Dear Investors,
“Why is the market going up? The economy is in terrible shape!”
In our discussions with investors over the past several months, we have been asked this question many times. Sure, the U.S. economy is still in rough shape. The unemployment rate remains at 10%. The Fed is still holding short-term interest rates at zero for fear that premature increases might set back the ongoing recovery. Housing is still declining in many regions, consumers are pessimistic and our country’s long-term fiscal outlook is challenging.
So why is the market going up? The reality is that these things are known factors and as such do not matter so much for the equity market, which moves in anticipation of changes in the economy. It would seem reasonable to assume that markets do their best during good economic timesbut this is not the case. Historically some of the sharpest investment returns have come during bad economic times when the state of the economy transitions from being absolutely horrendous to just plain bad. In the fall of 2008, investor Warren Buffett declared the U.S. economy to be in “freefall.” Now, with the economy still weak but certainly stronger than it was in 2008, this pattern of the stock market moving aggressively higher ahead of commensurate economic progress has occurred yet again. Over the last 54 weeks, the S&P 500 Index has rocketed more than 70% off its March 9, 2009 crash low.
Evidence continues to mount that the U.S. economy is on its way to recovery. There are many long-term challenges, of course, but for the moment a cyclical upturn is at hand. The March 2010 non-farm payroll report showed preliminary job gains of 162,000 for the month, the strongest month for jobs since March 2007. Retailers are growing again now as consumers come out of their bunkers and Corporate Americaoutside of the financial sectorremains in excellent financial shape. Companies have spent the last couple of years honing their operations, cutting costs and letting a mountain of $3.1 trillion of cash accumulate on their balance sheets. Corporate profit margins have bounced back sharply from a year ago and companies are now back in the mode of increasing dividend payments to shareholders. In the first quarter of 2010 alone, seventy-five of the S&P 500 companies hiked their dividends. Rising dividend payments are a solid indication of growing confidence in executive suites around the world.
But now what? After the huge move in global markets over the past year and the sharp rebound in corporate profits, investors appear to be getting more enthusiastic. (Investor enthusiasm, incidentally, is not something we like to see in the markets because asset prices peak when investors are enthusiastic, not pessimistic. We would prefer a steady wall of worry, if we had our choice.) With the mood increasingly buoyant as this recovery continues its transition from a wish to a hope to a reality, the Federal Reserve will have to move to extract itself tactfully from its easy money policies that helped to cushion the downturn.
The Fed has supported the economy with two stout crutches that it will soon have to remove. (We hope the patient will be able to remain standing after this occurs!) The first is the short-term interest rate, which now stands at 0%-0.25%. By raising the Fed Funds rate, the Fed will make short-term capital more expensive, lending less profitable for banks (who borrow short and lend long) and make it more palatable for investors to own short-term bonds. In short, a higher Fed Funds rate slows down economic activity by making capital more expensive.
The other crutch the Fed will likely remove in 2010 is the support it has provided to the credit marketsparticularly the mortgage market. Since the financial crisis erupted in late 2008, the Fed, in an effort to support the housing market, has been buying mortgage-backed securities in the open market in order to keep mortgage rates lower than they might otherwise be. In March 2009 it committed to buying $1.25 trillion of such securities in the ensuing year. Well, that year is now up and last month the Fed terminated its mortgage-backed security program. Mortgage rates are thus likely to tick up in the coming months, both from the absence of Fed buying activity as well as higher long-term rates that are reflective of a brightening economic outlook.
Outside of the U.S. the big story of the quarter was the Greek debt crisis. It is no secret
that several countries in the Eurozone have poor fiscal discipline and are piling on debt while continuing to run massive budget deficits. (This happens in plenty of countries outside of Europe as well, of coursesuch as here in the U.S.) Greece was the headline this quarter, but several other countries in Europe, including Spain, Portugal, Italy and Ireland also have very shaky finances and increasingly wary debt-holders. In future months and years we will be hearing more about the rising risk in sovereign debt as countries struggle to bring their spending plans into line with their greatly reduced tax revenues. The burden from the 2008-09 financial meltdown has thus not gone away; instead it has largely been shifted to the shoulders of national governments.
For the moment, however, a host of indicators are pointing to a stronger global economy in the months ahead. We appreciate your continued confidence and as usual we welcome your comments and feedback.
Best Regards,
Peter Thoms & Seph Huber
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Phone: 619-435-1701
