Letter - August 2010





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"Not sure? Don't spend."

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 positive.

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 slowly dissipates.

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 recovery.

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 gains.

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.

Tom Herzig


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