Market Comment Q4 2010

Every Which Way

Let’s see. The recession is supposedly over, but unemployment remains near 10%. The Fed began a program designed to lower interest rates still further and to create a little inflation. Markets responded by pushing rates higher, not lower. To assure continuation of economic stimulus, the current low level of income tax rates has been extended for two years, and personal social security taxes have been cut for two years-making the deficit even worse and causing Moody’s to say they may put the U.S. on negative credit watch. Solvency questions are again dogging several nations in the Eurozone. And U.S. stock market indexes finished the year around twelve month highs. Indicators of the future of the political economy are pointing in every direction. Is it possible to create a coherent description of this chaotic scene?

Unemployment. Continuing high unemployment may be the easiest to explain, although probably the most depressing. The U.S. lost more than eight million jobs during the financial crisis and subsequent recession, and so far only one million jobs have reappeared. Over that period, more than eight million people have grown to working age, exacerbating unemployment. Absorbing these people requires exuberant economic growth, which we are not getting. Okun’s Law, first put forward by Arthur Okun in 1962, posits a direct connection between growth and employment. In 2005 Andrew Abel and Ben Bernanke (yes, the same one) updated the original study and found that GDP decreases 2% for every 1% increase in unemployment. If we flip this around we can estimate that 2% growth in GDP is necessary to lower unemployment by 1%. GDP gained more than 2% in the first and third quarters of 2010 but not the second. This many months into the last three recessions, GDP was 4-6% higher that it had been at recession’s onset. Today we have still not reached the former high.

Interest rates and inflation. The Fed has a view that sluggish economic growth threatens to cause deflation. In an Orwellian definition, the Federal Open Market Committee (FOMC) has decided that the Fed’s statutory mandate to foster price stability allows it to decree that inflation is too low. Thus the FOMC began a second round of quantitative easing (dubbed QE2), a program of buying government bonds from banks in order to free up reserves, lower, short-term interest rates still further, and hopefully increase lending. This was supposed to gin up the pace of growth in hopes that increased demand for goods and services would stave off deflation.

Chairman Bernanke first floated a QE2 trial balloon in a speech in late August. The immediate market reaction was a decline in interest rates, the intended consequence. However, when the policy became official both interest rates and commodity prices accelerated moves in the opposite direction. The yield necessary to induce investors to buy ten-year Treasury notes is now 3.4%, up from 2.5% in early November when QE2 was adopted.

It can be argued that the beginning of a rebound in interest rates is a good thing. So far, Treasury yields have climbed only to levels seen in late Spring. The extreme lows during the summer were caused by another flight to quality among investors around the globe. Rates fell because of money piling into Treasuries in search of safety. Treasury yields and stock prices fell together. In recent weeks, stock prices and Treasury yields have been rising together, an indication that investors are once again willing to take some risk in hopes of return.

Commodity prices have been rising most of the year as global demand increases with the recovery and as speculators seek inflation hedges. Mostliquidcommodities have moved up significantly in recent weeks after a lull in early to mid-November. Silver is up more than 60% year­to-date, corn 43%, copper 35%, and oil 17%.

These surging prices are caused by growing demand from both industrial users and speculators. Despite sluggish economic rebounds in the U.S. and Europe, industrial production globally is at or near all-time records, led by growth in emerging markets like China, India, and other Asian countries. Speculators are well aware of that and are happily participating in the growth of demand.

Eurozone troubles. Worries over the financial status of Europe’s PIIGS (Portugal, Ireland, Italy, Greece, and Spain) have been in the news for quite some time. First Greece, then Ireland have required assistance from the European Union and the IMF to avoid default. At this writing, Portugal is the next most troubled. Interest rates required by bond markets on ten-year debt are a good indicator of the degree of difficulty facing each nation.

1004aThe bailouts of Greece and Ireland-and maybe others-are nothing more than lines of credit that allow the troubled nations access to funds at lower rates than they would be asked to pay on their own, but the credit lines do not solve the debt problems. In the short run, debt for a number of countries will actually increase. Europe hopes for economic growth that is sufficient to reduce debt gradually through time. This is plausible over a very long time, but in the next few years austerity programs will reduce government spending and thus the stimulus that might have aided growth. Further difficulties are likely.

One potentially positive side effect of Europe’s troubles is improving cooperation among the national governments. After the bailout of Greece, a one trillion euro bailout fund to run through 2013 was created by the EU collectively. In October, France and Germany, the two largest economies, reached an accord on how to extend such collective action beyond 2013 by asking bond holders of troubled nations to take haircuts in return for EU guarantees. That plan met with opposition, but a milder form of it came into being. The existence of a longer term bailout fund making all Eurozone countries responsible for each other could have salutary effects on fiscal responsibility and cooperation on tax and spending policies.

On the home front. Despite persistent unemployment, things are feeling better in the U.S. Consumer confidence has improved, and the National Retail Federation expects holiday sales to rise 3.3%, nearly reaching the 2007 record-although the post-Christmas storm on the East Coast occurred on an important shopping day and may trim results a bit. MasterCard reported that retail sales gained 5.5% in the period from November 5 through Christmas Eve.

Layoffs are fewer recently. If people who are working are less fearful about losing their jobs, they may be more willing to spend.

Other data do not agree with this ebullience. The Case-Shiller report on home prices in twenty metropolitan areas shows prices have fallen modestly for three consecutive months, which probably contributes to weakening in another index of consumer confidence.

1004bThere has been correlation all year between the University of Michigan consumer survey and the stock market. Rising stock prices are associated with rising confidence and vice versa. Does one cause the other? It is more likely that causation is mutual. There has long been a “wealth effect” associated with rising stock prices (and even more with home prices). People feel better about their financial health when stock prices rise, making them more likely to increase spending. This higher consumer confidence thus predicts a likelihood of higher future consumer spending, presaging greater economic growth and increasing investor interest in bidding up stock prices. If only home prices were rising as well, consumer confidence and spending could make much greater contributions to growth.

Does the rising U.S. stock market make sense? We have been saying all year that there was plenty of headroom in stock prices if uncertainties in other areas lessened. There are still plenty of unknowns in the world, but U.S. stocks were so cheap earlier that even modest improvements in confidence can go a long way.

Beyond the litany of issues discussed here, profits and profitability of publicly traded corporations continue to be a source of strength in the U.S. economy and in most of the world. At the 2010 stock market low in July, the S&P 500 was selling at only thirteen times 2010 expected earnings and twelve times then-expected 2011.

In terms of our Price / Value valuation model the index was selling barely more than half price. Today, after a 24% (!) gain from that low, the index sells at only fourteen times 2011 expected earnings and is priced at less than two-thirds of its value in our model.

We would not be so bold as to predict a rise to fair valuation any time soon; the many difficult issues in the political economies of many countries are ample reasons for stocks to sell at discounts. Nonetheless, it is still true that further relief from uncertainties can bring further market gains.

News From HeadInvest

We are thankful for this past year in which we welcomed aboard two new portfolio managers, Ken Blaschke and Steve Poulos, and Chris Wiers in technology and operations. With these additions we are even better positioned to serve our clients’ needs as we go forward in 2011.

For all of us our clients always come first. Our efforts as a firm continue to be focused on four basic activities: enhancing client service, strengthening our core investment process, improving operational efficiency, and helping additional clients reach their financial goals.

Many of you have observed that it would be more efficient to receive this Market Comment in electronic form. In the new year we will begin to make available digital delivery of this quarterly outlook and, for clients, our regular reporting package (with appropriate encryption). This will be only for those who prefer digital delivery. Traditional mail will always be available. For recipients who want to be in the vanguard of receiving this communication electronically, please e-mail your request to Diane Mitchell-Romano at [email protected]

Best wishes for a happy and prosperous new year.

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