April 2011

Dear Clients and Friends,                                                                                             

The stock market continued its advances in the first quarter in spite of a series of alarming geopolitical events including political unrest in Egypt and Libya, the Japanese earthquake, tsunami and nuclear crisis, and a continuation of the European sovereign debt crisis.  Most markets around the world did well but emerging markets lagged and Japan declined. 

The bull market has now continued for two years since it bottomed in March 2009 and is benefiting from improving economies, growth of corporate profits and low interest rates.   

Although stock markets declined after news of the tragedy in Japan, they quickly began recovering.  The S&P 500 declined 6% from its February peak but finished the quarter just 1% off its February high.  Foreign markets declined somewhat more than the US but also began to recover quickly.   The Japanese stock market, which comprises 7% of the total world markets, declined more than 16% before it also began to recover. 

The yield on the ten year US Treasury bond rose from 3.3% to 3.5% which is below the long term average, but above the very low yields of 2.1% in 2008 and 2.4% last fall.  Rising rates provided a headwind for bond markets and the Barclay’s Aggregate Bond Index (a broad bond market index with a high allocation to government bonds) had a miniscule loss.  Municipal bonds returns were weak due to investors concerns about the fiscal health of some municipalities while high yield corporate bonds continued to generate positive returns as a result of improving corporate profits.

 Returns for key indexes (including dividends) were:

Economic and Market Outlook    Economies around the globe are strengthening and corporate profits rising, providing a positive boost for equity markets.  For now, the Fed is maintaining low interest rates, which is another positive for both the stock and bond markets.  On average, stocks have fared much better during the third year of the “presidential cycle” than the other three.   While past performance does not promise future results it does provide another reason to be cautiously optimistic.

An old Wall Street adage is that “bull markets climb a wall of worry”.  That certainly proved true in the first quarter.  And without a doubt, there are things left to worry about, including the loss of life and property and economic disruption from the Japanese earthquake.  Reconstruction costs will only increase Japan’s already massive national debt and  global sovereign debt concerns.

Adding to our “wall of worries” is the sovereign debt problems in Europe which will likely to be back in the headlines again as the politicians in the European Union decide how to address the problem.   It would not be surprising to see a default by one or more countries that may rattle European financial markets but would also create buying opportunities.

The Federal Reserve’s quantitative easing (QE II) is scheduled to wind down in June and the Fed will then need to decide how and when to sell the $2 billion of bonds they have purchased since the financial crisis began in 2008.  If the Federal Reserve is able to end QE II without driving interest rates too high and if the

European Union is able to contain the sovereign debt crisis, global stock markets have the potential to continue to do well. 

Investment Strategy     While the market environment is attractive, the concerns mentioned above provide reasons to be cautious.  We continue to recommend the same cautious strategy as we did last quarter, and refer you to our January newsletter for further details.

It does not pay to panic     After hearing the news of the March 11 Japanese earthquake, some investors sold first and asked questions later.  They did the same thing after the September 11 tragedy, as well as many other major crises.    That may sound like a wise strategy, but history has shown that it is usually counter-productive.  Ned Davis Research identified what they classified as the 28 worst political or economic crises since 1940 and found that in 19 of those cases the Dow Jones Industrial Average was higher six month after the crises began.  The average six month gain following all 28 crises was 2.3%

Economic growth in a time of national debt   Conventional wisdom (and a key tenant of Keynesian economics) holds that government spending can boost economic growth.  A recent study by professors Carmen Reinhart and Kenneth Rogoff sheds new light on the topic.  In a study of 44 countries over a period of up to 200 years, they found that once national debt rises above 90% of GDP in developed countries, median (half of the countries are above and half below) economic growth declines almost 1% per year and average economic growth declines 1.7% per year.  The current debt of all US federal and state governments now totals over 85% of GDP, excluding debt held by the Social Security Trust Fund.  And with large on-going budget deficits, the US debt burden will be above 90% of GDP shortly. 

Ways to Beat Inflation     Inflationary pressures may increase and a recent Forbes magazine article highlighted ways to beat inflation.  Some of these methods include: emphasizing stocks rather than fixed income, investing in TIPS (inflation protected bonds), precious metals, commodities, natural resources, foreign currencies and high yield bonds.  Other methods include owning a home, having a mortgage (you get to pay it off with “cheaper dollars”), and delaying Social Security.

Aligning the interests of investment managers with the interests of investors            A recent Morningstar study determined that, on average, when fund managers invested more of their own funds the same way that they invested shareholder money, the funds performed better compared to their peers and had better Morningstar ratings.  While having fund managers invest their own funds the same way as they invest client funds, does not guarantee success, it does align the fund manger’s interests with the shareholders’ interests and provides them with greater incentive to do the best for their shareholders.   In selecting funds in which to invest, we do favor funds where the fund manager’s interests are aligned with investors.  In addition, we invest our own personal funds the same way we invest client funds (with variations due to risk tolerance and financial goals) and believe that helps align our interests with those of our clients.

Interrelationship between interest rates and stock prices        Declining interest rates help the stock market in several ways.  It reduces interest that companies pay, boosting their profits and makes corporate dividends more attractive to investors relative to bonds.  Rising interest rates do just the opposite.  However a gradual rise in interest rates may be the result of an improving economy, usually accompanied by rising corporate profits and still provides an attractive market environment for stocks. 

John W. Eckel CFP®, CFA