In the first quarter of 2010, the stock market as represented by the S&P 500 stock index advanced 4.8% from 1115 to 1169. The benchmark Ten-year Treasury note fell one basis point to 3.83% from 3.84%. The price of gold rose 2% to $1115 per ounce from $1093.
We believe the latest surge in equity prices stems primarily from two factors: 1) consistently better than expected economic data, and 2) continued exceptional monetary accommodation by the Federal Reserve. While the economic recovery has certainly not been powerful, especially relative to the magnitude of the preceding recession, it has nonetheless been stronger than the almost always backward looking Wall Street consensus has expected. When reality exceeds negative expectations, stock prices tend to rise. At the same time, the Federal Reserve has maintained, and has signaled that it will indefinitely maintain, highly accommodative monetary policy. Overnight interest rates are pegged at essentially zero, and while the Fed has completed a $1.75 trillion bond purchasing program with freshly printed dollars, it stands ready to reinitiate the program as needed to attempt keeping long-term interest rates low. This easy money policy has had the effect of pushing traditional cash savers into the bond market, and bond market investors into the stock market in search of higher returns.
While we feel this trend can continue for several more months, if not well into next year, we believe ultimately that the foundations of this rally are ephemeral. The economy has benefited from a snap back in demand after falling off a cliff in 2008 and early 2009. When this reflex is complete, it is far from clear what type of sustained driver of demand could plausibly take its place. Unemployment will still be historically high, the housing market will still be distressed, consumers will still be heavily indebted, the Federal budget deficit will still be in the neighborhood of $1 trillion per year, America will still be dependent on foreign goods, capital, and oil, and much of the fiscal stimulus from the Federal government will have run its course. Contrary to the hopes of some, after decades of decline, the export/manufacturing sector is not nearly large enough to become the primary source of economic growth anytime soon. Just when investors start to expect more from the economy, it may decelerate and begin to disappoint their expectations. To be clear, we are not looking for a move back into a recession once this recovery stage of economic expansion is complete, but rather a sustained period of subpar growth.
The easy money policy of the Fed has greater sustainability than continued economic strength, but ultimately is unsustainable as well. The Federal Reserve can continue to print dollars and inflate asset values only so long as the foreign creditors we rely on to subsidize our lifestyle are willing to accept dollars as a store of value and means of exchange. If this confidence in the dollar is lost, the Federal Reserve’s ability to suppress long-term interest rates will be overwhelmed and interest rates could move significantly higher across the board at the same time inflation moves to potentially destabilizing levels. Such an outcome would likely lead to an economic dislocation potentially much more severe than that witnessed as a result of the credit crisis of 2007-08. The upshot is that we believe this scenario, if it were to come to pass at all, is still at least five to ten years away. The dollar is the global reserve currency that all countries must hold to engage in international trade. So long as there is no serious competitor, the dollar’s status is secure, and a precipitous decline in its value and that of US Treasury debt is highly unlikely. The recent tumult in the European monetary union regarding Greece serves to reinforce the near-term viability of the dollar as the monetary reserve asset of choice. As such, easy Federal Reserve policy will continue to underpin financial markets, and is the main reason we are not negative on stocks in the near to intermediate term.
Longer-term, we believe the sensible way to prepare for slower growth, higher interest rates, and a weaker dollar is to gravitate portfolios toward higher dividend yielding sectors such as healthcare, consumer goods, and utility stocks, hard assets, such as gold and oil, and shares in multinational corporations and exporters. The thinking behind investing in the defensive equity market sectors is that their non-cyclical nature should serve them well in a struggling economy, and that their higher yields/lower valuations give them a measure of safety when interest rates and dividend yields rise, i.e. if the stock market as a whole were to be revalued from a current dividend yield of 2% now to 4% in the future, would it not make sense to hold stocks that are already yielding 4%? The thesis behind hard assets is more straightforward. If the supply of dollars expands faster than the supply of gold or oil, the price of oil and gold will appreciate in dollars. It is much easier for the Federal Reserve to print a dollar than it is for man to pull a barrel of oil or an ounce of gold out of the ground. Given the Fed’s need to print massive amounts of dollars to suppress interest rates and keep the economy from falling back into recession, we think this will continue to be a profitable trade with the added benefit that it offers an effective hedge on your stock positions. Lastly, multinational firms and exporters that do a large percentage over their business overseas would benefit from both a weaker dollar and exposure to relatively stronger foreign markets. We continue to be negative on long-term debt instruments. At current low yields, they offer very little in the way of potential reward, while presenting tremendous risk if interest rates were to move aggressively higher. We believe blending stocks with cash and short-term debt offers a better long-term investment strategy.
For the remainder of the year, we see the stock market trading in a range of 1050 to 1300 on the S&P 500. The 1300 level represents the pre-Lehman Brothers market from August 2008. We believe this level will offer significant psychological or “technical” resistance for bullish stock traders and investors.