Second Quarter, 2009
Persuasive arguments abound for why we are facing a deflationary spiral that could rival the “lost decade” of the recent Japanese economic and investment market experience. Equally persuasive arguments abound regarding how we have already entered the next long term inflationary spiral. In fact, nothing much has changed since we described this epic battle of conflicting economic theories in our last quarterly letter. Rather than being swayed by the see-saw action of economic forecasting opinion, we continue to look to the behavior of various market indicators to get a “feel” for the pulse of where the economy and investment markets are headed.
Individual investors and professional money managers alike can be excused for experiencing a sense of befuddlement regarding setting an appropriate asset allocation in the current economic and political environment. Our view is that markets give the necessary insights into this issue while commentators more often than not cloud the picture. We are, for the moment, generally left with the view that inflationary forces aren’t overwhelming deflationary forces or vice versa.
Consider a small sampling of the following market signals:
- Domestic and global stock markets have experienced strong gains during the second quarter, with a further acceleration of gains in July. The stock market now appears to be anticipating an economic recovery.
- Interest rates on government bonds have risen during the second quarter not because of rising inflation, but more out of sympathy for the prospect for an improving economy and the growing cash needs of both public and private borrowers. We monitor a market proxy for inflation expectations which represents the yield “spread” between regular treasury bonds and treasury inflation protected bonds. At the present time this indicator implies inflation in five years will be approximately 1.25%. We also note that the Federal Reserve has verbally indicated its desire to “anchor public inflation expectations at up to 2%” during the next few years.
- Gold appears to be largely directionless since the beginning of the year indicating a general lack of concern about both inflation and the direction of the US dollar. Regarding other commodities, we are close observers of the CRB RIND (Raw Industrial Index), defined as “a measure of price movements of 22 sensitive basic commodities (but excluding oil) whose markets are presumed to be among the first to be influenced by changes in economic conditions”. During the second quarter, and through July 30th, the CRB Rind Index increased 26% reflecting an upswing in optimism and purchases of numerous commodities utilized in various manufacturing processes.
Signs of economic improvement continue to percolate. Various investment and capital spending indices are showing marked improvement from their lows this past March. Housing has long been considered the lynch pin for economic recovery and the news has been very grim. However, signs of stabilization continue to emerge. Pending home sales have risen in each of the past four months. As we noted in previous quarters’ letters however, mortgage default rates continue to rise, now even among prime borrowers, and may continue to do so for perhaps the next twelve months. In spite of rising defaults, home sales have stabilized nationally at today’s lower home price levels and the volume of mortgage applications is increasing at an impressive rate. In short, it appears that a new stability in the housing market is beginning to emerge which will eventually provide some degree of additional underpinning to an economic recovery.
We do have a variety of concerns of a long-term nature, however, regarding future domestic economic growth.
- The stimulus package isn’t stimulating yet as consumer retrenchment and debt liquidation has more than offset the early stages of government spending (more on the stimulus package is provided below).
- Politicians continue to pay lip service to the importance of fostering global trade during this period of economic weakness while their actions demonstrate a pattern of increasing trade barriers, also called economic nationalism, as they seek to protect their collective home turf.
- The U.S. corporate tax rate now ranks 2nd highest in the industrialized world, and soon-to-expire Bush tax cuts and other proposed tax increases will further reduce U.S. economic growth and competitiveness in the years ahead.
- There is increasing alarm in the investment community regarding the push for greatly expanded industry regulation, increasing union influence, massive deficit spending and the anti-competitive consequences of the various proposed carbon tax schemes.
In the final analysis, efforts to undermine our global competitiveness will harm our domestic investment markets. There is hard evidence at hand for the malaise that concerns us:
- To date in 2009, the broad U.S. stock market has continued a six-year trend of underperformance when ranked globally for stock market returns.
- Fortune magazine has recently reported that the number of American companies in the Global top 500 has declined to the lowest level ever – 140.
- The U.S. “trade weighted” dollar has been in a pattern of decline since 2000.
These concerns have been steadily leading us away from investment in U.S. equities in your portfolio, and towards increased investment in higher potential growth markets around the world.
Is the Stimulus Package Working?
On June 2, the Director of the Congressional Budget Office (CBO) made a presentation at the International Monetary Fund (IMF) outlining the details of the stimulus package incorporated in The American Recovery and Reinvestment Act (ARRA) including a breakdown of funds spent to date (as of May 22, 2020). His presentation included the following facts:
- As of May 22, only10% of authorized expenditures had been disbursed.
- Only 24% of the $787 billion entire package is scheduled to be disbursed by 12/31/09. This will amount to $189 billion or an amount equivalent to 1.4% of total GDP.
- The entire stimulus package is divided into three components: 1.) infrastructure-type expenditures 2.) entitlements and 3.) revenue enhancements (personal and business tax credits, energy credits, etc.)
- Each component is scheduled to receive varying percentages of their total allocation each year over the next three years causing attempts to ascertain the program’s overall success in the short run to be a difficult undertaking.
To put the entire 3-year ARRA spending package into perspective, BCA Research estimates that consumers have cut their personal spending by an $800-900 billion annual rate. A large part of this savings is going into debt repayment which is deflationary in its economic impact. Thus despite promises from our politicians to the contrary, a 3-year, $787 billion stimulus package, one-third of which is earmarked for non-growth entitlements, can be expected to contribute in only a negligible way towards “jump-starting” the U.S. economy.
Asset Allocation
Based upon our assessment of economic and political factors, including our observations presented above, during the second quarter we began increasing client equity exposure. New equity investments during the past quarter have tended to focus on non-U.S. companies and exchange-traded funds or domestic companies having significant foreign sales. We anticipate further increasing client equity exposure after signs of economic recovery become more clearly pronounced and when technical market indicators demonstrate a more positive market sentiment. In the meantime we continue to hedge a portion of the value of client equity portfolios out of concern for the possibility of a market reversal.
In those accounts where individual bonds have been purchased, maturities have generally been held to less than ten years due to our longer-term concern for the Fed’s reflationary policies.
We are maintaining a meaningful position in precious metals and commodity-type investments as a strategy to benefit from future economic recovery and the aforementioned return of Fed-induced inflationary policies.
Tax information request
SIMI maintains a policy of capturing tax losses when securities in client taxable accounts have experienced meaningful declines. Last year provided us with ample opportunities to realize such losses, and we are now requesting either a copy of our client’s 2008 schedule D or the tax loss carry forward number alone, depending on client preferences. We continue to monitor this number on an annual basis as part of our strategy of minimizing tax liability from trading activity within client accounts.
Roth IRA Opportunity
In an environment of anticipated future tax increases and currently depressed asset values, there is an interesting opportunity that we felt should be brought to your attention. On January 1, 2020, the personal income limit which currently prohibits people earning more than $100,000 per year from converting a traditional IRA to a Roth IRA, will be eliminated. This is significant for several reasons. First, many IRA accounts have experienced significant value declines in the past two years, so an opportunity exists to pay a lower tax liability on the currently reduced value upon conversion to a Roth IRA. Roth IRA’s enjoy a permanent tax-free distribution feature not only on contributions but also on all account earnings. Secondly, personal income tax rates are likely to rise from their current levels, so your tax rate on the conversion value in 2010 may be lower than your future tax rate on IRA distributions if you do not choose the Roth conversion option. If you are interested, we encourage you to consult with your tax advisor. If a Roth IRA is appropriate for you, we would be happy to assist in the conversion process.