Thursday, July 1, 2010

Second Quarter Review

From the Desk of Joe Rollins

Nearly every day, I find myself reading the most negative and contradictory financial information that I have seen in a long time. It’s hard to reconcile the fact that the economy is actually in fairly good shape with the proclamations of the dire financial consequences we will soon suffer that I read and see on TV. While it’s true that unemployment is still high, it’s important to note that the economy has turned positive. Furthermore, there’s little doubt that the rest of 2010 will be economically positive. In spite of that, I hear all over the news that the country is falling into a double-dip recession. Wrong!

There’s no question that things could have done better financially over the last three or four years. However, the fact that we survived the tremendous credit scare just goes to illustrate how resilient and adaptable the U.S. economy is. While unemployment increased and many people suffered the negative effects of unemployment, the damage to the overall economy was fairly well held in check. There will be additional months of hard times for Americans, but I think unequivocally it could be pronounced that the worst is in the past. Yes, unemployment is at 10%, but maybe we should focus on the 90% employed.

Unfortunately, the financial results for the equity markets for the second quarter were discouraging. However, after an almost 80% increase in the S&P 500 from March 9, 2009 through March 31, 2010, it’s not unexpected to have a pull-back of some kind. While the correction has not been fun, it has only been shallow and controllable. For the six months ended June 30, 2010, the Dow Jones Industrial Average has a total return of -5%, the S&P Index of 500 Stocks has returned -6.7%, and the NASDAQ Composite has returned -6.6%. While these certainly are not robust returns, they can’t be classified as devastating, either. The major market indices were down 4% in the last two trading days of the quarter – this definitely isn’t the move of investors; it’s the speculators. The composite return of the Rollins Financial managed accounts is down -2.88%. That loss is only half of what the major market indices have suffered.

It’s important to put the year-to-date numbers in perspective, given the enormous increase in the equity markets last year. Even though the major market indices are down single digits for the first six months of this year, if you look at the one-year return on these same indices, things do not appear to be as negative. The Dow is up 19% for the one-year period ended June 30, 2010; the S&P is up 14.4%, and; the NASDAQ is up 16.1%. As you can see, these one-year returns are quite robust. All too often we focus on daily, weekly and even quarterly returns when we should be more focused on the long-term. Even though the major market indices are down for the year, they are only down a small amount, and those losses could effectively be reversed in a trading period as short as one month.

During the second quarter of 2010, we were bombarded with the negative news out of Europe and the ongoing battle between governments needing to balance their budget, yet their desire is to stimulate the economy. Recently, the G20 met in Canada and decided to reduce their respective countries’ deficits by 50% over the next three years. This goal is definitely honorable, but it’ll be virtually impossible to reach. Only Great Britain is taking the most difficult steps of dramatically cutting their federal budget and also raising taxes even though their economy is in recession. Unfortunately, the United States is not following their lead – although we are increasing taxes dramatically (which is very, very wrong); we have not taken any steps whatsoever to reduce federal spending.

What’s even more interesting about this recent downturn in the stock market is that it is based in a time when corporate earnings are just exploding to the upside. In fact, by every reasonable measurement, the U.S. stock market is as cheap as it’s been in a long time. Corporate cash on the balance sheets of major corporations is at an historic high, and corporate earnings are likely to set an all-time record during the third quarter of 2010. Isn’t it ironic that at a time when corporate balance sheets are in their best condition ever and corporate earnings are at their highest level in our financial history, stock market pessimism is overwhelming?

I couldn’t help but be bewildered this morning when I saw former Georgia governor Roy Barnes’ campaign commercial. As most of you know, he is running in the 2010 race for Georgia governor. In my opinion, Barnes is a classic “tax and spend” Democrat who doesn’t seem to understand the economics of running a government. That is why he was voted out of office the first time!

Two different commercials for Barnes were aired within two hours. The first was blatantly aimed at acquiring the votes of the teachers unions by guaranteeing that educator salaries would increase. He stated that the quality of education would increase by increasing teacher salaries. Maybe over the long-term that would be true to attract better educators, but over the short-term, it only pays the same teachers in the system more money. I question whether the 4% to 5% increase in compensation would serve to attract new and better teachers to the profession, but it will almost assuredly get votes from the very strong and important teachers union. The real question is who will pay for these higher salaries? You may rest assured it will be our tax dollars.

Perhaps someone should explain to politicians that giving government employees a raise does not make the economy better. If you give one group a raise by taking money from another group through higher taxes, then isn’t that a net zero? Duh!

The second commercial indicated that Barnes would immediately place 10,000 contractors to work renovating the buildings owned by the State of Georgia. While that’s a desirable act, it doesn’t explain where the money will come from to accomplish that project. It seems that politicians just cannot keep from spending your tax dollars.

I don’t need to write a long dissertation on why the first stimulus bill of the Obama administration failed since now even they concede that fact. They certainly wouldn’t be asking for more stimulus money if the first stimulus act had been successful. There are many reasons for its failure, but it only seems that they want to continue repeating those mistakes.

First and most importantly, the majority of the stimulus bill still hasn’t been spent. Even though we were looking for shovel ready projects, here we are almost a year and a half later and that money has failed to be spent. That’s your government in action. Hopefully once this money finally filters out from Washington over the next six months, it will help employment.

The part of the stimulus act that continues to baffle economists is the money that the federal government spent to subsidize poorly run state budgets. In fact, the new stimulus act recommended by the President proposes even more to state governments. Transferring the federal deficit to cover state deficits hardly provides any economic stimulus. Yes, it’s perfectly possible that some teachers and firemen would have their employment extended, but it’s only temporary. Since almost all states are required to balance their budgets annually, it is impossible to create long-term employment when the government subsidizes deficit in one or two years. We can only hope that Congress will finally adopt common sense and not approve a new stimulus bill. In fact, the U.S. economy would be much better off if the federal government got out of the economy’s way and just let it grow with its own momentum.

Many of my clients have expressed outrage with the federal deficits and congress’s complete inability to deal with those deficits. I agree, but unfortunately it seems like congress is only increasing those deficits instead of dealing with them. These deficits will have very negative, long-term financial consequences for this country. They must be dealt with reasonably and efficiently by our government, but to this point, our government has given no indication that they have the capacity or will to do so.

As bad as that financial condition is, quite frankly, it isn’t something that needs to be dealt with today. If any reasonable politician would come out with a plan to reduce the federal deficits and get back to a balanced budget over the next five to ten years, the equity markets would stabilize and confidence would be reestablished. The federal deficits do not need to be reversed in one year, but a plan must be established. Unfortunately, no one in Washington has any such plan at the current time. In fact, it appears that there plan accomplishes quite the opposite – to continue to spend excessive amounts of money with increased taxes and little hope of balancing the budget.

While the negativism of running the federal budget in Washington is a negative for the equity markets, the effect would be felt three or four years out rather than today. Let’s reserve judgment on that economic event until after the mid-term elections, when it is highly likely that a significant number of congress members will be replaced.

I find it almost hysterical when certain members of congress praise their recently passed financial reforms. First, it wasn’t Wall Street that created the financial crisis. It’s amazing to me how often politicians misstate facts to support their own objectives. As I’ve said in the past, every time I hear someone say the words “bail out,” I am outraged when I review the facts and see that Wall Street repaid all of the money loaned to them under the TARP with a significant profit to the federal government, but the car companies and AIG have not even tried. This wasn’t a bail out of Wall Street – but there was a bail out of companies for political reasons. The real cause of the financial meltdown in America in 2007 and 2008 was Freddie Mac and Fannie Mae. Interestingly, this financial reform doesn’t even address them and does nothing whatsoever to limit their incredible damage to the economy. The following chart explains why!

Much like the health care bill, we will soon find out that the financial reforms only add thousands of new federal employees. It will be a gigantic bureaucracy that will essentially make small banks a thing of the past. No small financial institution will ever be able to keep up with the gigantic bureaucratic compliance obligations of this new bill. There are no protections for consumers, and almost everyone’s cost to use bank facilities will increase. Your checking account costs will skyrocket, availability of credit on credit cards will be dramatically reduced, and the availability of credit to small businesses will be slashed. Financial reform? What a joke!

One bright aspect of the quarter was that the return on bonds was positive. Bonds have actually had a great six-month period, but I cannot help but think we are entering the bubble territory for bonds. It’s always good to have bonds in every portfolio since they tend to balance the portfolio and add some income aspects to it. However, it’s important to note that the 10-year Treasury bond is presently at 2.94%, which is trading at one of the lowest levels in our financial history. It is hard to imagine given the extraordinary spending required by our government to finance the federal deficits that just keep getting higher and higher that interest rates will stay low for very long. Therefore, I consider investing in bonds almost as risky as any investment class available today. It is perfectly okay to own a reasonable allocation of bonds, but an overweighting in this asset class could wind up being financially detrimental.

It may seem that I am relaying only the negative news as reported by the financial media, there are positive points that you cannot ignore:

  • Interest rates are at historic lows
  • Corporate earnings are high and getting higher
  • Corporate balance sheets are in the best condition in years
  • Price/Earnings ratio is trading at an almost historic low to future earnings
  • CD’s and fixed-rate instruments are providing virtually no returns
  • European governments are now moving toward austerity and the IMF has brought a safety net to the financial security of these countries
  • GDP is positive and likely to continue being positive for the next two years
  • Unemployment is still high, but it is getting lower every month
There is an incredible amount of good news, as illustrated above. In fact, there is more than enough good news to positively impact the financial markets for the rest of the year. Therefore, it is time for me to make some predictions based upon solid information rather than on speculation and the extreme positions maintained by the financial media:
  1. The second half of 2010 will bring an excellent equity market. This will bring the equity markets to a higher level at the end of the year than where they are today and will be nicely positive for 2010.
  2. Interest rates will increase regardless of what happens in the economy. Basic supply and demand for government bonds will force interest rates up since the supply of bonds will so overwhelm the demand. If that is the case, then bonds will be a bad asset class in which to be invested for the rest of 2010.
  3. Interest rates on CD’s will continue to be low for a few years. The banks have a high desire to make profits. One way for them to do that is by not paying high interest rates on CD’s. As such, CD’s and money market accounts will not be a viable alternative to equity investments.
  4. Unemployment will continue to be high and I doubt very seriously whether it will be much lower over the next two years. By the end of 2011, I anticipate an unemployment rate of approximately 8%. I see no reason why businesses will increase employment over the next two years given the avalanche of anti-business legislation out of Washington.
Given my predictions above, it seems like it’s a great time to be invested regardless of what you see on TV day-in and day-out. If you are currently not invested or are under-invested, now is a great time for you to increase your investments or make your IRA contributions for the current year. I really look forward to reviewing my predictions in January of 2011 to see if I’m correct.

As always, the foregoing comments are my opinions, thoughts and personal biases. In all cases, I could be wrong.

1 comment:

Anonymous said...

Hi. Point out one vote that Barnes made in his 30 years of public service that was a vote for raising taxes.