April 16, 2010

2010 2nd Quarter Newsletter

Where are we?

During the 1st Quarter, U.S. stock indexes gained 4-5%. While foreign stock markets didn't fare quite as well as the U.S. stock market, they still returned 1-2%. Conservative bonds and alternative strategies, meanwhile, posted modest gains during the quarter (1-2%), and commodity prices fell slightly. Private equity, higher risk bonds, and REITS posted strong returns (5% or higher).

The economy continues to be quite a rollercoaster. The S&P 500 has swung wildly from 1,561 (Oct. 12, 2007) to 683 (March 6, 2009) back up 1,169 (March 31, 2010). With the S&P 500 at 1,169 today, we have a long way to get back to the high of 1,561, but we are a long way from the low of 683. So where are we?

Comparing our current situation to historical stock market trends, it is clear we are in a pretty rare place. We have just emerged from a time when bonds outperformed stocks over a 20-year period. This has only happened twice before - in the early 1930s and the late 1940s. And, for historical context, the stock market did quite well the immediate five years following those two periods.

If we try to get some direction from historical Federal Reserve activity, we can look to 1994 and 2004 for guidance. In those two years, the Federal Reserve embarked on a measured cycle of interest rate hikes, and in each case the market declined briefly after the first hike and then rose for the next three years.

Perhaps we can get some clues from the economy. The Index of Leading Economic Indicators posted its 11th straight monthly gain in February. The economy is in fact growing despite the 10% unemployment rate. In prior recessions, unemployment rates typically reached their highest point 20 months after the recession began, and government data tells us this recession started 27 months ago in December of 2007. Initial unemployment claims are beginning to improve in a meaningful way. In fact, initial jobless claims are better now than in the last two "jobless recoveries" that began in 1992 and 2002. Temporary employment has also increased, which usually foreshadows permanent job growth.

Given some of this progress, why are we all so nervous? Let's begin with the size of the U.S. Government deficit. The deficit is 84% of the Gross Domestic Product ("GDP" - how we measure the size of the economy) and the deficit is growing. We have been measuring deficits and the GDP of economies since the time of Benjamin Franklin, and history tells us that when the deficit of a developed economy reaches 90% of GDP the economy grows very slowly in the immediate years following.

A second anxiety is inflation. The Federal Reserve stimulated the economy with billions of dollars, and that often results in inflation. However, those dollars are not moving through the economy with any velocity. Banks are not lending the dollars, and consumers are not spending the dollars. Until those two things change, inflation will not come. Not that we shouldn't be concerned in the long run and we have built elements into the portfolio to protect against inflation.

And finally, the top reasons that economists and the general public are nervous are health care and taxes. We have no politics or emotions to share with you, just facts. The recent passing of the Health Care Bill means that millions of Americans who currently do not have health care insurance will now have insurance. However, the passing of the Health Care Bill, in combination with the end of other tax cut legislation, means that taxes will increase for upper-income Americans. For example, taxes on Medicare will increase, and taxes on ordinary income, dividends and capital gains will increase for families earning more than $250,000 a year. Further, there is nothing in the Health Care Bill that suggests that health care costs will be reduced down for anyone. In fact, costs seem likely to increase.

As investors, we often take our cues from historical patterns. For example, the fact that Federal Reserve interest rate hikes are coming might lead us to bet that bond values will decline, and that bonds will underperform stocks. This was the case in the last round of interest rate hikes during 2004-2006. We might also bet that alternative strategies and real estate will outperform bonds in a rising interest rate environment. Does that mean we should sell all our bonds? We don't think so.

During the crash of the financial markets, author, scholar and hedge-fund manager Nassim Taleb's notion of the "Black Swan" event became famous. The theory posits that markets are unpredictable, and that truly disruptive events are likely to occur that will have a larger impact than anticipated. Perhaps the same is true for "White Swan" events, like the recent and unpredictable market upturn. So while we can - and will - make some "minor" bets to protect against known risks, it is also the unknown risks and opportunities that we need to prepare for. Therefore, we won't be selling all of our bonds because interest rates are rising, although we may compliment them with other income generating investments.

In summary, we are facing a number of possible outcomes, including interest-rate increases, inflation, another recession, flat markets, or a continued bull market. To be prepared for all outcomes, we position our clients through four baskets of assets, each with a purpose and a level of risk. We have a basket of growth assets in stocks and private equity. We have a capital preservation basket invested in conservative bonds. We have a basket of opportunistic alternative strategies that attempt to return more than bonds while keeping risk and volatility low. And we have an inflation basket of commodities, real estate, foreign bonds and TIPS, to protect against inflation. We have come to believe strongly that keeping substantial assets in each basket is the only way to compound wealth, reduce volatility - and increase sleep at night. We believe this investing philosophy is the right prescription for unpredictable times.

Please feel free to contact us with any questions. Thank you.

The Wagner Wealth Team