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A note to the headline-weary investor

Market Summary – 1st Quarter, 2011

Watching the news is downright depressing. Can you imagine, one year ago, being told that each of the events listed below would come to pass?

What would you have expected of your investment portfolio if you knew that the next 12 months’ headlines would include:

  • A terrible oil spill blanketing a portion of the Gulf of Mexico and causing great harm to natural resources and people’s livelihoods.
  • A growing list of European nations (Spain, Portugal, Ireland, Greece) becoming bogged down in serious debt struggles.
  • The U.S. and many state and local governments facing crippling budget deficits.
  • The Dow Jones Industrial Average suffering a plunge of 1,000 points in one afternoon (the “Flash Crash”), then rebounding just as quickly, with no full explanation of why it occurred.
  • The housing market in the U.S. still mired in its own deep recession.
  • The unemployment rate, lingering near 10% a year ago, enjoying only modest improvement.
  • Long-standing regimes in the Middle East being challenged or swept out of power by citizen uprisings that eventually lead to military intervention involving the U.S. and other western nations.
  • One of the world’s economic powerhouses, Japan, devastated by an earthquake, tsunami, subsequent nuclear power plant crisis and ongoing aftershocks.

With this much trouble in the world, many would assume that stocks were sure to suffer. Surprise! “Mr. Market” has once again befuddled investors. The S&P 500 gained 15.6% in the 12 months ending March 31, including a 5.9% return in the first three months of 2011. After going backwards in the weeks when the turmoil in Egypt, Libya and Japan were peaking, the market quickly regained its footing.

Can we learn lessons from the market?
Mr. Market’s resiliency should not be a surprise. We’ve seen it happen many times before. It is a clear reminder that the market (however you define it) is impossible to predict. There are just too many moving parts to forecast the direction of the broad stock market over the short term.

If you accept the premise that predicting the markets is futile, then you should not be discouraged. Wealth creation does not come from guessing the direction of markets in any given period but from being company specific. The art form comes not from only identifying a good business but also investing in a good business at the right price.

q111 cartoonWe cannot emphasize enough the importance of not overpaying for what may be a great company. Great companies don’t always make great investments, especially if the asking price is too high. For example, such outstanding companies as GE, Intel, Microsoft, Cisco and Time Warner are 50% below their highs established more than a decade ago.

In the short run, weak market sentiment or a struggling economy can delay the benefits of owning a good company. Investing in a business that offers good value and giving its stock time to realize its potential is often a rewarding investment strategy.
Investors who maintain a company focus are not as surprised as the rest of the investing public when their stocks perform well even in challenging times. Those who kept the faith over the past two years, in the face of all sorts of doom and gloom, were among the ones rewarded with a $6.6 trillion increase in wealth that was created by stocks between February 2008 and February 2010. In other words, the market value of stocks increased by $7 trillion in that time. Quality companies have benefited from the more favorable investment environment, as they ultimately always do.

Unfortunately, too many investors forget about companies and are still hung up on artificial categories, market trends and forecasts. And many remain on the sidelines. Market Rates Insight reports that total liquid deposits – checking, savings and money market accounts, reached a record high in March of $5.9 trillion. The onslaught of bad news on the geopolitical front continues to be a serious distraction for the average investor. Someday, much of this money will find its way back into the markets, but no one knows when distracted investors will act.

Average investors seem to be waiting for the perfect time to invest in stocks, as if this has ever existed. Since the late 1950s, the Dow Jones Industrial Average has grown from 500 to 12,000. After accounting for the impact of inflation, this results in about a 6% annualized growth rate in wealth. Many investors achieved prosperity despite a number of wars, assassinations, political scandals, significant recessions and a litany of other events that could be considered disheartening in terms of future prosperity.

To keep things in perspective, during this same period of time the U.S. dollar lost over 86% of its purchasing power. U.S. government bonds, bought for the primary purpose of protecting investment principal, would have seen the principal paid upon maturity suffer the same loss in purchasing power. That means the same $100 worth of goods bought in 1960 would cost more than $737 today, according to the Federal Reserve. Bonds simply don’t offer the opportunity to build wealth to keep pace with the challenges of the rising cost of living (inflation) and what appears to be an inevitable decline in government benefits in the future. Those sitting in cash are losing even more ground, effectively waving a white flag at the idea of wealth accumulation.

Beneath the surface – looking past the dreadful headlines
The headlines spawned by the negative events noted at the outset of this newsletter have dominated the news. But other moving parts, notably revolving around economic and market developments,
are contributing to the increasingly favorable investment environment. Consider these developments that have generally escaped the front pages:
The economy is back following the Great Recession. Only a year ago, many economists were warning about the risk of a double-dip recession. That talk has long since disappeared. The U.S. economy is growing at a modest but steady rate. Many economies around the world are doing much better.

Job creation in the private sector was the strongest it has been in five years based on data for February and March. While unemployment may still be uncomfortably high, it has declined from its peak of nearly 10%.
Corporate earnings are projected to reach record levels in 2011. Based on the earnings already in the books for 2010, companies represented in the S&P 500 have more than doubled earnings (from $38.85/share at the end of 2001 to $83.66/share at the end of 2010). Simply stated, companies are dramatically more profitable today than they were ten years ago. The normal expectation is that this kind of improvement would be reflected by comparable moves in stock prices. This has not happened. Though earnings of the S&P 500 have doubled, the index itself, a measure of investment performance, has only increased 15% during the same time period.

These examples point to the distinct possibility that the market’s two-year rally is not by accident but is driven by positive underlying economic factors.

I hear you, but what about the deficit???
Even those who are generally bullish on the outlook for stocks see a looming threat that could cause problems down the road. The threat is that our country and our states face serious financial crises. Budget shortfalls and growing debt problems have become the center of attention in Washington and many state capitals. Policymakers are coming face-to-face with the reality that current spending levels are unsustainable.

A recent article in Business Week (“USA Inc: Red, White and Very Blue, Feb. 24, 2011) outlines some of the salient issues.

For example, since 1965, the nation’s gross domestic product increased 2.7 times, but entitlement spending rose 11.1 times. The article points out that according to Congressional Budget Office estimates, “entitlement spending and net interest payments combined will equal all of federal revenue by 2025, just 14 years from now.”

While the challenges may be daunting, the resolve to fix what ails the government becomes more visible each day. Business Week points out that Americans have a history of making sacrifices if they are given a clear idea of the challenges ahead and what they can accomplish. Cutbacks in spending and potential increases in revenue will hurt, most likely across the board. However, solutions are starting to be put on the table for serious discussion.

We are even seeing signs of resolve on the part of policymakers to actually agree on an approach to manage the debt problem. News reports may focus on conflicts between political parties, and there is plenty of that. But in early April, Congress and President Obama came to terms on a spending bill for this year that showed a spirit of compromise. According to Donald Luskin, Chief Investment Officer of Trend Macrolytics, it showed something even more important. Luskin says the short-term spending cuts are “symbolic of the fundamental shift in political sentiment in favor of capital, capitalism and capitalists. This reinforces one of the pillars supporting the ongoing second leg of the bull market in stocks.” In other words, Luskin sees that the tone of the debate is one that is being cheered by investors. The focus continues to drift toward reducing the role of government rather than on increasing the tax burden for individuals and corporations.

A favorable piece of news was reported in The Wall Street Journal on March 30. It points out that “State and local tax revenue has nearly snapped back to the peak hit several years ago.” This is another sign of the economy’s strength. While tax revenues declined precipitously in 2009 due to the effects of the recession, causing government funding headaches, they bounced back dramatically in 2010. This is due to increased economic activity creating more tax revenue rather than changes in tax rates. This piece of good news does not mean government spending problems are at an end, but it does lend some encouragement.

What’s next and does it even matter?
You won’t read a prediction here about where the market is going to be six months or a year from now. If your time horizon is no longer than that, equities are not the answer. If the time horizon is longer, then the next six to twelve months aren’t overly consequential. As stated before, especially with quality companies purchased at reasonable value, patience tends to be rewarded.

Problems in the world have been with us interminably and will be as long as we live. However, it hasn’t prevented people from achieving wealth through investing. The strength of equities in the midst of a year where one crisis led to another is the perfect example of the benefits stocks can provide in both the best of times and the worst of times.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.