For those of us in New England, we were fortunate to enjoy day after day of beautiful weather throughout the summer. It was really something to behold and although browning lawns screamed “uncle,” it made for a tremendously enjoyable string of weeks and months. As the leaves are clearly changing and winter looms upon us, it is human nature to wonder if we’ll have to somehow pay for all these pleasant months with a brutal winter or dismal forecast for 2013.
As we look at the equity market and its own remarkable run, we find ourselves asking that same question. Given the 13% three-year annualized returns of the S&P 500, helped along by stimulative, aggressive and largely unprecedented Federal Reserve Bank (“the Fed”) monetary policy, many are wondering when we’ll have to pay for those sunny days and clear skies that we have mercifully experienced since 2009. What are the unintended consequences of the actions taken by the Fed and how and can we plan accordingly? Is there a fiddler somewhere who needs to be paid?
As usual, these types of questions are difficult to answer. Make no mistake though—the economic recovery by most measures is subpar and tepid, which is blatantly incongruous with the multi-year strength exhibited by the equity market. Our conclusion, “don’t fight the Fed” has never resonated more as Ben Bernanke and Co. have succeeded in willing the S&P 500 (and other US indices) upward in the face of a disappointing economic recovery. We currently sit just a few percentage points off all-time highs for the Dow and S&P 500.
In September, Bernanke reloaded the bazooka and announced a key development: Not only will the stimulus measures continue, but they will also be “open-ended.” After extensive and apparently very persuasive conversations with his fellow Fed policy makers throughout the summer, benevolent Ben announced that bond buying and other tools will be deployed even after the economic data (particularly the employment data) are on a sustained path of improvement. The market of course looked past the lackluster employment and manufacturing numbers surfacing around the same time, and stocks rallied as low rates as far as the eye can see free up risk capital and push investors more and more toward the equity market. On some level, it’s a wise move to leave the policy open-ended because the market tends to focus on deadlines and obsess upon end-dates (e.g. Debt Ceiling, Fiscal Cliff, Y2K, etc.). Thus, he has effectively taken a “target date” off the table. Crafty!
So why all this talk of the Fed when we have a presidential election unfolding before our eyes? Shouldn’t we be utilizing these pages to predict how this or that candidate’s victory will lead to “X” company doing well and “Y” sector underperforming? In our view: No! Although this presidential election, as they all are, is crucial for our nation, the single most important factor for the capital markets (bonds and equities) is the depth and duration of Fed stimulus, not whether or not President Obama is reelected or Mitt Romney is elected.
We generally don’t make big, bold predictions here at Berkshire Bank Wealth Management (see Meredith Whitney, Noriel Roubini and the “competition” to gauge how well these prognostications tend to go). We’ve drawn important lessons from those in our own backyard calling for an unending down market while missing the entire three-year rally – bad for them and their clients, and good for those who participated. The fact is, whether one agrees or disagrees with Fed policy, their initiatives have created a tailwind for stocks that will likely continue – short term and medium term – even in the face of slowing and disappointing corporate earnings growth and continued high unemployment. Bonds will be bought en masse (fact, not prediction) which will push bond yields lower, making them progressively less appealing, and to some degree pushing investors toward riskier assets such as equities.
The balancing act, however, is that although investors may be nudged along toward greater equity exposure, they’ll have to do so amidst a market that is rapidly approaching fair value while earnings growth dissipates. Absent Fed intervention, this would not be a recipe for a healthy market, but as mentioned above, the Fed is determined to keep the party going. Because of challenging fundamentals and slowing growth, we continue to gravitate toward the more noncyclical sectors of the economy that offer excessive dividend yield. Just this year we’ve seen a resurgence in Telecom and Healthcare stocks, not necessarily because these firms are innovators, but rather because their dividend yields are particularly competitive when compared to a typical investment grade corporate bond. Additionally, the long-term Fed stimulus, which hurts the value of the dollar and paper currencies globally, warrants designated exposure to precious metals. We will of course maintain exposure to a broad array of other sectors and asset classes but do so using a core group of carefully screened companies ideally suited for this unique environment. Our in-house research effort enables us to truly customize our portfolios for this challenging backdrop.
As we enter the final quarter of 2012, brace yourself for an interesting finish to the year. The European Central Bank will continue to roll out a program designed to shore up the Eurozone financial system by making “Outright Monetary Transactions,” a strategy to purchase bonds of struggling countries that are under European-Union sanctioned bailouts. For the first time since 2010, S&P 500 earnings growth will flatten and perhaps even go negative on a year-over-year basis. We’ll also want to keep a close eye on Israel’s rhetoric (and military action) directed toward Iran, as the Middle East is perpetually a potential tinderbox. The “Fiscal Cliff” (the termination of a multitude of favorable tax policies) is also creating a fair amount of anxiety, although we suspect a backroom deal is already in the works that would avert a shock to the system. While the aforementioned tiles construct the mosaic that makes up the proverbial “wall of worry,” we’ll stand by our central premise: The Fed’s aggressive policy will trump these other pockets of concern.
So when does the endless summer truly end and what are the consequences? There will come a day when the Fed will have to step away and it’s our belief that after years (yes, years) of aggressive monetary policy, the market will struggle to break the habit. At that time, a more conservative positioning will be warranted. For now, the old adage to “not fight the Fed” is in full effect. Once the Fed does step away, there will likely be a rapid rise in interest rates commensurate with increased inflationary pressure, as well as the removal of measures designed to keep borrowing costs down.
We wish all of you well as the year winds down and look forward to lively discussions over the coming months and quarters as these interesting times continue to unfold.
Charles N. Leach, III, Chief Investment Officer
Your Berkshire Bank Wealth Management Team:
Charles N. Leach, III, Chief Investment Officer
Kenneth B. Walker, Director of Investment Research
Richard R. Bleser, Portfolio Manager and Investment Analyst
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