2012
- THE YEAR AHEAD
The
year 2011 saw little progress in the equities arena. The financial
news has been discouraging. Our economy is growing, but far
too slowly to put a meaningful dent in the high unemployment
rate. The government's debt load continues to swell and our
elected officials seem incapable of implementing solutions.
Additionally, the possibility of a further slowdown in China
or of a total European meltdown adds meaningful risk to the
rate of global economic growth. So, what should an investor
be doing? Stock market returns have been virtually non-existent
since the current century began. With interest rates now so
low, it seems that there is more risk in the bond market than
there is return potential. Real estate has yet to turn up. And,
real earnings from sidelined cash are actually negative after
taking inflation into account.
And
yet…
In
this Investment Strategy Update we offer a scenario of hope
and optimism for investors. We believe the stock market lows
for this cycle have already been seen, during the first quarter
of 2009. While the next secular bull market in stocks may still
be a few years in the future, it is definitely setting up. In
the meantime, our expectation is for reasonable, though not
spectacular, stock market returns, which nonetheless should
be considerably better than those provided by the obvious alternatives.
As
always, we remind you that while we are attempting to forecast
the future, our continued investment success in these volatile
times will depend much more on our ability to interpret and
adjust to trends and events as new information becomes available.
The
Economy
The
U.S. economic outlook is a mixed bag. On the one hand, there
are some structural impediments to improved rates of growth,
as well as the tail risks associated with China and Europe.
On the other hand, U.S. corporations are in excellent financial
condition and our economic indicators have been improving. Furthermore,
there are developing trends and opportunities that could serve
to boost the longer-term outlook.
Working
against us at the moment is the fact that with the persistent
outsourcing of U.S. manufacturing in recent decades, the lack
of employment growth has become structural. This lack of growth
has only been exacerbated by the current combination of slow
growth, rising health care costs, and tax and regulatory uncertainties
that actually discourage U.S.
corporations from investing and hiring. Furthermore, the last
economic downturn was financial in nature, brought about by
excessive leverage and speculation in the banking, housing,
and consumer sectors. Financial recessions are always followed
by longer, slower economic recoveries because deleveraging has
to work through the system. Private sector deleveraging is well
underway in this country, but still has further to go.
Also,
believe it or not, we are concerned about the possibility of
excessive government austerity, both domestically and abroad.
It has become painfully obvious that European and other nations,
including the U.S., have lived beyond their means for too long.
The handwriting is on the wall and the global fixed-income markets
have begun to rebel. As a result, there is a strong movement
in the industrialized world towards fiscal conservatism. That
is good, to an extent. However, unless fiscal austerity is countered
by sufficiently easy monetary policies, the consequences will
weigh heavily on the global economy. The U.S. Federal Reserve
Board seems to have received that message. With business and
consumer spending well below trend and the banking system still
not adequately lending, a certain amount of net stimulus is
required to keep the economy moving. We think it likely that
there will be further monetary easing measures in our future.
Hopefully, Europe's monetary authorities will move in that direction,
as well.
As
to the longer-term positive trends, there have been tremendous
improvements during recent years in the technologies for finding
and developing our energy resources. America is now the world's
largest producer of natural gas, while the production of domestic
oil is increasing significantly, as well. Within a few years,
if properly incented, the U.S. can move meaningfully toward
energy self-sufficiency. In addition, we would note that U.S.
manufacturing is currently on an upswing. In an October 2011
report, "Made in America," the Boston Consulting Group
estimated that 800,000 manufacturing jobs could be returned
to the U.S. by the middle of this decade. They suggested further
that each of those additional manufacturing jobs would create
as many as four new supporting-job positions (e.g. restaurants,
transportation, etc.). The weakening of the U.S. dollar against
the currencies of some of its primary competitors has made the
prices of U.S. goods more globally competitive. Transportation
costs have been rising as well, as have the labor costs in China
and other low-cost regions. When considering that manufacturing
domestically has the advantages of excellent governance, greater
reliability, and far less chance of intellectual property theft,
"Made in the U.S.A." could again become popular.
Inflation,
Interest Rates, and the Bond Market
While
the prices of certain goods and services have been rising, the
combination of a slow- growth U.S. economy, ample productive
capacity, and an absence of wage pressure is hardly a recipe
for system-wide inflationary pressure. Besides, continued deleveraging
in the consumer, banking, and state and local government sectors
is deflationary in effect, as would be any similar actions taken
by the U. S. federal government. Fiscal austerity in Europe
will have a further dampening effect on the global rate of inflation.
But
the lack of current inflation should not lull us into complacency.
Food and energy prices seem destined to trend higher, long term,
as a result of continuing growth in emerging market demand.
Also, longer term, the Fed's ultra-loose monetary policy could
well result in a too-much-money-chasing-too-few-goods scenario.
An expansionary monetary policy is necessary for now, but one
can only hope that down the road, after the economy has started
to re-accelerate, actions will be taken to drain excess liquidity
from the system. If not, inflationary pressures inevitably will
rise, but that is almost certainly more than a year away.
Interest
rates are currently near their lowest levels in history. Economic
growth is quite slow, but rates can't really go that much lower.
And slowly but surely the deleveraging process will come to
an end, the economy will regain vigor, and interest rates will
begin to normalize. It is difficult to anticipate the timing
of the normalization process, however we would not be surprised
to see a 3% 10-year Treasury rate, versus the roughly 2% current
level, sometime during the next year or two, with a strong possibility
of still higher interest rates beyond that.
Thus,
we view the current U.S. bond market risk/reward tradeoff as
highly unattractive. Over recent years, large numbers of investors
have sought protection by investing in the bond market. We fear
that trend will end badly. Eventually interest rates will rise
to a more attractive investment level, but for now we continue
to maintain a short-maturity structure in our fixed income portfolios.
We are also strongly emphasizing quality, as today's yields
seem insufficient to justify much credit risk.
The
Stock Market - A Perspective
In
broad terms, stock market returns consist of earnings growth,
dividend yield, and changes in valuation. On three occasions
during the last 100 years, those factors have combined in such
a way that stocks have experienced volatile multiyear trading
ranges. These included the 26 years surrounding the Great Depression
- around Dow 100; for 16 years from 1966 to 1982 - close to
Dow 1,000; and currently since 1999 - near the Dow 10,000 level.
A
common element in all of those periods was the fact that each
began with elevated investor expectations and very high valuations.
For the most part, corporate earnings grew during those range-bound
periods, but fears of economic weakness, deflation, or inflation
(during the 1970s) caused valuations to trend steadily lower.
Both of the previous episodes were eventually followed by a
prolonged stock market advance - note, for instance, the 1950s/1960s
and the 1980s/1990s, each of which was driven by the profit
potential and productivity enhancements that came with new technologies
(e.g, automobiles, air transport, electronics, and computing).
It
is interesting to note that while technological innovation tends
to occur in a relatively straight line, the adoption of those
innovations is typically suppressed during good economic times.
Capital remains focused on what is currently producing profits
and, once employed, labor does not move that easily. But during
more difficult economic times such innovations are pushed forward
and, eventually, gain the critical mass needed to impact profits,
productivity, and investor expectations going forward.
Now
consider these cycles in terms of our current situation. Stock
market valuations have contracted by more than half since the
technology bubble of the late 1990s. The U.S. economy has labored,
overall, but the balance sheets of Corporate America are in
great shape, and earnings have been growing. S&P 500 operating
earnings in 1999 were $51.68. For 2011, these earnings should
come in close to $97.50. In addition, meaningful new technologies
such as mobile computing, cloud computing, and social networking
have been gaining momentum. And with the continuing development
of the less-industrialized world, an estimated 500 million people
will be added to the world's middle classes over the next few
years, boosting global consumption accordingly. Thus, we believe
that we are well on the way to setting up the next secular bull
market, but we are probably not ready yet.
For
now, the current long-term trading range remains intact. While
the forces noted above are building, other forces will continue
to hold us down for a while longer. There is the below-trend
U.S. economic growth, excessive unemployment, burgeoning public-sector
debt, and huge Euro-zone problems. Add to that, dysfunctional
governments on both sides of the Atlantic that seem totally
incapable or unwilling to solve what are essentially solvable
problems. But eventually those problems will be solved - if
not voluntarily by our elected officials, then under the forced
pressure of the financial markets. Understandably, there is
great investor fear and uncertainty about how things will turn
out. Nonetheless, the unknowns will inevitably become knowns,
and when that happens, investors will be able to shift their
focus to the growing stream of U.S. corporate profits and what
are increasingly attractive stock market valuations. In our
opinion, it is a question of time horizon. Not "if,"
but "when."
In
the meantime, the stock market remains captive to evolving news
events. The current environment of extreme volatility seems
likely to continue. While investor time horizons have become
increasingly short, we think this is an ideal time to be focused
on longer-term opportunities. Increasing global consumption
will include goods and services, as well as commodities, such
as clean water, food, and energy - at least some of which are
also likely to be in increasingly short supply. We are also
selectively attracted to companies active in the evolving technologies
that will combine to drive the next wave of profit growth. Our
current preference is to overweight high-quality U.S. domestic
stocks, particularly those that have meaningful and growing
dividend yields.
America
- Still Great
America
is still a great nation - industrious, entrepreneurial, open,
and caring. As a nation, we have a plethora of positive qualities.
Many of these were well summarized in a quote from management
consultant Byron Auguste: "youth, openness, dynamism…
unparalleled institutions of innovation… democracy…
high social trust, low corruption, and an historic link between
effort and achievement." In addition, we are blessed with
abundant natural resources.
Unfortunately,
in several respects we have lost our way. This has happened
over time, as it has in the past with all great societies. As
a nation, there is a delicate balance between creating and caring,
and complex choices have to be made which will determine whether
we will regain our competiveness or continue the slide into
mediocrity. Our current political rhetoric and regulatory environment
seem to encourage productive people to hold off on the sort
of wealth creation that spurs the economy and creates jobs.
We have too much debt, a deteriorating infrastructure, growing
income inequality, and health care and education systems that
accomplish too little for the money spent. In addition, we lack
leadership. These problems have evolved over many years and
did not just arise during the current or even the last two administrations.
We
strongly believe that our problems are fixable and that we have
the means to make our system work. It isn't about politics.
We require leadership, focus, and a national effort to restore
competitiveness. As a wealthy nation, we can afford to embrace
the non-economic aspects of greater social and environmental
responsibility, but only as long as we also foster growth and
development. We have to bring manufacturing back to the U.S.
We must incent and reward excellence, reduce regulatory complexity,
and modernize our educational system.
The
solutions to our shortcomings do not require a lot of government
spending, because more spending will not fix the problems. Neither
will austerity alone. America's budget deficit results from
the fact that we spend too much and take in too little. At 15%
of GDP, the current level of federal taxes is the lowest in
60 years. Spending has to be cut and revenue has to be raised.
The Bowles-Simpson Commission had it about right, in our opinion.
Conclusion
Investors
have much to worry about, but there are definite signs of progress.
As recently as a few months ago, there were three major concerns:
was the U.S. headed for a double-dip recession? Would the Chinese
economic slowdown result in a hard landing? And, would Europe
completely implode? More recently, some of these concerns have
eased.
The
U.S. economy has firmed. Our base case outlook is that, in the
absence of a severe shock, our economy will continue on its
current, slow-growth path. While lingering concerns remain regarding
China's economy, we hold the opinion that its policymakers have
room to maneuver and should be able to successfully navigate
a soft landing. Recent indications are that the Chinese government
will soon take action to stimulate its economy. As for Europe,
the day of reckoning is upon it. European governments refused
to address their problems, so the financial markets have forced
the issue (U.S. policymakers take note). Whatever the outcome,
a European recession is likely in 2012 and its citizens seem
sure to suffer a painful reduction in their standard of living.
Regarding
investments, there is little in the way of attractive alternatives
to stocks. With interest rates so low, the normally safer fixed-income
markets do not seem all that safe. Unless the level of U.S.
government debt is purposefully lowered, the markets will inevitably
force the issue here, as well. One way or another, U.S. interest
rates will eventually rise.
We
recognize that the shorter-term investment environment is highly
uncertain, with continuing systemic risks. Volatility is likely
to persist, and stock market valuations could become still cheaper
before the next secular upturn. Thus, we remain conservative
in our stock selection and overall asset allocation. Yet we
also find reasons to be optimistic. A substantial part of this
country's present difficulties have already been discounted
by the current low level of stock market valuations. U.S. companies
are in excellent financial condition and should be able to grow
earnings in line with an expanding global economy. Many sell
at reasonable valuations, with current dividend yields that
exceed the interest-income yields provided by high quality bonds,
sometimes from the very same issuer. We expect reasonable total
returns during the coming year - meaning attractive dividend
yields plus moderate capital growth.
This
nation is learning the hard way that expanding government does
not build new businesses or create long-run economic activity.
Healthy businesses, not governments, create jobs. We are a great
and resourceful people, but this is undoubtedly a critical time
in the history of our nation. Our incentives must be properly
aligned. To BTR's way of thinking, neither the political left
nor the right speaks for the majority of Americans. We need
a government that will work together for the common good. If
our current set of politicians will not do so, then it is time
to elect some that will.
As
a final note, we wish all of our friends and clients peace,
joy, health, and prosperity in the New Year and for many years
to come. 
