Welcome to our first quarterly update for 2011. For those of you following along, you may notice that we have changed the quarterly identifier with this newsletter. Whereas in the past your reports would have come with a newsletter for Q4, we have elected that with 2011, we will renumber our reports so that they more clearly correspond with the quarter we are in. Besides, we think it is better to be looking forward with our newsletter rather than merely discussing the events of the now seemingly distant past.
Perhaps the best way to kick off this new nomenclature would be to look back at some of the forward-looking statements I made with the last letter, written shortly before the November elections. At that time, I made four wise predictions:
Of these four, I am pleased to say that I was right on at least one of them. Congress did come to an agreement on tax legislation, and it is an agreement I view as favorable for the next two years. The Fed rolled out QE2, definitely not an “on hold” type of maneuver. The election, with a major power shift taking place, did not result in significant volatility…but the market has seen positive results, as shown below:
As we evaluate the various economic data, we are certainly seeing signs that our economy is clearly moving out of the recovery mode and may actually be in the very early stages of an economic expansion. Indeed, two indicators this quarter really catch my eye. The first, Real Capital Goods Orders, has continued its strong recovery through 2010 as the chart to the right indicates. BEA, FactSet, J.P. Morgan Asset Management. Census Bureau, FactSet, J.P. Morgan Asset Management
Further, new light vehicle sales have rebounded sharply, with renewed strength in the domestic brands.
Unfortunately, housing starts continue to be in the doldrums as excess inventory is worked off and prices adjust to the reality of a new post-housing bubble economy. Slight improvements in home sales, as evidenced in the graph below, are giving some signs of encouragement. Anecdotally, some friends who recently retired listed and sold their house (not quite for the asking price, but close) in just under a week…our expectation had been it could take as long as a year.
It is important to note that Q4 did give us a slight slowing in GDP growth, not only domestically, but around the globe. While this may be the beginning of a new trend, my personal expectation is that this is but a period of adjustment as the global economy eases into the expansion. However, we will continue to watch GDP indicators for a shift in the direction Census Bureau , National Association of Realtors , J.P. Morgan Asset Management of the economy.
Further, this chart does point out two important elements essential to our portfolio construction thinking: first, while the US economy is certainly growing, other portions of the world (indeed, the world economy as a whole) are exhibiting stronger growth than we are. Second, emerging economies continue to be a big player in the global economic expansion, and should not be left out of your consideration when building an investment portfolio. Obviously, everyone’s needs and objectives are very different, and in some portfolios the addition of equities of any type may not be appropriate. As always, we are here to help you craft the appropriate investment roadmap to guide you on your way to the fulfillment of your goals.
Yet another item bearing increasingly positive pressure on the economy is the strength of corporate and personal balance sheets. As the next charts show, household debt services ratios continued to decline sharply for U.S. consumers, and personal savings rates remain higher than they have been at any time since 1993.
On the corporate side, with cash now approximating 28% of balance sheets, we are finally seeing some of that cash get put to work (source S&P-FactSet) in the form of not only capital expenditures, but mergers and acquisitions as well. While this chart shows increasing activity in Q4, in the month of January alone I counted 11 major acquisition announcements, including companies like Qualcomm, Duke Energy, Concur Technologies, Smurfit-Stone, and Massey Energy.
This build up of purchasing power stands to make a significant impact on both the economy and equity markets as its employment accelerates. Indeed, the case for owning equities appears to be improving with each passing month.
However, an expanding economy does not bode well for all asset classes. We’ve talked about the risks to bonds for several quarters, and in Q4 some of those risks came to pass, with the 30-year treasury bond losing almost 10% of its value (9.86%), and even 5- and 10-year treasuries dropping 2.7% and 5.6%, respectively. Somewhat to my surprise, while there were hefty redemptions in municipal bond funds, taxable bond funds did not see significant net redemptions until December, and has seen only positive flows in January. My thinking is that there remains extreme volatility in the taxable bond sector, and we will continue to view that asset with caution. On the municipal side, redemptions have continued into 2011, and it is obvious that some values are being created, particularly if we are in a period of expansion where not all municipalities are going to default. Unfortunately, identifying these values and opportunities in the municipal market is very challenging. We continue to evaluate the opportunities there and may make some allocation to the sector if we find specific issues we are comfortable with.
Longtime readers of this letter know that two of my favorite pastimes are to ridicule the financial media’s analysis of whatever is going on, and to poll groups of investment advisors that I participate in and then do the opposite of whatever they are thinking. Up until recently, it was not difficult to find any number of sensationally negative articles predicting the impending demise of the U.S. economy and the world as a whole. In perusing major websites in preparation of this letter, I found very few “sensationalistic” articles, either positive or negative…which strikes me as odd. On the whole, the general slant of the articles I read was positive. Perhaps more importantly, I have noted a definite shift in the “bull-to-bear” ratio in the groups I participate in. As recently as early December, most groups were overwhelmingly skeptical of market gains, while more recently, the number is closer to 50/50. To me, the increasing confidence of advisors indicates that the investment cycle may be maturing, a feeling that corresponds to the extended technical indicators we monitor. This begs the questions, “Have we seen the extent of this leg of the bull market?”, and “Should I still be buying here or wait for the next drop?” While no one can predict with certainty, we can turn to some historical data to get some idea of what has happened with previous recessions and their subsequent recoveries.
As the chart shows, with the exception of one minor recession in the early 1900’s, the length of the expansion has exceeded the length of the recession, often significantly. Indeed, the more significant the recession, the longer the recovery, as is evidenced in the 1930’s, the early 60’s, as well as the early 70’s and 80’s. Further, explore the table to the left:
While it appears we are somewhere around “normal” in terms of the market recovery following such a recession, the data indicates that markets can go many times higher in an environment such as this, and we may be just entering the expansion that can be expected under these circumstances. In such an environment, price/ earnings ratios, technical indicators, and other market bellwethers can rise and stay at higher than normal levels. Thus, our position on the equity markets remains positive, though closely watched for any indications of a shift in the direction of the global economy. Of course, no manner of watching can predict the impact of a major geo-political event or natural disaster, so care must be taken to protect the gains we have through this period using techniques applicable to your individual strategy.
In all, we are excited for 2011 and look forward to the possibilities that the continuing global expansion may bring. Further, we look forward to the opportunity to sit down with you and review your road map in the coming year so that we may best remain your guide through these increasingly complex economic times.