Quarterly Letter To Clients Part V

Today we'll finish up our discussion on what if things are getting better?

A change in investor sentiment:  We noted back in October that investor sentiment was extremely negative.  This is still the case as the amount of money pulled out of mutual funds in 2011 ran at a very high rate which accelerated into the fourth quarter.  Much of that money has flowed into bond funds that are now paying historically low yields.  The S&P 500 now has a dividend yield not that much different from the 10 year US treasury.  This massively negative sentiment recalls the top of stock prices in March of 2000 when fund flows into equity mutual funds reached record proportions. We are not the only ones to notice this.  As we were putting the finishing touches on this letter, the financial magazine Barron’s arrived on our doorstep.  This was its cover:  

Bespoke Investment Group's co-founder Justin Walters framed it this way, “Things in the U.S. aren’t nearly as bad now as they were back in 2008 and early 2009, but don’t try and tell the retail investor that. They’re truly spooked.”2.

This mood has also hit Wall Street as 2012 is one of the few years in memory where investment analysts have collectively been taking down their forecasts. The poor sentiment amongst Wall Street professionals likely means that most negative investment scenarios have been priced into stocks. It could take potentially little in way of good news or an improving market to ignite a massive reallocation out of low yielding bonds into stocks.

Finally looking under the hood:   The 20^th Century experienced three Bull markets: {1919-1929-“Roaring 20’s”, 1947-1965-post-war boom and 1982-2000-the technology or “Long Boom” period}.  Each of these periods ended up being the beneficiary of an earlier expansion of research and development {R&D}.  This expansion largely resulted from earlier investments made as a result of war or in the case of the Long Boom an intense period of international political hostility {the Cold War}. That R&D ultimately found its way into civilian applications. Home refrigeration for example became available to the larger American public in the 1920s largely as a result of technologies developed to feed troops during World War I. Technological advances developed throughout the Cold War and systems developed from the space race {an offshoot of the Cold War} were the seed monies that built much of our economic expansion between 1980 and 2000.  We have been fighting wars in some form now since 2001.  There is massive R&D, particularly regarding miniaturization, of all sorts of military systems-think of drone aircraft for example.  Much of this R&D will likely enter the civilian economy in the future.  Areas that have already benefited from this include technology, medical devices and energy equipment.  Everybody can see the technological benefits that smart phones and tablet computers are bringing about but most don’t see the technical advances in energy development {think fracking} and biotechnology that are becoming hot growth areas in our economy.  If much of this paragraph looks familiar that’s because we first wrote about this  to you back in October, 2010.3.  Stocks are up nearly 11% since this was written. 

2. Source Bespoke Investment Group. 2011 ETF Performance

3. Solas! October 28, 2010, page 3.