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Confusion & Complacency

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BY MARY BERSOT CFA — The investment environment feels like it is standing still, waiting for something to happen. You would think the unrest in the Middle East, the earthquake in Japan or the dismal housing market in the US would send investment prices lower. Quite the contrary! US stocks have finished the best quarter in 13 years – ignoring negative headlines and world events.

Investors have not ignored the bad news. On the contrary, they are aware of the human tragedy and the impact of higher oil prices on the price of gasoline. However, these concerns haven’t been enough to derail the stock market because in the end it comes down to the alternatives.Stocks have climbed a wall of worry because other investment alternatives are not attractive.Cash is yielding less than 1% and bonds are around 4%. As long as companies report strong earnings and dividend growth continues stocks will remain attractive.

We have become accustomed to a constant stream of headlines about the economy making it difficult to sort out what is important. Unemployment at close to 9% is not a surprise and the dismal housing numbers are taken for granted. It’s not that people have stopped caring. However, strong earnings and improvement in some sectors of the economy, such as manufacturing, have dominated investor sentiment and overshadowed other disturbing headlines.

Inflation & Interest Rates
Inflation is rising which can have a dramatic and negative impact on the world economies and capital markets. Gasoline prices rose 19% in February while the Producer Price Index was up 1.6%. Optimism will erode as inflation creeps higher!

Commodity prices have risen to alarming levels and are beginning to slow economic growth. Oil at $108 per barrel, the highest since 2008, and higher costs for other materials will be felt at all levels of the economy and put significant strain on consumer budgets. The challenge will be to control commodity costs and rising prices without completely derailing the economic recovery. Interest rates are rising in other countries and it won’t be long before we are forced to follow to be competitive. We need to be worried when headline inflation approaches 4%. Signs that it won’t stop there would be disturbing.

The lesson learned in the 1970’s is that the central banks around the world can’t be too complacent about inflation and the only effective way to deal with it is through monetary tightening – raising interest rates to curb rising prices.

The recent financial crisis was a wakeup call for our leaders. We would hate for inflation to be the next “event” that gets their attention. Inflation has bottomed and is moving higher. The increase may be gradual, but it will force companies to raise prices or face lower profits. Can we expect companies to absorb the rising cost of the materials they use to produce their goods?

Inflation- and rising interest rates to control it- may be the catalyst to move investors away from complacency, especially if corporate profits begin to decline. The Federal Reserve has kept interest rates low to support our economy. At some point in the very near future they have to step back and let interest rates rise.

Higher interest rates also mean competition for stocks. If bonds and cash were to yield significantly more than the expected return on stocks (dividends plus capital growth) then investors would be inclined to switch from stocks. This is one of the most significant risks to the global stock markets that are again trading near pre recession highs. We are not at that point yet but the markets will react in anticipation of such a move.

The US Federal Debt


So what else could get our attention? If our nation’s debt, which finances the deficit, is downgraded the world will lose confidence in our government. This would be the greatest challenge our country has faced. US Treasury bonds and notes have historically been a safe haven when crises arise around the globe. Foreign investors have been willing to accept lower interest rates on US Treasury issues because they are safe. If we don’t get our spending under control and reduce our deficit we will no longer be a safe haven.

Our elected officials are on display as they debate the merits of spending cuts and tax increases. If they don’t act quickly to avoid disaster and agree on a long term solution, which looks increasingly difficult, we will be forced to raise interest rates to make our bonds competitive with other lower quality, debt burdened countries. Ten year Portugal bonds trade at 7.9% versus our 3.5%. Investors would expect to be paid for the extra risk and demand more interest for our government bonds if our debt is downgraded. It would be a tragedy if we were forced to offer rates on par with Portugal. Foreigners own 32% of the $14 trillion US Debt outstanding. If the US Treasury market loses its status as a safe haven and the rate paid on this debt were higher the additional interest cost would significantly add to our deficit woes.

There are solutions to the deficit crisis, such as a higher retirement age, reduction in entitlement spending and higher taxes. All remedies are painful but if we are to maintain our position as a world leader and safe haven we need to get our financial house in order. We can’t wave a magic wand and solve this problem. We need to beat the war drums and battle this to a solution that gets us back on the path to fiscal health.

Despite all these concerns, the US economy is gaining strength. Unemployment at 8.8% is high but it has steadily declined from recession levels indicating the job market is gradually improving. The reported housing data is still weak. However, home prices were at unreasonably high levels in 2007 and it will take many years for homeowners to recover their investment. Consumer confidence is strong and segments of our manufacturing sector are robust.

The global economy is even stronger and should advance over 4% this year and about 4.5% in 2012. This isn’t as high as the recovery year in 2010 but still strong enough to support our export market. Many US companies are focusing on growth initiatives in the emerging markets – China and India in particular – where revenues will be strong as the middle classes continue to grow.

The Bond Market
The real beneficiary of low interest rates has been the bond market. High quality corporate bonds are trading at premiums giving rise to the notion that interest rates will stay at these levels for some time. This may be a short term view.

It is hard to justify selling a bond that yields over 4% to invest in a money market fund at less than 1%. It is ironic that most pundits agree interest rates will rise and yet the bond market does not react in anticipation. Waiting for proof that interest rates will be higher may be too late. It is best to keep maturities short and some cash on hand to buy bonds at more attractive interest rates.

The tax exempt bond market has had its own set of problems. Municipal bonds declined sharply at the end of 2010 as fears grew that there was no end in sight to state and local budget woes. It didn’t help that interest rates rose while municipalities issued bonds, flooding the market with supply. This generated confusion and fear, creating a buying opportunity. Defaults will be few and far between and limited to high risk bonds.

The tax exempt bond market has recovered some from the end of 2010 as tax revenues slowly recover. Income tax receipts are bound to rise as unemployment declines and property taxes will recover with the housing market. This may take some time but it will happen as the inventory of foreclosed homes works its way through the system. Yields on quality municipal bonds are on par with US Treasuries before taxes which offer a rare opportunity to shelter income from taxes. Yields on tax free bonds will rise with the increase in interest rates but for long term investors, focused on quality, this is a market that may already reflect the interest rate risk.

The Stock Market
Corporate profits ultimately drive stock prices which have been exceptionally strong by historical standards. Profit margins are higher because of stronger economic growth at home and abroad and capital discipline – companies have put off spending on plants and equipment and have hired fewer people. As the economy continues to recover they will be forced to invest in their businesses. This could come at the same time that prices rise for the materials they use. The result could be lower profit margins. This will be the key issue for stocks for the second half of 2011. Companies with strong brands that can raise prices will be more attractive.

Expectations for corporate earnings are very rosy. The consensus earnings expectation for the Standard & Poor 500 Index is $98 for 2011, a 15% increase over 2010. Many industries such as airlines, food retailers, construction and utilities will be faced with higher costs. If reported earnings miss these lofty expectations we could be faced with a possible 10% to 15% correction. The market won’t shrug off headlines if they point toward lower profits. Stock valuations are not high by historical standards if earnings hold up. However, it is dangerous to rely on price /earnings ratios alone. Earnings expectations for 2011 and 2012 are high. Stocks are vulnerable if there is a hint of lower profits as companies report and give guidance to investors.

The stock market is resilient when the economy is growing. It won’t be a surprise if the market declines in reaction to higher interest rates and lower profit margins. However, it would be a mistake to assume wide spread losses will result or that the market won’t recover. This is especially true when the alternatives are not attractive.

A strong case can be made for large, high quality, multinational companies. Small stocks performed considerably better as the stock market recovered from the lows of 2009. Companies given up for dead came to life! Investors were willing to take risk again as the risk of bankruptcies abated. This has created a wide gap in valuation favoring large companies over higher multiple small stocks.

Large, high quality companies also recovered after the severe stock market decline. However, since they held up better during the recession it makes sense that they advanced less than the market as stocks moved higher. Large, quality companies can generate revenue in multiple economies and raise prices because of strong brand recognition – exactly the profile of stocks to own if inflation edges higher. The P/E ratio for large A to A+ rated companies is 14.5X while smaller B rated companies are trading at a P/E ratio of around 17.8X. This gap should narrow in favor of quality companies as investors expect less upside in the market and recognize the risks of lower domestic profits.

Stocks are generally the best performing asset class when inflation increases, assuming a consistent and manageable increase in costs and the ability to raise prices. Bonds will react negatively to rising interest rates (to control inflation) and higher prices for goods and services would reduce the real return on cash and limit buying power.

Investors are somewhat nervous about the stock market because of the substantial gains in the past two years and the possibility of higher inflation. This is positive for lower risk companies that are industry leaders – those with a global competitive advantage. This year should be relatively strong for stocks, assuming inflation increases at a moderate pace and interest rates don’t rise to a level (say 8% or 9%) that competes with stocks. Investors will take less risk withinthe stock market and favor quality, higher yielding companies with global revenues. The alternatives just aren’t that great!