The second quarter of 2010 reminded us that things can look unnecessarily gloomy the morning after a party.
It’s true that growth appears to be slowing from the first quarter, and the markets acted as if they needed to sober up from last year’s stimulus-induced recovery. While many investors are still concerned about a double-dip recession, several indicators are pointing toward continued global growth.
The second quarter was a bad time for most stock investors. The Dow Jones Industrial Average (DJIA) ended the second quarter down 10% and was down 6.3% for the first 6 months of 2010, although it is up 49.3% from its 12-year low of 6,547 on March 9, 2009. The Standard and Poor’s 500 Stock Index also dropped during the second quarter, with a loss of 11.9%, and was down 7.6% year-to-date. The NASDAQ fell 12% for the quarter and was down 7% for the 6-months ending June 30, 2010. Currently, the stock market is extremely volatile—in fact, for the first eight trading days in July, there has been an increase of over 6% for the DJIA, S&P 500, and the NASDAQ.
The European Debt Crisis
Many overseas stocks, especially the European stock market, took a double blow—they fell more sharply than U.S. shares in local currency terms, and the strengthening of the dollar further reduced their value when translated back into dollars. The debt crisis that spread across many parts of Europe is seen as one of the biggest threats to the performance of the U.S. stock market
over the next 12 months, according to a survey of professional money managers. (Source: Russell Investments – Investment’s Latest Quarterly Survey May 31, 2010)
Investors shouldn’t totally ignore or give up on Europe—at least not yet. The weaker Euro will make European products more competitive in foreign markets. Plus, profits generated in other currencies will translate into a greater number of Euros, which means higher earnings for European companies. While these investments involve special risks including greater economic, political and currency risks, the primary reason to hold European
stocks today is that they are cheap compared to most other stock market exchanges.
Gold vs. Treasuries
Many investors have piled into gold and Treasury Bonds recently, seeking investment alternatives. History suggests that possibly only one of those bets might end up paying off. After their strong increases, both gold and treasury debt are expensive, which could mean increased risk and less potential for profits.
Gold is not a truly efficient inflation hedge. Gold was one of the few bright spots, up 11.9% for the quarter and 12.7% for the 6 months ending June 30, 2010, and ended the quarter at $1,243.10 an ounce at quarter end. However, the real price of gold, adjusted for CPI inflation, has fallen about 45% in the last 30 years. Compare that to the real price of equities, adjusted for CPI inflation, which has risen approximately three and a half times in the last 30 years. (Nick Murray Interactive, January 2010)
As investors have piled into Treasuries in recent months, this demand has driven the yield of the benchmark 10-year note down to below 3%! Consider that 20 years ago the yield on 10-year Treasuries was 8.38%. (Source: Treasury Department, By The Numbers, June 14, 2010) The only time in history that 10-year Treasury yields were lower was in the fall and winter of 2008 – 2009, during the worst of the financial crisis. (Source: WSJ June 11, 2010 C1).
Inflation vs. Deflation
Should you worry more about inflation or deflation? Financial markets are sending mixed signals, so it seems that investors fear both scenarios. Many economists are not worried about inflation, since the latest government figures show that U.S. consumer prices, excluding food and energy, were up only 0.9% in April from a year earlier, which is the lowest level in 44 years. (Source: WSJ, May 20, 2010, A1)
According to most economists, deflation is more dangerous than most forms of inflation. When prices fall, consumers often put off their purchases to get great bargains later. There is a significant amount of money sitting on the side in money market accounts, bank accounts and Treasury Bills—$8 trillion, according to some estimates. When you combine a sizeable chunk of available money with extremely low interest rates (0.16% on the Treasury Bill as of July 12th, the lowest rates on record), in many cases the end result is inflation!
Hypothetically, let’s review an investor that wanted to earn $3,000 per month from their investments. If their money is invested in Treasury Bills that are earning a little less than 0.1%, in our example, the investor would need $36 million to generate $3,000 per month! Without that large sum, the investor would most likely need to add money from their principal to their earnings to reach the $3,000 mark. This would create demand for alternate investments, which might push the price up for these investments, which could lead to inflation! (Material discussed herewith is meant for general illustration and/or informational purposes only. This example is not indicative of any specific investment product or investor.)
Wall Street loves a Goldilocks economy – one that is neither “too hot” and likely to fuel inflation and higher interest rates (both bad for stocks), nor “too cold”, which often crimps corporate profits. In some respects we are seeing such an economy today, one that has struck a “just right” balance between growth and inflation. (Source: Economist June 5, 2010 pg. 18)
Many professional money managers worry that the huge stimulus the Federal Reserve and the U.S. government have provided to the economy over the past few years will inevitably push up both interest rates and consumer prices. While the threat does not appear imminent, a rise in interest rates could negatively effect the price of bonds, so it is not too early to consider steps to help protect the bond part of your portfolio. Individual situations will vary; therefore, these strategies and products may not be appropriate for all investors. It is important to speak with an investment professional prior to investing or making changes to your existing portfolio.
- Foreign bonds often provide protection against interest rate risk because they often own securities issued by other nations whose economies aren’t necessarily in sync with that of the U.S. Major commodity-exporting nations can also provide some diversification. One risk is the changing price of foreign currencies, which increases the volatility of foreign bonds compared to domestic bonds. Please note foreign securities entail special risks (such as currency fluctuations and political uncertainties) and may have higher expense and volatility. Some foreign bonds may involve below-investment-grade (“junk”) bonds, which are more at risk of default and are subject to liquidity risk. Investments in emerging markets may be especially volatile and diversification does not guarantee profit or protect against loss.
- Shorter-term maturity bonds decrease in value if interest rates rise, but usually fall less sharply in price than longer-term bonds.
- U.S. Treasury Inflation-Protected Securities, or TIPS, allow the principal amount to rise along with the Consumer-Price Index. Unfortunately, because the recent readings on U.S. inflation have been low, the yields on TIPS are unattractively low. TIPS are also more sensitive to any broad rise in interest rates. Investors should be aware that the TIPS principal is adjusted downward for deflation, and interest payments may be less than they would be if inflation occurred or if the Consumer Price Index remained the same.
Investing in a Rising Tax Environment
President Obama has had to deal with many problems, including the recession and the resulting significant drop in federal tax revenues. To address the mounting deficit, there have been a number of proposals to increase taxes on affluent families. This year, Congress approved an additional 0.9% tax on employment compensation in excess of $250,000 ($200,000 for individuals) and an additional 3.8% tax on taxable investment income earned by families with Adjusted Gross Income (AGI) above $250,000. Obviously, there is a case that additional tax revenues will be
needed, and the bulk of new taxes could likely be the responsibility of higher-income families, fair or not.
There are also a number of proposed tax changes in the works, but the odds of a tax increase will probably be higher after the fall elections. Is anyone surprised? Also, remember the next year brings changes in the estate tax, which has been zero for 2010 but scheduled to return next year with a $1,000,000 exemption with top estate tax rates at 55%! We will keep you posted.
Bear Market vs. Bull Market
Bulls argue that corrections are part of all Bull markets and that stocks will get back on track as investors refocus on the favorable fundamentals. Bears argue that expectations for earnings’ growth are widely optimistic and that stocks are not cheap considering the risk of a double-dip recession in the U.S. The outlook for many Bears is clouded by growing worries about Europe and the vitality of the U.S. job market. Jobs are a major key toward recovery; unfortunately, many economists believe that unemployment will still be above normal (8.6%) by the end of December 2011. (Source: WSJ, June 10, 2010 A8)
While the market action during the second quarter has been discouraging, Federal Reserve Chairman Ben Bernanke offered cautious reassurances, and there are a number of reasons to still maintain the course:
- The Dow has yet to issue a major sell signal. The question is whether or not the pullbacks indicate a Bear market or merely a correction in a Bull market. Based upon the indicators, it is more likely that this is a blip in the Bull market—no cause for panic! Corrections are a natural part of the economic cycle. In order to plan your investment strategies properly, it is best to look at the long term rather than the short term. Corrections can be scary, but we’ve seen them before and we’ll see them again. The retrenchment that began in late April is no different.
- Stocks are reasonably valued. The S&P index trades at roughly 13x expected 2010 earnings—modest relative to 20-year norms and very modest relative to bond yields. Many U.S. stocks are similarly cheap, and high-quality stocks are unusually cheap relative to low-quality stocks. Many stocks have raised or initiated dividends this year, whereas only 2 companies have cut or suspended dividends. (Source: Dow Theory Forecasts, June 14, 2010) Recent readings on inflation, interest rates, and corporate earnings (widely viewed as among the most important drivers of stock prices) have been favorable.
- U.S. companies are holding more cash in the bank than at any point in history.While this indicates persistent worries about financial markets and the economic recovery, companies earning little interest on their cash may choose to use it for hiring, investments, or payouts to shareholders. (Source: WSJ June 11, 2010 C1)
All these indicators are at least slightly encouraging for most stock investors. Profit-estimate trends suggest Wall Street analysts are becoming more optimistic about the future; however, there is no guarantee that these results will be achieved. Unfortunately, sentiment can change quickly at any time. Diversification is still extremely important.
There are roadblocks to a successful recovery, though. For example, housing is crucial, and if interest rates and mortgage rates increase, this would further reduce the ability of many homeowners to make their mortgage payments, causing problems in both banking and housing.
Balancing the Budget
Our nation’s financial position does not look good. We have never in modern times faced such dangerous, ongoing imbalance between the levels of federal spending and revenues. Our federal debt represents 90% of our economic output—the highest since the end of World War II—and more than half is owed to foreigners.
In addition, we have fewer workers funding Social Security payments for each retiree and no proven plan to control rapidly rising health care costs. The primary ways to balance our budget are to curb government spending and/or increase taxes. Unfortunately, most taxpayers will be affected by these changes.
Since 1950, economic expansions have lasted 6 times as long as economic contractions. Economic expansions are defined as “trough to peak” periods and economic contractions are defined as “peak to trough” periods. The average expansion has lasted 62 months while the average contraction has lasted 10 months. (Source: By The Numbers) So think long term—for yourself and your beneficiaries—and don’t forget the power of positive thinking.
One of the worst things that you can do is obsess over the stock market, minute to minute. If you do that, you’re likely to buy when people are optimistic about rising prices and the market is expensive, and bail out when pessimism reigns and the market is relatively cheaper. One of the best things you can do is to ignore the day-to-day peaks and valleys. You can ride out declines without losing sleep (or at least not much) if your food-and-lodging money is not at risk, so try to avoid investing in the stock market unless you have at least a cash reserve large enough to cover your living expenses for a minimum of 3 to 9 months.
If you have any questions on any of these subject matters, please write them down and we would be happy to discuss them with you personally. As always, we appreciate and thank you for being our client.