“I’ve found that when the market’s going down and you buy funds wisely, at some point in the future you will be happy. You won’t get there by reading ‘Now is the time to buy.’”
Peter Lynch
“In the business world, the rearview mirror is always
clearer than the windshield.”
Warren Buffett
As we write this on February 27, the S&P 500 index (total return) is down about 0.61% for the year. However, stocks ended a volatile two months on an up note, with the S&P 500 index gaining 3.1% during the month of February. So with five out of six companies beating their earnings estimates for the 4th quarter, what is causing this year’s volatility? We believe worries about future job prospects for U.S. workers, concerns about consumer spending, debt problems in Greece, and China’s recent efforts to curb their economic growth are all factors weighing on the minds of investors.
On Friday the Commerce Department announced that the economy grew by 5.9% in the final quarter of 2009. This reading is better than the government’s initial estimate a month ago of 5.7% growth, and it marks the strongest showing in six years. However, the expectation for the current quarter (January to March) is for much slower economic activity. About two-thirds of 4th quarter growth can be attributed to a burst in manufacturing activity as factories churned out goods for businesses to rebuild their depleted inventory levels. To save cash last year, many businesses let their inventory levels decline significantly. Our concern going forward is when will consumer spending start to increase measurably. Consumer confidence took an unexpected dive in the month of February, our unemployment rate stands at 9.7% and home foreclosures are at record high levels. If consumer spending remains lackluster, then this recent flurry of manufacturing activity - and its contribution to economic activity - will surely fade.
One of our favorite market strategists, Dr. David Kelly, CFA with J.P. Morgan Funds, believes the trends are moving in the right direction and the economy is about to produce some jobs. According to Dr. Kelly some of the issues to consider are:
• GDP Growth – Historically, payroll employment rises after one or two quarters of above-trend economic growth. Trend growth is 3%. Real U.S. GDP grew by 2.2% annualized in the 3rd quarter and by 5.9% in the 4th quarter, so it is reasonable to expect job growth to begin during the first quarter of 2010.
• Productivity – Efficiency gains have been fantastic, with non-farm business productivity growth experiencing its strongest nine months in over 40 years. Much of this has been achieved by working existing workforces to the bone. Eventually, businesses will begin to realize that their stressed out employees need some help.
• Corporate Profits – In order for businesses to start hiring, they need to have the cash to do so. Well, this cash is increasingly becoming available with the S&P 500 operating EPS for the most recent quarter now estimated to top $17. This is well above both consensus estimates and the $15.78 earned in the 3rd quarter of 2009.
• Layoff Announcements – According to a recruiting firm, Challenger, Gray & Christmas, Inc., lay-off announcements over the past three months are slowing and have shown an average year-over-year decline of 72%.
• Temporary Employment – The hiring of temporary workers, also a reliable precursor to full-time hiring, has risen by 247,000 workers in the last four months.
• Help Wanted Ads – According to the Conference Board, online advertised job vacancies stands at just over 4 million. This series, which is seasonally adjusted, has risen by almost 750,000 in the last three months and is at its highest level in over a year.
Even if Dr. Kelly is correct, an unfortunate reality is that creating jobs has always been a slower process than destroying them. During recessions of the past 50 years, the unemployment rate has risen by about 2% per year on its way up and then fallen by only 1% per year on the way down. We have no reason to believe it will turn out any differently this time around. By following this trend, if the unemployment rate stands at about 9.5% by the end of 2010, it could be four more years (the end of 2014) before its back to the mid-5% range that many would regard as full employment.
With a tremendous amount of uncertainty ahead of us, we believe it is more important than ever to have themes to guide our investment decisions. As we have outlined several times, our key investment themes continue to be:
• The next several decades would seem to favor growth in the emerging economies of countries like China, India, Brazil and others.
• The U.S. dollar is in a long-term downward trend primarily fueled by our federal government budget deficits and national debt levels. Our currency is expected to be particularly weaker when compared to currencies of countries with healthy government balance sheets, like China and other emerging countries with which we run trade deficits.
• U.S. dollar weakness and massive government debt levels at some point may lead to higher interest rates and increased inflation. With our dysfunctional Congress, we hold out little hope that recommendations from the new fiscal commission, headed by Alan Simpson and Erskine Bowles, will be acted upon. The longer they wait to bring down our budget deficits, the more long-term damage to our currency.
• Given the various challenges we face, future investment returns for all asset classes can be expected to be lower than the long-term historical averages and be accompanied by periods of above-average volatility.
With our investment management, we have for some months now recommended keeping the stock portion of our client portfolios at the lower end of our asset allocation target ranges (as guided by client Investment Policy Statements). Reflecting our U.S. dollar concerns, we have positions in both international stocks and international bonds. Given our view of more growth in emerging countries, we have targeted more of our international equity positions to emerging market funds. For inflation protection, we have been gradually increasing our holdings in Treasury Inflation Protected bonds. To reduce portfolio volatility, we have positions in alternative assets (a long/short fund and a currency futures/commodity fund).
Uncertainty intensifies the importance of comprehensive wealth planning for our clients. Only deliberate and continuous planning can answer key questions that each of us has about reaching life goals. When can I retire? What type of lifestyle will I be able to afford in retirement? Can I send my kids/ grandkids to the college of their choice without saddling them with substantial student loans? Most importantly: what should I be doing today to prepare for my desired goals of tomorrow?
These questions become more difficult to answer as uncertainty surrounding the factors influencing them increases. In fact, well-founded, accurate answers to these questions become almost nonexistent when comprehensive planning is not involved. There are simply too many facts, factors and assumptions to consider “in your head” and still reach the correct conclusions. For example, what can someone retiring in 15 years expect to receive from Social Security? The Social Security Trustees now estimate that by 2017 Social Security receipts (taxes collected) will be less than what is owed in benefits to retirees. This fact leads to further questions - will I be able to count on Social Security as part of my retirement income? If I can’t count on Social Security, how does that change what I should be doing today to prepare for my various financial and life goals? We have found that our clients would rather not leave their life goals to chance or in the hands of our government (whose rampant spending could be another conversation in and of itself).
We refer to the wealth plans we create for our clients as the “map” illustrating where our clients stand today and their desired destination. The investment portfolio and specific planning techniques serve as the “vehicle” our clients take for the trip. You won’t get to your destination in the most efficient, successful way without both the map and vehicle. Here are some of the things we’re doing to ensure that the clients who have chosen to work with us on planning are staying on the right path to success:
1. Annually updating client wealth plans to account for tax, legislative, investment, client situation and client goal changes.
2. Issuing written recommendations as part of every wealth plan that provide actionable items that will help better our client’s financial picture.
3. Advising on items critical to maximizing financial success, such as Roth IRA conversions, as part of the backdrop of a comprehensive wealth plan.
