Wednesday, February 17, 2010

January 2010 Market Update (Posted to our blog two weeks after sending to clients.)

If you know how to spend less than you get,
you have the philosopher’s stone.
Benjamin Franklin

As we write this on January 29th, the S&P 500 index stands down 2.6% year-to-date through January 28, 2010. Remember, the S&P 500 index was up almost 70% from its low on March 9, 2009 through December 31, 2009, so some breather was certainly in order.

Today, the Commerce Department announced that 5.7% was the “advance” GDP annualized growth rate for the U.S. economy in the 4th quarter of 2009. This rate of economic growth was well above the expectations of about 4.5%. Dr. David P. Kelly, PhD at JP Morgan has for some time argued that the cyclical recovery would be stronger than most experts were forecasting due to recoveries from deep declines in housing, autos, inventories and capital equipment- it appears he was right as to 4th quarter.

However, we believe even a stronger-than-expected cyclical recovery must be viewed in the context of the present structural challenges with which the entire world is faced. A brief summary list of such challenges reads as:

1. All economies, including the U.S. received significant stimulus in 2008 and 2009. The timing and method of removal of such stimulus, and the effect on these economies and the markets, is still unknown. China recently raised bank reserve requirements and instructed banks to slow lending, and world markets immediately fell.

2. The developed world, led by the U.S., is running huge budget deficits. While some of such deficits will go away with economic recovery (more tax collections, fewer government benefits to the disadvantaged), the projected level of future deficits at some point will threaten the economic health of many countries. A poster child for such problems today is Greece, where their total debt exceeds their GDP and a loss of market confidence has resulted in a present rate on their 10-year government bonds over 7% (note the comparable rate in the U.S. is 3.6% and Germany is 3.2%). For a moment imagine today’s U.S. economy with 7%+ interest rates—it wouldn’t be pretty.

3. The world is rebalancing from an excessive consumer in the U.S. (and some other developed countries) and an excessive saver in China and certain other countries. China is growing its domestic consumption and in a speech to the World Economic Forum yesterday, a Chinese leader pointed to 2009 domestic demand that contributed 12.5% to 2009 GDP while shrinking exports reduced their 2009 GDP by almost 4%. In the U.S. the savings rate has risen to about 5% from below zero before the economic crisis. This rebalance will take some time and it won’t be smooth.

4. Governments worldwide, including the U.S., feel the populist press to weaken their currencies to subsidize their exports, consider legislation of other protectionist measures and increase regulation/taxation of a financial sector that they had to save a year ago. None of this is particularly encouraging as to healthy economic growth.

So we have a possibly stronger than expected cyclical recovery in the context of larger structural challenges. With the daily noise emanating from these somewhat conflicting situations, it is more important than ever to have themes to guide investment decisions. Our key themes include (if it looks like we are repeating some of these from prior messages, we are):

• The next several decades would seem to favor the emerging economies of countries like China, India, Brazil and others. These countries do not have the huge budget deficits of the U.S. and other developed countries. These emerging countries also have more favorable demographics in terms of age (median age in U.S. is 37 years while median age in India is 25 years) and more opportunity for growth from lower economic levels (GDP per capita in U.S. is $47,000 while in China is $6,000).

• The U.S. dollar is in a long-term downtrend (particularly as compared to currencies of countries with healthy balance sheets, like China) primarily fueled by budget deficits. We must recognize that there can be periods of significant dollar strength in such trends, but we believe any strength will not change the long-term dollar weakness.

• Given the various challenges, future investment returns can be expected to be lower than the long-term historical averages and be accompanied by periods of above-average volatility.

So this is what we are doing as to client planning and investment portfolio management.

A majority of our clients have engaged us to perform comprehensive wealth planning. For these clients, we are doing our very best to gather proper information and update their wealth plan at least annually in order to continually measure their progress towards their financial goals. We are working to be very realistic on expected future portfolio returns assumed in these plans (well below historical averages), and we are advising clients to have more financial “cushion” to protect from future risks. Where specific planning opportunities arise (such as Roth IRA conversion), we are working with the accounting firms to develop the most appropriate recommendation given all client specifics (note Perry Moore has authored a very good 15-page white paper on Roth IRA conversions). We are always mindful that our wealth planning process is designed to increase our client’s long-term success in attainment of key life goals.

On portfolio management, we have for some months now recommended a stock portion at the low end of our Investment Policy Statement target ranges. Reflecting U.S. dollar concerns we have positions in both international stocks and international bonds. Given our view of emerging markets, we have targeted more of our international positions to emerging markets than to developed markets. To address portfolio volatility concerns we have positions in alternative assets with the goal of those alternatives helping to reduce overall portfolio ups and downs.

While the nature of our business is that we rarely do the exact right thing at the exact right time, we find value comes from trying our best to do that which improves our clients’ lives over the long-term. We work hard to keep our eye on that long-term ball.