Commentaries
- Market View
An economic recovery is underway and financial markets have responded strongly. Formidable crosscurrents remain and the current low interest rate environment presents challenges to investors. We continue to recommend a diversified portfolio of global and domestic high quality equities. New commitments to fixed income must be selective.
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The government has used many resources to help support the U.S. economy. Targeted stimulus is working, although questions remain whether it can spur longer term growth. Government stimulus has awakened fears of inflation, but additional forces have softened the effect so far. The recent stock market rally has been led primarily by lower quality companies that have rebounded after sharp 2008 declines. High quality companies offer superior risk adjusted prospective returns.
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Unprecedented governmental efforts have thus far had the desired results, and financial markets have begun to repair. The future course of economic growth and potential unintended effects of the government stimulus are important wildcards. Given the strength of the potential crosscurrents, investors must stay selective.
The Economy and Financial Markets
A wall of financial stimulus and government guarantees have stemmed the economic decline and begun to restore order to the financial markets. All categories of stocks fell precipitously in the first two months of 2009. A subsequent powerful rally strongly favored low-quality stocks that had been decimated in 2008. As a result, the Standard & Poor’s 500 Index produced a modestly positive six-month return and the Dow Jones 30 Industrials Index, which is dominated by somewhat higher-quality companies, produced a slight negative return. Most corporate bonds have produced attractive returns in 2009.
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The US economy is still contracting. The response of the federal government has been unprecedented fiscal and monetary stimulus. While the timing of the economic recovery is uncertain, we believe the US and the world economy will emerge from this difficult period stronger and more stable. Investors are likely to return to strategies backed by basic fundamentals.
Economic conditions in the US and around the globe continue to weaken. Real US GDP contracted 6.3% in the 4th quarter of 2008, the largest quarterly decline since 1982, and most forecasters expect a large drop in the first quarter of 2009. The Organization for Economic Co-operation and Development (OECD) projects the world economy will contract in 2009 for the first time in 60 years.
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The economy continues to weaken but government intervention is unprecedented and likely to expand. With short term US Treasury rates near zero, high quality stocks and bonds may offer unusual long term opportunities. After disappointing results from unproven investments, investors are likely to return their focus to strategies backed by basic fundamentals.
Economic conditions in the US and around the globe continue to deteriorate. The recession, which began in the housing market, is spreading to virtually every part of the economy. In the US, consumers, financial institutions and other businesses are rushing to pay down debt and cut back on spending. This process of deleveraging is occurring simultaneously throughout the economy and its impact is painful and revealing: assets are losing value, unemployment is rising, and foreclosures and bankruptcies are increasing. In addition, many states and local governments are in a cash squeeze and, as is typical in periods of significant market decline, frauds and scams are being uncovered.
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With October close to setting a record for the largest stock market drop in a single month, below are a few observations and a review of Birch Hill’s approach to investing in challenging markets.
The Stock Market Downturn
Through the close of business last Monday, October 27, the stock market (as measured by the Standard and Poor 500 Index) was down 27% for the month of October and 42% year to date. If the market ends the year at this level, the 10 year total return from stocks will be negative for the first time since 1938. All stocks have been subject to indiscriminate selling. Earnings, dividends, balance sheets, and price earnings multiples do not seem to matter as investors adjust to the unfolding credit crisis, pending global economic downturn, and forced deleveraging of aggressive hedge fund portfolios. We think it is quite possible that the volatility of the stock markets will continue for some time. One observer called it a bear market on steroids...
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The Investor’s Tax Landscape
In 2003 the Federal tax rate on long-term capital gains was temporarily reduced to 15%, the lowest capital gains rate since the early 1930s. Unless the current law is changed, the Federal rate will return to 20% on January 1, 2011. Some in Washington have called for a capital gains tax rate increase before 2011. Others have said that the rate should move to 28%. While anticipating legislative changes is a professional sport that is generally best left to Washington insiders, the existing law is clear and the current inclinations of Congress strongly suggest that investors will pay a higher Federal capital gains rate in the not too distant future. In addition, a number of states that also tax capital gains may feel significant budget pressures in the next several years and as a result look to raise capital gains tax rates...
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