Investor Newsline

October 2009

Strategy comments pertain to Capital Management Group investment strategies and reflect the authors' personal views about the subject.

Market Review & Outlook

The Rally Continues:

The powerful rally over the past six months has lifted most asset classes near 12-month highs, completely erasing the carnage from late 2008 and early 2009. Despite the recent strength that has produced some staggering returns - 78% for REITS, 63% for emerging markets equity, 50% for international equity, and 41% for high yield bonds over the past two quarters - most major equity indices are still 25-40% beneath their peaks in October 2007. This does provide some potential room for further appreciation, but it will require a return to robust economic growth and earnings growth; however, the conditions do not yet appear in place to allow for a sustainable, healthy rebound in the broader economy or in corporate earnings. We are encouraged that many of the "green shoots" first observed 4-5 months ago are now blossoming further - manufacturing surveys indicate a return to positive activity, retail sales have stabilized , levels of both existing and new home sales have been gradually increasing, and the Case-Shiller Index shows that national home prices have increased for three consecutive months (through July). This improvement in home prices is a very important factor, and if it continues to trend positively may help to offset the economic challenges that result from an estimated 34% of homeowners who are "underwater" on their mortgages and several million option ARM mortgages that will face difficult resets in 2010. Leading economic indicators (LEI) in the United States have risen for five consecutive months - after 20 consecutive monthly declines - and the global LEI for the 35 largest economies has also risen for the past five months; this is a strong signal that we have reached a turning point in the direction of global economic growth. Supporting the strength of the LEI, the IMF recently upgraded its forecast of global GDP growth for 2010 to +3%, with developed economies lagging at a rate of +1.2% (vs -3.5% in 2009) and emerging nations increasing at a more rapid pace of +5% (vs +1.7% in 2009).

But Is It Sustainable?

The turnaround in many economic indicators has provided the market with encouragement that the U.S. is on a path of economic recovery that will benefit global growth; however, there are many questions about the sustainability of the U.S. recovery and the composition of the U.S. economy coming out of the recession. Perhaps the greatest concern is the stubbornly high unemployment rate (9.8%) that is at a 25-year high. Unemployment is actually near 17% when looking at the broadest measure of unemployment measured by the Labor Department (U-6) that includes "marginally attached workers". Due to this elevated unemployment, a negative wealth effect, and increased savings rates, it is unlikely that consumer spending will be the strong driver of growth that is has been historically. Therefore, without a change in the mercantilist, export-led growth model that has powered the economies of many Asian and emerging countries for the past thirty years, it is questionable whether their growth rates will return to historical levels. In fact, many emerging nations are currently working to develop their domestic economies by expanding their infrastructure and developing social safety nets that may reduce savings and encourage consumer spending. The implications of this "global rebalancing" - including a continued decline of the U.S. dollar - has many profound implications for global growth and should be a focal point for investors. The chart (right) shows the difference in local currency returns and U.S. dollar returns for various asset classes in 2009 and clearly shows the additional returns to U.S. investors from having exposure to investments denominated in foreign currencies. As we continue to refine our investment strategies, we will be mindful of strategic satellite opportunities that provide our clients with greater global exposure and diversification into non-dollar assets.

Equity Review & Outlook

Rally Continues, Recovery Expected:

For the quarter based upon total return, the S&P 500 rose 15.6%, with the S&P 400 and S&P 600 up 20.0% and 18.7% respectively, reducing Y/Y declines to 6.9%, 3.1% and 10.6% respectively. YTD the S&P 500 is up 19.3%, the S&P 400 30.1% and the S&P 600 up 19.5%, with gains since the March 9th low of 56.7%, 71.0% and 72.4% respectively, among the strongest post low market rallies in history. The rapid pace and relentless advance of the markets gives some investors pause, with growing concerns that the market has "rallied too far, too fast". While we agree that the rally has been exceptionally strong, it is important to note that the steep decline experienced at the beginning of the year occurred against a backdrop of excessive fear that the world financial system was failing, with the potential for a repeat of the Great Depression. That fear caused investors to overly discount trough earnings, anticipating that the economy would face a very long recovery and that further corporate failures would require government assistance to restore order, significantly increasing deficits and slowing future growth. These fears overstated the economic problems, forcing stock prices to artificially depressed levels, which have been corrected in the rally since March. We expect further gains to be more modest in scope as investors become more focused on company specific fundamentals, a situation that historically has favored our investment style.

Staying Focused and Disciplined:

The main drivers of stock performance, including the economic and inflation outlook along with FED policy and interest rates, remain constructive. Y/Y nominal GDP growth ending June 2009 fell 3.6%, likely marking the low for this cycle. That compares with a similar percentage decline in 1949, which marked the low for the last 60 years. Following the 1949 low the economy grew for five years, peaking at 27% Y/Y growth during that period. We envision several quarters of positive growth ahead, with the potential for above consensus gains as inventories remain near historical low levels, providing the fuel to boost GDP as consumer confidence returns and spending increases. Inflation, as measured by the CPI, has fallen 1.5% Y/Y, a level not seen since 1949. The PPI for finished goods has fallen 4.3% Y/Y, the steepest drop over the last 60 years. The CPI commodities index has fallen 4.5% Y/Y, a level not seen in 55 years. While these declines are exceptional, implied inflation yields on five year TIPS are 1.4%, similar to levels seen during 2001-2004, suggesting future inflation expectations remain modest. The FED continues its policy of exceptionally low interest rates, attempting to restore strength to the economy in general, and the financial sector in particular. The weak dollar may provide a long term challenge, but the lower dollar has increased US exports, boosting GDP by over 3% and providing a needed stimulus to the economy. We are concerned about high government deficit levels and projections, and ongoing dollar weakness. However, we remain constructive, regarding to ongoing recovery.

Fixed Income Review & Outlook

Economic Recovery Likely Developing:

The deepening portion of the recession is very likely over, as most new economic data show improvement, or at least, that the economy is not falling further. Clearly, spreads suggest the worst is behind us. The economy is far from well, and many risks remain in areas such as commercial real estate, unknown or unreported problem assets held by banks and the government mortgage agencies, and unemployment that is likely to be slow to recover. The elimination or reduction of several stimulus plans will help us test the validity of the "recovery".

The Credit Sector Party is About Over:

As the left graph below illustrates, credit spreads are steadily returning to pre-crisis levels, having boosted returns on corporate and agency bonds relative to Treasures from higher yields and capital appreciation. Agencies no longer offer much value. For the quarter, corporate bonds returned 8.12%, compared to Treasury returns of 2.10%. Year-to-date, corporate bonds have delivered returns nearly 20% more than Treasuries. If one considers an average spread of 100 basis points as normal, then the move from over 600 to the current 200 bp level suggest 80% of this opportunity had already played out. Interestingly, current spreads are lower than late August 2008 before Lehman filed for bankruptcy, and near the levels observed on 12/31/2007.

Heightened watch on interest rates:

The dominant role of the government's hand in the financial markets today is a unique experience for most investors. Understanding the impact of the actions undertaken today and the ultimate exit strategy will impact the fixed income markets for some time. One observation: recently Edward Whitacre was appointed as the new Chairman of General Motors. Mr. Whitacre spent his entire career in the telecommunications industry and in the days following his appointment he admitted that he "does not know anything about cars". Does this inspire confidence in our policymakers? We remain cautious.

Strategy:

We remain somewhat concerned about the eventuality of higher rates, and continue to hold bonds with a slightly shorter than average maturity. Generally, we reflected this in our lack of exposure to long-term bonds. We are cautiously maintaining a strong overweight to corporate bonds of short and medium maturity, and are using government backed mortgage pools in lieu of Treasuries for their yield. Liquidity is still important, particularly when we see a need to change strategy quickly.