"Not sure? Don't
That's how Businessweek summed up what it
called the uncertainty principle: that companies play it
safe when unsure about future regulations and economic
conditions. The uncertainty principle applies to
investors, too. Without confidence and reasonable
certainty, capital can go on strike, preventing
recovery. On the other hand as Fed Chairman Bernanke
observed in 1980, the "resolution of uncertainty" can
lead to "an investment boom."
It is certainly premature to talk about an investment
boom, either by companies or investors. But an early
bull case can be made that the uncertainty is lifting a
little and investor sentiment is beginning to turn more
After the turmoil of recent years, many investors are
fearful and uncertain as to the future, alienated and
embittered by recent experience. Trading volume on stock
exchanges has been low all year, especially on days of
rising prices. Though the money flow into equity mutual
funds has turned positive this year, it is small
compared to the magnitude of withdrawal over the
previous two years, a sign of low demand for equities.
Investors instead husband their money in treasury
securities, money market funds and bonds earning
historically low, though positive, nominal returns.
For taxable investors, future tax rates remain an
area of uncertainty. The Bush tax cuts are due to expire
at the end of the year. The administration wants to see
rates revert to previous level for any individual
earning over $200,000 or $250,000 for joint filers. It
would like to see capital gains taxed at 20% up from 15%
now. Importantly, taxes on dividends, currently 15%,
would revert to the taxpayer’s highest marginal rate.
It is unclear whether the tax issue will be resolved
before the Congressional elections, now less than three
months away. But it has to be addressed by the end of
the year or tax rates will rise across the board for all
taxpayers. While no one likes to pay higher taxes,
resolving the uncertainty surrounding taxes would let
investors invest with more confidence.
Unlike investors in the stock market, corporate
investors in plant and equipment have begun to act more
bullish. Capital spending, which fell 16.6% in 2009
according to Fitch, has started to rebound and could
increase 3.1% this year and continue to rise in 2011.
Corporate balance sheets are robust with high levels of
cash to finance expansion. So capital spending could
surprise on the upside, a good sign for the economy.
Also, corporate mergers, rising dividends and stock
buybacks are beginning to reappear on the scene as
corporate confidence begins to return and uncertainty
When the financial meltdown occurred in 2008/2009,
business cut costs ruthlessly. As the economy stabilized
and began to recover, productivity of labor and capital
rose as companies met rising demand with existing levels
of capital and smaller work forces. As a result, profits
rose rapidly, restoring balance sheets at non-financial
businesses. Corporate America may now be the most
solvent part of the US economy. Consumers and government
remain hobbled with debt. The consumer, whose spending
represents 70% of GDP, weighs heavy on economic
Rising profits are a good thing for investors because
they are what ultimately drive stock values. It is good
news that second quarter earnings reports currently
being reported are strong. And as we examine consensus
earnings expectations for the next twelve months, we are
struck by the low valuations of the stocks. We have
seldom seen expected price/earnings ratios so low.
Another cause for investor optimism is the strong GDP
growth in many emerging/developing countries. This has
helped cushion the weak growth in the US and European
Union. As the world has become increasingly globalized,
corporations earn a greater share of profits outside
their home country. Strong demand and growth in the
emerging/developing countries has generated profits that
in earlier years were difficult to capture. Investors
take note. Stock markets could do well even if the
developed economies of the US and European Union remain
sluggish with unemployment high.
With a few exceptions, world stock markets have
performed poorly this year despite the robust growth in
many places. We expect as uncertainty begins to
dissipate, the returns to stocks will begin to revive.
We believe that there is plenty of capital on the
sidelines that will seek more than the paltry after tax
returns available from bonds. Should the stock market
begin to perform better, money could begin to flow out
of fixed income and back into equities, fueling further
Client portfolios returns so far this year are
slightly better than the S&P 500 index which is about
where it started the year. Despite unpleasant volatility
over the last few months, our strategy is to continue to
wait patiently for uncertainty to dissipate and capital
to begin flowing again.
Please read our important notice
about these letters and the securities they mention.