Market Commentary

2009 is not starting in an encouraging way. Virtually every investment class has been down in the first three weeks of the year. As we are again seeing weakness emerge in the markets, driven by poor employment and profit reports emeging from the 4th quarter, it seems appropriate to discuss my long term perspectives on the markets and explain their influence on my decisions and advice.

Broader Economy
The current US economic environment is highly uncertain. But, the intermediate term environment (5+ years) is generally quite positive.

We are currently in the worst recession since the end of the Second World War. It was largely caused by declines in the housing market and poor risk management at the largest global banks, coupled with a decline in consumer confidence. What has made this particularly ugly has been the seizing up of the credit markets and the Bush Administration’s inconsistent responses, which have undermined confidence in even the most conservative of investments.

High levels of press coverage of economic news and the recent election cycle caused a massive retrenchment by consumers, who drive the global economy. This has had the beneficial effect of transforming Americans from net spenders to savers, but the positive effects of this will take years to truly manifest themselves. This trend towards prudence has been devastating for the sales of high end retailers, homebuilders and auto manufacturers.

Unemployment rates are being driven by the massive dislocations in the financial, real estate and manufacturing sectors, but still remain below levels seen in the recession of the early 1990s. Unemployment rates in the 10+% range have been seen in several industrialized economies over the last 20 years, with eventual declines occurring once the recession ends. Because of technological and trade related forces, there remains a high level of probability that we see a “jobless recovery” with recessionary conditions, as employers seek cost saving technological solutions and restructure their budgets.

We are currently experiencing deflation, which is generally worse than inflation as a long term phenomenon. This deflation should be countered by the massive economic stimulus package being considered by congress, coupled with extremely low costs to borrow, which generate considerable problems with inflation once the current crisis ends.

Housing Markets

The environment for real estate remains extremely negative.

Housing is unlikely to recover to its highs achieved in 2005-2007 any time soon. The decline and recovery are likely to follow a much longer path, as houses are much less liquid than stocks or bonds. While mortgage rates remain persistently low, mainly due to radical government intervention, people simply aren’t buying. At the core of the problem is that the ratio of house prices to annual income has increased dramatically in recent decades, making it very unclear what ‘cheap’ means. A decade-long housing recession, followed by several years of slow growth may be possible in this space.

Investments in real estate can make sense as a “play for yield”, but I am reluctant to devote a significant percentage of client portfolios to these types of securities. Incomes need to increase relative to home prices in order to absorb excess supply, which seems to exist across the spectrum.

US Stocks

By most measures of valuation, US stocks look underpriced.

The current environment is extremely attractive to long term (5+ years) purchasers of US stocks. In the shorter term, the environment is very unclear.

The best values appear to be in the large cap growth space – in particular, companies with relatively low debt levels and solid brands. These firms will benefit from relatively low borrowing costs once the current panic is over. Value companies – which seem to be generally over-leveraged, are concerning. Dividend rates, while unlikely to be sustained at current levels overall, are extremely attractive to current income investors for the equity portions of their portfolios even at levels of yield lower than present.

International Stocks

International stocks, like US equities, look attractive, but considerably less so, due to currency issues and less transparency in terms of accounting. Virtually every problem, long and short term, that the US has, the Japanese and Europeans have worse. There are, however, some foreign markets that look particularly enticing – particularly so in Latin America and Southeast Asia.

Both developed and emerging markets performed far worse, relative to US equities, in 2008. There are several reasons for this, but in large part the declines were driven by mad dashes to build cash positions – selling anything that could be sold – and, from US investors’ redemptions.

Prominent exceptions are Australia and Mexico, where valuations and macro economic factors are extremely encouraging. China remains an appropriate holding for long term aggressive investors, as do the Emerging Markets generally.

Bonds

Bonds are an attractive investment outside of US government securities, which are extremely overvalued and pay an unacceptably low rate of interest. The most attractive bonds are those issued by banks and other financial institutions, but they are also the most risky.

The bond markets were extremely volatile and highly varied in how they performed in 2008, US Treasury bonds had one of their best years on record, but corporate bonds (a space dominated by financial companies) performing extremely poorly at the end of November and recovering rapidly at the very end of the quarter. For this reason, most bond mutual fund managers seem to have dramatically underperformed the Barclay’s Capital (formerly Lehman Brothers) Aggregate Bond index, as they generated cash to cover redemptions by selling (and thus, underweighting) investment grade corporate issues.

Due to their extremely high yields, I am inclined to invest in corporate bonds (although less so, in light of their recovery), high yield and preferred stocks, while keeping conservative clients core fixed income portfolios in short term bonds, money market funds and other investments unlikely to be affected by an eventual (and likely dramatic) increase in interest rates.

Commodities

Commodities performed extremely poorly in 2008. They are unlikely to (as a group) experience a dramatic comeback in 2009.

I am inclined to keep commodities exposure to a minimum because it is likely to be a poor investment long term (mainly due to technological factors) and because they have demonstrated that they do not possess the diversification benefits that their advocates saw in previous markets.

Gold reversed its negative post – Lehman trend, and I think that a powerful case can be made that it is a good long-term bearish investment. Oil seems like a better investment, however, given its centrality to the global economy and the fact that it’s price lies well below what most industry insiders seem to feel is an appropriate long term level. In general, however, I feel that commodity exposure should be viewed as speculative and should be limited.

Conclusion

This is the most challenging market for any current participant. We are currently experiencing uncertainties that are as substantial as at any time in the last 50 years. I encourage everyone to maintain perspective (as you all pretty much have – thank you very much) and remember that recessions, market declines and financial crises are part of the natural order.

That having been said, these are particularly challenging times and it is always a good time to talk, evaluate and review risk tolerance. As we reach out to clients over the next few weeks, please don’t wait for us to get in touch with you if you would like to review your portfolios. As we always have, we will get through this challenging environment.

Thank you again for your business.