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Third Quarter 2010

The recovery from the financial crisis of 2008 has been anemic and uneven, with the economy still showing mixed signals. GDP growth in the second quarter of this year was negatively impacted by an unusually large amount of imports, and should rebound in Q3 to levels above 3%, especially considering that business inventory building is increasing in order for U.S. firms to meet firming domestic demand.
As a result of the continued weakness in employment, however, the Fed is considering new simulative measures to stave off the threat of deflation.

In a September 21st Federal Reserve statement, language suggesting a fresh round of economic stimulus was used to pave the way for more “quantitative easing”, now being popularly nicknamed “QE2”. This policy could be announced either on November 3rd, December 14th, or January 25th, and is likely to drop interest rates further, supporting stocks and bonds, driving the dollar down, and boosting gold prices even higher. The first round of quantitative easing began at the end of 2008 and resulted in the Fed buying $1.7 trillion of treasury, mortgage, and agency bonds. The next round could be of significant size, meaning that the balance sheet of the Fed, which started at $800 billion in 2007, will bypass its current level of $2.3 trillion. “Balance sheet” here is a euphemism for debt. The Fed is piling on debt to resolve the debt crisis, which will have negative implications in the future, but not before such a liquidity injection has a chance to rally stocks, bonds, and commodities. Indeed, structural deflation resulting from the housing market (the housing component of CPI) is beginning to edge back up, while the CRB Commodity Index is hitting new highs. The CRB index measures 22 commodities whose markets are among the first to be influenced by changes in economic conditions, and is considered an early indicator of the economy. The regional Federal Reserve presidents are far from unanimous yet on QE2, and this decision should be monitored closely in the weeks to come.

Ten year bond yields are already approaching historic lows at 2.5%. When the effects of QE2 are fully built in to the market, yields will be even lower and bond prices higher. Over the last two years, US retail mutual bond inflows reached over $700 billion. To put this into perspective, it is the roughly the same number that went into equity mutual funds preceding the peak of the technology bubble in 2000. When the party finally stops and the inflation hangover begins, stocks are likely to benefit, as money begins flowing out of bonds and into higher yielding stocks. Profit growth among S&P 500 companies will bypass 40% this year, which is the fastest profit growth seen since 1988. While the economy suffers aftershocks from the financial earthquake of 2008, US corporate earnings are set to reach all time highs in 2011. High dividend yielding stocks are still attractive in a low interest rate environment, especially when their yields are higher than most fixed income instruments. There are 68 stocks in the S&P500 Index which pay dividends in excess of the average corporate bond yield of 3.8 percent, more than at any time in at least 15 years,

Whether the Bush-era tax cuts survive this fall or not, the risk of paralysis in fiscal policy has increased as Republicans and Democrats grow increasingly divisive. This is unfortunate, as the Fed will soon be out of monetary policy “ammunition” to stimulate the economy further. Both in the U.S. and abroad, the politically toxic issue of pension reform will take on increased significance in the public and private sector. The government needs to take strong measures over fiscal reforms at the Federal and State levels, which requires courage regardless of which party dominates the Congress.

Manufacturing expanded in the month of September for the 14th straight month, lending support to a bullish outlook.
The S&P 500 index still has a low valuation, with an estimated 2011 P/E of 13.5 times, compared with its average of 16.5 times since 1954.
There are nonetheless many risks still lurking within the economy, the most obvious being: 1) Potential U.S. state bankruptcies, 2) Potential default in Ireland or Greece, 3) A sharp rise in mortgage foreclosures, 4) No prolongation of Bush-era tax cuts due to Congressional gridlock, and, 5) While a weakening U.S. dollar will strengthen U.S. stocks, a dollar collapse would be negative. This is possible if “QE2” takes place on a scale that is much larger than expected.

Grant Rogers
Partner

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