It’s ironic that in an era of great economic uncertainty, the one bedrock certainty is that we’ve experienced the worst financial crisis since the 1930s.
If only the policies coming from Washington were as concrete. The perception among investors is that, fair or unfair, the federal response to the economic crisis has increased market uncertainty. That has prompted some investors to seek safe havens in more conservative assets, while others have stood paralyzed as the stock market reacts, sharply, in some instances, to the latest big economic news.
But financial markets seem to be calming down a bit and the investment landscape is shifting—for the better, as I will explain. First, though, some background data on the U.S. economy and the financial markets should be clarified.
Turning On the Printing Press
Item number one is the government’s response to the financial crisis.
More specifically, just how vexing is the government’s response to the economic crisis? Put it this way—the only thing that could stop Washington, D.C. today from printing more “stimulus” money is a breakdown of the national mint’s printing presses or its running out of paper to print our devaluing currency. Not that fiscal recklessness is a new theme in Washington. Even before this financial crisis, we had poor budgetary discipline, running a national record deficit of $455 billion last year (according to the non-partisan Congressional Budget Office, that deficit will rise to $1.7 trillion in 2010). The last time the deficits were this high as compared to gross domestic product was during World War II. And, our current level, however large, is still only half of its highest peak. Consequently, one of the key issues we’re watching is how the markets will absorb the huge amount of debt the government will issue in new Treasury auctions.
By and large, the U.S. government can raise money two ways: By raising taxes (not a popular option in a steep recession) or by issuing more Treasury notes, often to foreign investors in emerging economic behemoths like China and India.
In fairness, the Federal Reserve is trying to help the U.S. economy grow. But we’re seeing mixed results. Case in point: after exhausting conventional methods by pushing the federal funds rate to zero, it is now stepping up to unconventional methods known as “quantitative easing.“ The Fed recently announced its intention to buy over $850 billion in mortgage-related securities and $300 billion in government bonds to improve liquidity as their new tool method. With these actions, the Fed is virtually guaranteeing one outcome—a surge in money supply.
Is that a bad thing? In past economic times, an increase in money supply has helped kick start growth, and I believe it will help again. The key to this success will be the buyers of U.S. debt. Make no mistake, such investors are in the driver’s seat these days. They may want a stronger voice in demanding the terms on interest rates paid out for their investment in the U.S. economy. What Uncle Sam can least afford now is for deep-pocketed foreign investors to snap their checkbooks shut and look for other investments to ostensibly grow their money.
As a result, we may be getting a potentially bitter taste of burgeoning investor demand by watching the 10-year Treasury yield go up most recently from 2.5% to over 3.4%. This upward spike in bond yields shows that the bond vigilantes are trying to keep the Feds in check by making them pay more interest for the debt they are issuing.
Fear Was Depression
It’s not just about more U.S. Treasury auctions—and a more demanding investment climate. Many investors have been worried about the great global depression (and may still remain so). But even more investors fear massive inflation, which cuts into corporate earnings, household spending and portfolio performance. Who can argue? Fear is both a natural and rational response to an unprecedented fiscal and monetary stimulus now being injected into the economy. As of right now, though, I am not as concerned about near-term inflation, since we are in a state of over-supply, with 13 million workers looking for a job and only an estimated 68% of our industrial capacity now being utilized. Plus, inflation is defined as too much money chasing too few goods. The numbers bear that assessment out: Core inflation levels, as measured by the Federal Reserve’s Personal Consumption Expenditure Index (which the Fed likes to see somewhere between 1%-2%), checked in at 1.5% in the last week of May. The government doesn’t want you to worry about any of these things—but many investors are worried just the same.
Now onto more good news—at least for the shorter term. The most recent gross domestic production reports have shown that business inventories are lean, and to keep pace with glacial economic growth, companies will need to be cranking up the factory floors to get their products out into the market. That should stabilize the currently bleak unemployment picture. With more government intervention, the employment landscape could actually brighten as business shift into higher gear. Of course, in government and in economics, nothing comes easy—there are always consequences, usually unintended. In this case, a growing economy could mean that inflation will become a problem down the road. That could happen when the new, additional demand meets a lack of supply and sellers use the opportunity to raise prices.
In light of the above issues, I have advised our fixed income clients to have a highly diversified fixed income portfolio with a good portion in short to medium-term maturities. This should help protect investors from being locked in longer-term maturities at lower interest rates. It’s my belief that a future recovery will come from this stimulus and along with that stimulus comes its inevitable handmaiden—higher interest rates.
Are Stocks Cheap?
It’s a question I get all the time, and my answer is a stock one: “Only if they go up from here.“ It’s lamentable that so much money that was pulled from stocks in 2007 and 2008 is stuck in that safe treasuries mattress I mentioned above—not the healthiest place to be right now in light of a re-emergence in stocks. True, it’s no secret that the stock market is a scary place to invest, especially after going through these last few months, or any of the last market corrections, for that matter. That said, yes, I do believe that stocks deserve more respect than they are getting today. Buying stocks is the ultimate optimist’s game—you must first believe the economy will grow. Okay, sign me up. I believe the economy will grow with the Fed’s help and because of bigger macro events such as expanding population and improvements in technology, which lead to higher productivity.
We’re in a ditch right now, but it’s important to recall that Americans—our generation and scores of previous ones—created the greatest economy in the history of mankind. Roughly estimated, the 1950’s triggered growth in America’s middle class, resulting in a domestic population of 200 million. That growth of our middle class not only produced 60 plus years of U.S. expansion but also spread to myriad foreign bourses to fuel the emergence of this great global economy we recognize and today. History has a way of repeating itself and that’s what’s happening now. Demographic gurus calculate that the earth’s population will grow by an additional three billion over the next 25-30 years. With that kind of population spike, we’ll see a new great rise of a middle class (especially in “Pacific Tiger” countries and, yes, right here in the U.S., too). Overall, we’re looking at a global middle class of two-to-three billion strong. That’s a lot of productive consumers. It’s my belief that this growth in population will serve as a springboard that should pay long-term equity investors handsomely over the next few decades.
Last Communication Barrier
One last harbinger of optimism. Today, we live in the Information Age, where the Internet, is an economic platform that we can build on. The Internet is taking us to unexpected—and game-changing—places. Consider the grand topic of language, the last barrier, I believe, in human communication. Traditionally, language has been a crazy quilt of disparate voices, rising mostly in vain to make each tongue understood. Imagine watching the leaders of all our great counties of the world wearing headsets with an interpreter explaining the wisdom of the United Nations speakers. The time will come someday when we will be able to understand one tongue…one universal language. The Internet has already become the cornerstone of emerging universal language—individuals and businesses use the Web to communicate; to engage in commerce; to meet new friends, and to share knowledge and ideas. No matter if one party is in Miami and the other in Mozambique—the Internet has become a global town common where all are welcome and (virtually) all are understood.
The Takeaway
WrapManager factors all these developments into our portfolio strategy. Through a unique mix of money managers and allocation to asset classes, we provide every client with informed, personalized and customized investment service. We recognize that you have different needs for your money. We also recognize that it is important to understand your goals and tolerance for risk before making any changes to your portfolio. The bond, real estate and stock market volatility of late have all made us all more aware of the real definition of “change.“
But let’s also remember that you do have opportunities—even at this time. I believe that as you read this letter, the stock market and bond market will continue to be near-term volatile. Of course, it’s been said that investors never miss an opportunity to miss an opportunity. So let’s not miss this opportunity. I believe stocks are cheap, even measured by P/E ratios and in this dislocated environment, it’s important to look at a wider range of valuation measures which, when taken together, build a more convincing case that stocks are now a bargain.
In other words, despite confusing policy coming from Washington, and despite legitimate concern among Americans worried about their jobs and their financial futures, investing in stocks right now is a viable option.
The attached report and information have been prepared or produced by WrapManager, Inc. from sources and data believed to be reliable. Information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice, as an offer to sell, or the solicitation of an offer to buy any security in any states where such an offer or solicitation would be prohibited by regulations. WrapManager, Inc. is not a tax advisory firm. We recommend you contact your tax attorney or CPA prior to utilizing any of the tax-related strategies mentioned or discussed. Returns and experiences will vary for each client. Each client’s risk tolerance and investment objectives are unique to them. Past performance may not be indicative of future results. No assumption that future performance of any specific investment or product made reference to directly by WrapManager, Inc., on its Web site and in marketing materials, will be profitable or equal the corresponding indicated performance level(s). If performance numbers are generated gross of fees, a client’s return will be reduced by investment advisory fees and any other expenses. Opinions expressed are those of WrapManager, Inc. and are subject to change without notice and are not necessarily those of Prospera Financial Services, Inc., its directors, parent company or its affiliates. Securities offered through Prospera Financial Services and cleared through First Clearing, LLC. Prospera Financial Services - Member FINRA/SIPC.