“During times of universal deceit, telling the truth becomes a revolutionary act.”-George Orwell
A few weeks ago while in a diner I overhead a comment from a local politician that captured the essence of George Orwell’s quotation. The official said quietly to another person that the donor base supporting his political party was comprised of “artists and eccentrics who were fragile” and could not handle being told “what needed to be done” to fix the town’s fiscal issues. He was afraid the donors would stop supporting his party if the truth were told. I wonder how many similar conversations are occurring around the world right now!
The world is suffering from feeble leadership. This has become unavoidably apparent over the last six months as a nascent economic recovery has been squashed by the weight of uncertainty and indecisiveness. From the ridiculous circus of the debt ceiling standoff in August (which only deferred decisions until a committee reports in November) to the failure of European leaders to resolve Euro currency related issues, the lack of action is a pathetic abdication of duty. As an investor, I have the responsibility to manage your money prudently and with an eye on the long term. Therefore, in this update I’ll review the current investment environment, what actions I believe would improve the outlook for the coming year, and the steps I’ve been taking in your portfolios to prepare for the future.
Our economy has been experiencing an anemic recovery since the near collapse of the financial markets in 2008. The Fed has tried to fill the void by initiating quantitative easing programs and by keeping interest rates near zero. The problem is that our economy is suffering from the hangover of policies and behavior of the last few decades. On the positive side, consumers have begun resolving their personal balance sheet issues after years of under saving and over borrowing. Corporations are lean, much more efficient, and in sound financial shape. However, of concern is the fact that governments have yet to address necessary reforms. Many local, state, federal, and foreign governments have borrowed heavily from the future to support current programs. In some regions the burden has reached crisis level. Tax breaks, generous government union contracts, and expanding government programs are not simultaneously feasible, period.
The outlook for investments and the economy is heavily dependent on our leaders addressing structural reforms in both spending and taxes. The Federal Reserve has done all it can do with monetary policy to encourage economic growth. Money supply as measured by M2 has been expanding. However, the velocity of money, the rate at which money changes hands in transactions, has yet to recover. Consumer confidence and job creation remain subdued. With interest rates near historic lows, it is not the cost of money that is impeding the recovery; it is the lack of confidence. Economic activity occurs when two willing parties enter a transaction and the uncertainty caused by weak leadership is destructive. Until structural reforms are undertaken in an honest and meaningful manner, I believe that uncertainty will continue to weigh on the economy.
So with this scenario as a backdrop, I’ll review the actions I’ve taken in your portfolios. In the current interest rate environment the Fed is forcing investors to consider taking more risk. The two year treasury yields 0.24% and the ten year treasury is yielding 1.74%, rates that provide negative returns when inflation is included. Therefore, I am reluctant to reinvest maturing bonds at these levels. Instead, I have favored letting cash balances build. Where the need for current income is great I have been increasing exposure to MLPs, preferred stocks, and REITs. I added to client positions in Kinder Morgan (6.8% yield) and I have also begun slowly to add new stocks. I purchased shares of United Parcel Service (3.3% yield) because of the company’s excellent business model and exposure to international trade. UPS is also a potential beneficiary from any curtailment in mail delivery as the government seeks to reduce losses at the US Postal Service. I purchased shares of Dentsply International, a manufacturer of consumable dental supplies. The company generates over 60% of its sales from international markets and is trading near the low end of its historic valuation range. I also purchased shares in Roper International, a mid-sized manufacturer of industrial controls, fluid handling, and analytical instruments. I have eliminated some equity positions, specifically Met Life. I became concerned that the insurer’s exposure to European bank debt was too risky given the uncertainty of a Greek default.
Looking forward, I will continue to balance the significant short term risks in the economy and stock market with longer term opportunities. It has been many decades since the yield of the S&P 500 has been greater than that of the 10 year government bond. Most stocks are trading toward the low end of their historic valuation range so as uncomfortable as it may feel, I believe now is the time to do our homework and invest in well run businesses positioned to thrive when the level of uncertainty finally dissipates.
During this unique period in history, the outlook for the stock market is tightly woven with the political battle playing out across our nation and abroad. I believe the political environment will become more constructive after the 2012 elections, when voters have the opportunity to voice their opinions. I’m less certain the outlook will brighten in Europe due to the greater complexities of the political environment, so I’ll continue to remain wary of the Euro and PIIG nations.
On a final note, I want to welcome Michele Forte to Ayrshire Capital Management as Office Manager. Michele has many years of experience working within the office of a major international family and I’m delighted she is bringing her expertise to Ayrshire Capital Management. Please join me in welcoming her. Thank you for entrusting me with the management of your money and please call with any questions or comments.
JM Sam Nevin, Jr.