Out of the Frying Pan into the Other Frying Pan?

Recession Ending?

The pace of U.S. job losses slowed more than forecast last month and the unemployment rate dropped for the first time since April 2008, the clearest signs yet that the worst recession since the Great Depression is easing.
Payrolls fell by 247,000, after a 443,000 loss in June, the Labor Department said today in Washington. The jobless rate dropped to 9.4 percent from 9.5 percent.
The report stoked optimism for a recovery in the second half of 2009. While the Obama administration’s fiscal stimulus efforts are projected to have a significant impact on the economy, any rebound in hiring may be delayed as this recovery like the last may be labeled a jobless recovery. Unemployment is a lagging indicator.
We – as consumers - are by no means out of the woods, but we are moving in the right direction, many economists have revised forecasts to reflect moderate growth in the second half of 2009 and more of a pickup in 2010.
Even so, economists predict consumer spending, which accounts for 70 percent of the economy, will be slow to gain speed. Wages and salaries fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960, according to Commerce Department data issued this week.

Tax Increases?

The current administration recently raised its estimate for this year’s federal deficit by 5 percent to a record $1.84 trillion as the recession reduces tax receipts and increases the costs of propping up the economy. U.S. consumer prices may rise from 2 to 4 percent in 2010, according to economists in a Bloomberg News survey, and may head higher from there.
On August 2, 2009, on ABC's This Week, Treasury Secretary Timothy Geithner refused to rule out middle class tax hikes in an interview with George Stephanopoulos. Following is some of the exchange from the show:
George: "I know you believe that passing health care is central for getting the deficit under control. But independent analysts say even with that you are going to need to find new government revenues. The former deputy Treasury Secretary Roger Altman said it is no longer a matter of whether tax revenues should increase but how. Is he right?"
Tim Geithner: "George, it is absolutely right and very important for everyone to understand we will not get this economy back on track, recovery will not be strong enough to sustain unless we can convince the American people that we're going to have the will to bring these deficits down once recovery is firmly established."
The U.S. Treasury expects the U.S. national debt to bump up against the debt ceiling of $12.1 trillion (yes that’s trillion with 15 zeros) in the final quarter of 2009. One way to bring down deficits is to raise taxes.

Monetary Policy as the Economy Recovers

From the Board of Governors of the Federal Reserve System Monetary Report to Congress (July 21, 2009):
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve's legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.
In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve's dual objectives of maximum employment and price stability.

While the Fed has done a yeoman’s job averting depression it looks as if they have given short shrift to recovery plans. Specifically on dealing with the expected inflation that heavy economic stimulus brings.
We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation. Therefore, inflation-hedge securities should be in most investor’s portfolios when the economy begins to gain some traction. (Refer back to the beginning of this piece.)
A well diversified portfolio includes asset sub-classes such as agribusiness, managed timber, Treasury Inflation-Protected Securities, known as TIPS, commodities, energy and others. These mostly real assets have historically done well in inflationary environments.

CPB, August 2009

Sources: Bloomberg LP, the Board of Governors of the Federal Reserve

What Goes Down Must Go Up

Confidence or Prozac
In his most recent article, Jeremy Grantham describes seemingly reasonable people, armed with terrifyingly accurate data, foretelling of the end of the world. Investors with lots of cash become inert objects, mired in cement, and too terrified to invest. Those investors who are fully invested move from fear to denial and finally to panic, at the end becoming catatonic.
Grantham encourages all investors, before rigor mortis sets in, to evaluate where they currently are, where they want to be, and how they can get there. A clear “battle plan”, developed by taking motivation from both your head and your stomach, he says, should clear the way for investors to overcome “investment paralysis”.
Elaine Garzarelli, formerly a Prudential analyst, called the market correctly in 1987, when shortly before the market crashed in October she put her clients into cash, where they stayed until the mid 1990’s, ultimately missing out on much of the rally in the stock market during the Clinton administration. She was only half right. In other words, you have to be right twice about something that no one knows with any certainty.
For those who are waiting for the tide to turn before they purchase stocks, remember that human nature is hard to overcome. For instance, you decide to invest when the market moves up 10 percent. That day comes, but you may decide, “is this rally groundless?” Therefore, you wait until the market moves up another 10 percent – just to be certain. At that point, you decide to wait for the market to pull back a bit and then buy because you’ve already missed 20 percent. As you wait for a better day the market advances another 20 percent and now with current investor psychology very bullish (a condition usually evidenced somewhere near the top of the market) you decide to jump back in having missed 40 percent of the market’s appreciation. Unfortunately, at every signpost, the future is no more predictable than it was at the last one.
What goes down must go up
“Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.” This quote by Warren Buffett from his letter to Berkshire Shareholders sums it up quite well. It is worth noting that since market records have been kept, stocks have outperformed every other investment category – including the period of the Great Depression, when they lost nearly 90 percent of their value!
If you have substantial cash you will need to (re)invest at some point. There is motivation to start now (confidence), as long as you are willing to risk the possibility of short-term declines in return for long-term profits. Remember, the future is not foreseeable and the fundamental goal of equity investing is to buy lower and sell higher. RKM has long advocated a strategy of buying into market declines, given that the biggest risk for many investors is to over-allocate to cash, missing upward movements in the market, which normally happens rapidly and abruptly.
Year of the Ox (aka Bull!) –coincidence?
We don’t know when the market will bottom. But whether it’s this month or December of this year, we are confident it will. It the meantime there is a strategy for the large cap equity portion of a portfolio that offers high current income with the potential for long-term appreciation. We suggest adding high quality equity/income funds or “dividend aristocrat stocks” to the portfolio, as this likely increases current income with appreciation potential. The S&P 500 dividend “aristocrats” are the 52 companies in the S&P 500 index that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years. The current yield on several equity/income funds averages about 5 percent. That’s comparable to starting a 100 yard dash on the 50 yard mark, given that large cap stocks returned on average about 10 percent annually over the last 70 years. Investment income, whether from dividends or interest provides a cushion in down markets and many top-quality stocks have higher yields than the 30-year Treasury and better appreciation potential.
Grantham calculates the “fair value” of the S&P500 at 900, approximately 30% above where the index sits now. Although he believes that the index has a 50/50% chance of dropping below 600, many stocks and funds will have posted a double digit return per year above inflation for the next seven years. This might not be the absolute bottom of the market, but it is so close to a bottom, prudent investors are now investing.


Christopher Blakely 03/2009

Sources: The Wall Street Journal; Bloomberg LP, GMO North America