Posted by David Tillson 2008 Fourth Quarter
It seems that about the only positive statement that one can say about 2008 is that it is over! 2008 returns in the equity market were devastating, with the S&P 500 Index recording a -37% total return, the NASDAQ 100 down -42%, and the S&P Financial Index losing well over half of its value. Our portfolios generally outperformed the S&P 500 Index by approximately 750 to 850 basis points. Normally we would be very pleased with this relative outperformance, but we too did not escape all of the damage. Long term US Treasury bonds, on the other hand, returned a positive 30% for the year, with 25% in the last quarter alone. In early 2008, the Fed was still concerned about inflationary forces and tried to control the growth in the money supply. At that time, few investors would have imagined that 30-year Treasury bond yields would eventually fall to just 2.7% while the Fed was creating money at its current frantic pace. Under Milton Friedman’s monetarist economic theory which the US has generally followed during the past 30 years, higher inflation will eventually follow the rate of growth of the money supply. Since long-term bond rates usually forecast future inflation, it is curious that they are so low, and while these rates may yet rise sharply, at the present time fear of loss of principal trumps fear of loss of purchasing power.
We are now undeniably in the midst of one of the most severe recessions that we have experienced in the post war period. Recessions used to occur every four to five years and were viewed as a normal purging process which kept the economy in balance. The US experienced 9 recessions during the 38 years between 1945 and 1982. The average recession lasted 10 months and the two worst lasted 16 months. Our current one is only the third since 1982 and the prior two, 1990 and 2001, lasted only 8 months each. In hindsight, it should not have been such a surprise that this one would be so devastating. But, it has been a surprise, and it has not been limited to the US. Adults today under the age of 40 have essentially no experience with bad, recurring recessions and those over 40 most likely do not remember the lessons that recessions can teach. Wall Street’s greed and excessive leverage are being blamed for our current circumstances, but historians will undoubtedly paint a much more complicated picture when the history books and business school cases are written years from now. Greed has now soundly turned to fear, and many people’s plans for a relaxed, secure future have been turned upside down. Some investor’s now have such a heightened aversion to risk that only US Treasury securities or gold will suffice as a store of value. Trust in individuals and institutions has been weakened and since this downturn was so rapid and severe, people’s confidence in experts’ judgment and opinions has been severely shaken. Furthermore, while it is clear to nearly everyone that a huge amount of government help is needed by many sectors, there is a significant portion of the population who are upset and angry that this must occur. Those who managed their lives and finances responsibly and are now being told that they must pay to save the irresponsible ones, are justifiably angry. The lies and frauds that are now coming to light only add to this frustration and anger. It is very unlikely that this generation will return to the profligate ways of the 1990’s and 2000’s. Savings and not overspending will likely be back in vogue, and risk will again mean “loss of principal” rather than “higher returns.”
The negatives facing the financial markets abound, and range from our economy drowning in debt, rising unemployment, and a worldwide recession, to deflation, excess capacity, and huge state and local budget deficits. These problems are widely known and we may face others before any recovery takes hold. But, for every problem, there is a solution which creates an opportunity. Emotion is a key part of the financial markets, especially the equity market, and as Dustin Hoffman said recently “the stock market is a drama queen.” While a wildly emotional drama queen it may be, it has also been a fairly good forecaster of the future. Not that there are many positives that the market has been forecasting recently, but one can look at some of the data with an eye toward “the glass half full” and believe that “this too shall pass.” Eventually, today’s negatives will turn positive. Unemployment may in fact rise to 9-10% by summer, but this still means that 90% of the people are employed. Consumer debt has risen to 100% of GDP from only 50% in 1980 primarily as a result of the buildup in mortgage debt, but as the mortgage and credit card write-offs continue to mount, this ratio will decline to more normal levels. Plummeting housing prices have hurt some people, but prices and mortgage rates are falling to levels where housing affordability will be at a record high. The worldwide recession has slowed consumption tremendously, but this reduction of demand has led to sharply lower consumer prices. Gasoline prices alone have dropped below $2 per gallon from $4 last July which has the effect of a massive tax cut. As people eventually begin to focus on the possibility of a recovery, the panic of potential loss will subside and calmer emotions will take hold.
The stock market has been relatively flat for the past six weeks despite the large amount of poor economic news. In fact, some of the largest rallies were on days with the worst economic news releases. One could conclude that either all the bad news has been priced in, the market is being driven by technical or seasonal factors, or that for every bad economic data point, there is added pressure on the Obama economic team to do even more than they had planned. Market sentiment is that there will be a recovery in the second half of 2009. Only time will tell if this is too early, but at some point, the market will strengthen before any clear recovery signs are evident. One of the best indicators of future economic performance has been the slope of the yield curve. The differential between 10-year Treasury Notes and 91-day Bills reached 360 basis points last October which was the highest level since May 2004. Only three other times since 1952 has the yield curve been steeper: October 1992, June 1984, and August 1982. Another future positive is that so much wealth has been lost in the housing and stock markets that people will need to save more for their future. This increased savings will be invested with the ultimate beneficiaries being the stock and bond markets.
We believe that the US is more than halfway through this recession and that the massive government response will eventually take hold. We do not believe that the government has all the answers to the problems and, in fact, we expect that a great deal of money will be wasted along the way. But, the government must restore confidence in our institutions to allow the private sector to stabilize and begin its return to normalcy. We are most probably witnessing less of a bad, but normal cycle, and more of a complete resetting of expectations and behavior. Peoples’ beliefs, attitudes, and ideas of investment risk and return are being substantially reshaped for probably the next two generations.
Fourth quarter performance was driven by emotion – fear, stories, margin calls, and selling to meet mutual fund redemptions rather than fundamentals. Our portfolios’ largest contributors to performance were Exxon Mobil, AT&T, Raytheon, WW Grainger, and Home Depot. Exxon and AT&T, actually up for the quarter, were viewed as relatively stable safe havens. Raytheon benefited from the fact that their revenues are driven primarily by government contracts rather than commercial and industrial sales. Grainger, a late cycle company, showed relatively strong results due to a moderately positive outlook. Home Depot restructured enough over the past 18 months so that its profitability is now more closely matching investors’ reduced expectations. The quarter’s largest detractors, not surprisingly, were financials. Lincoln National, JPMorgan Chase, and Citigroup were all hurt by the nearly complete meltdown of the banking sector. Halliburton declined -45% over worries that plunging oil and gas prices would curtail drilling activity in North America and impact other projects in the Middle East. Medtronic fell by over a third on news that the Department of Justice was investigating the company’s marketing activities for potential off-label use of their Infuse morphogenic bone graft product. No new names were added during the quarter as we continued to reduce the number of names, including several financials and Coach, in the portfolio to the 30-35 range.
Our portfolios have been positioned with a defensive bias for the past six months,. This has served us well as stock selection and an elevated cash allocation allowed our portfolios to outperform the general market indices. Our challenge is to be able to maintain this spread when the market eventually recovers. We believe that 2009 will be a difficult, volatile year but equity performance will be positive. Our strategy is to gradually move away from our defensive tilt as we gain more confidence in our estimates of companies’ normalized earnings. We have always calculated normalized earnings estimates conservatively, but are now taking an especially sharp knife to our projections of profit margins, revenues, and growth. By continuing to rely on our investment process, we were able to navigate a very difficult year and provide a measure of protection to our portfolios. We firmly believe that our continuing reliance on our discipline will serve us well in the coming quarters.