Third Quarter 2011 Investment Thoughts

The third quarter of 2011 was a very challenging one for the equity markets. It seemed that fear really grabbed the markets as volatility rose dramatically. As we write this, the major indices have bounced back dramatically in the beginning of October. We recently wrote about our thoughts on the impact of the downgrade of US debt (link) and its impact on the economy. We always feel it is important to keep things in perspective in times like these. Since the market low in March, 2009, the S&P 500 index is up over 75%. It is never a straight line back up from market lows but throughout our history, stock markets have always recovered and grown over the long term.  There is no reason to believe this won’t be the case moving forward, even though there will likely continue to be more volatility than we have seen in the past.

From an economic perspective, you do not need to be an economist to know that the US is struggling to stay out of a second recession. The employment situation has not gotten much better. The monetary policy of the Fed seems to be running out of tools to address the situation. Europe may be in worse shape as Greece continues to seesaw between default and being saved almost daily. There is clearly a real lack of confidence in consumers here and abroad.

With interest rates as low as they are (the 10 year Treasury bill is under 2% as we speak), there is really no where for investors to go and earn any reasonable returns with safety. The struggle for income is a problem world wide as most markets have 10 year government bond yields that are a good bit lower than the dividend yields on the stock indices.  With cash reserves of almost $10 trillion, at some point a portion of this will be invested.  The problem with this is the lack of incentive for companies to invest this money.  With fear still gripping the markets and assurances from our government that interest rates will stay low through 2013, businesses and individuals have no incentive right now to invest this money. 

This could lead to slow economic growth over the next year or two but eventually rates will rise and businesses will begin to invest this cash which will help the economy grow faster.  Of course there is the risk in the meantime that any shocks to the system could push us into another recession, but most economists agree that this still has less than a 50% chance of happening.  Right now stock valuations and P/E ratios are very low and corporate profits are very strong.  Corporate profits drive growth and we continue to believe that the markets will persevere and grow in the long run.

What should you do in times like this? A couple of suggestions we would continue to make:

1. Make sure your cash reserves are sufficient to ride through a prolonged downturn. Keeping 2-3 years of cash flow needs in liquid, safe investments is never a bad idea.
2. Review your asset allocation to make sure it is still consistent with your goals. When we see dramatic differences between stock and bond returns, like this past quarter, it is easy to be out of line
3. Assess your exposure to alternative asset classes that may provide some uncorrelated returns to the stock markets. It is important to have your stock exposure diversified, but it may make sense to go beyond that and consider alternatives to help to smooth out the ride. 

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