A TEMPORARY CORRECTION, from Bob Doll, vice chairman and chief equity strategist for fundamental equities, BlackRock
Economic data continues to suggest that the recovery should be sustainable. Business and consumer confidence levels have been increasing, and last week’s retail sales figures were better than expected. While unemployment remains high, the number of hours worked has been picking up, which should translate into an increase in incomes. All of this is not to say, however, that we are completely out of the woods.
The Greek debt crisis points out the fragility of the global financial system. While it seems clear that the European Union will stand behind Greece, the situation does reinforce the fact that deflationary pressures exist.
The high deficits faced by the United States are a potential cause for concern, but in our view, there is no reason to expect inflation to worsen significantly in the next year or two. Given the background of an improving economy, the Federal Reserve has been starting the process of preparing the markets for greater policy flexibility and, ultimately, tightening, but we believe any interest rate increases are still in the future.
Despite all of the macro uncertainty, corporate earnings continue to be impressive. At this juncture, we are about 80% of the way through the fourth-quarter reporting season, and about 70% of companies have posted better than expected earnings and revenues. The best-performing sectors have been technology and consumer discretionary and the worst have been energy, consumer discretionary and financials.
From a stock market perspective, our analysis suggests that the current period of weakness is corrective and not anything more severe. Looking ahead, the negatives include the fact that there has been such a strong upturn since last spring (which suggests that some potential positive news has already been factored in) and ongoing deflationary threats, such as what is happening in Europe. On the other hand, the positives include low interest rates, accommodative fiscal and monetary policies, strong corporate earnings and the start of improving labor market conditions. Our belief is that these positive factors should win out over the longer term. In the near term, our sense is that the sharpest part of the correction is mostly over, but that we may only be about halfway through in terms of its duration.
THINK GLOBAL, from Phil Maisano, chief investment officer and vice chairman, The Dreyfus Corp.
Some U.S. investors may simply invest too little overseas and are therefore missing out on opportunities to diversify. In 2009, a declining dollar benefited investors that bought overseas assets. While the prospects for continued dollar weakness are not as strong in 2010, international diversification is still important.
Investors that do go global gain access to industry leading companies and potential growth rates that may not be available domestically. For example, the steel industry looks to be a prime beneficiary of the infrastructure builds (and rebuilds) occurring in many countries. According to the World Steel Association, the top nine steel producers in 2008 were foreign-based and the U.S. industry overall accounted for less than 7% of the world steel production. U.S. investors seeking to access the steel industry’s future growth must look overseas to best capitalize on increased steel utilization. The same scenario persists in many industries. There are fewer reasons for investors to limit their choices to domestic options. The globalization of the investing universe isn’t reversing and investors need to start thinking globally about investment decisions.
Demographics also support looking overseas for growth. While the U.S. represents over 25% of World GDP as of 2008, the latest full year figures available, the U.S. represents just 5% or so of world population. As more of the world population rises from poverty, a larger percentage of world growth should shift overseas and U.S. investors should participate in these opportunities.
THE NEXT TEN YEARS VS. THE LAST TEN YEARS, from Stephen J. Huxley, chief investment strategist, Asset Dedication
A common theme in financial headlines over the past several months has been the fact that stocks lost money over the prior ten years. This was true for 2008 and 2009. From the end of 1998 to 2008, the S&P 500 returned an average of –3% per year, and from 1999 to 2009, it returned –2.7%. These are sad numbers for long-term investors, and advisors should be ready to provide perspectives to worried clients about the next ten years.
One fact that needs to be remembered is that 1998 and 1999 were the final years of the greatest bull market in history. At the end of 1994, the S&P 500 stood at 459. At the end of 1999, it had more than tripled to 1469. If you start from the highest of highs, is it any wonder that it will take a while before you can reach it again?
If we take a broader view and look at all 10-year periods since 1927, average annualized returns on all stocks have averaged 7.7%. As expected, the Great Depression produced worse records, with average annual returns for 1929-39 at –4.1%, for 1930-40, –3.3%.
In the 10-year periods following these terrible records, however, the picture brightens. From 1939 to 1949 and 1940-50, stocks’ returns averaged 7.9% and 9.6% per year respectively, above the long-term average. But, of course, a major cataclysm had occurred: World War II.
Thankfully, there do not appear to be any major cataclysms on the horizon right now, though one can never tell. International and domestic political tensions are a perennial source of factors that can cause major bull or bear markets.
Some speculate that domestic politics played a role in the great bull run of the late 1990’s (in addition to the Internet and end of the Cold War). In November 1994, a Democratic president – Clinton – lost his party’s control of Congress. As Clinton shifted his policies toward the center, the markets took off. If that explanation is correct, and if the Democrats loses control of Congress this year once again, it could set the stage for good investor news over the next ten years. We shall see what happens in 2011.
THE ROAD TO RECOVERY IS NOT WITHOUT HICCUPS, from Steve Romick, president, FPA Crescent Fund
Historically, the period following a banking crisis has been characterized by weak economic growth for years, if not a full decade. The Great Depression lasted until World War II despite consensus views in 1937 that it had ended. Japan’s “Lost Decade” had many headlines that mistakenly declared that a recovery was at hand. We’re not sure what to call what we’re in, but at best it’s what many have called the Great Recession. We are confident, though, that the path will not be without hiccups. Over the near term, headlines may trumpet economic growth, albeit benefited by unprecedented and unsustainable stimulus, government guarantees, and low interest rates. As Leon Cooperman, founder and principal of Omega Advisors, recently mentioned, “If you pump enough adrenaline into a dead guy, he’ll get up and dance.” We do believe that a certain amount of government stimulus was necessary. Without the government’s involvement, we could have entered a depression; nevertheless, it will be future generations that will judge whether the government spent wisely on the way to adding trillions of debt.
We are stymied by the problems that we as a nation face, and lack confidence in our ability to divine what will happen. Besides, even if we did get the what right, we still need to get the when right too. When will the stimulus end? What has been its true contribution to GDP? Will the Fed successfully pull back the trillion-plus dollars of excess reserves without kicking off high inflation? In other words, how does the government put the genie back in the bottle?
Under the heading Be Careful What You Wish For, if the U.S. market continues to rally, then the likelihood increases measurably that the Fed tightens. The Fed will need to end a number of lending and market support programs, having already purchased $2 trillion of mortgage-backed securities, Agencies, and Treasuries, and they’ll need to remove $1 trillion in excess reserves from the banking system. The Fed has tools to allow for retrenchment, including the new ability to pay banks interest on their deposits. The private sector will then have to step in to replace the Fed. With so much money sloshing around in so many different programs, we believe there will be some bumps along the way—hopefully allowing additional opportunities, but…. We do not expect to be in Pamplona running with the bulls any time soon.
THE CASE FOR MUNIS, from Silver Bridge Capital Management
Last week, Moody's released updated data on default rates of rated municipal bonds. The average five-year historical cumulative default rate for investment grade municipal debt measured just 0.03%, 1970 through 2009, compared to 0.97% for investment-grade corporate issuers. Moody's noted that recovery rates are also stronger for municipal bonds, based on thirty day post-default trading prices, $59.91 vs. $37.50 for senior corporate securities. It's worth noting the bondholders ultimately recovered 100% of their investment in the largest default in municipal history—Orange County, CA.
ARE YOU SPECULATING? From Dorsey D. Farr, principal, French Wolf & Farr
In the 2003 movie Old School, Will Ferrell portrays Frank Ricard, a newlywed who has trouble letting go of his freewheeling bachelor days – a time when he was affectionately known as Frank the Tank. When caught running drunk and nude down the street by his wife and several of her girlfriends, Frank defends himself with a drunken exclamation: “Everybody’s doing it!” Predictably, Frank’s new bride views his response as insufficient justification for foolish behavior.
Why buy stocks at a 2.1% yield and 20 times earnings while the economy struggles to emerge from the Great Recession? Why buy junk bonds at a mere 7.5% yield or lend the government money for 30 years at 4.5% interest? Well, everybody’s doing it. Those feeling inclined to go streaking through the capital markets should recall what happened the last time “everybody’s doing it” was justification for foolish investor behavior.
REPORTS CALENDAR
Monday, February 15: Presidents’ Day
Tuesday, February 16: Corporate Earnings: Abercrombie & Fitch, Barclays, Kraft, Merck, Quest, Waste Management, Whole Foods
Wednesday, February 17: January import prices, January housing starts, January industrial production. Corporate Earnings: Deere, Hewlett-Packard
Thursday, February 18: January Producer Price Index, January leading economic indicators. Corporate Earnings: CBS, Dell, DirecTV, Hormel Foods, Gooyear, MGM Mirage, Wal-Mart
Friday, February 19: January Consumer Price Index. Corporate Earnings: J.C. Penney
