Monday, July 13, 2009

June 2009 Market Update (Posted to our blog two weeks after sending to clients)

“Face reality as it is, not as it was or as you wish it to be.”
Jack Welch, former CEO General Electric, author, commentator

The quarter ended June 30, 2009 looks like it is going to end with stocks up about 15% (as measured by the S&P 500 index) over the past three months. The S&P 500 index which is 925, as this is written on June 29, 2009, has come a long way from March 9th when it was at 676 amid great concern about the economy, deflation, deleveraging, and a government that couldn’t get its message right. So, what has changed?

For one thing, the economy has stopped dropping like a rock. This can be seen in the endless flow of economic statistics like the May unemployment release that indicated nonfarm payrolls declined 345,000 jobs compared to over 600,000 for each of the three prior months. Experts now think that the U.S. economy, which was dropping at an annual pace of around 6% in 4th quarter 2008 and 1st quarter 2009, has improved to a decline of around 3% in the quarter just ending and will become positive after that.

Another helpful thing has been a continued policy of low interest rates by the Federal Reserve (and central banks worldwide). Rates on savings accounts and other assets seen as riskless are so low that investors have found themselves accepting some risk in order to earn higher returns. Our entire system is based upon the risk/return equation, so it is nice to see the markets become more rational.

Fiscal policy has also helped as stimulus programs of the U.S. and other countries have helped to put money and spending into the economy. China has been the most successful with this as their 4 trillion Yuan stimulus (amounting to 12% of GDP over 2 years) has led to strong recovery as reflected in a 9% increase in May industrial production (as compared to May 2008). The World Bank recently revised its 2009 China growth forecast from 6.5% to 7.2%. Investors in China have been rewarded with a market that is up about 35% so far in 2009 (as measured by the Greater China Fund GCH)—compare this to the S&P 500 up about 4% for the same period.

What matters is where we go from here. For that we return to the key themes we have been developing since last fall. Our themes for how we invest client money include:

  • Developed countries will be faced with weak consumption as consumers deleverage and increase their savings rate to help restore lost wealth.
  • Emerging countries have a growth advantage with an emerging middle class, high savings rates (that can be redirected towards consumption) and low government debt.
  • High budget deficits will lead to increasing levels of government debt to GDP resulting in a weak U.S. dollar (and weak currencies of most other developed countries).
  • There is an increasing possibility of significantly higher levels of interest rates in the U.S. and other countries where government debt to GDP increases materially over the next decade or more.
  • There is a risk of much higher inflation (after 2 to 3 years needed to clear excess capacity) if governments worldwide don’t skillfully remove monetary stimulus.

It is important to understand that human behavior results in markets that overdo things on both the upside and downside.

This brings us to “what are we doing now?” Our approach has been to closely monitor worldwide economic and market events to either validate our themes, or cause us to change them. The above themes, which we believe events have validated, have led us to establish significant positions in emerging market equities (we like these for their better growth prospects and the ability to diversify away from the U.S. dollar). We also took sizeable positions in high yield bonds when the price of these went so low (and interest rates so high) as markets reflected the overreaction of investors fleeing risk. Our client portfolios have a reduced level of U.S. equities (as compared to a “normal” level) due to our concerns over a weak economy and a weak U.S. dollar. We continue to consider further diversification away from the U.S. dollar in form of investments like gold or managed futures. Given our concern over possible significant levels of inflation down the road, we are also evaluating a possible return to PIMCO Commodities Real Return fund, which combines a commodity position with Treasury Inflation Protected Securities (TIPS).

As of the end of June we have made no significant changes to client portfolios over the past 30 days. You can see the themes we see developing and some of the investments we are considering to act on those themes, however at present we are content to stay with what we have already done.

We are also very busy on the wealth planning side of our services. The unusual market conditions have created significant opportunity in high net worth scenarios to implement strategies that permit transfer of significant wealth to future generations without the cost of estate taxes that can take 50% from beneficiaries. These same unusual market conditions have created the need for us to help clients clearly evaluate their plans for retirement and other life goals and make changes wherever necessary. Our firm has professionals dedicated to providing these planning solutions and they are working very hard to add planning value where we can.