It paid to be practical in 2010. We started the year with relief that we averted catastrophe but were dimly aware it would be tough. How could it not be? Financial markets were in disrepair and the economy looked like it had only just made it through a re-stocking cycle. All other parts of the economy looked down for the count. But in the end, despite euro sovereign emergencies, deflationary fears and a phony currency war, both the real economy and financial assets had a strong year. It was hard to lose money: the dollar, US corporate bonds, overseas markets, US large caps and US small caps (the S&P[1] and Russell 2000[2]) returned between 2.5% to 25%.

But it came with volatility. The US market, for example, went through four distinct phases with a gradual upswing punctuated by two corrections of 9% and 17%. Similarly, bonds rallied hard in the first nine months despite (because?) of the European sovereign crisis yet sold off in the remainder of the year. As we’ve said before, this is not, and won’t again be, a buy-and-hold market.

 

All this is explained by the Fed. Its twin mandate of full employment and price stability conflicted in 2010. Full employment won. So the Fed re-tooled to move the politically and socially important employment numbers down from the grim 10% April peak. In doing so, it sent unequivocal messages to the markets that have proved tolerably accurate in combating weaknesses in the economy. Let’s look at these before moving to 2011.

 

The gloom lifted on the productive and manufacturing economy almost immediately after the September announcement of the $800 billion asset repurchase program or QE2. Business surveys improved and the output data appeared consistent with a 4Q GDP of 3%. Importantly, the growth is organic and sustaining as opposed to the inventory rebuild which accounted for well over half of growth in the first nine months of the year. We’re decidedly in the “glass half full” camp on this one and our reason is simple: purchasing and supply manager surveys look at order flows for up to a year ahead and businesses are slow to engage labor (it’s easier to extend overtime). Both have shown positive readings for months (December was the best in 20 years). We think a virtuous cycle has started.

 

As orders grow, so goes the labor market. Remember that employment job losses in the 2008 recession were more than the prior four recessions combined. Recovery was always going to be hard. The construction and housing industry accounted for 8% of GDP in 2006. Today the number is 4%. We used to sell 1.2 million houses a year. This year, we’ll be lucky to sell 280,000. The market is glutted. This left a lot of workers in the wrong part of the country with the wrong skills. The 2001 recession took four years for full job recovery. This one will take more than five. But after two years of near zero interest rates, unmistakable signs of a reemerging job market appeared towards the end of the year. By December, the unemployment rate had fallen to 9.4%: that’s 727,000 people back to work from the same time last year. Yes, the workforce increased by 1.1 million and we have miles to go. But it’s enough to instill much needed confidence.

 

Much is made of the financial imbalances, particularly the public sector. True, government borrowing has escalated sharply from the 2008 abyss. But it has been easy to finance because the private sector moved into surplus. Households paid down debt (there’s been a huge collapse in demand for revolving credit) and slashed spending. Corporations hold over $1.2 trillion in cash as operating cash flows exceeded the demand for new investments…indeed capital expenditures barely kept up with depreciation allowances. And amid the handwringing, the issuance of US Treasuries is set to fall by 16% in 2011. So government indebtedness is not such a big deal simply because it’s not what the government owes but a) how it’s financed and b) where the sum of private, government and corporate borrowing stands. In this context, the debt looks comfortable and we’ll be surprised by how much the deficit shrinks as tax revenues increase in 2011.

 

No deflation and no inflation. We must admit, because we trashed it at the time, that QE2 had its intended effects: there’s no deflationary fear. Sure, it will be interesting to see how the Fed unwinds its balance sheet and there’s a risk of asset price distortion…but we’re not there yet. Since late August, TIPS spreads have moved from 130 to 240. That’s the inflation break-even and as good an indicator as any of the forward inflation rate. It’s dead on where the Fed wants it. The best inflation measure is the PCE[3] core, which is at less than 1%…so if the indicator is at 2.3% and actual at 1%, it tells us that low rates will be with us for a while because (simply) the Fed has not met its QE2 goals.

 

So the bottom-line on the economy: It’s in decompression[4] mode. Settling in after trauma…it takes a while. The Fed runs an expansive monetary policy. There’s nothing inherently bad or weak about the US economy but it’s going through some painful adjustments after a decade of excess.

 

And this means for 2011:

Bonds

Fed buying of the seven- to ten-year Treasuries space after QE2 meant the market offloaded most of its gains and inventory in the back end of the year. This was not some cerebral debate about the inflationary consequences of easing and money quantity. It was an outright barroom brawl with the street locking in gains and selling to the only buyer in town. Rates increased quickly from 2.5% to 3.5%, erasing the return from the GT10[5] from 14% in the January to September period to 9.7% for the year. That’s what we mean by “expect volatility.”

But it’s not all bad news. There’s a lot of liquidity out there…we can see how well bid corporate and any good standing bonds remain. New issuance market (NIM) has been slow: it was down 22% in 2010, but expect a pick up in the New Year and the bond market to stabilize. Also, note that retail, foreign and pension demand will return in early 2011. Each one has a very real need to remain overweight in bonds.

So don’t discount bonds in 2011. The retail investor is not about to dump bonds and as long as inflation is so low and cyclical unemployment high, the Fed won’t let higher yields choke the economy.

 

Equities

Stocks have weathered well this year but what was disarming to see was “good” companies (low P/Es, dividends, strong balance sheet) underperforming. It was a second good year for small caps but, again, those with a speculative element made the running. We’re fine with this. When markets run fast, correlations narrow and the index/ETF buyers carry the weak. But it doesn’t last forever and eventually quality will out.

 

Get used to volatility because that’s the pattern when global policies are discordant and economic problems are as diverse as they are right now (e.g. China: inflation and consumers, Germany: bailouts, US: employment). Also, the more the market trades on macro news, the more swings we get…because it’s mood driven and the link between economic data and equities is weak.

This is still a time to be in equities. Here’s why:

1. Earnings momentum: Pricing power among large companies is strong and operating leverage still to the upside. For the last seven quarters, consensus forecast EPS have been 10% below actuals…and expect that again in 2011.

 

2. Valuation: The S&P trades on a forward multiple of 14x and yield of 2%.

That’s cheap in a ZIP[6] world. Cash yields are 8% above Treasuries and they go to pay: dividends. The market does not value income sufficiently and dividends are a vital driver of stock market total return. In 2010, they were 15%. For the last 10 years, they were 134%. The long-term average is 40%. We think about that when we’re shown the “must have” zero yield, growth-at-any-price fake-out stock. Shocking I know, but they are out there. Valuations are very important. And a nice fact to throw out when the conversation lags: utilities have outperformed the NASDAQ since the latter’s inception. So companies with strong financials, proven management and free cash flows should provide good returns.

 

3. Supply/Demand: Net issuance of stocks in the US is low and stock buy

backs are up to 2006 levels. M&A transactions are running about $200 billion annualized. These are good confidence indicators as much as anything. With outstanding stock declining somewhere between 2% to 3% a year on the same level of earnings, it’s a very good underpin to the market.

 

4. Yes, it’s still China: There are many “wow factor” stats on China but here’s one to make the mind race. Since 2005, aggregate real output in China rose 70%. In the US, it’s less than 5%. China is turning inward in a good way. Its external balance has shrunk from 9.4% of GDP in 2008 to 2.5% expected in 2011. The benefits should accrue to the Chinese consumer in the form of housing, healthcare and retail. Inflation is an overhang for the short term but tends to work its way out of the system.

And a nice kicker: for the last 80 years, we’ve seen only one down year in the third year of a presidential cycle. The average is +17%. It’s not one of those daft correlation things…it makes sense because policy tends to swing towards the center. This time, we have a renewed stimulus from the December tax deal plus the low rate, growth capacity upside.

So putting it all together…

1. Growth is still undervalued…that leads us to large cap names with strong balance sheets, financials and good management

2. Less correlation between markets, countries and sectors…we like to see that given our stock picking style

3. Capital investment and business spending cycles are still in upswing…keep exposure there

4. Maintain exposure to bonds…they provide solid real rates of return and protecting purchasing power is what investing is all about.

Sentinel’s Top 10 Predictions for 2011

              1. Unemployment drops to 9%…enough to contain workforce growth

              2. China inflation subsides and market comes back strongly

              3. Case/Schiller house prices show no real upturn

              4. US stocks outperform bonds but with no multiple expansion

              5. Dividend paying stocks outperform market averages

              6. Bond market treads sideways…GT10 year-end rates modestly higher

              7. Germany remains European economic powerhouse…

              8. …and flexes its new political influence in the ongoing euro crises

              9. Volatility remains…no straight run in these markets

              10. “Kick the can down the road”… “going forward”… “at the end of the day”… are banned as clichés of the year.

 

 

(c) Sentinel Asset Management

http://www.sentinelinvestments.com/