Posted by David Tillson 2009 Second Quarter
The second quarter finally provided a welcome change from the panic and despair that characterized the preceding six months. March 9th marked at least an interim bottom and very well may have marked the actual bottom of this bear market. When our first quarter comments were written in April, it was still quite unclear whether that rally would end with a retest of the March 9th lows or whether it was something more durable. We are not out of the woods yet, but the news has been generally getting less bad and all the chatter of green shoots has drowned out some of the “end-of-life-as-we-know-it” talk.
The S&P 500 Index gained nearly 16% in the quarter and actually rose 36% from the March 9th low. The rally was kicked off when hedge funds began covering their short positions after the sharp 22% decline that started February 9th. Financial stocks, especially those that had been on the verge of bankruptcy or nationalization, were exceptionally strong with several such as Citigroup, Bank of America, Prudential Financial and Lincoln National showing gains well in excess of 200%. Consumer Discretionary and Materials stocks showed similar gains with companies such as Dow Chemical, Owens-Illinois, JC Penney and Coach more than doubling. Many investors had expected the rally to falter in late April and the market to retest the March 9th low, but talk of green shoots began to grow stronger and acted as a counter to the negative news. Some of the green shoots were simply selected economic indicators getting less negative – not that conditions were actually improving. Others pointed to some surprising positive data points, although if this does turn out to be a very bad recession rather than a depression, those surprising positives were to be expected. Skepticism continued throughout the quarter and the market’s rapid rise slowed in June as it moved into positive territory for the year. Money flows were positive in April and May, but the $30 billion net inflows did little to offset the nearly $300 billion of net outflows in the December 2007 to March 2009 period. While there may have been some tip-toeing back into the market by long term investors, it was very little. This was a rally of speculative buying which can be clearly seen by its characteristics: the battered Financial sector outperformed the aggregate index by 20 percentage points; the smallest stocks outperformed by nearly 27 percentage points; the riskiest (highest beta) stocks by 25 percentage points; and stocks with negative earnings outperformed by 21 percentage points. These characteristics are typical of market bottoms.
The bull case for the US economy rests on 1) the unprecedented amount of stimulus being applied to the global economy, 2) the very positive yield curve, 3) improving credit markets, 4) the unfolding of a huge global inventory cycle, and 5) stabilization of the housing market. This recession is already 19 months long, the longest since the Great Depression of 1929-1933. The amount of stimulus that is and will be applied is staggering and unlike anything that has preceded us. Admittedly, it is unclear whether the stimulus will work and what the unintended consequences will be, but it has given the world some breathing room to work through the deleveraging process. All financial market participants have adjusted their tolerance for risk as evidenced by the very positive yield curve which will translate into higher quality earnings for those companies willing to lend. Lending itself will expand as banks gain confidence that they will be repaid. Inventories worldwide have been slashed to extremely low levels as companies tried to adjust to their sales having fallen off a cliff. As the economy’s decline begins to slow, confidence will grow and inventories will need to be rebuilt. Finally, the housing market will stabilize as inventories are worked down, prices have fallen enough, and as affordability reaches more normal levels. Natural growth in population, formation of new households, and the need to move for job relocation or retirement will all contribute to an eventual rise in housing demand.
While one must have a certain amount of faith to believe the bull case, the bear case can be well articulated by listening to any news report, talking to one’s neighbor, or reading any newspaper. The myriad reasons why the US will remain mired in a weak economy/recession range from continued credit problems, rising unemployment, and a severely weakened consumer to a weak dollar, probable inflation and a government bent on raising taxes and redefining major parts of our economy. We do not intend to innumerate all the negatives because most readers can do so on their own or even add to our list. Our forecast, or rather our most likely scenario, is one of cautious optimism where the recession ends in the next few months, housing stabilizes, stimulus funds continue to flow into the economy, and unemployment peaks by year-end. Challenges certainly remain and for that reason, we believe that the recovery will likely be relatively weak. If it turns out that the stimulus, stronger foreign economies and inventory rebuilding do produce a stronger recovery, it may be short lived because the Fed will be much more inclined to withdraw the stimulus funds more rapidly. Bernanke is a student of the Great Depression and one of the lessons learned from that era is that the Fed should not tighten too soon. Thus, while the Fed will try to get the timing right, it will be very difficult not to either overshoot or undershoot their targets and create either high inflation or a second recession. During past reflationary periods, stocks typically did quite well, which is why we believe that the equity market should perform favorably. Continued deflation, however, will be bad for companies and stocks. We believe that America is entering an era of frugality, where life will be smaller. Part of this frugality is forced, but much will be a welcome relief to many who struggled to participate in the excesses of the past 20 years. It is likely that we are entering a period of smaller homes, cars, paychecks, debts and retirement accounts. We will struggle through this adjustment but will eventually be a much stronger society.
Investing is a business of seeking risk, but once found, of controlling that risk. It is a business of allowing an analytical mind to battle against emotions. Good judgment must be used to determine when the crowd is right and a contrary position is wrong or too early. It is a constant battle between greed and fear. Equity investors are generally optimistic by nature, and while they acknowledge danger, they usually believe that the future will be better than the past. We at Eagle Ridge believe that this recession, while very severe, will end soon. We also believe that the next few years will bring continued change, but with that change will be opportunities. Fear will become complacency, but not greed, as the economy moves into a recovery mode. The chart shows 120 month annualized returns for the S&P 500 Index going back to the 1950 - 1960 period.
The lesson is that it is much better to invest in stocks after a period of very low returns than very high returns. We believe that this is one of those rare periods. We do not know how long the current environment will last, but unless the world is about to be met with yet another catastrophe, then we believe that several years from now we will look back on this period as one of the better times to invest in equities. While investing in stocks felt much better in the 1990’s, it turned out to be a less than ideal choice. Today, we are all a decade older with that much less time to build or rebuild wealth, which is why it feels so much more frightening to accept risk. But, when our society normalizes, even at a lower level, companies and their stocks will handsomely reward long term investors.
Contributors to last quarter’s performance included Teradata, JP Morgan, Bank of America and Halliburton. We added to our small Bank of America position after it became certain that not only would our banking system survive, but that they would be among those survivors. While we have low confidence in any bank’s earnings projection, we do believe that Bank of America is through the worst of this recession and that their equity base will not drop substantially from current levels. Further, we believe that they will be able to earn at least a 12-15% return on that equity which will produce $3-$4 in earnings power within our 4 year projection period. Even using a very conservative valuation estimate makes the stock very attractive from current levels. Teradata, the data warehousing company spun off from NCR a couple of years ago, had been hurt badly in this recession. However, it has reacted very positively to “less bad” economic conditions and the potential for increased M&A activity which could result in its being acquired. Halliburton too had been punished in prior quarters, but their increasing international presence has allowed them to diversify away from North American oil and gas exploration and their earnings results are coming in better than the market’s very pessimistic expectations.
Several companies which had contributed to performance in earlier periods hit the detractors list as the market moved toward rewarding lower quality and higher beta stocks. CR Bard, Wal-Mart and Roche actually declined modestly in the quarter as money moved out of these defensive names into lower quality stocks. Wal-Mart is still in a very strong position, but worries over unionization and overall consumer spending weighed on the stock. Bard and Roche were both impacted by potential political pressure on health care companies as the Administration pushed forward with their revising of our health care system.