Fagan Associates Archive for January, 2011

Investors in the U.S. stock market seemed to have a classic case of “bubble-phobia,” loosely defined as “fear that this bull market will collapse in a similar fashion to ones in the not so distant past.”  These symptoms can afflict both the experienced professional as well as individual investors and include a failure to commit an appropriate percentage of assets to stocks based upon a fear that the current bull environment is unsustainable.  This “bubble-phobia” can further manifest itself in a lack of action by the investor thereby keeping said investor out of the stock market and reducing one to being reactive rather than pro-active.

Our prescription for the above referenced malady is simple – set up disciplines and follow those disciplines.  One way or another, decisions are made.  Either you make them, or through procrastination, they are made for you.

To help ease your case of “bubble-phobia,” we point to several reasons why the stock market is not in a bubble.  First and foremost, investors can feel comfortable that relative stock valuations are reasonable.  The thirty stocks that comprise the Dow Jones Industrial Average are expected to earn an aggregate of $945 this calendar year.  With the Dow trading at just over 11,800 this places the Dow’s Price-to-Earnings (P/E) Ratio, a common tool used for valuation, at 12.5, somewhat below the normal historical range.

Corporate profits benefit from a stable interest rate environment, one which makes for a more healthy current business climate as well as enabling business to better predict future trends.  Over the past two years, the ten-year U.S. Treasury Note has traded between 3.00% and 4.00%, very predictable indeed.  Furthermore, the Federal Reserve appears to be on hold with regard to raising interest rates.  In fact, some believe that the next move from the Fed will be to lower rates.

At this time, rampant inflation appears not to be an issue.  Due to the slack in the economy, both the Consumer and Producer Prices Indices, key measures of inflation, are subdued and now, with oil trading somewhere around $90 per barrel, the pressure on manufacturers and service providers to raise prices appears to have ebbed.

The leading stocks over the past few months have been quality companies with sound earnings and foreseeable growth in corporate profits.  They have not been speculative companies.  Historically, a market led by the “blue chip” companies, usually has not reached its peak.  It is when it is led by the speculative companies, those that retail investors like, the market has historically topped out.

Finally, retail investors have not fully embraced this rally.  As long as “bubble-phobia” continues to persist, there is most likely room left to run.  At this point in time, stocks are still climbing that venerable wall of worry.  At this time and if history is any guide, after a brief, relatively shallow pullback, we look forward to strong stock market at least over the first half of 2011.

Much ballyhooed financial analyst Meredith Whitney, the president of Meredith Whitney Advisory Group, whose prescient call on the banking sector during 2008 brought her to prominence in the financial services industry, has made another call.  However, this one has resulted in some criticism from equally prominent investors.  Either way, we believe that municipal bonds and bond funds will experience some headwinds for a variety of reasons.

First and foremost, let’s recognize one fact that is indisputable.  As interest rates go up, the value of bonds decline.  The only circumstance that would lessen or eliminate this decline would be a rise in the credit quality of the security, an event that most of us cannot count on.  After a nearly twenty-eight year bull market in bonds, the chances of interest rates going up is greater than them declining.   In our opinion, if the recovery proves sustainable, eventually interest rates will rise from these levels.   Furthermore, should interest rates decline this would imply an economic slowdown, one that would more than likely result in a decrease in credit quality rather than an increase.  Heads you lose, tail you lose.

Ms. Whitney recently stated that a crisis in the municipal bond market “is the largest threat to the U.S. economy” and that “fifty to one hundred” counties and cities could default on their municipal bond obligations over the next twelve months.  Adding to their woes is the fact that according to the Center on Budget and Policy Priorities, a Washington Research Group, in the aggregate states will have more than $140 billion in budget deficits, a sum, that will put pressure on the $2.8 trillion muni bond market.  That said, during an interview with Bloomberg News, Bill Gross, who manages the world’s largest bond portfolio for Pacific Investment Management Company (PIMCO) believes that “ultimately, municipal bankruptcies will be at a lower level” and doesn’t “subscribe to the theory that there will be lots of them.”

We would fall more to the side of Bill Gross, thinking that the worst of the financial crisis is over and that municipalities, like individuals, are beginning to come to the realization that they must get their fiscal homes in order.  That said, given the likely interest rate risk in the future as well as the potential for Ms. Whitney being more right than wrong, we would urge caution when investing in longer-dated municipal bonds and bond funds or concentrating all of your investments in this arena in one state or one region of the country.

THE BOTTOM LINE – Make no mistake about it.  Like investors in all bond funds, investors in municipal bonds can lose money.  For example, one of the nation’s largest municipal bond funds, over the past three months, the Franklin New York Tax-Free Income Fund has fallen more than seven percent while a popular fund for local investors, the Rochester Municipal Fund has fallen more than ten percent, sizable losses for normally risk averse investors.  That said, we subscribe to the time proven tenet that a bear market for bonds is still like a day at the beach when compared to a bear market for stocks.  However, this day at the beach may be cold and rainy.  Do not sell all of your municipal bonds.  However, keep them in line with your objectives and tolerance to risk.

If it wasn’t just rhetoric, politics aside, contained with the recent “State of the State” address by incoming rookie Governor Andrew Cuomo was much that should encourage investors.  First and foremost, after noting that “today we are at a crossroads,” in our opinion the governor then immediately and accurately states that “we are at a time of crisis that has been created by national economic pressures, out of control State government costs and a dysfunctional political system that has lost the trust of its people.”  We believe that it is this dysfunction both within New York State and nationally along with the loss of trust that is greatly responsible for the lackluster business climate.  That said, let us be fair and state that Wall Street also shares blame for the current economic malaise.

Although the devil is in the details and time will tell, in our opinion Governor Cuomo seems to have the right solution to turn the state around.  Early in his speech, he attributes part of the reason that 800,000 New Yorkers our unemployed on “the crush of the second highest combined state and local tax burden in the nation.”  Cuomo observes that “New York’s already hostile business climate – ranked 50^th in the nation – must change if we are to have prosperity.”

Echoing other governors regarding austerity measures that must be taken, Cuomo states that “our government costs are simply unsustainable – at this rate government employee pension and employee healthcare costs will collapse the State’s economy.  The cost of pensions and health benefits for active and retired employees will grow from $1.3 billion in 1998-99 to $6.2 billion in 2013-14 – almost a 476 percent increase.  State spending continues to exceed income and inflation.  From 2000 to 2010 State spending grew at an average rate of 5.9%, while personal income only grew 3.8%.”  As much as we would like to disagree with Governor Cuomo, we can’t.  This level of spending is unsustainable and will crush our economy. 

The solution to the above is to take steps that most families in New York have been forced to take, reduce spending and attempt to increase income.  To this Cuomo proposing a reduction in the number of local government entities from the more than 10,500 that currently exist; the creation of Regional Economic Development Councils; commercializing the research done at our states’ universities; creating jobs through better utilization of New York’s Low Cost Power and capping property tax increases at the lesser of the rate of inflation or two percent.

Governor Cuomo also proposes the establishment of the Spending and Government Efficiency (SAGE) Commission “whose charge will be to undertake a comprehensive review of every agency of state government and recommend structural and operational changes” to the more than 1,000 of them.

On a more immediate basis, Governor Cuomo plans to close the more than $10 billion 2011-2012 budget deficit without new taxes or borrowing by imposing a one-year salary freeze on most public employees whose contracts expire as of April 1, 2011 and imposing a spending cap that will limit growth of government.

These are only some of the points addressed in Governor Cuomo’s speech.  We suggest you Google “New York At A Crossroads / A Transformation Plan for a New New York” to read the speech in its entirety.

THE BOTTOM LINE – In order to create an economy that is conducive to job creation, the private and public sectors must work together.  If both try to gain the upper hand or get the most that they can for themselves, both will fall far short of their potential, leaving New York and New Yorkers once again at a disadvantage to other states.

As songwriter and poet Bob Dylan once wrote, “The Times They Are A Changin’” and indeed they are.  Calendar year 2010 closed out with a bang for most of the major stock market indices while bonds went out with a whimper, quite different from the prevailing winds prior to the fourth quarter as the economic ship seems to be slowly righting itself after a tumultuous three years.  Furthermore, despite the challenges of a weak housing and labor market, we believe this recovery has staying power at least into the third quarter of 2011 when the stimulus from the current tax package begins to wane.  At that time, at the latest, we’ll see if the U.S. economy has reached a sustainable, non-government induced, recovery.

For the investor this means, that unlike 2010 which was back-end loaded, we believe that if history is any guide, investors, after a brief pullback, will reap the majority of their returns during the first half of 2011.  In fact, after analyzing the third year of a Presidential Election Cycle, which happens to be 2011, back to the year 1900, it can be determined that this year outperforms all others on nearly a 2:1 ratio with the vast majority of these gains coming during the first half.  Given the level of stimulus coming from the Federal Reserve in the form of Quantitative Easing and low interest rates as well as the continuation and enhancement of the Bush-era tax cuts, until proven otherwise, we see no reason why this “third year” will prove to be any different.

What we believe will ultimately be good news for stock investors will probably be bad news for fixed income (bond) investors.  After a twenty-year year bull market in bonds due to declining interest rates, we believe that interest rates will slowly, but surely head higher, thereby pushing bond prices lower.  With this in mind, investors should focus on bonds with maturities of less than seven years and non-U.S. Treasury securities like corporate bonds and bond funds.

Our belief as stated above is that at this time the U.S. economy is in a cyclical or short-term recovery, one that has gained its footing in great part due to the massive injection of dollars by the Federal Government.  However, whether or not this turns into a secular or multi-year sustainable economic recovery, one that is led by the private sector, remains to be seen.  That said, there are some signs that the trend for our economy has taken a turn for the better.  Initial claims for unemployment benefits have been declining, exports remain strong, orders for durable goods have recovered, consumers have greatly reduced their dependence on revolving debt such as credit cards, temporary staffing has increased and the just passed holiday shopping season was buoyant.

Finally, we believe that given the results of this past November’s election, the voting public has put both parties on notice, indicating their unhappiness with the status quo.  We can once again quote Bob Dylan who writes “come Senators, Congressmen please heed the call, don’t block up the doorway, don’t block up the hall.”  In other words, either get the job done or we’ll vote you out.  Let’s hope this sentiment continues.

THE BOTTOM LINE – After a brief single-digit percent pullback, we believe stock investors would be well-served to add to their investments, be they either mutual funds or individual securities.  For bond investors, be wary of long-dated bonds and bond funds, concentrating on shorter-dated maturities of less than seven years.  Finally, keep an eye on the economy.  After all, “it’s the economy stupid” was a phrase used by Bill Clinton nineteen years ago that still applies today.