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August 2010

Market Commentary

By: Wabash Capital Investment Committee

A year ago the media was referring to improving economic numbers as “green shoots” in what was hopefully an end to a deep recession set off by the credit crisis.  Economic reports showed the economy was starting to grow again.  By the end of last year, positive growth in GDP did indeed suggest that things were on the mend. 

Fast forward to summer 2010, and these same economic numbers have become less positive, causing worry that a double-dip recession is upon us.  Housing starts, existing home sales, employment data, retail sales, and the Conference Board’s Leading Economic Index (see chart) illustrate an economy that is struggling to gain momentum.

A double-dip recession is defined as negative GDP growth within the first year of a new economic expansion.  From a historical perspective, this is a very rare event.  A recession causes people and companies to cut back their budgets.  Inefficiencies and excesses that were a result of the previous expansion are washed out of the system, and those excesses take longer than a year to reemerge.

The most recent recession really highlights the changes we’ve seen in spending patterns.  Americans cut back on their personal spending to the point that the savings rate turned positive again.  To wit, the savings rate was recently up around 6% whereas it was negative for much of the last decade.  On the corporate side, the massive budget cuts and layoffs that drove unemployment to 25-year highs had the corresponding effect of increasing profit margins to record levels.  That is the reason for the yearlong rally in stock prices.

Recent economic data, while weaker, is likely pointing to slower future growth rather than a new recession. Real economic output remains well below pre-recession levels with the best evidence of continued thrift being the persistently high savings rate and business reluctance to appreciably increase spending and start hiring in big numbers.

The likely cause of the weaker data is the ongoing withdrawal of government stimulus and cuts to state budgets.  It is clear the economy is not standing on its own yet.  We think that until we see a self-sustaining recovery in the private sector, GDP growth will remain well below the 3% rate that is the norm in a typical expansion. 

From the standpoint of your investments, now is not the time to give up completely on stocks.  However, this seems to be what many investors are doing as they shift out of equities and into bonds.  While this move has been rewarded short term, we are not certain the long-term bond picture is so bullish.

If you step back and take a longer view, one has to consider that the amazing run in bonds the past decade could be a prelude to future underperformance.  The current fiscal backdrop supports that notion.  The Federal Reserve, using what they call quantitative easing, has made it clear that they will continue to provide whatever liquidity is needed to keep the economy moving forward.  Short term this has created a bullish environment for bonds, but longer term there is concern that the extra liquidity will increase inflation risk, which in turn would hurt bond prices.  We think it is a good idea to be prepared for this possible outcome.

If you are presently investing in bonds, we recommend sticking to shorter-term maturities so as rates increase you can reinvest in higher-income bonds.  We have also been buying TIPS (Treasury Inflation-Protected Securities) in portfolios the past several years as a hedge for potential future inflation.

With regard to equity markets, the flat performance in stocks over the past decade, especially the larger blue chip names, could mean this will be a good place to invest going forward. We note that many companies now pay dividend rates that exceed 10 -year and 30-year Treasury note rates.  This makes equities a more attractive investment, and any weakness in equity prices as a result of short-term volatility can be a good buying opportunity for longer-term gains.

Members of the Wabash Capital Investment Committee:

Donald Edwards, CFA  Committee Chairman

Chris Doll

Jim Exline