MARKET ENVIRONMENT AND OUTLOOK
The rally that started on March 9, 2009 continues in the first quarter of 2010. The S&P 500 was up 5.4% for the quarter, the MSCI- EAFE Index up 0.9% and the Barclays Intermediate Government Credit Index up 1.5%. It was another solid quarter as the economy continued to recover.
The market was led by a strong Gross Domestic Product (economic growth) of 5.6% in the 4th quarter. We still have further to go to regain what was lost during the 2007 to 2009 period, but the world stockmarkets are making headway. Although we have much to quarrel about with respect to the news media, the fact that we had two distinct periods of severe wealth destruction in the equity markets (2000-2002 and 2007-2008) must be acknowledged. It is going to take time to regain what was given up during those periods. Yet, we are on the way to recovery. Massive global government intervention in the credit markets averted the global financial meltdown. Once again, restoring liquidity, making money available and bailing financial institutions out of their own self created problems helped the world’s markets recover.
We are early in the year but there are enough signs that there is still more to gain from being invested in the stock market. The market recovery is not over. Companies are starting to hire, profitability is bouncing back off recession lows and capital spending by corporations is supplanting weaker consumer trends in bolstering economic growth.
The bond market is overbought and credit spreads have narrowed. As we have said before, the bonds we own in our balanced accounts are high quality, short-term maturity and good risk diversifiers. However, they do not offer much total return opportunity at these levels. The long bull market in bonds is over despite the massive amounts of money moving into the bond mutual funds. During the first quarter, we saw domestic equity funds begin receiving positive cash inflows after two calendar years of outflows, perhaps signaling that the individual investor is slowly coming back into the market.
OUTLOOK
It is probably safe to assume that this economic recovery is not going to be as robust as previous recoveries. That does not mean that a sizeable portion of what was lost during the most recent bear market will not be recovered. This has been a remarkable recovery to date. Through April 5, 2010, according to the Leuthold Group, this market recovery of 76% on the S&P 500 has generated the 5th largest recovery without a correction going back to 1900. We can assume that we will see some give back during the year but we feel the correction would simply be a point in time on the way to a further recovery for the market.
We are starting to see positive signs. Unemployment is at 9.7% and off its highs. With modest economic growth, the unemployment level will be slower to come down than in past recoveries but showing signs of peaking. Personal income levels are up year over year and retail sales have picked up sharply in the first quarter of 2010. Car and truck sales are off their low levels even with the expiration of the “cash for clunker” program. Eleven million units sold are far below past peak levels but it is moving in the right direction. Non-farm payrolls have increased, signaling that companies are starting to feel more confident about hiring and profitability. More importantly, consumer confidence has turned up as well. Capital investment has picked up and showing signs that it is more than just inventory rebuilding from recession lows. Manufacturing has clearly turned around. The S&P 500 earnings are projected to come in between $80 and $90, giving the market a P/E of 14 in a zero interest rate environment. Valuation is more than satisfactory. Our view is that profitability must expand beyond the financial sector. The financial sector has accounted for a disproportionate percentage of the earnings of the S&P 500 since the recovery from recession lows. We believe that earnings growth is now picking up for the other sectors as well. That does not mean that we do not have other headwinds to address. Housing is still a problem as the government programs have had difficulty in addressing the foreclosure issue. Household debt is still at record highs and bank lending is at very subdued levels. The recently passed healthcare bill will further compound the deficit problems facing the federal government. We are not commenting on the need or rationale for the program, but 30 million people cannot go onto Medicare or Medicaid and result in a lowering of costs. It defies logic (or maybe even common sense) and our government has never been good at accurately projecting the ultimate costs of the programs enacted. That is even before we address the looming budget deficits at the federal and state level associated with other entitlement programs.
What we have is a recovery that may turn out to be weaker than past recoveries, but nonetheless economic activity has picked up. Unemployment levels are not coming down quickly and economic growth is going to be lower than past recovery levels. Inflation will be modest and interest rates perhaps moving to 4 to 4.5% should not be a deterrent to further stock market gains. Companies are not expensive from a valuation perspective and the recovery is taking hold.
The current market tone is not one of extreme bullishness, but recovery and mending has started as reflected in the 5.6% GDP growth referenced at the outset. Personal income and spending have turned up despite unemployment at stubbornly high levels. Retail sales had a strong first quarter. Car and truck sales aided by the “cash for clunkers” program have turned up. Granted, 11 million units are far below
the 16 million recorded in the 2007 period, but up a million plus from the recession lows.
We are “on the mend” but without clear sailing. We are confident that that there is more upside opportunity in this recovery, but wondering how we are going to close budget gaps without derailing economic growth. Meanwhile, it is our view that there is more upside to the stock market.
MARKET ORIENTED CORE STRATEGY & OUTLOOK
Our Market Oriented Core Strategy was up 4.5% in the first quarter, lagging the S&P 500 benchmark which was up 5.4%. It was a solid quarter for our Market Oriented strategy. As we move into the recovery phase of the stock market, stock and sector selectivity will become dominant factors in future performance success. The initial rebound of the worst performing stocks coming off the bottom and leading the mid 2009 recovery is over. The market began to enter a more discerning phase over the last six months as evidenced by the improved performance of the highly ranked stocks within our selection model.
Despite the fact that financials were the best performing sector in the quarter and we are significantly underweight that sector, we more than held our own. The consumer discretionary, health and information technology sectors (our biggest overweight in comparison with our S&P 500 benchmark) compensated for our underweight of the top performing sector. We still cannot get comfortable with the balance sheets of the major “too big to fail” money center banks. JP Morgan Chase is the only major bank we own and we believe that their balance sheet and business strategy have proven to be less risky than those of its competitors.
OUTLOOK
The US stock market, despite negative “news media focus” extended its gains from the March 9, 2009 lows. Economic growth (GDP) in the 4th quarter coming in at 5.6%, as a combination of inventory rebuilding and consumer spending, helped surprise on the upside. The environment remains positive for the US market, although this recovery may be less robust than previous recoveries due to persistent high unemployment, lagging home sales, rising foreclosures and budget deficits at the state and local levels which will be drag factors in this recovery. However, that does not mean that one cannot earn good stock market returns in this slower growth environment.
We had strong performances from a diverse group of companies. Mylan Labs and Express Scripts both generated returns in excess of 15% in the quarter despite the overhang of the vote on healthcare reform during most of the quarter. On the consumer front, Nike continues to extend its market share by building its global franchise. The Nike “swoosh” has become a world recognized trademark. Priceline, the online travel agency also had a great quarter with revenues exceeding expectations. The disappointment in the quarter was the energy sector, which detracted from our performance. However, we still see those companies doing better as the world economy recovers.
It is easy to become negative based upon the news media but one can ask if things are that bad, why are retail sales increasing, economic growth up 5.6%, consumer confidence rising and earnings of the S&P 500 projected to come in at $80 to $90 dollars a share, providing a market with a reasonable P/E of 14 or 15?
What we do see is a positive year for stocks and more importantly, our Market Oriented core strategy is starting to identify those companies that can deliver excess price performance during this recovery period. We see a major rotation into stocks that have a global footprint (IBM, 3M, and McDonalds) and those that have a highly defined competitive advantage, such as companies like Akamai Technologies, Citrix and Oracle in the technology sector where companies are now expanding their technology capital expenditure
budgets.
It is reasonable to expect a pullback in the market after the strong recovery bounce. However, we are both optimistic and realistic about the remainder of 2010. There are concerns, but in our judgment, not enough to derail the recovery that started in mid-2009.
Our Worldwide Equity Strategy was up 4.6%, outperforming the Global Equity Index’s return of 4.5%, but lagging the S&P 500’s return of 5.4%. Our Worldwide Balanced Strategy was up 3.6%, also outperforming its Global Balanced Index which was up 3.4%.
We are pleased by our first quarter 2010 returns and by the fact that the market continues to rally off its March 2009 lows. Our underweight in the financial sector, which was a one of the top performing sectors in the quarter, was a drag relative to our benchmarks, but strong performances from other sectors and stocks in the portfolio positively impacted our results. The banking sector bounced back strongly in the quarter and we are underweight those companies. In fact, JP Morgan Chase is the only large money center bank that we currently own. American Express is the only other financial sector stock that we currently own. We are not comfortable that all the issues affecting the other banks have been resolved. We recognize that the market has subscribed to the “too big to fail mentality,” but we don’t believe that qualifies as an investment thesis although it would have been advantageous if we had shared that point of
view.
Regardless, we had some outstanding performers in the quarter. Teva Pharmaceutical, the Israel based global generic drug company, had a strong quarter and just announced its acquisition of Ratiopharm, Germany’s large global generic drug company. It is rapidly gaining market share as countries struggle to control drug costs by encouraging the use of cheaper generic drugs. Honeywell, through strong cost control and improving productivity, was our best performer in the quarter, up over 15%. Baker Hughes and CVS/Caremark also contributed double digit returns.
For our balanced accounts, our bond allocation underperformed the Barclays Intermediate Government Corporate Index as we have chosen not to extend maturities. We believe that the Federal Reserve is going to tighten monetary policy and we would prefer not to hold longer term issues, albeit giving up some current yield.
OUTLOOK
We are optimistic about 2010. That does not mean that we will not have a setback sometime during the year. The US stock market, despite negative “news media focus,” extended its gains from the March 9, 2009 lows. Economic growth (GDP) in the 4th quarter came in at 5.6% as a combination of inventory rebuilding and consumer spending which helped surprise on the upside. The environment remains
positive for the US market, although this recovery may be less robust than previous recoveries due to persistent high unemployment, lagging home sales, rising foreclosures and budget deficits at all levels of government which will be drags in this recovery. However, that does not mean that one cannot earn good stock market returns in this slower growth environment.
It is easy to become negative based upon the news media but one can ask if things are that bad, why are retail sales increasing, economic growth up 5.6%, consumer confidence rising and earnings of the S&P 500 projected to come in at $80 to $90 dollars a share, providing a market with a reasonable P/E of 14 or 15?
What we see is a positive year for stocks. We are overweight the Technology, Healthcare and Energy sectors. Technology is cheaply valued and corporations are starting to reallocate funds to IT budgets. As we said in previous outlooks, capital spending for improved productivity can only be postponed for a limited time as companies begin to lose ground to the competition.
It is reasonable to expect a pullback in the market after the strong recovery bounce. However, we are both optimistic and realistic about the remainder of 2010. There are concerns, but in our judgment, not enough to derail the recovery that started in mid-2009. There are major problems at the federal and state levels with respect to budget deficits which will be a drag on economic growth, but those problems are a bit further away in our opinion, although not to be considered inconsequential.
