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Investor’s CornerBy John Gudritz CFA
Principal
Front Street Investment Management LLC
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For as much as I would like to believe that this dramatic increase in the stock market since March 2009 is a new secular bull market, I am not there yet. The truth is that the S&P 500 Index is still almost 20 percent away from its October 2007 high. Granted, small cap stocks have had a better recovery, but in the end it is the large cap companies that are a more accurate reflection of our economy. I am concerned that this rally could end quickly and badly for reasons explained below, so I will rent this rally and be quick to take gains and not worry about the long-term right now.
It is possible that people will become complacent once again with their retirement savings as they watch the stock market continue to move higher. The lessons learned in 2008 of the perils of not incorporating risk management into one’s investment program may be forgotten as people chase this stock market recovery.
While the economy has improved to the point that the recovery has become self-sustaining, it is still very fragile. Unemployment is still very high and there are many people who will find it almost impossible to get a job that pays as much as the one that they were laid off from. That is especially true for those job seekers in their 50s. Even those people lucky enough to have not lost their job have not seen much in pay raises over the past few years.
Most people’s biggest investment — their home — is still declining in value. This is another reason that I am concerned about the employment situation. Many people are not able to sell their home and come out with any equity for a down payment on their next house, which is keeping them stuck where they are. We have not had to contend with this problem in prior economic recoveries.
One of the biggest risks to the economy as well as the financial markets is the serious financial challenges facing most municipalities. Most municipalities pay for the services that they provide primarily with property tax revenues and funds received from the federal and state governments. With property values declining, the taxes levied against them will fall unless the tax rates are significantly increased, which is not possible in most states without a vote. The federal and state governments have their own fiscal problems, so they will be sharing less revenue with municipal governments in the future.
We will continue to see layoffs of state and local government employees. In addition, with state and local government spending representing about 13 percent of the U.S. economy, the budget cutbacks will continue to be felt by the general economy in the form of slower growth.
The municipal bond market has declined rather dramatically in the last couple of months as investors have become greatly concerned about the ability of municipalities to service the $2 trillion of debt that is currently outstanding. There are a few respected experts on Wall Street actually forecasting $100 billion or more of municipal bond defaults over the next few years. That would be an historic event in this market and would cause great financial pain, especially among individual investors as well as many financial institutions.
While I personally do not think that the increase in municipal bond defaults will be that dramatic, I do believe that it is possible that it could be big enough to unnerve the bond market as well as the stock market as investors take action to reduce risk in their retirement portfolios.
We are not far away from the beginning of campaign season for the 2012 presidential and congressional elections. The huge federal budget deficit will probably be the big issue and there will be all sorts of spending cuts and tax increases debated in the year to come. This debate will actually start when the vote to increase the national debt ceiling comes before Congress in March. If nothing else, it is likely that the rhetoric will put a cloud over the stock market as well as the economy as investors and people in general contemplate what these deficit reduction programs mean to their pocketbooks.
In addition, there are serious issues overseas that investors will have to address sooner or later. The sovereign debt problems will continue to fester even if there is not an actual default. The austerity consequences will be felt by every exporting country. In addition, the powerhouse of the global economy, China, will be slowing its economy to reduce the inflationary pressures that have become a problem.
Our economy is not out of the woods yet. There are still serious issues lurking that could bring the stock market down in a heartbeat. That is why investors should continue to be mindful to manage the risk in their retirement portfolios.
John W. Gudritz CFA is a principal at Front Street Investment Management LLC, a fee-only investment management firm in Traverse City. Reach him at 866-933-7668 or visit www.frontstreet.com.