In the second quarter of 2009, the S&P 500 stock index rallied 15% to 919 on June 30th, from 798 on March 31st. Similarly, the benchmark ten-year Treasury yield rose sharply from 2.68% to 3.52% on hopes that a financial and economic catastrophe had been avoided. We would agree with that conclusion. Thanks to the trillions of dollars of support and subsidies granted to the financial sector through the TARP and numerous other Federal programs, along with a $787 billion fiscal stimulus package, an economic collapse has, for the time being, been averted. After the failure of Lehman Brothers in the fall of last year, the government made it clear to all that it would not allow another major financial institution fail, and once investors came to believe this, a major stock and commodity rally ensued. Additionally, economic data began to reflect a deceleration in the rate of economic decline. This data was widely touted by members of the government with the catchphrases of “green shoots” and “glimmers of hope.” The data and rhetoric further fueled the rally.
Needing more than relief and catchphrases to continue its upward tack, the S&P 500 peaked in early June at 946, with no new catalysts to push share prices higher. We believe the reality of a long, hard, low-growth slog to economic recovery may be finally registering with investors, i.e. no collapse, but not much growth to speak of either. The reason for this is that the debt load of the American consumer will take many years to be relieved through savings, debt repayment, and personal bankruptcies in a time of stagnant wages and asset prices. Essentially, consumers are rebuilding their battered balance sheets by spending less than they earn. Previously, the American economy was driven by consumers borrowing against their appreciating homes and retirement accounts to consume goods and services. That game is now over and is unlikely to return anytime soon enough to be relevant. The government must run deficits as far as the eye can see to ensure that the retrenching of the American consumer does not lead to a downward economic spiral.
Ultimately, however, the government must be able to withdraw its debt fueled stimulus from the economy. Ideally, the private sector of the economy will revive sufficiently sometime in the intermediate future to allow the government to begin the process of putting its fiscal house in order. However, if the economy is not able to sustain a recovery, and the government is not able to reduce its deficits, our foreign lenders may withdraw their support for the American dollar and American assets. This could lead to many troubles, the scope of which would make the last two years pale in comparison. At that point, the government would have to either massively raise taxes and cut spending, print greater and greater amounts of money, or default outright on its debt. None of these options is a good one. The good news, however, is that this reckoning will not be met until well into the future, if it comes to pass at all. The big question remains: what will replace the deficit driven “globalization” economic model of the past two decades that brought us to this juncture?
The best way to invest is to focus on companies and assets that would benefit from a declining dollar. This includes multinational corporations, exporters, and gold. To maintain portfolio diversification, we continue to focus on quality value names in other areas of the investment universe as well. Such investments consistently grow their dividend and trade at an attractive price relative to their dividend payout. We believe the closing low of 678 on the S&P 500 in March will hold for at least the next few years, although a retest later in the year remains a real possibility. For the remainder of the year, we see S&P 500 moving in a range from 750 to 1050.