Second Quarter, 2009
“Half-time Report”
Investors faced a challenging environment throughout 2008, with the S&P 500 (S&P) falling 38.5% and virtually all asset classes following suit in some relative proportion. It was a year where there was literally no place to hide, outside of pure cash or Treasury bonds. The decline continued in the first quarter of 2009, and by early March the S&P had dropped another 26%. From that low, however, a notable recovery rally began which allowed the market to close the first quarter at a loss of “just” 11.7%. There was no individual catalyst prompting the rally. Instead, there emerged a perception among some investors that the deterioration in our economy was slowing. With significant sums of cash on the sidelines, investors began chasing the market, and the rally continued into the second quarter. By June 30th, the S&P’s quarterly return reached 15.2%, recovering the first quarter’s deficit, and building a modest 1.8% gain on a year-to-date basis.
In the most recent three months, additions to the equity portion of client portfolios continued to be made at a highly selective, measured pace. Because many of the economic uncertainties cited in our last quarterly letter remain unresolved, we did not opt to depart from our conservative positioning. As a result of our actions in the first quarter compounded with gains in the second quarter, most portfolios exceeded the year-to-date return of the S&P 500.
“Block-and-tackle”
One of our most fundamental, ongoing activities is to monitor and assess key risks in the economy and market which could affect asset values. We rebalance the various asset classes, and implement over- and under-weighted positions according to the risks we find. Currently, indicators of our economy’s health are revealing a mixed picture. On the positive side, the Federal Reserve has made perfectly clear that it will take every step possible to promote a recovery. Also, companies in the financial services industry are showing great resolve in strengthening their balance sheets. Yet, there continues to be numerous, significant problems for the economy.
Thinking first about the American consumer: Unemployment is high and still rising. The average American is responding with an increased savings rate and reduced use of credit. This reduced spending is creating a tough retail environment which, in turn, is triggering lower returns for investors in the commercial real estate market as tenants negotiate lower rents. This “belt tightening” reaction is reinforcing what was already a slow-growth environment. In past recessions, one critical element in regaining GDP growth was the willingness of consumers to spend. Though unemployment is normally a lagging indicator relative to the timing of a recovery, we see the combination of high unemployment and increased savings as a reason to expect this recovery to be prolonged and uneven.
We see ongoing hurdles in the housing area, where some of the earliest indicators of our economy’s fragility emerged. There remains a tremendous surplus of unoccupied homes, homes for sale, and homes that people intend to sell once the environment improves. Though there has been some improvement in the volume of home sales, values are down significantly and banks have adopted stricter lending practices. Home values normally represent a significant portion of the average American’s net worth, and are a direct influence on their ability to access credit. We expect this to remain an overhang on the typical consumer’s buying power at least through 2010.
With our economy’s primary growth engine (consumer spending) sidelined, the Federal government has stepped in with a host of “temporary” stimulus programs. Nonetheless, most investors recognize the limits of what our Federal government’s efforts can achieve. In fact, there are numerous complications to the government’s efforts, including the following: 1) Taxpayers may soon face materially higher tax rates based on the need to pay for an ambitious new health care structure. 2) Several states are facing severe budget shortfalls. These states may rely on the Federal government to provide financial backing. 3) Many of the stimulus measures have yet to be fully drafted, approved, or implemented. 4) There is the possibility that our government will have difficulty attracting buyers of its Treasury debt as a result of these many issues.
As we contemplate the values of equities and other asset classes, one of the greatest uncertainties is what degree of growth we can expect in the near term and beyond. While many companies’ stock prices look “reasonable” or even “attractive” at these levels, analysts may be assuming these companies can eventually regain pre-2008 growth rates. We think that there will be certain S&P companies and/or sectors which will experience long term, or even permanently impaired growth rates.
A long-term, gradual shift is occurring in America’s economic dominance relative to emerging (and even some Western) economies. Countries such as China and India will likely enjoy GDP growth greater than the U.S. for the next several decades. Yet, the scope of our consumer’s buying power means that the decades-old relationship between U.S. consumers and foreign manufacturers will remain. Until the U.S. consumer regains her stride, we anticipate there will be continued volatility in many of the emerging economies.
Strategy going forward
We are confident the economy in the long term will behave as all cyclical things do, eventually turning more favorable. Professional investors are aware that recessions commonly end with the market already in a positive trend. The understanding is that by the time data comes out conclusively proving a recovery is underway, some astute investors will have already figured that out and their buying activity will be moving the market higher. This understanding does not always bear out, however, as the recent 2001 recession demonstrated. Amidst the bursting of the dot-com bubble, equity markets declined through October 2002, an additional 11 months beyond the official end of the recession in November 2001.
As our Investment Committee develops its market expectations and corresponding investment strategy, we are compelled to prepare for a market which likely won’t establish a particular trend in the next six months. Many of our clients’ accounts are currently invested on the low end of their long-term asset allocation mandates. Given the current degree of uncertainty, we believe the best course of action is to pursue an incremental (“dollar cost averaging”) program which transitions each account toward reaching its normal risk profile over the next six to eight months. We judge that by the end of that period, the economy will likely be demonstrating evidence of a recovery, clearing the path for a rising market. As we expect the markets to exhibit continued volatility, we will determine which investments to add as we move toward the allocation in your Investment Policy Statement.
While it is not currently a concern for investors, we anticipate inflation in the U.S. will eventually rise as the government’s stimulus efforts caused such an increase in the overall money supply. In the next 12 months, we will prepare for higher inflation by adding assets which perform well in higher-inflation environments. These may include diversified commodities funds, and/or greater exposure to TIPS investments (Treasury Inflation Protected Securities).
Lastly, we remain committed to pursuing fully diversified strategies, as it is never entirely predictable which asset class will enjoy the strongest growth in any given year. We expect the emerging markets category to be a strong performer as growth rates in many emerging countries are higher than in the US. We intend to hold not just domestic Large Cap equities, but also International equities, Emerging Markets, and Small/Mid Caps. Equally important will be managing a mix of fully diversified Fixed Income assets. We are currently biased toward those of short duration as interest rates are near historic lows.
As always, thank you for entrusting us with your investment portfolio, and for letting us guide you through this difficult and confusing time in the markets.