Know Your Finances: The Stock Market is Feeling Fit

In the midst of a very challenging
recoveryanother
intriguing year in the investment markets has come to a close. All may not be
perfectly right with the financial world (is it ever?) but the fiscal meltdowns
and weaknesses exposed in 2008 are further behind us, and companies and
individuals are absolutely healthier than they were. We now have an economy
that we know won’t die from its serious illnesses but, by the same token, can’t
seem to shake off the nagging coughs, chills, and spasms the illness leaves
behind. In other words, we are
still in the midst of a recovery. The stock market, as measured by the S&P
500, was up 15 percent for the year on a total return basis (price appreciation
plus dividends), which implies a healthier prognosis.

Important signs of recovery are in retail
sales and manufacturing growth; both are showing heartening vim and vigor,
while home sales and employment remain a bit feeble.

Investor behavior for the year began on a
confident note as talk of “double-dips” and “new normals” were subsiding and
there was even chatter in many circles that the Federal Reserve would have to
begin raising interest rates again soon to keep growth manageable.

And then the bad news began to flow. The
BP oil spill promptly depressed the nation, the May flash crash raised fresh
alarms about weaknesses in our financial infrastructure, and we fretted over
possible contagion from Europe’s troubles stemming from Greece’s debt crisis.
The market dropped 13 percent in May and June.

By the fall, politicians had whipped
investors into a frenzy ahead of the mid-term elections; people were scared and
angry over government spending, worrying that our huge debt burden would
undermine our recovery and scare foreign investors into dumping our dollars. It
didn’t help that banks continued to refuse to lend and the unemployment
situation hadn’t improved.

So what did investors do in September and
October in the face of a perceived threatening double-dip in the economy? They
bought stocks and continued to do so through yearend. Investors got started in
September as they heard rumors that the Federal Reserve might soon initiate a
second round of quantitative easing (QE2), which was finally announced on Nov.
3. Republican election wins in November and holiday sales kept momentum going
through the end of the year.

Quantitative easing is when the Federal
Reserve increases the government debt and buys treasury (or agency) bonds from
the marketplace with two goals in mind: (1) to increase the money supply in the
market and raise bank capital so that banks will lend more and (2) to lower
bond interest rates (which normally happens when bonds are purchased) to
encourage individuals to borrow with mortgages and other consumer loans. A
potential side effect is that all the additional debt makes the dollar weak
relative to our trading partners, which facilitates export growth. It is too
soon to know if QE2 will help or hurt our economy over the long-term, but we
expect that in the near term companies will benefit from the added stimulus.

We believe this stock rally has
legs. The recovery is real,
consumers and companies are better off and the job market is stabilizing.
It doesn’t hurt to remember that, historically, recessions don’t occur
more frequently than once every five or six years. We understand, though, that
it’s one thing for consumers and companies to believe in an economic recovery,
and another for investors to believe in the merits of stocks over other assets.
After the tumultuous decade we have had, investors are justified in feeling
jaded about stocks. We believe there are good reasons though to stay the course
with good quality stocks. Stocks do well when economies do better than
expected, which has been generally the case for the last 200 years and we don’t
expect that our growth has peaked out.

Companies and consumers are getting
near-term assistance from QE2 as mentioned above and from the new Tax Relief
Act, signed on Dec. 17. This tax
bill temporarily extends the Bush-era tax cuts which will be supportive of
consumer demand as individuals’ income, dividend, and capital gains tax rates
remained unchanged. Many individuals will benefit from a 2% point drop in their
payroll taxes and from a higher exemption from paying the higher alternative
minimum tax.

The bill also offers sizable incentives
for companies to invest in machinery and equipment. This type of corporate
spending trickles up and down and is welcome after the past several years of
belt tightening and restructuring.
In the aftermath of the recession company operations are leaner and
balance sheets have plenty of cash for capital expenditures, mergers and
acquisitions, stock-buybacks, and dividend increases.

Fear of inflation and higher interest
rates are another benefit for stocks as investors continue to sell bonds out of
fear of a dramatic loss of principal if interest rates should rise
precipitously. All bond types, from corporate junk to treasury, under-performed
stocks in 2010. We expect investors to continue to transition from bonds to
stocks as they recognize that high quality dividend-paying stocks pay almost as
much income to investors as high quality bonds. Also, stock price multiples are
not yet outlandishly high given expected earnings growth in 2011.

Ultimately we expect to see interest
rates rise (despite the efforts of QE2) as bond investors sell long maturity
bonds (bond selling drives interest rates higher) and from inflation triggered
by looser lending policies. Until
interest rates increase enough for bonds to be compelling investments again,
and until stock prices become overvalued again (which could happen at any
time), we are comfortable with allocations that favor stocks. In certain phases
of the inflation cycle, growth companies can actually pass through their
inflated costs to consumers and other companies and benefit by raising prices
on products and services.

Stock markets never go up in a straight
line and it is impossible to predict how long a climb up will be, how long a
plateau can go, or when it will be blocked again by a cliff edge. The key is to
stay true to your long-term asset allocations and keep valuation foremost in
choosing which stocks and bonds have the best return opportunity vis-à-vis
their risks.

We wish everyone a very happy and healthy
2011.

• Ellen Le is the founder and president of Ascend Investment
Management (www.ascendinvmgt.com). She has been a financial planner and
investment adviser for more than 20 years.

I look forward to receiving your
questions about anything related to investments, retirement planning, or the
economy. Send them to: ellen@ascendinvmgt.com and write “Chadds Ford Live” in
the subject line.

About Ellen Le

Ellen is the Founder and President of Ascend Investment Management. She was born in Philadelphia and has lived in the Delaware Valley for most of her life. When she is not researching investments and managing portfolios, she pursues her interests in tennis, bridge, hiking and art. Beginning her investment career in 1981 as a stockbroker at E.F. Hutton and Co., Ellen now has over 20 years of investment management experience. Prior to founding Ascend in 2006, she managed high net worth assets for many years at Bank of America, Mellon Bank, and most recently at Davidson Capital Management. At Davidson Capital Management, Ellen served as a Senior Vice President and Senior Portfolio Manager of the firm. She managed assets for more than 50 family relationships and was a core member of the firm’s Investment Committee.Ellen earned a BA in History from Brown University and a MBA in Finance & Investments from The George Washington University. She is a member in good standing of the Chartered Financial Analyst (CFA) Institute, which is a global organization dedicated to setting a high ethical standard for the investment profession. Her professional memberships include the Delaware County Estate Planning Council, Women Enhancing Business (WEB), and the Chadds Ford Business Association. She is a docent with the Delaware Art Museum and an active volunteer with the Brown University Alumni Association.

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