Download Meet Goldilocks` Ugly Sister, “She`s Not So Bad”

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News & Market Analysis: 3Q 2010 | OCTOBER 15, 2010
Meet Goldilocks’ Ugly Sister,
“She’s Not So Bad”
Financial markets had a strong third quarter. Modestly positive news on the economy
proved an elixir for the stock market, and the bond rally continued as inflation remained a non-issue. The happy result was positive returns in both markets:
STOCK AND BOND MARKET RESULTS
S&P 500 Stock Index
Salomon Medium-Term
Treasury Bond Index
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Merrill Lynch 3 to 7 Year
State G. O. Index
3rd Quarter
1st Half
Year to Date
11.3%
-6.7%
3.9%
2.3%
4.6%
7.0%
2.2%
2.3%
4.6%
MEET GOLDILOCKS’ UGLY SISTER; MAYBE SHE’S NOT SO BAD
While the US economy appears to be decidedly on the cold side of “just right”, investors demonstrate little fear of “too hot” inflation and diminishing concern about a “too
cold” dip back into recession. The consensus outlook is for a slog, but a slog is a lot better than a financial crisis or a recession. With interest rates at record low levels, investors appear to be regaining their appetite for risk. Minimal inflation and 0.10% money
market rates have made 2.50% 10 year Treasury yields seem reasonable. Likewise, the
low Treasury yields are making the stock market attractive on a relative basis, offering a
dividend yield close to 3% and the prospect of at least some growth in earnings.
“TOO HOT” APPEARS TO BE OFF THE TABLE
A return to robust growth seems very unlikely given malaise in the housing market and
the lack of progress reducing debt in the economy. A surge of investment in residential
real estate has historically been a necessary element of a strong recovery from recession. The recent recession was a direct result of a collapse of the housing market, and
all indications are that we are at least twelve months from working through the overhang of excess homes. Until that backlog is cleared, investment in new homes will be
restrained, and the slog will likely continue.
News & Market Analysis: 3Q 2010 | OCTOBER 15, 2010
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Debt is another major unresolved issue as the economy comes out of recession. After
three decades of increasing leverage, households hit the breaking point in 2007 and have
reduced debt since then, predominantly by defaulting on mortgage loans. The entire
economy, however, has increased leverage since the recession began as the government’s
efforts to fill the demand gap have led to large federal deficits. Since 2007, household debt
is down by $350 billion, but government debt has increased by $3.6 trillion.
Sector
Measure
1980
1990
2000
2007
Q2 2010
Household
Debt as percent
of income
57%
73%
80%
114%
108%
US Economy
Debt as percent
of GDP
136%
185%
179%
222%
243%
Sources: Federal Reserve’s Flow of Funds Report, Bureau of Economic Analysis
While government spending has played an important role in stabilizing the economy, the
surge in government borrowing is analogous to having treated a hangover with a few
more drinks. It reduced the recessionary pain in the short run, but has increased the total
amount of debt that must be paid off in the long run. At some point, the whole economy
needs to deleverage, and when that process begins, it will slow the rate of growth.
In the meantime, any increase in interest rates will act to limit growth. Rates have come
down dramatically since the recession began in 2007 (from 6.2% to 4.3% for a 30 year
mortgage). This has helped to propel the recovery, but if rates go back up and the increased stock of debt begins to reset at higher levels, growth will be impacted.
“TOO COLD” IS LOOKING LESS LIKELY
We believe that the Federal Reserve deserves high marks for its response to the financial
crisis and resulting recession, and we believe that Bernanke and his fellow governors
continue to be correct in their concern about the strength of the recovery and their bias
to action. Their willingness to deploy unconventional monetary policy, primarily printing money, is a significant factor in making a second recession a minority probability
outcome. The market is expecting a second round of “quantitative easing” before the
end of the year, and this should help to support asset prices and economic activity for as
long as the excess quantity of money remains in the economy.
The second argument against renewed recession is that economies naturally grow. As
population grows and the productivity of the workforce increases with new technology and improved business practices, the economy grows. It takes a significant shock
to knock an economy off this path, and we went through a big one starting in 2007. As
News & Market Analysis: 3Q 2010 | OCTOBER 15, 2010
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discussed above, the imbalances that set up the recession have not been fully resolved,
but the recession did have the effect of prompting corporate managements to streamline operations and to exercise extreme caution in investment in inventory and capital
goods. As a result, there is not much to be cut or reduced in the event that demand
growth slows. Without a pronounced inventory and investment pullback to amplify a
slowdown in household spending, it is difficult to envision the economy in recession.
STOCK MARKET LOOKING MORE ATTRACTIVE
Our view of the stock market has not changed significantly in the last two quarters.
Stock fundamentals are weak because the economy is slogging along, and earnings
estimates for 2011 are too high. Analysts are forecasting 15% growth in earnings, which
will be very difficult to achieve if the economy is growing 2%. Cost cutting was pursued aggressively starting in late 2008, so additional earnings growth will require a
boost in revenue that most of corporate America is unlikely to see.
On the plus side, stocks are not expensive. Even after the 10% advance in the third
quarter, the market is trading with a price to earnings (PE) ratio below 14. This is close
to the long term average, and while the earnings growth outlook may be weaker than
usual, the alternatives that stocks compete with are offering much lower than historically typical returns. Cash is paying near zero, ten year Treasuries offer 2.5% and ten year
single A corporate bonds pay about 3.6%. Stocks offer dividends near the level of a ten
year bond and, if the economy can grow even slowly, the opportunity to own a piece of
a growing stream of cash flows.
As a result, we are not pessimistic about the market, although we are being very selective in our portfolio construction. Given our outlook is for an anemic recovery, we are
limiting holdings of highly cyclical companies, unless their growth is unusually weighted to emerging markets. We are actively looking for companies that have predictable
business models, even if their growth is modest, and, especially, for companies that
appear to have the opportunity to grow at a rapid rate in spite of a weak economy. We
believe these companies will have scarcity value as the cycle evolves.
STILL VALUE IN BONDS AS INFLATION REMAINS QUIET
The bond market has been a very profitable place to be over the last two years. As mentioned earlier, interest rates have fallen broadly by about 2.0% percentage points since
the recession began in 2007. Falling rates increase bond prices, which makes for attractive returns when interest payments are added on top. Our strategy in both the taxable and tax exempt markets has been to own very high quality bonds (given concerns
about the economy) with long maturities. The long maturities have enabled us to lock
in high yields for clients for as long as we want to hold the bonds. With bond prices up,
however, we are constantly revisiting the question of whether the time has come to start
making sales.
In the tax exempt arena, the answer has been “not yet”, and we have continued to reinvest interest payments and maturities into 12 to 20 year bonds of very high quality. This
News & Market Analysis: 3Q 2010 | OCTOBER 15, 2010
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decision reflects our belief that inflation is not an immediate threat to bond prices and
that longer bonds continue to be an excellent diversifying asset against stock portfolios
and other equity assets that clients own. If we are wrong about the economy and inflation does become a concern, stocks should do well on an improved earning outlook; if
we are wrong and the economy double dips, then the bonds should do well as interest
rates continue to fall and the outlook for stocks gets marked down.
In taxable bond portfolios, the logic is much the same. Our trading activity has increased in recent weeks, however, because some of the corporate bonds that we bought
in 2009 have appreciated so much that we have decided to sell them. We have been
reinvesting the proceeds in bonds issued by municipalities, school and water districts,
and other entities that historically have used tax exempt debt, but are now issuing taxable Build America Bonds. We wrote about these last quarter and find that they offer
more attractive yields and credit quality than the corporate bonds we are selling.
ADDITIONAL COMMENTS
As always, we welcome any interaction with you and invite you to call or email with
questions or comments. Please find enclosed copies of our Privacy Policy and our
Proxy Voting Policy, which we send to you annually.
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