Bigger Picture

Posted on October 7, 2010 by David Laidlaw

The equity markets experienced a marked change in sentiment over the past quarter.  Coming off its April high of 1217, the S&P 500 plunged 16% to 1022 on July 10th.  Since that date, the S&P 500 has rebounded almost 12% and is now in positive territory again for the calendar year.

Among the positive developments, BP plugged its leaking well in the Gulf and the weaker European economies did not default on their bonds.  Listed stocks also produced strong earnings and guided analysts to expect continued positive cash flows for the remainder of the year.

Focusing on these short-term movements and their convenient rationalizations obscures the bigger picture of where the investor stands.  During the 1980s and 1990s, the stock market, the US economy and our corporations, experienced an unprecedented expansion.  This growth was fueled by a very large well-educated population bulge of baby-boomers who were at the height of their productivity in combination with the innovation that sprung from massively adopted networked computing through the Internet. 

As we know, the equity bubble first burst in early 2000.  Stocks traded at unsustainably high valuations that bore no relation to the cash returns they provided to the investor.  Addicted to growth, consumers (all of us, not some unrelated demographic in a different part of the country), governments and our banking system took on huge amounts of debt to fuel over-consumption and over-investment that was no longer being driven by a larger and increasingly productive labor force.  Much of this debt was supported by over-valued real estate.  This bubble also burst in 2007 and reached a scary crest two years ago. 

Over the past couple of years, the combined markets have been adjusting to restore balance to many of the distortions that evolved over the past two decades.  Real estate prices continue to adjust downward given the oversupply of housing and commercial real estate that developed.  Banks continue to fail as lenders face ongoing write-offs for imprudent loans based on the idea that real estate prices would continue to escalate.  Additionally, global competition is stiffer than ever as large swaths of Asia now have a significant educated class as well as economic systems where capitalism plays a much larger role than in the past.  This competition necessarily pressures US job markets especially in the manufacturing sector.

The recovery from the misallocation of resources that occurred over the prior years will necessarily be uneven with many stops and starts.  It will also take a long period of time since each sector of the economy has to wean itself from an overreliance on debt.  As we have written many times in the past, the public sector debt problems have not been realistically addressed by Federal, State or Local governments throughout the country.  No sustainable bull market is possible for any asset class until there is an honest dialog concerning the taxpayers’ collective liabilities and how to reduce them to a manageable level. 

Given these realities, none of the investors’ options are extremely enticing.  However, there are big differences between the attractiveness of the various investment choices:

US Stocks: Most listed stocks have proven that they are able to produce earnings in a slow growth domestic environment given corporations’ abilities to cut costs and appropriately size their businesses.  US companies are also able to grow overseas in the emerging markets.  Finally, US stocks are attractively valued compared to the cash flows that they are producing.

Foreign Stocks: In the developed markets, many multi-national companies are similarly positioned to multi-national US companies.  Growth prospects in Europe and Japan are limited since their populations are aging rapidly and those countries are in much worse fiscal shape than the US.  However, there are still ample growth opportunities in the developing markets as consumer-oriented economies are growing quickly and a wave of talent is being unleashed.  On the downside, the developing/emerging markets still face weaker investor protections and are much more susceptible to bubbles and over-reliance on exports to the US and Europe.

Bonds: Yields are at historically low rates across the maturity spectrum.  Given low yields, prices are necessarily very high.  Fearful individuals and governments with no other place to invest have driven prices to an unsustainable level.  In the long term, prices have only one way to go and that is down severely. We are keeping credit quality high and durations short so that we are able to roll holdings into higher yielding bonds when rates increase.  We also favor inflation protected bonds.

Cash: Interest rates are so low that cash holdings should be reduced unless liquidity is necessary to cover a pending need.

Real Estate: There are definitely sections of the country where a sufficient correction has occurred that real estate investment may be warranted.  Favorable investment would most likely be found in those Sunbelt markets that have seen the largest price corrections.  However, real estate still has further to fall.  A commentator on Bloomberg cited that in 1970 there were 25 million households with 2 parents and 2 or more children and 35 million houses with 3 or more bedrooms.  Today, there are the same 25 million households with four or more occupants and an incredible 70 million homes with 3 or more bedrooms. 

Gold/Commodities: Gold is at an all-time high so it would be surprising to see stellar returns going forward.  However, gold could continue to outperform since there is a limited supply and a committed group of investors that view it as a hedge against paper currencies.  Oil seems reasonably priced given the level of global growth.  However, any rapid increase will lead to lower future demand as always.

This simple comparison suggests to us that stocks (especially those with exposure to emerging market business) are relatively attractive.  However, the need for governments and households to reduce their debt levels substantially means that future returns will be volatile as growth could easily sputter given the removal of debt over the near term.