Lewis Wealth Management

Investment Management, Financial Planning, Consulting

Newsletter – 3rd Quarter 2010

leave a comment »

Executive Summary 

The third quarter of 2010 was a good one overall.  Both stocks and bonds are up year-to-date through September.  The outlook for the US economy remains mixed.  We are in an economic recovery, but it remains fragile.  The Fed is poised with another round of quantitative easing, but it can only go so far.  The national deficit remains a concern.  It must be managed and lowered over time.  If not, our future prospects for growth will be subdued. There are a lot of policy and tax issues that need resolution in Washington before the end of the year.  We all need to pay close attention, especially on the tax planning side.  The risk of policy error is heightened.  As investors, we are currently earning our risk premiums by staying disciplined during turbulent times.  This discipline should be rewarded in the long run.

Quarterly Investment Commentary

The US stock market had a solid third quarter.  The S&P 500 was up 11.29% for the quarter (up 3.89% for the year).  The US bond market, as measured by the Barclays Aggregate Bond Index, was up 2.48% for the quarter (7.94% for the year).  The markets in general continue to be a roller coaster, but equity markets have broken out of their previous range to the upside.

The Outlook for the US Economy

The National Bureau of Economic Research recently announced that the Great Recession officially ended in June 2009, marking the country’s longest and deepest recession since the 1930’s.  But why don’t we feel like celebrating?  It’s because there is still so much uncertainty about where our country is heading the next few years.  Economic historians would remind us that this is not an unusual state of mind during a recovery from a severe economic shock.  To be sure, there are reasons to be both bearish and bullish right now. 

The Bear Case

There are ongoing structural headwinds in our economy.  Consumers are in the long process of deleveraging.  Unemployment remains high.  Real GDP growth has decreased since the fourth quarter of 2009.  Credit is tight, and for small businesses, largely unavailable.  Housing markets are weak.  State and local governments (facing large budget deficits) are cutting back.  The federal budget deficit has ballooned.  There is tremendous uncertainty in Washington as the mid-term election approaches and there are many difficult policy issues to resolve before the end of the year.  As the baby boomers retire over the next 15 years, there will be challenges to our entitlement programs like Social Security and Medicare.

The Bull Case

We are in a recovery.  Industrial production and earnings have rebounded strongly.  Profitability is high (although due to aggressive cost cutting) and companies have very high levels of cash on their balance sheets. There has been a sharp rebound in merger and acquisition activity.  Emerging economies are showing strong signs of growth (which is good for investors and domestic multinational corporations).  Inflation and interest rates are low.  The personal savings rate rose to 6.1% in the second quarter (in the recent past, it was negative).

What’s the Fed Up To?

The Federal Reserve recently announced that it is ready to embark on a second round of “quantitative easing” (the so-called “QE2”).  Quantitative easing is the process the Fed uses to increase the money supply by buying securities, such as US treasury obligations, in the marketplace.  The seller of the security receives cash printed by the Fed, which increases the money supply.  The Fed’s objective is to increase the money supply thereby keeping interest rates low.  There are several consequences to this strategy: 1) the dollar will move lower relative to other foreign currencies (because of the relative increase in the supply of dollars); and 2) interest rates will remain low (good for borrowers, not so good for investors seeking yield).  The stock market is relying on QE2 if the recovery should falter, so we should keep our eye on the Fed.

There is a problem, however.  While the Fed continues to increase the money supply and its balance sheet, the velocity of money running through the economy (the money multiplier) remains low.  The Fed has less control over the multiplier.  Recall from our economics class that when new money flows into the economy, it multiplies.  For example, when new money is received by a bank (when it sells securities to the Fed, for example), it usually lends that money to businesses and consumers who will spend it on other things, and the recipients of those purchases will spend it on yet more things, and so on, and so on.  The problem is that banks have not increased lending.  Instead, they are building cash positions on their balance sheets.  Consider the following chart.  Until banks start lending, the Fed’s efforts to stimulate growth will have a muted effect on the overall economy.

What about the Deficit?

The US national deficit remains a serious concern.  Most respected economists believe that the Fed was forced to increase the size of its balance sheet to avoid a financial catastrophe and a second Great Depression.  The same can be said for the fiscal stimulus (of course, how the fiscal stimulus was spent will be the subject of endless dispute, some of which will be resolved by voters in the upcoming mid-term elections).  As you can see from the following chart, the debt burden has been radically shifted from the private to public sector; that is, when the private sector went underground in 2008, the public sector rushed in to fill the financial void as the lender of last resort.

But are these deficits sustainable?  The answer is no.  Consider the following chart that shows how many dollars of public debt it takes to create $1 of gross domestic product (GDP) (see the far right hand column).  Right now, it takes over $5 of public debt to create $1 of GDP.

Studies have shown that once a country reaches a point where its public debt is above 90% of its GDP, the underlying economic growth rate falls off substantially.  The US economy reached the tipping point this year.  The US federal debt is currently 93% of GDP.

Clearly, the US deficit must be carefully and prudently managed and reduced over time.  If not, we can expect below average economic growth in the US for the immediate future.  The US debt burden is easily financed at current low rates, but when those rates rise, the interest expense will follow accordingly.

The Political Angle

Regardless of the results of the upcoming mid-term elections, there is a lot of work to be done in Washington before the end of this year.  As you know, the Bush tax cuts expire on December 31.  If they do, tax rates will increase to prior levels on a variety of fronts.  In addition, Congress has neglected to fix to the estate tax situation.  If an agreement cannot be reached, the applicable exclusion amount will revert to $1 million with a top rate of 55%.  While a $1 million exclusion sounds like a lot of money, when you consider that life insurance and home equity may be included in the estate tax calculation, many more estates will be taxable.  Also, the AMT patch has not been passed.  This has the potential to sweep many more taxpayers into paying AMT.  We should all pay close attention to Washington after the mid-term election to see if the necessary compromises can be hammered out.  For sure, the risk of policy error is heightened. 

Recommendations

We all need to stay alert between now and the end of the year.  The recent rally in the stock market was welcome, but there are simply too many uncertainties to increase exposure to equities at the current time.  It is a good time to remain disciplined and focused on our asset allocations.  Having bonds and alternative investments (like commodities, real estate, and hedging strategies) will provide some downside protection in the event the stock market falters.

Speaking of bonds, trillions of dollars have flowed into bond funds as investors see that bonds have outperformed stocks on a rolling 20 year basis.  The only other time this occurred was briefly in the 1930’s.  It would not be wise to bet that the next twenty years will be the same as the last twenty.  This is a good reason to stick to your existing bond allocation and not increase it in an attempt to chase performance.  When equity markets improve, expect the herd to sell their bonds and start buying equities again.  This will put pressure on interest rates to rise, which will cause bond prices to fall.

On the financial planning side, we must be ready to react to what is going on (or not going on) in Washington.  I will send out another update before the end of the year when more is known about the outcome of the mid-term elections and the progress (if any) on the many outstanding tax and policy issues.  Finally, if we are in for a period of slow growth, we may need to revisit our financial plans and check our return assumptions.  This may be especially true if your investment horizon is short.

While there is a lot of uncertainty, history shows that investors who stay disciplined during turbulent times are ultimately rewarded.  We are all currently earning our risk premiums.  Keep that in mind.

If you have individual questions regarding your situation, please give me a call at (303) 500-0980. 

Thank you.  Austin Lewis

Sources of Information: Charles Schwab

This is an educational newsletter expressing an opinion only.  It cannot not be relied upon until your individual situation is taken into consideration by an experienced advisor.  This newsletter is not designed or intended to give you individual investment, tax or legal advice. I strongly recommend that you consult with you own financial/tax advisor and/or legal counsel for information and advice concerning your particular situation.  Past performance is not indicative of future results.

Written by Lewis Wealth Management

November 2, 2010 at 11:20 am

Posted in Uncategorized

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: