“Déjà vu All Over Again” – Yogi Berra

Recent political wrangling reminds us – once again – of the last two years of political deadlock and the potential economic damage which it can cause. The Congressional Budget Office (CBO) has estimated that the impact of the automatic spending cuts set to engage on March 1st would reduce economic growth by almost 3/4% annually and cause the unemployment rate once again to rise. None of this is good for US citizens, the US economy or financial markets.

Of course it is possible that some agreement may be reached in the next few days averting these negative consequences. However, given the current posturing of politicians on both sides it is very difficult to predict the outcome of this budget dilemma. Our sense – as was the case during the last "merry go round" at year end – is that an 11th hour agreement will be reached.

What if an agreement is reached?
We believe that this outcome is more likely. Disaster will be avoided, economic growth will remain on its wobbly path and stock markets will rally in relief. However, any agreement is likely to be similar to that at year end – a small temporary bandage applied to a very large wound. It is important to remember that we are at the beginning of our country's deleveraging process and that it will ultimately take years and many more of these political dramas to resolve.

With market indexes approaching 2007 levels, are stocks overvalued?
No. As we have suggested for the past year, the bull market in stocks is still intact and has further room to the upside. By nearly every metric, global stock prices are reasonably priced, particularly when compared to 2007 or 1999. Though stock prices are at levels not seen since those years, corporate profits since 1999 have tripled, creating what our team calls a "valuation phenomena" and the basis for continued stock market strength going forward. Our team believes that if the budgetary problems can continue to heal, stock prices will continue to discount this good news and rise accordingly. Interestingly, the most recent strength in stock prices, which started late last year, has been reminiscent of past global bull markets – virtually all sectors and industry groups participating on good trading volume. Most importantly we are also enjoying a re-emergence of foreign stock market participation, affirming once again the benefits of being global investors.

What if an agreement is not reached?
In this case, equity markets may tumble beyond a normal "correction." We are prepared for this possibility – or other market damaging news – through our Active Risk Management process. As you know, this involves your portfolio's allocation to the equity market, sector management and the use of carefully placed stop loss orders. Additionally, we have been particularly cautious to underweight industries that would be negatively affected by automatic budget cuts, i.e. defense contracting companies. These tools are intended to mitigate the risk of catastrophic loss.

Let's hope that our elected officials can come to an agreement in the next few days. It will be good for the economy, stock markets and all of us.

We hope this update finds you well. Please let us know if you have any questions or if your financial circumstances have changed recently.

Sincerely,

Your Team at Main Street Research