Outlook Newsletter - May, 2010
By James H. McBride, Managing Partner

As a surprisingly strong earnings season continues, the new bull market has entered the second phase where longer term investing replaces the trading of phase I as the primary market mover. We are still quite bullish for the longer term, but somewhat more cautious for the near term. Candidly, the markets are now overbought and we need a near term correction of at least 5% to “cool down” the volatility we have been experiencing of late.

There are still many dangers lurking that could threaten this economic recovery, the most significant being job recovery. So far we have made little progress, but the exceptionally strong recovery of corporate earnings bodes well for future job opportunities. We also worry about the huge amount of government debt forcing the rise of inflation – the easy way out for our government (and Congress) is to keep spending and hope to pay off its debt with inflated dollars. And then there are fears about European debt, China’s overheated economy and the specter of the “other shoe” dropping in the commercial real estate market. Add to those the current crisis off the Louisiana coast and its fair to say that “the wall of worry” that all bull markets climb is still fully intact!

We expect this current extreme volatility to continue until the traders take time off to enjoy the “dog days of summer”. To date the S&P 500 Index has reached a high this year of 1216 on April 26th from a low of 1053 on February 5th. As of the May 4th market closing it stands at 1174. Should it fall to 1154 it will be our first warning sign to harvest some profits. Much has been said and written about the debt problem in Greece and the potential for spill over into other European economies, and it is this heightened fear for recovery of the global economy that is one of the main catalysts for the current volatility.

Our strategy for the next several months is to de-emphasize international markets (poorest performers year to date) until the European debt crisis resolves itself to our satisfaction, emphasizing large, dividend paying multinational corporations based in the U.S. and limit our exposure to bonds. The strong recovery of the U.S. corporate profits bodes well for foreign revenues/profits from multinationals for the next several years. By stressing investment in U.S. corporations which receive at least 50% of their revenue outside the U.S. we can participate in foreign market recovery with less risk and volatility than we would experience in the direct foreign markets.

A longer term strategy is to limit our portfolio exposure to fixed income bonds/notes due to the strong probability of rising interest rates which will in time erode the principal value of these investments. Combined with an increase in inflation, the results can be devastating for income oriented portfolios.

Since September of 1981 when the Federal Reserve began aggressive money tightening to fight runaway inflation – the rate of inflation fell to under 3% by 1/1/1984 from that 9/81 high of 14.8%. Annualized returns from longer term government bonds have averaged 10.8% versus 11.2% for S&P 500 equities over that same nearly 30 year period (Tacita Capital report in Advisor Perspectives, 5/1/2010)).

It is our belief that the huge increase in U.S. government debt will support a higher risk premium, and our less courageous legislators will choose the easy way out and let inflation grow to pay down government debt in cheaper dollars rather than reduce spending. It is easy to project that until the debt issue is resolved, bonds are a very hazardous investment option.

So what can we substitute for bonds to obtain the necessary cash flow? We have researched alternative cash flow vehicles and believe that such vehicles as Master Limited Partnerships, preferred stocks, high yielding utility stocks and REITs used as supplements to basic fixed income positions can give us insurance offsets to inflation and rising interest rates. Your individual advisor will discuss specifics with you and help to choose the right combination to meet your specific needs.


AUTHOR’S NOTE: Shortly after I wrote this Outlook, the markets experienced the huge breakdown correction of May 6th and 7th, resulting in an overall correction of more than 5% in all markets. The Greece-European debt crisis is the excuse, but in the real world long term global recovery can be assured if governments quickly act together to stabilize the debt crisis. I think that will occur and that the USA’s recovery will continue to lead the way back through corporate profits via our strong multinational companies.

For questions or additional information on this newsletter, please contact us.

The projections of returns for specific investment types are estimates and projections and therefore prone to error. Actual returns may differ significantly from projections. Your experience will differ from the performance of specific asset types to the extent that several types exist in your account, and to the extent that your specific investments perform differently than the average of that asset type. Whether any of the asset types mentioned above are suitable for your account must be determined individually, and your portfolio may not contain some of the asset types described. These views represent an appraisal of possible events. Outcomes and performance is not guaranteed. The investments listed may go up or down in value, and they are not suitable for all investors. Securities offered through Ensemble Financial Services, Member FINRA (formerly the NASD, SIPC).