Response to a Client

I had a long client meeting on Friday afternoon.

The client - actually, an investment committee of four pretty smart people - asked a number of questions. I enjoyed the meeting, even though a number of the questions were fairly pointed and difficult.

They asked if I would send them a follow-up memo today. I just finished it, and thought I would share it with you:

Thanks for taking the time out of a very busy day on Friday to get together with me. I am glad we had the chance to discuss some of the issues around the portfolios, and look forward to future meetings.

I wanted to get back to you on the three questions that you raised on Friday:

1. What do I see happening in the market?
2. What investment recommendations do I have for the portfolios?
3. How can you help implement my suggestions?

Market Outlook

In my opinion, the most important trend in the economy and the market is deflation. The lack of inflation – and the possibility that general prices may fall – has caused interest rates on most investment grade bonds to drop to very low levels.

For example, as I write this note, the 2-year Treasury note is yielding 0.55%, and the 10-year Treasury note is yielding 2.95%. Most corporate bond yields have also dropped dramatically – e.g. IBM sold 3-year notes this morning yielding slightly more than 1%.

The challenge for investors and savers, then, is how to get their investments to grow without taking too much capital risk. At the present time, there are only two alternatives: longer maturity (beyond 8 year maturity) or common stocks.

Longer maturity bonds can offer some principal protection but could drop in price if interest rates rise. Moreover, although bonds can usually be sold prior to maturity, many investors are “buy-and-hold”, and so view buying a longer maturity bond as tying their money up. For this reason, many are reluctant to buy longer maturity bonds.

Which leads to stocks. I believe that investors will reluctantly be forced to return to the stock market simply for lack of any viable alternatives. In addition, I believe that dividend-paying stocks will be favored, especially by older investors who need income for living expenses.

The fundamentals for stocks are mixed. Second quarter earnings results were reasonably good, albeit against easy comparisons (the first half of 2009 was marked by very poor economic conditions). However, corporate earnings goals have been met by cost-cutting, since sales growth in general has been muted. I do not expect this trend to change any time soon. Unfortunately, this also implies a continued high unemployment rate, since companies will be reluctant to add to payrolls and increase costs without any clear sign of a resurgence in demand.

Still, with no particularly good alternatives, I think the outlook for the stock market is modestly positive.

Risks to my outlook include the possibility that the Fed might aggressively intervene in the credit markets to try to prevent deflation. In the past, prior to becoming Fed Chairman, Bernanke had given a couple of speeches in which he laid out the course that the Fed could use monetary policy to reverse deflationary trends. If the Fed acts in this fashion (and I am not sure that politically it would fly), it could reverse the deflationary trends, but set up a return of inflation in the years ahead. Inflation is the enemy of all investments.

Another possible risk would an economic relapse lead by a further decline in housing prices. Housing recovered earlier this year, but a good part of the resurgence was due to a combination of fiscal (i.e., tax credits) and monetary (Fed buying mortgages) stimulus. If housing slows again even in the face of historically low mortgage rates, this could tamp out any economic recovery.

There is no doubt this is a difficult investment environment. Interest rates are low, and it is not really possible to find a riskless investment offering attractive yields without extending the maturity of the bonds in your portfolio.

Many stocks offer dividend yields well in excess of the bonds issued by the same company, so on the surface it would seem to make sense to simply buy stocks. Of course, stocks are more volatile, so that investors need to have a longer time horizon to be in the stock market today.

It seems to me that the kind of frank discussion we had on Friday is helpful in airing the issues that you and I are facing.

I hope this memo is helpful. Please let me know if I can provide any further information.

Thanks,

Dave