Massachusetts Senate Election Creates Uncertainty in Washington

Stock prices normally are driven by earnings and how those earnings are valued (think p/e ratios).  Earnings are impacted by the state of the economy.  The economy appears to be recovering, although slowly, from its near death experience in the Fall of 2008.  So why the 3.5% drop in the market in January?

The victory of the Republican Senate candidate in Massachusetts on January 19^th, and the implications of that victory for the passage of the Health Care legislation, or indeed the passage of any major legislation in 2010, roiled the market.

President Obama’s 70 minute State of the Union message the following week indicated that he and his people still are having trouble focusing on just a few priorities to which they might be able to get the Congress to agree

Markets hate uncertainty.  And there is nothing but uncertainty in Washington at the moment.

Tom Friedman wrote in the New York Times from the World Economic Forum in Davos, Switzerland that he was being asked about “political instability” in the United States, something he says he has never heard before.  “We’ve become unpredictable to the world” writes Friedman.  “We’re making people nervous.”  And markets hate political unpredictability.  That is why people traditionally invested in the United States, instead of in Russia, or Iran or Honduras.

We have said that the stock markets, both domestic and international, would be “bumpy” in 2010.

So far that is exactly what they have been.

January started off up, then turned around and closed down 3.4% as measured by the Wilshire 5000 Index.  The international stock markets, as measured by the EAFE Index, were down 4.4% in January. The Emerging Markets, as measured by the EEM Exchange Traded Fund, were down 7.8%.

And February has had two days so far with the DJIA up over 100 points each day, followed by a day where the DJIA was down 268 points, followed by a day with the DJIA down 167 points on the day, than staging a last hour rally and closing up 10 points.

What Is Going On?

The stock market is still fragile from the near calamity of 2008—when the Great Recession came close to being the Great Depression II.  Fragile markets discount good news, like the 5.7% estimate of fourth quarter GDP.  And they have violent reactions to bad news, like the larger than expected jobless claims filed the day the DJIA went down 268 points.  Hence the markets are “bumpy”.

What Should We Do About It?

We could sell everything and go to all cash.

Unfortunately cash is yielding zero, or close to it.  That’s not terrible today when the inflation rate is zero, or close to it.  But as inflation rears its ugly head, which we expect to happen within the next 18 months, the purchasing power of portfolios in cash will not keep up with the cost of things that cash is used to buy—like food, clothing, shelter, gasoline, medical care, education, etc.  Not good.

CDs are not much better.  You need to go out over three years to get a two percent return.  You don’t want to be locked into a longer term CD when inflation comes.  And getting out of the CD before it matures will cost you an early redemption fee.  Not good.

We could sell all equities and go to all bonds or bond funds.  OK until the Fed starts to raise interest rates to combat the inflation.  At which point the value of outstanding bond and bond funds goes down.  For a bond fund with a 5 year duration, every one percent increase in interest rates causes that bond fund to drop about 5% in value.  Not good.

You could own individual bonds, and hold them to maturity, at which point you get back the par value of the bond.  Whether you make any money or not depends on what you pay for the bond when you buy it, what percentage interest you receive on the bond vs. the inflation rate during the time you hold the bond, and whether you may find yourself compelled to sell the bond prior to maturity, at some discounted price.  Iffy.

You could sell everything and buy gold, oil, real estate, funds that “short” the market, or other “alternative” investments.  Maybe those will do well.  Maybe they won’t.

Or you can do what Starmont is doing, which is to develop and manage diversified portfolios for our Clients, holding a little of a lot of different asset classes, managed by Best of Breed portfolio managers who have records over up and down markets that show that their portfolios do better than most.  Then look for opportunities in dislocations in the market that allow you to do a little better still—and make tactical adjustments to take advantage of those dislocations.

This approach reflects Starmont’s investment philosophy that long term investment results are best pursued through compounding reasonable gains and avoiding major losses. That is how we pursue our goal of growing and preserving our Clients’ net worths. That strategy has worked for Starmont Clients in the past, and we believe that it will work well for you now and in the future.

Tags: Bonds, CDs, Economy, Stock Market

This entry was posted on Friday, February 5th, 2010 at 2:44 pm and is filed under Blog, The Market. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.