With a Little Help from My Friends

Last summer my Peachtree Quarterly message was inspired by “Gimme Shelter” by the Rolling Stones. The market in the spring of 2008 was becoming more volatile as a precursor to calamitous events to come. Later in the summer, corporate earnings started to collapse, and then the market went into free fall.

These times are, I believe, more appropriate for the Beatles. We have been getting by “with a little help from our friends” in government. Since taking office in January 2009, the Obama administration has been throwing a lot of money at our economy trying to revive it. They have implemented one giant stimulus package and may be considering another. They are working to reform health care, improve education and create a new category of “green” jobs, all as a means of putting people back to work and easing the economic pressure, especially on the middle class. It remains to be seen whether these efforts will provide enough return on the investment of all of us who pay taxes.

Unfortunately, the government efforts are hampered by the current contraction among consumers. For the first time in decades, the U.S. savings rate is going up. That is good news in the long term because much of the current financial crisis was caused by people spending beyond their means. Americans are realizing that they no longer can afford to spend money they don’t have, and they appear to be making an effort to put their financial houses in order.

That is bad news in the short term, though. Consumer spending is the major driver of the U.S. economy. The reluctance of the consumer to go shopping has hampered the recovery effort, just as consumer spending created much of the boom that preceded this recession. Shoppers hit the malls armed with credit cards. Home buyers used ridiculously easy mortgages to buy houses they could not really afford. And many people started to live off their home equity. Then the housing market collapsed, and home equity disappeared. Credit for mortgages and other loans also dried up. Credit card companies raised interest rates and tightened standards. And the American consumer pulled back in a big way. To make matters even worse, the credit crisis and market collapse spread around the world, largely because of foreign involvement in the U.S. credit markets.

The good news is that, with a little help from our friends in Washington, credit markets are beginning to thaw. The bad news is that we are only lending to the best risks. In order for a recovery to be meaningful, the middle class needs to be able to buy houses and cars, and to go shopping again. And that will not happen overnight.

We are in uncharted waters as investors. The government is in uncharted waters as well. The $64,000 question is: Can the Fed supply enough money to keep us afloat? And can they do that while at the same time keeping inflation at bay down the road?

On the corporate earnings side, the surprise so far this year has been an improvement on margins caused by cost cutting and inventory sell-off. Below the surface, however, corporations reported weak revenue growth. Given this situation, the bulls suggest that any kind of revenue growth will fall to the bottom line. The bears counter that investors should not hold their breath until consumer spending, which represents 70% of the economy, comes back.

Since the market lows on March 6, stock indexes have posted three consecutive months of gains. U.S. corporate profits increased $42.6 billion in the first quarter to $1.307 trillion, so the economy contracted less. The question is whether this is a short-term result of cost-cutting or the sign of a longer-term recovery.

So what should investors do? I believe that, now more than ever, is the time to look for high-quality companies with strong fundamentals. That is no guarantee against a drop in stock prices, of course; stocks seem to have been especially capricious in recent weeks. But, in the end, I believe that strong, high-quality companies will survive the current crisis and thrive once the recovery begins. I especially like companies that pay investors a dividend and have a good return on capital. I also like investment grade bonds where you can identify with the company and feel comfortable with their fundamentals.

Meanwhile, we can watch as the government, companies and the markets work to return stability and ease the transition to the next economic cycle. At the moment, we are in a post-credit-bubble cycle. I am confident that we will recover from this and move into a cycle of economic expansion. However, I think there will still be ups and downs before we get there.

Garry K Schaefer
Atlanta, Georgia
October 7, 2009

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