Other Updates

The Economic Environment

In September, the National Bureau of Economic Research (NBER), the official arbiter of recessions, announced that the “Great Recession” ended in June 2009. However, discussions regarding the economy during the third quarter of 2010 focused on the possibility of a “double dip,” due to deterioration of several data points over the summer. The U.S. economy posted its fourth straight quarter of growth in the second quarter of 2010, with the final revision showing a real increase of just 1.7 percent. Expectations for the third quarter are similar, at about 2 percent on average. Although growth continues, the rate is decelerating.

With unemployment hovering around 9.6 percent, robust consumer spending is difficult to envision. Although the private sector has added jobs in each month of 2010, the pace of hiring has been lackluster. Meanwhile, government census jobs are winding down, and state and local governments are reducing their work forces, largely offsetting private-sector job gains.

In addition, the consumer savings rate has recently risen above 6 percent, a significant reversal from the slightly negative rate in mid-2008. This is indicative of households attempting to repair their personal “balance sheets” by reducing debt and accumulating cash. Although a positive change for overall financial health, this creates a short-term headwind for economic growth. Increased savings represents funds not spent into the economy, reducing the “velocity” of money. Given that consumer spending accounts for about 70 percent of U.S. economic activity, these factors suggest sluggish growth in the near term.

As growth expectations have weakened, the Federal Reserve has increased intervention. Since the Fed Funds rate is already near zero percent, reducing interest rates to prompt activity is not an option. Therefore, the Fed has focused on “quantitative easing,” a process that includes buying U.S. treasuries and mortgage bonds in the open market to keep interest rates low and push them lower.

Inflation expectations remain muted, which also helps explain extremely low interest rates on Treasury notes and other types of bonds. Given the high level of unemployment, spare factory capacity and the low velocity of money, inflation is likely to remain subdued in the near term.

In our view, recent data points are more consistent with a soft patch in an ongoing recovery vs. the beginnings of a double-dip recession. Having said that, participation in the global marketplace continues to be critical, as the world economy is currently growing at roughly twice the pace of the U.S.

The Stock Market

To say that stocks continued to trade within a fairly narrow year-to-date range, up 9 percent (April 23) to down 8 percent (July 2), is somewhat counterintuitive, given the increased levels of apprehension felt by most investors in recent months. But unlike the second quarter, which ended near the year’s lows, stocks actually posted strong results during the third quarter. Several major indices posted year-to-date increases as of September 30, 2010, due largely to strong third-quarter performances:

Results for the third quarter illustrate the unpredictability of the stock market. Entering July, stocks were at the lows of the year, with negative topics dominating the headlines, including:

• Greece and other European countries in the throes of a credit crisis
• U.S. economy showing signs of weakness
• U.S. unemployment stuck near 10 percent
• Growing legislative uncertainty, particularly around future tax rates
• Market “technicians” (those who use price chart patterns to make investment decisions) issuing ominous warnings about obscure configurations like the “Death Cross” and the “Hindenburg Omen” (Upon further study, these chart patterns seem to possess little predictive power, but did serve to scare investors)
• The approach of September and October, historically the worst months for the market

So investors had plenty to worry about. With the significant declines of late 2008 and early 2009 in close memory, caution reigned. However, despite all of these negative undertones, stocks posted extremely strong results in September; at 8.92 percent growth for the month, the S&P 500 posted its best September performance in more than 70 years.¹

There also were surprises at the sector level. Despite the aforementioned challenges to consumer spending, the consumer discretionary sector (which sells “big-ticket” items) is the top-performing market sector so far in 2010, up more than 12 percent. This is largely explained by the severe contraction in discretionary purchases last year in the depths of the recession. Some industries, such as automobiles and housing, declined so much they couldn’t drop much further. With the worst-case scenario already built into stock prices, even a modest recovery in these industries translates into great stock returns.

International stocks led the way during the third quarter, as the “flight to safety” trend eased. Investors became more comfortable with the view that the debt problems in Greece would not turn into a second global credit crisis. This allowed appealing valuation levels and superior dividend yields in many foreign markets to attract investors who had avoided these areas earlier in the year. Emerging markets rebounded vigorously, posting strong year-to-date returns for 2010 as well. These markets are experiencing a more robust rebound in economic activity, and we expect them to lead the international markets higher.

Often, strong stock market returns are delivered when least expected. This was the case in the third quarter, particularly in September. The most opportune time for investors often occurs when uncertainty is at its greatest. This period presents a classic example of the futility of market timing and reinforces the benefit of adhering to a disciplined investment approach.

The Bond Market

Interest rates continued to move downward in the third quarter, with the benchmark 10-year Treasury note declining in yield from 2.95 percent to 2.52 percent. The most recent rate drop seems driven by declining inflation expectations and the Fed’s quantitative easing program. Given the inverse relationship between bond prices and interest rates, total returns were strong again during the quarter, with the BarCap Aggregate taxable bond index gaining 2.48 percent and the BarCap Municipal index up 3.4 percent. For the full year, these indices have gained 7.94 percent and 6.83 percent, respectively.

While concerns about sovereign and corporate creditworthiness lessened in the summer months, additional attention was directed toward worsening state and local financial situations. Although most municipalities face a difficult budget environment, we continue to believe the investment impact will be issue-specific and not a systemic crisis causing widespread problems in the municipal market. Although default rates are rising, they are doing so from extraordinarily low levels relative to corporate bonds. In addition, in the rare instances of municipal defaults in the period from 1970-2009, the recovery rate averaged 67 cents on the dollar, far superior to the typical experience in corporate bond defaults.²

Bond returns are likely to become much more modest in the months ahead. Interest rates are at extremely low levels. Given that the majority of return from bonds derives from interest income over time, current yields imply unexceptional returns in the months ahead. Should interest rates rise, total returns would be negatively affected. Therefore, diversifying bond portfolios by geography and sector, and managing duration to reduce price risk, are prudent plans at this point in the cycle.

The Investment Outlook

With the economy moving forward at a sluggish pace and yield levels at record lows, the opportunity set for investors is changing. The recent actions of technology bellwether Microsoft provides an example of where opportunity may lie. This company’s shares have declined by about 20 percent in 2010. But given its significant financial health, so has its cost to borrow. In September, Microsoft issued debt at 0.875 percent, the lowest yield ever for a three-year corporate bond.³ Microsoft intends to use the proceeds, in part, to buy back their own stock. So although Microsoft can’t predict the short-run direction of its stock price, management sees tremendous value in the shares at the current price. The company is confident that over the long run, borrowing at historically low rates to buy back stock will add significant value for shareholders. Using debt at less than 1 percent to retire shares that pay a 2.6 percent dividend also improves current cash flow for the company.

While some companies are buying back shares, others are initiating or increasing dividends. There are many parts of the stock market, both here and abroad, where dividend yields are superior to bond yields for comparable quality companies. In a slow-growth environment and at today’s prevailing valuations, dividend-oriented stocks are worthy of consideration for both income- and growth-oriented investors.

Given the massive amount of cash remaining on both corporate and personal balance sheets, additional deployment of this cash seems likely in coming months, as evidenced by recent increases in merger and acquisition activity. Companies have an extremely low “hurdle rate” to clear to make these deals productive for shareholders. At some point, the opportunity cost of maintaining large cash deposits at sub-1 percent yield levels will cause individuals and corporations to seek new opportunities. Each of the methods of deploying cash indicated above should be supportive of stock prices.

One extraneous factor that may be inhibiting this process is the current political environment. The market abhors uncertainty. Given that tax cuts are set to expire, health care legislation is phasing in and regulation is increasing across many industries, businesses have generally been reluctant to act. In our view, this has been a key factor to the slow progress in employment trends. Needless to say, the mid-term elections will be particularly important this year, as market participants look forward to some degree of clarity regarding these issues.

Given the current environment, our stance regarding investment positioning as we close out 2010 is as follows:

• Continue to manage risk though global asset allocation
• Maintain a slight underweight to stocks
• Add income-producing U.S. and international stock investments at the margin for a more consistent return stream
• Complement the core of portfolios with satellite strategies in all asset classes

Staying with this approach should increase the odds of a successful finish to 2010 and prepare you for what lies ahead in 2011.

¹ Source: Standard and Poor’s

² Source: J.P. Morgan

³ Source: Fidelity Investments

The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please contact your advisor for a personal consultation.