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Market Insight- Fourth Quarter 2009
The stock market, as measured by the S&P 500, provided a wild ride in 2009 but a satisfying 26% return for the full year as investors gained renewed confidence in the economy as the year progressed. After an unnerving 55% dive from the all-time high levels achieved in 2007 to early March of 2009, the S&P 500 sprinted to a record gain of over 67% for the last nine months of the year. We are pleased to report that after excellent relative equity performance during 2008’s 37% market drop, our clients generally enjoyed strong equity performance in 2009 as well. The key to our long-term success is careful attention to risk management. Our job as your investment advisor is comprised of two parts. The first is to make money in good markets, and the second is not to lose significant amounts of money in bad markets. Clients who have been with us during good and bad markets appreciate our risk control techniques. Dumont & Blake’s Outlook for 2010 Most investors’ expectations for stocks are usually based on what happened over recent periods. For many it is the prior calendar year results that set the mood for their future expectations. Based on 2009 results many investors expect continued market growth in 2010. However, we believe that stock prices are linked closely to two factors: corporate earnings and what investors will pay for those earnings. Corporate earnings growth is generally a result of economic growth, which in current times means an improving economy. While we are glad that the U.S. economy has bottomed and is in a modest recovery, we do not believe the recovery will be nearly as robust as would be expected following a major recession such as the one just experienced in the United States and globally. Coincident with this expected lackluster recovery, we believe that high levels of unemployment will continue for an extended period of time. Given the many policy uncertainties coming out of Washington, as well as the extraordinary increases in government debt and deficit spending, employers, entrepreneurs and small business owners are very cautious and will remain so. In conclusion, with the caveat that forecasting market returns is a futile exercise, our outlook for stocks in the year ahead is based on our expectations for a modest, jobs-challenged economic recovery. We believe that single-digit equity returns are attainable and warranted, but not significantly more. If market returns are substantially higher we fully expect your portfolio to participate. On behalf of all of us at Dumont & Blake I want
to wish you a healthy, happy, and prosperous new year. Fixed income markets showed mixed returns as
yields began a slow but steady ascent from the multi-decade lows reached earlier
in 2009. Generally, during 2009 lower quality bonds delivered significantly
higher returns than high quality, Treasury bonds or even equities. Standard
intermediate term Treasury notes declined in value during the year as interest
rates rose from the extremely low levels at the start of the year. Even with the
increase in rates during 2009, fixed income investors are challenged to find
adequate yields without taking significant principal risk. Although the U.S. economy clearly resumed a growth phase during the latter part of 2009, the rate of growth is sub-par and tenuous at best. We see a number of potential headwinds which will challenge sustained, strong economic growth in the U.S. In addition to the huge federal budget deficits (estimated to surpass $1 trillion again in fiscal year 2010), we note that many states and municipalities are also facing significant budget woes. A large part of the states’ fiscal troubles come from ever increasing unfunded mandates emanating from Washington. This will only be exacerbated by the combination of the end of stimulus funding along with the increases in Medicare and Medicaid spending into the next two decades as baby boomers retire. We are firmly convinced that federal and state income taxes will rise over the next several years, as budget deficits on the federal, state and local levels remain unsustainably high. Unemployment remains uncomfortably high with the December employment report released in early January showing the unemployment rate holding at 10.0%. The current unemployment rate understates the severity of job losses. The Labor Board estimated a decline of an astounding 661,000 people seeking work in December. Without this change to the estimated work force, the jobless rate would have risen to 10.4%. The December labor force participation rate fell to 64.6%, the lowest since 1985. Coincident with the decline in the employed, U.S. consumer credit fell by a record $17.5 billion in November. Revolving credit, such as credit cards, declined by $13.7 billion, also a record, as consumers continue to retrench and re-prioritize their spending. Without meaningful improvements in budget conditions at all governmental levels, along with an improving labor market, it is very difficult to make a plausible case for robust and sustained economic growth. As we await the fourth quarter GDP report, we note that fully two-thirds of the 2.2% GDP growth in the third quarter related to vehicle purchases which were heavily supported by the Federal government’s “Cash for Clunkers” program. In addition, Federal spending rose by 8% reflecting stimulus spending, so this also artificially boosted reported GDP during the quarter. The fourth quarter of 2009 will show the first year-over-year earnings gains for the S&P 500 as a whole since the second quarter of 2007. This should end the longest stretch of earnings declines since S&P began tracking operating earnings in 1991. While corporate earnings have surprised to the upside in the past few quarters, we continue to focus on revenue growth for most companies. Staff reductions and delayed purchases of equipment can only last so long before top-line growth must drive earnings. There is one issue that we are studying but
which will only be accurately answered in hindsight: At what level of interest
rates will investor perception switch from reflecting better economic conditions
to one that is negative and changes investment appetite from equities to fixed
income? Our best estimate is somewhere near 4.50% on the 10-year note, but that
is just an educated guess. Stocks no longer look as extremely undervalued as they were during the spring of this year. Although earnings estimates for both 2010 and 2011 have moved steadily higher for most of the past six months, we believe a great deal of this is already factored into current stock prices. We did not meaningfully change our portfolio
positioning during the fourth quarter. Client portfolios were structured to
benefit from the expected improvement in economic news while cushioning against
the risk of a double-dip slowdown. We remain underweighted in the financial
area, a position we have held for about 18 months now. While the financial
sector is in much better health than it was 12 months ago, there are still
several challenging issues such as commercial loan defaults and the need to
improve capital structures that these institutions must surmount before we would
be comfortable aggressively buying in this sector again. To say that 2009 was a stressful journey for investors would be a significant understatement. The volatile movements in many distinct asset classes remind us again that investing combines reward and risk. Many investment managers focus only on reaching for higher returns while paying little attention to the level of risk incurred. We continue to view our primary role as your risk manager. For several years, this has been the key driver of our investment management duties. Dumont & Blake clients fully participated in the sharp rise in equity markets since the bottom in March. This sharp jump in equity prices of almost 70% in less than ten months is not likely to be seen again for a generation or more. The fact that we attained that level of investment performance while remaining significantly underweight the financial sector in client portfolios is even more rewarding to us because we achieved these returns while taking less risk in client portfolios than the market in general. Although financial stocks returned well over 110% from the March bottom, we believed that many of these companies were too speculative to buy for client portfolios. While this portfolio positioning subtracted some potential additional performance gains over the last nine months, the overall portfolios did quite well. Client equity portfolios have generally outperformed the S&P 500 over the past one- two-, and three-year periods.
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