April 2011 - Commentary: The "Great Intervention Rally" Continues

As the current bull market celebrates its second anniversary, it’s a good time to reflect on the market’s performance, the state of our economic recovery, and the challenges we face ahead.

Since the March 9th, 2009 trough, global equity prices have doubled. Along the way, of course, there were several corrections as part of the natural ebb and flow of the market. Throughout this chapter of the recovery, Sand Hill Global Advisors remained disciplined, taking advantage of that volatility with an eye towards the underlying strength of this cyclical economic recovery.

An important corollary to our investment thesis was based on the concept that the large bellows of the Federal Reserve Bank and the U.S. Federal Government would rekindle the dying embers of the private sector by any means necessary. This abnormal support of unprecedented monetary and fiscal intervention was an important driver in our "buy the dips" mentality throughout the period. Trillions of stimulus dollars from the Federal Government and from the Federal Reserve’s printing press became the economy initially, and allowed the country’s private sector kindling to ultimately catch fire.

Today we find ourselves at the tipping point of this great experiment. There is a wide spread (and perhaps, well-deserved) belief that the government response to the credit crisis was necessary and effective. The economic recovery, the well-functioning credit and equity markets, the rise in business and consumer confidence and the improving job market are all successful outcomes of this intervention. However, the peak impact of these extraordinary measures is rapidly coming to a close - and stimulative tailwinds will become economic headwinds in rather short order.

The Federal Reserve’s second round of quantitative easing, or “QE2,” will come to an end this summer. The impact of this will be the equivalent of removing a significant interest rate cut. Additionally, by most measures, the Federal Reserve is the largest buyer of Treasury Bonds in the open market today, suggesting that the current interest rate environment will change. Furthermore, the unwinding of the Federal Reserve and the Treasury Department’s significant balance sheets has begun. Although the end of QE2 and its ancillary impact on the economy is widely discussed and therefore likely to be “priced into the market,” it nevertheless marks the first step in the dismantling of the crisis-era financial props put in place to bolster the economic and financial markets.

Meanwhile, as we progress through the back half of 2011, federal stimulus programs designed to boost the economy will also peak and begin to decline in significance. With an election year on the horizon and a Congressional “mandate from the people” to address the budget deficit and our debt ceiling, federal budget cuts will begin to take effect. Previous Congresses and Administrations have relied on the assumption that we can grow our way out of this onerous debt burden. That is no longer the case. Furthermore, tax rates on income, capital gains, sales and property will all need to rise in the future to offset our indiscretions in recent years. Each of these will weigh on our economic growth potential in 2012 and beyond.

Yet, despite rising uncertainties, hope springs eternal. The market remains remarkably resilient, with the S&P500 rising an additional 5.4% during the first three months of 2011. Uprisings across the Middle East and North Africa have left several venerable leaders ousted and sent oil prices skyrocketing. A massive earthquake and tsunami struck Japan, leaving more than 28,000 dead or missing and forcing shutdowns in key industries. For that matter, a simmering European debt crisis, as Portugal became the third country in the EU to require a bailout; the housing market’s significant renewed weakness; and even the worries about the long-term challenges posed by the US budget deficit, had little impact on the markets. So, what’s going on?

There are several explanations. In part, this resilience is attributable to the fact that by most metrics, the valuation of equities is not stretched. As the chart shows, global equities remain well below long-term historic averages, and quite significantly so given the steady flow of modestly positive economic data. Meanwhile, investors are willing to look past issues in Europe, Japan and China as temporary speed bumps, “valleys to be looked through” in Wall Street parlance, as we focus on the next rising mountain top of our cyclical recovery.

But most powerful, is a growing sense of optimism that the private sector kindling, embodied by the positive turn in the employment market, has caught fire, and the baton is ready to be passed to the private sector as government stimulus programs are unwound.

We often look to history as a guide in our process. Unfortunately, we have only one instance to draw upon for a cut back on quantitative easing, and that was last year. Between April and August, the Federal Reserve let its balance sheet contract and during that interval, we experienced a significant consolidation in the markets. What will happen this time around?

While it is true that an end of government stimulus could signal policy makers’ comfort with the economic expansion - which in turn could cheer stock investors and drive the markets higher - we are not so sure the economy is ready to stand alone. Economic momentum appears to once again be slowing with the normal maturity of the recovery but also as a result of the collective weight of recent geopolitical events.

We have detailed our strategy for 2011 in our Quarterly Investment Outlook. The environment we operate in today will be one that is extraordinarily challenging. It is one that is historically without precedence. Moreover, with the very strong run in the markets since late August, which incidentally was triggered by the Federal Reserve’s latest dose of quantitative easing, we have chosen to err on the side of caution for our clients until some clarity of outcomes can be obtained.

Although the intermediate outlook for the global economy remains pretty decent by the metrics we monitor, we are pondering the world, post liquidity withdrawal. We also believe that markets that appear cheap may be cheap for a reason - and that optimism based on the immediate past experience is no substitute for a forward-looking, fundamentally-based investment approach focused on the challenges that lie before us.

This information has been developed internally and/or obtained from sources which Sand Hill Global Advisors, LLC (“SHGA”), believes to be reliable; however, SHGA does not guarantee the accuracy, adequacy or completeness of such information nor do we guarantee the appropriateness of any investment approach or security referred to for any particular investor. This material is provided for informational purposes only and is not advice or a recommendation for the purchase or sale of any security. This information reflects subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. This material reflects the opinion of SHGA on the date made and is subject to change at any time without notice. SHA has no obligation to update this material. We do not suggest that any strategy described herein is applicable to every client of or portfolio managed by SHGA. In preparing this material, SHGA has not taken into account the investment objectives, financial situation or particular needs of any particular person. Before making an investment decision, you should consider, with or without the assistance of a professional advisor, whether the information provided in this material is appropriate in light of your particular investment needs, objectives and financial circumstances. Transactions in securities give rise to substantial risk and are not suitable for all investors. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without the prior written consent of SHGA.