Posted by David Tillson 2012 First Quarter

One of the more famous quotes from Shakespeare’s Macbeth is the title character’s reductive account of the meaning of life: “It is a tale, told by an idiot, full of sound and fury, signifying nothing.” Last year’s round-trip to virtually the same price at which the S&P 500 began felt similarly meaningless. Investors endured a huge amount of “risk-on/risk-off” noise and macro-driven volatility, but ultimately to what end? In our quarterly wrap up of 2011, we stated our belief in a different tale for 2012, a year which would be characterized by healthier, double-digit returns based on more rational behavior and healthy corporate profits. We didn’t realize much of this return prediction would be realized in the first quarter. Stocks opened this year with their best first quarter in over a decade, but also notable, the strong performance was accompanied by mounting evidence that the U.S. economic recovery has some staying power. 

The strong performance was driven partially by continued improvements in a number of U.S. economic indicators, but probably more so by the European Central Bank’s decision to flood the EU banking system with $1.3 trillion in cheap 3-year loans, which lessened fears of further bailouts. The U.S. bond market experience was the mirror opposite of stocks: long rates spiked sharply as prices tumbled, a reminder that bonds are, in fact, not “risk-free.” Bonds have enjoyed a 30-year bull market in the U.S. and have been a safe haven the past several years. However, we feel that in the next 5-10 years the jig could finally be up. To quote Shelby Cullom Davis, as Warren Buffet saw fit to do in Berkshire Hathaway’s recent annual report: “Bonds promoted as offering a risk-free return are now priced to deliver return-free risk.” 

This is not to say the concerns of 2011 have been vanquished. In the U.S. structural reforms are still needed to deal with mountainous levels of government debt and uncertainty still remains around tax reform and entitlement spending. The EU economy appears to be tipping into recession with sovereign bond rates in several countries creeping up yet again. With China’s growth sputtering, global growth is also slowing and the market is taking note. Combine all these concerns with the psychic scars that remain from the last recession and voila, you have a recipe for making sense of a riddle we discuss almost daily: why investors would still shun high quality, dividend paying companies for bonds which will most likely produce a negative real return. Investors’ fear of loss-of-principal is setting most of them up for the eventual realization that their purchasing power was what they actually lost. The two graphs below attest to the degree to which those fears are reflected in recent investor behavior. The first is essentially a comparison of stock and bond yields while the second shows the massive flow of funds out of stocks into bonds since 2007. While Fed policy has been most instrumental in keeping interest rates low, investors’ need for principal protection has created the almost insatiable demand for “safe” assets at any cost. Like all else in life, this too will prove to be cyclical. 


For the past decade, we have witnessed the painful, but necessary process of ‘Creative Destruction.’ Joseph Schumpeter, who popularized this economic theory over a century ago, believed that economic innovation always arises out of a crisis. Clearly, we have just seen such a crisis. Most large-cap U.S. companies have emerged from the last two recessions in much better shape than prior to the crisis. Balance sheets have been purged of leverage and productivity is up markedly. Moreover, many large U.S. companies have used the prior destruction to create new and innovative products and services and expand into regions overseas. Apple, a company that was nearly left for dead in the late 90’s, reinvented itself by creating an ecosystem of non-PC centric products that has literally reinvented computing as the world knew it. Home Depot which by all accounts should have suffered greatly post housing-bubble, actually thrived by reinventing its approach to instore customer service and product assortment. 

Schumpeter may not have imagined the actual morass called our housing crisis, but we suspect that he would not be terribly surprised by its outcome either. More pain is yet to come, but there is evidence that we are entering the later innings of this crisis. Why is housing so important? Jobs is one reason since an estimated 2 million housing-related jobs were lost since the peak 6 years ago. Another reason is that underwater mortgages have frozen many people in place, unable to move to a better job or to downsize when they retire. New housing starts are still running at only half the normal historical level despite the formation of 6 million new households since 2005. This classic supply/demand cycle will self-correct with time. While pricing is still falling modestly in many markets, we believe 2013 should mark the bottom for U. S. home prices as supplies of delinquent inventory have been whittled down to less than 15 months in most markets. A more normal housing market will not solve all of our problems, but it will go a long way toward stabilizing consumers’ confidence in the future which bodes well for economic growth, consumer spending and employment. 

Lastly is valuation and expectations. We look at the stock market’s lost years between 1999 and today and note that, given a choice, we vastly prefer today as an investment starting point versus the end of the 1990s. The back-drop of fear rather than greed has always been a better starting point to invest. S&P earnings since 1999 have doubled while the market remained even. Valuations are reasonable, if not cheap. Dividend payouts and earnings growth expectations are both low, inflation is restrained and access to capital for healthy U.S. companies is extremely cheap. If earnings do, in fact, grow slowly, but the market has assumed an outcome that will be even worse, it could take only modest levels of earnings improvements to justify some expansion in P/E multiples. Annualized returns on a 10-yr rolling basis make it clear just how unusual a period this has been for U.S. stocks. 

We encourage clients to take the long view on this relative value question between equities and bonds. We do not believe investors will profit by trying to be market-timers or by following the trading wisdom of short-term pundits. More likely people will get hurt in allowing emotions or the excess of information available today to prompt choices that supersede a rational, longer-term investment decision. Without being dismissive of today’s risks, we think people will look back 10 years from now and recognize what an attractive moment this was for the long-term equity investor.