A September to Remember
The month of September can be very exciting. Children return to school, leaves begin to change color, and people begin to prepare for the colder months ahead. For US equity investors September is also exciting, but generally for the reasons many would like to forget. Historically, this is the worst month of the year. Surprisingly, this September’s 9% return was the highest in over 70 years.
What has materially changed in the financial markets? Where do we go from here? In this Quarterly Review, we will address these questions and as always, articulate our investment strategy.
The Winds of Change are Blowing on the Banks of the Potomac
Market prognosticators have opined that the September rally was driven by anticipation from investors that winds of political change were beginning to blow in Washington. The current administration enjoyed a period of high popularity in its first year in which the President and his team provided the necessary stimulus to keep the struggling economy from falling deeper into recession. However, this popularity has waned. High deficit spending, stubbornly high unemployment, and a health care fix perceived by some as expensive and ill-timed have all been cited as reasons for this decline in popularity. This has given way to fissures within the Democratic Party and the creation of the Tea Party, both of which have materially changed the outlook for the mid-term elections.
This shift has not gone unnoticed by the incumbents in Washington. The President recently announced a series of economic initiatives that have positive market ramifications. These include increasing infrastructure spending, an extension of research and development tax credits, and positive changes to the tax code that would ultimately make it easier and more advantageous for businesses to purchase capital equipment. While many details still need to be worked out, these initiatives are positive for the economy and signal that the administration may be taking a slightly more pro-business stance.
A key area of political debate is the fate of the Bush tax cuts which are set to expire at the end of this year. Earlier in the year, the debate centered on whether to let the cuts expire. Now the debate is centered on what portion of the tax cuts will remain in place. Investors have a strong interest in preserving most aspects of the tax cuts. Many investors continue to support the economic theory that reduced taxes are paramount to stabilizing economic growth and ultimately paying down the nation’s debt. With recent mid-term election polls showing the outlook becoming dimmer for the Democrats, the probability of many of these cuts remaining in the tax code is increasing.
It’s Official…The Great Recession is Over – What Now?
In mid-September, the National Bureau of Economic Research announced (somewhat belatedly) that the recession officially ended in June 2009 – over a year ago. It will go down as the longest reported recession since the Great Depression and one of the most destructive as evidenced by the loss of over 7 million jobs. Now that we know we exited this dark period over a year ago, where are we now? While most agree that the country has emerged from the recession, debate continues as to what type of economic environment we find ourselves in. Is the ‘double dip’ scenario (one in which the economy falls back into recession) a material threat, or are we experiencing a typical mid-cycle slowdown on the way to brighter days? While we recognize the near-term headwinds our economy continues to face (high unemployment, weak real estate values and high deficits – topics we have covered in past editions of the Review), we tend to side with the latter scenario. Here’s why.
• Improving Corporate Sentiment: Recently, Warren Buffett, Steve Ballmer (CEO of Microsoft) and Jeff Immelt (CEO of General Electric) addressed a conference in Montana. Their comments provided a positive perspective on the mid and long-term economic prospects for the US and global economies. This optimism is not limited to these three corporate titans, but has also been voiced by leaders in numerous other sectors. It is our belief that US companies, approaching record levels of profitability and flush with cash, will be a driving force behind improving and sustainable economic growth.
• The recovery is weak, but economic data is getting better: As we have stated for nearly two years, our economy has its problems that will not be resolved overnight. That said, we are beginning to see improvements in important economic metrics. Consumers, having just paid down a material amount of debt, have begun spending again. The weak labor market, possibly the most pressing concern facing the economy today, is showing signs of improvement as evidenced by the rapid decline in weekly new unemployment claims and sharp rise in temporary staffing. Lastly, bolstered by new orders and increasing demand from international markets, regional and national manufacturing indices remain at levels consistent with economic expansion.
• The Federal Reserve – Quantitative Easing Part II: In mid-September, the Federal Reserve announced that it remains committed to doing everything it can in terms of using its balance sheet to stimulate the economy. The Fed made it clear that low economic growth rates are not acceptable and they are ready to begin a second phase of quantitative easing. This statement is significant because it signals that the Fed currently does not see inflation as a key near-term risk to the general economy and it now has a laser focus on improving the slow pace of economic growth. While this second round of stimulus has not officially begun, it has prompted declines in what are already historically low interest rates. The Fed is hoping that these low borrowing costs will improve confidence levels among consumers and corporations that have been hesitant to spend. It remains to be seen how this ultimately will manifest itself in the financial markets, but we are optimistic these stimulative actions will underpin the current economic recovery.
Markets are in Rally Mode…Where Do They Go From Here?
Any time an asset appreciates sharply in a relative short period of time (like the Equity and Fixed Income markets have done recently), it is our responsibility to re-evaluate the attractiveness of that asset. For equity markets this involves a diligent review of the health of corporate profits and what investors are willing to pay for those profits. Much like earlier in the year, the earnings outlook continues to reflect a vibrant and profitable environment for US corporations. The companies of the S&P 500 index, or the 500 largest US companies, are expected to grow earnings 35% y/y in 2010.
Looking forward to 2011, this number is expected to grow nearly 16%. This figure would represent an all-time record for S&P 500 earnings. Both of these estimates have trended higher in recent weeks which is a positive sign for investors. Earnings growth, long an important catalyst for higher stock prices, should be viewed within a price framework (Price/Earnings) in order to evaluate the timeliness of an investment. Priced at approximately 12X expected earnings, the US equity market is currently 20% below its historical average. This environment, characterized by above average earnings growth and below average valuations, historically has been one that is advantageous to patient investors. While uncertainty remains, the prognosis for the US equity market looks promising.
International markets, while providing valuable diversification benefits, are also attractive investment alternatives. The global economy seems to have decoupled to some extent with the larger countries (Europe, US, Japan) facing below-average economic growth, while smaller countries (Australia, China, Brazil, South Korea) are exhibiting higher growth. These countries also offer lower levels of debt, favorable demographics, lower valuations, and higher yields. Exchange traded funds (ETFs) allow us to participate in these attractive international markets and we continue to favor the countries mentioned above. We also continue to invest in Canada due to its solid fiscal position and its significant resources.
While we are currently finding timely opportunities in the equity markets, we remain committed to maintaining a diligent focus on risk management. We have recently reduced our exposure to several fixed income strategies. While good news for borrowers, the historically low interest rates have created a challenging environment for income investors. We believe current yields no longer compensate investors for the inherent risk of rising interest rates. However, we have no intention of changing our long-term allocation to this important asset class and we continue to search for appealing opportunities.
Conclusion
The third quarter was a pleasant surprise for investors. While we recognize the uncertainties and inherent volatility in the market today, we do believe the ‘double dip’ scenario is unlikely and economic data will continue to show signs of improvement. We will maintain a prudent level of diversification and a disciplined approach to managing your wealth and we are available to discuss your investment strategy anytime. Furthermore, we are looking for like-minded clients and are happy to meet with friends and family whom you believe would benefit from a complimentary review of their wealth management strategy.
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