The Long View—2010: A First Quarter Update

The first quarter of 2010 logged impressive gains. Overall performance considerably exceeded conservative estimates and the market environment has been quite positive for the economy and for equities. The DJIA had its finest first quarter in 11 years, and the S&P 500; its hottest first quarter in 12 years. The NASDAQ notched its best 1Q since 2006.

Overall, for long term portfolios, we remain quite bullish on US equities and we’re generally bearish on foreign stocks and bonds.

Despite considerable headwinds, the quarter was almost unambiguously positive for stocks. Against warnings of a correction, a double dip recession, and a tepid recovery with sustained high unemployment, stocks were red hot. It was a quarter in which a new and largely unfunded entitlement was created, new and unexpected taxes on capital gains and investment income were imposed and unemployment remained at 9.7%. But, despite these factors, the dollar made a comeback, the housing market stabilized and the global economy revved up its collective engines. The first quarter was a very positive time for aggressive, bullish investors.

Domestic economic health appears to be improving. Consumer spending, the prime driver in a recovery, increased by 0.4% in January and 0.3% in February. Consumer sentiment was up and down in the quarter: in the Reuters poll, it went from 74.4 in January to 73.6 in both February and March, about where it was last September. The Conference Board survey read 52.5 for March, up from 46.4 a month earlier yet below January’s reading.

Inflation remains low. The Consumer Price Index went north by 0.2% in January but stayed flat for February. At the end of February, the Bureau of Labor Statistics estimated that we had seen 2.1% inflation over the last 12 months. Towards the end of the quarter, we began to see interest rates on US treasury bonds increase, which presents some evidence that concerns are beginning to mount about the impact of long term structural deficits. However, this is also an indicator of the relative attractiveness of stocks and a general movement out of bonds for bullish reasons.

The economy appears to be maintaining momentum. From January to March, the Institute for Supply Management’s manufacturing index read 58.4, 56.5 and 59.6; its service sector gauge also went positive in all of those months, coming to 55.4 in March. Durable goods orders soared 3.9% in January and increased another 0.5% in February for a third straight monthly gain. Retail sales advanced 0.3% in February after an adjusted 0.1% gain in January. We anticipate that retail sales will continue to remain strong and manufacturing will continue to recover. 

Economic Data/Currencies

Data	Current	Year over Year	Notes
Consumer Price Index (CPI as of 3/18)	0.0%	+2.1%	Excluding food and energy, annual inflation is at its lowest level in six years
Unemployment rate (as of 4/5 for March)	9.7%	+1.1%	162,000 jobs added to nonfarm payrolls is largest increase in 3 years
Gross Domestic Product (GDP) (as of 3/26 for Q4)	+5.6%		Lower than earlier estimates, but up from Q3′s 2.2% growth
As of March 31, 1 euro equaled:	$1.35	Dollar +2%	In March, dollar hit its highest level since May 2009
As of March 31, $1 equaled:	¥92.70	Dollar +.5%

Unemployment remains persistently high and will likely remain high. This is broadly distributed across the economy, but is particularly persistent in the manufacturing, hospitality, construction and retail sectors – areas unlikely to recover quickly and characterized by low skilled labor. Companies appear to be enhancing productivity as opposed to hiring new personnel through technology investments and managerial innovation. The unemployment rate was 9.7% in every month of the quarter.

The notable development that the economy added 162,000 jobs in March, the largest month-over-month surge in payrolls in nearly three years, is somewhat less significant when one considers that approximately 25% of that growth came from 2010 Census hiring and other temporary initiatives. We expect that firms like Salesforce (CRM) will continue to benefit, as companies look to increase their investment in technology like cloud computing and outsourcing that will allow them to avoid hiring personnel and making large capital outlays, particularly in light of the challenging political and tax environment.

The health care’s passage makes health plan stocks attractive. We don’t expect the current health care bill to be actually implemented in its current form between now and 2014. But the effect of the legislation is such that managed care firms will now effectively operate as utilities going forward – under any scenario. Given the death of the public option, this means more stability in earnings for these firms. These firms have relatively slim profit margins (4-6%), cost compression is unlikely to be very effective, and we expect some consolidation in the space, but a relatively clear financial outlook for these firms will come wake of heavy regulation. Considering the price earnings ratios of the handful of players are quite low – Aetna (12.4x), UnitedHealth (10.2x) and Humana (7.7x) and companies with relatively stable earnings in the utilities generally trade at considerably higher multiples (e.g., PG&E [13.5x], Consolidated Edison [14.3x], Southern Company [16.3x]).

Global economic health also suggests a recovery, but less strong. Essentially, the long term structural problems facing Japan and Europe are far more severe than the US and the politics are much more complex.

The story that earned the most headlines was Greece, but this represents only the tip of the iceberg, as similar problems of measurement and reporting of government finances are pandemic throughout the EU. As March ended, the leaders of the European Union states indicated a bailout was forthcoming, putting world markets more at ease, but the nature of such support is unclear. Quite soon, the leaders of Europe will have a choice – either engage in a series of (unpopular) budgetary  reforms or attempt to borrow to meet shortfalls in tax collections. Given the lower rate of growth in Europe that can realistically be achieved under the best of circumstances, the valuation of European stocks seems ‘reasonable’ to slightly ‘overvalued’, at least in aggregate.

World financial markets generally under-performed the US. Stock indices in China and Hong Kong (and Portugal and Spain) had a rough quarter. Outside of those regions, other benchmark indices posted quarterly gains. A roll call: DAX, +3.3%; FTSE 100, +4.9%; CAC 40, +1.0%; Nikkei 225, +5.2% (buoyed by a great March of +9.5%); Australian All Ordinaries, +0.2%; RTSI, +6.7%; Bovespa, +2.6%; Sensex, +0.4%; MSCI World, +2.7%; MSCI Emerging Markets, +2.1%. The Hang Seng slipped 3.0% for the quarter and the Shanghai Composite fell 6.7%. We remain, overall, bearish on Chinese and Emerging Market equities.

Commodities markets were mixed, but generally negative. Nickel is hardly precious, but this base metal was the hottest commodity of the quarter, thanks to a drop in inventories and high demand (especially in emerging markets) for stainless steel. Nickel advanced 34.9% on the LME (London Metal Exchange) in 1Q 2010. Gold futures gained 1.5% for the quarter; silver futures rose 4.0%, while platinum futures rose 12.0% and palladium soared 17.4%. How about copper? Another gain: 5.5% this quarter. The U.S. Dollar Index had a strong quarter, gaining 4.1%. As for energy futures, oil gained 5.5% and heating oil 2.2% in 1Q 2010, but natural gas futures fell a miserable 30.6%. The winter was rough on some notable crops: while orange juice gained 4.8% last quarter, soybeans were down 9.5%, cocoa 9.7% and corn and wheat both dropped 16.8%. Sugar did worse, falling 38.4%. We remain generally bearish on commodities as an asset class, but trading opportunities do still present themselves for highly aggressive clients.

Housing prices & interest rates continue to fall. This was the quarter in which the clock ticked – the perception was that time would soon run out for homebuyers to take advantage of federal housing credits and federally-aided low mortgage rates. So what happened? Home sales weren’t that great, leading analysts to wonder what they would be like next quarter without tax breaks and the Federal Reserve buying mortgage debt.

 Existing home sales fell 0.6% in February for the third monthly dip in a row. New home sales dropped 11.2% in January and then 2.2% more in February to the lowest level on record. The bright light was pending home sales, particularly the February statistic from the National Association of Realtors: +8.2%, reversing January’s 7.6% retreat. The Federal Reserve has slowly moved out of explicitly supporting real estate finance and we expect that interest rates will begin to creep up on mortgages in the coming months.

 So, this is likely a good time to finance or refinance. Mortgage rates trended slightly downward, at least by Freddie Mac’s measure. The average rate on a 30-year FRM was 5.09% in Freddie Mac’s first survey of 2010 (January 7) and 5.07% in its April 1 survey. As for movement on other rates, here are the numbers across the same time span: 5/1-year ARMs, 4.44% down to 4.10%; 1-year ARMs, 4.31% down to 4.05%; 15-year FRMs, 4.50% down to 4.39%. That having been said, housing markets continue to look weak and real estate continues to have a gloomy outlook. We have been shedding real estate exposure in most client accounts. We think that the overall trend for real estate will continue to be negative for several more years and discourage clients from allocating more of their portfolios towards real estate if they have considerable exposure to the property markets through real estate in their homes.

History favors a positive second quarter outlook. Are we on pace for Dow 12,000 or higher and double-digit gains this year? The first quarter of 2010 hints at that direction. During years in which the S&P, DJIA and NASDAQ have had positive 1Qs, those indices have notched average annual gains of 12% or better. So far, the potholes on the road to recovery haven’t been that deep – and we don’t expect growth in earnings or the aggregate economy to be a problem for the next few quarters. Outside of the housing sector, the manufacturing and service sectors are growing and consumers are spending a little more. Notions about the stock market being ahead of the recovery should fade as evidence mounts that the recovery is gaining strength, justifying higher valuations, meaning that stock prices should grow in excess of profits for a little while, anyway.

This isn’t to say that the markets aren’t full of risks. If the last two years have taught us anything, equity investing is only appropriate for people with long time horizons for that money and a strong stomach. The effects of the health care legislation on the inflation outlook, partisanship in Washington and an increasingly hostile regulatory environment all help drive the potential for market panics and unexpected recalibrations of investor expectations. A substantial correction is always possible, but the environment is highly conducive to investors with a time horizon of several years.

Our emphasis has been on blue chip growth stocks, more aggressive forms of fixed income and we view the health care legislation as providing opportunities to invest in managed care and other health care stocks on a short term basis. We see the expected tax increases in coming years as an opportunity to take advantage of currently low rates to rebalance portfolios for the long term.

I’ll be back with another quarterly update at the start of July. If you have any questions or concerns about what I’ve written, please don’t hesitate to contact us.