News & Insights
To The Presses: Keeping The Economy Afloat
Investors are feeling much better about their accounts since the rally that began this spring has continued through the summer. Unlike past rallies this one seems determined to stick. Certainly, investor appetite for risk has been whetted by the 20% + returns in the indexes since March. Bond prices have dropped from their historical levels since early June, pushing yields on the ten year note past 4.5%, signaling the end of the great bull market in bonds. The stock market has largely shrugged off the increase in long-term interest rates.
Alan Greenspan has succeeded in changing the goal of American monetary policy from the maintenance of price stability (i.e. fighting inflation) to protecting us from the specter of the exotic condition called deflation. In our judgment the risk of deflation is quite low, but it does provide a convenient rationale by the central bankers for the maintenance of extraordinarily low short-term interest rates and the availability of "easy money". Since mid to late 2002 the cumulative effect of the policies pursued by The Central Bank and the tax cuts enacted by congress have been massively stimulative. The Fed has signaled that it will print the money necessary to support the economy.
Long term rates, set by the market (not the "wise men" of the Fed) are signaling that Greenspan will succeed, that is low rates and the increase of the money supply, will enable fairly robust economic growth and prevent a destructive debt-driven deflationary cycle. As a consequence, forces have been unleashed that will over the next two or three years weaken the dollar, cause higher inflation and the consequently higher long term interest rates.
Stocks, Bonds and Cash: What it Means to Investors
The real improvement in the economy has been discounted by the stock market and generally prices of stocks are not cheap. While valuations are not out of line across the board, speculative fervor has caught on in some sectors, particularly in that old repository of boundless hope and questionable optimism: information and technology (up 34.89% in 2003). The anticipation of an economic recovery has pushed the more economically sensitive stockssuch as steel, paper and retailers into fully priced territory. Relative to these, steadier areas such as consumer staples and health care have been left behind.
Not only have the more volatile sectors powered the rally ahead but also those stocks judged to be of lesser quality as measured by steadier earnings, dividend growth and balance sheet quality have performed better than the higher quality issues. For instance, in the second quarter within the Russell 2000 small-cap universe, those shares ranked "A" by Standard and Poors for earnings and dividend consistency were ahead by 11%, while those ranked "C" were ahead by 41%. This indicates a high level of speculation within the market.
While we are skeptical of the speculative nature of this rally, several factors support continued gains in stocks. First, while dodgier companies have earned outsized returns most all stocks have posted some gains. 484 members of the S&P 500 were in positive territory in the second quarter; in other words, the rally is broad.
Second, the "cash mountain", that is the enormous amount bank deposits, money market funds and saving accounts we spoke of in last quarter's comment, has barely budged off its high. This provides the potential for further investment in the stock market by investors. We think this will be manifested by a rotation into the higher quality issues that have lagged in this market.
Energy shares, such as the integrated oil companies, the exploration companies and the mid-stream gas producers should do very well as we believe energy prices will stick at higher than expected levels. Selected materials and commodity-based shares will continue to surprise on the upside as a weaker dollar and a return to inflation provide a tailwind for those investments based on the price of increasingly scarce materials.
The developed countries' markets as represented by the MSCI EAFE index are sharply up this year. Even with this advance, these markets remain reasonably priced relative to the U.S. even when adjusted for their less robust economic prospects. The stocks of emerging economies remain an absolute and relative bargain even though they are smartly off their ten-year low recorded last year. We continue to recommend exposure to these investments.
The end of the great bull market in bonds has occurred in the last few months, validating our strategy to place money in shorter duration securities. In our view, on the next year or so concerns about inflation will supplant fear of the deflation that has driven policy for the past few quarters. In that environment, U.S. Government issued TIPS (Treasury Inflation Protected Securities) should do quite well. These securities include a small interest coupon AND a periodic adjustment to their principal tied to the underlying inflation rate. They are appropriate in tax-deferred portfolios such as charitable remainder trusts, IRAs and qualified retirement money.
The extraordinary period of the last three years for investors continues and it would be a mistake to substitute the recent stock market rally for an "all-clear" signal. However, the improvements in the economy and corporate profitability are tangible and cause for a constructive view on the markets. Smart investors will look to markets in addition to the U.S. stock market for growth and stability in their portfolios.
The Altavista Investment Team - Fall 2003