Overview & Outlook
There has been much to celebrate during 2009 as the stock market ended its’ free-fall and set off on one of the biggest single year gains since the Great Depression. We have also seen continued improvements in many economic indicators such as temporary hires, corporate earnings and initial unemployment claims. Credit markets are no longer frozen and many companies from around the world have been able to successfully issue debt and equity to strengthen their balance sheets. Due to the global nature of today’s economy, negative elements fed on themselves on the way down, but thanks to the swift action of governments and central banks from around the world, we were able to prevent further disaster. Globalization may now help us during the recovery and the stimulus programs enacted in 2009 come in to full effect during 2010 which could possibly lay the foundation for a self-sustaining recovery going forward.
Despite the steadily improving flow of news, we remain cautious because of many structural issues carried over from the last few years that remain to be dealt with and because of the significant caveats that apply to much of the good news. For example, the big recent fall in initial unemployment is to be expected at the end of the year because companies usually try to avoid the bad PR of laying off employees going into the holidays.
At this time last year, investors were excessively bearish on the economy and were pricing in a large probability of a complete collapse of the financial markets. Over the course of 2009, the market became decidedly less pessimistic and began pricing in a strong recovery. The S&P 500’s projected 2010 price/earnings ratio of 19.9 is above the historical average of approximately 16, but is still within normal ranges experienced during the early stages of a recovery. Although we do not feel that the market is significantly over-valued at current levels, looking ahead we see few catalysts for significant sudden additional gains and after pouring over historical data, we believe there is a relatively high likelihood that the market will correct moderately to the downside as previously mentioned issues play out and the following headwinds begin to manifest:
- Tepid Employment Outlook
Although the initial unemployment claims numbers have been declining recently, a disturbing trend in the data has been emerging in which continued unemployment has been rising almost proportionally. This indicates that a growing number of people have been and are being disconnected from the labor market for almost a year. These people will lose their unemployment benefits soon, depressing their ability to contribute to the economy while also subtracting from the spending power of those who remain employed because many people are now using discretionary income to support family members and friends who have fallen on hard times. U.S. holiday consumer spending was up slightly in 2009 from 2008 but remains a long way off from 2007 numbers.To make matters worse, many of the jobs that have not yet come back (such as manufacturing, financial services, automotive, etc.) are not likely to return to pre-crash levels of employment and sectors that are growing such as health care are not hiring as much as they normally would be because of persisting uncertainty regarding regulation in the sector.
- Withdrawal of Monetary and Fiscal Support
A large part of the recent global rally has been due to strong fiscal and monetary policies enacted around the world during the crisis but these will be fading out and expiring over the next couple of years as central banks and governments withdraw liquidity to keep inflationary pressures from building into additional asset bubbles. The U.S. Government is by far the biggest borrower in the world and it hasn’t even come close to issuing all of the debt that is required to fund its’ growing deficits. Now that a complete global financial meltdown is off the table, investors are already demanding higher yields to make purchasing sovereign debt worthwhile considering the balance sheet problems facing the issuers. The U.S. is in one of the worst fiscal positions of all developed nations because of our ballooning spending and declining revenue base. If this can’t be brought under control, Yields on treasuries will eventually put serious pressure on an already fragile credit market and economy.
- Hobbled Banks and Declining Credit
Commercial banks are the backbone of the worlds’ credit markets and they have been badly injured over the past few years and are still being held together by unprecedented levels of legislative (termination of mark-to-market), monetary (lowering of central bank discount rates around the world) and fiscal (TARP, etc.) support. The banks are still being hobbled by a multi-year build up of toxic “assets” and exceptionally high default rates on a wide range of consumer and commercial loans. The situation is most acute in areas such as Greece, Ireland and Dubai where lending practices were utterly absurd but is also impacting nations with highly developed financial systems like the U.S. and the U.K.
This has significantly curtailed the ability of banks to loan out new funds in the market, which would in turn spur economic growth. These toxic assets are also likely to have a very slow and rocky path to recovery because commercial real estate has longer rental lockup periods than the residential market so much of the damage may not have even occurred yet. Meanwhile, the “green shoots” of a recovery in the residential market could easily be trampled from the large shadow-inventory that banks are holding and as more and more people remain unemployed for so long that they can no longer make payments.In recent prior U.S. recoveries, we have always been assisted by expanding credit and declining savings rates which spur demand, however, the most recent recession seems to have fundamentally changed things and our economy is no longer being boosted by leverage. The weakened banks can no longer increase the credit they give out (in fact, credit has been contracting) and Americans have begun rejecting their debt-loving nature, sending the national average savings rate above 4.5% in 2009 for the first time since 1998.
The markets rejoiced and rallied on the news that many of our nations’ major banking institutions had returned to profitability. Unfortunately, the opposite reaction could take place when/if investors realize that the return to profitability was heavily aided by taxpayer support and that normalized bank earnings will be lower going forward because of weakened balance sheets and lower levels of lending.
- Persistent Structural Uncertainty
In the past, the U.S. has often been the leader in many monetary, structural and regulatory matters but we seem to be in a state of ‘paralysis by analysis’ this time. Very intelligent individuals are looking at the same data but drawing very different conclusions on what it means and what should be done about it. There continues to be a great deal of uncertainty concerning the Federal Funds Rate over the next several years and government intervention in the markets as we mentioned in our newsletter from the Third Quarter.There are also other issues that have been temporarily swept under the rug which could come back to haunt during 2010 such as health care reform, regulation of the financial industry, changes to the tax code and taxes on greenhouse emissions. We feel that these are important issues that must be tackled comprehensively and in a timely manner. Unfortunately, this will likely continue to be a challenge for the current Congress and could become even worse following the 2010 midterm elections. Every day that goes by while these issues are in play is another day that executives will delay decisions on hiring and expenditures because of uncertainty about the impact of their decisions.
Despite the challenges still facing the U.S. and global economy as well as the many caveats for good news, we remain focused on the long term and strongly believe that stocks and bonds around the globe will be higher in five years than they are now. The U.S. has especially difficult challenges ahead of it but we have faced challenges in the past and emerged stronger than before. This may mark the end of America as the world’s sole superpower but we feel that the rise of other competing nations also means an expanding middle class abroad creating a larger market for us to sell our goods. We see this as a great opportunity for America over the long term because it could help to resurrect key sectors of our productive manufacturing capacity, lower our trade deficit and provide a source of strength for our middle class.
We will continue to regularly revisit our investment thesis and will incorporate new information throughout 2010 with an emphasis on protecting recent gains and preservation of the capital that you have entrusted to us. Given the uncertainty surrounding our domestic and global outlook, we feel it prudent to position client portfolios so that they may benefit from the widest range of outcomes while keeping risk low by not making outsized bets on any single country, industry or asset class.
Our prudent and defensive posturing over the past two years helped our clients lock in gains before the 2008 crash and emerge relatively unscathed from the worst financial crises since the Great Depression. We use this comparison because of the great similarities between then and now. The Great Depression began in 1929 when the market fell steeply following years of greed and financial excess (sound familiar?). Market sentiment quickly recovered and stocks experienced one of their greatest runs in history over the next several months as investors covered short positions (bets that the market will fall). The rally took the market all the way to the half-way back point (almost exactly where we are right now) but investors began taking profits as they waited for the projected fundamental economic improvements that did not materialize and the market proceeded to dive and didn’t fully bottom until almost four years later in 1933.
Mark Twain once said “History doesn’t repeat itself, but it does rhyme” and with this perspective in mind we approach the uncertainty that lies ahead with caution and an emphasis on flexibility and capital preservation.
The S&P 500 composite slowed its’ growth gaining only 6.04% during the fourth quarter to rack up a total gain of approximately 26% during 2009. However, it is still down almost 23% from the July 2007 market highs. Meanwhile, our average composite client portfolio is less than 6% away from the 2007 highs after rising 1.42% in the fourth quarter and 6.64% in 2009.
The MSCI EAFE (European, Asian & Far East) index underperformed U.S. equity markets with a gain of only 1.1% in the fourth quarter, bringing its’ 2009 gain to 23.23% which approximately matches the S&P 500. The index now sits only 35.8% below its’ 2007 highs. We feel that recent underperformance was partly due to the strengthening U.S. Dollar and disparities in when different global markets bottomed.
The Barclays Capital U.S. Aggregate Bond Index underperformed equities, shedding 1.65% of its’ value during the fourth quarter after reaching a multi-year peak on November 30th. The index is now down 0.97% over the past year as investors have moved money into equities although it is still up 16.73% since the lows in 2008. The recent fall in price has mostly been caused by bond investors moving into riskier stocks, as well as fears regarding rising inflation which are reflected in the significant relative outperformance of our inflation protected treasuries.
Investing Words of Wisdom for 2010
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
– Warren E. Buffett