Here are some thoughts put together by our investment team on where we have been and where we may be going. 

 

 

Rising over eight hundred points in five weeks, the Dow Jones Industrial Average peaked July 22, at 12,724, nearing the closing high for 2011, set April 29. Thoughts of second half economic strength quickly evaporated, however, as Congress and President Obama clashed over raising the U.S. debt ceiling, clearly demonstrating why the public continues to lose faith in “big government.” Also, for the first time in history, Standard & Poor’s downgraded the U.S. credit rating, which only added to market and economic uncertainty. By quarter end, dual concerns of a European financial meltdown over sovereign debt, and the banks that hold it, coupled with increased rhetoric about a double-dip recession in the United States, spooked investors.

At the closing bell on September 30, the Dow closed at 10,913, a decline of 1,800 points from the July high, and down 12 percent for the quarter. The S&P 500, another proxy for large cap stocks, though broader based, was down 14 percent. Depending on the index used, mid cap stocks were down 19%-20% and small caps fell 20%-22%. Surprisingly, given fear of a recession, large cap growth outperformed value, but not in the smaller indices. All major large cap sectors were down, except utilities, which saw a modest increase of 0.4%. Consumer Staples (-4.9%) and Technology (-8.0%) were the other top performers. The worst performing sectors were Materials (-25%), Financials (-23.1%) and Industrials (-21.5%). Energy, which we view positively for income and long-term gains, was down 20.9%.

Although gold rose 8.2% in the quarter, it was not the safe haven many had counted on. From the August 22 all-time high of $1,979.9 per ounce, to the quarter’s close five weeks later, gold dropped $358 or 18.1%. By the end of the quarter most all asset classes had sold off, save U.S. Treasuries. Despite their downgrade, and not seen since the Lehman collapse of 2008, investors sought the ultimate in safety, pricing the ten year U.S. Treasury bond to yield a meager 1.93%.

Similar to taking bad tasting medicine, market corrections like this do provide opportunity for the future. An important component of investment management is not merely raw performance, but also tax planning. Price declines allow for losses to be taken so to offset future gains. Granted, this strategy cannot be implemented in retirement accounts, but even there, opportunity may exist to upgrade a particular holding due to this market decline. We will look to be making these kinds of adjustments between now and year end.

In the absence of uncertainty, the market generally rises. With uncertainty, though, investors require lower prices to compensate for the added risk. There has been much uncertainty in the markets of late. Will the economy fall back into another recession (we don’t believe so), will Greece (or Spain, or Italy, or Portugal, or Ireland) default on their sovereign debt (we believe at least one will), what will the political landscape look like a year from now (more favorable after November 2012), and so on? We are putting the finishing touches on a piece titled, “The Other Side of the Valley.” It will put recent events in a historical context, which, we believe, provides a glimpse into what could be a profitable future. It will be mailed to you and be available on our website.

Thank you for your patience, but more importantly, your trust during this difficult period for the market.

 

Friday evening, it was announced Standard & Poor's had downgraded the pristine AAA credit rating of the United States to AA+. It was the first downgrade of US credit worthiness in history. The administration was quick to criticize Standard and Poor's, stating they miscalculated their figures by at least two trillion dollars, that's $2,000,000,000,000.00, which they had, but, if the water is above flood stage, it doesn't matter by how many feet. Some in Washington even seek an investigation of S&P. Do politicians, bureaucrats and the administration really want the private sector dissecting government math that long ago lost transparency and credibility? The fact is S&P gave the administration and politicians an ultimatum: come up with $400 billion in annual spending cuts for ten years, an amount their own commission said was possible, or risk downgrade. The number agreed to in Washington, which for most cuts, doesn't take effect until 2017, was an annual cut of $270 billion, or a shortfall of $1.3 trillion over ten years. Unfortunately, that's one year's deficit spending now. Only in Washington can such fiscal irresponsibility exist that would have long ago bankrupted individuals and corporations.

Many are now speculating what the downgrade means. Will Treasury bonds fall?, will the stock market crash?, will borrowing costs rise?, will this lead us to another recession? History does show that when a borrower's credit rating is lowered, bond prices fall, which increases the yield, given the added risk. Concern is warranted given the substantial number of interest rates tied to yields of US notes and bonds. Too, there are certain entities allowed to purchase only AAA credits. An adjustment to US treasury prices would be rational, but will it take place?

First, the other rating agencies have not lowered the US credit rating. Moody's does not look like they will further review their rating for some time. Fitch says they are conducting a review and will have a decision at month end. If two of the three ratings agencies remain at AAA, most will ignore S&P's stance. The other interested party is the market. For bond prices to materially fall, the other AAA credits must have the liquidity to absorb additional demand, and be judged more credit worthy than the US. Before Friday, there was approximately $47 trillion in AAA sovereign debt among sixteen nations. Now there is $32.4 trillion among fifteen nations. At $14.5 trillion in external debt, the US was 31% of the total. This exceeds the combined total of second ranked United Kingdom ($9 trillion) and third place Germany ($4.7 trillion). Some too are rightfully concerned by $30 trillion, or 93%, of the balance, being tied to Western European countries, which are experiencing their own financial distress from potential defaults in Greece, Italy, Spain, Portugal and Ireland.

Our crystal ball is not as transparent as we'd like, but we don't see this downgrade having a material effect on the markets. While it should, it's more a political issue, given the fact the United States continues to be the world's sole superpower, both militarily, and economically. This will no doubt extend recent market volatility, but we believe we continue to be in a period where stocks should be accumulated and that patience will be rewarded.

 

Through Friday, November 5, the stock market, as defined by the Standard & Poor's 500 Index, is up 11.8% year to date. Almost eighty percent of this performance came in the prior three months, as investors anticipated election results favorable to greater fiscal responsibility and more accommodating taxpayers, individuals and businesses alike. Typically, when anticipation turns to reality, there is a "buy on the rumor, sell on the news" posture that would have the market lower after the results of the election, but the Federal Reserve changed the rules by outlining QE II, otherwise known as the second round of quantitative easing. With the Fed committing to purchase $75 billion of Treasury notes and bonds per month for eight months, the expectation is for intermediate to long-term rates to fall, thus an easing in interest rates. The fed assumes lower rates of entice businesses to expand, which will lead to hiring and training new employees, thus reducing what is becoming a persistently high unemployment rate. Another expected benefit of lower rates is a falling US dollar, thus making US exports more attractive in global markets. In promoting the Fed's plan, one stated and notable desire of QE II is to foster a higher US stock market, which Wall Street immediately took note of by rallying the Dow Jones Industrial Average over 200 points the day after the announcment. Even before QE II, the Fed had aggressively taken measures to stimulate the economy. How it unwinds is yet to be understood, but the landscape created from this is quite favorable for the US equity investor. With yields near zero and expected to be there for many months into the future, US stocks are inexpensive, especially those paying dividends. The Wilshire 5000, the broad market US index, has risen ten straight weeks, The best showing since 1992, and two away from a record twelve weeks set in in 1985. Should the market take a breather? Perhaps. Is there a wall of worries to climb? Definitely. Given the current backdrop and duration the Fed is telegraphing, however, the overall market outlook appears positive.

The National Bureau of Economic Research stated the recession ended in June. If so, this recent downturn lasted eighteen months and was the longest period of economic contraction since World War II. There are many who would disagree with NBER's conclusion, especially the 9.6 percent of the working population who are unemployed, and the near twice that who have given up looking for work, or simply goes unreported. We believe high unemployment will persist for sometime. This is, in part, due to the fact that job creation requires an employer willing to hire, and with current tax and fiscal policy (think increased goverment regulations, the looming expiration of the Bush tax cuts and the health care bill), it is not difficult to understand why small business, typically the main driver for job growth, remains on the sidelines.>

Despite this, we see value in the stock market. In fact, for the first time in a generation, we view common stocks as less risky than bonds. Revenues are improving, earnings are advancing and cash assets are building. Large growth companies, an area we believe provides the best current value are raising dividends, buying back shares, and participating in selective, generally intelligent, acquisitions.

While we are currently in the third longest period of stagnant returns in over one hundred years, according to Ned Davis Research, stocks have gainds significantly in every decade after a ten-year period in which they lost ground. Our crystal ball will not tell us the day this market turns around, and we may well see continued stagnation in the equity markets, but for now, we take comfort in the companies we invest in. With bonds priced where they have no place left to go, but down, we are quite pleased with an investment that pays us materially more than the ten-year Treasury, with far greater growth prospects.