Overview and Outlook
2009 has so far been shaping up to be a rather historically exceptional year for the stock market. The CBOE Volatility Index (also known as Wall Streets Fear Gauge”) has averaged about 20 since it was created in 1990. It has never fallen below nine and it only rose into the 40’s a handful of times during periods of severe economic trouble. During 2008, the volatility index peaked above 80 and stayed above 40 for several months.
U-6 unemployment (which includes normal unemployed, marginally attached workers, part time who would like to work full-time, and unemployed who have been discouraged from the labor force do to the economy) has climbed all the way to 17%. The only time since the Great Depression in which U-6 unemployment rose this high was 1984, but the market did not rally until U-6 unemployment had peaked in that case. Meanwhile, the Dow Jones Composite Index is on track to set one of its’ biggest yearly gains in history.
Although many economic indicators are no longer in free fall, they still do not resemble any form of real growth and in many cases are still getting worse. We have had recent upticks in GDP over the last three quarters. However, this growth is off of a very low baseline and has been fueled largely by government stimulus programs as well as central banks from around the world flooding markets with excess currency and creating artificial growth through historically unprecedented low interest rates. The true fundamentals affecting our economy such as unemployment, home sales and corporate profits are not significantly better than they were during the March lows preceding our recent rally and improved productivity has come mostly from layoffs. The stock market usually turns up before the rest of the economy, however we still view this rally as very delicate because the key drivers of the recent rally are likely to be short lived. There are several key factors which we feel could derail this fragile situation.
- Government Legislation – We took a giant backward step in free market capitalism over the last year. The actions by our government may have prevented a complete collapse of the financial markets, but they also served to eliminate the competition of the large incumbent financial firms and solidified their position as too big to fail. This new Government sponsored financial oligopoly has lower incentives to lend because of diminished competition and this lack of credit will in term inhibit the growth of other smaller – but better managed – financial firms.
- Federal Funds Rate – The Federal Reserve made history for the United States back in 2008 when they lowered rates to an effective level of zero. This would normally cause extreme inflation but it hasn’t yet done so because banks are still not lending even when they can effectively borrow the money for free. At the first sign of even a moderate recovery (most likely before we see any improvement in employment), the Federal Reserve will be forced to increase rates to prevent hyperinflation because of the already precarious position of the Dollar due to our high debt to GDP ratio. This would most likely cause a double dip recession like in the early 1980’s and could severely shake the confidence of the markets.
- The U.S. Dollar – Low interest rates and monumental federal debt levels (accompanied by a political environment in which the government has strong pressure to spend more to keep employment up) are currently putting strong downward pressure on the Dollar. This is positive for U.S. exporters in the short term, however, our country is a net importer so consumers whom account for a large portion of domestic spending and demand, are having their pockets pinched by the invisible government tax of poor monetary policy. Oil and many other commodities that we depend on are also priced in Dollars which will exacerbate the already high price of oil.
- Too Much Money Chasing Too Few Assets – If things are so bad, why is the stock market setting records for growth? It comes down to simple supply and demand. Markets are being flooded with money by central banks and a great deal of money remains in money market accounts after last years fall. The amount of stocks to buy has remained relatively constant although fewer stocks are worth owning now. This phenomenon of more money chasing fewer investments has caused a artificial rise in their price (but not value). This can be seen by the simultaneous rise in gold, stocks and bonds which typically do not rise in unison.
- Gravity of Reality – Markets tend to overshoot in both directions due to excess pessimism on the way down and excess optimism on the way back up. We undoubtedly overshot on the way down as many asset managers were discounting the possibility of a complete meltdown of the financial markets comparable or worse than The Great Depression. That scenario was taken off the table when unemployment and GDP appeared to have ceased their free-fall and stocks took off rallying. A large boost in confidence came from the return to profitability of many major banks. Unfortunately, their profitability has been buoyed by taxpayer support and new accounting rules that let banks determine the value of their assets for themselves and not based on market realities. Consumer credit and commercial real estate are continuing to deteriorate which will weigh on financial earnings moving forward. Many other companies have also seen growth in earnings but it has mostly been from layoffs and cost cutting. Very few companies are seeing growing revenues going forward which is a more important measure of growth. When people realize that things are only less worse and not actually better, the market will likely pull off of these euphoric levels and back to a more conservative valuation
We will be revisiting our investment thesis regularly over the next quarter as we continue to carefully watch these indicators and incorporate new information into our models. Our primary goal at Pacific Mountain Advisors is to preserve the capital that our clients have entrusted to us, with achieving growth coming in a close second. We expect to maintain a somewhat skeptical stance on the market due to the extraordinarily uncertain business environment and regulatory landscape that we face going forward. By avoiding severe losses such as in 2008, we are not forced take on additional short term risk in order to outperform in the long term. Therefore, we expect to underperform the market on the upside in the short term as we strategically add to equity positions in a cautious manner.
The S&P 500 composite gained 15.6% during the third quarter, however, it is still down almost 7% during the twelve month period ending 9/30/2009. Our average composite client portfolio is handily beating the market over the past twelve months with a loss of less than one quarter of one percent and a gain of 2.95% during the third quarter.
The MSCI EAFE (European, Asian & Far East) index outperformed U.S. equity markets with a gain of 19.52% in the third quarter and is now up almost 4% over the past twelve months. We feel that they will continue to outperform because of lower levels of leverage as well as their greater potential for economic growth when the world reemerges from recession.
The U.S. bond market performed quite well during the third quarter despite the large equity rally as the Barclays Capital U.S. Aggregate Bond Index gained 3.74%. The index is now up 10.56% over the past year with a large portion of the move taking place in junk bonds and other riskier forms of debt. This growing appetite for risky debt could be a reflection of the unprecedented low yields that investors are receiving on their safer short-term Treasuries which have been bid up in price by risk-averse investors.
We feel that we are in an enviable position at the moment relative to other asset managers and advisors because of our prudent risk management which helped us sidestep the majority of the 2008’s carnage. With the benefit of time on our side, we have the freedom to be opportunistic in our investments rather than buying out of a desperate need to recoup losses from last year.
We have been gradually entering and accumulating select global positions with strong secular growth potential as well as high quality dividend and fixed income yields. This strategy boosts portfolio cash flow and helps put a floor under prices because of the inverse relation between price and yield which makes stocks and bonds more attractive as they fall in price. Equity dividends also mitigate the effect of inflation on portfolio performance over the long term because their payouts are on a nominal basis.
Investing Words of Wisdom
The most common cause of low prices is pessimism… It’s optimism that is the enemy of the rational buyer [of stocks].
– Warren E. Buffett