Download PDF of May 2011 Quarterly Review

Weathering Multiple Shocks – Will the Stock Market Push On?

Since our last Review, the financial markets have faced a litany of global shocks. The tragic disaster in Japan, not only created incredible anguish on a human level, but its potentially harmful effect on the global economy also worried investors.

The ongoing social unrest in the Middle East triggered a sharp upward move in oil prices that has only recently shown signs of abating. While here at home, slow job growth, a weak housing market, and rising government debt continue to keep investors awake at night.

Despite these shocks and nagging concerns, we believe the US economy continues to grow at a slow, but healthy pace. Our positive view is bolstered by several encouraging metrics including: a labor market that is beginning to show material signs of improvement, nine straight months of improvement in Leading Economic Indicators, continued capital investment strength, strong personal consumption growth, and expanding retail sales. The final metric that supports our optimistic view is perhaps the most important. Corporate earnings, which are near record highs, have formed a rock solid foundation for the stock market to continue to build upon.

In this Quarterly Review, we discuss the complexities of a few developments we see today and how they could affect financial markets. We also discuss the benefits of adding international equities to a diversified portfolio.

Your Portfolio—What We’re Watching Today

One of the benefits of working with a financial advisor is that you have a professional money manager watching the markets on your behalf and responding accordingly. We generally don’t make short-term changes in your portfolio based on current world events because studies show that market timing rarely works. A better approach is to create a long-term strategy and stick with it. However, we do closely monitor political, economic and financial events around the world in order to continually fine-tune our long-term strategies, monitor potential risks and look for new investment opportunities as they emerge.

Middle East and Northern Africa Social Unrest

As we mentioned above, the situation in the Middle East and North Africa and its impact on oil and other energy prices is on most investors’ minds today. While prices have come down recently, Americans are still paying an average of $4 a gallon at the pump (Source: AAA). While economic growth has marginally added to energy demand, the political and social unrest in the Middle East is fuelling speculation and driving prices up. The outcomes from these social uprisings are impossible to predict, but the region does appear to be in a volatile transformative cycle. Thus far, the turmoil has been in the marginal oil producing nations such as Libya, Egypt, Morocco, and Bahrain. However, if these social uprisings begin to gain momentum in major oil producing countries like Saudi Arabia or Iran, the impact on oil prices and global economic growth could be severe.

The Upcoming Federal Reserve Policy Change

The Federal Reserve’s second round of monetary stimulus often referred to as quantitative easing (QE2 for short) is scheduled to conclude on June 30. This program, which will have injected $600 billion in liquidity into the economy when complete, was intended to lower interest rates and spur lending by actively buying longer-dated Treasury debt and mortgage-backed securities. The question on investors’ minds is whether or not our economy can stand on its own without the added support of the Federal Reserve and the US Treasury. While today’s economic momentum remains healthy, only time will tell if the recovery is strong enough to go it alone.

How will the QE2 expiration effect interest rates? Over the past five months, the Federal Reserve has purchased approximately $100 billion in securities every month. When this purchasing stops, it leaves a void in the market. Who will fill this void? Japan has been a big buyer, but they must now focus on reconstruction. China continues to be a large buyer, but it has recently announced intentions to increase non-dollar foreign exchange holdings. The US credit markets remain the largest and most liquid in the world, so buyers will ultimately pay for this liquidity – but this short-term supply/demand imbalance may require higher interest rates to entice buyers. While we don’t know exactly how this will unfold, we do believe it warrants a cautious approach to fixed income investing and we have positioned our portfolios to better withstand or moderately benefit from an upward move in interest rates.

Corporate Earnings Resiliency

The equity markets have been rising steadily for some time. In fact, the S&P 500 Index has experienced only one monthly decline (as measured by total return) in the past ten months. As such, it is natural for investors to view stock prices as expensive and the market as over-extended. Currently, we do not share this view.

Although the possibility of market weakness based on negative investor sentiment or shock factors always exists, as wealth managers it is our job to take an objective view of the investment landscape. Currently, earnings of S&P 500 companies are expected to reach a record level of $97 per share – a 15% improvement over 2010 levels. What’s important is that this figure is trending upward not downward. Priced at just under 14x earnings, today’s equity market, even after doubling from its March 2009 lows, represents a compelling opportunity for risk tolerant investors.„

The Debt Ceiling and the Sinking Dollar

Every day, the federal government spends more money than it takes in. It makes up this difference by borrowing money. So every day, the US Government’s debt increases and sometime in the next month this figure will rise above $14.3 trillion. There is a law in place – first passed in 1917 and amended many times since – that caps the federal debt ceiling at $14.3 trillion. According to Treasury officials, our nation’s debt will hit this figure any day.

Since the debt ceiling’s introduction in 1917, Congress has never failed to raise it in periods such as this. In fact, as the chart shows, Congress has raised the limit ten times in the last decade. However, now in the midst of a heated spending debate, some members of Congress are threatening to vote against raising this debt ceiling without some evidence of substantial cuts in government spending. It is likely that after significant posturing and negotiating from both sides, the ceiling will be adjusted once again and the US will not default on its debt. That said, this clearly reflects the growing negative attention given to our country’s ballooning debt levels, and while equity and credit markets have prospered as this debt has rapidly increased, the value of our currency has not.

As the chart shows, the trade-weighted value of the US dollar is near a 3-year low. While this benefits many of the large, globally focused companies we currently favor, currency devaluations like this one can reduce consumer spending as inflation becomes a concern. Today, inflation remains subdued, but the rate has been slowly increasing. Because of this, we are watching the value of the dollar closely and positioning our portfolios prudently. We continue to believe exposure to broad-based commodities, large US equities, and tactical positions in attractive international markets are opportunistic ways to invest in this falling dollar environment.

International Investing —Adding Growth Potential and Diversification

We believe including international equities in a well-diversified portfolio makes sense for the growth-focused investor. In addition to providing access to faster growing economies, international equities may offer attractive diversification benefits for U.S. investors. As your financial advisor, Collins & Company may recommend an allocation to international equities within your overall portfolio, but only if it is a good fit for your time horizon, risk tolerance, and investment objectives.

Diversification is the Key

The most obvious advantage of investing internationally is portfolio diversification. One of the lessons we learned from the Great Recession of 2008 was the Global Economy is now interconnected more than ever before. That said, investing overseas remains a very prudent strategy for managing portfolio risk. International markets, both emerging and developing, will often display widely different sets of economic circumstances at any point in time. For instance, if the United States suffers a slowdown, economies in Asia or South America, due to drastically different local forces acting upon them, may continue to post meaningful growth rates. Because of these economic differences, equity markets in these countries may exhibit non-correlated returns with those of the United States – potentially lowering overall portfolio volatility.

Accessing Faster Growing Economies

Investing in certain international markets also allows an investor to capitalize on higher relative growth rates. Driven by growing middle classes, responsible government stimulus, and strong natural resource bases, many countries such as China, South Korea, and Australia are displaying economic growth greater than the US and other developed countries.  Outsized economic growth generally leads to similar growth in corporate profits – the life blood of a healthy stock market.

Expanding Opportunities Abroad

According to Standard & Poor’s, more than 70% of the world’s publicly traded equities are located outside the United States. Many of these firms no longer dominate just their home country, but now compete on a global scale. For many years, investors were unable to invest in many of these companies due to a lack of liquidity and high trading costs. Now, mainly due to the growth of Exchange Traded Funds (ETFs), investors are able to freely invest in most international markets and take advantage of these opportunities with a security that offers daily market trading (like a stock) with minimal fees.

Positive Currency Effects

The three major global currencies (the US dollar, the euro, and the yen) are all facing significant challenges. While each currency faces specific issues, investors tend to focus on the high debt levels of each currency bloc and the demographic challenges each faces. Investing directly in international markets (via ETFs) allows investors to not only participate in the growth opportunity of the market but also provides exposure to the market’s home currency. This currency exposure further adds to the diversification benefits and also provides upside potential given a further decline in the US dollar.

Looking Ahead

We remain optimistic regarding the health of the US and global economies. We recognize there have been recent disappointments in economic data, but believe the positives (record corporate earnings and an improving labor environment) more than outweigh these. We also recognize that this investment environment remains fluid and complex, and you can rest assured that we continually monitor risk within portfolios and adjust accordingly. 

As always, we are available to discuss the content of this review anytime. We sincerely thank you for your ongoing confidence you place in Collins & Company and look forward to helping you achieve all that is important to you.

Important Disclosures

Collins & Company’s Quarterly Review does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. We recommend that investors independently evaluate particular investments and strategies, and encourage investors to seek the advice of a financial adviser. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. This is not an offer to buy or sell any security/instrument or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Member SIPC, FINRA.