October 2010
3rd Quarter Summary
Thus far in 2010 we have seen the S&P 500 have a positive first quarter, followed by a decline of 11.9% in the second quarter amid a lot of news media pessimism on the outlook for the U.S. economy. The third quarter saw a gain of 10.7% that I think most people would not have predicted.1
Bonds have outperformed stocks so far this year. Investors have rushed to buy Treasuries at record low interest rates. This week the 10-year Treasury bond is yielding 2.61%.2 Many stock-oriented income investments have provided much better income opportunities than Treasury bonds. Any signs of a pick up in the economy could see Treasury interest rates reverse course and interest rates go up a bit. The situation we currently see with Treasuries is largely emotionally driven and is the opposite end of the pendulum swing from what we saw in 1980. 1980 was a time of high inflation, generating fears of locking rates that might rise further. Yields went as high as 15% for 20-year Treasury bonds as investors were afraid of higher rates the next year. In retrospect, when bonds offered 20-year annual returns of 15% few bought, yet many are buying Treasuries today with yields in the 2% range!
Money has flooded into bonds and bond oriented funds this year as fears of further recession or a very weak economy have driven investors towards the bond market. While mutual fund inflow/outflow figures do still show stock based funds losing investment and bonds gaining, the past few weeks have seen a significant decline in both equity outflow and bond inflow.3 This is what one would expect to see as fears of further recession or a very weak economy give way to optimism over future economic growth.
Corporate Cash
We have seen an interesting trend in corporate balance sheets over this past year that I don’t believe has gotten much press. As fear has driven investors into the bond market, a number of financially stable large corporations (Microsoft, IBM, etc.) have issued bonds at record low interest rates. Much of this money has then gone into stock buyback programs in which the companies are buying back their own stock. This indicates both caution to spend on either new equipment or employees and a belief that buying back shares of their stock is a good investment.
As I have mentioned in previous newsletters, a number of large corporations have increased cash reserves over the recession and are now looking at quite a large reserve. In fact, as of June 30th, S&P 500 companies had a record $843 billion dollars of cash reserves, up from $773 billion one year previously.4 $843 billion is equivalent to 11.6% of these companies’ stock market value! Corporate officers can better analyze how to spend this cash once 2011-2012 tax policy is defined. We are likely to see more stock repurchases, dividend increases, mergers and acquisitions, and capital spending once CEO’s and CFO’s can determine the best way their particular company can spend this cash.4 The spending of this cash will benefit the overall economy.
Lastly, S&P 500 companies reduced dividends by $40 billion in 2009. The first nine months of 2010 have seen an increase of dividends by $15 billion. While dividends are obviously not back to their 2008 levels, there is expectation amongst analysts that the next year will see further increases. The level of increase we are likely to actually see will be determined in part by the midterm election and its effect upon tax policy.4
Our Outlook
A portion of our clients are retired and currently drawing money out of their accounts, generally at a rate of 4 1/2—5% of their account values annually. These withdrawals have largely been covered by income generation within the accounts. In contrast, a number of other firms plan for growth of principal in order to cover the bulk of income needs of their clients. I feel more comfortable with accounts generating the income needed by their owners and plan to continue to invest along these lines.
We do still have a fair number of assets within the bond market, but mostly within mutual funds focused on shorter term, corporate, and international bonds. Treasuries do appear to be overpriced. The market has shifted between stocks and bonds during this recession to recovery period. I have enclosed 2 graphs that show this change. Both compare the S&P 500 and the Barcap U.S. Aggregate Bond index to each other. These indices are both widely respected measures of either the broad stock market or the broad bond market. As you can see, 2009 was a good time to have exposure to the stock market as stocks rebounded from their fall from 2008 through early 2009. As stocks regained some of their lost value and investors have retained a sense of unease regarding the economy, bonds have become a more attractive place to be.
The positive September in the stock market seems to be signaling that a double dip recession is not likely to happen. Uncertainty is the bottom line of the moment. The economy shows gradual signs of a recovery. Many investors are waiting to see the results of the upcoming midterm elections. There is a general feeling that a Republican dominated Congress will be better for investors and a number of people are waiting to see if this does in fact happen. There is also a hope that Federal corporate and personal income tax policies will be clearly stated after the election. The elections are an important data point we need to get past both for investors looking for concrete policy guidance and for those who have been influenced by varying emotions after the turbulence of the past 2 years.
2) http://www.bankrate.com/rates/interest-rates/treasury.aspx?ec_id=m1021205
3) http://www.ici.org/pdf/flows_data_2010.pdf
4) Wall Street Journal, 9/29/2010, Blue Chips Surge 10.4% Even as Small Investors Pull Back
The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different. The information provided is not written or intended as tax or legal advice and may not be relied upon for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.