Economic Forecast - The Joyless Recovery

Welcome to the new, more frugal America. A financial advisor's
utopia, where "staycations"* are more exotic than vacations
and where becoming a "recessionista"* is everyone's dream!

*Definitions found at the bottom of the page

So you aren't buying the savings hype? We didn't think so. While it is true that the savings rate in this country has risen dramatically, the impressive amount of savings has been created primarily by necessity, rather than by a shift in mentality. And even we, wet blanket financial advisors, have to admit that Americans making up fancy vernacular is a way to sugar coat their true feelings on spending less.

Americans were very happy prior to the 2008 economic collapse. Credit was easy to come by and skyrocketing real estate values allowed them to use their homes like an ATM machine. Spending money was never so easy. Comparatively, today's de-leveraging (or reduction of credit) is painful. Frugality is hardly the "American Dream". It is no wonder then that 74% of Americans believe that the U.S. is still in recession, despite the National Bureau of Economic Research indicating that the recession ended over a year ago⁽¹⁾. However, this painful de-leveraging process is a crucial step in the recovery and the "feel good" years of excess spending are what we are recovering from. During the free spending days, American balance sheets became bloated with mortgage and credit card debt. Like a diet after the holidays, the recovery won't be enjoyable, but we feel it is necessary for Americans to repair their balance sheets so that we can have a healthier economic future.

Market Performance:

In our last report, we noted that concern of a double dip recession was weighing on equity valuations and thus, valuations looked attractive. In September, reports of better than expected economic data suggested that a second recession was doubtful, and the markets saw a sharp snap back in valuations. This caused the S&P 500 to have its best September since 1939. As of September 30th, the returns for the 3rd quarter and year-to-date were as follows:

Source:   Data obtained from J.P. Morgan's Guide to the Markets.
International represented by MSCI EAFE Index.
Emerging Markets represented by MSCI Emerging Market Index.
High Credit Bonds represented by the Barclays Aggregate Bond Index.

The Joyless Recovery:

Since the second quarter of 2009, we have written in the Weston Observer that we expected a slow recovery. The primary reason for this outlook was the elevated debt level of the American consumer. Beginning in the 1980's, the U.S. savings rate was on a steady decline until the recession in 2008⁽²⁾. This drop in savings, and subsequent rise in spending supported by higher credit card and mortgage debt, fueled the strong equity bull markets of the 1980's and 1990's. During this time period, Americans felt less of a need to save as their portfolios and real estate values were consistently rising. However, it increased the size of their debt. In 2008, their real estate and portfolio values fell. As a result, investors were left with high debt levels and lower asset values. This left the consumer's balance sheet in disarray. As the consumer picked up the pieces from the "Great Recession", they had no choice but to increase their savings rate to begin paying off the debt overhang from the previous decades of free spending. They also felt the need to play catch-up with building retirement assets to compensate for their lower net worth. Since the consumer makes up 70% of the U.S. economy, a crippled consumer was a large road block for future economic growth.

By most indications, the U.S. consumer has already made a lot of progress in reducing debt. This has happened much faster than anticipated. The Federal Reserve reported that the consumer's debt level as a percentage of disposable income fell to 12.13%⁽³⁾ in the second quarter. This is well below the 2008 peak of 13.96%⁽³⁾ and is now in line with the 30 year average of 12.09%⁽⁴⁾. The Commerce Department also reported that the personal savings rate reached 5.8% in August. This is up from a 2005 low of 0.8%⁽⁵⁾.

Today's sacrifices are potentially setting the stage for a more meaningful recovery in future years. In a recent speech, Federal Reserve Chairman Ben Bernanke noted, "Consumers are reducing their debt and building savings, returning household wealth-to-income ratios near to longer-term historical norms. Stronger household finances, rising incomes, and some easing of credit conditions will provide the basis for more-rapid growth in household spending next year⁽⁶⁾."

A stronger consumer who is willing to spend could be a cure-all for many of the problems facing our economy, including the high unemployment rate. Berkshire Hathaway's Chairman Warren Buffett was recently asked when he would begin hiring more employees and he simply replied, "When demand picks up⁽⁷⁾." While we do not expect the American consumer to go back to their free spending ways overnight, a healthier consumer will ultimately be the best recipe for this pick-up in demand.

Market Outlook:

We maintain a cautiously optimistic outlook for equities. Since we believe that employment gains and a pickup in construction will be slow to materialize, we expect the near-term economic recovery to remain sluggish. However, based on a healthier consumer, we believe the probability of a better than expected market recovery is beginning to outweigh the probability of a second recession.

As of September 30th, the S&P's forward looking price to earnings ratio was 12.3 times earnings. This remains well below the fifteen year average of 17.2 times projected earnings⁽⁸⁾. Based on the negative market sentiment, we believe it will be a long time before equities once again approach their fifteen year average. However, we feel that as investors begin to gain confidence in the recovery and the market trauma of 2008 becomes more distant, valuations will continue to trend higher. A return to more normalized valuation metrics would provide an additional boost to equities.

If the economy does continue its recovery then we would expect all equity classes to continue their positive momentum. However, we believe blue chip growth stocks and the emerging markets appear most attractive today. We favor blue chip growth stocks due to historically low valuations relative to other equity classes. In addition, compared to companies with smaller capitalizations, they have easier access to low cost financing as well as larger exposure to the emerging market economies. While emerging market equities have seen a strong run-up in prices, we believe the strong pace of growth in the emerging economies will continue for many years making the current valuations an attractive entry point.

Given the Federal Reserve's second round of quantative easing, we are less concerned about a short-term increase in interest rates. However, the economy remains fragile and risk reduction strategies, including bonds and hedging strategies, remain an important component to a well balanced portfolio. We favor municipal bonds in the high credit quality sector and emerging market debt in the high yield sector.

Getting Cash back to Work:

Despite the strong market returns of September, we do not believe investors with high cash balances have completely missed the boat. Although it is likely to be a bumpy ride, we believe there is the potential for a sustained bull market given low valuations and our expectation for a continued economic recovery. Furthermore, with cash yielding close to zero, many money market accounts have a negative real return when considering inflation. Therefore, we would recommend developing a strategy to redeploy this cash.

Besides fixed income investments and alternative hedging strategies, which we have discussed in past reports, there are other risk reduction strategies that may be appropriate for some investors. One such approach is the incorporation of an annuity with guaranteed living benefits. These products do have their pros and cons, but for the appropriate investor can be an effective risk diversification tool.

*Staycation - A holiday in which you stay at home and visit places near to where you live.
*Recessionista - A person who is able to dress in a fashionable way even though they do not have a lot of money to spend on clothes.

Footnotes:

1. Data obtained from CNN.
2. Data obtained from the U.S. Department of Commerce.
3. Data obtained from the U.S. Federal Reserve.
4. Data obtained from Bloomberg.
5. Data obtained from the U.S. Department of Commerce.
6. Speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 27, 2010.
7. Quote obtained from Fortune.
8. Data obtained from J.P. Morgan's Guide to the Markets.

The views expressed here are those of Weston Financial Group, Inc. and are subject to change based on market and other conditions. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is neither representation nor warranty as to the current accuracy of such information, nor liability for decisions based on such information. Past performance is no guarantee of future results.

It is important to remember that investing entails risk. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Credit and market risk includes the risk that an issuer of a bond will be unable to make interest and principal payments when due. Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss in portfolios employing this strategy. The value of a portfolio will fluctuate based on market conditions and the value of the underlying securities. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio.

A variable annuity is a long-term investment designed to create guaranteed income in retirement. Annuities are not a deposit, not FDIC insured, not insured by any Federal Government Agency, not a bank credit or union guaranteed, and may lose value.

Weston Financial Group, Inc., a registered investment advisor. All material presented herein is believed to be reliable. Investment recommendations and opinions expressed in these reports may change without prior notice.