Wow—what a wild year it’s been in the stock market! The stock market just posted its best September in decades. It was the strongest September on a percentage basis for the Dow Jones Industrial Average in 71 years. (Source: WSJ, October 4th, “Trading Volumes Sink…” C2) The Dow increased 7.7% in a fairly steady climb throughout September, rather than the volatile swings seen earlier in the year. The S&P 500 gained 8.5% total return in September, its best September results since 1939 and its fourth best performance for any month in the last twenty years. (Source: BTN Research) The S&P 500 is up 3.9% year-to-date through September 30th. The NASDAQ also is up 4.4% for the year through September 30th and it also increased 12.3% for the quarter.
Third quarter volume in stock trading was about 25% below the second quarter level, perhaps because investors felt a lesser need for hedging strategies. Does this signal a broad return of investor confidence?
U.S. Economy
The recession is over! (According to the National Bureau of Economic Research, it officially ended in June 2009.) With millions jobless, foreclosures rising and home prices still low, it may feel as if the economy is still shrinking. It is such a long climb back up out of the trough that it could be months or even longer before we can see much daylight, assuming the recent growth rate continues. Unfortunately, when growth is weak, unemployment is likely to remain high, and wage growth will be low or non-existent, making it difficult for consumers to increase spending or businesses to either raise prices or justify investing in expansions. (National Bureau of Economic Research).
But there’s more good news:
- Fears about a worst-case, European-led global meltdown have eased. (Source: Kiplinger Letter, August 2010)
- August of 2010 was the busiest on record for mergers and acquisitions volume worldwide. (CNNmoney.com, September 7, 2010)
- BP declared its Gulf of Mexico well permanently sealed on Sunday, September 26.
Still, the question remains—what awaits right around the corner? Recovery or double-dip recession? The U.S. economy and stock market are still sending mixed and confusing signals. Many investors are making the “glass is half full” argument, but thanks in large part to the dismal economy, we have an unhappy public and epic discontent:
- Trust in government is at a historic low of 22%.
- Only 25% have a favorable view of Congress—the lowest favorable ratings in more than two decades.
- 71% say they believe the financial industry played a major role in causing the current recession. (Zogby International, August 9, 2010)
Even as job creation remains weak, U.S. corporate profits hit record levels. A Wall Street Journal analysis found that the companies in the S&P 500 posted 2nd quarter profits of $189 billion, up 38% from a year earlier. The strong growth is expected to continue for the third quarter.
Many investors believe that corporate investment will be an important aspect of economic growth. Despite the hefty profits, most companies are not expected to boost spending on new employees, products, or equipment any time soon. In fact, many corporations are holding record amounts of cash—about $600 billion more than normal—in low yielding fixed-income instruments as they wait to see the outcome of policy and regulatory decisions, according to Martin Regalia, chief economist at the U.S. Chamber of Commerce. “It is an indication that uncertainty is palpable and it is affecting economic growth.” (Source: Investment News, “Retroactive estate tax for 2010…”, August 22, 2010)
Shareholders looking for a fair return on their investment would rather see resources go to dividend increases, stock buybacks, acquisitions and higher capital spending. There could be a surge in special dividends during the last quarter of 2010. Corporations have good reason to share some of their profits sooner rather than later: unless Congress acts before the end of the year, the top federal income-tax rate on corporate dividends will rise from 15% in 2010 to nearly 40% in 2011!
Global Economy
World trade has come roaring back to within 2% of its old peak (see chart). The collapse and rebound in trade played an important role in the global recession and recovery; now it may be the key to how strongly the global economy can grow.
The International Monetary Fund predicts that the global economy will grow by 4.2% over 2011 (although America and other developed countries are expected to experience continued sluggish growth because of budget cuts). (Source: The Economist, October 9th, pg16) The 2010 4.8% growth is well above the recent growth rate of 4%. Yet there is a gap between the vitality of the big emerging economies (some of which are close to 10%) and the sluggish growth of many developed countries.
Unemployment
The U.S. economy lost 95,000 jobs in September—more than expected, thanks to a smaller-than-forecasted rise in private-sector employment to offset cuts by state and local governments. The jobs report increased expectations that the Fed would take more steps to stimulate the economy at its next meeting. (Source: Barron’s, October 11th, “Punk Payroll…” pg 8)
Quantitative Easing
Many investors believe that the Federal Reserve will have to launch another big bond-buying program by the end of the year to help keep interest rates low and prevent the economy from tumbling into another recession. This is referred to as “quantitative easing” (QE). QE creates more money to purchase assets and is often used as a way to stimulate the domestic economy by lowering the costs to finance and putting more money into the banking system. Unfortunately, the dollar has fallen 7% in the six weeks since the Federal Reserve began discussing it. (Wall Street Journal, “Dollars Fall Rocks World” A1)
The prospect of further QE by the Federal Reserve helps to explain why gold, equities and bonds are all performing well at the same time—an unusual circumstance. Investors are buying gold in case QE leads to inflation, and stocks in hopes that QE will revive the economy and head off a double-dip recession. In addition, the yields on many bonds have fallen because the Federal Reserve often spends most of the QE money buying our own country’s debt. With inflation and deflation both possible consequences of a debt crisis, some investors are buying gold as a hedge against inflation and bonds as a hedge against deflation.
Inflation or Deflation
Will it be deflation or inflation? Either could be damaging to businesses. Inflation causes rising costs to eat into the bottom line, and deflation causes consumers to cut back on purchases as they wait for prices to drop further, often leading to more layoffs, less demand and a spiral of sliding prices.
So, what can investors do to guard their portfolios from deflation or inflation? Many investors believe that blue-chip stocks that pay dividends and technology shares often do well in either scenario. Emerging markets with strong fiscal and trade surpluses and strong economic growth should hold up well. Bonds usually do well in deflationary periods. And don’t forget cash! However, diversification appears especially prudent. (Source: WSJ, October 4th, R1)
Inflation has dropped considerably over the last ten years (see chart), with about 1.5% “core” CPI forecast for the U.S. for 2011. One reason for such a low inflation is a fear of spending. While increased savings rates are usually good, the U.S. economy is dependent on consumer spending. Figures released by the Commerce Department in July showed that 70% of the nation’s Gross Domestic Product (GDP) is made up of consumption. When we spend less, we grow slower and create fewer jobs. Until consumers feel more secure, they are unlikely to increase their spending and we are unlikely to see much of a recovery. (Source: Bob LeClair’s Finance & Markets Newsletter) So remember—it’s not just shopping, it’s retail therapy!
Gold
Some investors want to participate in the recent price increase in gold, which had risen to $1,374.80 a troy ounce by October 13, 2010. But how does that relate to actual returns for investors? Gold’s hidden costs include higher taxes than on most other investments, zero income, the danger of unscrupulous activity (false quality gradings, for example), and high transaction costs, storage costs and commissions. Gold may never become worthless, but it can still lose value and is extremely volatile. (Dow Jones Commodities News via Comtex, October 13, 2010).
Interest Rate Risk
If inflation starts to increase, the Fed may start to raise interest rates to keep inflation in check. If interest rates go up, bonds usually go down in value. Interest rates don’t have to rise much for bond investors to realize substantial losses—in fact, even the fear of interest rates going up is often enough for the value of bonds to go down.
While treasury bonds are less volatile than stocks and have guarantees that stocks don’t, bonds are far riskier than some investors appreciate. Interest rates are at their lowest levels since the 1950s. Investors who grasp for that last percentage point of yield and buy long-term bonds are making a gigantic bet that rates will fall even further or at least hold even. However, with rates this low, the question really isn’t if they will rise, but when. If inflation rears its ugly head and interest rates rise, investors would still receive their investment back if they hold their bonds until maturity—but not in real terms of course. If they sold after rates rose but before bond maturity they’d suffer a loss.
New Tax Law Changes
At the time of this writing, consumers and businesses lack certainty about the future impact of income taxes, and we likely won’t know anything about the tax law changes until after the November elections. President Obama wants to keep current tax breaks for lower and middle income taxpayers, but favors higher rates for the wealthiest 3% of Americans—singles whose taxable income exceeds $200,000 and married couples with taxable income above $250,000. Congressional Republicans argue that current tax rates should be extended for everyone, noting that many of the taxpayers targeted for tax hikes are small business owners and that higher taxes on them could derail the economic recovery.
The inability of Congress to decide what to do about the expiring Bush-era tax cuts means you can procrastinate on your year-end tax planning guilt-free! Normally, it makes sense to reduce your income and increase tax deductions as a way to reduce your tax bill. If Congress extends the current tax rates for your income level, that’s probably what you should do. However, if your tax rates will increase in 2011, it may make more sense to reverse that strategy—accelerate discretionary income (such as a year-end bonus) into the current year, when your income tax rates are lower, and push donations into January when they will deliver a bigger tax-saving bang for each buck you deduct.
We will keep you updated as the government finalizes what they are going to do with the tax laws.
Conclusion
Today’s investment climate appears to be a paradox—a desire for safety and a craving for yield. In fixed-income markets, the flight to safety has driven bond yields to all-time lows. At the same time, investors are pouring money into emerging markets and junk bond debt at a record pace. In the stock markets, many investors are torn between their frustration at the lousy returns of blue-chip stocks over the past ten years and their expectation that stocks should outperform other investments. As a result, many of the least-risky blue-chip stocks are still extremely cheap, while the shares of some firms with less-predictable or speculative prospects are expensive. (Source: Kiplinger’s Personal Finance, November 2010, #33)
For example, the average growth stock in the Standard and Poor’s 500 Stock Index is currently trading at 16.2 times the past twelve month’s earnings. That compares to an average price-to-earnings ratio of 20.6 since 1995, according to Birinyl Associates, which illustrates that the values are a much better bargain today then they have been in the past. (Source: WSJ, October 4th, “Growth & Income”)
As this report has shown, there are obviously many factors to take into consideration before investing into anything! However, you should still consider keeping an adequate liquidity, diversify properly, and maintaining your risk tolerance level.
P.S. Remember—never waste a crisis! Think about reviewing your investment portfolio using the lessons you learned from recent experiences.
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