Posted by David Tillson 2009 Fourth Quarter
As we now move into a new year and a new decade, we still vividly remember the events that were swirling around us a year ago. Last January’s lull marked only a temporary resting point in the bear market that started October 9th, 2007, and ended March 9th, 2009. The decline in the Dow Jones Average from 14,000 in 2007 to 9,000 in January 2009, had been painful enough, but the additional 2,500 point decline to the March 9th low of 6,500 really put Wall Street and Main Street to the test. But, the recession did not turn into another Great Depression which the equity markets greeted with a huge sigh of relief. While the market’s very strong 68% rise off the low was a welcome, if not barely believable, reprieve, it still left investors 25% below the October 2007 peak. The strong rally was one characterized by the smallest sized, the lowest quality, the lowest priced, and the highest risk companies showing extremely strong performance through the third quarter. This “junk” rally came to an end in the 4th quarter as performance was determined much more by fundamentals and sustainable growth rather than by a simple rebound and price momentum.
We are optimistic for 2010 and have confidence that the market’s more normal behavior that we experienced in the 4th quarter will continue into the coming quarters. We believe that the economy will continue to recover, core inflation will stay low for the foreseeable future, strong corporate profits will lead to surprisingly strong S&P earnings, and that the valuation for the market will remain in the 16-18x range. We expect that stocks will produce a positive return for the year, but that performance may be front-end loaded as stocks could possibly languish in the second half if it appears that economic growth is slowing. Barring any exogenous event such as a major terrorist attack or natural calamity, we do not expect a major decline in the market in 2010. In only six months, investors’ focus will begin to turn to 2011 and beyond, and the events of 2008-09 will become more and more distant. Obviously, much will change between now and 2011, but we believe that the “teens” decade will resemble the 1980’s: a period of difficulties, but a good time to bet on Corporate America and stocks. One major difference however, is that the 1980’s decade was characterized by declining interest rates whereas this decade will likely face rising rates. Given that investors have a newfound appreciation for risk and that bankers are less willing to extend credit to weaker borrowers, we believe that larger, well capitalized companies will have a significant advantage in access to capital, the potential for growth, and ability to increase market share. Companies with large exposures to international markets should do better than average if those economies grow faster than the US, but we are not convinced that the developed international economies will necessarily grow substantially faster. Even without the added growth, with the dollar still very weak, these large multinational companies will benefit from the tailwind of foreign sales being converted into more dollars. Finally, US large cap stocks have severely lagged most all other asset classes during the past 10 years which contrarian investors and believers in reversion-to-the-mean find quite intriguing. If history is any guide, investors will be handsomely rewarded by choosing the out-of-favor, yet still solid, investment.
Interest Rates: The Fed is unlikely to begin to drain excess reserves from the financial system before the economy is on sound footing, and employment will be a primary indicator of economic soundness. With unemployment claims decreasing and company hiring plans for 2010 increasing, the employment picture is showing signs of stabilizing. We believe that it is probable that employment will be strong enough and corporate profits will be sufficiently robust that the Fed could move as early as the third quarter. Some fear that as soon as the Fed begins tightening, the stock market rally will reverse or at least be severely dampened. While rising rates have in the past often reduced the valuation that investors are willing to pay for stocks, under current circumstances, rising rates may send a signal that the economy is stronger than many expected and that the Fed expects growth to continue. What will impact the market, both positively and negatively, is whether the expected “Goldilocks” scenario of a growing economy, rising employment, higher S&P earnings, and a slightly more business friendly administration turn out as wished for. The probability of success in the first three items is fairly high but increased regulation, higher taxes, greater unionization, and reduced labor and economic flexibility make the fourth the wild card. However, if sub-par economic growth occurs over the next few quarters resulting in unemployment remaining stubbornly high, the unacceptable political ramifications of continued bleak employment prospects would probably lead President Obama eventually to a more pro business stance. The Fed will in time raise rates to drain some of the excess reserves from the system. When that happens, we expect that short term rates will rise faster than long term rates and that the rise will not be so substantial that it will choke off the recovery. Inflation is an eventual worry, but should not cause problems over at least the next couple of years. One of the largest risks that we do see today is uncontrollable government spending and the resulting necessity of issuing more and more debt. Most consumers and corporations have learned the lesson that too much debt will ultimately cause unbearable pain. The jury is out whether that lesson has been understood by the government sector, both Federal and state/local. The US cannot run trillion dollar deficits, push more costs onto the states, and fail to recognize the unfunded and even unrecognized liabilities that have already been promised without eventually running out of investors willing to buy our debt. The mid-term elections are looking to be a potential turning point for whether spending in Washington can be controlled. As these elections near, the markets will handicap the results: lower stock prices and higher long term interest rates if it appears that current trends will continue; a better stock market and only somewhat higher long term rates if it appears that spending trends can be slowed. The results of the last Tuesday’s Massachusetts Senatorial election gives us great hope that Washington will finally really begin to focus on this problem.
Dollar: As we mentioned in our third quarter letter, the Real Trade Weighted Dollar Index is very close to a longterm secular low that goes back 50 years. It has reached, but not breached, this level 3 times since the early 1970’s and each time, it has rebounded. Given the 25% surge in real goods exports, we believe that this time will be no different. Our market is too large for other countries to ignore, and the world’s economic health still depends to a large extent on the US. Longer term, if the dollar weakens further, imports will become more expensive and less competitive. Foreign companies will be forced to increase even more their investment in the US, ultimately strengthening our economy and adding jobs, or they will risk losing revenues and market share. In the near term, as foreign investors seek an alternative to the dollar (such as the Euro), it has the effect of weakening the dollar, thereby forcing foreign central banks to buy even more dollars or risk revaluing their own currencies upward making their trade situation much worse. Barton Biggs, author of Wealth, War & Wisdom and formerly the Chief Global Strategist for Morgan Stanley, recently commented that in terms of currencies, people are going to buy another piece of paper, one that is highly liquid, has a call on real assets and earnings power and has a yield. “That currency is called high-quality large-capitalization stocks. They may become a substitute, to some extent, for dollars and currencies.” An interesting thought, and one that would take an investor back to Ben Graham’s beliefs of how to invest successfully. We agree with Barton Biggs’ view because we believe that true long term investing is to be an owner of that company in which you invest. The companies that Mr. Biggs is suggesting as currency substitutes will survive through the bad times, will grow their earnings over the long term, and will eventually be valued appropriately by the market. As Ben Graham said, “Value will out.”
Demographics: This year marks the 53rd birthday of the median baby boomer. The 78 million people in this group have driven the economy and capital markets over the past five decades, and many of us are now in our 60’s. The boomers heavily influenced consumption, housing, and savings/investing trends ever since they came of age in the 1960’s and they are not done yet. The past decade has been a terrible time for many of this group to save and prepare for retirement, and many are realizing that they will have to work longer than they had planned and in jobs that were not what they dreamed of. Behavior will change, if it has not already. Many people who had depended on technology stocks for their retirement ten years ago decided that housing was a better bet. Bonds have not been a large part of many portfolios for over 20 years because growth was fashionable and interest rates were so low. So much perceived wealth has been lost during these past two bubbles that those now nearing retirement will put a much greater emphasis on preservation of what they have rather than growing their assets. Annuities with their guaranteed income for life will become more popular. Spending will be diminished as people are more frugal and are not allowed by financial institutions to borrow as they did in the past. On the one hand, this growing predilection for safe investments, despite their low returns, comes at a very opportune time. Demand for bonds and guaranteed return investment products will likely increase just as the Federal and state governments need to issue huge amounts of debt. But, for those investors who are able to handle the volatility risk, we believe that it will be a very good time to invest in the common stock of US companies.