Let me outline our current economic/market situation for you:

Exceptionally low interest rates— It goes without saying that rates are at levels  we haven’t seen in the past fifty years.  This translates to lower borrowing costs in our economy for consumers and businesses.  Low interest rates are typically a strong catalyst for economic growth.

Banks ARE loaning—There is a real misconception in our economy that banks are hoarding cash and not making loans.  Well, it’s not true.  Banks are holding heavy cash levels, but they’re also loaning.  Standards have gone up, which needed to happen, but money is available.   

Corporate America is Wealthy—As of the end of 2010, corporate America was sitting on some $2 trillion of cash and short-term equivalents.   I would guess that amount
has gone up by 10-15% in 2011.  Again, what we’re experiencing is not a wealth problem, corporations simply don’t have enough visibility or confidence to expand their businesses and create new jobs.

Valuations Look Attractive—Corporations have the potential for continued earnings growth, yet we haven’t seen multiples rebound from 2008-2009 levels. The S&P 500 index currently trades at about 13 times its forecasted earnings for next year. Historically, the index has traded a few points higher than that. If we throw in the fact that earnings have been exceptionally strong over the past two quarters, we are trading at VERY low valuations.

If we were in a blind conversation and I outlined the above economy, you would think we’re in the middle of a massive bull market.  I’ve just defined a strong economic environment with the potential to drive stocks higher.  Then, why are we suffering through all this volatility?

Our “confidence crisis” stems from several things.  We don’t see a lot of cohesive leadership on the political front in our country today and confidence stems from the top.  Further,
as a country, we don’t have a lot of confidence in our European brethren.  Greece doesn’t seem to know if it’s coming or going and won’t get out of it’s own way to help itself.  So, globally there are reasons for concern.   If you were a CEO, would you stick your neck out in this geopolitical environment?

The good news is that confidence is a finicky thing; it comes and goes like the wind.  The positives outlined earlier are significant catalysts for what we feel could be a major market run, but that’s a longer-term perspective.  The short-term will more than likely remain choppy, but we see a real silver lining to this economy.  When business and consumer
confidence firms, we should see the markets put together a nice long-term run.

Of course, in an environment where perception can drive reality, downside momentum could continue in the short-run. But, in the end, earnings drive the markets and the economy drives earnings.  A broad range of leading economic indicators continue to suggest positive GDP growth of about 2% in the second half of 2011.  In fact, the most reliable among them is the Conference Board Leading Economic Indicator, which is currently suggesting 3.8% growth. Let’s take a look at some key drivers for an economic reacceleration: 

1. Economic/financial conditions, which tend to lead economic growth, are very easy. In the absence of a shock it is hard to justify a recession scenario in the face of such easy financial conditions.
2. Some key cyclical sectors of the economy such as autos and residential investment are already depressed, making them less likely to weigh on growth. As well, business investment has lagged this cycle, suggesting it’s unlikely to grind to a halt as it did in 2008/09.
3. The negative effects of some temporary shocks, such as the Japan earthquake and rising energy prices, have abated and Japan’s recovery has alleviated some supply chain constraints.
4. Initial Jobless Claims have improved over the last several weeks with the four-week moving average of claims dropping from 428,000 to 408,000. Moreover, Friday’s non-farm payroll increase of 117,000, coupled with a gain in average hourly earnings, is not consistent with an economy in recession.
5. Earnings have been very strong in our most recent quarter and corporations are flush with cash.  I can’t stress this point enough.  Earnings drive the equity markets and earnings have proven strong and resilient to this point in 2011.

We’re not naïve enough to believe all is rosy in our economy.  We also are nervous watching the stock market collapse, but this impressive list of “stimulative forces” should cause real GDP growth to bounce back during the last half of this year.  In the end, we are probably in for more volatility in the equity markets.  Technical damage like we’ve seen in the past couple weeks does not undo itself overnight.  Historically, this type of volatility can take several months to play out, but this type of volatility can also create a lot of opportunity as the markets calm and we look forward to taking advantage of our current market condition.  We remain cautiously optimistic for the second half of 2011.

I must admit the prospects of a government shutdown and debt default seems scary.  But would it actually lead to a capital markets collapse, as many worry it will?  Well, let’s look at the facts.  In a “worst case” view, a US default could have several repercussions.  First, we could see credit ratings agencies like Moody’s, S&P and Fitch downgrade US debt.  From our perspective the downgrades would be more damaging than the default itself as they would more than likely force increased selling pressure on all forms of US debt.  As we all know from “Investing 101”, lower bond prices would lead to higher interest rates.  Couple that with the fact that we are at historically low rates and you may see a “snowball” selling effect in the bond arena (corporate, municipal and treasury) which would also cause the opposite effect in interest rates, shooting them higher. 

Further, our economy is expanding, but there’s no mistaking the fact that we are in a slow growth recovery.  Rising interest rates would put a dampening effect on our economic recovery, as borrowing costs would go up.  Thus, the failure of our government to raise the debt ceiling could easily slow the economy, hurting the equity markets, while also hitting bond investors. 

But wait, there is a silver lining.  History doesn’t give a lot of comparisons, but it’s worth remembering that we’ve been down this road before. Remember the government budget crisis in 1995, which followed the 1994 midterm elections in which the Republican Party won control of both the House and the Senate? That crisis led to not one, but two separate government shutdowns, one in mid November 1995 and the other from mid-December 1995 through early January 1996. And yet, far from crashing, the stock market performed quite well during this time frame.  The Dow Jones Industrial Average was trading around 3,800 on the day of the 1994 mid-term elections.  When the first government shutdown began in mid-November 1995, the Dow was trading around 4,900.  

Remember, the markets are a discounting mechanism; so much of the fear over a shutdown was already “baked into the cake” back then and is more than likely baked in now.  The results from 1994 to 1995 don’t guarantee that we will have as happy an outcome this time around, of course.  But they are a helpful antidote to those who worry that such a shutdown would necessarily be bad news for the capital markets.  What the market cannot discount are things that are truly unexpected and unanticipated.  Hitting the debt ceiling, and political gridlock in responding to that, do not fit into this category.  The market knows this issue is looming and investors have already discounted accordingly.  Remember, the S&P 500 is already off 5% from its highs and the markets have essentially gone sideways since January, even though corporate earnings have continued to improve.  Thus, the market has at least partially discounted this debt ceiling situation. 

The capital markets are signaling to us that America will not default on its obligations.  Spending cuts and reforming a broken budget process, are top priorities for the American people and should be made more of a priority for the President and members of Congress.  Like you, I worry about how the equity and bond markets will react if we default.  But, the capital markets are telling us that some type of deal will get done and historical precedence tells us that all is not lost even if a deal does not get made.  The situation itself is disconcerting, but it shouldn’t have a long lasting effect on the economy or corporate earnings and we all know earnings drive the capital markets, not politics.

Following a two-year rally in stock prices, it’s natural for investors to wonder if equity prices are now fairly valued or perhaps even overvalued.  In our view, global equity markets still offer attractive valuations and the potential for continued upside growth. Our outlook on stocks reflects the favorable characteristics we are continuing to see in our economy; low-interest-rates, strong corporate balance sheets and attractive valuations.  Additionally, we’re on track to create about 2.5 million jobs in 2011, which would be a big positive for our continued recovery. 

Borrowing Costs Remain Low—While the yield curve is steeper than it was a year and a half ago, interest rates are still relatively low. Companies that need to access the capital markets can do so at attractive interest rates. Rates could, and probably should, rise at some point in the future in response to inflationary concerns.  We aren’t seeing significant inflationary pressures to date, but that can change very quickly. 

Balance Sheets Getting Stronger—Coming out of the financial crisis, corporations have done a good job of conserving capital and cutting costs.  With a high level of cash on their balance sheets, they have been able to pay down debt, increase dividends, and in some cases buy back shares.  When we first started to see earnings improve, it was often attributed to cost cutting (i.e. layoffs and shutting down factories).  Now, we’re seeing earnings improve from operations because companies invested wisely during the downturn.

Valuations Look Attractive—Corporations have the potential for continued earnings growth, yet we haven’t really seen multiples fully rebound from the 2008-2009 levels. The S&P 500 index currently trades at about 13.5 times its forecasted earnings for next year. Historically, the index has traded a few points higher than that, so we believe the U.S. market may be undervalued. Profit margins look like they may have peaked in the short-term and this may be working to compress valuations. 

We also believe that growth stocks are more attractively priced than value stocks at this point in the economic cycle. Historically, growth companies have traded at a nine multiple-point premium to a value company, whereas today they trade at a two multiple-point premium. So not only are stocks in the U.S. cheap in general, we believe there’s a real opportunity to buy undervalued growth companies.

Economic and market  trends remain strong.  We seem to be hitting a soft-patch in the short-term, but that’s normal in the stair-stepping action of an economy or market.  We are cautiously optimistic for the remainder of 2011 and 2012 and feel our current market doldrums will eventually give way to higher prices for 2011.

Nonetheless, the division among FOMC members suggests that the bar for additional easing (beyond QE2) is fairly high. Absent a further deterioration in economic growth prospects and a resulting resurgence in disinflation concerns, the FOMC’s “exit timeline” is likely to unfold as follows:  end QE2 on June 30, end reinvestment of MBS proceeds into Treasury securities (this shrinks the Fed’s balance sheet and marks the initial phase of “tightening”), remove the “extended period” language from the FOMC statement, and initiate the first rate hike “a couple of months” later, in Bernanke’s words. We still see Q1 2012 as the earliest possible date for this rate hike.

The recent earthquake in Japan and the ongoing aftershocks have been nothing short of catastrophic.  Like most countries in this post recession economy, Japan was just struggling to its economic feet when this disaster delivered a historic punch.  The Tsunami’s and nuclear fallout have been almost too much to bear. 

The biggest question for Japan and perhaps the global economy is; will this natural disaster be a knockout blow or a setback before a painful recovery.  We feel like it will be the latter.  The Japanese people are a very efficient and determined people.  It’s not to say rebuilding the country will be without challenges.  But, if you choose to see the recovery as “glass half full”, coming out of this tragedy they have the opportunity to rebuild, modernize and encourage growth of new economic activity.  In 1995, Kobe was devastated by an earthquake. They rebuilt the city with an amazing offshore port, modernized the housing stock, and made a tremendous qualitative change. Now they have the chance to do the same for Sendai. 

The Japanese economy is resilient and protected enough to rebound from its worst catastrophe since World War II.  More than 90% of its wealth is generated in an industrial band running south from Tokyo, at least 300 kilometers from the devastated northeast. Further, Japan is handicapped by a debt that is the worlds heaviest but, unlike the US, most of the debt is home-owned and not exposed to international speculation.  This is a positive spillover from a very nationalistic culture. 

That said, if nuclear meltdowns affect the power supply throughout the country the optimistic scenario may fade. With production slowed or shut down Japan’s livelihood will be at risk and cleaning up a widespread nuclear disaster will take decades of effort and expense. That’s when the economic ripples will spread. Even without a nuclear calamity, Japan has had serious and long term infrastructure damage.  Moreover, that could mean pulling out some of Japan’s overseas savings, along with part of its $2 trillion in foreign investments.  Early estimates put insured losses from the latest quake at around $30 billion, suggesting heavy repatriation of funds to Japan by insurance companies to pay claims. 

Now, let’s switch gears and focus on the effects for the US and global economies and our recovery.  The effects of the earthquake on economic activity are still “up in the air”, but we believe the effect on the US economy should be limited.  Exports to Japan make up less than 5% of total exports, and a decline in personal consumption-related exports may very well be offset by increased investment-related exports.  Although concerns over the situation in Japan have tightened US financial conditions on the margin, oil prices have declined by 5%. 

One important variable is the effect of a disruption of imports from Japan on US and global production, particularly in the auto sector.  While a disruption in the supply of motor vehicles from Japan could lead to a slight increase in global production, the more important risk is that global auto production relies on inputs manufactured in Japan; a disruption of more than a few weeks in the supply of key components, such auto parts or semiconductors, could have a more meaningful negative effect on US output and the output levels around the world, though once again this should be a more temporary effect.

Will we finally see a “real” economic recovery?

Yes.  What makes us so much more optimistic?  The biggest positive has been a sharp improvement in the economic data since last summer.  The change in real GDP is on track for a 5% (annualized) growth rate in the fourth quarter of 2010. This is the fastest organic growth pace since 2006.

Will the housing market recover meaningfully?

Not in 2011. The housing market is the only major sector of the economy where the news over the past few months has failed to improve materially.  It has actually gotten a bit worse and the reason is the still-large excess supply.  We have only unwound about one-third of the pre-bubble increase in  homeowner vacancy.

Will the trade deficit shrink substantially?

No. An improving economy will help, but the deficit probably won’t see a significant drawdown until 2012 or 2013.

Will the unemployment rate fall?

Yes. We expect a decline to 9% by the end of 2011 and a further drop to 8% by the end of 2012. The relationship between changes in real GDP and changes in the unemployment rate remains as close as it ever was.  Thus, an accelerating economy should lead to more jobs.  This is one area of the economy where we could see a positive surprise.

Will interest rates continue higher in 2011?

Yes.  The turn to above-trend growth in the United States coupled with continued strong momentum in the emerging world will translate into a gradual updraft in bond yields.  This is a red flag for fixed income investors but an overall positive for the economy.

Will the state and local budget crisis derail the recovery?

No. The situation is unlikely to get better quickly. State governments still need to cut spending and raise taxes to offset the loss of federal stimulus funds, but there is also some good news.  Real state and local tax receipts are now rising at a solid pace. If the economy recovers in 2011-2012 as we expect, this increase is likely to gain momentum.

We remain comfortable with the markets for 2011.  However, we believe equities are a bit overbought in the short-term.  As the markets consolidate/correct we will use the opportunity to reweight our holdings toward growth.  We believe 2011 will be a strong year for both the economy and the markets.  We are also seeing several new emerging sectors come through our research and we will adjust to take advantage of them as the timing presents itself.

Many factors have contributed to the concerns surrounding the municipal market.  The general economic slowdown has had a well-publicized negative impact on state and local government revenues and budgets. The revenues of many other municipal issuers, like toll roads and utilities, are also tied to the overall level of economic activity.  Other issuers, like  school systems and health care providers, rely on state funding.  So, most municipal issuers have been operating within tighter budgets.  Also fueling the concerns have been underfunded pensions and retiree health care obligations impacting some municipal issuers, and the phase-out of federal support for the muni market in the form of aid to the states and the expiration of the Build America Bond (BAB) program.  Due to these factors, some prognosticators have suggested that the municipal bond market might become the scene of the next subprime-mortgage-like market meltdown.

We don’t think municipal bonds are exposed to the kind of systemic risks that would cause a domino effect of defaults.  There is no single risk factor, such as leverage, poor underwriting standards, or speculation that is causing stress to the whole muni market like we saw in the real estate melt down.   In reality municipalities are very similar to corporations in that each is run differently.  Each municipality has a differing level of risk and is affected differently by the economies gyrations.   Different issuers are under varying degrees of stress. And budget stress in the past has not automatically translated into widespread defaults on bonds.  There are credit features unique to the issuers of municipal bond debt that help shield them from default. General obligation bonds, for example, are secured by the full faith and credit of an issuer’s unlimited taxing authority to pay its obligations. We think debt loads and annual debt service costs are manageable for the vast majority of municipalities. The weighted-average state debt service for the top 20 states with the most debt outstanding for example, is 3.9% of expenditures.  All this to say that we believe the likely outcome for municipalities will be the same as it was for corporate America during the financial crisis; spending cuts and tax increases, not widespread defaults on debt.

Further, many of us have heard a number of pundits comparing the current problems in the municipal bond market with the subprime meltdown we saw in the real estate market a few years back.  Certainly, municipalities have their own unique issues.  But, investors in subprime had one underlying assumption that fueled speculation in the asset class: that the housing market would continue to appreciate. The entire market was dependent on this factor so the risk was in fact systemic: cracks in the housing market led banks to stop lending, which in turn reduced demand. The cycle of easy credit and speculation came to a grinding halt.  Those with exposure saw the value of their investments plummet and widespread defaults resulted. Then the world was exposed to the underwriting dysfunction that was rampant throughout the market and the significant amount of leverage incurred to boost returns.  We don’t see this type of asset class risk in the muni bond market and comparing the two borders on the absurd.  Leave it to the media…

The municipal market is not a homogenous market.  Looking back to 2008, the calendar year returns for the larger municipal bond funds in the Lipper General Municipal debt peer category ranged from -42% to +4%.  This wide range far surpassed the average variance of about 4% over the past 20 years.  Further, the historical default rate for the municipal bond market is around 2%.  While that default rate may go up during these trying times, we feel that if we invest in the right places, we will steer clear of “at risk” municipalities.  Finally, a strong economy can cure many ills.  This was never more evident than in the fourth quarter when municipalities across the country saw a huge spike in revenues, thanks to a reinvigorated economy.  If the economy continues to improve, which we are confident it will, most municipalities will fair just fine.

Case 1 – We have a client, let’s call him Joe Smith, who we thought should roll over his traditional IRA to a ROTH IRA and we were exploring the best way to do this.  As background, Joe owns a sizeable plumbing company (S-Corp) which, in years past has been very profitable and a local leader in the industry.  However, the bear market has hurt many businesses and Joe’s is no exception.  His revenues were off 30% in 2009 and, from all accounts, look like they will be flat to slightly higher for 2010.  The lower revenue base also caused Joe to have a net operating loss (NOL) for 2009 and he should have a relatively sizeable one in 2010 as well.   By definition a NOL is a period in which a company’s allowable tax deductions are greater than its taxable income, resulting in a negative taxable income. This generally occurs when a company has incurred more expenses than revenues during the period. Now, Joe typically has a NOL in any given year because he is always buying new equipment/trucks for the depreciation expense.  However, the economy has caused a larger NOL than usual and, in this case one we could use.  We rolled Joe’s traditional IRA over to a ROTH IRA and because of the larger than normal pass through loss from his business, he is essentially transferring his entire IRA from taxable to tax free at NO COST to him.  We are attaching the entire rollover amount to 2010 and not using the allowable 2-year spreading that is available under the new tax since we expect Joe’s business fortunes will change for the better in 2011 and beyone.  Keep in mind that this strategy would not work for a C-corp as it is not a pass-thru corporation.  However, it will work for an S-corp or an LLC.  If you’re a small business owner this is definitely something you need to explore.  If you are looking for a financial professional to help you with this type of transaction, feel free to contact us.

Case 2 – We have another client, let’s call her Jane Brown, that wanted to roll her traditional IRA, with a value of $380,000, to a ROTH IRA but wasn’t sure how much she could roll over and how it would affect her tax bracket.  Further, she wasn’t able to write a check from her own pocket if there were taxes due from the rollover (not unusual with many clients in this economy).  Our advice to her was to roll the ENTIRE amount and re-characterize dollars later if need be.  Here’s why.  The new tax laws allow for a re-characterization of converted dollars up to October 15^th of the year following your conversion.  Thus, in our case, Jane would have up until October 15^th of 2011 to re-characterize the dollars we moved to the ROTH back to a traditional IRA if we made the move in 2010.  There would be no penalty or interest for re-characterizing the money we moved to a ROTH.  Now, Jane is 63 years old and semi-retired.  Therefore, if she were to take money out of the converted ROTH, it would come out penalty tax free as long as she’s paid the taxes owed on the rolled amount.  Further, we have a nineteen month window with which to re-characterize. We told Jane to roll the entire amount because, if the markets continue to appreciate, she can take the gains from her account and use those dollars, tax free, to pay the taxes due on the conversion.  In real terms, if the account grew from $380,000 to $450,000 by October 15^th, 2011, Jane could take out the $70,000 of gains from her new ROTH IRA, tax free, and pay the taxes owed on the conversion amount.  The full $380,000 will need to be declared as income for 2010 so this will move her tax bracket up, but she will pay the taxes owed on the conversion from market gains and not from her own pocket.  Moreover, with the new tax laws, she has the option to pay that tax liability over two years.  Therefore, we may elect for her to pay half in 2011 and half in 2012 if we feel the markets will still be moving higher.  In essence, she will have over two years pay the taxes due and most, if not all, of that liability can be paid through the dollars she gained from market appreciation and not from any money she would have to come up with personally.

Inflation is the rate at which the general level of prices for goods and services is rising in a country.  A direct effect of higher inflation is a reduction in purchasing power.  Central banks attempt to stop severe inflation in an attempt to curb excessive growth of prices.  As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year.  The obvious problem in an economy would be excessive inflation.  In our previous example, if inflation were 20%, that pack of gum would rise in price by $.20 in one year.  That’s an excessive jump.

Low interest rates typically spur economic growth, which is why the FED has kept our rates so low for so long.  Economic growth naturally creates inflation but above-average economic growth can cause excessive inflation.  Thus, many economists are worried we may have a serious inflation problem several years down the road because rates have been kept artificially low for too long.  The FED will most likely start raising rates in 2010, but there is certainly a risk that inflation gets too high.  If this happened, the FED may be forced to raise rates quickly to combat inflationary pressures.

In our estimation, we are not at risk of significant inflation in the foreseeable future.  Historical research shows us that inflation typically hits a trough a full two years AFTER the end of a recession (chart below).  The same should hold true today.  The FED will begin methodically raising interest rates this year and we believe they will be ahead of the curve on inflation.  By our calculations, significant inflationary pressures wouldn’t come into play until 2012-2013.  As long as the FED begins to tighten lending standards some time in 2010, they should be able to keep inflation at manageable levels.