In the third quarter of 2010 the stock market, as represented by the Standard and Poors Five-hundred stock index, advanced 10.67% to 1141 from 1031. Relief that a European financial crisis had been seemingly adverted and data suggesting the United States would not relapse into recession drove gains. The yield on the benchmark ten-year US Treasury note fell to 2.52% from 2.95% as investors came to expect further purchases of government bonds by the Federal Reserve to support the economy. Gold rallied 8.02% to $1307 per ounce from $1210 per ounce as some investors feared that the Federal Reserve’s activities would ultimately lead to much higher inflation.
While the market is little changed for the year, the road to this point from January 1st has certainly seen its share of volatility. Investors have alternatively been seized by expectations of a “V” shaped economic recovery, a European led global financial crisis, relief, fears of a “double dip” US recession, and relief once more. We see this pattern being the template for years to come. Much sound and fury, but in the end, you are left with a US economy growing at a subdued pace due to over indebtedness, underemployment, and uncompetitiveness. “The New Normal,” as some have called it.
There is no easy way out of this condition, particularly given the state of political paralysis in the US. Fiscal policy is likely to be a drag on the economy with the expiration of spending authorized by the American Recovery and Reinvestment Act of 2009 and the low probability of getting any sort of meaningful stimulus measures to take its place, assuming the Republicans taking at least one house of Congress this November, as now seems likely. As an important offset, however, the Federal Reserve has signaled its willingness to purchase increased amounts of long-term US Treasuries if the domestic economy and inflation do not accelerate. This is in effect printing billions, if not trillions of dollars, and injecting them into the financial system. We feel that such “quantitative easing” was central to pulling the economy out of recession in 2009, and we are confident that further such easing in the future will have the desired effect of providing support to the economy and prices.
In such a low growth environment, our strategy to focus on dividend income should continue to outperform. We emphasize companies that both pay and grow a robust dividend. Furthermore, exposure to healthier overseas markets should also be a profitable exercise. We achieve this primarily through investment in multi-national and export oriented American domiciled corporations. Finally, we believe that the economic malaise America finds itself in will ultimately result in a much weaker dollar. Debt cannot continue to grow faster than the economy indefinitely, and the authorities will result to debasing the dollar in order to both increase trade competitiveness and inflate away the debt. Commodities, more specifically gold and oil, have historically performed well in inflationary economic environments such as the 1970s. Gold in particular offers protection against monetary turmoil more broadly, as America is not the only nation resorting to the printing press to boost competitiveness. Once again, stocks in companies exposed to non-dollar international markets should also do well. While this inflationary outcome is likely many years down the road, rest assured that we are positioning your portfolio today to prosper both now and into the future.
For the remainder of 2010, we expect the stock market, as represented by the Standard and Poors Five-hundred, to trade in a range from 1050-1250, with the market closing the year at the upper end of that band. We believe there is room for further gains if the economy continues to expand, albeit slowly, as we expect it to. Many investors, both retail and professional, have shunned the stock market in recent years, and as the financial and economic environment stabilizes, they may be lured back into stocks, particularly when interest rates on fixed income investments offer such little return. This would drive share prices higher. Bond yields still have the potential to move lower if the Federal Reserve increases its purchases of US Treasury notes and bonds, although we continue to believe they will move much higher in the long-term. Gold may consolidate its recent gains, but we feel that the case for higher prices we have advocated for many years continues to be in place. Ultimately, the printing press will have to serve as the primary source of government funding, resulting in a much weaker US dollar and higher commodity prices, particularly gold.