This quarter has been dominated by news on two major fronts: The U.S. debt downgrade by Standard and Poors was announced in August and secondly, the announcement of the Greek debt issue, which continues to dominate economic headlines. Year to date (end of third quarter) the S&P index is down 10.46% and the Dow Jones Industrial Average is off 5.7%. As you will recall, the year started off on a positive note, with corporations offering upbeat earnings outlook. As the third quarter unfolded, global demand began to slow, thus causing the same corporations to lower their expectations for the remainder of this year, now extending into 2012. Regarding global demand, it might come as a surprise to our readers that 50% of S&P company profits are now derived overseas, thus the comment regarding the concern for the decline in demand abroad.
Granted, the U.S debt downgrade was expected by many, but when the news finally came to fruition, the markets certainly reacted negatively. The volatility index began to soar as well as trading volume on August 5th, the first time our sovereign debt was downgraded in its history. The debt downgrade did its part in rattling the markets, but once the dust settled, foreign investors soared toward our Treasury issues as European markets continued to struggle.
Some would argue that the Greek economy’s impact on the Euro is miniscule compared to other issues which world leaders are facing. From one perspective, the Greek debt issue is minor, representing only a small percentage of European economic GDP, as it only contributes 2%. Having said that, it is important to realize that Greece shares its economy with the European Union, which is where the problem lies. The European countries already have a debt burden with weaker nations in its economy like Spain, Italy and Ireland. So although Greece only makes up 2% of the EU’s GDP, the fear is that the currency will continue to suffer as European banks hold the debt of the combined nations, thus possibly further weakening the Euro currency.
Adding to the concerns, the Federal Reserve Chairman, Ben Bernanke recently granted his first television interview. In a rare interview, the Chairman made a telling statement, stating the biggest risk to the economy was “the shortage of political willpower to strengthen the economy.” Before Mr. Bernanke made this statement to CBS, he had previously stated that the Fed would not be able to provide all that is needed to ameliorate economic woes. Many interpret this statement to mean that the Fed has just about used all of its tools, and the future of the recovery is in the hands of elected officials.
The Fed recently participated in an operation which is intended to help spur the economy, but not to the degree that politicians could make if they simply cut government spending. The recent stimulus which was announced by the Fed was referred to as “Operation Twist” whereby the central bank sold its short term treasury holdings and bought longer term treasury issues. The intention of the Fed move was to push longer term bonds (25 to 30 year treasury) down to levels which would make mortgage lending less expensive. In addition to lowering mortgage rates, the strategy is expected to also make lending for commerce cheaper. The long term treasury issues reacted immediately and fell to levels not seen since the 1940’s at 2.8%.
Although the “Twist” was telescoped by the Fed, the stock markets still took a tumble around the world. Many investors interpreted the move by the Fed as exaggerated and unnecessary, thus the steep decline in stock prices.
So, going forward what are investors to make of all that is occurring? First, the main thing to know is that this is not 2008 again. That is to say, while there are many concerns globally, there are also some positive points that should not be overlooked. Over the summer we saw food and fuel costs rising dramatically; these costs are now coming down as demand is slowing. The housing market is going through its fits and starts, but needs a boost. With the Fed action, home buyers are likely to see 30 year mortgage rates near 3.5% in the near future. Additionally, bank regulators have been very diligent since the financial meltdown, requiring such action as contingency plans for future problems, higher capital ratios, tougher lending standards and the list goes on. Our point here is that Americans are saving more, banks are stronger, costs are coming down or not rising as much as anticipated, and U.S corporations are flush with cash, estimated to be about $2 trillion.
While there are most certainly bright spots in our economy, there are realistically reasons to think twice before leaping into the stock market in an aggressive manner. Adequate cash and fixed income levels should be a part of the asset allocation model, and depending upon risk profiles, these reserves should be used to make buys in stocks which represent long term prospects. We do not encourage buying stocks on the first upswing in the markets, rather we believe that patience and small steps will provide the best solution.
While there are real economic concerns, we also know that recessions occur in a natural economic cycle and the most recent recession was very deep. Fears of another recession occurring are talked about daily in the media, but the majority of economists still believe that a double-dip is unlikely. While we do not commit investment policy to short term economic reports, we do look at the trends in certain areas such as the retail sector. Same-store chain store sales are still above last year. According to Redbook Research, sales in these stores are up 4.2% vs. 2.7%. Railroad traffic is also up almost 4% over last year. The most recent manufacturing report showed an increase up from 50.6 to 51.6. These indicators can be volatile but the most recent reports are not recessionary. Historically, when the Fed keeps rates low, recessions do not occur.
GLOSSARY
In today’s 24/7 economic news flow, we hear terminology being used that is often arcane to some. We thought it might be useful to define some of these more obscure terms which are commonly used in the media.
Also, we recognize that uncertainty often makes investors uncomfortable. We want you to know that we continue to be focused on the long-term investment objectives which have served our clients for many years. We remain diligent in our work to search for issues which offer rewards for patience. We thank your for your continued support.
Arms Index:
Also known as a trading index (TRIN)= (number of advancing issues)/(number of declining issues)(Total up volume )/(total down volume). An advance/decline market indicator. Less than 1.0 indicates bearish demand, while above 1.0 is bullish. The index often is smoothed with a simple moving average.
Automated Clearing House (ACH):
A collection of 32 regional electronic interbank networks used to process transactions electronically with a guaranteed one-day bank collection float.
Ladder Strategy:
A bond portfolio strategy in which the portfolio is constructed to have approximately equal amounts invested in every maturity within a given range.
Market Capitalization:
The total dollar value of all outstanding shares. Computed as shares times current market price. It is a measure of corporate size.
Refunding:
The redemption of a bond with proceeds received from issuing lower-cost debt obligations with ranking equal to or superior to the debt to be redeemed.
Wash Sale:
Used in the context of general equities. Purchase and sale of a security either simultaneously or within a short period of time, often done with the intention of recognizing a tax loss without altering ones position. See: tax selling.
Yield to Maturity:
The percentage rate of return paid on a bond, note or other fixed income security if you buy and hold it to its maturity date. The calculation for YTM is based on the coupon rate, length of time to maturity and market price. It assumes that coupon interest paid over the life of the bond will be reinvested at the same rate.
