Year of the Rabbit: Time to Calm the Nerves

What will this new year bring? It remains to be seen whether 2011 will mark the third year of a bull market rally…a cooling-off period for risky assets, following a 90% gain in the S&P 500 stock index since the lows of early 2009…or a pause and pull-back in the markets due to artificial economic stimuli, money printing and continued weak employment.

With rapid expansion of the world’s emerging markets, specifically China, we thought we’d take a look at what’s called for in the Chinese New Year. The Chinese have one of the fastest growing economies in the world; with huge fiscal reserves, they are also the largest foreign holder of United States government debt, with over $900 billion of our IOUs. We owe them nearly $1 trillion – so we can be assured they will be watching closely to make sure we are putting ourselves in a position to pay them back. The Chinese New Year, on February 3, will usher in the Year of the Rabbit.

According to Chinese tradition, the Year of the Rabbit is a time to stop, catch your breath and calm the nerves – a time for negotiation. It is said to be a good time to create a safe, peaceful lifestyle that allows you to deal calmly with any problems that arise. Given the economic events of the past two years, the Rabbit may be just what we need. Let’s bring the decibel level of political shouting down a few notches. Let’s step back and work on fixing our fiscal problems, rather than pointing fingers and arguing about who’s to blame. Let’s recognize that not all firms or countries will (or should) survive; instead, let’s address how to navigate the transitions that we’re sure to encounter. After all, Rabbit people are relatively careful when it comes to finances.

Without question, our economy is improving. Two back-to-back years of gains in the equity markets (26.4% in 2009 and 15% in 2010) are pricing in the recovery and return from the abyss of late 2008 and early 2009. (For additional data on how 2010 turned out, refer to the “Market Roundup” article in this issue.) Earnings for the 500 companies in the S&P 500 index are predicted to set new record highs in 2011. Even after two solid years of performance, the market valuation remains reasonable; the market itself is still 26% below the highs of 2007. So we have record earnings at the same time that the market remains 26% lower than where it was three years ago, when earnings were lower.

From a valuation perspective, equities appear to have more upside potential through 2011. The Federal Reserve is keeping its foot on the accelerator of fiscal stimulus, and Congress has extended the Bush-era tax cuts, including many new goodies courtesy of earmarks and successful lobbyists on the Hill. The Fed’s stimulus will take place through continued artificially low Fed Fund interest rates. Near 0%, these rates are coupled with a second quantitative easing program launched last November to purchase an additional $600 billion of U.S. Treasuries. Supposedly, the program was designed to stimulate demand for housing and broad-based consumer consumption. Its unstated objective appears to have been a back-door bailout for financial institutions working to recapitalize their balance sheets.

Regardless, the result is expected to be more favorable winds for riskier as¬sets, including stocks and commodities, and a hindrance for bonds as interest rates rise against the desire of the Fed.

Do you ever wonder where the Fed gets the money to buy all those bonds? They create it out of thin air. They buy the bonds from the sellers (usually not our Treasury, but primary bond dealers such as Goldman Sachs), credit the dealer’s account for the sale and move on. Voila: money out of thin air. The liability goes on the Fed’s balance sheet (remember, as taxpayers, we share this balance sheet). At this moment, they have no idea how they are going to reduce the massive amount of liquidity they have injected into our financial system – an amount which now exceeds $2 trillion. Not to be confused with the federal debt issue we have written about in the past, this is an additional liability our financial system must reconcile.

That brings me to some New Year’s resolutions – always best to keep them few in number and achievable. As a country, let us resolve to:

  1. Work together to deleverage our country and set the course for a sustain¬able path of growth, prosperity and personal accountability for ourselves, our children and generations beyond. We’ll need to swallow some bitter medicine; politicians on both sides of the aisle must be willing to sacrifice their careers to stand up for decisions that are right for the country.
  2. Resolve to let the Year of the Rabbit bring calm and clear minds to the table to work globally, in a fiscally responsible manner.
  3. Work for the long-term sustain¬ability and growth of the fragile system that supports increasingly integrated connections on a global scale. (Through the Face Time app on an iPod Touch, you can carry on a live video chat with a per¬son on the other side of the globe in real time—that is an interconnected world.)

Here’s to a great year ahead! We appreciated the opportunity to serve each of our clients in 2010. We look forward to seeing many of you at our annual Economic Outlook events in Arizona, California, Minnesota and North Dakota.

Thank you for the trust you place in us.

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