Posted by David Tillson 2009 Third Quarter
The third quarter saw a continuation of the equity rally and by September 30th, the S&P 500 Index was up 56% from the March 9th low. In the past 20 years, only two other quarters (both during the tech bubble) had higher returns than this and last quarter’s nearly 16% returns. Decimated Financial stocks had the sharpest rebound and were followed closely by similarly devastated Industrial and Consumer Discretionary stocks. Small and mid-cap stocks outperformed large caps and value beat growth. In general, investors’ appetite for risk returned. This was well reflected in the stark differences in underlying fundamentals between those companies that led and those that lagged. Companies in relatively poorer financial health, having low profit margins and heavy debt loads, were among the top performing issues. They were joined by stocks priced under $5 per share, those with the highest betas (a measure of volatility), those with negative earnings, and those not paying a dividend. Investors who months earlier had hoarded cash at zero percent interest sought higher returns in the shares of previously battered companies. Many have questioned how the market could rise so strongly in such a short time given that there was little foreseeable improvement in the economy. The short answer is that the panic faded as the survival of the banking system became assured. Enough time had passed that emotional decisions made in haste could be rethought. Speculators were willing to buy based on little more than the momentum of things getting “less worse.” Just as the market had overshot on the upside in the late 1990’s and 2007, it overshot on the downside this year.
Economics is the social science that studies the production and consumption of goods and services, looking at human behavior as a relationship between wants and needs, and scarce resources. Behavioral economics has recently evolved as a separate branch of economics to better understand how human, social, and emotional factors affect economic decisions, market prices, and the allocation of resources. It is behavioral economics which best describes the reasons for the meltdown in late 2008/early 2009 and the subsequent melt-up following March 9th. Having a strong appreciation for both disciplines is critical for successful investing over the long term. One may dominate the other at times, but both disciplines are always working to drive the markets. As we noted in our April 2009 letter, Lord Keynes understood behavioral economics well before it was recognized. He 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.” We have used several charts in past letters to illustrate some of the influences of emotion on the markets. This chart was first shown in April to illustrate what historically has happened 6 and 12 months after a market trough.
We believe that this is yet another indication that this recession probably has much more in common with past economic conditions than was earlier feared. It is very telling that the 32% six month gain was very much in line with past recoveries. Our expectation is that history will repeat and that the market will rise further, but by a lesser amount, by March 2010.
Since March, we have seen some movement toward relying once again on the science of investing as analysts study economic and company data to divine the future. However, many investors no longer believe that the old metrics and relationships are still valid. Others believe that they are valid, but choose to use the 1930’s as their benchmark. Today, pessimists and skeptics are quite vocal because it is easy to clearly articulate all the problems with no solutions that we now face. Optimists are silent because they will certainly face disbelief and possibly even ridicule. This is the opposite of what we saw in the late stages of the tech and housing bubbles when skeptics were ridiculed. The pendulum has swung! Emotion, and thus the understanding of behavioral economics, continues to maintain its strong grip on the markets.
The 1980’s was a period comparable to today in terms of misery, fear and hopelessness. For those of us who are old enough to remember, it was a difficult time, but we were 30 years younger with much more time ahead of us to create wealth. We are now at a stage where recreating lost wealth is much, much more difficult. The 1980’s had stubbornly high interest rates, rolling recessions, and the phrase “Rust Belt” describing the wasteland that was the Midwest. Our auto, steel and electronics industries were being overtaken by Japan. By the end of the decade real estate markets were hemorrhaging and unsafe mortgage lending practices led to the S&L crisis. Resolution Trust Company (the TARP fund of its day) was formed to deal with the hundreds of bank and S&L failures. America’s preeminent position in the world was being questioned as the value of the dollar plummeted. The Real TradeWeighted Exchange Rate Index fell from a high of 130 in early 1984 to 80 by the end of the decade, where it remained until 1996. Interestingly, after rising to 110 in 2002, the index has now fallen back to that 80 level. We believe that the 1980’s is the better comparison to today versus the 1930’s, but we are still concerned that like the late 1930’s, meaningfully higher tax rates, protectionist measures such as the recent tariffs on imported Chinese tires, and a much stricter regulatory environment run the risk of derailing the recovery as they did in 1937-38.
Unemployment and consumer spending are still of major concern. Unemployment at 9.7% in August is expected to exceed 10% in the next few months, higher than the 9.0% peak reached after the 1973-74 recession and close to the 10.8% peak reached after the double dip recessions of 1981-82. Historically, the peak in unemployment marked the end of a recession and if this relationship still holds, either this recession has not yet ended or unemployment has already peaked. Many economists believe that the recession did end in July or August. Some also believe that businesses cut their workforce too deeply and that some rehiring is about to occur, giving credence to the continued validity of this relationship. While this would be good news, it will not signal an end to the high unemployment rate. Consumers will still be in a non-spending mode which may impede large scale hiring and strong GDP growth since conventional wisdom suggests that consumer spending is 70% of GDP. However, this may overstate the importance of the consumer since personal consumption expenditures includes both goods such as consumer electronics which mainly stimulates foreign production and imputed services such as rent that you theoretically pay yourself to live in your own home but does not represent a cash outlay. All told, consumers’ “out-of-pocket” spending drives roughly 40% of the economy, still large, but possibly a smaller impact than many fear. We do not underestimate the gravity of today’s myriad problems, but despite potentially many set-backs and much anguish, we believe that they will be overcome. Our potential budget deficits are alarming but hopefully, some sanity will return to Washington. Our system of government is messy at times, but it has generally served us well for 240 years.
Finally, the S&P 500 Index’s price trend since the 1920’s shows its fluctuating, yet steady rise through good and bad times. Like the past 12 years, we have experienced similar periods in the 1930’s and 1970’s when investors turned from nearly total optimism and greed to general pessimism and fear over a 10 to 15 year time span.
These moves seem to have happened roughly 30 years apart, enough time for our children’s children to repeat our mistakes and create the next bubble with its subsequent bursting. We believe that history will show that this is one of those times when a base is being built and that the market, and the economy, will begin to rise again. The memories of the past 10 years will remain fresh for some time, so the rise will probably be muted and controlled. Just as the memories of only gains in the 1990’s led to a massive surprise of the magnitude of losses in the 2000’s, we suspect that unexpected gains in the next decade could surprise us as well.
Despite our giving back some of last year’s relative outperformance, we remain completely confident in our investment process and discipline. As we mentioned in the first paragraph, the last six months were not at all typical. Our reliance on sell targets calculated using fundamental company analysis and realistic assumptions has served us very well for the past three decades and we are not about to jeopardize future performance by veering far from what we know and believe in. We analyze companies and build portfolios from the bottom up, rather than try to divine how the markets or sectors will perform. We believe that superior performance is generated by investing for the long term using patience and good judgment. As Benjamin Graham said: Value will out.