During the last month, we passed the one year anniversary of the stock market’s most recent crisis low. We remember quite clearly that ugly Monday in March (3/9/09), 3 days after the S&P 500 hit an intraday low of 666, then closed at 676.53, reflecting a point where in the wake of the credit crisis, panic selling appeared to capitulate. At that point the S&P 500 traded at the same level it first crossed in 1996, 13 years earlier. During that period we felt many of the same emotions that you felt. We cannot reiterate this message enough: it is in situations such as those where adhering to a plan and ignoring the crowd is essential to success. With no plan or understanding of what a client might need, it would have been very easy to cut our losses and try to stop the pain. Had we done that we would have violated our disciplined approach and more importantly, our clients would not have participated in one of the most robust stock and bond recoveries in recent history.
Today, only a bit more than a year later, the S&P trades over 1,140, nearly a 70% increase from that infamous low. What a difference a year makes! Even with that gain it should be remembered that the S&P still stands 20%+ below its 2007 high, so it’s important to “zoom out” when looking at the recent rally to put it in context.
The last year and a half has been full of economic upheaval accompanied by stock and bond market volatility. We believe the worst has passed and that while these waters are navigable, significant risks remain. Acknowledging these risks, we see many reasons to be cautiously optimistic. Let us explain why.
Many economic variables have either improved or stabilized over the previous 12 months. As we wrote last quarter, prognosticators, even those who are experts, often get it wrong. Currently, the conventional wisdom is that consumers are retrenching and are unwilling to make discretionary purchases. The data we examine confers just the opposite message: the recent report for individual store sales showed overall sales were up 0.3% in February from the previous month. If you back out motor vehicle sales the number was even larger at 0.8%. This data does not seem to portray a weak consumer. Additionally, the average ticket price at Home Depot and Target (two retail bellwethers) has risen. We would venture to say that reports of the death of the American Consumer have been greatly exaggerated.
According to Morningstar, Industrial production fell almost 15% this recession, which is one of the largest reductions in history. With consumer spending picking up pace, we believe manufacturing and production will begin to ramp up. Production cannot lag forever and keep up with growing consumer demand. According to the Census Bureau, inventories are down almost 9% year over year. What this tells us is that instead of making new goods to satisfy consumer demand, manufacturers simply shipped goods they already had in inventory. So the question now becomes how long producers will wait before rebuilding inventories, at which point the virtuous cycle of hiring begins. Presently manufacturers are pushing workers (as measured by hours per worker and productivity figures) versus adding to payrolls. Soon we will reach the point where the band snaps and hiring begins.
Unemployment has persisted during this recovery longer than we had hoped, as many employers are uncertain about the sustainability of the stimulus spending and its effects on demand. Employers are also greatly concerned by policies coming from Washington that will affect variable costs, health care and taxes. The debate concerning the recently passed Health Care Bill is beyond the scope of this letter. However, one of the main takeaways for investors is that as these new bills and spending programs become law, the uncertainties surrounding the issues will diminish.
We do not see a robust employment picture developing any time soon. Encouragingly, the mass layoffs that companies used to balance cash flow have all but ended. This sets the stage for hiring back full time workers and eventually lowering the unemployment rate. Full employment (most view this as 4% unemployment vs. the current ~10%) will not happen for the foreseeable future. We find it likely that 8% will be the range over the next two years.
Where does the “cautious” come in for our “cautiously optimistic” view? There are a number of risk factors we are monitoring closely. They include:
- European Sovereign debt crisis
- Chinese attempts to slow growth
- U.S. Tax Policy/Government Spending/The end to Quantitative Easing by the Fed
The fiscal problems in Portugal, Italy, Ireland, Greece and Spain (shortened to “PIIGS” by creative Wall Street traders) have been well publicized. These countries are all members of the European Union and have adopted the Euro as the common currency. EU members agree to keep debt levels below a certain percentage of GDP in order to ensure sound fiscal policy and prevent the need for a financial bailout caused by irresponsible borrowing by any one country. The PIIGS (Greece in particular) violated these agreements and used financial derivatives to hide high debt levels. The normal tactic taken by a country in this situation is to debase the currency and print money to offset the financial obligations, more commonly known as “monetizing debt” (this is what Ben Bernanke and the Federal Reserve have been doing for months in the U.S.). This strategy is not an option for countries that have a common currency and no central bank; thus insolvency issues arise. This is playing out now in Europe and investors are nervous. We believe the EU will work this out, led by the stronger countries (Germany and France) and potentially the IMF, but it further undermines confidence in the financial markets. This has led to a strengthening of the U.S. Dollar relative to the Euro.
China and the U.S. are in the midst of a love/hate relationship. Both parties would be economically challenged, to put it nicely, if they divorced. China is heavily dependent on U.S. imports and the U.S. is heavily dependent on China reinvesting its trade surplus into our Treasury market to fund deficits. As one of our portfolio managers likes to say “we send China paper and they send us plastic.” If any one side gets disgruntled with the other the global economy would be destabilized. One upcoming date of interest (other than it being the tax deadline) is April 15. This date is the when the U.S. Treasury department must decide who, on the sovereign level, should be classified as a currency manipulator. Most currency traders will acknowledge the Renminbi (the formal name for the Chinese Yuan) is perhaps 25-40% undervalued versus the dollar based on economic fundamentals. This perhaps should be considered manipulation but it is unclear if we have the political will to state this publicly and create a stand-off with China when they are funding our Government at the moment. Time will tell.
U.S. tax policy, government spending, quantitative easing on behalf of the Federal Reserve and inflation are all closely linked, and all present risks to our economy. We have just embarked on the largest Keynesian Economic spending experiment since the New Deal. Government spending is widely considered to be unsustainable and will be curtailed as our stimulus efforts wind down. The Federal Reserve is ending their program to purchase government and mortgage backed-bonds and we are unsure what the economic effect will be. Rising inflation (if gold prices are an indicator) is widely viewed by many as a foregone conclusion. We simply cannot see a scenario where we have high unemployment, low industrial capacity utilization, weakness in the housing market and high inflation. We see the likely scenario as low to no inflation in the short run and hopefully low to moderate inflation in the long run. This assumes a modest economic recovery that will include increased employment.
This is a longwinded way of saying that we acknowledge there are headwinds facing this recovery. We hope that the naysayers will acknowledge that there are fewer headwinds today than 12-18 months ago. When we view all of these data points collectively, we tend to lean towards optimism.
What we’ve seen from the markets more recently is that the specter of 2008 remains very fresh in the minds of investors. As we observed during the September, December and March earnings seasons (when companies give quarterly reports) there has been a clear trend. Earnings have consistently beat the expectations of analysts, but stocks initially fell after earnings were announced, only to rise again in the succeeding months. In other words, investors don't seem comfortable waiting; they are quick to move on to another investment for fear they will be hurt by staying with their current portfolio.
We continue to see attractive opportunities lying in plain sight. Large, diversified companies with high barriers to entry in their respective markets are selling for very attractive prices. When looking just at price/book ratios, various analysts believe stocks have been this cheap only three times in the last 120 years. Even more importantly, when these investments are weighed against the alternative of cash or short-term bonds, it is clearly the rational choice to invest in these types of equities with one caveat – one must have an adequate time horizon to benefit from this strategy.
It is a well known maxim that when it comes to investing in the equity of a business, the price paid and the time horizon are two of the most important factors to consider. Today we think many prices are right. As we mentioned earlier though, many investors are looking for instant gratification; their time horizons are not properly calibrated. So even with the right price, if a boring company announces earnings that aren’t spectacular, investors are prone to sell the stock. We believe that one quarter’s performance, positive or negative, should have very little impact on the price of a business that operates for the long term. We believe in the concept of “time arbitrage,” which means a 3 to 5 year investment horizon is much more successful than a 3 to 5 (day/week/month/quarter) one. This may appear to be an unpopular approach, but it has served our clients quite well over time.
The consensus estimate for the earnings of the S&P 500 in 2010 is $75, a figure that is based on a very weak recovery in GDP of around 2.5%. We think this figure is too conservative. Reviewing 2009, analyst profit estimates were consistently low right through the fourth quarter. In fact, over 53% of S&P 500 companies beat analyst expectations for the fourth quarter of 2009. For 2010, we expect GDP growth between 3.5% and 4.5%, which implies profits north of $80 for the S&P 500, possibly as high as $85. Profits in 2011 could approach $100. Using a price earnings multiple of 16 implies an index level of 1,360, almost 15% higher than current prices. Using a price earnings multiple of 15 on 2011 earnings implies another gain of more than 10% next year. Neither of these earnings multiples is aggressive, particularly if interest rates remain fairly low.
The bond market was mostly positive during the first quarter, as investment inflows are still more heavily weighted toward fixed income securities. The overall taxable fixed income market was up 1.78% for the first three months of 2010. This performance, similar to recent quarters, can be attributed to a strong showing in corporate credits and asset-backed securities. Investors continue to unwind the “flight to quality” trade and turn to asset classes that were most affected by the recession. The laggard in the taxable space was the long U.S. Treasury bond, which turned in a negative .07% return. This may not sound that bad but for the month of March the long Treasury was down 2.57% and the weakness has continued into April.
Overall our strategy has not changed for taxable bond accounts. We have been buyers of “step up” Agency debt, where the coupon adjusts higher over time, as we feel that rates are headed higher for U.S. debt. We have been pleased with the way the market has absorbed the massive supply of US bonds. As we work through the economic issues we outlined above, we believe investors will demand higher yields to continue funding US deficits. Value remains difficult to find in corporate bonds. Spreads (or the premium you receive for owning riskier debt) are as tight as, or tighter, than before the credit crises began.
The securitization market, or the practice of pooling loans, credit card receivables, private mortgages, etc., is showing signs of life, which will be an engine of growth for our economy. We do not see a full securitization market recovery in the short term. The market is realizing though, that underwriting standards have improved greatly and the yield levels have begun attracting buyers. If this market ignites again it could be the fuel for our economy that has been lacking, putting pressure on inflation expectations and thus rates.
The municipal market has performed well, despite the headlines of budget shortfalls for virtually every state. In fact, the market has been so healthy that we are finding little value in the new deals that are coming to market. North Carolina just issued a $487 million General Obligation bond at rates that were very good for state finances. An investor would have to tie up their money until 2027 in order to achieve a 4% rate! Our strategy in the municipal market has also changed very little although it is different than our taxable strategy. We are taking gains in the short end of the curve and reinvesting at more attractive rates in later dated maturities. We are firm believers that the prospect of higher taxes coupled with constrained tax-free issuance (due to the Build America Bond stimulus plan) will create an attractive supply/demand dynamic and keep longer rates low relative to the taxable market.
At the risk of repeating our letters from the last 6 months, we continue to believe the “risk rally” of the last twelve months will lose steam as higher quality stocks pick up the baton in 2010 and 2011. In our portfolios, we have moved from defense to offense as the economy has continued to right itself. We recently had the opportunity to have a one-on-one visit with the management teams of two of our holdings. We came away impressed with the amount of cash on their balance sheets and the pending backlog of new orders. Both management teams stated that one big problem is the uncertainty over legislation coming from Washington concerning the cost of health care and environmental regulations (Cap and Trade), etc. We keep getting the message that the business world is primed for growth, but are cautious and awaiting clarity from Washington so they can plan for the future.
In 2009 the markets surprised us all by going up. It paid to be a long-term investor and to stay patient in the midst of the storm. In 2010 the market may very well upstage conventional wisdom again by staying up. We look forward to it.