Webcast: 2011 Forecast

The webcast “Forecast 2011,” was held Dec. 7 in New York. The transcript was edited to acknowledge passage of the Obama-GOP tax compromise. It was moderated by deputy editor Evan Cooper and senior editor Jeff Benjamin. InvestmentNews: David, give us an idea of what's going on and where we are going. Mr. Kelly: If you look at the overall economy, we've seen an economic recovery that started over 18 months ago. We think as we go into 2011, it will strengthen somewhat. Growth ran at about 3% in the fourth quarter and could strengthen to 4%. But even if that happens, unemployment will come down very slowly. We think it will be five years before we get to full employment. If you look at the profit picture, though, profits are continuing to rebound very strongly. It has been a V-shaped recovery in profits, which we expect to continue. Inflation is expected to be relatively low, but we think we will avoid outright deflation. With interest rates, we think the Fed will continue to be very “easy,” even as the economy recovers. We don't expect any move toward tightening until the end of 2011, at the earliest. The dollar, in the long run, will drift down. To me, the key questions for 2011 are stimulus and confidence. We have an answer to one of those questions. The Federal Reserve is determined to do everything it can to stimulate the economy; that's why they are completing these large-scale asset purchases. The federal government also seems to be very anxious to continue to stimulate the economy. The net effect of the tax agreement is, of course, to expand the deficit, but it removes some uncertainty and it stimulates the economy. The remaining question here is one of confidence. If confidence improves in 2011 because of the stimulus, and because we are getting past what happened in 2008, expect strong economic growth, higher interest rates and higher stock prices. I think it is very important for investors to be positioned in a way to take advantage of that improving economy and not just get victimized by higher interest rates. InvestmentNews: David, we will come back to how investors can do that. But let's hear from Stephen Wood and get an alternate viewpoint from him. Mr. Wood: Our view of the macro environment is not terribly dissimilar from David's, but we are a little bit less optimistic for 2011. We are looking GDP growth of near 3%, maybe 3.5%. Same ballpark, but a little bit different in terms of expectations. And our expectation for a square-root-shaped economic recovery — with a jump up and then a plateau — is something we have been holding to for about a year and a half. We see no real reason to come off of that. Part of the square-root-shaped logic is that typically, the depth of a recession dictates the strength of the subsequent recovery; the deeper the recession, the stronger the bounce-back. But not this time, which is where you get that plateau effect and the square-root-shaped recovery. Coming into the end of [2009], we were looking at exit strategy and sovereign risk as the themes for 2010 and 2011. Unfortunately, we were very right on that. The Fed has gone from exit strategy to quantitative easing. Now you are seeing sovereign risk rear its head most notably in the eurozone but also in the municipal bond space in the United States. That's going to continue, but I think the day of reckoning for the United States is a little bit further out. Our clients and investors just need to accept the fact that we have moved into a lower standard of living. We are already there; the extent to which you recognize it and deal with it is really the only variable you can control. So [there'll be a] lower standard of living, a lower-return environment, and we must adjust expectations and investment strategies accordingly. I also agree with David that shorter-term inflation looks very tepid. Three years out, you will begin to get some bubble-up, but you really have to go out the better part of 10 years to pierce 2% in terms of inflation expectations. And while there is certainly a lot of weakness in housing and unemployment, which will be there for a while, corporate America is doing fantastically well; David, your earnings-per-share recovery being V-shaped is spot-on. Corporate America has rarely been this healthy, this cash rich and this profitable. Margins and operating earnings look great. So from an investor's perspective, I think core Europe and America have a lot of great corporate stories. InvestmentNews: Stephen Van Order, tell us what you think is coming. Mr. Van Order: What Stephen and David pointed out, again, just plugs into the historical record for economies that suffer a severe financial crisis and are deleveraging. As debt people, of course, we watch the deleveraging going on in the private sector and leveraging up in the government sector and see 2011 as another year in the repair and recovery from the crisis. This process can take quite a long time — if you start with mid-'07 as T-minus-zero, we are now into our fourth year. We think the economic-recovery phase — in other words, getting back to fourth-quarter-'07 levels — will be complete by the first quarter. In general, growth should be slower than average, which dovetails with what our other commentators are saying. The Fed's monetary policy, which drove rates down quickly with the $1.5 trillion purchases of agencies and the additional purchases of Treasuries, is a stimulus, as is the compromise on taxes. While I agree with our other speakers that you need to continue to support the economy, what's missing — and what hopefully we'll get before the bond market has to go on some kind of a buyer's strike — is some more serious talk about medium- to long-term deficit reduction to pay for this. We think rates will remain low, but [there will be] heightened volatility as all of these forces play out. We think that even though rates are going to have a bit of a soft cap on them, keeping portfolio durations conservative makes sense when interest rates are this low. It is a steep curve — you can stretch for it, but you need to be careful. And in line with the comments about the strength of the corporate balance sheets and earnings, we think that corporate America is in relatively better shape than other parts of the economy, and spreads remain attractive there. I'd be very careful about municipals; there are reasons they are attractive compared to Treasuries. InvestmentNews: Stephen Wood, can you give us a deeper take on the tax deal? Aren't we talking about a $700 billion to $800 billion expense? Mr. Wood: Yes, but the stimulus is clearly needed. And whether you are on the right side of the fence or the left side of the fence, I don't think anybody would responsibly be calling for a withdrawal of stimulus in the worst — and first global — economic downturn in seven decades. What a lot of investors need to keep in mind is the following: New information moves the market; old information doesn't, because it's already priced in. For example, unemployment is not doing well and is not going to improve. That's old information. The housing situation is old information, too, as is a lot of what's happening in Europe. Where we see real change is in positive information. And we have seen a measurable and consistent uptick in the macro data when you net everything out. Fiscal policy and the tax agreements are big factors. What we're not seeing is a destabilization of forecasts from guys like us, and stability in forecasting is a critical component of investing. InvestmentNews: David, how do you factor the tax deal into your outlook? Mr. Kelly: I think the agreement was positive for equities and negative for Treasuries. When I look at the overall deal, I think the key thing is that both sides got what they wanted in terms of stimulus for their own constituents. It was a bit like all the kids around the Christmas tree, and Santa Claus is handing out presents to everyone. It's just that I feel a little sorry for Santa Claus — in this case, the federal government — for taking on a lot of debt, which is why I think this is very negative for Treasuries. I think it is also somewhat negative for municipals, because lower tax rates make returns on stocks more attractive while making the tax-free aspect of municipals somewhat less attractive for upper income individuals. Overall, I don't expect the market to get it right immediately. But the market does react very well to what is obvious, and what is obvious is that this is somewhat positive for equities and somewhat negative for Treasuries. What I think people are missing here is the effect of uncertainty on confidence. Two things we learned in the past month: First, the Bush tax cuts expired. Second, we learned that the Obama administration, when push came to shove, moved to the center after the November elections. That is a very important message. I don't want to make a political point here, but it did look a little bit in the past two years as though we might be seeing a more ideological government. This move back to the center on the part of the Obama administration may come as a comfort to many people, who like to be governed from the center. The reason I think this is very important is because it affects confidence. Think about what low confidence is doing to the economy. It's holding back vehicle sales and home sales. It has corporations keeping cash on their balance sheets and holding down dividend payout ratios. It is holding down the amount of cash going into equity mutual funds. It is holding down price-earnings ratios. Across the whole spectrum of the American financial environment, low confidence has been holding us back. If this agreement, along with some better economic data, causes confidence to move up, I think that could get you to 4% growth. Mr. Van Order: In that environment, there would be, of course, a fundamental reason for interest rates to start to rise. Right now, if inflation is going to stay low, the real rate of interest could rise anyway because of expectations of higher borrowing costs and higher risk in holding bonds at such low yields. If this move supports the economy and gets people thinking more optimistically, we could see improvement in equities. But what is better for the economy is typically bearish for bonds, especially if you are starting from a very low interest rate base, as we are. That said, we still need to see how things play out. InvestmentNews: Let's discuss muni bonds. How does the tax deal affect the muni market, especially the sunset of the Build America Bonds program? Mr. Van Order: What the Build America Bond programs did in a very clever way was provide municipal issuers with access to the taxable-bond market. Between mutual funds and individual [issues], about 70% of municipal bonds are held by individuals. When you have crushing borrowing needs during a time of great financial strain, the ability to tap that market was huge. And it was quite successful. I don't believe we will be able to go back to raising money in the old-fashioned muni market for the next few years. Think of it as a pressure release valve for municipalities. I think they are going to have to revisit it. There is a lot of volatility, and municipal yields have corrected quite sharply against Treasuries and corporates because of the rush to get financing done before the window closes. The other thing that will have to be taken up is that states are still going to need federal aid because local governments are going to need state aid. The issue is just not going to go away. And it will come to the forefront when states such as California and Illinois have to tap the market. InvestmentNews: Originally, there was talk that since Build America Bonds were given a tax break one way while traditional muni bonds were given a tax break another way, the whole thing was kind of a wash. Has it turned out that way? Mr. Van Order: The latest figures from the Congressional Budget Office would agree, because foreign investors and pension funds [who bought the bonds] didn't have to pay tax on them. It's estimated that the bonds imposed about an $8 billion cost on the market, which you might think of as a cost to support a major market sector. But people were not in a mood, especially around election time, to get involved with redoing another source of government support for a market. Still, considering the current municipal-market situation and the borrowing needs of state and local governments, continued access to the taxable market seems like a good idea. We will see how that goes. InvestmentNews: It sounds like you are thinking that even though lawmakers last month refused to renew the Build America Bonds program, it's not dead yet. Mr. Van Order: I think there are people — particularly at the Treasury and the Fed — who are going to keep this issue in front of lawmakers. It could go away for a while, but if the municipal market comes under a lot of strain, particularly from some of the big state borrowers, then this kind of pressure release valve will come back. InvestmentNews: David, do you have a take on that? Mr. Kelly: There may be some sort of backlash in Congress about any further increases in spending or increases in the deficit. But I'm not an expert in the politics of this. I just would say that the fact that it was omitted from the package last night, along with the fact that tax rates are going to be lower on stocks and on income, all make this deal not great for the muni market. InvestmentNews: What do you think of the relative strength of the United States vis-à-vis foreign investing, and what is your international outlook for 2011? Mr. Wood: I won't be an expert on Ireland; I will leave that for David Kelly. But Europe is going to continue to be fragmented and have tremendous issues, structural as well as immediate. You are going to see core Europe continue to do relatively well and the peripheries drag down the aggregate. I think the U.S. could surprise a bit to the upside. And that is why we have taken our GDP numbers up to 3.4% to 3.6% — closer to Mr. Kelly's numbers. They were lower before. In emerging markets, you are seeing rich valuations and very rich currencies. But you are seeing fantastic fundamentals. The “whither China” question is going to be the most relevant. You are seeing commodities begin to sniff out the fact that this aggressive exit strategy and tightening cycle by the Chinese is probably going to be exhausted by mid-2011. So when China becomes more of an engine of global growth, it's probably going to be a pretty bullish sign. If you look at things from a currency perspective, the Chinese are currency managers as are the Germans, especially when most European trade is intra-European. I think that in the ugly contest of dominant currencies, the U.S. dollar could probably come in closer to the wrong end. For investors, a global perspective is mandatory, both in equities and fixed income. Mr. Kelly: I would agree with that. I think it is very important for people to continue to be diversified internationally. When you look at Europe versus emerging markets, it is really a matter of value versus growth. There are problems with European debt, and the reforms we are seeing in Europe, in terms of countries dealing with their budget deficits, are a good thing and very necessary. But the main thing I would say about Europe is that their stocks are really cheap. Everybody has bought into the gloom in Europe, and to some extent, I agree with it. But I do think that there is sort of a value strategy there because there are very-high-dividend-paying stocks in Europe that don't depend on European growth but rather benefit from growth around the world. Those valuations are a little bit rich, relative to history, but you could say that these emerging markets are not your father's emerging markets. They really are emerging and are growing strongly. And I don't really see a change to that; it's a secular trend. In Europe, therefore, it's gloom, but not doom. And in emerging markets, it's boom but not bubble. There are opportunities in both for international investors. The one area that I am not terribly keen on is Japan, because Japan has a debt problem that makes our debt problem and everybody else's look very minor. And Japan isn't really dealing with it. It's going to be a big problem for them. Mr. Wood: One point I'd like to add: As emerging economies emerge and become more closely correlated to ours, American investors are losing some of the diversification benefits of having emerging markets stocks in their portfolios. InvestmentNews: What assets actually are non-correlated these days? Mr. Wood: In 2008, you essentially had two asset classes on the planet: Uncle Sam and everything else. We've moved away from that over the last couple of years, but the close correlations really have handicapped the ability of many people to manage their portfolios. Mr. Kelly: Yes, but we need to realize that the 2008 financial crisis was a very special type of financial crisis. It wasn't a bubble in any particular asset class, it was basically a liquidity shortage. When we ran out of liquidity, everything that involved any risk at all went down in value. Consequently, since 2009, anything that involves any risk at all has come back in value. So I expect that over the years, because of changing economic fundamentals or changing linkages around the world, correlations have gone up, which is something we will have fight against and diversify a way around. I do think that the last few years have been a rather special case here and I hope that we can avoid another big financial crisis. And if we can have more asset-specific problems going forward rather than just a huge liquidity crisis, we may see less in the way of high correlations than we have seen over the last two or three years. Mr. Wood: I would suspect that is true, as well. InvestmentNews: David, you mentioned Europe a few minutes ago. Where specifically are the opportunities in Europe? If you look at the eurozone, some people could say there was a case for going long select equities there and maybe short sovereign debt. Are there any areas you could highlight? Mr. Kelly: It's clear that Germany is far and away the star in Europe right now. It is deemed to be the winner in terms of debt problems, even though it has plenty of debt. But it has low borrowing costs, which helps with internal confidence. France is doing surprisingly well, also. In equities, multinational European stocks have more exposure to emerging markets than multinational U.S. stocks. So I think that makes looking at European stocks a matter of looking at it company by company rather than country by country. Overall, sovereign debt is going to be a problem that will come up again over the course of 2011. We will be keeping an eye on it, but the critical question in the end is whether the eurozone can afford for any country to leave. I believe the answer is still no. If that's the case, and if that's the policy answer European leaders continually come back to, then over time, these sovereign-debt earthquakes should diminish. But obviously, they will be a very big issue in 2011. InvestmentNews: Stephen Van Order, would you mind chiming in on the sovereign-debt issue in the eurozone? As a follow-up to that, what do you think about the possibility of some kind of quantitative easing in Europe? Mr. Van Order: Let me address that from the angle of someone investing in fixed income in the U.S. and how that affects our markets. Foreign investment in U.S. bonds — Treasuries, for example — has remained pretty robust. It has ticked down a bit, but it still rounds roughly to 50% of the debt outstanding. Eventually, the Fed is going to move in and essentially become the biggest holder of Treasuries in the world, but I don't think that is going to stop foreign investors from looking at markets, particularly our markets, particularly at times when there are concerns about liquidity and safety. In terms of quantitative easing or moving to unsterilized operations in Europe, it seems that that would be more a function of whether the euro area looks like it is going to slide into real trouble. But we don't see signs from the European Central Bank that they are especially concerned. There would have to be some macroeconomic development, like the risk of Europe going into a recession, to get them to that point. Mr. Kelly: I agree with that. We need to remember the difference in economic culture between Europe and the United States. In the United States, the seminal economic event of the last century was the Great Depression. And Ben Bernanke is determined to do anything necessary to avoid the Great Depression, including dropping money out of helicopters, so to speak. In Germany, there is still a memory of the hyperinflation of the 1920s and of hyperinflation in other places. The Germans in particular are much more conservative when it comes to ideas of printing money to buy sovereign debt. They got forced into taking some actions in May and I think they will continue to do what they need to do to react to crises. But by nature, they are a more conservative bunch than the U.S. Fed. InvestmentNews: We have some questions from attendees. One of them asks about precious metals, oil and agricultural commodities, and where those fit into your forecasts and growth outlooks. Mr. Kelly: Oil certainly has the potential to rise over the next few years. While there is plenty of inventory out there, we see strong growth in India and China, and no real movement in the United States toward a sensible energy policy, which means we will continue to overconsume oil. The world really does have a problem in terms of producing enough oil. Oil also can operate as a hedge against a certain kind of uncertainty. If we have some breakout of hostility in the Middle East, such as conflict between Iran and Saudi Arabia, or ourselves and Iran, oil could shoot higher. And one of the great risks to any portfolio is a big spike in oil prices. So I think that that is a sensible commodity to have in a portfolio. As for other commodities, I think, in general, it makes sense to have some exposure, but if you are going to be an individual investor in commodities, make sure you are using a very experienced fund management team to do this for you, because this is an area where individual investors frequently lose their shirts. And the last thing on gold; people should buy it for the right reason — they want to own it. People need to remember that it is very volatile and its long-term track record is not good. I'm not saying it is not going to go up — it may well go up some more — but it is not the sort of stable, safe asset class that people think it is. Mr. Wood: I concur. You want to invest in gold globally and professionally. At $1,400 and change per ounce, how much protection does gold afford a new entrant? Global commodities make a lot of sense because I think you're seeing “biflation” taking place, especially in the United States, as housing prices and owner-equivalent rents drop dramatically at the same time that commodities are bubbling up. Also, global REITs — there are a lot of real asset plays that provide you with the correlation benefits we were speaking about earlier. Those increasingly will become part of a portfolio. Mr. Kelly: Just to agree with Stephen on the global REITs issue, a key question that many financial advisers are asking right now is, what to do about clients who are in long-term fixed-income instruments now that long-term interest rates are going up. People need a more diversified income stream, and one of the many sources of diversified income is global REITs. They provide a good income stream without exposing you to a backup in the long end of the U.S. Treasury market. InvestmentNews: And which part of the global REIT market is most appealing? Mr. Kelly: They tend to be concentrated a little bit more in Asia — at least the REIT portfolios that we run — whereas when you look at the stock side, less of it is in Asia. But again, I think I would leave that up to a professional manager to find the best opportunities out there. InvestmentNews: Steve Van Order, what is your outlook on the junk bond market? Mr. Van Order: Especially with the commitment from the government to support the economy and the fact that we might just be moving from recovery into expansion, high-yield bonds definitely can make some sense. The spreads are still attractive, but it is not the kind of thing where you can pick a couple of issues. Right now, for example, our credit guys are particularly paying attention to what we call “covenant light,” or issues coming to market whose covenants are a little looser. Would I rule them out? In terms of the additional spread they offer over Treasuries, no. But as the yield chase continues, you just have to be more and more careful and try to have as many names as possible in your portfolio. InvestmentNews: Anyone else want to comment on that? Mr. Wood: I want to toss one to Steve Van Order. In the muni space, what is your input on issuer and vintage in terms of credit risk? Mr. Van Order: That's a great point, Stephen. In municipals, looking ahead, let's take a glass-is-half-empty approach, because state and local governments are going to continue to struggle. We are not sure whether we can get to the point where a large state really does suffer a short-term inability to access the market and requires some kind of a guarantee facility from the federal government. If you expect defaults are going to increase, it is important to pick the bonds based on how good they look fundamentally. Of course there is no bond insurance, and that was a bit of a misnomer anyway. Sticking with the state and essential services, if you really want to be very conservative, would make some sense. But there is a reason why municipals are as cheap as they are [compared with] Treasuries right now. You just have to be careful in that environment. So that would be our advice for someone concerned about the municipal market's becoming our version of the European government debt problems. Mr. Kelly: I would like to add two things to that. One, while it is important that we differentiate between bond investors and equity investors, nobody, of course, wears a label on their forehead. And I think it is very important that people not consign themselves glumly to being bond investors who are going to lose money in this environment. I think it is very important to have an appropriate diversified portfolio and to get your income from that portfolio. If you think this is a time to be a little overweight equities versus fixed income, then you should do that. If you think you need to have other sources of income, then you should move there. My second point is that there is a big difference between global sovereign-debt issues and municipal issues, because municipal governments in the United States are small relative to the federal government and relative to their own economies. And almost none of them is allowed to run any ongoing budget deficit. That means having to make tough choices in tough times. We've already seen lots of layoffs, but if push came to shove and they had to raise taxes to pay the bonds, they could. What's more, the increase in taxes to do that would be relatively small, compared with the GDP of the state or the municipality. So in most cases, it is not one of those situations where you raise taxes so much that business goes elsewhere and the municipality actually loses revenue. From that perspective, and given that the actual history of municipal defaults is very low, I expect it to continue staying low. My last point: Municipal finance responds to the overall economy. We had some very good chain store sales numbers in November, and we're seeing some increases in vehicle sales. If retail sales move up, state sales tax collections around the nation will rise. We think that real estate prices ought to be stabilizing, and they have kind of stabilized. That isn't helping property tax revenue at this stage, but at least it should not be getting worse. We are not that pessimistic about the credit side of municipals, but we do think that they will be affected negatively by rising interest rates in the Treasury market. InvestmentNews: Is this a good time to buy dividend-paying stocks? Do you think there is room for growth there, or will demand increase? Mr. Kelly: I think there certainly is room for growth. The one thing that I think people ought to pay attention to is just how low the dividend payout ratio is. It is one of the lowest we have ever seen. Companies are holding on to cash. Profits have seen a very strong revival, but corporations, just like everybody else, have been very reluctant to spend. Confidence has been low and they are not quite sure if they believe that the improvement in profits will last. As a result, the dividend payout ratio is very low. Now, if they are very low, then it is reasonable to assume that over the next few years, dividends will actually grow faster than earnings. And I think that is a positive for dividend-paying stocks. If push came to shove, I don't think that dividend-paying stocks will necessarily do better than more growth-oriented stocks over the next few years. But certainly, if you are looking for income, I think dividend-paying stocks will do a lot better than high-quality fixed income. Mr. Wood: Looking at high- dividend-paying stocks as a replacement for fixed income would not be prudent, in our opinion. In a low-return environment, you want to be very careful when you reach for yield. Mr. Van Order: I concur with some of those thoughts, but I want to clarify the scenario we see playing out on municipals. While we have concerns like everyone else, we're not really worried about municipal defaults. When we look at the relative attractiveness of dividend yields against Treasuries and corporates, the valuations and spreads are there. It really is just a question of, “How well you think we are going to do going forward?” InvestmentNews: David, what is your forecast for the real estate market? Mr. Kelly: Let's first divide the market into home sales and housing starts. With regard to sales, I think we will see some gradual improvement. We have seen some improvement in the mortgage applications to purchase in the last few weeks. We have seen improvement in the pending-home-sales index. And I think we will gradually see some more people buying homes. Since the level of home sales is still pretty low, we will see some moderate improvement in 2011. We also probably will see some stronger improvement in housing starts, which are now extremely low. I know there is a lot of inventory out there, but we are seeing some signs of a tightening of the rental market. The inventory of homes on the market for sale also is gradually coming down. I know there are a lot of foreclosures moving through the system, but the most important factor still is very good affordability. The one negative is the recent rise in long-term interest rates, which will push up mortgage rates somewhat. But I really don't think that people are avoiding buying houses or building houses right now because mortgage rates are so high. So I think we will see some improvement in 2011. Most importantly, given current affordability, if you get some improvement in economic growth, I think we have seen the last of the big price declines nationwide. Prices will generally move up in 2011. Getting back to more-average levels of sales and homebuilding over the next three years would do an awful lot to help confidence and economic growth. Mr. Wood: The wealth effect really is what we have been talking about since the beginning. And while home prices and household wealth have really taken a hit, part of what the Fed is trying to accomplish with the wealth effect is to put a floor underneath housing and unemployment, as well as create significant upside with equities. I think recovery in housing prices is going to be very episodic. Certain trouble areas — Southern California, Las Vegas, Phoenix, Florida — are going to continue to struggle, but other parts of the country will probably fit in the average range. It's still going to be location, location, location. And I think the numbers that the Fed is looking at are really speaking to it wanting to create some positive wealth effect from the portfolio side of households. InvestmentNews: Stephen Van Order, do you have a take on that? Mr. Van Order: The decline in housing prices that we got nationally seems to be roughly in line with what has happened in other countries. The “sand” states Steve just alluded to are going to continue to be troubled areas. There are going to be hurdles and bumps, like working through the stalled foreclosures, getting that process cleaned up, and moving things out. Inventory looks like it is going to continue to be big. We are past the days where the housing sector led economic growth. Now the question is whether the housing sector will be a material drag on growth. Just let it recover over the next few years. Mr. Kelly: I agree; the amount of activity coming from housing starts isn't going to be that huge. Higher home sales will help, as they are central to people's perception of the economy. If you begin to see home prices move up a bit, you begin to see people think that they actually are going to get some of their money back on their house. And that can help consumer confidence, which adds a little to overall economic growth. Mr. Wood: It has fallen so far already that it can't be much more of a drag. Mr. Kelly: Just to put some numbers on that, at its peak, U.S. housing starts were 2.3 million units annualized. I think that was January 2006. At its trough we were 500,000 units. Now we are up to roughly 600,000 units. In other words, we fell by 1.8 million units from peak to trough. If we went to zero tomorrow, we would only fall by a third of that. So at this point, you could say there is no U.S. housing industry anymore. Mr. Wood: And if you look at historical figures, normal demand is what, 1.2 million units? It takes a number of years to burn off excess building. It's just an inventory issue. Mr. Kelly: If you look at population growth over the past 40 years and match that against housing starts, including multifamily-housing starts, our current population growth of about 2.6 million people would actually translate to about 1.6 million housing starts. So I think we are about 1 million short, and that is why I think inventories will tighten. InvestmentNews: What about the REIT market in the U.S.? REITs had a very strong 2010. Mr. Wood: REITs provide a primer on asset allocation and diversifying your bets. Coming into 2010, obviously, this was an area that had languished. As a result, REITs were a stellar performer. And if you look at that, compared with other opportunities like China, which is down significantly, REITs in a professionally managed sense make a lot of sense and always should have been — and will continue to be — part of a properly diversified portfolio, both from the U.S. and from a global perspective. REITs increasingly are going to be area-specific and location-specific in the U.S. However, investors are going to need to have a global perspective. InvestmentNews: What should advisers be doing for 2011? Obviously, it depends on the investor, but what are some specific suggestions for them? Mr. Kelly: We have to recognize that there is a real psychological problem with American investors right now. I'm not criticizing American investors. Given what they have been through, it is not surprising that people are very negative on stocks and very complacent about fixed income. But they need to be balanced. And I think it is important for advisers to take a leadership role here, particularly with regard to investors who want income. Dividend-paying stocks are not exactly a substitute for high-quality fixed income, but I do think that if you are trying to get a stream of income, dividend-paying stocks ought to be part of it. I think you have got to find a diversified flow of income assets from REITs, from dividend-paying stocks, as well as, say, from high yield, and diversified within fixed income across asset classes around the world. But I think it is very important to get that diversified-income stream to clients in 2011. I think it is important to show the leadership, giving people a balanced view of the economy so that they can make balanced decisions about how to invest. InvestmentNews: Steve Van Order, anything to add? Mr. Van Order: This stimulus package, I think, is just another shot across the bow that says that the government, despite what we heard all around the elections and what may popular be out there, is ready to do some big things. For example, Ben Bernanke's appearance on “60 Minutes” in which he said that additional [quantitative easing] is certainly a possibility. That is something that is important at this point in the cycle for recovering from this financial crisis, which is going to take several more years. Still, you can't keep kicking deficit reduction down the road, or the bond market will have a conniption at some point. In the bond market, corporates came through this whole mess a lot better then many people thought. Spreads are attractive. In municipals, there are going to be opportunities when there is tumult in the market. For those interested in what we call a yield chase and want to boost returns — sometimes by using leverage — be very, very careful. While the Fed probably won't stop easing anytime soon, at the end of the easing game, you'll have to be very careful and pay attention to market value versus book value. InvestmentNews: Steve Wood, your last thoughts? Mr. Wood: We think that the risk of a double-dip recession is receding; a square-root economic recovery is the most likely event. Becoming overly conservative too early probably is not in the best interest of investors who are healthy and moving into their 60s as they retire. The actuarial numbers of a healthy woman in her 60s are about three more decades. Portfolios are going to need to be more global, more sophisticated and more robust. They are going to need not to have REITs and credit exposure from a global perspective, but commodities and listed infrastructure. These are probably investment strategies that people don't understand; I don't think the average investor has the capability. So for the financial professional, there is a great opportunity to provide significant value-add to your clients. Your clients need far more sophisticated, robust and disciplined portfolios than they needed 10 or 15 years ago. The audio webcast and slide presentation are archived at InvestmentNews.com/webcasts.