Friday, January 8, 2010

"After the Flood" - Excerpts from My Fourth Quarter Letter

After the Flood

Stocks dropped relentlessly during the first two months of last year. In just the first 68 days of 2009, the S&P 500 plummeted -25%. Then, in one of the most remarkable capital markets turnarounds in US history, stocks soared by +65% in the next 10 months, and the market wound up the year posting solid gains.

The reasons for the turnaround are varied, of course, but to my mind the most important factor was the Federal Reserve. Led by Chairman Bernanke, the Fed unleashed a torrent of liquidity into the financial system in a series of innovative and creative techniques. Among their efforts were the so-called “quantitative easing” measures which drove mortgage rates lower and stabilized the housing market.

So far, so good. Only problem is: what does the Fed do now?

Nearly all are in agreement that the US central bank will need to gradually withdraw its support from the financial markets. It is neither sustainable nor desirable for the US government to be the sole supplier of credit and financial support. Moreover, once the economy begins to show signs of real improvement, the welcome flood of monetary stimulus that the Fed provided last year could lead to significant inflationary pressures.

Some would argue that the bond market is already anticipating higher inflation through the recent upward move in longer term interest rates. Although the posted federal funds rate remains 0% - 0.25%, longer maturity US Treasury yields have moved from 2.5% to 3.8% in the last 12 months, despite Fed protestations that they will be keeping rates low for the foreseeable future.

In short, the economy is improving, and the financial system has been pulled back from the brink of disaster, largely helped by the Fed’s flood of money into the system last year. The challenge for 2010, then, will be to find the optimal investment balance in a world where Fed- provided liquidity is receding from the market.

Consensus earnings estimates for 2010 call for S&P earnings to be up +24% for the year, followed by a +21% rise in 2011. Low interest rates and rising earnings estimates typically lead to good stock market performance, so we would seem poised for a another positive year. Stock sectors that we currently think are attractive include health care; technology; energy; and utilities. We are more cautious on the consumer discretionary area, especially after the strong move that retail stocks made at the end of last year.

Risks to stocks lie mostly in the credit market, as they have for the past two years. If the Fed moves too aggressively to remove its stimulus, for example, the economy could falter, causing earnings to fall short of current expectations.

By the way, in my opinion, I would be careful to simply assume that longer maturity bonds are risky at this juncture. The overwhelming consensus of investment managers seems to be that interest rates are headed higher, which could mean that all of the “bad news” is already in bond prices. Moreover, one only has to look across the Pacific Ocean to Japan to see an example of a country where a financial crisis lead to 20 years of low (below 2%) interest rates.

My New Blog: “Random Glenings”

I recently started a blog ( where I publish various articles that may be useful in thinking about today’s investing issues. I will also be including various financial planning articles, including thoughts on such topics as Roth IRA’s and discussions on changes in the estate tax laws.

I hope you will have the chance to take a look at it. Please do not hesitate to let me know if you have any suggestions to make the site more useful.