, and put the kibosh on corporate earnings. Verdict: this factored in the Great Recession back in ’08, but we don’t see it as a dominant issue this next year. Perhaps in 2011.

Stimulus – just a sugar fix? There are those that will argue that the hundreds of billions in stimulus spending is a short term jolt to be followed by a painful sugar crash: temporary relief at best, leading to longer term misery. Could be, but we doubt it. The next phase of this deeper economic recovery will happen when all that government money, currently in the hands of homebuyers and sellers, auto manufacturers and dealers, banks and consumers will now turn into jobs, capital equipment, goods, and production. That’s the intermediate term goal, and while we’re clearly not there yet, we feel it’s more likely to do the job than not.

Deficit perception. Despite the rabid hectoring evidenced by “Tea Party” activists and Limbaugh-philes, the $1.4 trillion deficit is actually indicative of fiscal effectiveness, although it will be a real (though manageable) challenge going forward. Let’s not forget the collective insomnia of these same, now suddenly emboldened groups during the whitewashing and steadfast denial of the issue through the prior nine years, mute at a time when the government should have been building a surplus to help cushion itself for the inevitable downturn, playing make-believe that the cost of the Iraq war and massive tax cuts was a gift from the tooth fairy. Let’s be clear: the hundreds of billions that the government has had to throw down on the table to bet the farm has staved off financial Armageddon, and the vast majority of the bet took place prior to January 1, 2009. The additional stimulus funds provided under the new administration are providing a key shot-in-the-arm to the recovery.

Even so, the cost of carrying such a large deficit requires borrowing. And while borrowing rates are very cheap right now, they will inevitably rise over time. The US dollar and the attitudes of international investors may be negatively impacted, some will argue. Perhaps, but the more reasoned response will be the impact of an improving economy here – a robust American economy will present the greatest positive impression to both the dollar and the international community. A growing economy will lead to greater revenues, and then deficit reduction. While the Johnny-come-lately deficit hawks should be taken to the mat for their hypocrisy, it’s important to keep in mind that there is a time for deficits – and this is one of them. Investing prudently in the future of the US economy makes sense, especially in a time of crisis, with “prudently” being the operative term.

So, yes, the deficit will be a challenge – but a surmountable one, as long as the US doesn’t return to its tooth fairy mentality of massive social program cuts, slash taxes on the wealthy, and remove key safety nets.

 

The Fed – Moving Forward. Federal Reserve Chairman Ben Bernanke had better be a good dancer – a better one than he was in ’07. This is transition territory. He has to carefully manage a balancing act between encouraging a too-loose monetary policy (and terrifying inflation-phobes), and applying too-early-tightening of the financial strings of the economy. Any klutzy fumbling one way or the other will spook countless hoards of domestic and international investors. Based on the recent Fed minutes, the actions will be executed carefully, looking first to reduce the size of the Federal ownership and purchases of government securities, which it has previously been aggressively buying to keep prices up. Ben will need to dance deftly around inflation trends and expectations, and we can expect a glacial-like transition to take place over the next year, so as to step on the fewest possible toes. Should the Fed move too aggressively to restrict money supply the recovery could be choked off in the middle of an important growth phase.

So don’t be surprised if Ben and the Fed continue a delicate two-step. At the end of the day, at least until early to mid 2010, and with unemployment over 10%, we simply don’t expect the Fed to raise interest rates, despite the clamoring by deficit and inflation hawks. They’ll talk about it a bit, and oh-so-gracefully ease into tightening, but only if the jobs picture begins to dramatically improve.

 

Unemployment. What does the recently stated increase in productivity of 9.5% mean to real people (versus, say, economists)? Does it mean that you, Mr. Smith can expect to be rewarded for all your added output? Not according to recent figures, which have suggested minimal real wage growth in…. forever. What is means to you, Ms. Smith is, simply, that you’re probably working your tail off. You’ll soon complain to your boss, who’s likely to realize from the logic of your argument and pained, sleep-deprived facial expression that maybe, just maybe he or she better think about getting some additional help. After all, sales orders look like they may start picking up after an awful year, and you, one of his important employees, just can’t do anymore. Time, then, to hire. And pay you a little more, to boot.

And that, my friends, is the plan. Someone has to restock those inventories, take those orders, assemble those parts. Forget about wage increases, people are just happy to have a job. But workers must be added, and quickly. In fact, don’t be surprised to see an actual increase in payroll jobs before the year end, followed by a slow, but persistent increase in business hiring through 2010. Sure, we’ll all hear the reports about the 10% unemployment rate, but the reality should be a significant turning around in the coming months. If 10% is still the number come mid 2010, prepare to see more a strong press for more stimulus dollars. The ruling political party is not likely to watch passively as their hopes and plans unravel in front of them.

 

The Markets: Earnings and Approaches

 

In this last earnings season, corporate earnings beat estimates over 80% of the time. That’s a heck of beating, even if the bar was set absurdly low. But, truly, things are improving in corporate America. Companies that many thought would never be profitable again are flying high. Heck, even Ford Motor Company is turning a profit.

As we’ve said before, earnings drive stock prices. With the S&P500 trading at around 16 times earnings, the price is not cheap. But as earnings are expected to increase over the next year, somewhere between 10% and 20%, the earnings profile looks very good for equities.

What’s important to also keep in mind is the tough bind that fixed income investors are in. After witnessing the paper destruction of what were thought to be fairly secure fixed income portfolios, grandma and grandpa are now having to contend with nearly 0% money market rates, and suddenly realizing that they may need to find ways to bolster yields and returns, even despite the pain recently experienced. For them and for many other investors, equities and corporate bonds – higher risk investments – may become more appealing.

What’s more, there remains an enormous amount of cash still on the sidelines earning those incredibly low rates. As markets – both equity and bond – continue to rally, and as more and more even cautious investors don’t want to be caught missing the boat – those funds will likely begin to flow into the markets, putting additional upward pressure on prices.

 

What now for investments? Over the last few months, as we’ve being doing since earlier this year, we have continued to move to restore allocations to normal levels. As we’ve seen the last month, however, we expect continued rises and dips amid a moderate level of concern that the economy is still fragile – evidenced by continuing weak employment numbers and personal savings -- and uncertain domestic and international markets. A variety of market sectors and geographic regions remain attractive: i.e. technology, emerging markets, select health care and biotech, commodities and large multinational and international firms benefitting from a weak US dollar. While we continue to fine-tune portfolios, we will continue to monitor the markets with vigilance, however.

For the bond markets, government treasuries remain very richly priced, and with paltry 3.5% interest rates for 10 year Treasury bonds, the risk seems high. To a lesser degree, not much can be said either for 2 year Treasuries at less that 1%. Bonds spreads between higher yielding corporate issues and high quality issues have narrowed considerably. With short term money market and other bonds so low, it seems that the willingness to incur risk is rising in bonds just as it has in equities. Bond investors need to remain wary about a change in interest rates. Municipal bond holders must also be cautious – as discussed above, municipal revenue is going to be under pressure and some municipalities may struggle to retain their current credit ratings.

The upshot is that this is a good time to invest in a variety of areas, but also an excellent time to take your own temperature on what’s happened these past two years, how you felt about it during its worst, and how you feel about it now. It’s also a fine time for fixed income and soon-to-retire investors to track income needs and review expectations. The high growth in the markets suggests that many investors have moved past their intense anxieties of just a year ago. The question – are they unwittingly moving to the other side of the ledger of irrationality to take on undue risk – is a reasonable one to ask. For now, the markets, bellweathers of an improving economy continue to point upwards.

To all, a wonderful Fall and Thanksgiving season.
And as always, please feel free to call with any questions or thoughts.
Peace,
Ron Stein

Good Harvest Financial Group
631.423.6501
rstein@goodharv.com