Nearly 400 years ago, French philosopher RenÃ© Descartes wrote"cogito ergo sum" ("I think, therefore I am"). If he were alive today and reporting in English, he might be informing the world, "I am writing an investment forecast for 2011, therefore the world hasn't ended." Two years after the most widely publicized financial crisis in U.S. history-at least, until the next one-financial planners and clients can look at the coming year with a trace of optimism.
Judging from an informal survey, observers generally are upbeat. "Talk of a double-dip recession has just about disappeared," says Brian Gendreau, a Gainesville, Fla.-based market strategist with Financial Network Investment Corp. Even though unemployment is sticking close to 10% in the United States and the housing market is still searching for a firm foundation, modest growth is the consensus forecast for 2011. After a very good year for stocks in 2009 and (as of this writing) further gains in 2010, investors hope to keep climbing back toward the twin peaks of 2000 and 2007.
For a successful ascent, planners need to know which worries are real and which shouldn't keep them awake at night. According to Jason Thomas, chief investment officer of Aspiriant, a wealth management firm with offices in San Francisco and Los Angeles, it's safe not to fret over municipal bond risk, inflation, and at least for 2011, higher interest rates. He's skeptical about the "New Normal," the idea that we're about to witness a permanent reduction in economic growth. What worries him are "disruptions in the financial system, the depletion of natural resources and geopolitical crises."
EYEING THE ECONOMY
As long as the United States and the global economy continue to grow, corporate profits may follow. Stocks may head north, especially in sectors such as tech, energy and industrials that tend to benefit most from growing economic activity. Some oil companies may do well if oil prices rise, says Quincy Krosby, a Shelton, Conn.-based chief market strategist with Prudential Annuities, which may happen if the United States and emerging markets grow as projected, especially if European demand is up. "On the other hand, a sputtering economy probably will drive investors from stock market risk to the safety of cash, Treasuries and perhaps gold."
The Federal Reserve forecasts U.S. growth to be in the 3%-3.6% range in 2011. But many observers are more cautious. "We anticipate lackluster growth in much of the developed world," says Sarah Ketterer, CEO of Causeway Capital Management in Los Angeles. "The United States, Europe and Japan must shrink serious fiscal deficits."
Martin Murenbeeld, chief economist of DundeeWealth Economics in Toronto, forecasts that the American economy will grow by 1.5%-2.5% next year. Given the makeup of the new Congress, government consumption and investment can't be counted on to add much steam, he says, and trade actually subtracted from GDP this spring and summer. Without boosts in exports, or spending by business or government, Murenbeeld expects the Federal Reserve to once again pump money into the economy: "QE2 could be followed by QE3."
SAILING ON THE QE2
Easy money policy began in late 2008 and 2009, with the Fed buying hundreds of billions of dollars worth of mortgage-backed securities from large commercial banks-QE1, for "quantitative easing." In the latest round, QE2, the Fed will purchase $600 billion worth of Treasuries.
The goal is to spur economic growth, even at greater risk of inflation. One supporter is Bob Turner of Turner Investment Partners in Berwyn, Pa., who points to a strong report from the Philadelphia branch of the Fed, which produces an annual survey he describes as the "canary in the coal mine" for growth. Turner believes the Fed's move will enhance this recovery and is intended to result in rising prices and interest rates. In short, a little inflation wouldn't be a bad thing.
In fact, few observers are seriously concerned about inflation in this country. Calling QE2 a "bold move," David Hallman, vice president and director of research at United Capital Financial Advisers in Newport Beach, Calif., nonetheless agrees that inflation isn't a "major concern in 2011." In his view, the Fed is trying to reinflate the economy, indicating that it fears deflation more than inflation.
As Ketterer notes, businesses in the United States, Europe and Japan all have excess capacity, so they're unlikely to raise prices for products. "We do not expect any sign of consumer price inflation in any of those three areas in 2011, given the excess capacity in these regions," she says.
Wage inflation is also unlikely, as more industries shift. "With labor from developing countries increasingly able to substitute for jobs in the developed world, broad wage inflation looks highly unlikely."
BEST BOND BETS
Low inflation typically means flat interest rates, normally good news for bondholders. Be that as it may, interest rates have come down so low that bonds aren't attracting much enthusiasm for 2011. Murenbeeld, in fact, sees cause for alarm: "The baby boomers have blown up the equity market in 2000-01 and the housing market in 2007-08," he says. "Next, I expect a blowup in the bond-debt Treasury market in 2011-12."
Planners should approach the bond market with care. Thomas is using what he calls a "barbell approach" with his high-tax bracket clients in municipals. On one end: high-quality, low-duration municipal bonds. On the other: long-term, lower-quality but higher-yielding munis. "A BBB-rated, 20-year municipal bond can have a yield three times as high as a AAA-rated bond," he notes. Low tax revenues and expensive pension commitments may make municipals volatile, but not necessarily risky over longer periods.
"It's vital to distinguish between risk and volatility," he says. "Even Treasuries, which are considered extremely safe, can have volatility, as we've seen in the past two years. We think the yields to maturity in munis now are substantial enough to justify the risk of actually losing money."
Among taxable bonds, corporate bonds have some backers. Among them is Jason Brady, a managing director with Thornburg Investment Management in Santa Fe, N.M., who likes bonds at the bottom of investment grade or those that just miss it. "You're well rewarded from the extra risk," he says, citing an extra two percentage points over Treasuries on a BBB-rated bond compared with the 50 or 75 basis points you might get on one rated AAA.
Investors can find "pockets of opportunities" in fixed income now, reports Tom Carney a portfolio manager for the Weitz Funds in Omaha, Neb., but only if they search diligently. Carney has bought "cushion bonds," which might be close to a call date despite a longer maturity. If the bond isn't called, investors can get an above-market return.
Planners are bullish about stocks for the year, expecting at least a repeat of this year's gains. Murenbeeld has a rule of thumb for periods of low yields: "Generally, we think investors should be significantly overweight in selected equities whenever 10-year Treasury yields are below 3%," he says. He is focusing on natural resources and stocks that will benefit from investments in infrastructure (including expanding bandwith) and alternative energy.
Others see broader stock market advances this year. "We expect another positive performance for most equity markets in 2011," Ketterer says. "Monetary policy in much of the developed world will remain accommodative, and liquidity will support equity prices. "The S&P 500 could gain as much as 10% next year before the U.S. market's valuation fully discounts the likely near-term earnings growth," Ketterer says. The stampede into emerging-markets equities will probably continue, although the pace may slow as investors realize that they can get some of that superior growth through less expensive companies listed in the developed markets."
According to Ketterer, the most appealing companies based in the industrialized world may be those that can tap global markets. "Debt repayment and fiscal austerity will dampen prospects for government and consumer spending in the large developed countries," she says. "However, the global corporate sector has plenty of financial strength and the ability to spend on expansion. This bodes well for companies that can make value-enhancing acquisitions or invest directly in more rapidly growing countries and regions."
Thomas, too, is excited about global economic growth. To participate in that growth, investors can own companies that are headquartered in an emerging market, he says. Or they can buy high-quality companies based in the developed world that do lots of business in emerging markets. He cites Nike, Caterpillar and IBM as companies that fall into the second category.
"You have to go back to the Industrial Revolution to see what can happen when productivity skyrockets in a short period of time," he says. "The growth potential goes beyond what we saw with Japan and the Asian Tigers in recent times."
Therefore, 2011 shapes up as another year to reconsider investments in developing nations. "Most investors are underweight in the emerging markets, but we're overweight," Thomas says. "Our clients generally have 15%-20% of their equity holdings in emerging markets."
On the other hand, the situation in Europe does not look so rosy. Krosby believes the sovereign debt problem in Ireland could easily spread to other nations, including Portugal and Spain. "The markets are waiting for a comprehensive plan that can help limit contagion risks," he says. "At some point, investors may have to accept a restructuring of the debt."
Krosby believes these events could strengthen the dollar against the euro, causing an overall flight to quality as the markets distinguish which U.S. banks have exposure to the debt. In addition, an increase in Europe's sovereign debt problem would introduce more uncertainty into the global economic landscape during a difficult period, Krosby says.
While developing countries are expanding, U.S. companies have enviable balance sheets, and, in fact, quarterly earnings have exceeded expectations for seven quarters. "The key driver is not QE2, but QE7, Turner quips, adding, "This is the real story behind the recent stock price gains."
With record cash balances, record free cash flow and low debt, some U.S. companies have begun to report record earnings and will be using their cash to buy back shares, raise dividends or buy one another, Turner predicts. U.S. stocks currently trade at about 12 times expected 2011 earnings, according to his calculations, below the historical ratio of 15, and they're also cheap compared with Treasuries.
Finally, the relative lack of participation can prevent volatility. As Turner puts it, "Sentiment toward stocks is subdued, which should keep them climbing the wall of worry."
Tech and industrial stocks should lead the market, he predicts, driven by cloud computing and the wireless Internet. Some stocks on his list: Qualcomm, Apple, F5 Networks and Salesforce.com. Among consumer stocks, which should profit from an improving economy, Turner likes Google, Amazon, Coach and Starbucks. Materials and energy stocks look good as well, but financials, healthcare and utilities are regulated, slow-growth industries that he expects to lag.
In these low-yield times, investors may well continue to prize dividends as they did this year. Jeffrey Phillips, chief investment officer of Rehmann Financial in Troy, Mich., argues that a tax increase on dividends will dampen that demand. But there's a chance that the low tax rates on dividend income will be extended for at least some investors and either way, the companies may have admirers because of their strong balance sheets.
"The payout ratios may indicate that the dividends are well-covered," Phillips says. "Mature consumer goods companies might be attractive dividend payers, and the same can be true of selected large financial companies."
Thomas says that his firm doesn't necessarily seek dividend-paying stocks, but that his clients often hold such issues because of his firm's bias toward value. "Our value bias can lead to equities with significant payouts. That includes REITs and master limited partnerships (MLPs), which are durable parts of our clients' portfolios." His firm always recommends that clients hold some REITs, which now may yield over 4%, and some MLPs, which typically own energy-related ventures such as pipelines and now might pay over 6%.
With or without current yields, real estate and natural resources such as energy investments may be effective ways to diversify clients' holdings. Murenbeeld says there's no quick money in U.S. real estate, but because the Fed is working hard to keep prices up, longer-term investors should see a buy,
Thomas' clients hold their REIT allocations in 401(k) plans or IRAs to defer the tax on the hefty dividends. Thomas also recommends investing in a Goldman Sachs exchange-traded note for exposure to commodities, which he sees as critical for all clients. "Investing in commodities is a way to hedge against possible depletion of natural resources. We really don't know what will happen if oil fields decline, for example."
Of course, the alternative investment that caused the most excitement in 2010 was gold, which reached a record high of more than $1,400 an ounce. Further increases might or might not be in store for 2011, but some industry pros think it should be in clients' portfolios. Kimball Brooker, associate portfolio manager for First Eagle Funds, suggests gold for between 5% to 10% of a portfolio; he believes a smaller amount won't accomplish much.
Although the consensus outlook is for modest growth in stocks this year, and perhaps superior performance in some issues, not everyone believes the third year of this recovery will be charmed. "Our economic problems this time are structural, not a normal post-WWII cycle," says David Wright, lead portfolio manager of the Sierra Core Retirement Fund. "The labor force grows about 1% per year-about one million workers-and the U.S. economy will not grow fast enough to reemploy the currently unemployed and underemployed for at least five years. Job anxieties and reduced personal income will continue to burden aggregate consumer spending, so the cycle appears likely to be the reverse of the virtuous cycle of the late 1990s, lasting through at least 2011."
This slowdown could be worldwide, according to Wright. "Despite the Fed's efforts, we see domestic GDP growth slowing next year to less than 1% and possibly going into a recession. Higher growth is likely in emerging markets, perhaps averaging 4%, but Europe and Japan will be moribund."
Why is Wright skeptical? He believes that the wind-down of government stimulus programs is already showing up in slower growth, inventories have mostly been built up and investors will be disappointed when they compare corporate earnings to previous years. The result could be a major disappointment. "We expect the next 25% or greater move in the Dow Jones Industrials or the S&P 500 to be down," Wright says. "An even larger cyclical decline would not surprise us."
If this forecast is correct, U.S. Treasuries would benefit in the usual global flight to safety, mainly in the longer maturities. High-grade corporate, municipal and European bonds would also perform well. Wright favors PIMCO Foreign Bond (PFORX), which hedges against a rising dollar, and the Dollar Index (a measure of the value of the U.S. dollar), available to investors through mutual funds and ETFs.
Hopefully this year's results will skew more toward boom than gloom. Even so, planners might want to add a few safe havens to clients' portfolios in case the three-peat turns out to be yet another 21st-century bear market.
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