It has become clear that our economy needs to be resuscitated. Overall, the conditions in the US economy have likely worsened in the past three months. As a result, policy makers have concluded that the current trend of slow recovery needs to be enhanced. The Federal Reserve is about to serve us another round of Quantitative Easing (QE2) which will be deemed to be crucial to reinvigorating the economic recovery.
No government policy maker has ever dealt with these kinds of adverse economic conditions. The intended process and impact of QE2 will be for the Federal Reserve to buy back large quantities of Treasury bonds mostly from member banks. These purchases will inject new reserves into the banking system, supposedly lower long term interest rates, and hopefully restore confidence to investments which have risk, like stocks. Will QE2 be effective?
Bill Gross, who runs the world’s biggest bond fund at Pimco, recently stated in an industry presentation, “To suggest that the private market come back in is simply impractical.”1 His feeling, shared by many, including Tim Geithner at the Treasury Department, and Ben Bernanke at the Federal Reserve, is that our economy is in need of this life support from the Federal government.
The financial markets have been giddy with anticipation of QE2. Stocks hit a five month high in the first week of October. All classes of bonds have been rising in value. Gold has notched $1300 per ounce recently. This anticipated flood of liquidity is driving up asset and commodity prices.
My favorite economist, Tony Crescenzi, also of Pimco, recently wrote, “The efficacy of QE in particular represents a major unknown even for the Fed, as few truly know the effect that a given amount of QE will have on financial conditions, and few truly know the impact that any loosening of financial conditions will have on the economy.”2
Failing to Forecast
In early July, famous forecaster Robert Prechter, predicted a sharp decline for stocks with an eventual target of 1000 on the Dow. More ripples of pending calamity followed when a technical indicator, “the Iron Cross”, signaled a sharp decline was ahead. Then as September rolled near, another signal, the “Hindenburg Omen,” made an ominous forecast. These were just two of the widely covered indicators that predicted a stock market drop.
Do you remember reading predictions about how bad September would be? Pattern followers cited September as historically the worst month of the year. This observation was based on studies which showed the average S&P decline over the past 50 years to be 1.29%. September has been down 65% of the time over the past 50 years.3
We certainly felt the backlash of these pessimistic forecasts. Fortunately, these turned out to be false warnings. The S&P 500 surged 11.30% for the quarter. As for September, it ended up being the best month of the year so far, up nearly 9%. September was actually the best performance for the calendar month in 39 years. Go figure. It was interesting and certainly gratifying that the experts were largely wrong on their predictions.
Be Prepared for Drops
Stocks are the only game in town, so to speak. Money market rates are zero. Corporations and sovereign wealth funds have bulging cash levels and this has awakened a merger mania over the past few months. Every week, we are greeted with the news of several takeovers.
Despite the recent momentum to the upside, the stock market is due for a pause. The fourth quarter will probably not end as well as the third quarter. Our economy is struggling and this malaise will likely continue. The anticipated political power shift emerging after the elections gives a tailwind to stocks, for the time being. It would be wise, however, to be prepared to sell this rally and assume that stocks will be close to their highs for the year at that time. Since June, the dramatic recovery of almost 15% should trigger some profit taking. Usually a period of consolidation follows an advance of that magnitude.
Hedge fund manager David Tepper remarked, on CNBC on September 24th, that stocks would head higher regardless of the condition of the economy due to more projected QE2. This was the case that caused the short-term rally at the end of September and early this month. Tepper seems right on target, but given the recent run, too much is being pinned on a favorable outcome of QE2.
Peregrine Returns and Strategy
We are taking defensive measures in guarding our portfolios from a stock market decline that could happen sometime in the fourth quarter. Our best defensive measure is to trim equities from portfolios substantially enough so as not to endure too much of a setback and at the same time not so much as to dampen the potential return from a rebound in stocks.
Interest rates seem very likely to stay low and could move lower in the months ahead. Bond values enjoyed sharp gains in both the second and third quarters. Despite the constant predictions of higher interest rates, our position is that rates will likely fall further first.
In the third quarter, our equity composite climbed 7.07% versus 11.30% for the S&P 500 index. For the nine months of 2010, our Equity Composite was up 2.39% versus the S&P 3.35%.
Our balanced composite gained 4.76% for the quarter and is up 6.05% for the year. This strong performance was bolstered by our holdings of long term Treasury bonds, which have been highly out of favor by many experts. For 2010, our long term Treasuries have risen in value by 16% through September 30 and have contributed to about 3% additional income during that period.
Many of our equity investments have recovered following the sharp decline in the second quarter. In addition, we have added many new names to our portfolios which have outstanding growth characteristics. These companies have business profiles that suggest the beginning of major advances.
An example of these favorable positions can be found in many companies that serve Latin America. This region has favorable economic circumstances and many companies throughout this region stand to dramatically prosper.
1 Investment Highlights 8-23-10
2 Blog by Anthony Crescenzi 10-6-10
3 Source Bespoke Investments
Past performance is no guarantee of future results. Investment management involves the possibility of losses. Significant general stock market moves up and down can influence the performance of client portfolios. Composite returns are based on client portfolios of over $100,000. Not all clients are included in the composites. All returns include the reinvestment of dividends. All returns are net of fees. Composite returns are derived from aggregated, time-weighted returns for clients of Peregrine Asset Advisers. Individual client returns can deviate from the composite returns. While Peregrine uses the S&P 500 as a benchmark, Peregrine does not attempt to mimic the structure of this index. Individual client portfolios vary. The number of securities held also varies per client.
Do you have questions or would you like to know more, contact Dan Botti.