Heads or Tails - Special Economic Report

The question lately is which way is the stock market moving? Well, first off, we need to determine which way the economy is moving. Usually, I am not at such a loss for sensing which way the economy is going. However, on one hand there are many positive indicators and on the other hand there are many negative factors. I understand the frustration of an economist in the sense that they spend their entire life studying the markets and even then they are usually only half right. If you had that kind of track record in most businesses you would be sitting in the unemployment office.

The markets however, are dynamic, moving, and ever changing. The factors leading to this are that people, companies, and countries make up and influence the markets. What appears normal and status quo today may be outdated and out of the norm six months from now.

Adding to this are the problems that appear that no one sees coming. A few examples of past incidents such as terrorism, accounting scandals, market panics and manias, wars, and gas shortages. What will be the new problems that we don’t see coming? It is anybody’s guess but top on my global list will be water shortages in many areas, fossil fuel shortages, medical crises such as an unpredictable flu strain or worse, continued terrorism using newer techniques unknown to us, currency crises of several countries since money seems no longer to be backed by much, and geo-political tension with the advent of several newer countries possibly possessing atomic weapons. Hint, think Iran and North Korea.

If that was not enough we need to look at the problems facing just our country alone such as a large trade deficit, a large budget deficit, raising medical prices, lack of funding for future social security benefits and Medicare benefits, and an aging population. Compounding these problems and making them far worse is a complete lack of backbone in our politicians to address any issue of real importance with integrity and substance. In short, our politicians are not really solving any problems lately!

If this wasn’t enough, how about our increasing reliance on a service economy? Who thought up that one? What person or think tank would see that as the way to grow a country into prosperity? History has shown that you must offer something of substance and value over time to receive good things back such as a living wage for your people and a prosperous country for future generations. A service economy will only last so long. I note that Japan and Germany have not abandoned their manufacturing economies and they are exporting far more than they import! Our service economy reminds me of a luxury car sitting in the driveway with no gasoline in the tank. It may look pretty but it will serve no real purpose in getting you to where you want to go!

Keep in mind the recent release of hot air out of the residential real estate market shows how vulnerable we are. Not to mention that the equity markets have been moving too far ahead of their 200 day moving averages, or that some big money folks are getting out of the market. But, before you think that I am a little negative, read on…

While I feel that heads of many public corporations are paid way too much in compensation, I believe many of these large corporations are enjoying tremendous free cash flow. And where there is free cash flow there are profits! Profits usually lead to increased share prices. Add to this the continued liquidity in the markets. Both here in the U.S. and abroad, there simply is no shortage of cash. Private equity groups have also been illustrating this fact with a good amount of corporate buy outs recently. Imagine a private equity group buying out Chrysler. No one saw it coming. Note, that current P/E ratios are not at all excessive for large companies such as those making up the Dow Jones Industrial Average and companies making up the S&P 500. In fact, many growth stocks are now looking cheaper than value stocks. This is occurring due to normal market rotation. Many investors were chasing smaller size companies and also investing into mostly value style company stocks.

Actually, market rotation is the normal course of events. It occurs when investors go from side of the boat to the other. First, they may be invested into only large size companies, and then they wake up and realize that those stocks are overvalued. So you guessed it…they head over to smaller size stocks which had not participated in the great rally of 1981-1999. So once they run up the prices there (which they have), then it is back to large cap stocks. Likewise, investors loved the American equity markets in the 80s & 90s, yet lately they have been in love with the foreign markets. So, expect that love affair to lessen in the next few years and for investors to rediscover what’s good about American companies. So what is good about the American companies? Think earnings, established management teams in place, a strong rule of law in our land, and importantly the probability of consistent dividends to be had in the near future. As baby boomers get older I expect many large American companies to focus more on paying out dividends. That is a good thing, since baby boomers will need the money to live on during retirement.

In my opinion many large American companies are priced at attractive prices. However, having said that, you can not fight the market. If you attempt to buy and hold these stocks you may miss out on other investments that will outperform them in the near term and also see your current holdings drop during that time. So how do you play this type of market? Very carefully!

While I like the markets, I am very cautious at this point in time. Why? Currently I feel the leadership of the Federal Reserve is employing a policy of tight money and also are keeping us in the dark. While they state this want to fight inflation by increasing interest rates they also state that they are in no hurry to do so. So this thought line automatically cancels out an interest rate drop which would be so great for the housing market and the stock markets. Why would they proceed with this course of action? They do not want to see the stock market explode upwards with speculative gains based solely on an interest rate drop nor are they sad that the recent bubble in personal real estate has started to deflate. In short, the Federal Reserve has us in a place that is equal to a flip of the coin. Heads, they lower interest rates and the stock and housing market goes up, or Tails, they increase interest rates to fight inflation, increase the value of the dollar but risk sending us into a recession due to the weak housing market.  Make no mistake; any interest rate increase would pummel the housing market just as it tries to stabilize. So here we are…facing a flip of the coin. Does the Federal Reserve lower interest rates or increase them. Keep in mind that even if they do nothing that still will be a decision that has consequences. Too much hanging on one factor if you ask me.

So once again, how does one play this type of market? Carefully and by focusing on global growth and income with a value bent. Ignore the hype and only buy companies making money and paying some of that money out in the form of a dividend. Also, do not ignore good bond managers and importantly think global bonds as well to protect yourself from a further drop in the dollar. I have some common sense suggestions:

• We have been moving our clients into balanced asset allocation models with notable bond positions and international equities.
• We have reduced our clients’ equity exposure (remember the Wall Street adage, “Pigs get fat, hogs get slaughtered.”)
• We have used several investment strategies that stress dividend paying stocks with a value bent.
• We are using proven fund managers, who have experience with these types of markets. Think of the top names in the bond and equity management business.
• We have transferred market and financial risk to insurance carriers who have the financial strength to guarantee that those investors involved will always get a minimum income stream for the rest of their life (and spouse if elected) regardless of market downturns.
• We follow what is working in the markets and move with it if it makes sense and move away from what is not working.
• Taking into account as much as possible the global macroeconomic trends we invest into those items that look bullish over the future. Hint, Foreign REITS are one example.

While I think these steps will allow our clients to fully participate in the markets with far less risk than other investors will face, there are no guarantees. Only by evaluating what your true comfort level is and designing a portfolio to suite your needs can we hope to maintain a strong relationship with our clients. And make no mistake that is our intention.