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October 2010 Investment Journal 

The S&P 500 closed October at 1,183.26, gaining 3.69% for the month. Stocks rose further from a combination of more expected benefits from "quantitative easing", and some decent earnings reports. Gold rose 3.04% to rest at $1,346.75/oz., as concerns about bad debts and copious printing of un-backed paper currencies continued. In the bond market, 30 Year Treasuries declined 4.8% in price as their yield rose to 4.02%. Bond investors switched gears in October back to an "inflation is coming" stance as all eyes drifted towards the imminent Nov. 3 FOMC meeting.

Economic indicators in October overall showed no signs of a sharp divergence up or down from the slow growth, muddle-through trend that has marked the past year. Profit reports came in as usual, "beating the numbers" (what else would management do?), but with a mostly cautionary tone and outlook for next year.

The big event this month was Fed Chairman Bernanke's speech in Boston MA on October 15, and it was a doozy. His comments centered on how the Fed can combat disinflation and create "a little" inflation by printing more money to buy bonds (rewind to 1979 during the Volcker era Fed and one might question the sanity of the Fed's current management)!

The only debate now before investors is how much QE will be employed, and on what time scale. In our view, the evidence shows pretty clearly that virtually no amount of additional stimulus will produce the desired effect (GDP growth, new jobs etc.). (This is also the big debate inside the Fed.) Many feel that the US is now effectively in a "liquidity trap", and the Fed's actions are just "pushing on a string". All the money sloshing through the system can't be effectively deployed in new (and productive) property, plant, and equipment (aggregate demand is absent and so is certainty on taxes and regulations), so it winds up chasing financial assets. Another classic bubble in the making?

This all-on, all-the time focus by the markets on Quantitative Easing misses a big point. For those who were listening, the NY Fed let the cat out of the bag when Brian Sack, a senior official there commented that QE policy "adds to household wealth by keeping asset prices higher than they otherwise would be". Talk about a Ponzi scheme! The real question is not how much or even when QEII is unleashed, it is "what happens if QEII fails to produce the desired effect"? (Now re-read the Sack quotation above.)

From our viewpoint, markets in October anticipated much of the benefits of QE II, the election results, and earnings season (i.e. much good news is already priced in). Sentiment indicators currently register a very high number of bullish investors. The rising tide of liquidity may continue to lift all boats, but the duration and timing of the reversal is highly uncertain. Investor complacency is back, big time, and that means unanticipated outcomes can have outsized effects---especially negative ones. It is a good environment to keep some loose change.
On the research front, we had a chance to attend the country's leading independent investment advisor conference (Schwab's IMPACT) in Boston MA. Over 3,000 attendees brought vital new perspectives and ideas to the table. We continue to be very impressed with the developments afoot in the mutual and exchange-traded fund industry, which was prominently represented at the conference. Access to global markets and non-correlated strategies continue to gather momentum, and add to the diverse alternatives that were not available even two or three short years ago.

Thank you for reading our monthly Journal, and we'll be updating you again right after the Thanksgiving break.

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