A colleague of ours recently attended a meeting where the chief investment officer (CIO) of a major mutual fund company opened with this quote: “If this isn’t trouble, it will do until trouble gets here”. We concur. The third-quarter was plagued with everything from the inexcusable public debate over raising the debt ceiling in August, to the more recent concerns over Greece and its persistent debt issues. The never ending fear of financial insolvency abroad as well as here at home, based on government’s irresponsible spending, have taken a significant toll on equity markets worldwide. The Standard & Poor’s 500 index retreated a punishing -14.33% in the third quarter alone bringing the year-to-date return at quarter end to -10.04% on a price basis. Both the Dow Jones industrials and the NASDAQ, also found themselves firmly in negative territory for the quarter and the year. The Dow Jones Industrial Average returns of -12.09% for the quarter end and -5.74% for the year along with the NASDAQ returns of -12.91% for the quarter and -8.95% for the year, are less then confidence inspiring. Interestingly, bonds were the recipients of capital flowing out of the stock markets around the world with the Lehman Brothers Aggregate Bond Index rising 4.02% for the quarter, resulting in an impressive 6.74% year-to-date return. It is important to note that government bonds were major beneficiaries of this flight to quality. The very bonds that lost their triple-A bond rating in August of this year have been some of the most productive investments so far in 2011. Indicating that investors worldwide still regard U.S. Treasury bonds as some of the safest, if not the safest, paper assets available. However, this move does reflect significant deterioration in the global economic standing of the United States, which has had a AAA credit rating from S&P since 1941. In other words, we may still be the best but we are not what we used to be.
Technical Market Overview
Out of the last 39 trading days in the third quarter, the Standard & Poor’s 500 Index was above its 200 day moving average only nine days, with the last 10 days firmly below the 200 day moving average.
Reductions in the economic growth rate by the government and virtually every Wall Street firm, make anemic growth the consensus view; combined with the seeming inability of governments both here and abroad to deal with their sovereign debt issues in a substantive way, this may be the catalyst for a global double dip recession. If the Standard & Poor’s 500 remains below its 200 day moving average or accelerates its downward movement, this very well may prove to be the early stages of the next bear market. It would not be unusual to see stocks stage a rally due to the abrupt sell off this quarter; however, if the volume of shares traded on the up days is not significant, any rally could prove to be a mere interruption to the already established downtrend. It is important to note that as with all market observation tools such as the 200 day moving average of the S&P 500, there is no guarantee that the market trend will continue or that this or any other indicator will prove to be as valuable as it has been in the past.
Issues Influencing the Market
European Debt Crisis
The most recent issue affecting our markets is the Greek debt crisis. One may ask why a country with a gross domestic product (GDP) roughly the size of the economy of the state of Rhode Island would have such an enormous effect on the world’s markets. The answer is: if Greece cannot adopt an austerity plan that returns their economy to solvency, the outside countries and banks that have purchased their bonds and guaranteed their loans will incur significant financial loss. Combine that with Spain, Portugal, Ireland and Italy amongst others experiencing their own financial difficulty that may ultimately necessitate bailouts and that brings the entire European Union’s solvency into question.
These losses may cause banks, and in fact some countries, to lose their respected credit ratings due to Greece’s inability to repay their creditors. With the globally entwined financial markets, many large domestic banks doing business in Europe will undoubtedly be damaged, if not rendered insolvent by a single member of the European Union going bankrupt, let alone several of the members. We believe this disturbing trend may be in its early stages rather than nearing an end. With the majority of the economies in Europe being on the verge of insolvency, it is apparent that the promises made by these various governments are unrealistic and unachievable at the present level of productivity. Until citizens of these various countries recognize that working longer hours with greater productivity, postponing retirement and becoming more independent rather than dependent on others (i.e. the government), the financial issues facing their countries may never be solved.
Federal Debt Limit
As discussed in last quarter’s newsletter the government remains in negotiations to achieve a long-term solution to the $14 trillion debt under which our economy currently labors. After a historic exercise in political posturing in August, the long-term solution was relegated to a group of 12 politicians equally divided among both parties. It seems unfathomable that the founding fathers who established the Senate and the Congress with approximately 535 members to most effectively represent the American people and that those very representatives decided the most difficult fiscal decision ever made in this country will be made by only 12 people. It’s fair to assume that both political parties will choose their most ardent partisans to represent their parties’ agendas, setting the stage for another stalemate of epic proportion. The safeguard against such a stalemate is that if significant cuts are not agreed upon, there will be automatic budget cuts in areas dear to both parties. In addition, it’s important to realize the sheer size of our debt has a dampening effect on economic growth, with capital being siphoned from the private sector in order to pay the interest on the government’s borrowing. In the future, as our economy heals and the need for investment capital increases, the private sector will be in direct competition with the federal government for the capital needed to fund private sector business. We believe it’s paramount that our political representatives arrive at a reasonable, substantive and sustainable long-term plan to meaningfully reduce our federal debt. Without such reform, it will be difficult to maintain the standard of living Americans have come to enjoy and in fact expect.
The housing market appears to be hovering at or near the lows reported earlier this year, which indicated a 31% decline in home prices from their peak in 2006. As long as housing prices remain at such depressed levels it will make a robust, sustainable economic recovery difficult, if not impossible.
The housing market constitutes about 30% of the U.S. economy as measured by the total gross domestic product (GDP). With unemployment stalled at an unacceptable 9.1% combined with damaging effects of legislation like the “Dodd-Frank Wall Street Reform and Consumer Protection Act” leave little hope for a near term rebound in housing prices. In our opinion, only when the buying public is convinced they will continue to have a job and the banking industry has a clearer understanding of the impact of such wide reaching legislation such as the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” can the housing market have a sustainable recovery. The extreme over-regulation in the banking industry has only exacerbated the problems rather than elevating them.
The unemployment rate stubbornly remains at 9.1% as measured by the U-3 (total unemployed), as a percent of the civilian labor force (official unemployment rate). The broader and perhaps the best overall measure of unemployment is the U-6. The U-6 includes the total unemployed, plus all persons marginally attached to the labor force, plus the total employed part-time for economic reasons as a percent of the civilian labor force and finally all persons marginally attached to the labor force. This broader indicator now stands at 16.5%, up from Augusts’ 16.2%, further indicating virtually no progress toward economic recovery. For the first time in more than 50 years, there were no jobs created in the month of August. This dismal showing caused yet more downward pressure on the stock market, contributing to its 14.33% loss in the third quarter.
The gauge for consumer expectations dipped to 47.0 from 47.4, the lowest level since May 1980. The economic outlook for the next 12 months fell to 38 from 40, the lowest since February 2009, when the world economy was gripped by the credit crisis. The Thomson Reuters/University of Michigan’s preliminary reading on the overall index of consumer sentiment edged up to 57.8 from 55.7 the month before, which had been the lowest level since November 2008. “Overall, the data indicates that a renewed downturn in consumer spending is as likely as not in the year ahead,” survey director Richard Curtin said in a statement. It certainly appears that consumer spending will not be strong enough to enable the rapid job growth that is needed to offset the consumers’ reduced long-term expectations. Without the consumer supporting the economy through retail consumption for the holiday season, this may add yet another challenge for economic recovery.
As outlined last quarter, risk mitigation remains the primary goal of our portfolio management strategies. With the difficult economic environment briefly outlined above, it goes without saying that preservation of capital is our goal. Bonds remained the most productive investment choice for virtually the entire third-quarter. When economic conditions improve, a shift toward equity investments may prove more profitable and insulate portfolios from declining bond prices as the Federal Reserve inevitably begins to raise interest rates. However, it does not appear this shift will be in the near future.
As you know, the process we use to manage your portfolios is a trend identification/following process. This system is designed to statistically identify emerging price trends in a wide range of asset classes, ranging from domestic stocks and bonds to international stocks and bonds, as well as commodities and precious metals. This process has proven to be particularly beneficial in the third quarter of this year. Virtually every portfolio managed by utilizing the SuM-it investment process significantly outperformed the Standard & Poor’s 500 during the third quarter of this year. We remain confident that the unbiased, unemotional and statistical evaluation of price movement will continue to add value to the portfolios managed by this process. Nonetheless, it’s important to bear in mind that there are no guarantees that any system will work as well in the future as it may have in the past.
In conclusion, it’s now apparent the economic recovery has stalled and appears to be teetering on the brink of a double dip recession. It is our belief that the catalyst needed to resume economic growth is a change in attitude toward corporate America. The same entities that create employment and prosperity have been excoriated by Washington, causing perhaps the greatest divide between government and business in recent history. The extraordinary regulation in the banking industry is just one example
that has caused the banks to be more reluctant to make loans due to the unprecedented scrutiny by the regulators. This is causing further credit tightening at a time when the small to medium business community, along with the housing industry need liquidity most.
The relationship between government and business should be a cooperative one, focused on creating substantive long-term employment. The government’s role is to create an unobstructed environment in which the private sector can create, innovate and bring products and technologies to the marketplace.
The role of business in this equation should be to create goods and services that are in demand and have a positive impact on the consumers’ quality of life. If this positive synergy can be reestablished, our trade imbalance would be reduced, if not disappear, and we may return to the level of prosperity that made America the most highly sought after destination for immigrants in history.
As we draw closer to the national elections, we believe the market will trade based on its perceived prognosis for a more conducive business environment. Once investors become convinced that earning a profit will no longer be considered greedy or inappropriate, we believe the enormous capital in corporate America’s checkbook will be reinvested in new products and plants, with unprecedented prosperity being the end result. The capitalistic foundation on which our economy is structured is the solution to our current economic position, not the problem. We remain quite optimistic that as the American people make their views abundantly clear in the upcoming election, it will allow the politicians no other choice than to reduce federal spending and balance the budget. A legitimate balanced-budget will begin to extricate our country from its massive debt and our economy will respond positively with a renewed optimism towards the future.
WESTERMAN GROUP, LLC is a Licensed Investment Advisor Securities offered through Silver Oak Securities, Inc., office of supervisory jurisdiction, 3339 North Highland Avenue, Jackson, TN, 38305 (800) 610-6869 Member FINRA/SIPC
Disclaimer and Sources
No investment strategy can guarantee profits or protection from losses as securities are subject to market volatility. The analysis, ratings and/or recommendations made by the The Westerman Group, LLC computer models do not provide, imply or otherwise constitute any guarantee of performance. No guarantee is offered by The Westerman Group, LLC regarding the accuracy, market predictive powers, suitability or profitability (either expressed or implied) of any information provided. Indices are unmanaged and direct investment in them is not possible. Actual investment performance of any trading strategy may frequently be materially different than the pursued results.
Google Finance (for price history of S&P 500 and other indexes) – finance.google.com