Save & Invest - First Quarter 2011
http://www.watermarkasset.com/articles/51/1/Save-amp-Invest---First-Quarter-2011/Page1.html
By Mark Miller
Published on 04/18/2011
They’re about to take the training wheels off the economy and we’re
going to find out if housing and employment can recover without
government stimulus and quantitative easing propping them up. With the
first quarter payroll tax effect behind us, and the Federal Reserve’s
purchase of $600 billion in Treasuries (QE2) on track to end in June,
the economy is going to have to show that it can stay up on its own.
Another round of government intervention may not be so easy to come by...
They’re about to take the training wheels off the economy and we’re going to find out if housing and employment can recover without government stimulus and quantitative easing propping them up. With the first quarter payroll tax effect behind us, and the Federal Reserve’s purchase of $600 billion in Treasuries (QE2) on track to end in June, the economy is going to have to show that it can stay up on its own. Another round of government intervention may not be so easy to come by.
The Fed’s Bernanke closed out the purchase of more than $1.2 trillion in mortgage backed securities (now known as QE1) one year ago. Stocks promptly sold off nearly 14% through the end of August, changing direction only when he indicated in a speech at Jackson Hole, Wyoming, that the Fed would initiate another round of asset purchases (QE2). U.S. stocks, along with the price of food and energy have soared since then. The end of QE2 could well signal another selloff, albeit more mild, as the economy transitions from two years of fiscal stimulus toward fiscal restraint.
The market, as measured by the S&P 500 Total Return (TR) stock index, continued where it left off in December, gaining 2.4% in January, 3.4% in February and then going flat in March with a 0.4% gain. For the quarter, the index was up 5.92%, a strong performance.
International developed and emerging markets trailed the U.S. but still jumped 3.4% and 2% respectively. The best U.S. asset classes were small cap (+7.7%) and mid cap (+9.4%) stocks. Bonds, measured by the BarCap US Aggregate Bond Index, held steady gaining just under a half percent in the quarter.
JOBS
The economy continues to be plagued by high unemployment, though there is some comfort in the March numbers. The Labor Department reported 216,000 net new jobs for the month; 230,000 private sector job gains and 14,000 government jobs lost. The jobless rate dropped to 8.8% while there were approximately 100,000 fewer discouraged workers in March.
As reported by Gluskinsheff.com, the economy has managed to recoup just 17% of the recession job losses; usually at this stage, heading into the third year of an expansion, the level of payrolls is at a new all-time high.
The Wall Street Journal reported, in the chart to the right, that the recovery rate in jobs, after the most recent recession, is the lowest of the past four downturns. The economy is still seven million jobs shy of pre-recession employment. While jobs are finally being created, at 200,000 net new jobs per month, it would still take years to get back to the pre-recession peak in the employment-to-population ratio.
So, on a positive note, people are going back to work. Still, it is very slow going and, unfortunately, real average weekly earnings were flat in March and only up one penny in February. While this is not unexpected given the slack in the jobs market, Gluskinsheff.com also reports that energy and food now absorb about 23% of U.S. wage and salary income – not a good sign for the consumer.
HOUSING
The Standard & Poor’s/Case-Shiller Home Price Indices were released on March 29th. To quote their headline, “Home Prices Off to a Dismal Start in 2011”. According to David Blitzer, Chairman of the Index Committee at Standard & Poor’s, January brought “weakening home prices with no real hope in sight for the near future”.
Further, the Atlanta, Cleveland, Detroit and Las Vegas markets now show average home prices that are below their January 2000 levels. Washington DC is the only market that has weathered the recent storm. Though it was up only 0.1% in January, its annual gain was a healthy +3.6%.
It is still more than 10% above its March 2009 low and ranks number one among the 20 markets with an average value almost 85% above its January 2000 level.
Gluskinsheff.com reports that new home sales have collapsed at an 82% annual rate so far in 2011. The unsold inventory of new homes has expanded from 6.8 months’ supply in December 2010 to 8.9 months currently. Both the median and average prices for new homes have sagged at over a 60% annual rate.
According to U.S. Census data, there are 3.7 million homes that are vacant and are for sale. This is 30% above normal. The National Association of Realtors reports there are 3.5 million homes that are occupied but with a for sale sign on the front lawn. This is 50% above normal.
CoreLogic, a leading provider of consumer, financial and property information analytics and services reported on March 30th that the shadow inventory of distressed homes declined in January to 1.8 million units, or nine months’ supply, down from 2 million, also a nine months’ supply from a year ago. In addition to the current shadow inventory supply, there are nearly 2 million current negative equity loans that are more than 50% “upside down” that will likely become shadow supply in the near future.
The shadow inventory is calculated as the number of distressed properties not currently listed on multiple listing services that are seriously delinquent (90 days or more), in foreclosure and real estate owned (REO) by lenders. Shadow inventory is not typically included in the official metrics of unsold inventory.
Add it all up, and that’s a lot of homes to sell. Absent a viable system of mortgage financing, other than the bankrupt and government owned Fannie Mae and Freddie Mac twins, we have a real mess on our hands. Unfortunately, the only solution to the problem appears to be the very slow bottoming of prices.
INFLATION
The Federal Reserve continues to be one of the most accommodative central banks, and that is causing the dollar to weaken against many currencies. Oil prices have risen above $100 per barrel and retail gas prices are now above $3.50 per gallon, more than $4 per gallon in California. These prices become a tax on growth, eroding real incomes, which remain flat or down in the current environment.
One of the arguments against Fed intervention in the markets is that the excess liquidity leads to inflation. We see it already in the price of food and energy. The counter argument (and the Fed’s position) is that this is temporary. And, in fact, the primary trend in bank credit, real wages and housing is still one of deflation, not inflation.
Since 1971 we’ve had seven periods in which we’ve moved from a low (less than 3.4% rate) to rising inflation environment. In this period, the best performing asset classes are equities and commodities. The worst, of course, is cash.
STRATEGY
Moving to the second quarter, and to confirm the economic recovery, we want to see companies reporting top line revenue as well as profit growth. The most recent S&P 500 operating earnings per share number of $21.92 for the first quarter is approaching the $24.06 high from Q2 2007. The consensus estimate of the next twelve months’ rolling earnings is $100.93 per share. We need to see confirmation of that trend. If earnings stall or decline, look for stocks to pull back.
We continue to avoid U.S. government bonds in favor of high grade corporates, foreign bond holdings and real return strategies (inflation protection). Municipal bonds sold off heavily at the end of 2010 and the worse the price, the more attractive they’ve become. States have cut back sharply on expenses and borrowing this year creating what appears to be an undervalued asset class.
We remain extremely focused on risk management. We added an equity-linked CD strategy to certain retirement accounts this past quarter. This instrument pays an annualized return based on the performance of a basket of equity exchange-traded funds, with a minimum payout of 0.75% per year. It is FDIC insured and runs for five years. We are using this for principal protection.
At the end of the quarter we saw the maturity of our first S&P 500 Structured Note, purchased early in 2008. The note outperformed the S&P index over the holding period while providing a 10% downside buffer against declines. We anticipate that we will continue to utilize the structured note strategies in 2011, seeking equity returns with less risk.
Despite the gloomy news, our economy is still growing, just very slowly. Some things, like rapidly appreciating home values, are gone and won’t be back any time soon. Other opportunities, in foreign investments and energy, are probably going to be with us for some time. U.S. stocks, even after the sharp gains off the bottom in March 2009, remain relatively inexpensive compared to their own history and relative to other world economies.
CONCLUSION
In the short term, we expect to see increased volatility as we near the end of QE2 in June. The budget battles in Washington will play out in the news causing uncertainty for investors, and the markets don’t like uncertainty.
Over the next three to five years, we are more optimistic that the economy will continue to recover, that housing will find its clearing price, and we’ll have a new system of financing that is fair to borrowers, lenders and investors. In the meantime, it’s going to be a bit wobbly without those training wheels.
REGULATORY ISSUES
In compliance with new SEC regulations, Watermark has prepared and filed its Firm Brochure and Brochure Supplement as replacements for SEC Form ADV Part II. The Brochure and Brochure Supplement are available for your review at www.watermarkasset.com, and the SEC website at www.adviserinfo.sec.gov. You may request a paper copy by calling us at 925-648-4730 or emailing us at advisors@watermarkasset.com.
Each year at this time, or as required, we will notify you of any changes or material updates to the Brochure and offer to send you the most current copy. We have also included a copy of the Watermark Privacy Statement with our quarterly reports.
ELECTRONIC RECORDS
For some years now we have provided our clients with binders and paper reporting packages. We want you to know that we are now offering a flash drive storage card for the electronic storage of your documents. If you would like to “go paperless”, please let us know and we will send you an encrypted storage card and arrange to deliver our materials, and your custodian’s statements, to you electronically.
529 TUITION PLANS
Finally, we want to be sure that you are aware that as of the end of 2010, funds from 529 Tuition Plans may no longer be used to purchase a computer or internet services. This was a provision under the American Recovery and Reinvestment Tax Act of 2009 for tax years 2009 and 2010 only. A bill, The Savings Enhancement for Education in College Act (H.R. 529) was recently introduced to reinstate computers as a qualified education expense. As of now, the bill has been referred to the House Ways and Means Committee for review. For more information on 529 plans please see www.savingforcollege.com.
Mark Miller Eric Lai John Wenzel
The Fed’s Bernanke closed out the purchase of more than $1.2 trillion in mortgage backed securities (now known as QE1) one year ago. Stocks promptly sold off nearly 14% through the end of August, changing direction only when he indicated in a speech at Jackson Hole, Wyoming, that the Fed would initiate another round of asset purchases (QE2). U.S. stocks, along with the price of food and energy have soared since then. The end of QE2 could well signal another selloff, albeit more mild, as the economy transitions from two years of fiscal stimulus toward fiscal restraint.
The market, as measured by the S&P 500 Total Return (TR) stock index, continued where it left off in December, gaining 2.4% in January, 3.4% in February and then going flat in March with a 0.4% gain. For the quarter, the index was up 5.92%, a strong performance.
International developed and emerging markets trailed the U.S. but still jumped 3.4% and 2% respectively. The best U.S. asset classes were small cap (+7.7%) and mid cap (+9.4%) stocks. Bonds, measured by the BarCap US Aggregate Bond Index, held steady gaining just under a half percent in the quarter.
JOBS
The economy continues to be plagued by high unemployment, though there is some comfort in the March numbers. The Labor Department reported 216,000 net new jobs for the month; 230,000 private sector job gains and 14,000 government jobs lost. The jobless rate dropped to 8.8% while there were approximately 100,000 fewer discouraged workers in March.
As reported by Gluskinsheff.com, the economy has managed to recoup just 17% of the recession job losses; usually at this stage, heading into the third year of an expansion, the level of payrolls is at a new all-time high.
The Wall Street Journal reported, in the chart to the right, that the recovery rate in jobs, after the most recent recession, is the lowest of the past four downturns. The economy is still seven million jobs shy of pre-recession employment. While jobs are finally being created, at 200,000 net new jobs per month, it would still take years to get back to the pre-recession peak in the employment-to-population ratio.
So, on a positive note, people are going back to work. Still, it is very slow going and, unfortunately, real average weekly earnings were flat in March and only up one penny in February. While this is not unexpected given the slack in the jobs market, Gluskinsheff.com also reports that energy and food now absorb about 23% of U.S. wage and salary income – not a good sign for the consumer.
HOUSING
The Standard & Poor’s/Case-Shiller Home Price Indices were released on March 29th. To quote their headline, “Home Prices Off to a Dismal Start in 2011”. According to David Blitzer, Chairman of the Index Committee at Standard & Poor’s, January brought “weakening home prices with no real hope in sight for the near future”.
Further, the Atlanta, Cleveland, Detroit and Las Vegas markets now show average home prices that are below their January 2000 levels. Washington DC is the only market that has weathered the recent storm. Though it was up only 0.1% in January, its annual gain was a healthy +3.6%.
It is still more than 10% above its March 2009 low and ranks number one among the 20 markets with an average value almost 85% above its January 2000 level.
Gluskinsheff.com reports that new home sales have collapsed at an 82% annual rate so far in 2011. The unsold inventory of new homes has expanded from 6.8 months’ supply in December 2010 to 8.9 months currently. Both the median and average prices for new homes have sagged at over a 60% annual rate.
According to U.S. Census data, there are 3.7 million homes that are vacant and are for sale. This is 30% above normal. The National Association of Realtors reports there are 3.5 million homes that are occupied but with a for sale sign on the front lawn. This is 50% above normal.CoreLogic, a leading provider of consumer, financial and property information analytics and services reported on March 30th that the shadow inventory of distressed homes declined in January to 1.8 million units, or nine months’ supply, down from 2 million, also a nine months’ supply from a year ago. In addition to the current shadow inventory supply, there are nearly 2 million current negative equity loans that are more than 50% “upside down” that will likely become shadow supply in the near future.
The shadow inventory is calculated as the number of distressed properties not currently listed on multiple listing services that are seriously delinquent (90 days or more), in foreclosure and real estate owned (REO) by lenders. Shadow inventory is not typically included in the official metrics of unsold inventory.
Add it all up, and that’s a lot of homes to sell. Absent a viable system of mortgage financing, other than the bankrupt and government owned Fannie Mae and Freddie Mac twins, we have a real mess on our hands. Unfortunately, the only solution to the problem appears to be the very slow bottoming of prices.
INFLATION
The Federal Reserve continues to be one of the most accommodative central banks, and that is causing the dollar to weaken against many currencies. Oil prices have risen above $100 per barrel and retail gas prices are now above $3.50 per gallon, more than $4 per gallon in California. These prices become a tax on growth, eroding real incomes, which remain flat or down in the current environment.
One of the arguments against Fed intervention in the markets is that the excess liquidity leads to inflation. We see it already in the price of food and energy. The counter argument (and the Fed’s position) is that this is temporary. And, in fact, the primary trend in bank credit, real wages and housing is still one of deflation, not inflation.
Since 1971 we’ve had seven periods in which we’ve moved from a low (less than 3.4% rate) to rising inflation environment. In this period, the best performing asset classes are equities and commodities. The worst, of course, is cash.
STRATEGY
Moving to the second quarter, and to confirm the economic recovery, we want to see companies reporting top line revenue as well as profit growth. The most recent S&P 500 operating earnings per share number of $21.92 for the first quarter is approaching the $24.06 high from Q2 2007. The consensus estimate of the next twelve months’ rolling earnings is $100.93 per share. We need to see confirmation of that trend. If earnings stall or decline, look for stocks to pull back.
We continue to avoid U.S. government bonds in favor of high grade corporates, foreign bond holdings and real return strategies (inflation protection). Municipal bonds sold off heavily at the end of 2010 and the worse the price, the more attractive they’ve become. States have cut back sharply on expenses and borrowing this year creating what appears to be an undervalued asset class.
We remain extremely focused on risk management. We added an equity-linked CD strategy to certain retirement accounts this past quarter. This instrument pays an annualized return based on the performance of a basket of equity exchange-traded funds, with a minimum payout of 0.75% per year. It is FDIC insured and runs for five years. We are using this for principal protection.
At the end of the quarter we saw the maturity of our first S&P 500 Structured Note, purchased early in 2008. The note outperformed the S&P index over the holding period while providing a 10% downside buffer against declines. We anticipate that we will continue to utilize the structured note strategies in 2011, seeking equity returns with less risk.
Despite the gloomy news, our economy is still growing, just very slowly. Some things, like rapidly appreciating home values, are gone and won’t be back any time soon. Other opportunities, in foreign investments and energy, are probably going to be with us for some time. U.S. stocks, even after the sharp gains off the bottom in March 2009, remain relatively inexpensive compared to their own history and relative to other world economies.
CONCLUSION
In the short term, we expect to see increased volatility as we near the end of QE2 in June. The budget battles in Washington will play out in the news causing uncertainty for investors, and the markets don’t like uncertainty.
Over the next three to five years, we are more optimistic that the economy will continue to recover, that housing will find its clearing price, and we’ll have a new system of financing that is fair to borrowers, lenders and investors. In the meantime, it’s going to be a bit wobbly without those training wheels.
REGULATORY ISSUES
In compliance with new SEC regulations, Watermark has prepared and filed its Firm Brochure and Brochure Supplement as replacements for SEC Form ADV Part II. The Brochure and Brochure Supplement are available for your review at www.watermarkasset.com, and the SEC website at www.adviserinfo.sec.gov. You may request a paper copy by calling us at 925-648-4730 or emailing us at advisors@watermarkasset.com.
Each year at this time, or as required, we will notify you of any changes or material updates to the Brochure and offer to send you the most current copy. We have also included a copy of the Watermark Privacy Statement with our quarterly reports.
ELECTRONIC RECORDS
For some years now we have provided our clients with binders and paper reporting packages. We want you to know that we are now offering a flash drive storage card for the electronic storage of your documents. If you would like to “go paperless”, please let us know and we will send you an encrypted storage card and arrange to deliver our materials, and your custodian’s statements, to you electronically.
529 TUITION PLANS
Finally, we want to be sure that you are aware that as of the end of 2010, funds from 529 Tuition Plans may no longer be used to purchase a computer or internet services. This was a provision under the American Recovery and Reinvestment Tax Act of 2009 for tax years 2009 and 2010 only. A bill, The Savings Enhancement for Education in College Act (H.R. 529) was recently introduced to reinstate computers as a qualified education expense. As of now, the bill has been referred to the House Ways and Means Committee for review. For more information on 529 plans please see www.savingforcollege.com.
Mark Miller Eric Lai John Wenzel