Why the Federal Reserve is our favorite investment manager.
In our Third Quarter Review, we addressed why we believe the economic recovery is sustainable. Thankfully, we have continued to see improvement in most economic indicators, confirming our view. Concerns still exist though, especially regarding government spending. So many people are wondering, “Is the market rally sustainable”?
4th Quarter Review
After a short breather in October, the market rally continued, with the S&P 500 gaining another 6% for the fourth quarter, bringing the total rally (since March 10) to over 60%. While fears of a double-dip recession have dimmed slightly, there is growing concern about the sustainability of the market rally, especially in light of the out-of-control government spending.
Let’s take a quick look at some recent news updates, then address two questions many of you are asking.
Investor Sentiment – Finally, after experiencing a 60% rally, investors have become more optimistic, with surveys showing significant improvement in investor sentiment*. (Notice how investors become positive after a substantial rally – a little late to the party) However, in our view, investors are still quite leery and hesitant to invest. *Based on American Association of Individual Investors AAI.
Consumer Sentiment – Consumers have started to feel the strengthening in the economy as the sentiment numbers have continued to improve, albeit at a very slow rate.
*Based on University of Michigan Consumer Sentiment Index and The Conference Board
Economy – GDP growth for the third quarter was revised down to 2.2% from the original 3.5%, which provided fuel for the throng of naysayers. But positive economic news continues to grow. Consumer spending, corporate profits, housing prices, home sales, jobless claims, exports, and industrial production have continued the improvement we indicated the last two quarters.
Healing in the Financial System – With one of the steepest yield curves in history, engineered by the Federal Reserve, and a personal savings rate of 4.7%, banks are starting to earn their way out of the hole they were in. We expect the Fed to keep short-term rates low for most of this year, but will likely start the increasing process within the next 3-6 months, which is great news for your checking & savings accounts.
Inflation – Inflation continues to be tame, as we expected. If inflation becomes a serious issue, it won’t likely be for 2-3 years. Refer to our 2nd Qtr. 2009 Review for a more detailed discussion. *Based on data from US Bureau of Labor & Statistics
Unemployment – Job losses continued their improving trend and November produced a surprising month of job growth! Since unemployment typically peaks about 6 months after the end of a recession, we believe sustained job growth is likely to resume by the end of the first quarter. *Based on data from US Bureau of Labor & Statistics
Will government deficits derail the fragile economic growth?
There is no question government stimulus was a factor in the economic growth experienced in the 3rd (and likely 4th) quarter. While many argue this is a reason the economy will struggle to continue growing (as stimulus spending subsides), many also argue the resulting large deficits will be a stumbling block to recovery.
To be clear, we believe all government entities should operate with a balanced budget. There is no reason for the federal government to be as large and in-debt as it is and will continue to be barring a radical change.
We also believe the fiscal situation of the federal government is largely misrepresented. First, there is a significant difference between spending and investing. Recent reports of record deficits fail to mention that some of the “spending” was really “investing”, meaning it wasn’t an expense; it was an exchange for a corresponding asset. Examples include the government investments in financial & automotive institutions. On January 12, the Federal Reserve announced record profits of $52.1 Billion for 2009 as a result of the so-called “bailout” programs. Out of the kindness of their hearts, they gladly sent $46.1 billion of this to the Treasury, making them one of our (taxpayers) best investment managers.
Second, all fiscal reporting I have ever seen only covers the government debt, which is only one side of the balance sheet. The government also has significant assets, of which I have never seen a complete listing or tally, if it even exists. So, while our $11 Trillion debt sounds massive (which it is), it is probably not near as bad as it sounds.
So we don’t believe the current deficit spending will derail the economy anytime soon. If anything, it is helping to jump start economic growth. More concerning, in our opinion, is the future liability of the existing social programs like Social Security, Medicare, Medicaid, etc and the potential tax hikes being discussed. Drastic measure will have to be taken at some point to address these issues, which will certainly have an economic effect 10-20 years from now.
Is the market rally sustainable?
This is probably the most common question we are receiving now. The correct answer depends on how you define “sustainable.” There is an old market adage, “The market climbs a wall of worry.” We certainly experienced this as the market moved steadily higher in 2009. Many of these worries still exist and the market will likely respond positively as they improve.
The market cannot go up in a straight line forever, so we believe one or more pullbacks of 5-15% are inevitable at some point this year. However, nobody know when this will be or how long it will last, so trying to time it is futile.
Despite the likely pullback, we believe the market can go higher from here and potentially finish the year with nice double-digit returns, very much like we experienced in 2004 after the strong recovery year of 2003.
Naturally, there are many variables and factors that are constantly changing. We will work hard to stay informed and to help you make wise decisions about your money.
We hope 2010 is a year of growth for you: spiritually, personally, and financially!
Darren T. Munn, CFA
Camelot Portfolios, LLC is a Registered Investment Advisor offering portfolio management services to clients. Branch Office is located at 1700 Woodlands Dr. Suite 100 Maumee, OH 43537. All disclosure documents and ADV II / Schedule F are located at www.camelotportfolios.com . Please review the disclosure documents and ADV II / Schedule F before investing. Hard copies may be obtained by calling (877) 315-5558.
The views expressed in this letter are for educational purposes only and are subject to change at anytime based on market and other conditions and should not be construed as recommendations. This letter contains forward looking opinions that involve risk and uncertainty that could cause actual results to differ materially from those expressed. Readers are cautioned not to rely on, nor our we obligated to update our forward looking statements. Readers assume all responsibility for any investment decision made as a result of the views expressed herein. Camelot Portfolios, LLC is not associated with any broker dealer. Disclosure: