2009 has been a volatile year for investment markets. Stock indexes fell more than 30% in the first 3 months and have advanced 50% since. Real estate has continued its downward spiral, though at a slower pace. Interest rates, once at levels only seen during the 1930’s Great Depression, have begun to advance, but are still extremely low. To many, this environment is unsettling. However, to our team, it is “business as usual” in regard to what markets do during a Great Recession. So what’s next for the economy, stocks, bonds and real estate?

You may recall that, last April, we forecasted that “The Great Recession” would end by the start of 2010. Though the recession is still lingering, our leading economic indicators continue to support that the recession is close to an end and that global growth should begin in earnest over the next few months. Our research suggests that this next global economic expansion should last 7-9 years, but could be very different than past expansions. In the US, we expect slower than normal growth and continued unemployment. We also envision rising tax rates. Overseas, we see significantly higher economic growth, particularly in China, India, Korea and Brazil. There are risks to our view which include a continued decline in the US dollar, a “double dip” recession and an implosion in commercial real estate. We will be monitoring these and other risk factors very closely.

Over the past 6 months, stock indexes have advanced a whopping 50%, leading many to assert that there can be little upside left. We would disagree due to the following facts: Typically, stock prices will make up all of their recessionary loss within 2 years. The only periods where this was not the case was when stocks were wildly overvalued before the decline. At the start of this recession in 2007 stocks were not overvalued - it was the real estate market that was in bubble formation. Given that stock indexes are still down 30% from their pre-recessionary levels, an additional 50% increase would be needed over the next 18 months to fully recover the recessionary decline. We think that this performance is a possibility. However, it would come with the usual volatility, and it would require the economy to continue to expand and avoid the risks outlined above. Our research continues to suggest that investing internationally — as well as domestically — will yield the best results in this new era. At the present time, stock prices are reasonably priced and corporate profit growth is better than expected in most sectors of the economy. We will continue to manage the risk of your portfolio through your asset allocation, sector and industry exposure, and the use of stop loss orders.

It has been a difficult environment to acquire bonds. Interest rates are still at historically low levels. If our forecast of a global economic recovery comes to fruition, this low interest rate environment will be a short term phenomenon. During the first year of an economic recovery interest rates typically soar higher, investors leave risk free investments, and the Federal Reserve nudges rates upward — we do not think this recovery will be different. The Fed has already begun discussing when to raise interest rates. This is the time to keep bond quality high and maturities very short. There is tremendous risk in long term maturity bonds given that prices decline sharply in the face of rising rates. Though current interest rates are low, remember that this will be a short term phenomenon. As rates rise and begin to peak, we will have plenty of opportunity to “lock in” higher rates without the risk of future interest rate increases depressing our bond valuations. Over the years, we have witnessed eras similar to this and the misfortune of investors who have “reached” for yield through longer maturities or poor credit quality, only to result in investment losses. We will be careful to avoid making this mistake.

The residential real estate market appears to be declining at a slower pace and we think that it is possible that we may be at the beginning of a long bottoming process. Our research suggests that there will not be a “V” shaped recovery in residential real estate, but rather a more prolonged period of stagnant prices. Commercial real estate continues to concern our team. Many commercial real estate investors are in need of finding new loans for those that are maturing. There is simply no financing available due to the fact that banks have much more stringent lending terms. This combination of circumstances does not bode well for the commercial real estate sector. If banks lighten up loan qualifications this would relieve the current problem. We will be watching this closely.

We hope this note finds you well. If you would like to discuss any of these issues, or others, feel free to contact us.

All of us here wish you and your family a safe and happy holiday season!

Sincerely,

James E. Demmert
Managing Partner