After exceptional lows in March, markets rallied in the second quarter. While the advance was broad-based, the groups that suffered most in the decline bounced most. Banks and materials led the charge higher with each sector enjoying returns of over 100%! Investor sentiment improved, and other economic indicators declined at a more moderate pace. “Green shoots” was the buzz phrase in the press, and determined optimists began to hunt for whatever data they could find to construct a sustainable, positive argument. Steven Goldberg wrote an interesting book a few years back called When Wish Replaces Thought. In it he criticizes advanced education for abandoning the honest, open Socratic dialogue which catechizes students using open-ended questions to discern a conclusion. In its place, Goldberg suggests that modern educators begin with a conclusion they find philosophically appealing and construct supporting logic.
A 15.9% return for the S&P 500 would be a great year, so it was certainly an outstanding quarter. After reaching a sub-670 level on the S&P 500 in early March, investors wondered if stocks could possibly recover and even if capitalism and corporate America might be doomed. What a difference 90 days can make! While the increase in share prices brings relief to frazzled nerves and diminished accounts, there has been scant evidence of sustainable earnings increases.
Perhaps the March decline was overdone (as most major swings are), but this rally’s foundation is more emotional than empirical. A simple measure of share price is a multiple of earnings: a share of stock trading at $14 with $1 per share in earnings has a multiple of 14. When share prices increase, either the earnings or the multiple is increasing (or both). The recent rally from March lows was based on a 6 point increase in the multiple and not an increase in the earnings.
As choruses of insistent, happy voices declare that the worst is over, it seems as if the higher share prices resulting from exuberant multiple expansion have fully discounted a very positive recovery scenario. A multiple-driven price increase always creates a vacuum. These vacuums are resolved when either the multiples contract or earnings increase and “catch up.” Our analysis of the broad market suggests that it will take longer than the consensus expects for earnings to merit the current rate of increase in the average share price of index members. Stock selection is critical in this environment, and our fundamental, dogged analysis has never been more important.
Don’t Worry. Be Happy.
“In every life, you have some trouble. When you worry, you make it double. Don’t worry. Be happy.” Bobby McFerrin would not make it as an investment advisor. But, you feel better, don’t you? Remember how you felt in March? This feels better, right? Why? You feel better because prices are up, and your brokerage statement has a larger balance. The 24-hour business TV crisis has passed (much to the chagrin of business TV executives). It’s sunny and warm, and “the livin’ is easy.” “Experts” have scripted an economic recovery for the third quarter and year-end. That feels good, and all heads are blithely bobbing.
At lunch last week with Jim Bullard, president of the Federal Reserve Bank of St. Louis, the topic was “exit strategies.” Jim was suggesting plans to gently wind down the current, unprecedented levels of stimulus and recently-established liquidity programs. The size of the monetary base has doubled in the last two years. Economists cannot envision how this scale of increase will not transform into inflation at some point. But, there is another side to this story.
Household net worth has fallen by more than $14 trillion dollars over the past two years; that amount is larger than the entire US Gross Domestic Product (GDP). De-leveraging investment banks have also removed something over $2 trillion from the asset base. The dilemma for market participants is attempting to parse the tea leaves of unprecedented increases in the monetary base versus unprecedented decreases in the asset base. There is a tug-of-war to be sure, but which side will prevail? Those focused on the monetary base suggest troubling levels of inflation in the not-too-distant future, while those following asset trends fear a deflationary spiral. Deflation is upon us: housing prices and the prices of other hard assets have fallen. Basic materials have enjoyed a rebound, but will it last?
The inflation or deflation assessment may be the most critical macroeconomic judgment of the Obama administration’s tenure. June’s unemployment rate was 9.5%. We believe that that number will easily exceed 10% and perhaps 11%. Insecure employees spend less, and they don’t borrow to spend. This suggests that the consumer, who still represents the lion’s share of GDP, will not be increasing their share of the economic pie. Jobs and homes represent Joe Six-pack’s two largest assets, and the first is fragile and the second is falling. Joe is not happy. Our conclusion is that while recoveries will occur in share prices and in the US Economy, both will take longer than current analysis suggests and much longer than current sentiment demands. If we have the luxury of choosing, inflation seems preferable when one studies Japan. They have been unable to break free of their deflationary collapse, and they have been adding stimulus for almost 20 years.
The inflation or deflation outcomes are each problematic for investors. White House Economic Advisor Larry Summers uses a refrigerator analogy to explain this paradox. Given a choice between a simple, energy efficient, inexpensive refrigerator and a water-through-the-door, fancy, top-of-the line model, consumers will choose one or the other based on what you tell them about their job security and direction for the economy. He points out that consumers typically make the right decisions about these sorts of things. However, if you tell the consumer that both job status and the economy will change dramatically a year from now, but you can’t tell in which direction, no refrigerator will be purchased. This parable applies to investors too as evidenced by the huge amounts of cash on the sidelines. As people become more persuaded by the inflation forecast, money is moving into hard assets like gold and rate sensitive assets like Treasury Inflation-Protected Securities (TIPS).
Investing in growing companies with experienced managers and solid balance sheets is the only sensible investment approach. Trying to guess and trade the volatility will eventually catch you without a chair when the music unexpectedly stops. Whether inflation or deflation becomes our destiny, a carefully selected and scrutinized portfolio of solid, global corporations provides the best foundation we can imagine. C.S. Lewis said that certain major decisions would be eternally enjoyed or endured. While we decline the burdens of eternity, the reality of clear consequence for every decision we make is always at hand. Near-term consequence may be pleasant or unpleasant, but long-term consequence is supremely important. We are pleased with the way our clients’ portfolios have endured and enjoyed but in no way believe that the all-clear has sounded. Rest assured that our approach is ever rife with caution.
Nancy Wentzler is Chief Economist for the Office of the Comptroller of the Currency and one of the smartest human beings we know. She is a good friend and is most concerned about “policy risk.” Policy Risk may be loosely defined as whatever may come out of the government next. This letter has addressed the doubling of the monetary base. There has been additional fiscal stimulus, and we fear there will be a good deal more of each. The Obama Administration is tackling issue after issue with blinding speed and determination. The deficit is increasing at record pace as is the National Debt. Healthcare is the current new program that will come with a price tag over $1 trillion. As new banking regulations are enacted and capital requirements adjusted, Nancy looked up from a recent lunch and asked “Where are they leading us? What are the goals?” Many are hollering “follow me,” but they don’t tell us where. Oddly enough, we follow anyway.
Nancy wonders about government’s desired outcome. How many banks will be left standing? How will their efforts be coordinated and regulated to prevent those things that led to the current collapse? What sort of consequences have already been created by various recent policy decisions that may not become evident for years, and when they do, will it be too late?
Most reasonable strategies come in two parts: this is where we’re going, and this is how. The current administration, for all that it has done (and a lot of it seemingly quite good), has failed to articulate the “where.” Our worry is that if they told us where we were being led, we might not want to go.
We don’t actually know what the market will do going forward. We believe that our guesses on this topic are educated to be sure. Farr Miller & Washington’s investment team is experienced, thoughtful, and skilled. However, we are smart enough to know that we do not (and no one else does either) know for sure where the market is headed. After all, if Warren Buffett professes not to know where the economy is headed, how could we possibly say otherwise? If we start with this basic assumption, which is that we can’t forecast the future with much accuracy consistently over long periods of time, then it would be irresponsible to set up client portfolios to adhere to our potentially faulty macro forecasts. Instead, we take the view that we don’t know what will happen and, given that we don’t know, which companies are we most comfortable owning over the next five years? The companies that we are most comfortable owning typically have the following characteristics: 1) a long track record of growing EPS faster, and in a more stable fashion, than the overall market, 2) great balance sheets, 3) high free cash flow generation, 4) high returns on capital, and 5) great management. If we buy 30-40 companies with these characteristics across a variety of industries at reasonable valuations, then we should have a reasonable chance of generating returns in excess of the S&P500 over long periods of time. This has been the case since the firm’s inception in 1996, and we obviously hope that this track record (e.g. we are ahead of the S&P 500 over the 1-yr, 3-yr, 5-yr, 7-yr, 10-yr, and 12-yr periods) will continue going forward.
We continue to stick to our discipline. We buy companies that we believe are attractive long-term investments, and we sell companies that we believe offer our clients sub-par long-term returns. Our cash levels have built up a little in the past two months as we’ve found more companies to sell than to buy after such a sharp recovery in the market. Cash is a residual of these buy and sell decisions. Our client portfolios have recently become even more conservative after this recent 40% run-up. This has not been a conscious, top-down decision. Instead, our individual stock picks have left the portfolio more conservative because the riskiest names have bounced the hardest over the past 3 months and have thus become less attractive while the safest stocks have not participated.
Hang in there,