Review & Outlook

Our take on the investing, financial, & economic themes of the day

Fourth Quarter

11 January, 2011 by Mark O'Brien in Quarterly Letters

Stocks rose on average 11 to 13% in 2010, which is a little better than their historical average of 10% a year.  And last year made it two in a row that stocks registered double-digit gains.  The previous year (2009) was even better than 2010, with stocks rising more than 20% on average, though the latter big performance came at the end of such a miserable decade for stocks that investors did not care if stocks went up 20%, because portfolios were still so far underwater.  But now, with 2010 over, investors seem to care about stocks again.  Another year has passed, and it is the start of a new decade, and the arithmetic is starting to look different.  Stock portfolios are back to where they were in the fall of 2008, when Lehman Brothers  failed  (the unofficial start of the financial meltdown);  and  they are even within striking distance (about  18% shy) of the all-time high of 14,164 reached in October 2007. While some 8.8 million jobless Americans don’t feel anything close to normal, the rest of the population – – and that includes investors – – appears to be moving in that direction.

Should stock investors feel better?  I think so.  Not so long ago there were accidents all over the place waiting to happen.  Well, the accidents happened, and while people are still dealing with the consequences, the accidents are unlikely to happen again.   Behind us, then, are conflicted rating agencies, somnambulant boards of directors, ineffectual regulators, skewed compensation schemes and wildly speculative computer programs dressed up as “financial engineering.” No, members of the financial and investment community are going to be on the extra cautious side for the foreseeable future, which is indeed cause for encouragement.

Unfortunately, though, that is not the end to the story. Members of the financial and investment community may have learned their lesson (that is, at least until the next bull market) but not the central bankers and politicians, who are still hard at their financial engineering.    I am referring to policy makers in the Federal Reserve and Treasury Department who, in a time of multiple foreign wars and the attendant expenses, are printing money.  In the name of economic stimulus, one arm of the government (the Federal Reserve Board) is loaning vast sums of money to another (the U.S. Treasury).  This legerdemain goes on over the objection of existing debt holders, who recall the tragedy of Germany in the last century, when the price of one pound sterling rose from 20 marks to 310 billion marks in 10 years. (See When Money Dies, by Andrew Fergusson for a fascinating account of German financial engineering in the 1920s.)  There are more contemporary examples.  Right off the bat one thinks of Greece, Italy, Ireland, Portugal, Spain and untold numbers of republics in South America and Africa, where central bankers and politicians said “Don’t worry; we’ll  step on the brakes when we have to,”  which is exactly what our central bankers and politicians are saying now.

This brings me back to the 11 to 13% climb in stock prices in 2010.  How real was it? Did the stock market do this on its own or was it the short-term effect of more financial engineering?   It is a worrisome question.  In mid-summer, when the stock market was down 10% ,  central bankers at the Federal Reserve  announced a $600 billion money-printing program called Quantitative Easing Two, or QEII for short   (the Roman numeral “II” signifies the second  such program in as many years).  Almost immediately the stock market responded.  It recovered the lost 10% and then added another; altogether it was a 20% swing in six months.  But one quakes if this is the plan – – every time the market sputters, the government prints $600 billion in new money.

In the United States the federal budget deficit represents 11% of national income; total federal debt is 95% of national income.  In Europe the comparable figures are actually better at 6% and 80%, respectively.  By piling on debt to finance deficits (aka economic stimulus), America appears to be creating the conditions that engender European-style stagnation.  We may be seeing signs already.  Some 18 months after the recession ended, at a time when unemployment is typically falling, unemployment has only inched down from 9.8% to 9.4%.  The housing sector refuses to get better, and in the face of rising mortgage rates and still more foreclosures, may actually get worse in coming months.  One of the few bright spots is taxes, though here the good news is that they won’t go up for two years, after which all bets are off.

So this is not the best of economic recoveries, to put it mildly.  Stock and bond market expectations probably ought to be muted while we, as a political economy, work out this public-sector debt problem.  In this climate we still like big-cap blue-chip stocks.  They don’t need a great economy to grow two or three percent a year.  They pay dividends that exceed the yield of the 10-year Treasury note  (presently 3.30%).   I haven’t seen this before; usually dividends are a fraction of the 10-year Treasury yield.  But the rich 3.3% dividend plus 2 to 3% price appreciation makes something in the 6 % range for stocks in 2011.  Since half their sales are overseas, these big companies can participate in fast-growth markets in Indonesia, Brazil, China and India.  So there’s potential to do better than 6% in 2011. But we like the fact that these companies are practically debt free, with plenty of room to borrow at low rates if they have to, and they are reasonably priced by historical standards. Companies that fit the profile include familiar names like Exxon, Emerson Electric, McDonalds, Sysco, Johnson & Johnson.

In the bond market the best value has been in the municipal sector.  Yields in both taxable and tax-free munis are at long last remunerative, and compared to money market rates, they are an absolute steal at 4 and 5%.  But one must know the market and stay with the strongest states (no New Jersey, New York, California, Illinois) and essential service and general obligation bonds.  In other sectors of the bond market, though, prices are still very high and yields very low.

In closing let me alert you to our newly redesigned website.  The address is the same ( but the website itself has a number of new features, including occasional comments from me and associates Sally Sulcove and Ben O’Brien on new economic and investment news.  Take a look and let me know what you think.


Mark O’Brien