Sentinel News

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The disorder of the last two years seems finally at rest. In rapid succession we have had a housing bubble, major bank defaults, the most severe recession in a half century followed by the biggest peacetime stimulus plan. Recently, the economy and stocks have regained some confidence, yet there remains an uneasy feeling about the future. So what now and what to expect?

There was huge damage to the economy. Aside from falling indicators such as GNP, production and output, probably the most harmful result was that net worth in the U.S. fell from $60 trillion to $46 trillion in less than a year. Thus, the average household was poorer by 25%, equivalent to an entire year's worth of economic output. The consumer was in trouble and needed help.

Governments' dominant role and influence cannot be overstated. Their actions center on three policies: low interest rates, through debt repurchase programs and easing of funding requirements; lender of first resort to financial institutions; and architects of numerous stimulus plans. They have generally been successful. But the balance is fragile and palliative rather than remedial. To understand better, let us look at the economy, the credit and stock markets.

The Economy: the economy has showed progress in recent months but with caveats. First, for every positive leading indicator, such as increases in the Purchasing Managers' Index (PMI) and capital expenditure, there were equally strong negative indicators, notably personal income. Incentives such as "cash for clunkers" and a first-time homebuyers' credit helped the headline numbers but have not changed the underlying downward trends. Disconcertingly, we have also seen reported economic indicators revised down in the following months. But the biggest concern remains unemployment. Or more accurately underemployment. The headline number of 9.8% is understated. Once we count workers on furlough, part-time, reduced hours and those no longer seeking work, the number is closer to 16%. In that light, it will be some time before the economy is in full recovery.

Credit Market: money has been artificially cheap for 2009. Short-term rates have not risen above 0.2%, allowing banks to rebuild capital at attractive terms. The Federal Reserve has confirmed its intent to maintain an "accommodative" monetary policy and a $1.3 trillion Mortgage-Backed Securities repurchase program. This, along with an equally expanding fiscal policy, means that there remains a large supply of government debt.

Normally, this spells upward pressure on interest rates and inflation. But we remain confident about the credit outlook for two reasons. First, buyers are plentiful. Aside from pension plans looking to match under-funded liabilities with fixed income investments, banks are rapidly expanding their securities purchases. With loan demand at a 50-year low, banks are using capital to purchase Treasury and Agency securities, at a rate of over $50bn per month¹. Second, inflation remains low. Traditional inflation signals, such as gold, the yield on Treasury Inflation Protected Securities (TIPS) and the spread between two- and ten-year government bond yields suggest calm on inflation. Historically, the most potent inflation drivers have been wage push and demand-pull. But with excess labor and low input prices, the risk tilts toward deflation rather than inflation. The dollar may remain under pressure, it has lost between 3% and 6% to the Euro and Yen this year, and there is no stated policy to support or reverse its long-term decline. But for the next few months, government bonds should continue to provide strong, real rates of return.

Stock Market: the stock market gains from the March lows have been mightily impressive. This is due to two very solid reasons and one disconcerting reason. First, companies showed an impressive resolve to cut costs. They ran inventories down, reduced capacity and workforces and produced remarkable productivity gains. They also re-built balance sheets (worldwide corporate debt issuance totaled $1 trillion in the first nine months of the year) and improved cash flows, most notably in the financial sector. To some extent, however, the government is fuelling the rally by producing close to zero financing, making shares extremely attractive. All sectors seem to be enjoying a boom and those with exposure to emerging markets, even more so.

The result has been a re-valuation of the market to where it is no longer cheap. The market trades on a forward and cyclically adjusted (based on a ten-year average) price-to-earnings ratio of 18. We have seen the rise of the so-called "beta" trade where stock prices rose sharply as investors revalued companies that appeared on the brink of bankruptcy just a few months ago. Companies with low prices, no yield, low returns on equity, and often no earnings performed very well. This was a party we at Sentinel did not attend. We believe that strongly managed companies with long order books will prosper and positioned our portfolios to take advantage of the relative value on offer. We also like companies that will benefit from rising incomes in emerging markets. And we are conscious of liquidity.

Finally, three observations:

Earnings Season: In the midst of third quarter earnings reporting season, we see companies managing their middle and bottom lines well. Top line growth is elusive but is there for the fast-moving and adaptable. If we can get through the earnings season without a major political or financial upset, the rest of the year should hold stable.

Values: We see valuations as reasonable but no bargain. Sentiment remains fragile and some consolidation around the 1,000 to 1,100 level on the S&P 500²seems likely. We would place our trust in companies that have reliable cash flows, defensible franchises, visible earnings and strong management. There are plenty of companies trading with well-covered dividends. Cash-in-hand should provide an important part of total return. These have lagged recently but we feel they have more staying power.

Breadth: Seventy percent of global growth in 2009 comes from emerging markets. The theme of global rebalancing means, to Sentinel, a gradual and inevitable tilt towards economies that have low debt, thriving companies and coordinated public policy and private enterprise. China, for example, has led the way showing GNP growth in excess of 7% and foreign stock markets have had a strong year. Even with a gain of 19.2% in the year to September 30th, the U.S. market trails many Asian, Latin American and European emerging markets by a long measure. There may be continued strong opportunities in selected international markets where the government, consumer and corporate sectors are healthy and less prone to political risk.

Please take a moment to read our Portfolio Managers' commentaries. They provide more detail on the outlook for their markets. Many of us here at Sentinel have significant holdings in the Sentinel funds. Investors should continue to monitor their needs but we try to follow the great rules of investment: diversify, manage risk and buy quality companies. It has held well for us over many decades.