In this commentary I will explain why I’m cautious; how I could be wrong; what’s at stake for me and my clients; and how we’re invested.
March 9, 2009 marked the low on the S&P 500. Since then the index is up over 70%, and economic data are improving. So we’re out of trouble, right? The crisis has past? I don’t think we’re out of trouble. The worst is likely behind us, but an “all clear” seems premature in spite of how often we hear it being sounded.
Economic data are improving. Reports show a leveling in housing prices and unemployment claims. Industrial production has picked up meaningfully. Retail sales have shown signs of life, and the most recent reading of consumer credit was actually positive for the first time in a year. Merger and acquisition activity and inventories are rising. The yield curve is steep (a condition favorable for banks and a sign of recovery) Interest rates remain near historic lows, and there are no immediate signs of inflation. This is what an economic recovery looks like. This is what a Bull looks like, but it tastes kind of funny to me. It looks like beef, but I’m thinking soy substitute.
Consumer debt levels remain very high after trillions in lost wealth from the housing and stock markets. That means that many consumers are ill-prepared for retirement while still facing significant monthly interest payments. The need to rebuild nest eggs and pay down debt will continue to weigh on spending. At the same time, a lot of those consumers are out of work. Consumers with lots of debt and no job are ill-prepared to buy a house or much of anything else. With the pool of home buyers impaired (read demand), there is no upward pressure on housing prices. Housing prices are being artificially supported by mortgage remediation plans (to keep folks in their homes), homebuyer tax credits from the government, and very low interest rates. About 25% of all mortgages in the United States are for amounts that exceed the value of the mortgaged property. This means that you might have a $300,000 mortgage on a house that you can’t sell for $250,000. 25% of ALL mortgages in the US fall into this category. I believe home prices, as measured by the S&P Case-Schiller indices, will go lower.
Commercial real estate is in trouble too, but the troubles are not yet center stage. It is not in the economy’s interest to focus on them, so regulators have allowed the banks to cook the books to keep this issue off the radar screen. The additional weakness that a mark-to-market would cause the banks is potentially devastating. But allowing the banks to defer recognition of these losses sounds a lot like Japan to me.
Additional risk stems from the deplorable fiscal condition of governments across the globe. Sovereign debt from developed countries was once considered rock solid, but is now in question. Germany may have to cover Greece’s debt to protect the Euro and so that its own holdings of Greek bonds don’t plummet and undermine Germany’s own debt rating. Italy, Ireland, Portugal and Spain could be next. And many US states are in similarly precarious financial condition. Were it not for the support of the US government, many states might be scrambling to avoid default at this point. At the very least, the soaring deficits across the globe will be a drag on growth for years to come. At worst, we could experience another debt crisis.
The big question for the US government is when and how to remove its financial support from the economy. Chairman Bernanke told Congress in recent testimony that ‘the economic recovery is not yet self-sustaining.’ Sustenance is being provided by government, and that sustenance is cash. The Fed says that several asset purchase plans that it established over the past eighteen months will be allowed to expire this spring. The expiration of these purchase plans will coincide with the expiration of tax credits for home purchases. The famous Bush tax-cuts are set to expire this summer, and income tax rates will likely go still higher in the future to fund the government’s excessive spending. The cost of healthcare to businesses is expected to rise, and capital gains taxes are expected to rise as well. Higher taxes to cover the economic rescue and unrelated policy initiatives (read: healthcare) will weigh on growth for some time to come.
Following the Crash of 1929 and the Great Depression that followed, stimulus was added. Stimulus drove the economic data and stock prices higher. Believing that the strength was real and ‘self-sustaining’, and fearing inflation should monetary policy remain too loose for too long, the Federal Reserve tightened. They proved premature, and both the economy and share prices swooned for several years to follow.
I believe that we are in a similar post-crash recovery, driven by stimulus programs and quantitative easing. I think that we are witnessing a cliff-hanger mystery as monetary and fiscal officials attempt to judge and orchestrate a delicate ballet between “just enough” and “not too much.” Time will tell if they get it right. There is a LOT at stake, and it is way too soon to sound an “all clear.” But one thing is clear: the longer will remain dependent on government cash, the greater the drag on economic growth in the years to come.
Now you know why I’m cautious. It should also be pretty obvious how I could be wrong. If there is some real organic substance to this recovery that extends past the government’s infusion of trillions of dollars, I will have missed it. My cautious posture in our portfolio will lag a highly charged, momentum-filled recovery. We are positioned to make money in that we remain fully invested, but our cautious posture will keep us from the front of the pack. I’m comfortable with that as are our clients. Our caution has wrought great benefits in recent years and since the inception of our firm. We manage real people’s real money. We have never been sanguine with the prospect of underperforming in any market cycle, but if need be we would rather apologize for a lack of investment risk than for too much.
Farr, Miller & Washington has a clear investment discipline. It is driven by fundamentals such as earnings growth, debt ratios, returns on equity, and cash flow. Our portfolio emerges from lots of dogged, ongoing research. Portfolio concentrations are in healthcare, technology, consumer staples, and industrials. We are under-weight in highly cyclical areas such as banks and financials, real estate, commodities, and transportation stocks.
Multi-national blue-chip companies make up the preponderance of our holdings. The valuation metrics for our average holdings do not seem excessive. Balance sheets are solid, managements are experienced, and earning opportunities are ample. In a slower recovery or downturn, these companies should do best. In an off-to-the-races, meteoric, momentum-driven rise, they will appreciate but may lag.
The past few years and indeed the twenty-plus years of my career have taught me some painful and hard-won lessons. One of the most important things I’ve learned is how important it is to protect principal. Watching percentage gains and losses is important, but watching the balance is supreme. A strong percentage rally following a steep decline may feel good, but it may also provide a lower account balance than a more modest rally from a more modest decline. Limit your declines. Access opportunity, but limit decline.
Having said all this, I would be remiss to not toot my own horn a bit. Following out-performance versus the S&P 500 in 2008 gross and net of fees, the Farr, Miller & Washington Large-Cap Equity Composite had a solid 2009, and we are slightly ahead of the index through February 5, 2010. Please email us for our audited historical performance report. The formula of limiting losses in down markets and keeping up in strong markets has worked for us.
Investors are essentially optimists: they expect things to be better in the future. I believe things will be better in the future, but this current Bull tastes a little too much like chicken.
Hang in there,