2009 First Quarter

Posted by David Tillson 2009 First Quarter

March provided a ray of sunshine to an otherwise miserable beginning of 2009. Performance of the S&P 500 index in both January and February broke new records as the worst declines in each of those months going back to 1934. This follows June, 2008, as the third record breaking month within the past year. Only one other 12-month period since the end of 1933 has the distinction of having more than one month as a record decline, that being September, 1937, and March, 1938. During the 1930’s the stock market experienced many rallies only to be followed by further declines. We ask ourselves daily if we are in the midst of a strong bear market rally, or, is this the beginning of something more durable and lasting. The vast majority of investors believe that it is the former and currently, we don’t disagree. Deflation is a terribly difficult thing to reverse. It is based on emotion as well as fundamentals and people begin to believe that they will be better off by waiting and doing nothing which translates to: rent rather than buy; save rather than invest; do without rather than replace. This change of behavior is powerful and can be very long lasting. US consumers may finally have met their match and it will take another couple of generations before spending with abandon again takes hold.

It is easy to be bearish and as a colleague once said to us, being bearish and pointing out all of the potential problems that the market may encounter makes one sound very smart. While the bears are wrong most of the time, in periods such as this, having been right can make one’s career. Behavioral economics studies have shown that an individual’s fear of loss is about twice as strong as their desire for gain. The realization of loss is very painful and not easily forgotten. However, investing at its most basic level is to buy low and sell high. The problem, aside from knowing when a stock is low or high, is that it feels much better and safer to invest when the markets seem stable and strong and few problems are on the horizon. The bears are ignored and eventually retreat to hibernate. Money flows into the attractive asset classes and investors rest assured that they will have a safe and prosperous future. Since at least the 1920’s the stock market has compounded at approximately 10% annually. If one were to have stayed fully invested throughout the last 85 years, a $1,000 investment in 1925 would have grown with dividends reinvested to more than $2,000,000 by December 2008. However, studies have shown that the vast majority of investors do not stay fully invested through market cycles. They typically invest heavily in rising markets and sell in bear markets, which causes their actual realized return to be closer to half the index (or fully invested) performance. The effect on wealth creation is dramatic – that $2,000,000 would be only $90,000 if the investment compounded at 5.5%.

Clearly, investing in an environment such as today takes a strong stomach and confidence that the economies around the world will eventually regain their footing. The news about the economy and the financial markets is still very negative and there are few signs that it will end soon. We are unwinding 15 years of ever-increasing consumer spending, rising debt, taking on more and more risk without a commensurate premium, and blind acceptance that promises can be made as long as delivery on those promises lies far enough into the future. The return to more fiscally conservative times is fraught with dangers and uncertainty, and the road will undoubtedly be bumpy. While there is little doubt that the economy is not still collapsing, it has not yet bottomed either. We have worked through the post Lehman collapse and its aftershocks of freezing of credit, plummeting consumer spending and slashing of inventories. The worst is behind us, but the future – geopolitically, financially, and economically, is still very uncertain.

It is as difficult today to see how the fundamentals in our economy will ultimately produce sustained growth in GDP as it was two years ago to foresee the utter collapse in our economy that we are now experiencing. When the market hits bottom is anybody’s guess and only time will tell if March 9th was it. The 25% rally off the bottom was very welcome by investors, but given that the market had declined 57% since the October 10, 2007, peak, we will need another 85% rally from here to set a new high. Given the daunting challenges yet ahead, that level is likely several years ahead of us. The market will not move in a straight line however, and the largest gains will occur very quickly when news moves from being very negative to just “not-so-negative.” Those who have waited for evidence that we are on more solid ground will likely miss these gains before recommitting to the market. Despite this, we do not intend to suggest that all longterm equity investors should be fully invested all the time: that is an individual asset allocation / risk tolerance decision. The comment is an observation that plays into our analysis of behavior of investors and stocks which then helps us determine valuation and timing of purchases and sales. The chart uses month end prices only and thus under-measures both the actual peak-to-trough percent decline and the later gains, but is still an enlightening picture of investor behavior. As can be seen, once a trough was finally reached, the bulk of the first year’s gains were captured in the first six months. 


Just as crocuses are harbingers of warmer times, there have been some signs that better times are ahead. The media has been focusing on the terrible employment numbers, foreclosures, AIG bonuses, bankruptcies, and toxic loans. It is impossible to argue that these are not important, but in some cases, they are lagging indicators. We acknowledge that the financial system and credit markets are still far from normal and that employment is still plunging. Commercial real estate is just starting its decline. And finally, government’s intrusion into the private sector along with some of the policy initiatives being discussed, are not positive for equity valuations. On the positive side, or maybe just the “less negative” side, there are signs that economies and markets will begin to stabilize in the not too distant future. The worldwide reaction to providing liquidity to the system will eventually kick in. Contrarians note that 85% of investors believe that we are still in a bear market. China appears to have stabilized and possibly turned up. Several factors which should continue to help stabilize the economy and ultimately be an engine for growth include low mortgage rates and increased refinancing activity, growth in the money supply, very low prices for homes and autos, a positively sloped yield curve, low energy prices and low inventory levels. Furthermore, total money market funds reached a record high on March 9th of $3.6 trillion and should be a future source of demand for US equities once individual and institutional investors eventually reenter the market. To put the $3.6 trillion in perspective, it was nearly 53% of the total market value of the Wilshire 5000, which compared with the next highest peak level of 28% on October 7, 2002.

We are generally feeling more positive about the prospects for the market for the remainder of the year but despite having a positive view, we do also endeavor to remain intellectually flexible. Our investment process and discipline has been able to withstand the test of time, but we are always open to new information and question whether our discipline needs to be tweaked. We believe strongly in fundamental analysis and the ability to project a company’s potential earnings power years into the future when conditions normalize. We also believe strongly in investors’ behavior continuing to be as erratic as it has been throughout history. Lord Keynes observed that few investors were really concerned with a stock’s worth but, merely with what others thought would be the change in its perceived value: “They are concerned, not with what an investment is really worth to a man who buys it for keeps. But with what the market will value it at, under the influence of mass psychology, three months or a year hence.” During the Great Depression, Keynes was able to increase his net worth by 65 times. …good advice!

The portfolio’s 1st quarter contributors included companies primarily in the Consumer Discretionary and Technology sectors. Kohl’s was a very strong performer, benefitting from less competition as bankruptcies mount, good operating controls and inventory management, and from consumers trading down to companies such as Kohl’s. Home Depot, although not in the top five, was a strong contributor for some of the same reasons. Teradata and Intel both performed well in anticipation of an ultimate rebound in economic activity. The detractors to performance were either companies whose stock prices had held up relatively well in prior quarters or which were tied to the financial sector