Q3 2010 proved to be a profitable one for most asset classes, both equity and fixed income. Risk was rewarded on the equity side as international equities and domestic small/mid caps outpaced their large domestic counterparts. Fixed income investors were also rewarded for taking risk as high yield bonds outperformed investment grade and government fixed income. As interest rates continued to fall, longer maturities benefited more than short and intermediate term maturities.
While we experienced significant improvement in investment returns during Q3, unfortunately the underlying economy has not recovered with the same vitality. Most indicators of the macro-economy have been lackluster.
Economic Overview
GDP has expanded now for six (6) consecutive quarters. While GDP growth is positive, the rate of growth over these last six (6) quarters has been anemic. Nominal GDP still remains well below its high during Q2 2008.
In the household sector, disposable personal income is increasing. Individuals with more disposable income should equate to a positive for the overall economy as those individuals theoretically would go into the marketplace and demand goods and services. However, what we have seen instead is that individuals are using that increased income to save more and reduce debt. Both increased savings and debt reduction are long-term positives for individuals; however, in the short term they are detractors from the overall economy as this is money that is not stimulating general economic activity.
Just the opposite of the household sector is the government sector. The federal government is posting historic deficits in an effort to stimulate the economy. While this should be viewed as a positive in the short run, the long-term implications are troubling. The federal government has implemented both fiscal and monetary policies directed at stimulating the economy. While the Federal Reserve has dropped the discount rate to near zero percent, it has also begun serious consideration of quantitative easing through the purchase of additional fixed income assets.
Even the business sector presents a mixed picture. Many positives are noted in the business sector, specifically inventories remain near all time lows, productivity remains elevated and manufacturing output has begun to increase. However, utilization rates in the manufacturing sector remain low and are significantly below levels that would require capital expansion.
Interest rates remain near historic lows. Low interest rates should be a significant positive for the economy as it should encourage borrowing for consumption and expansion. Unfortunately despite the near record low interest rates, demand and/or access to credit remains weak.
The yield curve remains upward sloping; however, the curve has flattened as interest rates on the long end have decreased. The flattening of the yield curve indicates less optimism about future economic growth.
The employment landscape also provides some mediocre news. The unemployment rate remains high at 9.6%; however, it appears to be stabilizing. In addition, the duration of those individuals unemployed has begun to decrease during Q3 2010.
Duration of Unemployment measures the amount of time an average worker spends unemployed before securing another job. While the duration of unemployment remains elevated at twenty (20) weeks, it has decreased from more than twenty-five (25) weeks. Shaded areas represent recessionary periods.
Currently, inflationary pressures are tame. Prices have been rising, albeit at a very modest pace. We do perceive many possible inflationary pressures on the horizon; significant liquidity, extremely low interest rates and increasing energy costs. Each of these pressures must be managed skillfully to abate significant inflation.
Investment Overview
The overall attitude of individuals and business alike is one of caution. While consumer sentiment is off its lows of 2008, it remains weak. There are many uncertainties regarding the upcoming mid-term elections and specifically the expiration of some existing tax rates. Over the course of the last year, substantial assets have moved out of equity investments and into fixed income investments. Meanwhile, both individuals and business have increased their cash positions.
Despite a cautious macro-economic backdrop we find reason to remain optimistic about the equity markets. Overall market multiples remain low, earning estimates remain strong, corporations are holding historically large cash positions and we believe these historically low interest rates will eventually foster economic expansion.
The overall market is continuing to trade at low multiples, both trailing and forward. Earnings estimates for 2010 have remained strong and earnings are estimated to be at an all time high for 2011. In addition, the dividend yields on equities are becoming even more attractive when compared to alternative low yielding fixed income instruments.
Corporations have stockpiled historic amounts of cash. Eventually, as the fear sentiment dissipates, shareholders will demand value and force corporations to make a decision that will enhance shareholder value. It is our opinion that corporations will use their cash reserves to 1) buy back shares, 2) make acquisitions and/or mergers 3) pay the cash out to shareholders in the form of a dividend or 4) invest in capital to expand capacity. Any of these actions should be viewed as a positive to shareholders and the equity markets as a whole.
At the end of the second quarter, cash represented a record 12 percent of the market cap of all the non-financials in the entire S&P 500, up from 10 percent at the end of last year and less than six percent three years ago. The measure excludes financial stocks, which must hold cash as reserves on their loan portfolio. Companies now have enough cash on hand to pay their annual dividends a full five times, or to carry out 4.4 years worth of stock buybacks. A decade ago, both of these ratios were under two times, according to S&P senior index analyst Howard Silverblatt.
We do, however, have elevated concerns over the possible increase in interest rates and its corresponding effect on bond prices. As interest rates rise, bond prices fall. The longer the duration/maturity of a fixed income instrument, the more volatile it will be in responding to interest rate changes.
Conclusion
The overall economy remains sluggish. We do not perceive the economy as worsening at this time, but are disappointed in the rate at which it is improving. Despite the languishing economy, we find many reasons to be confident in a more robust recovery. Productivity remains high, GDP continues to increase, unemployment levels seem to have stabilized, government intervention from both fiscal and monetary policies are promoting growth and there is tremendous liquidity.
We believe there are many pressures for an inflationary environment and we have elevated concerns regarding bond prices in a rising interest rate environment. We do, however, believe that equity valuations are attractive and have confidence that corporate earnings will remain strong. In addition, we believe that eventually the significant cash reserves of many corporations will be invested to the benefit of investors.
Pension Consultants, Inc. is a Registered Investment Advisor. Securities offered through Securities Service Network, Inc. Member FINRA/SIPC.
