Winds of Change: Resetting Market Expectations

The winds of change are in the air, and we are not talking about the change of seasons as we move into fall: closing up the lake place, getting the children back into the school routine, or settling in for some serious gamesmanship on the field. Instead, we are talking about market expectations, global growth, the political landscape, and the global recognition of countries and governments living beyond their means and amassing unsustainable debt burdens. As we have observed investors’ behavior over the past six weeks of volatility in the markets, we are reminded of the old lyrics from The Mamas and The Papas’ “California Dreamin’”: “All the leaves are brown, and the sky is grey.” Investors clearly have adopted this view of the world as the global economy seems to be working through a “fearcession,” not a recession. Such a negative perspective could be harmful to investors’ financial health, causing them not to recognize, or simply to ignore, the opportunities available.

The Environment Today

This is not 2008 all over again, when the global financial markets were struggling with the housing crisis, credit implosion, corporate failures and massive government bailouts. The environment today is materially better than the crisis days of 2008-09, although you would never know it by looking at yields on the 10-year U.S. Treasury bond. As recently as late August, yields dipped below 2% on the 10-year, lower than in the height of the financial crisis of 2008-09. This is primarily a reaction driven by fear of the unknown, not by any actual crisis: fear of debt talks. Fear of European banks failing. Fear of a sovereign debt default out of the Euro zone (although one could argue that the voluntary restructuring of Greek debt recently was a default, from a technical credit default swap perspective it was not). Fear of a double-dip recession. Fear of … you get the point. There has been no technical default. There has been no bank failure. There has been no major financial institution failing. It appears to be more of a “fearcession,” and if we are not careful, the powerful nature of a negative feedback loop could tip us into a recession – one that would be more self-induced by the collective negative attitude than by any actual crisis triggering the event.

Our Outlook

Our perspective is that we will not enter into another recession. In fact, for many of our readers who were able to attend our Economic Outlook earlier this year, the year is playing out very much as expected. Recall that the theme this year was “55 MPH Speed Zone Ahead,” with its main message that we expect growth to be slow for some time, in the range of just one to two percent. Many other firms came out early in the year with much higher expectations and have since had to lower them. Our original outlook stands and is right on track: positive growth, just slower than anyone would like. We expected unemployment to remain stubbornly high, at over 8% for some time to come. It has, and it will. We expected headline risk from the Federal Reserve ending its second quantitative easing program in late June, and there was. We expected noise in the markets over raising the debt ceiling – and with political rhetoric and posturing throughout the spring and summer, Washington did not disappoint on this one. There was huge drama and market noise over this debate, and there will continue to be.

No surprise, no change to our outlook. We expected corporate earnings to continue to grow; they have and at double-digit rates. Valuations remain more favorable for stocks than bonds, so we continue to have an overweight in equities. Right on track, no change to our position.

 What Has Changed?

So what has changed? Most meaningful has been the recognition by the Federal Reserve that our economy will remain soft for several years. At their August 9 meeting, the Fed announced that they will hold their short-term overnight lend rate, the Fed Funds rate, at virtually 0.00% until mid 2013. That was a change, the first time in history that the Fed has specified a time horizon for an interest rate lock. So what does this mean? Fixed income investors will need to reset their expectations of returns and coupon income, as interest rates are expected to remain very low for the better part of two years. Remember, the yield on the 10-year U.S. Treasury is at historic lows, near 2.0%, while headline inflation is running in excess of 3%. That situation delivers a negative real rate of return even prior to paying the taxes on the earnings. A yield of 2% would indicate that the 10-year bond is trading at 50 times earnings with no potential for growth. Contrast that to the S&P 500 stock index that is trading at 12 times earnings with a dividend yield of 2.2%, higher than the yield on the 10-year Treasury. Providing we do not talk ourselves into another recession and that corporate earnings come in near expectations, stocks provide much greater long term potential at this junction.

For investors seeking income, this is a very difficult environment. Given the Fed’s position, it will remain difficult for several years. By default. this will tend to push investors into investments other than traditional fixed income to seek income and an acceptable return. That will require investors to accept additional risk as they seek opportunities in areas such as preferred stock, high dividend stocks; higher yielding, lower quality bonds; and real estate investments.

Here at Bell State Bank & Trust, we have delivered a high-income stock strategy for over six years that is currently yielding 5.8% and is comprised of 85% common stock, 15% real estate and preferred stock. Strategies like ours are gaining momentum as investors recognize that in a slow-growth environment with positive earnings growth, more of the total return of the stock market most likely will come in the form of dividends rather than from capital appreciation.

 Opportunities Do Exist for Investors

As difficult as the recent market environment has been, opportunities exist for long-term investors to earn a reasonable income stream coupled with growth potential. We are committed to delivering to our clients a service level and portfolio structure that balances the client’s objectives and the risks required to achieve those goals. With investable assets approaching $3.0 billion within our Wealth Management Division, the effective and efficient investment stewardship of our clients’ assets is our number one priority. Thank you for your continued confidence. Get out and enjoy the wonderful fall weather – where all the leaves are not brown, nor the sky grey.

Continue reading the Financial FOCUS newsletter or view previous Financial FOCUS newsletters.

 

2 Responses to this post...

  • Holly Holte on Oct 10, 2011 at 2:00 pm #

    Question: If you have an Ira CD can you take money out anytime if the rates go up. In other words can you a a 5 year CD and only keep it for 2 weeks or any time?? Or are there any new rules on the IRA s in the last 5 years?? What would be the best rate for a retired customer with a IRA CD at your bank??

  • Bell State Bank & Trust on Oct 11, 2011 at 11:46 am #

    To answer your first two questions – With the traditional IRA, you can start distributions at age 59 1/2, and the CD does not need to have matured.

    Regarding new rules on IRAs – In the last 5 years, the amount a person can contribute has increased.

    As for our rates – IRA rates can change weekly. You can access all of our rates here.

    You may want to consult your tax advisor to learn more and see if IRAs are right for you. If you have any additional questions, feel free to call or stop by one of our 14 locations.

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