Mid-Year Review

Even though companies comprising the S&P 500 are projected to earn 18% more this year than in 2010, as estimated by Bloomberg, the stock market until recently has been reacting to a barrage of negative political and economic news.

From a global investor’s view, it is frightening to look at the European debt issue (Greece, Ireland, Portugal, Spain), the slowdown in China (though it may be temporary), the lack of leadership worldwide (except for Merkel in Germany), the mortgage mess and government problems in the United States. These macro issues, among others, weigh heavily on the psychology of investors; yet a slow recovery, even with unemployment at currently high levels, does not necessarily mean that stock markets cannot perform. Ultimately, stock prices reflect corporate earnings. The S&P 500 is currently valued at approximately 9.3 x cash flow, which has only been the case 19% of the time since 1988.

The 10-year Treasury note began the year at 3.33%, which we noted as the title of our January “Capital Ideas”. Somewhat remarkably, it has worked its way down to its current 3% level. Perceived weakness in the economy and the stock market has driven interest rates lower.

This has been extremely fortuitous for the U.S. government. Borrowing at almost no cost is a great advantage. Hopefully, this will not change rapidly; if it does, it will bring the U.S. deeper into debt and probably result in yet another crisis.

So what do we see for the balance of the year? We believe the economy will sputter along, the stock markets will finish the year up between 5 and 10%, and that 10-year interest rates will trade between 2.5% and 3.5%.

The current and projected weakness in the economy is also helping to keep financing costs manageable for borrowers, and more specifically, homeowners. However, the continuous printing of money is detrimental to future interest rates. Fighting inflation and defending a weak dollar may require quick and decisive action, without which, interest rates may rise precipitously.

The unemployment picture reflects both the weak economy and inherent structural problems. In order to illustrate this point, let’s consider the following real-world examples.

First, there is a company with one receptionist on each of its four floors. These employees can easily be replaced by four computer monitors, cameras, and a single employee.

Second, there is a job opening in Richmond, Virginia for a computer engineer. A candidate from New Jersey is qualified and applies for the position. However, since he purchased his home in 2006, his mortgage now exceeds the value of his home by $100,000 and he is unable to move — unless he abandons his obligation. Thus, because of the national housing and mortgage crises of the past few years, the company in Richmond cannot fill the position locally and the problem has become exacerbated.

These anecdotes remind us that the unemployment issue is not a simple one. The U.S. is in a transitional phase. Therefore, we need leadership to provide explanations and implement new programs that will guide us through this period.

As we muddle along, the prospect of serious instability keeps us up at night. Whether it is the oil markets, Middle Eastern politics, terrorist events or the intransigence of politicians, it feels as if a calamity may occur at any given moment.

On a positive note, good surprises will be generously embraced. Therefore, it is important that we do not discount positive outcomes in the affairs of the world. In other words, we must be careful that concentrating on the bad does not prevent us from realizing the good.

This is and will always be a world open to the positive, the optimistic and the energetic. Naysayers have had their day and have prospered recently from their wagers.

Generally over time, the world advances. We continue to see this over and over again through the improving quality of life for more and more people on this planet.

The shame is that our government continues to rot. Rather than performing its duty as a representative governing body, it has become a full-time fundraising machine. Without serious election reform, this problem will likely get worse.

In order for the U.S. to remain a leader, it is imperative that we have good leadership. My message is to get involved and speak up! Do not let the status quo continue. Call your Representatives in Congress. Call your Senators.

We pay our legislators — let’s hold them accountable.

Let’s use our Democracy.

Have a good summer.

Seymour W. Zises