2010 4th Quarter Commentary

“Everyone takes the limits of his own vision for the limits of the world.”
Arthur Schopenhauer

Last quarter we discussed our take on the future of the economy, noting that economics is a dismal science and thus we are required to take a less apocalyptic and more measured approach to our forecasts than the soothsayers in the media. We noted that economic forecasts over the last 12 months have been anything but consistent or accurate and that caution is therefore warranted.

While 2011 looks to be different and somewhat more constructive than 2010, there is no question that uncertainty remains. We begin by noting that while no one is clairvoyant, there are certainly trends and patterns that we watch carefully. Even as late as December, the economic ground was shifting under our feet due to the uncertainty surrounding tax policy and the sustainability of the Bush era tax cuts.


As with any economic recovery, positive factors compete with negative ones, with the positive forces usually prevailing. Along the way, movements are uneven across time and economic sectors. As we saw in 2010, markets can be volatile as investors debate the strength of the recovery.

We start with a few problem areas to pay attention to heading into 2011:

  • State, Local and Federal Government Budgets
  • The Housing Sector
  • The European Debt Crisis
  • China’s Economic Growth

State and local government budgets remain strained. Budgetary cuts have resulted in significant job losses over the last year. Public payrolls fell by 250,000 in the 12 months ending in November (while private-sector payrolls advanced by about 1.1 million)[1]. Many states are struggling against the backdrop of increasing liabilities (pensions, social programs, healthcare, etc.). While these problems aren’t new, they represent a drag on the economy. On a brighter note, the Census Bureau recently reported that state and local tax revenues actually increased by 5.2% in the third quarter compared to a year ago.[2] This is the largest quarterly increase since the fourth quarter of 2007 and will help as local governments work to close deficit gaps.

As we noted in the last quarter’s letter, an improvement in GDP will need to come from the export, private investment and consumption components of the GDP formula since Federal government spending cannot continue to fill the gap. With a new congress in Washington, it appears they are ready to move quickly to cut spending, but new lawmakers must walk the tight rope of appropriate versus inappropriate government cuts in light of the fragile economy. Our economy is driven by psychology and business needs to have confidence in our leaders. Rational and thoughtful approaches to this issue will have the dual benefit of lowering our fiscal deficits while inspiring business confidence. This would be the best of all possible outcomes. We will continue to monitor this situation closely.

The housing sector is expected to remain a drag on the economy in 2011, though most of the economic damage is already done. The consumer is the most powerful force in the economy, and the value of his home used to dictate much of his spending habits. In an America where savings rates were negative, many families were subsidizing their paychecks by spending the equity in their ever-appreciating homes. Everyone who reads a paper or listens to a news program can tell you that mortgage delinquencies and foreclosures are expected to remain elevated for some time. Of course, many investors are concerned that home prices could fall further (as much as 20% by some estimates), which prognosticators fear could quell the growth in consumer spending. A further moderate decline in housing prices will not significantly affect consumer spending because we believe the consumer has already accepted the idea that it could take years to see home prices re-appreciate. While the housing market problems will continue to be severe for many households and could last for quite a while longer, its impact on the economy should not derail the recovery. In short, we think the majority of the pain has already been felt.

The European debt crisis seems like a slow-motion train wreck –not unlike the housing situation in the U.S. As we wrote previously, the EU and IMF set up a €750 billion backstop in the spring. We’re now seeing the implementation of that backstop. Europe needs to come to grips with its long-term debt issues with long-term solutions, not short-term fixes. Greece and Ireland are in the midst of their debt intervention, with Portugal and Spain potentially not too far behind. In an intricately connected world economy, bankrupt sovereigns are bad for everyone.

China continues to grapple with inflation that is considerably higher than the government’s stated goal. As a result, it has been slowly raising interest rates and taking other actions to slow its torrid growth. These actions continue to flame fears that China will take even more drastic steps to slow growth in 2011. China’s economy has been a major engine for the worldwide recovery from the Great Recession of 2008. No one wants to see that engine significantly slowed, including the Chinese central planners.

What about the positive economic forces? For all the negative press around “QE2”, the second round of quantitative easing by the Fed, Federal Reserve policy remains accommodative. For all the bad press, any talk of a “double dip” in the economy has been taken off the table, which we think is very good.

It appears to us that the economy is about to move into a stronger, more balanced and more sustainable recovery. Until the third quarter of 2010, consumer spending had been increasing at a steady but weak 2% pace, which was not enough to really get a significant lift in hiring or overall economic activity. However, things began to change in the third quarter of 2010 as consumer spending accelerated to almost 3%, and some economists suggest it could accelerate to as much 4% in the fourth quarter on the back of the strongest holiday season we’ve had since 2005.

A lot of companies could hobble along at 2% consumption growth without having to hire a lot of new people. Manufacturing from overseas can handle 1% of that growth coupled with the contribution of 1% productivity increases. However, with 3% to 4% growth, that story changes and jobs have to be added to the domestic economy. Consequently, better hiring rates seem more likely if this consumption growth continues. It also helps the psychology of business owners when they see increased end demand for their goods and services.

The extension of the Bush tax cuts is good for psychology as well. We have learned not to underestimate the beneficial impact of the “wealth effect” on economic growth. The wealth effect is a psychological construct that shows how important the idea of confidence is in our economy. When we are fearful, we seek safety (we sell stocks and buy bonds or settle for cash). When we feel confident, we are willing to take risks and commit ourselves to future payoffs (we sell bonds or use cash to buy stocks, or invest in our own businesses). When end demand for goods and services is growing and the equity market is reflecting that growth, business owners feel more optimistic and begin to invest in both new equipment and in labor. This drives employment higher which allows consumers to buy homes, cars, and begin to spend and invest again.

We think large companies are using every trick they can to avoid hiring new, permanent employees, but in spite of this, indicators show that business is beginning to invest in permanent positions to keep up with expected demand growth in 2011.[3] Consequently, with renewed confidence, an improving job market, a reduction in payroll taxes and a more attractive balance sheet (lower consumer debt coupled with higher asset prices), we see a light at the end of the tunnel for the American consumer.


This year marked the second year of positive returns for the stock market indices following the declines we saw in 2008. The indices were led by small and mid size companies in what is often referred to as the “risk trade.” In other words, the stocks that saw the greatest upside move were for the most part those that were more speculative in nature and will benefit from a robust economic recovery. Not coincidentally these small/mid caps are the same that were most affected during the downdraft out of fear of persistent economic decline. The valuation between small and middle capitalization stocks and that of larger more established stocks has widened to a level not seen in many years - some would argue as far back as 1995. We find this encouraging as the best “value” we find today is in names we view as not only cheap, but also safe, relative to their peers. At the end of the day the price of a stock reflects its underlying valuation. On a 3 day or 3 month period this doesn’t always play out, but we focus on the long term and know that if history plays out as it has, valuation will drive returns and the “cheap stocks” we are buying today will be the beneficiaries.

What does this mean to you? Valuation spreads should narrow, either at the expense of the risk trade or to the benefit of the blue chips. Considering we purchase small, mid and large cap stocks in our portfolios our equity accounts are positioned in a way that should allow 2011 to be another year of solid risk adjusted returns. Another way to look at it is this: if the economy grows in 2011 as we think it will, then current earnings estimates for many companies may in fact be too low. While we see a number of companies selling for what we think are unreasonably low multiples to their forward earnings, if estimates rise from here, those multiples shrink even more. This should lead to material price appreciation and would have a very favorable impact for our equity positions.

Beyond the valuation gap, we are also seeing a pickup in mergers and acquisition (M&A) activity in the market. As companies sit on large mounds of cash while earning paltry rates of return, they begin to look for opportunities to improve their situation by buying back their own stock or buying other companies. While mergers can often times be value destroying propositions on a company by company basis, overall M&A activity demonstrates increased confidence in the future and is generally good for stock prices.


Bonds began the year out of favor as the prospects for economic recovery brightened. The 30 year U.S. Treasury bond started 2010 with a yield of 4.64%. As the previously mentioned troubles in Europe cropped up, bonds rallied and investors sought the safety of dollar denominated bonds. Bonds rallied (yields fell) from April until August, bottoming out at 3.51%, equating to over a 20% total return. The Federal Reserve began discussing further monetary stimulus measures, commonly referred to as “Quantitative Easing” or in lay terms, the Fed purchasing of U.S. Treasury debt in the open market. Traders anticipated these purchases and helped push yields to the low for the year. As the year wound down, an announcement was made from the White House confirming that the Bush era tax cuts would be extended for all Americans as well as new Estate Tax laws that were more conservative than expected. This compromise did two things: positively, it brightened the prospects for future economic growth, but negatively it added to the growing U.S. deficit for 2011 and 2012. This resulted in a bond sell-off that concluded with the 30 year settling at a 4.34% yield, a solid 15% drop from the August high. That market was volatile!

As we enter the New Year, there appears to be a rotation from bonds to stocks in asset allocation decisions across the spectrum. In a reversal of recent trends, last month equity mutual funds saw a net inflow of capital while bond funds saw net redemptions. This simply signals that risk appetite is clearly returning to the retail investor. With this in mind we expect bond yields to trend upward until the next event occurs that increases risk aversion, either domestically or internationally. While inflationary pressures are still muted and real yields remain attractive, it can take time to rebalance the market into equilibrium when money is being reallocated. We believe taxable yields will likely end the year higher than they are today.

Municipal bonds also enjoyed nice returns for the first 11 months of the year, until news that the Build America Bond (BAB) program extension was not included in the tax package. Remember the BAB program was part of the stimulus effort by the Federal government that subsidizes 35% of the interest payments on new taxable municipal bonds.  Consequently municipalities rushed to market immediately and issued bonds while the U.S. Treasury subsidy was still available. This brought an unexpected supply of bonds to market at the same time that several analysts published scathing comments on the health of municipal finances. We concede there are several states/municipalities that we would not want to invest (anything in Illinois or California for example) in. In the lower rated states (typically those hardest hit by the real estate bubble) the issues of underfunded pensions and years of overspending have now come home to roost. In fact, as little as 5 states make up nearly half of the estimated $148 billion in budget shortfalls nationwide.

As always, security selection will play a key role in staying out of harm’s way, and to date we believe the credits in which we invest remain quality investments. North Carolina remains a AAA credit (1 of 9 countrywide), Virginia, South Carolina, Tennessee and others also offer credits we find attractive. We do not buy into the story of widespread municipal defaults in the face of an improving economy. There will be outliers with lower rated credits that struggle and end up in a restructuring. However we do not expect the issue to be of the size and the scale that the naysayers predict. More importantly, we do not expect it to affect the investment grade credits we are buying.

We see green shoots sprouting. As previously mentioned, The Census Bureau released 3rd quarter state tax revenues which showed revenues grew by over 5% on a quarterly basis versus the prior year. It also showed annualized growth for the first time since the 4th quarter of 2008. Also, the Philadelphia Fed index showed 45 of 50 states with growing economic situations in November, up from zero reporting expansion last year at this time. The point here is that state finances are not immune to recessions, and there is a lag effect before budget pressures appear, especially with large stimulus checks from Uncle Sam delaying the pressure. However, the economy is improving, revenues are increasing in most states at the same time that cuts to spending are being made. We believe this will lead to balanced budgets for the majority and in the meantime is giving us an opportunity to invest in quality municipal bonds at attractive prices. The market has temporarily painted all municipal bonds with the same brush of fiscal irresponsibility. We believe that the more fiscally sound states will trade at a notable premium to the have nots as this all plays out.


We continue to observe this economy with a watchful eye knowing that while we have passed through quite a storm these last two years, risks remain. While we have reason to be encouraged and hopeful, vigilance remains the order of the day.

We do not think the volatility in the bond and equity markets is going away any time soon, so it is easy to conceive that market valuations will continue to fluctuate, at times dramatically, and going forward, as always,  investing will require good judgment, a firm grasp of the facts and prudence. We continue to pay close attention to the price we pay for the assets we invest in, whether bonds or stocks. If we remain disciplined in our approach and require a margin of safety on our purchases, we believe that the long term results will be rewarding.

[1] The Brookings Institution, “U.S. Job Market Remains in the Doldrums” December 3, 2010

[2] http://www2.census.gov/govs/qtax/2010/q3t1.pdf

[3] Staffing employment in December was 16% higher than in the same month last year, according to the ASA Staffing Index.