What a difference twelve months makes for the investment markets! The Federal Reserve and the U.S. Treasury department have arguably taken the necessary steps to repair the financial institutions during the first half of 2009 and now the patient investor is once again been issued a reprieve. What do we make of the past twelve months? The obvious explanation can be traced to five major financial institutions that failed each representing an estimated $1.0 trillion in assets that were forced liquidated at one time causing the 50% drop in stock prices from peak to trough. Forced liquidations were spawned in mutual funds and hedge funds exacerbating the decline. World stock markets followed in suit and at the end of the day trillions were lost from June through March 9, 2009. 401-K’s became 201-K’s in a matter of nine months. Fear gripped the financial system as the world economy slipped into a recession.
Fast forward to the present and economists are optimistic about the impact rampant monetary growth, multiple economic stimulus packages, and the possibility that housing might turn in the immediate future. Housing remains weak as foreclosures continue at a healthy pace. Unemployment data suggests that job losses are occurring at a lower rate of change and appears the worst is over. Low short term interest rates around the world will at some point begin to foster real economic growth. At the risk of rising commodity prices, the Federal Reserve continues to push money into the financial system. With only 10% of the stimulus package spent, we believe the remaining amount will be used in 2010 which just happens to be a Congressional election year. Economic recovery should be in full bloom as our respective Congress people attempt to either keep their positions or lose them to challengers.
Cash for Clunkers sold over 800,000 cars in August. Taxpayers subsidized the auto industry to the tune of $4 billion that was dominated by Toyota and Honda. The American car companies (which two are owned by taxpayers) did not reap the large benefits of this. However, if priming the pump was necessary, the car industry might see consumers willing to replace its older fleet as the economic cycle appears to be rekindling. Unfortunately, consumers are holding on to their cash and are not incurring new debt as of yet.
The government’s attempt to socialize part of health care has stalled as Congressmen went home and were yelled at by constituents. Many debate both sides of the argument. Past Presidents Carter and Clinton attempted to do the very same thing only to be thwarted. Government handouts have become common even under President Bush as he passed the Drug Benefit program that has given seasoned citizens cheap Viagra and helped bipolar patients with their anti-depressants. One causes blindness the latter numbness. We are not sure which is being taken by Congress!
With the recent rally in stock prices across the board, the market may be ahead of itself for the time being. We have had three years of stock price appreciation since March 9, 2009. Valuations may be too optimistic about 2010 earnings.
Returning Function to a Dysfunctional Market. Normalcy is being restored as Geithner and Co. reach out and touch the banks like E-T restoring the dead sunflower in the Extraterrestrial. Actually, the banks have dumped enough bad loans into the Federal Reserve portfolio that the banking triage has at least stymied the Great Depression II. Bernanke did take some of the TARP money and sent it to Europe to provide International banks with emergency lending capabilities. The stock markets in Europe have responded favorably along with the rest of the world. Fed policy has at least opened up clogged financial arteries and has served as a financial Lipitor to those markets. Saving the banking system at least is the first step in solving the crisis. The toxic assets still exist. Yet, the prospects of an economic recovery might buy the necessary time that the trigger mechanism will not vaporize what capital is left in the major banks.
Bernanke’s brilliant move over the past twelve months has been the enormous rally in U.S. Treasury bonds in December enabling large holders of these securities to reap huge profits which is usually the largest banks, China and PIMCO. Appetite for Treasury bonds remains healthy even with the recent price rise. The same players continue to purchase massive amounts of freshly printed bonds as $1.7 deficit spending during 2009 has come to the aid of the recession. Mathematically, we cannot come up with any reason to buy bonds. Early moves in commodities and more recently gold indicates that markets are expecting inflation. The financial tug of war between inflation and deflation baffles the markets as housing prices continue to be weak.
Financial Triage for the American Consumer. Recent Congressional discussions hint that loosening lending standards for home owners might come back as it was in the early 2000’s under Bush and Co. Consumer savings rates have risen over the past twelve months and credit card usage has actually come down as well. The twelve step program for credit card usage has started to work. Tax rates need to fall not rise for full recovery to occur. Yet, if our tea leaves prove correct, the inflation tax is coming as wages rise and tax payers are elevated into higher tax brackets. This phenomenon, referred to as “bracket-creep”, will exert pressure on households as wholesale price increases shrink the purchasing power for the consumer. Just as the American consumer begins to breathe easier the new wrinkle in the economy will be inflation, where many dollars chase too few goods.
Many market strategies are recommending large cap stocks due to their lower valuations. However, during inflationary times, small capitalization issues act more favorably than large cap stocks. High yield bonds perform better than Treasury bonds. Inflation increases corporate cash flows and this is especially positive for smaller companies and junk bonds. Inflation is truly a bad thing for U.S. Treasury bond holders as inflation erodes the value of these instruments. At this juncture, the jury is still out on whether the financial markets can shift from deflation to inflation.
Buy and hold strategies are finally kicking in. Although it has been recently said that the day trader is coming back into the market, the broad based market rise since March has trickled down to many of the downtrodden and financially distressed companies. Hope springs eternal as significant rallies have occurred across the board. Policy makers are hinting at positive signs the economy is turning. The real economy will not be in full-recovery mode until housing turns.
We remain guarded and cautiously optimistic that economic recovery can occur. The stock market is a leading indicator and with its rise, the CBR’s basket of leading indicators turned positive during the second quarter and we expect upward momentum in the fourth quarter. This will be a welcome relief for us as your investment managers and hopefully your patience is rewarded with higher portfolio values.
Russell L. Robinson
Robinson Investment Group
5301 Virginia Way, Suite 150
Brentwood, Tennessee 37027