Save & Invest - Third Quarter 2010
http://www.watermarkasset.com/articles/49/1/Save-amp-Invest---Third-Quarter-2010/Page1.html
By Mark Miller
Published on 10/8/2010
Three Yards and a Cloud of Dust
It feels like a Woody Hayes economy,
“three yards and a cloud of dust”. The legendary Ohio State football coach described his offense as a
“crunching, frontal assault of muscle against muscle, bone upon bone,
will against will”. After decades of over spending and over leveraging,
guilty or not, who doesn’t feel like a player for the famed Buckeyes?
We’re all in the game, making progress, three yards at a time...
It feels like a Woody Hayes economy,
“three yards and a cloud of dust”. The legendary Ohio State football coach described his offense as a
“crunching, frontal assault of muscle against muscle, bone upon bone,
will against will”. After decades of over spending and over leveraging,
guilty or not, who doesn’t feel like a player for the famed Buckeyes?
We’re all in the game, making progress, three yards at a time...Three Yards and a Cloud of Dust
It feels like a Woody Hayes economy, “three yards and a cloud of dust”. The legendary Ohio State football coach described his offense as a “crunching, frontal assault of muscle against muscle, bone upon bone, will against will”. After decades of over spending and over leveraging, guilty or not, who doesn’t feel like a player for the famed Buckeyes? We’re all in the game, making progress, three yards at a time.
We learned that the Great Recession officially ended in June 2009. Unofficially, the US economy continued to improve during the quarter, but GDP growth slowed to an annualized 1.7% rate; hardly the stuff of strong recoveries.
Stock and bond markets sent mixed signals in Q3. Interest rates declined and bond prices moved up while stocks recovered from the second quarter selloff. The S&P 500 index jumped 11.3% over the summer registering a positive year-to-date total return of 3.9%. The BarCap US Bond index pulled ahead another 2.5% in the quarter and 7.9% for 2010. The excitement, though, was overseas as foreign stocks (EAFE Index) jumped 15.8% and emerging market economies topped all others, gaining more than 17% in the three-month period.
Now, three years off the market highs of October 2007, the US, Europe and Japan continue to embrace a strategy of Quantitative Easing (QE – printing money) in an attempt to ignite economic growth and head off deflation. To-date the results have been mixed.
In the US, the Fed (Bernanke) announced that after purchasing $1.2 trillion in mortgage securities, it would use the proceeds from maturing loans to begin purchasing US Treasuries. The result: more money in circulation, lower long-term interest rates and a weaker dollar. The weak dollar is driving higher prices and returns on foreign investments and commodities like gold, silver and oil. It isn’t that these holdings are necessarily becoming more expensive on the world market, but rather that it takes more of our weaker dollars to purchase them. US stocks are rallying on the prospect of better overseas sales and continued low interest rates.
There are, of course, potential consequences to a QE strategy. Sometime down the road, interest rates will rise again, dramatically increasing the cost of US debt. Inflation, too, is a potential problem. And of course, printing money may only mask over our problems, not solve them.
Investor Behavior
Much has been written about bond bubbles and investor behavior. Are investors foolishly abandoning stocks in favor of bonds,
creating the next bubble to burst? We doubt it. The Fed has clearly stated that it will keep interest rates low for the foreseeable future. That’s good for bond prices. Real income in a deflationary cycle is good. Bonds can deliver both income and safety of principal. While bond fund purchases are strong, it appears that investors are funding them by moving money out of money market funds into higher yielding bond positions. As the chart on the right illustrates, money market holdings have decreased in 2010 while bond and world equity investments are on the rise. Absent either an increase in interest rates or sustained US economic growth, investors may have this one right.
The Uncertainties
At this stage of the recovery we should be seeing a strong and steady rise in employment. We are not. The housing market continues to flounder, with prices searching for the right level and lenders (other than the government) staying away from the mortgage market. As a result, GDP, while positive, remains weak.
Federal tax rates are scheduled to rise for everyone in January. If that happens, stocks will surely adjust downward accounting for lower net returns. Of particular interest to investors, the maximum long-term capital gain rate will increase from 15% to 20%, and the 15% qualified dividend rate will expire. All dividends will be taxed at ordinary income rates, the highest marginal rate being 39.6%.
The recession has severely impacted government tax receipts as shown below. Congress, in recess until after the November elections, will have to find a balance between rising government debt and the risk of choking off a fragile recovery with higher taxes. There is no easy answer.
Strategy
We may be in for a prolonged period of low interest rates, though hopefully not as long as Japan. We will continue to maintain our bond allocations but will rebalance and take gains in those accounts that have seen substantial growth off the lows of 2008. We are looking at increasing foreign bond holdings both for additional income and as a way to hedge against a falling dollar.
We are comfortable with our US stock allocations though we remain very cautious. Growth may stall or fall from already low levels. Upcoming earnings reports will provide clarity. Our structured notes offer a downside buffer against further US stock volatility.
Foreign stocks remain attractive. Should the outlook for the US economy turn negative again, we will increase overseas equities.
We substituted the PIMCO All Asset All Authority fund for the PIMCO All Asset position where appropriate across our client base. The manager of the All Asset fund has the ability to short the US market when he believes it is overvalued. We view this holding as an additional hedge against a US stock decline.
Small investments in energy and commodities remain attractive in light of the weaker dollar. Where appropriate, we will continue to add small allocations.
Summary
Despite the challenges outlined above, we are not necessarily pessimistic investors. Markets around the world, including our own, are functioning much more rationally again. That offers prudent investors the opportunity to reap investment gains. Asset allocation, both strategic and tactical has never been more important, or better rewarded. And, let’s remember, it may not have been pretty, but Coach Hayes won three national championships and 13 Big Ten Conference titles…”three yards and a cloud of dust” at a time.
Housekeeping Items
Moving into the fourth quarter, we will be contacting those clients who have yet to take Required IRA Minimum Distributions. We will also discuss Roth Conversions with those who have expressed an interest in this opportunity.
As always, we value the trust and confidence you have placed in our firm.
It feels like a Woody Hayes economy, “three yards and a cloud of dust”. The legendary Ohio State football coach described his offense as a “crunching, frontal assault of muscle against muscle, bone upon bone, will against will”. After decades of over spending and over leveraging, guilty or not, who doesn’t feel like a player for the famed Buckeyes? We’re all in the game, making progress, three yards at a time.
We learned that the Great Recession officially ended in June 2009. Unofficially, the US economy continued to improve during the quarter, but GDP growth slowed to an annualized 1.7% rate; hardly the stuff of strong recoveries.
Stock and bond markets sent mixed signals in Q3. Interest rates declined and bond prices moved up while stocks recovered from the second quarter selloff. The S&P 500 index jumped 11.3% over the summer registering a positive year-to-date total return of 3.9%. The BarCap US Bond index pulled ahead another 2.5% in the quarter and 7.9% for 2010. The excitement, though, was overseas as foreign stocks (EAFE Index) jumped 15.8% and emerging market economies topped all others, gaining more than 17% in the three-month period.
Now, three years off the market highs of October 2007, the US, Europe and Japan continue to embrace a strategy of Quantitative Easing (QE – printing money) in an attempt to ignite economic growth and head off deflation. To-date the results have been mixed.
In the US, the Fed (Bernanke) announced that after purchasing $1.2 trillion in mortgage securities, it would use the proceeds from maturing loans to begin purchasing US Treasuries. The result: more money in circulation, lower long-term interest rates and a weaker dollar. The weak dollar is driving higher prices and returns on foreign investments and commodities like gold, silver and oil. It isn’t that these holdings are necessarily becoming more expensive on the world market, but rather that it takes more of our weaker dollars to purchase them. US stocks are rallying on the prospect of better overseas sales and continued low interest rates.
There are, of course, potential consequences to a QE strategy. Sometime down the road, interest rates will rise again, dramatically increasing the cost of US debt. Inflation, too, is a potential problem. And of course, printing money may only mask over our problems, not solve them.
Investor Behavior
Much has been written about bond bubbles and investor behavior. Are investors foolishly abandoning stocks in favor of bonds,
creating the next bubble to burst? We doubt it. The Fed has clearly stated that it will keep interest rates low for the foreseeable future. That’s good for bond prices. Real income in a deflationary cycle is good. Bonds can deliver both income and safety of principal. While bond fund purchases are strong, it appears that investors are funding them by moving money out of money market funds into higher yielding bond positions. As the chart on the right illustrates, money market holdings have decreased in 2010 while bond and world equity investments are on the rise. Absent either an increase in interest rates or sustained US economic growth, investors may have this one right.The Uncertainties
At this stage of the recovery we should be seeing a strong and steady rise in employment. We are not. The housing market continues to flounder, with prices searching for the right level and lenders (other than the government) staying away from the mortgage market. As a result, GDP, while positive, remains weak.
Federal tax rates are scheduled to rise for everyone in January. If that happens, stocks will surely adjust downward accounting for lower net returns. Of particular interest to investors, the maximum long-term capital gain rate will increase from 15% to 20%, and the 15% qualified dividend rate will expire. All dividends will be taxed at ordinary income rates, the highest marginal rate being 39.6%.
The recession has severely impacted government tax receipts as shown below. Congress, in recess until after the November elections, will have to find a balance between rising government debt and the risk of choking off a fragile recovery with higher taxes. There is no easy answer. Strategy
We may be in for a prolonged period of low interest rates, though hopefully not as long as Japan. We will continue to maintain our bond allocations but will rebalance and take gains in those accounts that have seen substantial growth off the lows of 2008. We are looking at increasing foreign bond holdings both for additional income and as a way to hedge against a falling dollar.
We are comfortable with our US stock allocations though we remain very cautious. Growth may stall or fall from already low levels. Upcoming earnings reports will provide clarity. Our structured notes offer a downside buffer against further US stock volatility.
Foreign stocks remain attractive. Should the outlook for the US economy turn negative again, we will increase overseas equities.
We substituted the PIMCO All Asset All Authority fund for the PIMCO All Asset position where appropriate across our client base. The manager of the All Asset fund has the ability to short the US market when he believes it is overvalued. We view this holding as an additional hedge against a US stock decline.
Small investments in energy and commodities remain attractive in light of the weaker dollar. Where appropriate, we will continue to add small allocations.
Summary
Despite the challenges outlined above, we are not necessarily pessimistic investors. Markets around the world, including our own, are functioning much more rationally again. That offers prudent investors the opportunity to reap investment gains. Asset allocation, both strategic and tactical has never been more important, or better rewarded. And, let’s remember, it may not have been pretty, but Coach Hayes won three national championships and 13 Big Ten Conference titles…”three yards and a cloud of dust” at a time.
Housekeeping Items
Moving into the fourth quarter, we will be contacting those clients who have yet to take Required IRA Minimum Distributions. We will also discuss Roth Conversions with those who have expressed an interest in this opportunity.
As always, we value the trust and confidence you have placed in our firm.