In 2010, the stock market overcame two significant macroeconomic concerns to continue its post-financial crisis rally. The stock market, as represented by the Standard and Poor’s Five-hundred stock index, closed 13% higher at 1258. Fears regarding fallout from European sovereign debt crisis and possible “double dip” recession in the United States held back stocks for much of the year. Climbing the proverbial wall of worry, however, share prices managed to end the year with solid gains. Bond prices rose and yields shrank on the fears cited above and the second round of major bond purchases initiated by the Federal Reserve. The yield on the benchmark ten-year Treasury note closed the year at 3.31%, down from 3.84%, but significantly above the low yield of 2.33% reached in October. Gold continued its multiyear rally with the price increasing 29% to $1419 per ounce. Continued easy fiscal and monetary policies throughout the developed world have been the major driver behind higher prices.
Looking to 2011, the positive case for the stock market is the undeniable momentum in the US economy. After experiencing a mid-year slowdown, growth has accelerated, and with the Federal Reserve and the US Government continuing to pour liquidity into the system with bond purchases and tax cuts, the strengthening looks to continue into the new year. Stronger economic growth should translate into increased spending, investment, corporate profits, and, ultimately, hiring. Such an environment would be supportive to the stock market and make it resilient in the face of external shocks, such as the European financial crisis. Furthermore, on a standalone basis, bond purchases by the Fed, (popularly known as QE2,) can have the effect of moving money into other financial instruments such as stocks or gold, driving up their prices independently of economic conditions. While high unemployment is a long-term drag on the economy, it could stay the Federal Reserve’s hand in discontinuing its bond purchasing program in 2011, which would be a positive for the stock market, but a significant concern if it does not. Finally, after two major bear markets in a decade, many individual investors have been shunning stocks in favor of bonds. Based on recent reports of flows into and out of mutual funds, however, it seems that this trend has begun to reverse and that retail money is now flowing out of bonds and into stocks. This trend will provide further support for stock prices, if it continues.
Weighing against the stock market are several factors. The most immediate is the pronounced enthusiasm of professional investors for stocks. The stock market finished strongly in 2010 in anticipation of the stronger economy discussed above. This pulled potential price appreciation from 2011 into 2010. Along the same line of thinking, based purely on the amount of ground covered by the stock market rally since the crisis low of March 2009, it is only natural for the stock market to decelerate at this point in the cycle. After gains of 23% in 2009 and 13% in 2010, we would expect to see any further appreciation to be more muted. Europe continues to be a major source of potential instability. While European and international authorities have thus far kept the crisis contained, there is no guarantee that they will be able to do so in the future. If the European sovereign debt crisis were to infect the international banking system, the US stock market could come under significant pressure. The US housing market remains under considerable pressure from excessive inventories of homes. As housing is the largest financial asset for many Americans, this could provide a limitation on spending from US consumers. Additionally, the finances of US state and municipal governments also bear watching, with many facing large budget deficits and the removal of Federal financial support with the expiration of the 2009 stimulus law.
We continue to believe that the long-term bond market has begun a secular bear market that started when the benchmark ten-year US Treasury note bottomed at 2.04% in December of 2008. As such, we think yields will continue to move higher with the strengthening US economy. Keeping any increase in long-term yields constrained will be the still relatively modest pace of economic expansion and the gravitational pull of zero percent overnight interest rates that essentially allow banks to borrow for nothing and lend at the long-term rate, booking the spread as profit. Gold will continue to serve as the refuge for those who believe that the extraordinary monetary and fiscal accommodation of the past decade will ultimately end badly when it comes time to settle our debts as a nation. We believe gold’s decade long bull market will extend well in to the next, as American politicians have made no serious attempt, as of yet, to address our massive and ultimately unsustainable trade and fiscal deficits.
For 2011, we expect the S&P500 stock index to trade in a range of 1150 to 1400 and finish in the upper half of that range. It ended 2010 at 1258. We have confidence that our principle strategy of focusing on value, quality, diversification, and patience will continue to deliver maximum long-term value to our clients regardless of short-term market fluctuations. Please feel free to contact us with any questions or comments. We thank you for the confidence you have placed in us, and we wish you a happy and prosperous new year.
Patrick Mauro, Daniel Mauro, Henry Criz