Bartlett Commentaries
Market Commentary, 07 / 2010
The second quarter brought a resurgence in financial market volatility and a worldwide correction in equity prices. The widely-followed Dow Jones and S&P 500 benchmarks fell 12% and most foreign stock markets fared worse, with a 15% decline for the benchmark EAFE Index. Investor confidence has been shaken by a recent moderation in the pace of U.S. recovery, ongoing financial problems in Europe, and concern that Chinese policymakers would slow their economic growth rate in order to contain inflationary pressures in that country. Meanwhile, bonds delivered positive returns for the second quarter, with U.S. Treasury securities leading amid apparent “safe haven” buying.
Labor market conditions remain very sobering. Unemployment is at 9.5% in the U.S. following meager improvement in May and June, when private sector job additions totaled only 116,000. Putting this in perspective, The Wall Street Journal recently estimated that getting the U.S. jobless rate back below 8% would require 250,000 new jobs per month for the next three years. None of this is very surprising to us; our past commentaries have alluded to the likelihood of a very long time required for improvement in the labor market.
We believe moderate economic growth is the most probable scenario, notwithstanding all the “double dip recession” commentary in the media. Very recent manufacturing and service sector data indicate U.S. growth is indeed slowing, and the prospect of fiscal tightening (tax increases and spending cuts) in Europe and eventually in America is a looming headwind for global growth. Nevertheless, with unemployment high and core inflation recently measured at only 1%, we think monetary policy will be very accommodative for some time to come, perhaps well into 2011. Consequently, short-term interest rates are likely to stay very low, which is good for business. We are also encouraged by an uptick in activity for dividend increases, share repurchases, and strategic acquisitions. Business fundamentals are improving, which is in stark contrast to the 2008 situation.
Taking a four to five year time horizon, we think stock valuations are relatively attractive even assuming the possibility of subdued economic growth. This seems clear when we contrast stock and bond valuations, something that requires more detailed elaboration.
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- In every case, sometimes by a substantial margin, the dividend yield from the stock exceeds the bond yield, which is historically very unusual. Using just one example, an investor could buy a 5-year Procter & Gamble bond and, based on its current premium price, earn a 1.9% annual total return assuming it was held to maturity. Alternatively, that same investor could buy the stock with the same time horizon, receiving a 3.2% dividend yield. Even if the stock price is 6% lower five years from now – an outcome we deem has low probability because we expect the company will keep growing its revenues and earnings – the stock would still provide the same annualized total return (dividend yield +/- price change) as the bond, and a higher total return than the comparable Treasury security. Put simply, stocks should outperform most bond and cash alternatives even assuming sluggish economic and market conditions.
The companies highlighted above – and many others we could cite - are certainly not “speculative” by any measure. These and many other stocks are very attractively valued, relative to bond and cash alternatives, even under conservative economic and business assumptions. In addition to attractively-priced blue chip companies, we find good value among selected small and mid-cap companies and in foreign equity markets as well. We plan to patiently maintain most existing equity holdings while staying alert to opportunities presented by market turbulence, which may allow us to purchase investments we previously deemed too high-priced. As for bonds, we prefer selected corporate and municipal issues, emphasizing shorter maturities because low absolute yields on longer maturities provide little margin of safety. Treasury securities are not appealing at current levels. Finally, money market rates are expected to hover barely above zero during the next year, so cash reserves are maintained primarily for anticipated withdrawals.
Be assured we are aiming for an appropriate balance between return and risk, grounding our investment assessments in realism rather than optimism or pessimism. Asset allocation, diversification, valued-based security analysis, and active management remain our guiding principles. We think this approach should provide good risk-adjusted performance over the long haul.
For more information on this topic, please contact us. At Bartlett & Co, we assist high net worth individuals and their families in defining & reaching their life goals.