MARKET ENVIRONMENT AND OUTLOOK
The 4th quarter of 2009 was another solid recovery quarter for the stock market. The S&P 500 was up 6.0% for the quarter, the MSCI-EAFE up 2.2% and the Barclays Intermediate Government/Credit index up 0.3 %. The S&P 500 finished the 2009 calendar year up 26.5% and the MSCI-EAFE, representing non-US stocks, was up 32.5%. The Barclays Intermediate Government/Credit index finished the year up 5.2%.
Calendar 2009 provided an excellent opportunity for investors to earn back some of lossesassociated with the global financial meltdown of 2008. It was not without some trepidation as no one could (or can) predict the exact impact of the various government programs that have been implemented. What can be said is that providing liquidity to the financial system on a coordinated basis with other central banks around the world has circumvented a depression type scenario. A lot of money has been placed into the system to stabilize employment, repair balance sheets, support state unemployment programs and salvage jobs in the automobile industry (General Motors and Chrysler). As Chairman Bernanke said, “we see some green shoots but we are still a long way from where we were.”
As the economy recovers, we are already observing differences in this recovery from previous recoveries. The expected growth rate is forecasted at 3 to 4%, much lower than when coming out of previous recessions. The consumer is cautious, saving more and paying down credit card debt. Housing is still under duress with an estimated 25% of mortgagees in the United States under water; the current value of the house is less than the mortgage. Clearly, the seeds planted in programs designed to forestall foreclosure and modify loans have been slow to bear fruit.
OUTLOOK
In the twenty five plus years that we have been writing these quarterly pieces, we never knowingly repeated what we may have said previously. However, in reading the commentary that we sent to you in the 3rd quarter, we find that what we said then is just as appropriate now. Therefore, we’ve reiterated our previous outlook and placed our updated comments in italics. Our view is that stocks will outperform bonds and cash over the next 12 to 18 months. We must admit that view is based upon current expectations that the economy will show continued signs of recovery as the global economy picks up.
GDP is forecasted to be in the range of 3 to 4.5% for 2010. It is less robust than in past recoveries, but moving in the right direction.
What are we looking for?
- We want to see housing sales begin to pick up and foreclosure activity level off. We still have not seen improvement here. Housing prices still have more to fall and the foreclosure modification programs are not working as designed.
- JOBS! There is no sustainable recovery until corporate America begins to once again hire workers. The major consensus is that unemployment has not yet peaked. More than likely, we will see 10% unemployment before we can say we are on the way to asustained recovery. Unemployment has always been a lagging indicator (by the time itpeaks, the rally in stocks is well underway) and we hope that it is true this time around as well. Unemployment has hit the 10% target and may move higher. The good news is that the job loss rate has slowed.
- The consumer needs to rebuild his net worth. This will happen when corporate America begins to invest new capital in plant and equipment and starts to rehire. While this is happening, consumer spending will be restrained. The consumer is feeling better about his/her net worth as retirement assets and investments have rebounded. However, consumer credit is still contracting which detracts from building a stronger economic recovery.
- We want to see top line revenue growth. Company earnings outside of the financial sector have held up very well but most of the improvement in profitability has come from cost cutting, i.e., personnel and IT budgets. Although IT spending should be up, we are only now starting to see evidence of an upturn.
- We want to see fiscal discipline restored to federal, state and local community budgets. We see a real conflict developing between the public and private sector where public sector wages and benefits outstrip what the private sector can offer to its employees. The difference is that the public sector is an employee of every taxpayer and the taxpayer is going to revolt. Contraction in public sector employment is inevitable unless changes are made to salaries and benefits. This has not been resolved; there continues to be major issues at the state and local levels due to past poor decisionmaking by elected officials.
- We would also like to see both political parties work together in a bi-partisan way to address the major issues. We are political agnostics but a greater feeling of cooperation in Washington would do wonders for Main Street. The fight over health care has shown that there is no willingness for reaching a bi-partisan consensus.
In summary, some progress has been made on most of the issues that we identified in last quarter’s commentary. Employment is key if we are to resolve the foreclosure issue and restore consumer confidence. We are in uncharted waters where a massive amount of government spending is the engine that is laying the groundwork for recovery. At some point, the private sector has to step up to maintain the economic momentum. Meanwhile, we are “on the mend,” but we expect a more uneven recovery as we adjust to the deleveraging impact that we are experiencing.
MARKET ORIENTED CORE STRATEGY & OUTLOOK
Our Market Oriented Core Strategy was up 6.7% in the 4th quarter, outperforming the S&P 500 benchmark’s return of 6.0%. Although making money for our clients, the year’s performance was disappointing with the preliminary calendar year numbers indicating a return of 10.6% compared with the S&P 500 return of 26.5%. Obviously, on an absolute basis, the number is disappointing but not inconsistent with previous bear markets where our quantitative strategy lagged as the lower ranked stocks bounced off the bottom.
We recognize that it takes a certain leap of faith on your part when we say that the results are consistent with our research. The point we made in last quarter’s commentary is that quantitative based, fundamental strategies do not always conform to discreet calendar periods but need to be assessed over a market cycle. At the risk of being boringly repetitive, our Market Oriented Core strategy held its own in the down market segment that started with the market peaking in October of 2007 and bottoming on March 9, 2009. We did not build as much of a defensive margin over the benchmark index as we have in previous bear markets. This was due to the fact that the majority of the market collapse occurred quickly, in two distinct time frames: October/November of 2008 and January/February of 2009. In the past, most
bear markets have provided adequate time for quantitative rankings to adjust to changes in the expected price performance of a security. The short and unprecedented time frame did not provide an opportunity for the rankings to defend better in the down market environment. We performed better than the market during the down cycle but not as well as we have in previous bear markets. Therefore, the bounce off the bottom left us lagging more than usual, especially with 24% of the S&P 500 selling at less than $10 a share on March 6, 2009. As you would expect, those stocks did not rank well within our system but were the leaders in the first few months of the recovery.
OUTLOOK
We are only 10 months into the market recovery. Because we underperformed the market during the 2nd and 3rd quarters of 2009, which were the two primary “bounce back” quarters of the market recovery, we are lagging across the full market cycle (October 2007 through December 2009). The recovery is not over and our expectation is to close that gap before the up market cycle, which began in March 2009, is completed.
We made the statement previously that we believed the market had seen its lows in March of 2009 and we have no reason to change that view. That is not to say that we are without future headwinds. However, because of the massive amount of stimulus money that has been committed, we have averted a global financial meltdown. Economic growth (Gross Domestic Product) in the first half should come at 3.5% to 4.5%, positive but not as robust as in previous recoveries. Although the stock market has responded favorably to the prospect of an improving economic environment, we are still facing some large hurdles.
Our quantitative rankings have begun to shift toward the higher quality companies with an expectation of generating both positive earnings momentum and a high level of free cash flow. We are very cognizant of the issues that are yet unresolved. Despite the vast commitment of dollars from the federal government, a sustained recovery is still facing major headwinds. Unemployment is at stubbornly high levels and may be headed higher. The cut back in state and local spending is an additional growth impediment, while consumer sentiment has been negatively affected by a reduction in personal net worth.
We are of the opinion that there are areas of the market that are poised for growth, despite the looming issues of concern. Stocks are no longer as undervalued and are now more dependent on earnings followthrough. We are optimistic that we are on the mend, but very much aware that we are still faced with a two trillion dollar federal budget deficit, a seemingly fractured Congress and the need to bring down
unemployment levels. Job loss from the private sector has started to bottom which is a good sign. However, private industry needs to step up and invest in new technology, hire workers, in turn, bringing down unemployment and providing stronger underpinnings to the housing market. An increase in employment would solve a multitude of issues such as housing overhang, declining tax revenues at the state and local level, and consumer confidence/spending.
We have a great long term track record which is why you have chosen to allow us to invest your assets in our Market Oriented Core Strategy. We have not lost confidence in our ability to generate superior returns. Our objective in the next 6 to 9 months of this up cycle is to confirm that our strategy is working as designed and as such, meeting your expectations.
We thank you for your support and certainly do thank you for your confidence in us.
Our Worldwide Equity Strategy was up 7.0% for the 4th quarter 2009, outperforming both the Global Equity Index return of 5.3% and the S&P 500 return of 6.0%. For the 2009 calendar year, the strategy finished up 30.9% in comparison with the Global Equity and the S&P500 indices, which were up 27.7% and 26.5% respectively. Our Worldwide Balanced portfolios also outperformed the benchmark for the quarter with a return of 5.2% vs. the Global Balanced index return of 3.3% and for the calendar year with a return of 21.4% vs. the benchmark’s return of 18.8%.
The numbers speak for themselves. We are pleased that we have taken the first step in earning back some of the assets that were given up in 2008 and early 2009. As you well know, we held our own during that period but for all practical purposes, it was a pyrrhic victory because of the severity of the downdraft. Nonetheless, we are more than pleased that we have restored a good portion of what was lost and hopefully, if the markets cooperate, we will build upon that base in 2010.
Our portfolio responded well following the market bottom on March 9, 2009. We had top performing stocks in a variety of sectors. For example, in calendar 2009, Peabody Energy was up 98%, American Express was up 118%, Joy Global was up 125%, and Cymer was up 75%. It was a quiet year for sales turnover. The portfolio we owned at the beginning of the year was attractively priced and had, in our opinion, substantial upside potential. When looking for new stocks to add to the portfolio, we often found that the companies that we owned represented better value than those that we were analyzing. Our newest purchase is Accenture, a global IT consulting company that designs data centers, consults for multi-national corporations and provides input in systems design. The company is well positioned to capitalize on the upturn in capital spending in the technology sector which we believe is poised for growth. Companies can only postpone investments in productivity enhancing technology for a limited period of time before falling behind their competition.
We also continued our purchase of short term, high quality corporate bonds, with yields and return potential that exceeded that of US Treasuries. For balanced accounts we still see value in the corporate bond sector, but the attractiveness from a pricing standpoint has diminished as interest rate spreads have narrowed between high quality corporate bonds and US Treasuries. Overall, we are pleased that our view that the market had bottomed in March of 2009, following the massive injections of liquidity by the central banks around the world, was substantiated by above benchmark returns. The key issue is what to expect for 2010.
OUTLOOK
We made the statement previously that we believed the market had seen its lows in March of 2009 and we have no reason to change that view. That is not to say that we are without future headwinds. However, because of the massive amounts of stimulus money that has been committed, a global financial meltdown has been averted. Economic growth for the first half of the year should come in at 3.5 to 4.5%, positive, but not as robust as in previous recoveries. Although the stock market has responded favorably to the prospect of an improving economic environment, we are still facing some large hurdles.
We are very cognizant of the issues that are yet unresolved. Despite the vast commitment of dollars from the federal government, there are critical issues to be resolved. Unemployment is at stubbornly high levels and may be headed higher. The cutback in state and local spending is an additional growth impediment, while consumer sentiment has been negatively affected by a lack of income growth and a
reduction in personal net worth. We are of the opinion that there are areas of the market that are poised for growth, despite the looming
issues of concern. Stocks are no longer as undervalued and are now more dependent on earnings followthrough. We are optimistic that we are on the mend but very much aware that we are still faced with a two trillion dollar federal budget deficit, a seemingly fractured Congress and the need to bring down unemployment levels. It appears that job loss from the private sector has started to bottom, which is a good sign. However, private industry needs to step up and invest in new technology and hire workers which, in turn, bring down unemployment and provide stronger underpinnings for the housing market. An increase in employment would solve a multitude of issues such as housing overhang, declining tax revenues at the state and local level, and consumer confidence/spending. We own well positioned companies, many with a global franchise, good dividend support and solid balance sheets with high levels of free cash flow. We remain overweight the technology and health care sectors, while underweight financials. As we stated in previous commentaries, what was given up in the 2008 and the first two months of 2009 cannot be recouped in 12 months. We had a severe bear market in a very compressed time frame, despite the fact that valuation, interest rates and inflation were not issues. Government spending has replaced private investment to help the first leg of the recovery. Calendar 2010 could be the transition year as private capital and spending starts to replace government stimulus which is the objective of a free market economy.
We thank you for your support and certainly do thank you for your confidence in us. Please feel free to contact us if you have any questions.
