The airwaves are more cluttered than ever with permabears and the overly bullish, both projecting massive moves in opposite directions for the broad US equity markets. I maintain that the economic “truth” lies somewhere in between. For some time I have suggested that the economic recovery would be uneven and inconsistent and the markets range bound. I see no reason to alter that view currently.

As I have previously written, we are facing certain headwinds of tax and regulatory issues. The uncertainty of policy in Washington has led to corporate indecision and almost paralysis. Until we get some clarity on policy decisions, I believe that we will remain in our current range. When we do get the needed clarity (perhaps the November elections) it appears quite obvious to me that stocks are ultimately cheap on a relative basis.

The low level of interest rates remains the most compelling bullish argument for stocks. For the first time since 1962, the yield on the DJIA exceeds that of bond yields. In fact, nearly 80% of the companies in the S&P 500 have earnings yields that are greater than bond yields. Second, at under 12x 2010 earnings estimates, equities seem inexpensive to a multi-decade average P/E of 15x.

There is little argument that this environment has been unsettling and caution and diversification remain our priority. The talking heads continue to banter about a double dip and that has had a significant effect on confidence. I will suggest, however, that the U.S. stock market has already discounted a douple dip (if it even happens) and it is time to begin to fade the growing negative consensus and adopt a variant view by becoming more constructive on stocks.

Inconsistent Growth

We remain in a period of inconsistent and uneven economic growth, as previously indicated, that will continue to be difficult for corporate managers to navigate. This will likely lead to a continued expansion in usage of temporary workers over full time employees, creating a headwind for the all-important employment number.

Lumpy growth and the existence of non-traditional headwinds (fiscal imbalances at the federal and state levels, higher marginal taxes, burdensome regulatory backdrop, etc) could serve to cap the market’s upside. That said, we are in an environment where the risk premium (S&P earnings yield less the risk-free rate of return in fixed income) is at the highest level since 1980, when the great bull market started. This means that stocks are currently cheap relative to bonds……or that bonds are significantly overpriced and in bubble territory.

I am most comfortable with the latter, given the aforementioned nontraditional headwinds, and tip in favor of shorting bonds. Even with a surprise equity market run that could come from economic clarity, the result could be an even larger drop in fixed income prices. Just how expensive are bonds? Consider that a 2.89% yield on the U.S. 10 year Treasury note is priced at a P/E multiple of 34.5x (the inverse of 2.89%) against the S&P’s P/E multiple of only 12x.

Position: Long TBT and Rydex Inverse Govt Bond Fund

Trading Range

Our equity markets appear to be stuck in a very definite, and tight, trading range much as I predicted in my opening piece at the beginning of the year. I did not, however, expect the wild volatility or rapidity between the highs and lows. The quant funds and program trading are affecting the market wildly and probably warrants a strong look from the SEC (more on that in a later piece).

There are a number of headwinds that many talking heads are pontificating will keep this market from breaking out of the range to the upside as they certainly have deflated P/E multiples.

• Rising taxes
• Fiscal imbalances at the federal and state levels
• Quiet residential and nonresidential construction
• European debt crises (Spain, Greece, Portugal, etc)
• Anti-business Obama Administration

While these are truly headwinds, they are at least now mostly “known” and most would argue have been priced into the equity markets. That said, improvements in those key headwinds, and more significantly, improvements in two or more of those noted above could be the catalyst we need to break out to the upside.

A look at the 2011 earnings projections (which have been muted) tells me a different story when you aggregate them. The S&P 500 now trades at only 11.5x those projected earnings numbers, a very low number historically. More significantly, the S&P now provides an 8.7% earnings yield (the inverse of P/E ratio). Compare that to a 2.95% return on the 10 year Treasury note and the market starts to look pretty attractive.

All that said, this market was and is still driven by fear. When the headwinds start to diminish that fear will be replaced by greed. It will be too late at that point to make the real gains……Be greedy when others are fearful!

Europe

Having spent the last two weeks traveling through Europe, I wanted to post my reflections on the European Union. As anticipated, the rich history and culture of the areas of Spain, Italy, France, Monaco, and Malta are an amazing experience to say the least. My simple goal in traveling the region(in addition to experiencing the histories and beaches!) was to get an “on the ground” understanding of what is taking place from the perspective of the citizens, not the media’s perception.

My first takeaway was quite simply, Confusion. The European superpowers (especially Spain) are in total disarray. The average worker has an overwhelming sense of entitlement; Entitlement to an afternoon siesta, entitlement to a government wage, entitlement to a comfortable retirement. Repeatedly our group heard, “I work for the state.” Keep in mind that many of these comments came from sales people in stores, waiters, bartenders, cab drivers…This populist mindset is a dangerous road. Just ask Greece!

The weak currency has been labeled in the media as the opportunity for Americans and Asians to travel to Europe on a bargain. I was a believer-until I actually went. When you speak with the locals, you learn that prices on everyday items for them have dramatically increased in price. Simple things like food are considerably more expensive than just six months ago. While impossible to quantify exactly, the math suggests that prices have increased almost in lock-step with the decline in the Euro vs. the Dollar and Yen. That’s a wash for the international traveler, but really unfortunate for the resident. And they are feeling it.

Put simply, until the Eurozone returns to more capitalist persuasion with regard to savings, work ethic, retirement, and business building, the confusion will continue. It appears that the Euro will continue to slide vs. the Dollar. I would also wager that they are headed for an environment similar to our economy of the late 1970’s with high interest rates and run-away inflation. I’ll avoid the region for quite some time with regard to our investment line-up. I hope they find their Ronald Reagan to climb out of the mess.

On a positive note, the international consumer is alive and well. Visitors from all over the world (non-EU) were gathered at the various historical attractions in mass. Trains were full of visitors as were the restaurants. So, the global consumer and therefore likely their economies are healing and confidence has returned amongst those. I am returning to a more bullish (still cautious) perspective on the U.S. Equity markets and the Asian markets. To quote the great Doug Kass, “I am seeing rays of sunshine, but I still wear my raincoat to work each day.”

On a final positive note, the emerging market zones I visited are bustling and active. Specifically, Tunis in Africa is hungry…..hungry for capitalism, hungry for tourism, hungry for the rewards that come from hard work. The same can be said for Valletta, Malta. To that end, there is likely handsome potential for selectively investing in the emerging markets again…..more to come on that front.

NATURAL GAS

Natural gas has continued to weaken in price to 40 year lows. I am surprised by the continued slide as it is domestic, it is plentiful and it is cheap. We’ve seen oil prices spike up as far as $150 a barrel since 2008, while the new technologies and sources of natural gas, in contrast, continue to expand and make the fuel superior to crude in every way. But, so far, environmental hurdles and a reticent Washington have slowed the embrace of natural gas as the transition fuel to renewable sources of energy.

The inability of the Obama administration, so far, to embrace this clean alternative has not slowed the energy players from seeing it rather clearly. We have seen a tremendous amount of merger and acquisition activity in this space. Most notably was the massive takeover of XTO Energy by Exxon for $41 billion. And there have been a number of other smaller yet significant takeovers. This is a “tell” that Big Oil sees the future clearly and they are competing for position in the natural gas space. This should, at some point, lead to higher natural gas prices (UNG) and escalating stock prices for the group.

Further evidence of an improving economy, along with continued easy monetary policy from the Fed, have continued to lead markets higher. The DJIA has been up 9 of the last 10 trading days. The Healthcare Reform vote even had no immediate negative effects on the markets as it appears that just “having it behind us” is enough for the markets.

Encouraging data points in housing start revisions, cap utilization rates and CPI reports are also welcome signs that the macro environment is recovering. Credit card delinquencies are dropping signaling that the consumer is stabilizing.

All of these data points seem to be pushing the markets north and subsequently “squeezing” the short sellers to cover. Combine this with China paying up for everything, especially iron and copper, and we have had a nice run up.

I remain cautious in this market, especially given $80+ oil as that has proved to be a real consumer deterrent above this level. A continued focus on capital strength and companies with strong balance sheets is advisable. Notably, we are seeing real momentum in the mobile internet space, as projected. This sector should continue to thrive as more and more users switch to smart phones and notebooks like the iPad. Lastly, natural gas bottoming? Seems to be the case. If the current administration will acknowledge and embrace nat gas as the logical bridge to cleaner energy, we could see explosive growth here.

The Federal Reserve surprised the markets late yesterday with a 25 basis point increase in the Discount Rate to 0.75%. This sent futures down sharply initially but by market open, futures had stabilized based on the Fed’s comments about future increases. This falls right in line with one of my “10 for 2010” projections that rates would indeed begin to rise in 2010. I think this is a bit sooner than anyone expected, however.

The biggest risk to the retail investor in this next cycle will be the massive inflows into bond funds of late under the auspices of “safety.” Bond prices move inversely to interest rates creating a dangerous set-up for those retail investors if rates continue to rise…..and the Fed has shown its hand. Interest rates have been forced down to artificially low levels and should rise just based on the enormous stimulus infused into the monetary system. As bonds have just come off of their best performance decade in more than 100 years, we should expect a reversion to the mean of sorts, creating a dangerous situation for bond investors.

The likely challenge for the remainder of 2010 and 2011 will be making money in what could very well be a sideways equity market and negative bond performance. Positive returns will require tactical capital allocation. Specifically, stock selection will be paramount and companies with strong balance sheets and solid, predictable earnings should be the focus. In short, individual stock selection will “rule the day” for the foreseeable future.

1. ANOTHER SLOW START - The S&P 500 was down 3.6% (total return) in January 2010. The loss is the 3rd consecutive year in which the stock index has started with a decline in January. The S&P 500 was down 6.0% in 1/08 and then lost 8.4% in 1/09. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the US stock market (source: BTN Research).

2. HISTORICAL DATA - The S&P 500 has produced a negative total return for each of the last 3 Februarys. The stock index was down 2.0% in 2/07, down 3.2% in 2/08 and then lost 10.6% in 2/09. February’s average performance over the last 20 years (1990-2009) is a loss of ½ of 1% (i.e., -0.5%), ranking February as the 10th best month over the 2-decade period (source: BTN Research).

3. IN THE NEXT YEAR - The S&P 500 has gained at least +25% (total return) 8 times in the last 25 calendar years (i.e., 1985-2009), including last year (the stock index gained +26.5% in 2009). In the calendar year following the 7 previous “25% and up” years, the S&P 500 was up 6 out of 7 years, gaining an average of +14.8% annually (source: BTN Research).

4. SOME DISAGREEMENT - Ben Bernanke was approved for a 2nd 4-year term as Fed Chairman by a 70-30 vote in the Senate last Thursday (1/28/10). The 30 votes against Bernanke’s confirmation were the greatest number of votes opposing a Fed Chairman nominee since 16 senators voted against Paul Volcker’s nomination in 1983. Bernanke’s new term will run to 1/31/14 (source: Federal Reserve).

5. RATES GOING UP? – There are now just 2 months remaining (i.e., February and March) in the Fed’s program to purchase $1.25 trillion of mortgage backed securities. The program, which originally began with Fed purchases in March 2009, will stop by the end of next month. Eric Rosengren, the President of the Federal Reserve Bank of Boston, predicted last month that mortgage interest rates will rise by as much as 0.75% when the purchase program ends (source: Federal Reserve).

On the heels of Goldman Sachs powerful earnings report, President Obama announced a plan to tax and further regulate the banks, sending stocks down considerably. The proposal says that banks cannot own, invest, or sponsor hedge funds or private-equity funds for their own accounts. The plan also proposes a limit on the size of a bank’s activities. Unfortunately for the markets, there is little clarity as to the specifics of that plan and we all know the markets dislike uncertainty.

The President seems to be positioning, whether for financial stability or political posturing, the banks in a light of “villains vs. victims,” with the banks clearly being the villains. While this may be sensational, it will be damaging to the profitability of the financial institutions and Wall Street will take its toll on those. So far, the administration is focusing on the biggies, the Goldmans, the Wells, the BofAs, the JP Morgans….the big financials who got it right to at least a degree better than the smaller players. Sure they made a lot of money from the TARP program that saved them, but wasn’t that the point? Why isn’t the administration focusing on what went wrong with Fannie, Freddie, Lehman, AIG? Why aren’t those CEO’s being deposed?

The Massachusetts Senate race gave us a glimmer of hope for the markets, as evidenced by the run-up Tuesday on the rumor that Brown would win. The voters and the markets gave us a clear message Tuesday-Americans (and therefore the markets) love gridlock. Perhaps the President is just trying to change the news headlines?

How the Build America Bond Program Will Impact Municipal Bonds
by Brad East
The Build America Bonds (BABs) program, a new piece of legislation from the Obama Administration, focuses on aiding struggling state and local municipalities across the U.S. The program, part of the American Recovery and Reinvestment Act of 2009, creates taxable municipal bonds, a radical departure from the long-standing tax exempt status quo for munis.

While bonds issued under the BABs program are fully taxable, the issuer receives a direct subsidy equal to 35% of the bonds coupon, or stated interest rate. The intent is to make some of the benefits of traditional muni bonds available to investors outside the highest tax brackets.

For many years there has been talk within the Treasury Department and the IRS that the tax exemption for municipal bonds is an inefficient subsidy since it allows only the highest taxpayers to benefit from the tax exempt income. At current tax rates, top bracket earners avoid paying 35% on that income. That benefit obviously will increase if/when taxes go up.
The BABs program will have significant benefits if it is embraced by lower bracket earners who need taxable income from their investments. The program will make it easier for municipalities to raise needed funds by bringing in a large new group of investors that have not previously participated in the municipal bond arena.

There is some question about what effect this program might have on existing tax exempt municipal bonds. The BABs program only allows bonds to be sold for new projects, not to refinance debt incurred in the past. An issuer can’t issue BABs to call old debt. Therefore, if the BABs program gains significant momentum, the municipal bonds currently in the marketplace are less likely to be redeemed early. As a result many of the bonds already issued are, in-effect, non-callable. More importantly, if new issues of tax exempt bonds are virtually non-existent, the demand for existing issues by the highest tax payers could increase significantly.
Some critics of the program argue that while BABs might have some benefits for those outside the highest tax brackets, the wealthiest individuals will still reap the most rewards. While this might be the case, I applaud the program’s goal of trying to bring the median income individual into the muni bond market. This could very well be a nice addition for those living on their income from investments (like CD’s, etc.) and a huge win for municipalities in those parts of the country that are struggling right now.
That said, the biggest winners just might be those that already own the old-style, tax exempt version of municipal bonds. We are telling our clients to hold on to their high quality Arizona tax free bonds.