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Uncertainty—The New Normal

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BY MARY BERSOT CFA — THE ECONOMY: It has been two years since the severe recession began and it is still hard to conceive of a scenario for robust US economic growth. The magnitude of the decline in housing prices and job losses means it is doubtful we will witness growth equal to or better than 2007 any time soon. It will take years for consumer and investor confidence to be restored to the level needed to reduce unemployment to normal levels and reignite a rally in home prices.

We will muddle along with anemic growth for some time until America’s financial health is restored and companies are more confident and begin hiring again. The economy is slowly recovering.  It is tempting to believe the future will look like the present.  It won’t.  The only certainty is that what we know today can change – and change quickly.

Massive stimulus programs totaling almost $900 billion haven’t restored job growth as much as hoped for; leaving Americans concerned about the level of government spending and the US deficit. Historically low interest rates haven’t been enough to encourage demand for loans, even mortgage loans. Taking on more debt for most people is not an option.  The good news is that the savings rate is rising and credit card balances are shrinking. This unwinding of debt is a painful process but in time financial health will be restored.


Housing is Key

Housing is a key part of our economy and traffic and sales are still weak. Little progress has been made to jump start the growth in new and existing home sales in spite of low mortgage rates and tax incentives.  Lenders have tightened standards and buyers are cautious.  Despite high inventories of distressed properties to work through, interest in single family homes has been anemic.  Household wealth fell by 2.8% last quarter due in large part to continued declines in housing prices and a market flooded with foreclosures.  It is also hard to relocate for a new job if the mortgage amount is higher than the home value.


The Job Market

A growing economy normally means a growing job market.  The two are connected in that companies need sustainable levels of growth in revenues to feel confident and hire more employees. It doesn’t help that regulatory requirements in many industries and the federal tax rate are yet to be clarified. Unemployment has probably peaked but we still have over 14 million people out of work. The unemployment rate could stay close to the current 9.5% for several more quarters or until there is more confidence in the economic recovery. Technology has replaced people in a variety of industries resulting in unemployed workers without the skills to find another job.  More training programs are needed to match the skills with jobs available.

A weak housing market combined with job worries mean low consumer confidence.  People spend money when they feel good about their financial health.  A positive announcement in either housing or employment would provide the catalyst for confidence the economy is on the mend.


The Growing Deficit

The deficit – which is over $1 trillion and growing – is and will continue to be a major concern. Bailouts, social benefits and stimulus packages have been costly and have to stop.  Warren Buffet said in an op-ed New York Times piece that “the United States is spewing a potentially damaging substance into our economy- greenback emissions”.

The Bush tax cuts, which expire at the end of this year, were implemented at a time when the US had a surplus of funds. We are now faced with a deficit that is projected to grow $1 trillion per year and reach almost $10 trillion by the end of this decade.   Alan Greenspan warns that if interest rates rise the cost of the debt will be catastrophic.  The solution to the problem – reduce spending, increase taxes or both – is mired in politics.  Raising taxes is difficult in a slower than normal period of economic growth.  Politicians are afraid to cut spending.  If this standoff continues as the deficit climbs then we will be in uncharted territory and may be faced with a problem never experienced before.

Forecasting economic growth in the face of this uncertainty is like measuring the distance to the moon with a ruler.  Until there is clarity in government policies, there is true demand for goods and services and the job market is restored to a more healthy level it will be hard to know what the US economic growth rate will be.  The more uncertainty there is, the more caution prevails and this in turn further slows economic activity. A business that isn’t expanding and building plants won’t hire people.  They will let cash accumulate as they are now and wait for more signs that they won’t need it later.

We will continue to see wide swings in reported economic indicators because of the nature of this recovery and the level of uncertainty lenders, companies and individuals feel. However, a double dip is unlikely. The CEO of Caterpillar Tractor said it best; “I’m a bit more optimistic, but not certain”.

Investors continue to look to the past to predict the future. This recovery does not look like past recoveries so predicting what will happen is difficult.  This uncertainly is paralyzing.  Fortunately, nothing lasts forever and there will be some clarity after the midterm elections and the resolution to the debate over the expiring tax cuts.  The public is also growing more and more concerned with the deficit which means politicians will be more inclined to respond.

It is critical to remember that sentiment and fear can be worse than the situation calls for.  It is when expectations are low that the stage is set for positive reactions in the capital markets to any piece of good news.  This is the case now.  A few quarters of good news in housing and jobs would build investor confidence.


We won’t see another 60% advance in the stock market but that doesn’t mean we will test the March 2009 lows.   We said in our last report that “the key to stability in the stock market is revenue growth and sustainable earnings growth”.  This is still true.  Eighty percent of the S&P 500 companies reported better than expected earnings growth for the second quarter.

Corporate profits have rebounded quickly in spite of the sluggish economic recovery. This profit recovery was well telegraphed and expected before companies reported last quarter.  The uncertainty today is whether or not earnings in the next few quarters will roll over to recession levels.  August looks like a weak month for sales in many sectors but for the most part earnings will still be strong and long-term valuations for stocks, especially the large multinational companies, are attractive.  Growth in the emerging markets is still strong and many of the large US companies are able to take advantage of these economies.

Large, quality companies (S&P100) have lagged smaller companies (S&P500) in the market upturn resulting in high yields and low price earnings multiples for household names like Chevron, Microsoft, Philip Morris and Proctor & Gamble. The yields on these mega-cap investments are over 3% and higher than bond yields! Investors are focusing on yield and larger companies could now be poised for an extended period of better performance like the 1990’s.  Money that moved to bonds could flow back again to stocks to increase income!

Corporate cash balances are the highest they have been in 30 years and will contribute to dividend growth, stock buybacks and merger activity. The appetite for risk is reduced since the April highs and expectations for revenues and earnings have been lowered to a reasonable level.  The market hates surprises and those companies that everyone owns where expectations are high could be vulnerable. Overall, the market is not overpriced.  It is in a tug of war between fundamentals which are improving and investor sentiment which continues to be volatile.

The stock market will not rise dramatically higher in 2010 as it did after March 2009 when the S&P 500 Index was at 666.  The market fell too low when stock prices more than reflected the bad news in the economy. Volume is about 30% lighter than it was last year as investors wait to see what happens.  Those who bought stocks on margin are gone.

There will be rough patches as the imbalances in the economy and the effects of years of excess borrowing are put behind us. We can expect the market to be volatile until the mid-term elections are over. Gridlock in Washington over tax increases and government policies are fostering uncertainty. In this environment it is almost impossible to predict the near term performance of the market.   Investors will be worried until there is a string of positive announcements and there is confirmation that the economy is growing.

It is important to separate emotions from fundamentals. What will work in this environment are companies with healthy amounts of cash, low debt and the ability to increase revenues and dividend payments. These qualities, more than the economic sector or stock market outlook, will define an attractive company in 2011. Stocks are moving in tandem with economic projections and headlines.  The focus is not on individual company fundamentals but on the short term market reaction to conflicting data.  The tendency is to chase performance and follow the herd.  This volatility will not last and investors who look for opportunity today will be rewarded in the long run.

Stock prices will continue to fluctuate as moods shift from optimism to pessimism.  Inflows to bond funds, even at today’s historically low rates, have been impressive and a massive amount of cash is still on the sidelines earning practically nothing.  If investor confidence improves these funds could move quickly into stocks- another reason to stay invested and not bet against the market.


The bond market is the beneficiary of uncertainty and confusion.  Investors, especially individual investors, have turned their back on stocks and been willing to accept very little return for peace of mind. Since 2007 billions of dollars have come out of the stock market and been invested in bond funds as the chart below indicates.

This trend is likely to reverse as confidence improves. The idea that conservative investors favor bonds to reduce risk is a widely held concept and fostered by financial planners and strategists.  The baby boomers see bonds as the best vehicle to lower the risk level of their holdings and preserve wealth in retirement. This is reinforced by recent gains in bonds since the Federal Reserve is committed to low interest rates to save the housing market and economic recovery.  Ten year Treasury note yields have dropped from 4% to 2.5%.

The sovereign debt crisis – the worry that countries like Greece and Spain would not be able to pay back their debt – caused a flight to quality in May.  The US government is still perceived as a safe haven and foreign investors flocked to our Treasury market.  These funds further increased the demand for our bonds and drove rates lower and bond prices higher.

As long as inflation is low there is no problem maintaining a low interest rate policy.  However, once economic growth is resumed and more assured, inflation and interest rates will begin to creep higher.  It is tempting to believe the environment will not change.  We believed this at the height of the tech and housing bubbles and we could very well be looking at a bond bubble today.  Bonds will be range bound until there is confirmation the economy is on the mend.  However, when they break out of this range it is likely the direction in prices will be down with yields higher.  The lost decade in stocks could be matched by a lost decade in bonds going forward.

Tax exempt bonds may be less vulnerable to losses if interest rates move higher.  Income tax increases (for those in high brackets) are around the corner making the after tax return on municipal bonds higher than on taxable issues of similar quality and maturities.  The Bush tax cuts expire at the end of this year and it is likely that at least the top income earners will be faced with higher taxes to fund the deficit and healthcare reform. Government spending has increased substantially while revenues from taxes are down.  It is no secret that many states, including California, are struggling with budget deficits and stubbornly high unemployment.  Investment in high quality revenue obligations versus general obligations is the best strategy for residents of troubled states.


Today’s economic environment, political agendas and global competition make investing difficult.  There are thousands of choices and conflicting reports to add to the confusion.  With cash yielding less than one percent it isn’t easy to know what to do.  Individuals, especially aging baby boomers, have pulled massive amounts of money out of stocks to pay down debt, repair their balance sheets and buy bonds. They fear another market crash but will feel more confident as they restore their financial health. Funds will then flow back into stocks, especially if interest rates are on the rise.

It is important to remember that things will not remain as they are now forever.  It is likely that bonds have more downside risk than upside potential.  How low will interest rates go?  We are not in a recession and the economy is on the mend.  Investors holding bonds due in 10 years or more could now have capital gains of 10%.  As interest rates move higher these gains will evaporate and conservative investors with low risk profiles could end up with losses from their bonds and bond funds they did not expect.

Stocks are volatile and it is understandable that there is concern about the market which has been in a push-pull all year.  However, when quality stocks yield more than a ten year Treasury note it is time to look at the relative attractiveness of the two asset classes.  If stocks stay where they are today the income alone is almost the same as for bonds.  This is very unusual and it is likely that this relationship will revert to what is more normal.  Bonds yields have historically been 4% more than stocks and if they again yield this much more it will mean that bond prices dropped or stock prices increased.  If investors sell bonds today and increase stocks then the results could be quite positive.

What does this mean in terms of strategy?  It is hard to ignore what everyone else is doing.  It was hard to sell technology stocks in 1999 when the sector was over 40% of the S&P 500. It was hard to pay rent when you could buy a house with no down payment in 2007.  Today, it is hard to sell bonds, the “safe” investment, and buy stocks after the substantial market decline in 2008.  Sometimes the best strategy turns out to be the one that is hardest to do and out of step with what everyone else is doing. It is tempting to chase returns and buy what has produced the best results. This behavior is what causes many investors to throw in the towel and buy at the top or sell when everyone is most afraid.

Asset allocation, the dividing of your portfolio among bonds, stocks, cash and other investments, could be the deciding factor in 2010 in terms of investment success.  This is not a time to follow the “typical” advice for conservative investors and heavily weight bonds, especially if interest rates begin to rise.  This does not mean that all bonds should be sold.  The best strategy is to shorten maturities and hold some cash.  It is inevitable that interest rates will move higher from here.

This is also not a time to take extreme positions, either in asset classes or individual investments. The budget deficit could be $1.5 trillion this year, we have mid-term elections on the horizon, the economy is weaker than normal at this point in the recovery and investors are worried. Nothing today is assured – economic forecasts, stock market predictions and the direction of interest rates are not easy to call in the short run so balanced portfolios are prudent.  Avoid chasing what has worked, look for opportunity and have confidence the uncertainly will abate in time.  This should result in less volatility and a renewed focus on fundamentals rather than emotional reactions to today’s headlines.