March 12, 2010Two months ago, we published an update titled Shifting Gears. In that update, we emphasized our conviction in the durability of the current recovery and our view that the economy would likely shift gears as 2010 progressed. Generally speaking, we've had the view that the economy will be stronger than the stock market in 2010, which is the exact opposite of what occurred last year.
What we did not discuss is what this might mean from a portfolio strategy perspective. In client portfolios, we have been shifting gears a little more actively in anticipation of changing economic seasons.
Those that have followed our firm know that we compare our selling discipline to taking care of a garden. Weeding out bad stocks, pruning healthy ones, and transplanting names as seasons change are all necessary to maintain the vitality of the overall portfolio.
I would emphasize that these changes aren't indicative of a shift in our bullish stance, but simply a recognition that certain economic sectors tend to do better than others during different stages of the economic cycle. With the engine revving at the red line after an incredible acceleration off year ago lows, it is now time to downshift, grab the next gear, and experience a different kind of torque.
We generally categorize the stages of the economic cycle in four basic buckets - early expansion and recovery (accelerating growth), late expansion (normal growth), early contraction (soft landing), and late contraction (recession.) While all economic cycles don't necessarily include all four stages, they often do.
Since March 9, 2009, a tad more than a year ago, the economy began what we can now safely label its early expansion or recovery stage. In the most recent quarter, gross domestic product grew nearly 6%, a significant improvement from last year at this time when it was declining at a similar rate and it felt like we were in a spiraling free fall. As is often the case, the stock market moved well in advance of improving economic news, and the S&P 500 is now up 72% from its lows, with most of the gains coming in the earlier months of the recovery. (The Broadleaf Growth Equity portfolio is up 90% over the same time period. [i][i] )
We now believe that the economy is moving past its early recovery phase and into its late expansion mode where growth still occurs, but at a slower and more sustainable pace. How long this phase of the cycle lasts and at what rate of growth it settles is subject to considerable debate, but generally speaking, stock market gains tend to follow a similar trend of moderation.
We would be the first to point to easier monetary policy as a significant factor in turning the economy around one year ago. With many worldwide economies now back on track, several international monetary policy boards have already started to raise rates to keep inflation from becoming a problem. It is not unreasonable to expect the Fed to eventually follow suit.
What is different about our Fed, however, is its dual mandate. Not only is the Fed accountable to price stability, but it must also act in a manner conducive to full employment. Our Fed has likely been slower to reverse course as compared to its global counterparts because of this dual mandate.
With the unemployment rate now officially ticking down from its highs in the 10% vicinity, the likelihood of a reversal in Fed policy measures increases as the voice of inflation hawks grow in relation to those most concerned about jobs. What constitutes "full employment" is subject to considerable debate, but given the recent change in trend, the likelihood that we're now moving on a path towards "fuller" employment seems more likely than one in the other direction.
I would reiterate, however, that just because the Fed starts raising rates, doesn't necessarily imply that the stock market will quickly fall apart. As we wrote in our last update, Fun with Charts, history suggests that a stable pattern of economic growth tends to have a greater influence over stock market returns than Fed policy moves during later stages of an expansion. While the stock market may pause as it digests the change in policy direction, the durability of economic growth will likely play the greater role in determining the medium term outlook for the stock market.
We are well aware that no two economic cycles are the same; each one has its own nuances and yet at the end of the day, most still rhyme. In this recent version of the nursery tale, the recovery appears textbook, while the downturn was not. The verdict is still out on how powerful and durable the last two stages will be. We know that growth will slow to a more sustainable pace, but we don't know what that pace will be. Two, three, or four percent? Only time will tell.
To prepare for the change in economic seasons, we have slowly and steadily been pruning the gains we've enjoyed from the sectors that did the best during the economy's bleakest winter months and have been transplanting seeds to those areas most likely to thrive as summer arrives.
Summer, as any Ohioan would care to admit, can't come soon enough.
(c) Broadleaf Partners
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