Broadleaf Partners

I have been intensely more interested in the situation developing in Ukraine over the past few months than those that circled Greece, a country of similar size, or Libya and the Arab Spring a few years ago. For the most part, I've taken geopolitical flare-ups in stride in terms of their potential impact to the stock market and the economy. In general, this approach has been the right one.

Most sell side firms publish their outlook for the economy and stock market at the end of December and in early January. As a buy side firm, we really arent under any expectation to share our outlook for the coming year and, as funny as it might sound, some of our clients dont even care to know what we think, only that we handle what they hired us to do, which is to outperform the market indices over a full market cycle and help them attain their financial goals over time.

I am not a particularly good salesman. From the time I first meet a prospect to when they become a full-fledged client, it can often take two years even when they initiate the first meeting. Fortunately, growing the firm isnt one of my primary roles, a responsibility that does fall to Bill Hoover, my business partner. The beauty of our relationship is that while Bill devotes his time to our firms outside efforts, I am able to spend almost all of my attention tending to the portfolios of those who have already hired us. (View a printable version of this Economic

The stock market has continued to do very well over the summer months, reaching new, all-time highs and proving to even the most stubborn of skeptics that Great Recessions can become Great Recoveries for those with the appropriate time horizon. While our industry spends a great deal of time and effort focused on relative performance results compared to appropriate benchmarks, the greatest value any financial advisor or money manager can provide is usually addressed far less often; simply keeping you in the game.

About ten months ago, I wrote about my new bulldozer-yellow Jeep Wrangler, comparing the sensation of Driving with the Doors Off to investing in the New Normal, or as I like to call it, a slow growth for as far as the eyes can see environment. While the pavement had always been a mere twelve inches beneath my feet, Driving with The Doors Off made the experience far more real, far more alive, and far more aware of the risks that had always been there. In the New Normal it feels like we are always and everywhere just one small pothole away from the next economic disaster.

As has occurred in each of the last three years, the economy should continue to plug along, not as we might like it to be, but as we can reasonably expect. Growth scare or not, we suspect that the end of 2013 will show that continued progress lies ahead, but perhaps not exactly in the same pattern as it has thus far.

The media has made a spectacle out of the Dow Jones Industrial Average reaching new all-time highs. The Dow Jones Industrial Average and the S&P 500 indices do not include the compounding effect of dividends paid by member companies. Any retiree will tell you that dividends represent a return of capital and useful income in the real economy. If you had reinvested those dividends back in the index as they were paid, the old time highs reached in October of 2007 likely would have been passed some time ago.

Writing about Apple is painful. Not because I have lost money in recent months or have no insight to provide, but because the media will likely report on it ad nausea for the next few days. It is perhaps human nature that the news which is most readily produced is also the news that is most easily consumed. If you want to be read, it's best to write words that people will read. While this makes for great entertainment and advertising, it hasn't typically been the best way to get new investment ideas.

Many events have transpired since our mid-September update, but not much has really changed. Economic growth should remain slow for as far as the eyes can see, as each region of the world struggles with its own version of the New Normal. Capitalistic animal spirits have gone the way of the modern American male and while not completely extinct, he's decidedly more metrosexual. Flannel has ceded ground to the skinny jean and ambition has given way to contentment. Save for the halls of America's top military brass, unbridled passion is simply no longer.

Dissatisfied with progress on the jobs front, the Fed went "all in" yesterday in its much anticipated, most recent policy announcement. Unlike QE1, QE2 and Operation Twist, the latest addition to the monetary smorgasbord is open-ended, meaning that it has no pre-established termination date. Policy will remain stimulative for as long as it takes to see a substantial improvement in employment. Rather than keeping rates low well into 2014, it could now be well into 2015 before they tick back up.

Two months ago I bought a bulldozer-yellow Jeep Wrangler, replacing my eight year old black Audi A6. While the A6 had been a wonderful car, I was ready for something new and a Jeep fit the bill. Driving with the doors off was a lot of fun, but certainly a different feeling than I was used to experiencing. The stock market over the last two months and perhaps even last three summers has been a lot like that, different, but ultimately rewarding.

This mornings payroll numbers were disappointing, a fact that is being reflected in the performance of todays stock market, now down nearly 2%. Total non-farm payrolls were expected to show a gain of 150K, but increased only 69K, while the total unemployment rate edged up to 8.2% from 8.1% previously. While still in positive territory, the numbers just werent encouraging in the face of so much global uncertainty coming out of Europe and China. A client sent us a short email exclaiming Yikes and then asked us if the world was coming to an end. This was our unedited response.

In spite of the election year politics and an imposing fiscal cliff, a once in a generation shift is at work in the economy, aligning the stars uniquely in our favor. In its own return to vanilla ways, America is in the early stages of an industrial renaissance, made possible by the advent of cheap natural gas and a corporate sector that has taken its fiscal medicine. Were fitter than anyone on the planet, open to business, and ready to compete. Consumer confidence, in spite of high unemployment, is at record levels, and people are even starting to buy homes again.

While almost all commodities (ag, chemicals, and energy) have tended to move up and down together in price, oil has always beat to a different drummer, likely as a function of the ebb and flow of geopolitical concerns and the physical location of most known reserves. I would guess, however, if natural gas is in such abundance domestically, it could very well be the case around the globe. The prospect for $200 oil might be as remote as NASDAQ 5000.

A significant shift in investor psychology is underway after many years of prolonged and painful drought. Just as a stronger economy engenders hope about the future, it also has the benefit of smothering the noxious fumes of political division. The biggest risk to the economy right now may be rising gas prices. At the same time when gas prices were at similar levels last year, mortgage rates were higher, consumer confidence was much lower, and employment trends were moving in the wrong direction. Can the United States reassert its leadership in the global economy? We believe it is and it can.

We remain bullish on the stock market. In an environment of low or non-existent bond yields, stocks may not only represent a compelling alternative source of income, but likely have a far better risk reward profile when it comes to upside return potential. After more than a decade of being the cellar dweller of annual asset class returns, domestic common stocks may finally be due for some positive mean reversion. This doesnt mean were headed back to an era of multi-year, double digit returns but, that given a choice among alternatives, stocks should prove to be the best game in town.

We remain biased to a slow growth environment for as far as the eyes can see, an environment which continues to favor innovators. At the same time, with concerns about a slowdown in China emerging and Europe likely already in recession, the Economic Cycle may deserve some increased attention as a driver of alpha in the portfolio, particularly with a global monetary policy bias towards easing and leading economic indicators in the United State now improving.

The behavior of the stock market of late has been a lot like Forrest Gump practicing ping pong-blazingly fast and completely mesmerizing. After zoning out, I had to ask myself, did that really happen? I've experienced many ups and downs in the stock market over the last twenty-five years, but rarely have I ever seen so many high speed, directional changes compressed into such a narrow period of time. By my count, the S&P 500 experienced four round trip volleys of ten percent or more since early August, before moving to higher ground in late October-all on lighter than normal volumes.

Weve recently concluded that the innovation cycle will become paramount to wealth creation in an environment of slow growth and when credit is relatively scarce. The economy and financial markets are fluid and dynamic. While scarce today, banks will eventually start lending again, changing the dynamics of a muted economic cycle. And while innovation is always an investable theme, in an environment where growth is scarce, such scarcity can also lead to situations where select groups of stocks become wildly overvalued as was the case for the Nifty Fifty in the 1970s and technology years ago.

In an environment where the economic cycle will likely remain subdued for the foreseeable future and the credit cycle is virtually nonexistent, where are investors likely to find the greatest investment values? Barring an outright recession, the greatest wealth creation will likely accrue to those companies most focused on our third driver of stockholder value, the innovation cycle. When growth is scarce and credit is in short supply, those companies that can still grow in spite of these constraints become scarcer still, and the premiums they are afforded should climb.

As an investor, it is important to realize that while you can win the occasional stage race by going it on your own and betting big on a single stock or perhaps along the outcome of a singular event like the debt ceiling, more often than not, the market like the peloton will usually catch and pass you by, leaving you in the dust. Like the peloton, evidence suggests that few investment managers outperform the market year in and year out, but over time, those that understand the race they are in significantly increase their odds of emerging victorious.

Since February, the markets have been hitting new recovery highs, succumbing to market pressure, then reversing course and moving on to higher highs. The pattern is beginning to feel a lot like a broken record.Currently, we've been experiencing a renewed downtrend, with the market off 6% from its April highs. While these moves are normal following a 30% plus advance in just eight months The truth, however, is the uninterrupted steady gains we experienced from August through late February may be far more unusual for the markets than the back and forth gyrations of the past three months.

Silver and gold may still look good as decoration but the metals have also lost some luster in the dental profession (gold vs. porcelain crowns) and for anyone who uses a digital camera instead of old guard film. (Silver is used in film processing.) As most know, silver shot to new highs last week amidst a frenzy for precious metals and perhaps, their perceived inflation hedging capacities. This week, the story was a bit different, with the metal experiencing one of the most stunning drops since the Hunt Brothers tried to corner the silver market back in the early 1980?s.

The S&P 500 fell by roughly 16% from April to July last summer, and then moved sideways until people started to discount the prospects of the Fed engaging in QE2. As the markets picked back up following the recognition that the Fed would stay easy given high unemployment and very little inflation and the elections afforded a more balanced political agenda, leading economic indicators began to follow suit, the economy firmed once again, and the stock market finished up 15% for the year. Today, the situation, while different, nevertheless rhymes.

The stock market has continued to perform exceedingly well so far in 2011 and is now up roughly 7% year to date. While an oil spill or European contagion type event could always disrupt the progression, the stock market, S&P 500 profit levels, and leading economic indicators are all pointing to a similar conclusion. The economy is likely to graduate from its recovery phase to an outright expansion sometime this year. It's time to start letting yourself feel good again.

What the world needs isn't better stock picks, but a better understanding of the source of true wealth. Without the latter, at least in my opinion, there can be no former.

In 2011, we remain optimistic, believing the economy will progress from its recovery phase into expansion territory sometime during 2012. A more favorable regulatory and political environment should be a positive for corporate America, which may finally begin to spend its huge accumulated cash hoards, not solely by returning it to shareholders in the form of stock buybacks and dividends, but by also hiring new employees and upgrading their capital equipment as demand trends improve. A continued trend of bond market outflows and equity inflows should also prove constructive for the stocks.

For 2011, we believe this trend of bond outflows and equity inflows will likely continue, overwhelming any concerns about valuations or fundamentals.In the short run, I've come to realize that fund flows, or investor desires for specific favored asset classes over others - tends to exacerbate price movements in both directions, often for much longer than most expect.I see great things for the stock market in 2011. While an improving economy will help, a shakeout in bonds may be just what the doctor ordered to get investors truly interested in stocks again.

Where might the unexpected upside come for investors? Two areas. Dividends may attract some money away from the bond market as a source of yield, providing some relative capital appreciation potential for stocks. On a longer term secular basis, the emerging market consumer may also be worth paying attention to. As the wealth of overseas economies grows and makes its way into the hands of its citizens, a growing middle class should emerge with the same needs and wants that many of those in the United States have enjoyed for years.

Last Friday David Tepper, who runs a very successful hedge fund, made a convincing no-lose case for stocks in an interview on CNBC. In the stock market as in sports, anytime winning seems easy, it is usually a decent signal that you might be treading in dangerous territory. During such times, it has usually paid to increase rather than decrease one's aversion to risk. Equities could indeed move higher from here and likely will, but buying under the influence of a pipe dream that they are a no-lose proposition would be as foolhardy as an offense with no defense.

The odds of slower growth rather than a double-dip went up considerably with Wednesday morning's Institute for Supply Management manufacturing index release and probably even more so for the markets as a whole. The index came out at a strong 56.3, compared to expectations of 52.9. Generally speaking a reading under 50 indicates contraction rather than expansion in the manufacturing sector. While the manufacturing sector expansion may not represent a sea change akin to what investors became accustomed to in the go-go 1990's, it is nevertheless positive.

We could be on the cusp of a major sea change in the markets, one in which cash-rich companies - which are in far better shape than governments - begin to compete for investors through the dynamics of dividend yield. Investors who can start to capitalize on these changes now are likely to benefit as the groundswell for all things bonds begins to find a suitable and potentially even safer path towards stocks with rising dividends.

There is no doubt that economic growth is slowing after a significant reacceleration off the Great Recession lows that occurred 16 months ago. The only question at this point is how much it slows. After peaking in the four percent vicinity, most economists now expect GDP growth to slow to something in the 2 percent range. It is nearly always the case that when deceleration occurs during a recovery, folks in our industry begin to wonder if growth will merely slow to a 'soft landing' outcome or if we will crash land in a 'double dip' recession.

Going forward, we may indeed be operating in an extended period of slower growth, the so-called 'new normal.' In such an environment, nominal gains in the stock market may be lower and dividends and active management may therefore play a more dominant role for investors who outperform. Broadleaf has been favoring stability over cyclicality, except where cyclical improvements have gone unrewarded, and innovators over companies that participate in more mature markets. They have also favored domestic companies rather than those with international sales exposure.

This year should bring only measured gains in equity markets, even as the economy demonstrates solid growth. A near-term range of 1050 on the downside and 1150 on the upside may likely persist until we get some sense of closure on both Europe and offshore drilling. If we can get past these issues, a year-end target of 1250 would still seem plausible, roughly the level where the markets traded when Lehman went down a year and a half ago. The good news is that this year-end target now represents a 14 percent gain from current levels as opposed to only 5 percent one month ago.

Recently televised riots on the streets of Greece, a collapsing euro, and ineffectual monetary policy efforts by a politically divided European Union have all heightened concerns and comparisons of the current Greece 'fire' to our own mortgage mess a couple of years ago. While our banks and financial system are much less exposed to Greek and European debt than the European banks were exposed to our own mortgage problems, our Fed and Treasury departments, unlike Europe, stood united in doing whatever they could to prevent a second Great Depression.

During the depths of the downturn a little over one year ago, many investors were quick to provide a lesson on the mathematics of loss. A 50 percent decline would require a subsequent 100 percent gain - not a 50 percent gain - to get back to even. Such truths, it seemed, were a justification for remaining bearish and a comfort perhaps to some, in making the painful decision to sell. Unfortunately, while the mathematics of loss is indeed an investing truth, it may also be an author of lies by suggesting that the only investor goal worth its salt is 'getting back to even.

The economy is shifting from its early recovery phase of rapid growth into a late expansion phase of moderate growth. While low interest rates were critical to market success in 2009 during the early stages of the expansion, economic growth patterns tend to have greater influence in later stages. As economic seasons change, it will be necessary for investors to weed out bad stocks, prune healthy ones and transplant names in order to maintain the vitality of their overall portfolios.

Investors need not worry about the Fed's recent increase in the discount rate by 25 basis points, to 75 basis points, even though this rate hike may be the first in a series of many such increases. The last time the Fed started to raise rates, in mid-2004, the S&P 500 climbed from roughly 1100 to 1567 three years later.

The authors are bullish on US equities, noting that ?that at current rates of improvement, S&P 500 profits could be back to the peak levels achieved in 2006 by the second quarter of this year,? and when profits were at that level, the S&P 500 was 30% higher than it is now. The economy is stronger than many suspect and they forecast ?a recovery based on the strength of corporate profits and business spending rather than the consumer.?