2012 Second Quarter

Posted by David Tillson 2012 Second Quarter

After a very strong first quarter, the economy and stock market returned to the pattern experienced in the past two years. It seems as though optimism rises each New Year only to be quashed as spring arrives. This year, investors once again had high hopes of the economy shifting from its shaky footing to a more robust, self sustaining recovery with job creation moving into a rising secular trend. Instead the second quarter showed only 1.9% GDP growth and the monthly non-farm payroll numbers fell back to a 75,000 average from the 250,000 average of the first quarter. The Eurozone’s problems have moved to the front burner again and China’s weakness has only added to investors’ anxiety. America’s political system continues to be nearly dysfunctional and while usually a divided government can be good for the business environment, that is not the case now. The Fiscal Cliff is five months away and this game of chicken is unsettling. Election rhetoric will undoubtedly be highly charged and quite negative which is disquieting. With all of these and other factors on investors’ minds, it is little wonder that the market moved back into a “risk-off” mode. Fear continues to dominate behavior. Demand for safe US Treasury securities has driven interest rates to historic lows. Through the first half of July, investors are on track to pull another $5 billion out of equity funds for the month, bringing the year-to-date amount to -$37 billion, the second biggest outflow next to 2008. Contrarians take note! 

The glass-half-empty picture is quite clear. Less clear is the picture of the glass-half-full, and it is also harder for many to believe. Optimists are watching several indicators of better days ahead. Eventually, all the sellers of stock will have sold and when this occurs, this headwind will turn into a tailwind. Housing, having been in a four year slump, is showing strong signs of stabilization nationally and in certain areas, even growth. The combination of rising rents and very low mortgage rates are having a positive impact on the housing market. Overall bank loan growth has been accelerating which is positive for economic growth. Other indicators that point to optimism for the US are continued low interest rates, the cheap dollar, the manufacturing renaissance, the energy boom, the tech boom, corporate cash balances and US demographics. Despite having strengthened recently, the US dollar is still historically cheap which makes goods manufactured here attractive relative to our trading partners. This, along with much lower wages, is why we are seeing more manufacturing return to the US. Major natural gas finds and improved fracking technology have dramatically changed the outlook for energy supply in the US. Natural gas reserves which were not recoverable years ago now have the ability to turn the US into a major world energy producer. Contrary to many major countries around the world, the US population is still growing which leads to household formations, rising demand for consumer goods, and less stress from an aging/retired population. Finally, low interest rates historically have been used by central banks to spur economic growth. However, since near zero rates have not had the intended effect of spurring growth, the European Central Bank (and possibly the Fed) is discussing the impact of a negative deposit rate for banks. While this would push banks to not hold excess reserves (they would have to pay the ECB), we are not certain of the unintended consequences of such an action since we believe that risk should be taken, not forced. Despite this, having the ability to borrow at ultra-low rates should spur growth eventually. 

What is an investor to do? And what is safe? First, one must decide whether they invest or whether they trade. A trader concentrates on the here-and-now while an investor embraces ownership. A trader is only interested in how much someone will pay for their investment now while an owner is focused on earnings and cash flow, on safety of their company, and on future growth. Whether an owner can sell their company to someone else today is incidental. Next, one must decide what they mean by safe. Lately, safety is being purchased at almost any price. The world is dealing with too much debt and too many promises. One significant difference versus past deleveraging cycles is that today government debts and promises are at the heart of the problem. Debt is a contract, and it is either repaid or it is not. When it is not, it is a default. When governments decide not to repay debt, whether it is Greece or saving General Motors, the default is usually called a restructuring, but the result to the debt holder is the same – principal is lost. Having a safe investment includes not only return of one’s principal, but also the ability to maintain purchasing power. Central banks’ ultra low interest rate policies are destroying purchasing power but bond holders still believe that their principal is safe. We shall see. Lastly, one must decide on the purpose and time frame of their investment portfolio. Clearly, immediate needs should be covered by very safe, very liquid assets. Beyond this and the “sleep-at-night” portion of a portfolio, we believe that assets should be invested as prudently and unemotionally as possible in order to fulfill the reason that people save in the first place: to protect and improve a standard of living for themselves, their family and their community. 

Many in our profession believe that risk equals volatility. If you are a trader, that is true; if you are an owner, it is not. Looking at the S&P 500 price for the past 15 years one can clearly see how volatile the market was. If you stayed fully invested throughout this period, did volatility matter? Not so much, and, in fact, if you opened your statements only about every two to three years, you would have thought that the value of your ownership share stayed flat at 1,200 for the entire time. What you did notice however, was that earnings had more than doubled and your dividends had increased 80%.

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If we apply this same logic to a company, the argument becomes even more compelling. Today, owners of solid businesses with good growth prospects can earn more from dividend payments alone than they can from a safe 10-year US Treasury Bond. As an example, Wal-Mart currently pays a dividend of $1.59 per share resulting in a 2.2% yield at its current price versus 1.4% for the bond. 

And, Wal-Mart has increased its dividend 13% per year for the past 5 years! Its decade-long flat stock price may have been frustrating to a trader, but the owner enjoyed an ever increasing yield. Admittedly, Wal-Mart was somewhat more volatile (but no less safe), but that seems a small price to pay for a superior “coupon” and actual growth in income. 

To answer our question of “What is an investor to do?” - we repeat our mantra of the past few years: have a historical perspective, remove emotion, and trust that our society will successfully weather this storm as we have those of the past. People today are tired; they are weary of what has occurred in the past decade; they are fearful that even worse things may happen. Most everyone now recognizes our problems and they realize that there are no easy solutions. An investor today needs to think logically and realize that, just as in 1999, the rules and lessons of the prior decade may not serve them well going forward. That which we had believed was safe may be risky; that which we believed was risky may be safe. Our advice is to trust that business in general will survive and prosper, if allowed. We believe that owners will continue to share in the profits of their businesses, but creditors may be asked to share in the solution to “we have too much debt” by enduring restructurings and defaults. This deleveraging cycle which is now centered largely on government debt, likely has years to run but this fact should not frighten owners of businesses. As job creators, owners are part of the solution. For investors in common stocks, the next five years should prove to be a very attractive time to be invested – current income is high, valuation is low and earnings are growing.