Outlook - May 2010

Overview:

As I scan various periodicals I find a re-occurring theme: the market rally has been unexpected, stubbornly strong, and persistent. Additionally, most equity market analysts seem to indicate an expectation of inflation and a subsequent rise in the ‘fed funds rate’ sometime in 2011.

(Fed Funds rate - http://en.wikipedia.org/wiki/Federal_funds_rate )

However at the FOMC meeting of April 28th the Federal Reserve (Fed) stated they would keep the Fed Funds Rate somewhere between 0% and 0.25%. They further stated that there are several economic issues that cause them concern. Additionally they do not foresee inflation any time in the near future.

(Federal Reserve - http://en.wikipedia.org/wiki/Federal_Reserve_System)
(FOMC - http://en.wikipedia.org/wiki/Federal_Open_Market_Committee )

I still hold that the real issues facing us in 2010 and 2011 are:

I would like to call particular attention to the second issue. How is the Fed going to shrink its balance sheet back to normal size? The final answer will not be clear for several years. However, the actions taken by the Fed in the coming months and year(s) will determine our economic strength, stability, and worldwide influence for many years. At the very heart of the matter is how accurate the Fed’s predictions are. It is easy to see what we should have done, difficult but not impossible to see today, and critical that we see tomorrow. One tool in the Fed’s tool box that tends to go unnoticed is reserve requirements, or amount of funds that a depository institution must hold in reserve against specified deposit liabilities. The recent increase in reserve requirements has a trickle-down effect that reaches far beyond one bank’s ability to lend and one company’s ability to borrow. The lesson that the history of money supply teaches us is that to ignore the magnitude of money supply changes is to court monetary disorder. Time will tell whether the current monetary policy is enduring and a challenge to that lesson.

(What is money supply? - http://www.econlib.org/library/Enc/MoneySupply.html )

Current State of the Recovery
Things improving:
• Corporate Earnings
• Business Spending
• Manufacturing
• Consumer Spending
• Exports
• Technology Spending
• Emerging Market Economies

Things getting less worse:
• U.S. Employment
• U.S. Housing Prices

Things that are concerning:
• State and Local Finances
• Federal Budget Deficit and Borrowing
• High Commodities

Congress, the deficits, and lending:

State and local governments’ poor fiscal situations have been hit by sharp declines in sales (sales tax receipts) and income taxes. Simultaneously more and more owners are contesting home valuations which will lower property taxes. While sales taxes are typically the first to rebound in a recovery, income and property taxes tend to lag the economy. These three sources of income affect our national, state, and local governmental budgets to varying extents. While the national government does not benefit from property taxes, the state of Texas does not benefit from income tax. Both are affected by sales taxes. This conundrum is further aggravated by recognition that governments have not put aside enough funds to cover pension, retirement, and health care benefits.

With all this working against local and state governments, the national government has had to step in and pick up the slack. That means the national government has been taking on more obligations while suffering from some of the same setbacks. In fact the deficit is now approaching a trillion and a half dollars.

While the government is raising money by borrowing from foreign countries via the issuance and sales of U.S. Treasury Notes, large companies have been able to do likewise and issue bonds. For a while large, highly rated companies were forced to pay a tad higher interest rate on their bonds, but more recently the fear has come out of the corporate bond market and with a lack of yield elsewhere, fixed income buyers have been willing to accept relatively low yields from these corporations. At the same time bank lending still hasn’t recovered and it is very hard for smaller and midsized companies to get credit. This has led to the smaller publicly traded companies issuing stock to raise capital which dilutes the share holder’s interest. This is a catch 22 for investors. It appears to be smart thing to do for companies but does damage to the shareholders. Non-publicly traded companies, on the other hand, do not have the choice to issue shares, which puts their balance sheet under pressure. Since they are the engine of employment growth, this bears watching.

Foreign Markets:

I will not spend a lot of time here. Everyone that has a television, radio, or reads the newspaper knows that Brazil, India, China, and Russia get most of the press when it comes to investing in foreign markets. The reality is Texas alone has a greater impact on the worlds GDP than all of these countries except China. The world share of GDP for each of these countries is: China – 7.4%, Russia – 2.8%, India – 2.1%, Brazil – 2.8%. What is to be discerned here? While I believe there is money to be made investing in these foreign countries, they are what they are: a small part of the Global GDP and the U.S. alone still makes up 24.4% of the world’s GDP. While these developing markets are an engine of growth and demand for basic materials and natural resources, the U.S. economy will still dictate whether or not the global recovery is intact. I would be remiss if I failed to mention Greece here. Are you ready for this? With all the headlines about sovereign debt in Greece, the fact of the matter is Greece only makes up 0.6% of the global GDP. It is more important to us to keep the economic recovery in New Mexico intact than it is Greece.

Source for GDP info: http://www.usgovernmentspending.com/us_gdp_history
Also: Bloomberg, Factset, OECD

What does this all mean?
In general it looks like the recovery is underway, but with some pockets of weakness to keep an eye on. That covers the fundamentals. The next step on any investment is to look at the price, or valuation. Is an investment cheap or expensive relative to both its own history and alternatives? Many of you asked me to look at stocks this quarter. There are many ways to measure stock valuations and there’s no one right answer. A common way is to look at bond yields against stock earnings yield. Bond yield is simple --- it’s the coupon payment you receive for every $100 in bonds you own. Earnings yield is your share of a company’s earnings for every $100 in stock you own. Now this is not strictly an apples-to-apples comparison. Some analysts believe earnings yield should always be higher because stocks are riskier than bonds. The counter argument is that over the long term, earnings have grown while bond coupons stayed flat, arguing for you to accept a lower earnings yield on stocks because of the implicit inflation protection they’ve offered. So on these measures here’s how bonds and stocks looked at the end of March. Based on analysts’ 2011 earnings estimates for all the companies in the S&P, the index had an earnings yield of nearly 8%. This isn’t as attractive as last March’s level of nearly 10%, but to most analysts it looks reasonable against what you can get from Treasuries or corporate bonds. Here at Alamo Asset Advisors we continue to pay attention to valuations, earnings, risk, and business cycles.

We are finding value in individual stocks that are in the right time of their business cycle such as in basic materials, natural resources. Additionally we continue to find great ideas in companies that are changing the way everyday folks live their lives, such as smart phones, power management, communication management and medical advances. We have also found value in finding ways to replace the banks in the lending cycle. All in all, the weight of the evidence from where I am sitting demonstrates that the economic recovery is progressing and may well turn out stronger than many investors expect, and that the bull market in stocks is intact but getting more and more mature. So, I see more opportunities than risk over the intermediate term. We are working hard to exploit those industries that are in a good part of the cycle and we expect will deliver growth in earnings, margins, and revenue. I encourage all of you to become more active in our national decisions and hold people accountable for how they spend our hard earned money. I once heard my friend, Howard E. ‘Ben’ Davis say, “Get informed or get out of the conversation." It is time we all get informed, get involved, and make a difference.

Alamo Asset Advisors is the operating name for E&C Private Wealth Management, an independently owned Registered Investment Advisor. Securities offered through WFG Investments, Inc. WFG member FINRA and SIPC.