Markets in Transition

Ever watch a sporting event with the volume turned down? It may take away from some of the “drama”, but you also don’t have to listen to the idle chatter and biased views of the commentators. You can focus on the game. Exercising volume control can also be a good investing discipline. Tune out the chatter and focus on what’s really going on.

Let’s take a look at recent events. Just three months ago, many saw as surprisingly robust economy and there was talk of “inflation.” Well, in the blink of an eye, market consensus appeared to reverse course. Worries about a “double-dip recession” came to the head; “deflation” became the catchphrase. Have circumstances changed so much that the world has gone from imminent inflation to deflation in the span of three months?  We don’t think so. Our advice is to tune out the noise and focus on the fundamentals.

Transitioning Markets

Financial markets can be inconsistent during periods of transition, swinging from optimism to pessimism at the drop of a hat. We believe that the swings are a reflection of the market’s underlying unease regarding the following macroeconomic issues: 

• The uneven pace of economic growth

• Large public sector debt burdens & interest rates

• Global trade imbalances

The market can’t seem to decide which of these issues really matters or what consequences might follow. As long as these challenges are unresolved, worries are likely to continue to fluctuate.

(Our opinion is getting economic growth on a sustainable path is the primary challenge, the other two take a back seat for now – Government Debt is cyclical in nature and will be somewhat corrected as the economy recovers).

The good news is the Fed appears keenly aware and has signaled that it will do what it takes to help prevent the economy from slipping back into a recession. As such, we expect the Fed will be forced to maintain its zero interest rate policy until 2011 or possibly even 2012. Bottom line, we don’t see interest rates moving higher until the economy is more stable. That is likely to take time.

Outlook

Corporate profits have rebounded strongly. More importantly from an investor’s perspective, corporations have large cash reserves, with cash flows exceeding capital spending (that’s a good strategy for individuals too). In our view, favorable fundamentals are quite supportive of equity valuations going forward.

Base case: The economic recovery continues at a slow pace and the Fed remains accommodative for an extended period. The yields would likely remain low and within range bound levels; equities will remain volitile, drifting toward the upside.

Our portfolio strategy is designed to deal with a transition period in which economic growth is lackluster and interest rates remain low and range-bound for an extended period. This transition phase will eventually give way to a rising rate environment, but we don’t see that happening for some time. We practice dollar-cost-averaging Into & Out of positions (having a good Sell Discipline is key).  We’re also investing in “guard-rail” type strategies to preserve capital first, yet provide for some growth as well.

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Sources: Loomis Sayles, WSJ, CNBC.com