The Year in Review and Looking Ahead

At the end of every year, we like to look back at the year and share some thoughts on what worked, what didn't, and how the next year is shaping up.  While there are still a handful of trading days left this year, the markets are looking like they will post another up year.    

As we began 2010, we believed most of the stock market's cyclical gains were probably behind us and it would be important to try to generate income from dividends and interest in order to achieve a positive absolute return as we expected the markets to be volatile and news driven.  In general, having a more defensive bent would make sense if this were to occur.  This forecast turned out to be correct for most of the year with the S&P 500 dropping over (6%) into February, rising 16% from that low until end of April, dropping (17%) from April into July, rallying 10% from July into beginning of August, falling roughly (7%) into the end of August, and finally rallying over 18% from August to put us where we are today.   All of the return this year has happened since September.  

We had some trouble trying to get our heads around a post-credit-bubble environment in which global central banks have charted much different courses, with the net effect being a muddle-through, erratic, global recovery. Every time it looked like there would be trouble, the capital markets suffered, and Chairman Ben Bernanke rode to the rescue with his quantitative easing. The Bank of England and the Bank of Japan have also been quite active in priming the liquidity pump, and the jury is out on their level of success and how long it will continue.

We turned more positive on the markets in October believing the time for being bearish had past and we said volatility in the markets should be used as a opportunity to increase exposure to those areas expected to perform well in 2011.  We expected the volatility to continue into the fourth quarter as it did all year, allowing some low risk entry points to increase exposure to stocks, but it didn't materialize as we believe investors began to realize the US government is going to permanently backstop risky assets and markets in order to bring about the wealth effect per the Fed Op-Ed several weeks ago.  This will have unintended consequences, but we will save that discussion for another day.

So, while there were more fits and starts for the economy than we expected, we would say we got the market volatility correct for the most part; however, the appreciation of US markets in the last quarter turned out to be much greater than we expected with no downside volatility. 

As the stock market continued to move higher in the fourth quarter, interest rates also began to move higher, putting downward pressure on bond prices as investors shifted funds from bonds to stocks, especially dividend paying stocks.  Many income producing equities did in fact perform well in the fourth quarter, something we probably suspect will continue as market participants continue to look for yield, particularly if the pain of declining bond prices becomes more pronounced.  Ever since the second round of quantitative easing (QE2), interest rates have spiked to the upside, exactly the opposite of what most had expected would be the case. 

For 2011, we believe this trend of bond outflows and equity inflows will likely continue, overwhelming any concerns about valuations or fundamentals.  In the short run, we've come to realize that fund flows, or investor desires for specific asset classes - tends to exacerbate price movements in both directions, often for much longer than most expect.   For anyone that doubts this tendency, just take a look at tech stocks ten years ago, housing prices five years ago, commodities prices three years ago, and Government bonds recently.

We believe with the Federal Reserve "having the stock markets back" and corporate earnings continuing to meet expectations, the markets can continue higher.  In addition, the added liquidity of investors pulling funds from bonds should help fuel higher prices.  Although volatility has been non-existent the past few months, we don't expect it to disappear completely.  Given how everyone is positive on the markets for 2011, we expect volatility will return in the first quarter of next year, if only to keep everyone honest.

As we see it, several factors play into a positive stock market environment in 2011.  First and most important, is a more politically friendly environment for business.  Given the historic changing of the guard in Washington D.C., it appears as though President Obama is going to take a more centrist approach as Clinton ultimately did following his first two, difficult years in office.   

One of the biggest strengths of the economy in the past year has been the level of corporate profits and cash balances, but most executives have remained cautious with their actual spending given recent memories, the prevailing anti-business sentiment, and tax and regulatory policy uncertainty.  The good news is that these headwinds may now prove to be tailwinds, turning the ability to invest capital into actual action.

Another positive for stocks may very well be the state of the bond market.   Rising interest rates may actually be a positive to the extent it signals an improvement in the economy, which we suspect is the case today.  Bernanke, like him or not, appears willing and ready to do whatever it takes to keep the economy and specifically the stock market moving in a positive direction.    

Higher interest rates, of course, also means tougher times for bond investors as bond prices decline.  While the back up in yields may not matter much for investors intent on holding until maturity, we would suspect that a large percentage of recent bond buyers has been investing on the basis of total return and the allure of rising prices than simply their yields, even if unknowingly so.     

As history has it, the third year in a President's term tends to be positive for the markets as the current administration is likely to find ways to stimulate the economy and spur economic growth and stock prices; to be sure they are re-elected the following year.  We hope that 2011 follows this tradition.

US National Debt

Here's a new way to think about the U.S. government's epic borrowing problem: by as early as 2015, the estimated interest due on US government outstanding debt will be $533 billion - which is equal to a third of the annual federal income tax revenue expected to be paid that year. 

Fortunately or looking on the bright side, the record levels of debt issued in the past few years have paid for stimulus and other rescue programs that prevented the economy from falling off a cliff; and the money was issued at very low interest rates.  But low interest rates won't be around forever.

As interest rates rise and the economy improves, the private sector borrowers will likely return to the debt market and compete with the US government for capital. At that point, the country's interest payments could increase dramatically.

The Congressional Budget Office, which makes the debt and interest payment forecasts, already baked some increase in rates into the numbers.  Of course, there is always a chance those estimates may prove too conservative.

Below is a table showing our outstanding gross debt and the percentage of GDP the debt represents (in billions of dollars). It is projected to be over $14 trillion at the end of this year and represent 94% of our GDP.

2000 5,628.7 58.0
2001 5,769.9 57.4
2002 6,198.4 59.7
2003 6,760.0 62.6
2004 7,354.7 63.9
2005 7,905.3 64.6
2006 8,451.4 65.0
2007 8,950.7 65.6
2008 9,985.8 70.2
2009 12,311.4 86.1


Below is a link to the Treasury's website which posts the monthly as well as annual interest payments on the debt.  Click on the link to be taken to the website.

http://www.treasurydirect.gov/govt/reports/ir/ir_expense.htm

Equity Risk Premium Explained

Equity Risk Premium can be defined as the excess return that the overall stock market provides for an investor over the risk-free rate of US Treasury bonds. This excess return compensates investors for taking on the relatively higher risk of the equity market. The way to think about equity risk premium is to define it as the difference between the expected total return of the S&P 500 and the expected yield on Treasury bonds over a period of time.

As an example at the basic level, if 10-year Treasury bonds are yielding 3% annually and the expected 10-year annualized return of the S& P 500 is 5%, the equity risk premium is 2%.  In other words, investors are expected to achieve a 2% higher annualized return in the stock market versus the Treasury bond market.  The equity risk premium has historically averaged around 4%, which means a 4% better annualized return by investing in stocks over bonds on average.  Equity risk premiums in general tend to be higher in recessions and lower in recoveries.

At present, based on calculations of forward earnings, normalized historical earnings, and market valuation models, the average 10-year return projection for the S&P 500 is 4.00% annually.  Currently, the 10-year Treasury is yielding 3.25%, making the current equity risk premium .75%; one of the lowest readings in recent years.  Of course, we should expect a lower reading in a recovery.

However, the likely premium for equity risk is at the low end of the typical range.  Why does this matter?  Based on the current assumptions, for a return of roughly .75% over the expected return on Treasury bonds, equity investors are accepting risk that is approximately 3 times greater than that of US Treasury bonds - the risk/reward scenario doesn't seem favorable.  The last time the equity risk premium was really low was in the late 1990's, as investors believed stocks would continue to go higher and didn't feel the need to be compensated for the additional risk.

Of course, the expected 10-year annualized return for the S&P 500 is an assumption based on models and could increase from current levels, especially if economic growth improves.  If economic growth expands at a faster rate in the future, we should see the expected S&P 500 annualized return percent move higher as well.  However, it will need to increase to approximately 7.25%, based on interest rate of 10-year Treasury yield of 3.25%, to reach the historical equity risk premium average of 4.0%.  Also, if the 10-year yield continues to rise, the expected annualized return of the S&P 500 will need to increase even more than 7.25% in order to keep pace and move toward the long-term average of 4.0%.  Unless economic growth begins to pick up significantly, we should expect the equity risk premium to remain at the lower levels of the range as the economy continues to recover.

Equity risk premiums can also be applied to sectors of the market and there are certain sectors whose equity risk premium is higher than the equity risk premium of the broad market; meaning a better valuation of that sector and the likelihood of out performance versus the broad market in the future.

While investment decisions can't be made on one indicator or valuation model alone, it does help to use various market and risk valuation metrics to assist in the decision making process.

Smart Money / Dumb Money Update

The latest results from the Smart Money / Dumb Money index show that retail investors (dumb money) are very confident in a rally while institutional investors (smart money) are not as confident in the markets continuing to rally.  These numbers don't mean the market can't continue to work higher in the short-term, but typically any short-term gains are quickly erased by a larger correction, especially when readings reach these extreme levels.

 

 

Smart / Dumb Money Confidence

 

The Smart Money is 33% confident in a rally.
The Dumb Money is 71% confident in a rally.

Jobs Report and QE2

Surprisingly the BLS reported today that jobs gained 39,000 and the unemployment rate moved up to 9.8%, the highest rate since April.  Private payrolls gained a mere 50,000 compared to expectations of upwards of 160,000.  Both jobs and the unemployment rate were worse than every single economist estimate, which has us noting that economists and forecasters as a group are an optimistic group.

Here are the details of the jobs report this morning:

• Payrolls increased 39,000, less than the most pessimistic projection of economists surveyed by Bloomberg News, after a revised 172,000 increase the prior month, Labor Department figures showed today in Washington.
• The jobless rate rose to 9.8 percent, the highest since April, while hours worked and earnings stagnated.
• The unemployment rate was forecast to hold at 9.6 percent, according to the median prediction of 83 economists surveyed by Bloomberg. Estimates ranged from 9.4 percent to 9.7 percent.
• Overall payrolls were forecast to climb by 150,000, according to the survey median, with estimates ranging from 75,000 to 200,000.
• The report also showed an increase in the number of long-term unemployed Americans. The number of people unemployed for 27 weeks or more increased as a percentage of all jobless, to 41.9 percent, the highest since August.

Keep in mind, were it not for millions of people allegedly dropping out of the labor force over the last year as their benefits ran out, the unemployment rate could be over 12%.

So with this poor jobs report shouldn't the markets be declining in reaction?  Shouldn't the market sell off on the bad news?  The answer would normally be yes - however, with the Federal Reserve providing QE2, market participants believe lower employment growth means more QE (maybe even QE3), which adds a underlying layer of support to the market and keeps investors confident in the economy and capital markets.

While adding some confidence to the capital markets, QE2 has not helped the interest rate picture.  Interest rates, across the board, have actually been spiking since the announcement of the QE2 program on November 3.  See chart below.



It turns out (as many believe) the Federal Reserve is more or less powerless to lower rates from prevailing levels.  QE2 was likely not really designed to drive rates down from current levels but merely to try to prevent a dramatic rise in interest rates and to promote more stability in the capital markets.

So the paradox we discussed in October regarding interest rates is beginning to be resolved.  Excess liquidity provided by the Fed is now starting to create expectations of future inflation and causing bond yields to rise (prices drop), whether or not this is the beginning of a new trend remains to be seen.

ISM Non-Manufacturing Report

This morning saw another good report from the ISM Non-Manufacturing Index, with the overall index rising to 55 and strong readings in Business activity (57) and New Orders (57.7) and an improvement in employment to 52.7.  We are still happy to see a continuation of growth in the US service sector.