Quarterly Economic Update
The second quarter of 2010 reminded us that things can look unnecessarily gloomy the morning after a party. Itâ€™s true that growth appears to be slowing from the first quarter, and the markets acted as if they needed to sober up from last yearâ€™s stimulus-induced recovery. While many investors are still concerned about a double-dip recession, several indicators are pointing toward continued global growth.
The second quarter was a bad time for most stock investors. The Dow Jones Industrial Average (DJIA) ended the second quarter down 10% and was down 6.3% for the first 6 months of 2010, although it is up 49.3% from its 12-year low of 6,547 on March 9, 2010. The Standard and Poorâ€™s 500 Stock Index also dropped during the second quarter, with a loss of 11.9%, and was down 7.6% year-to-date. The NASDAQ fell 12% for the quarter and was down 7% for the 6-months ending June 30, 2010. Currently, the stock market is extremely volatileâ€”in fact, for the first eight trading days in July, there has been an increase of over 6% for DJIA, S&P 500, and the NASDAQ.
Despite the recent increase, there is a good deal of pessimism caused by a number of recent investor concerns, such as:
ï‚§ BP oil crisis
ï‚§ Are we headed toward inflation or deflation?
ï‚§ Lack of trust and confidence in the global economy and world leaders
ï‚§ Social Security concerns
ï‚§ The housing market
ï‚§ Growing U.S. deficit
ï‚§ High unemployment
These are only a handful of the various worries that contributed to the stock marketâ€™s drop in the second quarter. Uncertainty equals confusion, and confusion often causes anxiety and fear.
The European Debt Crisis
Many overseas stocks, especially the European stock market, took a double blowâ€”they fell more sharply than U.S. shares in local currency terms, and the strengthening of the dollar further reduced their value when translated back into dollars. The debt crisis that spread across many parts of Europe is seen as one of the biggest threats to the performance of the U.S. stock market over the next 12 months, according to a survey of professional money managers. (Source: Russell Investments â€“ Investmentâ€™s Latest Quarterly Survey May 31, 2010)
Investors shouldnâ€™t totally ignore or give up on Europeâ€”at least not yet. The weaker Euro will make European products more competitive in foreign markets. Plus, profits generated in other currencies will translate into a greater number of Euros, which means higher earnings for European companies. However, the primary reason to hold European stocks today is that they are cheap compared to most other stock market exchanges. The average European stock sells for only 10 times the estimated 2010 earnings; their P/E ratio is 25% less than the average P/E of U.S. stocks. (Source: Kiplingerâ€™s Personal Finance August 2010 p.36). Note: It is important to note that international investing involves special risks including greater economic and political instability, as well as currency fluctuation and risk.
The EU recently announced a plan of nearly $1 trillion to avert a public-debt crisis that threatened to derail the worldwide economic recovery. Stocks surged in Europe and the U.S. after the EU leaders agreed to a massive action to prevent Greeceâ€™s financial troubles from spreading throughout the region. (Source: WSJ, May 11, 2010, A1)
Gold vs. Treasuries
Many investors have piled into gold and Treasury Bonds recently, seeking investment alternatives. History suggests that possibly only one of those bets might end up paying off. After their strong increases, both gold and treasury debt are expensive, which could mean increased risk and less potential for profits.
Gold is not a truly efficient inflation hedge. Gold was one of the few bright spots, up 11.9% for the quarter and 12.7% for the 6 months ending June 30, 2010, and surging to a record $1,243.10 an ounce at quarter end. However, the real price of gold, adjusted for CPI inflation, has fallen about 45% in the last 30 years. Compare that to the real price of equities, adjusted for CPI inflation, which has risen approximately three and a half times in the last 30 years. (Nick Murray Interactive, January 2010)
Gold can be a hedge against fear and chaos. It has the potential to offer reassurance, and as global finance has grown ever more complex, it has also become a badge of mistrust in the modern political economy. Whatever you do, please remember that gold (just like any commodity) is considered a high risk investment. Note: Please remember the price of commodities, such as gold, are subject to substantial price fluctuations over short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and therefore concentrated investing may lead to higher price volatility.
As investors have piled into Treasuries in recent months, this demand has driven the yield of the benchmark 10-year note down to below 3%! Consider that 20 years ago the yield on 10-year Treasuries was 8.38%. (Source: Treasury Department, By The Numbers, June 14, 2010) The only time in history that 10-year Treasury yields were lower was in the fall and winter of 2008 â€“ 2009, during the worst of the financial crisis. (Source: WSJ June 11, 2010 C1).
Treasuries and gold typically move in opposite directions depending on investorsâ€™ concerns about inflation or deflation. Each offers potential preservation against further market turmoil, and may be a good hedge against the other. While both have benefited from worries that the European debt crisis might continue to spread, they may not move together forever and past performance is no indication of future trends and results. If inflation increases, Treasuries could fall and gold could gain, but if inflation continues to slow or turns into deflation, it could be the opposite.
Should you worry more about inflation or deflation? Financial markets are sending mixed signals, so it seems that investors fear both scenarios. Many economists are not worried about inflation, since the latest government figures show that U.S. consumer prices, excluding food and energy, were up only 0.9% in April from a year earlier, which is the lowest level in 44 years. (Source: WSJ, May 20, 2010, A1)
According to most economists, deflation is more dangerous than most forms of inflation. When prices fall, consumers often put off their purchases to get great bargains later. There is a significant amount of money sitting on the side in money market accounts, bank accounts and Treasury Billsâ€”$8 trillion, according to some estimates. When you combine a sizeable chunk of available money with extremely low interest rates (0.16% on the Treasury Bill as of July 12th, the lowest rates on record), in many cases the end result is inflation!
Hypothetically, letâ€™s review an investor that wanted to earn $3,000 per month from their investments. If their money is invested in Treasury Bills that are earning a little less than 0.1%, in our example, the investor would need $36 million to generate $3,000 per month! Without that large sum, the investor would likely add money from their principal to their earnings to reach the $3,000 mark. This would create demand for alternate investments, which might push the price up for these investments, which could lead to inflation! (Material discussed herewith is meant for general illustration and/or informational purposes only. This example is not indicative of any specific investment product or investor.)
Wall Street loves a Goldilocks economy â€“ one that is neither â€œtoo hotâ€ and likely to fuel inflation and higher interest rates (both bad for stocks), nor â€œtoo coldâ€, which often crimps corporate profits. In some respects we are seeing such an economy today, one that has struck a â€œjust rightâ€ balance between growth and inflation. (Source: Economist June 5, 2010 pg 18)
For investors who own bonds, that part of your investment portfolio has most likely come through the recent market turmoil in fairly good shape. However, donâ€™t take that steady performance for granted. While safe from a credit perspective, Treasury investments still entail interest-rate risk.
Many professional money managers worry that the huge stimulus the Federal Reserve and the U.S. government have provided to the economy over the past few years will inevitably push up both interest rates and consumer prices. While the threat does not appear imminent, it is not too early to take steps to help protect the bond part of your portfolio. Individual situations will vary; therefore, these strategies and products may not be appropriate for all investors. It is important to speak with an investment professional prior to investing or making changes to your existing portfolio.
Rising interest rates and renewed inflation would be a double blow to bond investors. When interest rates rise, the market value of existing bonds falls and in an inflationary environment, the purchasing power of bondsâ€™ fixed income payments usually drops as well. This can be more pronounced for longer-term securities.
Many factors, including the European debt crisis, have sparked renewed worries about the durability of the global economic recovery and have probably delayed the time when the Fed might start raising interest rates. Many economists expect this to begin by the first half of 2011 to hopefully avoid a return of inflation. If the federal government has to sell larger quantities of Treasury bonds to finance its enormous budget deficit, this would add to the upward pressure on interest rates. Higher interest rates would most likely push down the prices of many kinds of bonds.
There are a number of ways to diversify your bond portfolio planning for these risks:
1. Foreign bonds often provide protection against interest rate risk because they often own securities issued by other nations whose economies arenâ€™t necessarily in sync with that of the U.S. Major commodity-exporting nations can also provide some diversification. One risk is the changing price of foreign currencies, which increases the volatility of foreign bonds compared to domestic bonds. Please note foreign securities entail special risks (such as currency fluctuations and political uncertainties) and may have higher expense and volatility. Some foreign bonds may involve below-investment-grade (â€œjunkâ€) bonds, which are more at risk of default and are subject to liquidity risk. Investments in emerging markets may be especially volatile and diversification does not guarantee profit or protect against loss.
2. Shorter-term maturity bonds decrease in value if interest rates rise, but usually fall less sharply in price than longer-term bonds.
3. U.S. Treasury Inflation-Protected Securities, or TIPS, allow the principal amount to rise along with the Consumer-Price Index. Unfortunately, because the recent readings on U.S. inflation have been low, the yields on TIPS are unattractively low. TIPS are also more sensitive to any broad rise in interest rates. Investors should be aware that the TIPS principal is adjusted downward for deflation, and interest payments may be less than they would be if inflation occurred or if the Consumer Price Index remained the same.
The Global Economy
The $58 trillion global economy is almost too big to imagine. California is about $1.8 trillion strong, so we can think of the world economy today as about the same size as 32 Californias. (Source: Fortune Magazine, July 5, 2010, â€œNew Global Opportunityâ€) The U.S. accounts for 8 Californias and it is larger than the economies of the next 4 countries combined: Japan, China, Germany and the United Kingdom. (Source: Nick Murray Interactive, August 2009) The European Union plus Switzerland, Norway, Canada, New Zealand and Australia make up another 10.5 Californias, and prosperous Asiaâ€”Japan, South Korea, Taiwan, Hong Kong and Singaporeâ€”gives you another 3.5. That brings us now up to 22 Californias, which means the rest of the worldâ€”the BRICs, (Brazil, Russia, India and China), the whole Islamic world, including its oil-rich states, most of southeast Asia, all of Latin America and Africaâ€”is the equivalent of about 10 Californias, with China accounting for about a third of that output.
Now letâ€™s divide the world using another method: The population in the first group is about 1.1 billion, or 16% of the worldâ€™s total. The rest of the world is home to 84% of the people of this planet. This enormous disparity between the distribution of the worldâ€™s population and its economic wealth has led to two distinct arguments:
First there is the case that the global economy is both wrong and dangerous. It is wrong because we diminish our humanity if we in the â€œrich worldâ€ allow billions to live stunted and miserable lives when they donâ€™t need to; it is dangerous because poverty and disease donâ€™t stay confined. (Source: Fortune Magazine, July 5, 2010)
The second argument is concerned more with the markets and less with morals. The pragmatist sees 4 billion potential producers and consumers and huge opportunities for economic growth and corporate earnings.
Though these two beliefs are often argued by people who like debating each other (for example, corporate titans and antipoverty activists), thereâ€™s a growing agreement that they are not in conflict. A great example is China.
The global recovery has been driven by growth in China.
China has become a major part in the business community, growing 8.7% in 2009. On the consumption side, China is a huge and growing market and managed its stellar growth despite a 16% drop in the value of its exports. China has now surpassed Germany as the number one exporter in the world, and is considered the largest automobile market in the world. (Source: Fortune Magazine, July 5, 2010)
Following pressure from the U.S. and other members of the group of 20 major economies, China moved during the second quarter to make the exchange rate more flexible for its currency. This could be an important milestone on the path to rebalancing the global economy. (Source: WSJ, June 21, 2010, A1)
Stock market gains of more than 80% in 2009 occurred against the backdrop of massive fiscal stimulus and an explosion of debtâ€”the root of Americaâ€™s wrenching 2008-2009 correction. According to official figures, Beijing injected the equivalent of $575 billion into its economy starting late in 2008. At almost 15% of Chinaâ€™s GDP, that push, in relative terms, dwarfed Americaâ€™s $787 billion stimulus, which amounted to less than 6% of the U.S. economy. (Source: On Wall Street, 2010, page 42)
During the second quarter, the Chinese government reported two worrisome statistics: Gross Domestic Product (GDP) is growing at 12% a yearâ€”which is serious inflationary territoryâ€”and urban property prices are rising just as fast despite efforts to cool the housing market. Home-buying activities surged 82% in 2009, and house prices rose 24% nationally. In places such as Shanghai, home prices rose during 2009 to a level that was 87% higher than the previous 2007 peak.
China has tens of millions of people with significant disposable income, and a significant number of purchasers of real estate actually pay cash. However, it isnâ€™t just real estate that consumers are buying. China was considered the worldâ€™s second-largest market for luxury goods (after Japan) for 2007, according to the research center Li & Fung. Many men went straight from shabby to silk ties!
There can be little doubt that the pace of asset growth in China will slow from last yearâ€™s remarkable record. The markets may suffer a period of retreat. However, there is little to support the parallels the media has made comparing China and the economic crisis in Japan and in the United States.
Investing in a Rising Tax Environment
This report is not meant to be political, but many of the problems that we are faced with today are the result of earlier issues. President Obama has had to â€œpick up the piecesâ€ and try to reconcile these items, including dealing with the recession and the resulting significant drop in federal tax revenues. To address the mounting deficit, there have been a number of different proposals to increase taxes on affluent families.
This year, Congress enacted the largest social program in decades. To finance this sweeping national healthcare program, Congress approved an additional 0.9% tax on employment compensation in excess of $250,000 ($200,000 in the case of individual taxpayers) and an additional 3.8% tax on taxable investment income earned by families with Adjusted Gross Income (AGI) above $250,000.
Furthermore, it is likely that additional tax revenues will be needed to finance mounting federal expenditures. The deficit is still projected to grow significantly, even before incurring additional costs of economic stimulus, healthcare reform, and the increase of Social Security and Medicare outlays. The bulk of new taxes would likely be borne by higher-income families. Many taxpayers are unsure whether or not this is â€œfair,â€ for while the wealthiest 1% of Americans own 35% of the total net worth in the nation (Source: Edward N. Wolf, New York University, By The Numbers), they already pay more in Federal income taxes than the bottom 95% combined. (Source: Fortune May 24, 2010 pg 52)
There are also a number of proposed tax changes in the works. However, the odds of a tax increase will probably be higher after the fall electionsâ€”is anyone surprised? Many affluent taxpayers should also be on the lookout for changes in the estate tax laws. The estate tax expired at the end of 2009 and has been zero for 2010. Unfortunately, it is scheduled to return next year with top estate tax rates at 55%! That compares with 2009â€™s $3,500,000 exemption and a top estate tax rate of 45%. Many taxpayers are expecting/hoping for a reinstatement of last yearâ€™s exemption and rates. We will keep you posted.
Bear Market vs. Bull Market
Stocks still remain under pressure, with the Dow being hurt by concerns about Europeâ€™s debt-plagued economy and Chinaâ€™s efforts to slow its growth. While the market action during the second quarter has been discouraging, there are a number of reasons to still maintain the course:
â€¢ The Dow has yet to issue a major sell signal. The question is whether or not the pullbacks indicate a Bear market or merely a correction in a Bull market. Based upon the indicators, it is more likely that this is a blip in the Bull marketâ€”no cause for panic! Corrections are a natural part of the economic cycle. In order to plan your investment strategies properly, it is best to look at the long term rather than the short term. Corrections can be scary, but weâ€™ve seen them before and weâ€™ll see them again. The retrenchment that began in late April is no different.
â€¢ Stocks are reasonably valued. The S&P index trades at roughly 13% expected 2010 earningsâ€”modest relative to 20-year norms and very modest relative to bond yields. Many U.S. stocks are similarly cheap, and high-quality stocks are unusually cheap relative to low-quality stocks. Many stocks have raised or initiated dividends this year, whereas only 2 companies have cut or suspended dividends. (Source: Dow Theory Forecasts, June 14, 2010) Recent readings on inflation, interest rates, and corporate earnings (widely viewed as among the most important drivers of stock prices) have been favorable.
â€¢ U.S. companies are holding more cash in the bank than at any point in history. While this indicates persistent worries about financial markets and about the sustainability of the economic recovery, it may also represent a longer-term behavioral shift. Although this has helped many companies reduce their worry about short-term borrowing as banks continuing to pull back on lending, they are earning almost no interest on their holdings of cash, making it more difficult for them to achieve expected returns. Therefore, many economists believe that they are either going to use this excess cash through hiring, investments, or to make payouts to shareholders in the form of dividends or share buybacks. (Source: WSJ June 11, 2010 C1)
All these indicators are at least slightly encouraging for most stock investors. Profit-estimate trends suggest Wall Street analysts are becoming more optimistic about the future; however, there is no guarantee that these results will be achieved. Unfortunately, sentiment can change quickly at any time. Diversification is still extremely important.
There are roadblocks to a successful recovery. For example, the housing market is crucial. The severity of the recession has eroded the credit quality of many households and business borrowers, and many banks remain hesitant to lend. In addition, if interest rates increase, mortgage rates will most likely rise along with them. This would reduce the ability of some investors to make their mortgage payments and could, in turn, cause more problems for both the banking and housing economies.
Unfortunately, real estate didnâ€™t do well either for the second quarter. New-home sales fell almost 33% in May, the biggest drop since 1963 when the government began keeping records. The median price of a new home ($200,000) is down 9.6% from a year ago. This was primarily due to the expiring of the first-time homebuyerâ€™s tax credit at the end of the quarter.
The recovery that started last summer with the help of Government stimulus now hopes to evolve into a self-sustaining expansion. In the first quarter of 2010, GDP reached an all-time high. Following the Great Depression, the U.S. took 15 years to return to its previous GDP level. Japanâ€™s growth took nearly as long to recover following its â€œlost decadeâ€ of the 1990s. But in just a few quarters, the U.S. economy has taken monumental steps toward recovery. (Source: WSJ, June 8, 2010 A19)
Bulls argue that corrections are part of all Bull markets and that stocks will get back on track as investors refocus on the favorable fundamentals. Bears argue that expectations for earningsâ€™ growth are widely optimistic and that stocks are not cheap considering the risk of a double-dip recession in the U.S. The outlook for many Bears is clouded by growing worries about Europe and the vitality of the U.S. job market. Jobs are a major key toward recovery; unfortunately, many economists believe that unemployment will still be above normal (8.6%) by the end of December 2011. (Source: WSJ, June 10, 2010 A8)
Although retail sales are bouncing back from recessionary lows, hiring in this sector is returning at a much slower pace. This bodes poorly for unemployed Americans who have long looked to retail for a dependable source of jobs. In the short-term, we have a jobless recovery, and if you donâ€™t have employees, you donâ€™t have customers. Only Government payrolls are up substantially year over year. (Source: Barrons, June 14, 2010 pg 32)
Federal Reserve Chairman Ben Bernanke offered reassurances about the economy in testimony to the House Budget Committee last month, saying that a new recession was unlikely and that the Fed still expected the U.S. economy to grow at 3.5% annual rate in the months ahead. However, his tone was cautious, given the headwinds facing Europe and the recent turmoil in financial markets. (Source: WSJ June 8, 2010 A19)
Balancing the Budget
Our nationâ€™s financial position does not look good. We have never in modern times faced such dangerous, ongoing imbalance between the levels of federal spending and revenues. Our federal debt as a percentage of our economic output is greater than at any time since the end of World War II. The Congressional Budget Office projects that in a decade our national debt will reach 20 trillion dollars, more than half of which is owed to foreigners. That represents 90% of our economic output (GDP)! At that pace, interest on the federal debt is expected to cost us $1 trillion per year.
In addition, our population is aging, with fewer workers funding Social Security payments for each retiree. We have no proven plan to control excessive and rapidly rising health care costs, so the nationâ€™s financial situation appears to only get gloomier. Many economists believe that the primary ways to balance our budget are to:
â€¢ Curb government spending.
â€¢ Increase taxes.
Unfortunately, most taxpayers will be affected by these changes and it appears that Congress cannot come to terms with many of these issues.
Unlike when we experienced our sub-prime crisis, Europe has not provided a fiscal stimulus. So, there is a possibility of Europe slowing down, which could then cause global growth to slow, indeed that is a possibility.
The problems facing the equity markets today are no longer an anomaly. The market has battled many catastrophes. Remember SARS? How about the Asian Bird Flu? Or even the Great Stock Market Crash in 1987? Guess what? The stock market is based more on psychology than on numbers. Unfortunately, confidence is an important and fragile commodity. Confidence in big U.S. banks and the resilience of the U.S. economy has been hurt by the worries over Europeâ€™s problems, but feelings are notoriously unreliable.
Since 1950, economic expansions have lasted 6 times as long as economic contractions. Economic expansions are defined as â€œtrough to peakâ€ periods and economic contractions are defined as â€œpeak to troughâ€ periods. The average expansion has lasted 62 months while the average contraction has lasted 10 months. (Source: By The Numbers) So think long termâ€”for yourself and your beneficiariesâ€”and donâ€™t forget the power of positive thinking.
One of the worst things that you can do is obsess over the stock market, minute to minute. If you do that, youâ€™re likely to buy when people are optimistic about rising prices and the market is expensive, and bail out when pessimism reigns and the market is relatively cheaper. One of the best things you can do is to ignore the day-to-day peaks and valleys. You can ride out declines without losing sleep (or at least not much) if your food-and-lodging money is not at risk, so try to avoid investing in the stock market unless you have at least a cash reserve large enough to cover your living expenses for a minimum of 3 to 9 months.
If you have any questions on any of these subject matters, please write them down and we would be happy to discuss them with you personally. As always, we appreciate and thank you for being our client.
Note: The views stated in this letter are not necessarily the opinion of Comprehensive Asset Management and Servicing Inc., and should not be construed, directly or indirectly, as an offer to buy or sell any securities mentioned herein. Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. With any investment vehicle, past performance is not a guarantee of future results. Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice.
Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.
Indexes cannot be invested in directly, are unmanaged and do not incur management fees, costs or expenses. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. Rebalancing investments may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events will be created that may increase your tax liability.
This optimism about the future does not minimize the fact that we have gone through one of the worst economic periods in market history. Remember that equity markets are volatile and an investor may lose money and there is no guarantee that securities will appreciate. This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
In general, the bond market is volatile, bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. The investor should note that investments in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Sources: Wall Street Journal (68/10, 6/10/10, 6/11/10), Business Week (), New York Times (), By The Numbers (3/15/10, 5/24/10, 6/14/10), Barronâ€™s (6/14/10), Times Magazine (5/3/10), Kiplingerâ€™s Personal Finance (6/9/10, 8/2010),The Economist (6/5/10, 6/19/10), Bob LeClairâ€™s Finance Newsletter (), Forbes (7/19/10), USA Today (), Nick Murray Interactive (September 2009), Fortune Magazine (5/24/10, 7/5/10), Market Watch (7/8/10), Dow Theory Forecasts (6/14/10), Investment News (7/6/10), AARP Magazine (June 2010), Monday Morning Outlook Newsletter (6/7/10)
Investment Advisory services offered through Comprehensive Capital Management, Inc., an SEC-Registered corporation. Securities offered through Comprehensive Asset Management and Servicing, Inc. Member, FINRA/SIPC/MSRB
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