As we close out Q1 2010 we pause to take a look back. On the macro economic and investment fronts, we actually have little to report that we did not cover in our Annual Forecast. A italicized summary of that forecast follows and ambitious readers can find the entire piece here. Every serious investment discipline requires constant review and evaluation. Any model is only as good as its inputs. Though we have yet to see any unanticipated trends develop, we continue to monitor both the more broad, long term economic outlook and the more immediate investment situation. With these in mind what follows is a quick note regarding our current outlook and strategy. As always, if the evidence changes, so will our conclusions...
“Strong economic growth that the US experienced at the end of 2009 should continue into early 2010. Government stimulus will add to inventory rebuilding, the ongoing benefit of low interest rates, and growth in exports currently bolstered by the recently weak US Dollar. This will be accompanied by an improving employment outlook and somewhat reduced inflation as residential rents plunge and the US Dollar begins a countertrend rally.
Later in the year, interest rate increases, a slowdown in the pace of stimulus spending, and the continued deleveraging of the consumer will temper the expansion. Slower (but still positive) growth will be accompanied by an inflationary uptick as the Dollar turns back down.
The prospect of higher interest rates will limit the Dollar's decline and put a ceiling on stock prices, while the actual increase in rates will end the rebound in home prices. Prices of both homes and stocks should end 2010 not very far from where they ended 2009.”
So far the world of 2010 is moving forward according to our script. The economic and employment pictures are clearly improving, despite an unusually severe winter. Corporate profits are recovering and inflation is restrained by the combination of strong dollar, tight fisted corporations and falling residential rents. Simply put, we are in the sweet spot of the economic recovery. All this good news is reflected in an extension of last year's stock market rally to new 18 month highs. As we approach what I have suggested is the high end of the 2010 stock market range (S&P around 1200), market bulls are prancing proudly, and our Diversified Sector Portfolio has recovered virtually all our market losses from the Oct 2007 highs. At this moment prudence demands serious self examination rather than popping of champagne corks.
Bullish stock market technicians see no upside resistance until the S&P 500 approaches 1230. Curiously, this level coincides almost exactly with the average year-end forecast of most major economists. As long as interest rates remain steady (10 yr TBonds below 4%), it is hard to argue against at least a brief spike to those levels. A brief rally above S&P 1200 in the near future is a very different proposition than either sustaining those levels through year-end or moving even higher. Those more optimistic outcomes require investors to ignore the 900 lb gorilla in the room that got us into this mess; trillions of dollars of public and private debt.
For past last year, excessive focus on the debt problem has been a recipe for locking in the monstrous stock market and real estate losses from 2007 to 2009. Ignoring that problem could prove equally disastrous for investors in the next year. Unlike a year ago, stocks and home prices are not seriously undervalued. Unlike a year ago, interest rates are poised to move higher, not lower. Unlike a year ago, the debt of sovereign nations looks riskier than the debt of many cash-rich corporations.
While the aggregate (public & private) debt burden remains at unsustainable levels, historically low interest rates have radically reduced the annual interest cost of that debt. This reduction in the cost of “debt service” is the foundation of the current recovery. Much like sinking Venice, this foundation will weaken as we move toward 2011.
I've written before of this debt problem and impossibility of avoiding it. At this point it nearly goes without saying that it is the most serious and significant issue facing our economy and in fact the global economy. Having said that, it is important to know that it is unlikely to result in any economic collapse in the next couple of years. Corporate payrolls are at skeleton levels. Even in the event of return to recession, corporations are unlikely to reduce further. Non-financial corporations have record levels of cash on their balance sheets that should enable them to weather any economic storm. Moreover, they have converted short term debt into long term borrowings on very favorable terms that they can easily service in any foreseeable economic scenario. The economic downside is limited. The economy is growing and will get even better before it slows down.
Investors however face a different dilemma. A year ago stocks were priced for financial Armageddon. Today the stock market is priced for at least a couple years of improving economic growth and a rapid recovery in corporate profits to near record levels. The debt Gorilla makes that sanguine outcome unlikely. Add to that the huge increase in government spending relative to GDP and the inevitable 2011 tax increase and it becomes hard to envision another boom.
While we were happy to participate in the market gains during the past year, we began reducing our exposure to the stock market at S&P 1150 and will reduce more if stock prices rise. We plan on cutting the remaining holdings severely should stocks rally above S&P 1200 (which still seems possible). Even if my current caution proves excessive and markets gain another 10% as suggested by the most bullish of analysts and money managers, market history suggests a subsequent retracement back to S&P 1200 would give us a chance to get back in later on. Because of the limited upside to stocks in general from these levels, we have shifted our portfolios over the past months toward income producing investments that improve the risk/reward ratio for our clients.
At least for now our 2010 forecast remains unchanged. When the dust settles, US stocks are likely to end the year very near where they began.
Clyde Kendzierski
Chief Investment Officer
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