Steady As She Goes

Over the past few months we have been in a risk-on, risk-off trading environment, and shares have fluctuated within a clear trading range. There seems to be a renewed willingness to take on some risk in September as economic data so far in the month has been much better than the data we received in late August. Perhaps most importantly, the private non-farm payrolls in August were better than expected and last week’s jobless claims fell more than expected. There has been some census noise recently, but the market nevertheless took the news positively. In addition, recent housing data hasn’t been as bad as feared. These two issues – housing and unemployment – had created a lot of fear in the markets in August that led to the selling of stocks and the buying of Treasuries.

Last week, in contrast, we saw a dramatic sell-off in Treasuries as money slowly trickled back into stocks. However, retail investor sentiment is still pretty bad (although much improved over the past couple weeks), and the retail investor remains largely on the sidelines right now.

There are a few things that may bring the retail investor back into the market in the near term. First, the elections may deliver a Republican majority in Congress. Not only is the gridlock in Congress good for the market (no dramatic policy changes), but a Republican Congress may mean that the Bush tax cuts are more likely to get extended (in addition to other “pro-business” policies). Second, we are likely to get more clarity regarding the new bank regulatory landscape as the Basel Committee delivers their recommendations over the next few days/weeks. And last, we are likely to get a report on the causes of the “flash crash” that has instilled fear in many a retail investor. To the extent that the retail investor gains more comfort and gets off the sidelines, the market could move higher in the near term.

For our part, we definitely would not rule out an end-of-the-year rally. However, we would stick to quality, blue-chip stocks with strong balance sheets and above-average dividend yields. Relative valuations for these types of stocks have seldom been better, and we believe they are clearly the better alternative to very low yielding Treasuries at this stage in the game.

In the more intermediate term, we remain cautious. We believe it is likely that housing prices have further to fall, and we believe the consumer is engaging in a more permanent shift in her spending/saving patterns. The baby boomer is ill-prepared for retirement and simply cannot continue with her/his reckless spending. Debt will continue to be paid down, spending growth will be modest, and economic activity will be subdued. In this type of environment, we believe quality, defensive blue chips will outperform.

Hang in there,