Investor Optimism Prevails

While revolutions took place in the countries of North Africa and a natural disaster of epic proportion struck the third largest economy in the world, investors continued to believe in and buy stocks.   Though volatile in March, stock markets were not only resilient but produced healthy returns for investors.  Are these investors ignoring geopolitical and economic crises in an attempt to make up lost ground or are they looking ahead at an economy that they expect will make its move into a full recovery? 

It seems the answer is a bit of both.  The U.S. economy is clearly improving with GDP growth forecasts for the remainder of the year coming in at over 3%.  Dr. David Kelly, Chief Market Strategist for JP Morgan, says the global economy as well is moving back into balance and believes 2011 will provide solid returns for many of the world’s markets.   However, spooked investors that spent 2009 getting out of the market have been flooding back with hopes of capturing some of the market momentum.  In the first quarter alone, $33 billion flowed back into stocks and stock mutual funds.  During 2010, $37 billion came out of these funds and in 2008 and 2009, nearly $243 billion exited from stock investments with most of that finding a home in low paying bond investments.  

Clearly there is still a significant amount of cash on the sideline and we’re seeing the momentum from last quarter continue to move markets ahead year to date.  The fourth quarter of 2010 saw double digit returns for broad market indices in the U.S. with smaller companies outperforming their larger counterparts.  For the first quarter of 2011, large U.S. companies returned 5.9% while small company stocks returned 7.9%.  The disruptions in the Middle East drove energy to the top spot returning 16.8% for the quarter.  The laggards were the consumer staple stocks and the financial sector companies with 2.5% and 3% returns for the quarter respectively.  Internationally the stock markets of the developed countries produced a slightly more modest 3.5% as concerns of fiscal issues and slow Eurozone growth kept much enthusiasm in check.  The emerging markets also saw modest growth of 2.1% for the quarter after returning more than 19% in 2010 and a whopping 79% return in 2009. 

The outperformance in small U.S. company stocks may partially be attributable to smaller companies having less exposure to international markets amid a strengthening U.S. economy. Tony Crescenzi, a portfolio manager at PIMCO, believes in the U.S. “there’s more confidence that the economy has achieved escape velocity.”  In our December commentary, we discussed the government’s stimulus termed QE 2, or quantitative easing round 2.  The Federal Reserve used all of their tools to move the economy out of the doldrums.  The recent economic statistics seem to confirm the stimulus has worked even if the recovery has been much less spectacular than recoveries of the past.  The escape velocity that Mr. Crescenzi refers to is the needed pickup in corporate and consumer spending that is needed to maintain economic growth without the artificial boost given by government stimulus.  We’ve seen personal consumption post a hefty gain in February and the March jobs report showed an impressive pickup in hiring by private companies.  We still haven’t seen any real improvement in real estate and housing but personal and corporate finances are improving.  Personal savings rates are back to nearly 6%, a figure that hasn’t been seen since the mid 1990s and corporate profits have improved dramatically.  Corporations are also holding a record $1.9 trillion that they have available for capital expenditures, business investments and ultimately hiring.

The artificial boost in the form of the Fed’s QE 2 stimulus is scheduled to end in June and there is even talk of raising interest rates by year’s end.  St Louis Fed President James Bullard recently said “If the economy is as strong as I think and hope it will be in 2011, I think it will be time for us to start to reverse our ultra aggressive and ultra easy monetary policy.”  This policy change has already started in Europe with the European Central Bank becoming the first monetary authority in a major developed economy to raise rates since the financial crisis.  However, the decision of when and how much will be crucial.  Withdrawing stimulus too early could reverse the positive statistics coming from the private sector while leaving too much stimulus in the economy can create massive inflation and hamper future growth due to government debt levels.  Thomas Forester, Chief Investment Officer for the Forester Value Fund, illustrates how much government stimulus has been put in the U.S. economy when he says if these levels were implemented during normal times, “it would lead to 10% GDP growth and probably 5-10% inflation. But obviously, these are not normal times.”

We have no doubt there will be rocky patches ahead as the economic baton is handed back to corporations and consumers, but know that the sustainability of recovery cannot rest so heavily on government intervention.  The portfolio managers are taking this time to be opportunistic and are buying companies they see as very attractive.  They also remind us that they invest in companies, not economies, and that you don’t have to be an optimist on the economy to find stocks that do very well in different scenarios.  Keep in mind that you were well balanced before the sub-prime debacle and the precipitous downturn that followed.  You stayed the course and endured the emotional aspect of being a long term investor. There will always be questions as to when does the market run out of gas.  Our philosophy, that you have come to understand, revolves around a total return perspective over periods of time.  The strategy of building a portfolio allocation around your ongoing cash-flow needs has proven to be solid.  We continue to take advantage of raising fixed income during positive markets to build cushion in the portfolio for any rough times ahead.  Although we are not rewarded today as much in fixed income because of low interest rates, we have created a safety net for your peace of mind.  We will continue to focus on finding the best investments that meet your needs and objectives and look forward to working with you throughout the year.