Renewed Optimism – January 2011

January 20, 2011

Dow Jones Average: 11,823
S & P 500 Index: 1,280


 

Renewed Optimism
 

In recent months there has been a discernible shift in the mood of the public at large and investors in particular. Even though underlying economic conditions remain challenging, the public seems more positive. There are a number of plausible reasons for this subtle, yet noticeable change in attitude. New jobs are being created at a slow, but steady pace, and real estate prices have stabilized for the moment. These important trends give comfort to the vast majority of Americans who are employed and own homes. When the economy was spiraling down in 2007-2009, even people who were employed, had sizable equity in their homes, and a retirement portfolio, felt threatened by economic forces beyond their control. The fear of impending doom has largely abated.

The vitriol and fear-mongering that spewed forth during the mid-term elections accentuated negative feelings among citizens of the country. The rhetoric has died down considerably since the Republican Party swept to power in the House of Representatives. A more civil tone has accompanied a sharing of political power and responsibility. There is even talk about Democrats and Republicans sitting next to each other during the State of the Union address. More pundits, economists, and politicians increasingly see the economic glass as half full rather than half empty. As the economy slowly mends, there is grudging admission that the Obama administration’s economic policies, i.e., the stimulus package, financial and auto industry bailouts, and Fed easing, were necessary measures in extraordinary times.

While the general public was focused on the elections, the investor class was obsessed with tax policy. The tax cut compromise, engineered by the White House and the lame duck Congress in December, was an unexpected year-end present for investors. It was in fact not a compromise at all as both sides got more than they anticipated. All of the Bush era tax cuts were extended for two more years, while additional cuts in FICA (the social security tax that affects every worker) and business taxes were instituted. The fact that all the tax cuts will be covered with money borrowed from Chinese savers doesn’t seem to concern anyone. The government is using the national credit card to give everyone a nice gift. Paying down the balance on the card is a problem for another day.

Investor enthusiasm in the wake of the great tax cut deal sent the stock market steadily higher. Optimism leads to more aggressive stock buying, higher prices, a feeling of greater wealth, more optimism, and a desire to keep buying. Trends in stock prices tend to be self-reinforcing. Of course at some point all trends break, ushering in a period where the opposite direction becomes equally powerful. There was unbridled optimism at the stock market peak in early 2000. Real estate investors were fearlessly snapping up investment properties at the peak of the real estate market in 2006. A surge in optimism after substantial price appreciation in any asset category, whether it is gold, stocks, bonds, or real estate, is always a reason for caution.

Current Strategy

The stock market rose steadily in the early months of 2010, fell sharply during the summer as investors worried about a double-dip recession, and then rallied strongly at year-end on the surprisingly large Federal tax cut. We took some profits early in the year at high prices, and bought a sizable list of stocks when prices fell during the summer. Our timing on stock sales and purchases was particularly accurate through much of 2010. As fall turned to winter it seemed probable to us that the market would end the year with a modest, single-digit return, constrained by concerns about political gridlock and Republican led economic austerity measures. The December surge in stock prices, spurred by the stimulative tax cut, took us and many others by surprise. In retrospect it would have been wise to add a few more stock positions ahead of the tax cut deal.

With the market more elevated due to the December rally, it has become harder to find buys that have a decent risk/reward ratio. We are searching far and wide for reasonable investments. Economic austerity measures in many European countries have pressured share prices and created some attractive buying opportunities. Our latest purchases, made a couple weeks ago, were Phillips, the well-known Dutch manufacturer of medical equipment, lighting, and technology products, and Telefonica, the international telecom provider headquartered in Spain. Share prices are more subdued in countries where governments are raising interest rates to fight inflation or cutting budgets in response to deficits. If and when the U.S. is forced into similar action, the U.S. stock market may give up some of its recent gains.

 

The bond market was hit hard by passage of the tax cut package. Financial analysts generally feel that action in the bond market is the best predictor of future inflation and economic growth. The bond market is bigger than the equity market and is typically less driven by emotion. Bond prices and interest rates tend to move in small increments as investors digest bits of news that change the global economic equation. The fact that interest rates on U.S. Treasury Notes spiked from 2.5 percent to 3.5 percent in December shows just how much the tax cut deal shocked bond investors. Interest rates on municipal bonds and treasuries have suddenly become more attractive than they were a few months ago. While yields are still not ideal given the potential for inflation, we may replace some maturing bonds with new purchases at current interest rate levels.

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