Tuesday, October 5, 2010

The Building Blocks for a Great Investment Year

From the Desk of Joe Rollins

As you may be aware, September is historically the worst investment month of the year. In fact, only September has the distinct – and not exactly coveted – record of being the only month that has an average negative return. As we entered the month, the financial press proclaimed that we were headed for an even bumpier ride than usual during September. However, this past September actually defied the odds and wound up being an excellent month for investors.

For September of 2010, the S&P 500 was up 8.9%. For the year through September 30th, the S&P was up 3.9%. The Dow Jones Industrial Average’s performance was even better, as it was up 7.9% for the month of September, while being up 5.6% for the year through September 30th. Fortunately, Rollins Financial’s total assets under management also reflect impressive returns. For the year through September 30th, our total assets under management have had a return of 7.1%, which means that our returns have exceeded the S&P 500 return by a stunning 82%. For the third quarter of 2010, Rollins Financial’s assets under management had a total return of 10.43%.

While most investors may not consider a 7.1% return to be robust, it can be put in perspective by comparing it to historic results for the financial markets and considering the miniscule yields currently available on interest paying investments. For example, a risk-free, two-year Treasury currently yields a rate of 0.41%. That means for every $100 invested, you will earn $0.41 for the year. Furthermore, you would need to hold that two-year Treasury bond for a total of 17.5 years to have a gain of 7%, the return earned by Rollins Financial during the first nine months of 2010.

I am completely baffled by investors who instead of investing in the stock market are willing to accept interest rate returns that are so low they could almost be considered a rounding error. For example, we received instructions this week from a client to put a significant portion of his investment portfolio in money market rates. At the current time, money markets are paying virtually nothing since the earnings are hardly enough to even pay the management fees.

For an interesting perspective on interest rates, I suggest you read Charles Schwab’s editorial published in The Wall Street Journal on Saturday, October 2nd - Enough With the Low Interest Rates! Nothing could be clearer to the average investor that low interest rates are hurting the investment results for all Americans who rely on fixed rate investments for retirement income.

As an investment advisor, I find this apprehension to be even more baffling when major U.S. corporations are paying significant dividends that are well in excess of the amounts earned by investing in interest paying certificates. For example, the dividend rate on major corporations such as Chevron (3.5%), AT&T (5.8%), Verizon (5.9%), Johnson & Johnson (3.5%), and General Electric (2.9%) far exceed any type of interest rate that you can earn on a risk-free investment; plus, you have the opportunity for capital appreciation.

So far, 2010 has felt like a roller coaster ride for many investors. Through June 30, 2010, the S&P 500 was down 6.7%. For the month of July, the index rebounded handsomely at 7% only to fall 4.5% in August. Therefore, the first six months of the year were down, July was up, August was down and September was up. Volatility is definitely present in the financial markets. However, as we have often pointed out, an investor shouldn’t be concerned with daily or weekly returns. Rather, investors should be focused on long-term returns, which have been excellent.

Clients continue to ask me how stock market performance can be so good given the negative nature of the U.S. economy. A great deal of the ongoing conversation regarding the economy is mischaracterized by the financial press. I am not sure that this mischaracterization isn’t politically motivated given the mid-term Congressional elections scheduled to take place next month.

While it can’t be said that the economy is great right now, it is perfectly okay. The second quarter GDP was up 1.7% and we discovered during September that the recession officially ended over one year ago in June of 2009. Furthermore, it is anticipated that the GDP for the third quarter of 2010 will be approximately 2%. While this certainly isn’t vigorous, it is still positive and the economy is stable.

Given the extraordinarily low interest rates that are available on interest-earning certificates, along with the extremely high profits being enjoyed by major corporations, there is ample reason for the stock market to move even higher.

There are many contradictions in the financial press due to the political biases of the newspaper publications printing articles. For instance, The Wall Street Journal, which is known for its politically conservative views, has been critical of President Obama’s moves to improve the economy. In an article in Monday’s edition of the WSJ ("Propelling the Profit Comeback"), the increased profitability by American corporations – the most important component to higher stock prices – is discussed. The article reports that the U.S. Commerce Department estimates that the second quarter after-tax profits rose to an annual rate of $1.208 trillion, up 3.9% since the first quarter, and up 26.5% since the first quarter of 2009. If you need any other reason for stock prices to be up, this is it.

The estimated profits for the second quarter of 2010 is the highest rate of profitability ever in the history of American finance. Even if you adjusted this figure to accommodate for the percentage of national income, it is still the third highest since 1947 -- exceeded only by two quarters during 2006 in the course of the economic expansion.

Ironically, the reason for these extraordinary profits is the very thing that is holding the U.S. economy down – an accumulation of cash by U.S. corporations that are not hiring due to the uncertainty of the fragile recovery. What U.S. corporations need to expand their workforce is a better economic outlook for the U.S. economy and some sort of confidence in the regulations coming out of Washington. You may rest assured that all U.S. corporations would increase employment and expand their operations if there was a demand for their products. Even though the economy has recovered, it is not as strong as investors would like it to be.

In contrast, "Cheap Debt" was published on the front page of Monday’s edition of the New York Times. The NYT is known for its progressive approach regarding economic matters, and American corporations appear to be demonized in recent articles. The NYT seems to indicate that U.S. corporations have a moral obligation to increase employment. In this particular article, it is implied that with interest rates so low in the current marketplace, major U.S. corporations are borrowing billions of billions of new debt at miniscule interest rates without increasing employment. The reporter correctly points out that U.S. corporations have accumulated close to $1.6 trillion in cash – the highest ever recorded – but have not increased employment or built news plants or equipment.

The NYT article also reports that Microsoft is one of the most profitable corporations in U.S. finance (perhaps even the most profitable in U.S. finance history outside of the oil industry). Microsoft reportedly recently borrowed a significant amount of money in the open market on a three-year debt offering of 0.875%. Given that they could invest this money at approximately 2.6% in a 10-year Treasury, you can see the spread in interest rates, which earns them significant profits. However, Microsoft apparently has no intention of increasing employment or expanding their plant or equipment.

Even more remarkable is the long-term borrowing by corporations less financially sound than Microsoft. For example, Norfolk Southern Corporation recently borrowed $250 million in 100-year bonds at an annual rate of 5.95%. Basically, they borrowed at 6% per year for a century. Those types of long-term interest rates are rare, indeed.

The one thing the WSJ and the NYT articles agree on is that corporate profitability is extraordinarily high. Again, stock prices are influenced the most by high profitability. As I pointed out in my August 2nd post - "Whoops, Did I really read that in America?" - I believe that U.S. corporations have no obligation to hire when they do not need the personnel. Once again, it appears that the NYT and I must agree to disagree on this subject.

In any case, corporate profitability continues to be excellent, interest rates continue to be low and the U.S. economy continues to improve. Given that excellent investment criteria, I do not expect anything other than additional profits in investing in the upcoming 12 months.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.