2010 Third Quarter

Posted by David Tillson 2010 Third Quarter

 The market’s roller coaster ride continued into the third quarter with two positive months and one negative month. The quarter’s strong 11.3% rise erased most of the second quarter’s decline and did leave us with a positive return for the year. This has been a year without direction and the market has been driven not only by economic news but by factors such as the “risk-on/risk off” trade, high frequency trading, and the flow of funds into and out of various asset classes. Fear and greed are still very much alive and while the details of this crisis may be different from past ones, investors’ behavior is following a predictable path. 

This excerpt from TIME magazine could have been written anytime in the last two years. But, it is actually from the September 28, 1992 issue, published 18 months after the end of the 1991 recession. 

Business cycles will always be a part of the economy and some will be much worse than others. Wealth is destroyed, created and transferred as we move through them, and people will have their lives changed in ways that they didn’t expect. Today’s problems are severe, but are they more severe than what we experienced in the 1991 recession? Or in the 1973-74 recession? 

Near the end of the quarter, it was announced officially that the recession had ended – in June 2009. This is little solace to the millions still unemployed, but the National Bureau of Economic Research (NBER) looks only at various measures of economic activity to make its determination of beginning and ending dates, not at how the population feels. They noted that there were 20 recessions in the 91 years ending in 1991, but only two since that time. Clearly the population is not accustomed to recessions and the severity of this last one has undoubtedly changed investors’ and consumers’ behavior, just as the Depression did years ago.

The Commerce Department has recently noted that the recovery that started 16 months ago has lost momentum. Will this turn into yet another recession? Only time will tell, but our bets are that it will not, at least not yet. While another recession so soon after this last one could be devastating, recessions in general are actually very healthy for the economy. They restore balance to peoples’ views of fear and greed, risk and return, and their sense of fairness as reckless behavior gets punished. However, today’s economy is too fragile and people have not yet regained a rational sense of how to invest for the longer term. Fear of what will happen next week instead of next year is driving investment behavior. Traditional investors who become owners based on fundamentals (earnings, balance sheet, cash flow) have temporarily relinquished their influence on the market to traders who quickly move in and out of sectors using quantitative algorithms and ETF’s (exchange traded funds). The risk-on/risk-off trade has become popular and very easy to execute as individuals and professionals alike are able to immediately react to the latest announcement. High frequency trading (extremely rapid trading to capture minuscule profits) has been another phenomenon impacting markets. As in the past, short term trading strategies will work until they do not, and over time, value where it truly exists will be recognized by the market. 

Despite the problems that are reported on daily, there is evidence that a more normal time may be ahead of us. The mere awareness of a problem means that it is being addressed. The Fed still has the ability to respond to economic weakness, and just the expectation of additional quantitative easing has recently lifted the markets. Some economists have estimated that if the stock market rallies significantly, quantitative easing works, and if the upper income tax cuts are extended, real GDP might be lifted by as much as 1.0% over what it otherwise would be. The dollar’s decline, while not positive over the long term, should lift exports with a lag and lift multinational company profits immediately. Inflation expectations remain well grounded around the 2% yearahead level and the Fed has raised its inflation target in part to set consumers’ expectations to prevent a deflationary mindset. The money supply numbers have all reaccelerated over the past 6 months which could eventually boost the economy and may explain the higher inflation target. Employment does remain stubbornly low and is below the level expected from past recoveries. However, hours worked is rising which should translate to employment gains in the private sector. Capital goods spending is increasing and should remain strong in part because companies can’t put off replacing old structures and equipment forever. In addition, technological innovation is a potential savior to the unemployment problem as some entrepreneur will try to get a jump on the competition by investing heavily in a new technology. Competitors will then be forced to follow. Finally, international companies are now viewing the US as a low cost production base. 

The primary negatives in our view are debt, consumer and business sentiment, protectionism, housing, and unemployment. The build-up in government debt is a major concern, but addressing some of the previously untouchable entitlement programs may be the silver lining to all of this. The expected change in Washington could be a catalyst for fiscal policymakers to put in place a credible plan for bringing deficits down to sustainable levels over the medium term. Corporate debt is not a problem and we anticipate that companies will issue more debt in coming months. Household leverage is falling steadily and debt-to-personal-income at 111% is the lowest level since 2004. The savings rate is above 6%, which is a positive for debt reduction although a negative for consumer spending and GDP growth. Consumer sentiment remains stuck in a state of limbo but at a level which suggest that consumers see the economy deteriorating over the next six months. Business confidence is still very shaky due primarily to increased regulation, healthcare, tax uncertainty, protectionism, the perception that President Obama is anti-business, and the recent slowdown in economic activity. Signs of heightened trade tensions have raised the possibility of currency interventions and trade wars as countries try to protect their exports and save domestic jobs. Unemployment and housing will both take years to resolve and will depend on sentiment and the economy normalizing. 

Perhaps, as Alan Greenspan said a couple of weeks ago, the US economy’s salvation lies in dullness. It may be useless to try to stimulate business executives’ animal spirits as long as they are still fearful of another financial calamity. What’s required, he said, is an extended period of calm – long enough for executives to regain their confidence and start thinking about new opportunities again. In other words, “boredom.” 

To summarize, our outlook for the remainder of 2010 and 2011 is that the US stock market continues to move higher, that interest rates will also move modestly higher, and that unemployment will begin to trend downward. We believe that housing prices will stabilize but that a full recovery is still years away. Washington will not be “fixed,” but a year from now the electorate will probably feel that something positive is being done rather than feeling only anger and fear. The repositioning of portfolios away from stocks and into bonds will have run its course, removing what has been a very significant head wind for stocks. The flow of funds out of US stocks should reverse sometime in 2011 as investors gain confidence in the economy and realize that corporations are expanding and hiring. Revenues rather than cost cutting will then drive profits. 

Valuations on stocks, especially large cap stocks, are now very low relative to any other alternative. The growing stream of dividends that stocks provide will continue to be important to all investors, but especially to individuals who depend on their portfolios for income and for protecting their purchasing power. And finally, the 1992 TIME magazine article was a little early, but was prescient in foretelling one of the greatest bull markets in history as people turned away from negativism and fear which created a long lasting, very strong bull market.