Posted by David Tillson 2010 First Quarter
What a difference a year makes! Last year at this time, we were all wondering if the rebound that began in mid-March 2009 would continue much past the first six weeks. Much of our economy was in a freefall, with fear, and even panic, ruling investors’ and consumers’ behavior. The mayhem was not limited to the United States, and not all countries around the world reacted in the same way or were hit with the same intensity of the contracting economies. Most countries worked to create massive amounts of stimulus as they attempted to contain the fallout from the deleveraging of the financial system. Banking systems were tested to their limits and people worldwide had a not unreasonable fear that the damage could not be contained. Many investors were expecting a retest of the March 9th lows after the short covering by hedge funds was complete. Economies and banking systems were too fragile and the debt problems seemed too widespread to give investors the confidence to believe that we could work our way out of the morass easily or quickly. But March 9th was the bottom. The economy has stabilized, but it has not been easy and it has not been quick. While it does now appear that our economy will grow for several more years, the considerable challenges still ahead of us will require much hard work, sacrifice, and acceptance of potentially undesirable choices.
This chart was created in early 2009 to give us some indication of what we might expect going forward after such a devastating bear market.
It was first shown in our quarterly letter a year ago to illustrate what historically has happened 6 and 12 months after a market trough. We used it again in our October 2009 letter as we were growing very confident that we had experienced a very bad recession but not a depression. In that letter, we made the comment 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.” Our prediction did turn out to be correct and the total 12 month increase is certainly in the expected range given the 60 year history. This, along with many other signs, gives us further comfort in our belief that the worst is behind us and more importantly, that by studying the past we can gain valuable insights into what the future might hold.
The recession probably ended in June or July of last year, but the National Bureau of Economic Research will likely not make it official for another few months. This will be good news for the financial markets in general and the labor market in particular. The March employment report seemed to have signaled the beginning of a recovery with payrolls rising 162,000. But hinting of this turn were jobless claims that had been steadily declining from their peak a year ago and the six consecutive month rise in the Conference Board’s leading indicator “employment trends index.” ISI Group has been reporting for some time now strengthening company surveys across a wide variety of industries, including retailing, trucking, restaurants, airlines, chemicals, and even homebuilding. With any resurgence of economic activity comes a rising concern of inflation. Just as we saw “green shoots” of economic recovery a year ago, some green shoots of inflation are becoming noticeable. US import prices are rising at a 5.8% annualized rate, steel prices are set to increase by a third, apartment rents rose 2% in QI, retailers pricing power has been rising, and ISI’s temp employment companies’ survey of wage pressure has increased from 32 to 45, nearly half way to its prior peak in 2007. Despite the green shoots, we do not believe that inflation will become prevalent at least for several more quarters, if not years. Core inflation (excludes volatile food and energy costs) is still expected to fall this year to approximately 0.3% in the US and 0.2% in the euro area. The OECD economies have a tremendous amount of excess capacity built up from the global economic slump, and companies will remain under pressure to cut prices to keep customers. Bill Gross, co-chief investment officer at the major bond investment company PIMCO, sees major central banks keeping interest rates near zero at least to the middle of next year, a belief which we share. With these low rates, excess capacity, and little maneuvering room by central banks, deflation cannot yet be ruled out. As Japan has learned over the past decade, deflation can be debilitating and difficult to reverse. Faced with falling prices for their products, companies are reluctant to expand and hire workers while consumers delay purchases hoping for better prices in the future. The deflation scenario would be worse than an inflationary one and while we think that the probability of deflation is higher than inflation, we also believe that both are unlikely, at least in the next several years.
2010 will undoubtedly be a year characterized by politics. We recently read a very interesting piece on the powerful emotion of anger, which is in abundance in today’s society, and how it can meaningfully reduce a person’s ability to make decisions that maximizes their welfare. This has implications not only for our own investment decisions, but for our society as a whole. Behavioral economists assessed how subjects played the “Ultimatum Game” after watching either a movie clip with strong negative emotional content or a brief segment of the TV show “Friends.” The Ultimatum Game is where one subject offers another a split of a certain amount of cash; if the person receiving the offer turns it down, no one gets any money. If they accept, both parties receive the proposed split. Even though classical economics says that any offer should be accepted because something is better than nothing, in the real world stingy offers get refused because they are considered unfair. After viewing the “angry” movie clip, subjects rejected offers that are generally accepted when no emotional stimulus was present. That finding – that human emotion can dramatically trump selfinterest – has ramifications in many areas. The wave of popular anger against Wall Street for example, has the potential to create outcomes that actually harm the country’s long term financial competitiveness. We are now seeing politicians trying to show their constituents that they are doing something to prevent another meltdown of the financial system. Senate hearings where bankers are grilled and chastised probably do little to truly understand the causes of the meltdown, but they are good theater for the people back home. These actions tend to keep populist anger at a high level which plays into a related part of the Ultimatum Game. When the experiment was repeated days or weeks later, the outcome was the same. The players who had been angry during the previous round once again rejected offers that tend to be acceptable to less angry people. The Ultimatum Game shows humans care about fairness almost as much as money, and unless they are getting their “fair share” they tend to reject offers that leave them notionally better off. We currently see an electorate which may be angry enough to jeopardize their long term well being to punish the inequality they feel from decisions made during the financial crisis. We are hopeful that our political leaders will soon move from vilifying Wall Street and corporate America to a more constructive stance focusing on solutions.
Taxes are one area where these potentially less logical decisions will be felt most. Federal spending has mushroomed well beyond any level that could be imagined two years ago. Revenues obviously could not keep pace during the recession, but now it is extremely unlikely that even with normal GDP growth, the deficit will return to a manageable level without major changes in fiscal policy. The federal budget deficit is expected to be materially above $1 trillion again this year, putting the ratio of all federal-debt-to-GDP at approximately 85% by 2010 year end, up from 62% at 2007. Deficit spending that adds to debt as a percentage of GDP is unsustainable and will lead to higher interest rates regardless of inflation. It is unlikely that spending cuts alone will be able to reduce the deficit materially, but hopefully they will be part of any higher tax legislation. There is $8.7 trillion of personal income versus $1.7 trillion of corporate taxable income. Therefore, it will fall to individuals to bear the brunt of increased taxes. The top income tax rates of 33% and 35% will revert to 36% and 39.6% in 2011 with the expiration of the Bush tax cuts. Capital gains and dividend taxes will increase from 15% to 20% in 2011 and to 23.8% in 2013 with the new Medicare tax. Despite this, equities will remain more lightly taxed than most interest producing assets and the roughly 20 percentage points tax advantage that equities will continue to enjoy (since 2002), is the biggest in US history. Yet even these tax increases will not be enough to put much of a dent in the deficit. A European style Value Added Tax (VAT) is being discussed as one of the few viable answers. Despite President Obama’s pledge not to raise taxes on anyone making less than $250,000, the VAT tax would be a direct tax on consumption rather than on income. Not that we agree with a VAT tax, but there actually might be some merit on penalizing consumption relative to savings given what we have just lived through.
The value of the dollar has also been a concern and as recently as last December, many people felt that the US dollar would continue to weaken for years into the future. While this may yet happen, recent events with Greece and other weak EU countries illustrate the dangers of projecting relative GDP growth and inflation rates, and thus foreign exchange rates, too far into the future. Political stability, nationalism and protectionism, consumer behavior, and regulatory and tax policies will all greatly influence the US dollar. Simply looking at the strength of Ford and GM versus Toyota should sway some dollar bears.
In summary, we certainly recognize the challenges that the world faces and are aware of how bumpy the road ahead might be. But, we also strongly believe in the resilience of our society and that the US will regain some of its standing on the world stage. The US is faced with a larger and much more powerful government sector, higher taxes, probable reduced consumer spending and GDP growth, and stubbornly high unemployment. On the other side of the ledger however, are lower amounts of debt everywhere except in the government, a higher savings rate and more frugality by consumers, a renewed appreciation of risk, a need to reinvest in the capital stock of the country, and a rapidly growing move by the electorate to reign in uncontrolled government spending. Capitalism is not dead in the US; it just needed some stronger regulation to keep it on track.
In terms of the equity market, we believe that the stage is set for a resurgence of large cap multinational companies. Big stocks are trading at the steepest discount to small companies since at least 1982. Large capitalization stocks, as tracked by the S&P 500 Index, lost an annual average of 0.7 percent in the 10 years ended March 31 according to Bloomberg. The S&P 100 Index (the largest 100 companies) fell by 2.2% annually. Those returns trailed annual gains during the same period of 6% by the S&P Midcap 400 Index, a proxy for midsize stocks, and 3.7% by the Russell 2000 Index, a small company index. We, along with many other value managers, share the view of Jeremy Grantham of Grantham Mayo Van Otterloo Co., that it’s “nearly certain” that the highest-quality large stocks, known as blue chips, will outperform the market in the next seven years as more investors come to consider them underpriced. This should bode well for Eagle Ridge’s investment process of creating portfolios with out-of-favor, yet financially solid, larger companies with above average long term prospects.