July 13, 2009

2009 3rd Quarter Newsletter

The second quarter showed signs of some healing for financial markets. We all started to breathe again. Investors became more comfortable with risk, shifting some money out of Treasury bonds and into riskier bonds, stocks, and commodities. The S&P 500 gained 15% for the quarter and is up 1.8% for the year. We note that June was a flat month for the domestic stock market and that most gains occurred in April and May. Emerging market stocks and commodities also performed strongly as investors bet on a global recovery. Corporate and mortgage-backed bonds returned to levels not seen since before the financial world collapsed last September.

Economic data continues to show signs of a possible bottom to the recession. Leading indicators such as unemployment claims, layoff announcements, housing sales, inventory declines, consumer expectations, yield spread between Treasury bonds and more risky bonds, and consumer spending all appear to be turning the corner. By pointing out these leading indicators, we by no means seek to minimize the difficulty of the current environment, with unemployment very high and financing still very difficult.

Optimism can be contagious though, and just as there can be a capitulation decline in stock prices, there can be a capitulation rally. That is what has occurred. In the face of the leading economic indicators and market momentum, even some of the bears capitulated and invested in stocks in April and May.

The Federal Reserve has been quiet since its unprecedented moves last fall. The Fed is showing no signs of extending their program to purchase Treasury bonds to keep interest rates low, nor has the Fed started to withdraw stimulus or raise interest rates to control inflation. The Federal Government, on the other hand, does not seem to be content to watch the economy, and has aggressive spending plans that will dramatically increase the U.S. deficit. This is raising legitimate concern about our country's balance sheet, the strength of the dollar as the world's "reserve currency," and China's position as chief buyer of our debt. We think that while the dollar may decline, it will keep its reserve status for the foreseeable future, as other currencies simply lack the liquidity and/or strength to replace it.

Inflation is a serious long-term concern due to the Government's unprecedented injection of dollars into the economy. More dollars chasing the same goods and services can cause prices to increase. For now though, high unemployment, excess global capacity and low wages lead the Federal Reserve and most economists to believe that inflation is currently controlled, less than 2% on an annualized basis. We tend to agree, but believe it important to have inflation protection in the portfolios now, because it will be too late by the time the need for protection is obvious. On that topic, we note that some hedge fund managers, like the famous John Paulson, are making huge trading bets on increased inflation.

In general, we believe the economy is reaching bottom but that the recovery will be slow and potentially choppy. Bill Gross of Pimco coined the term the "new normal," and we have adopted it. We believe that we may not see a short-term reversion to historical corporate earnings and stock market returns. We may have to lower our expectations. The consumer in a consumption based economy is saving more and spending less. Corporations are being forced to borrow less, regulation is increasing, and corporations will have to show real earnings growth to increase stock prices significantly above current levels. Growth will also be slowed by the eventual requirement to pay down the debt amassed by developed countries to stimulate the global economy. These are large headwinds, and we are adjusting our expectations for returns of the portfolios and for our retirement plans to prepare for this "new normal."

While cash and Treasury bonds were the investments of 2008, we want to emphasize that asset allocation is working in 2009. Our typical portfolio (absent a sale of equities) has outperformed both the S&P 500 and Treasury bonds in 2009. Commodities, emerging market stocks, and municipal and corporate bonds have made significant contributions. We continue to emphasize alternative investments as well. Our current suite of alternative mutual funds earned 6.4% during the last 10 years, better than the negative return of the S&P 500 and the 4% earned on Treasury bonds during the same timeframe.

For more details on our economic view and investment strategies, we encourage you to come in for a meeting, call us, or review our recent web presentation. The link to the presentation can be found on our website.

Sincerely,

Wagner Wealth Management