Q3-10 Update

On the strength of the best September since 1939, the S&P 500 climbed 10.7% in the third quarter and regained positive territory for the year. Stocks are now up 2.3% this year. There were few newsworthy events to spur stocks and the trading volume was below average. The low point of the quarter occurred around the time Federal Reserve Chairman Ben Bernanke vowed to take action if the fledging recovery stumbles. Ironically the struggling economy may be attributed to the strong third quarter stock market performance as investors expect additional quantitative easing (QE). We have prepared a quick summary of QE at the bottom of this note. Other factors in the September surge point to a mildly improving economy with stabilizing housing and unemployment, manufacturing expanding, and commodity prices increasing. Corporate balance sheets are stronger and acquisitions have become a popular use of cash.

Corporate earnings have not disappointed. Companies have been able to steadily improve the bottom line since the lows of 2008. Operating earnings on the S&P 500 should come in at $80+ for 2010. 15 X $80 make the case for 1,200 on the S&P 500. Alternatives like cash and bonds offer historically low yields with very little if any chance of price appreciation. As the calendar moves further away from the crisis of 2008, year to year earnings growth becomes more challenging. Expectations are higher and it is less likely for earnings to surprise to the upside.

Gross domestic product growth was 2.7% in the first quarter and 1.7% in the second quarter of 2010. The remainder of 2010 is expected to show low growth around 2.5%.

Commodities were up 11.6% in the third quarter. Crude oil was up 5.7% to $79.97 per barrel. Goldwas up again about 5% to $1307.80 per ounce. Gold continues to rise steadily even as global equities increased. Gold is sought to preserve wealth in volatile markets and declining paper currencies. Agricultural commodities were up sharply with a wheat, corn, and soybeans up 45%, 39.9%, and 16.7% respectively. Natural gas was down 16.1%.

The housing sector continues to bounce along the bottom. The number of starts and existing home sales is improving from record lows. There are still plenty of foreclosures in the pipe and lots of inventory to work through.

The unemployment rate came in at 9.6% in August. Weak job market expectations remain but the rate seems to have stabilized.

The Federal Reserve maintained the 0.00% to 0.25% range for federal funds. Despite continuing dismal prospects for fixed rate investments, the move to lower risk drove the yield on the 10 year treasury down to 2.52%. The Fed is still not concerned about inflation. They are more concerned about deflation at this point. High unemployment and idle capacity do not put much upward pressure on prices.

Core consumer prices continue to rise at a historically low rate between 1% and 2%. Even though there is very little inflation officially, continued large deficits and the creation of dollars may play a prominent role in the future.

Equities all over the world also moved higher in the 3rdquarter. Excluding the U.S., stocks were up 15.9% on the Dow Jones Global Index. European equities were up 6.7% and Japan was up 6.2%. The emerging markets were stronger with China up 11% and Brazil up 14%. Other Latin American stocks were up sharply and India and South Korea approached all-time highs.

The midterm elections could have some impact on the financial markets. Perhaps part of the September rally can also be attributed to the political forecast. A change in party power could impact business regulations, the cost of doing business, and whether tax rates will be increasing next year. After that the calendar turns to the third year of the Presidential cycle which has been historically strong.

Idle Cash
Continued government efforts to support the markets and stimulate the economy have driven down interest rates. The yield on a 10 year US Treasury obligation is less than 2.5%. A 5 year CD has about a 2% yield. Highly rated corporate debt pays less than 1% for a year. Money market funds are essentially paying nothing. These investments are safe. Principal will be repaid with a paltry return and almost no chance for price appreciation.

There are alternatives with much higher current yields. Dividend paying stocks are one example. Several big companies have issued debt to pay dividends. Microsoft issued $1 billion of three year notes at less than 1%. MSFT common stock yields 2.6%. This is not meant to be a recommendation to buy Microsoft rather an indication of the potential higher risk reward scenarios that are available. There are plenty well-known common stocks that pay a dividend with a chance for price appreciation. Intel common stock yields 3.3%, Verizon is about 6%, UPS 3%, McDonald’s 3.3%, Johnson & Johnson 3.5%, Procter & Gamble 3.2%, ConocoPhillips 3.8%, General Electric 2.9%, and Excelon 4.9%. Of course these stocks can go down in value. They most likely will decline at some point. A small change in the stock price can offset the yield on paper. We mentioned some widely held large companies as examples. Not necessarily investment recommendations for all.

Unsecured corporate debt is another option. General Electric Public Income Notes (GEC) have a 6.1% coupon with a long dated maturity (2032). Since they are currently callable we don’t want to pay more than par value ($25) but will buy when they trade lower. Similar issues from JP Morgan (JPM+X) and Wells Fargo (WSF) have lower credit quality and higher yield. These are also now trading at a slight premium.

Senior corporate debt is worth a look too. Goldman Sachs has a 5 year note yielding about 3.5%.

Federally tax exempt municipal bonds may be more appealing as tax rates increase. This is especially true if the capital gain and dividend rates go up. A highly rated 5-year municipal bond can yield 2.5%.

Quantitative Easing (continued from above)
Quantitative easing is a monetary policy used by the central bank to increase the supply of money. The central bank essentially prints money and uses it to purchase financial assets (government bonds, mortgage backed securities, and corporate bonds) from other financial institutions. These purchases give banks access to more cash with the thought that it will in turn be lent to stimulate the economy. We are not necessarily advocating such a course of action although we are of the opinion that is has at least temporarily helped to prop up asset prices. QE resulted in a reflation of stock, bond, and commodity prices in 2009. The risk is that it is ineffective in stimulating the economy or that the easing could ultimately lead to high inflation and / or dollar weakness. The Fed can push money into the system but can’t force lending, borrowing, spending or investing.

Please let us know if you would like additional information on any of the above.

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