Posted by David Tillson 2012 Third Quarter

Four years ten months and counting! That is the time since the beginning of the 2008 global recession, which some refer to as the Great Recession, the Lesser Depression, or the Long Recession. Whatever one chooses to call it, it did significantly change people’s lives and its effects will be felt for at least a generation. As we have noted in earlier commentaries, financial bubbles are fun while the band is still playing, but cleaning up the mess from such a blow-out party is hard work and not very rewarding. The cleanup crew usually wishes that the party had been smaller and had not lasted into the wee hours of the morning. Bringing this analogy back to the financial markets, the cleanup crew is essentially everyone who was not somewhere in the back woods living off-the-grid. The economy in the US is slowing and people are worried about another recession. Many countries in Europe are already in recession and China’s slowdown looks like a hard landing. Our unemployment rate is still far too high, many state and local finances are strained, and the federal budget is operating at trillion dollar deficits. Many in the cleanup crew are Baby-Boomers and Generation Y’ers, who have had their worlds turned upside down, but for different reasons. For the Boomers, housing market problems, stock market volatility, and extremely low interest rates have decimated their retirement plans. Lack of job opportunities and massive student debt have left the twenty-somethings wondering how they will move on to the next stage of their life. Not a pretty picture, but also not totally bleak either. Expectations have a lot to do with how our future unfolds. 

Up until the decade of the 1990’s, recessions were expected to occur about every four to five years, corresponding to the business cycle. They were usually not severe but did have the effect of bringing everyone back to reality, reminding investors that risk does not always mean return; it sometimes means loss. Given that it has been nearly five years since the last recession, if another one occurs soon, it should not come as a surprise nor should it be feared. The stock market has been a fairly good predictor of recessions and at the moment, it is not signaling one. Market commentators will continue to warn of the euro, the debt ceiling, deficit spending, the fiscal cliff, etc., but for stocks, what matters is earnings power and valuations. 

We often ask ourselves “Where are we in the business and the market cycles?” US companies today are in much better shape financially than they have been in many, many years. Currently, near term earnings estimates are weakening somewhat but are not declining precipitously. At $100 per share, companies of the S&P 500 are earning close-to-peak earnings even when the current earnings season’s disappointments are factored in. However, this peak is not at all extended and in fact, earnings are exactly on the trend path that the S&P 500 has traced for the past 90 years. Contrast this with the past five major declines where peak earnings started on average 30% above this trend line, we conclude that this slowdown will be shallow and is largely already being discounted by the market. With the P/E (price/earnings) ratio at 14x, valuation is well below what would be expected based on interest rates. A P/E ratio closer to 17-18x would be more normal when considering today’s low bond yields alone. This interplay between earnings power and valuation is really the only thing that matters for stocks over the next two years. 

Historically, we are due for a slowdown or recession and corporations have been operating defensively as they wait for a downturn to prove to shareholders that they can continue to earn a reasonable return. Many people today seem to be waiting for the big event that actually drives the global economy into a recession. So far the land mines have all been false alarms, but a slight recession might actually help prove the point that business cycles are normal and can actually be healthy. If earnings remain healthy in a modest recession, it could be what gets investors to look seriously at stocks once again. 

History has proven to be a decent guide when forming expectations for the future, and we have written extensively in earlier letters about similarities between current and historical events. Our expectations today are: 1) economic conditions are challenging but the problems are solvable; 2) the US will not soon return to the excessive growth and behavior of the prior two decades and; 3) the general population of the US will grudgingly accept the new reality of “less is more.” Some of this reminds us of the 1950’s and 1960’s. After the Depression and World War II, people were still quite fearful despite the position in the world that the US enjoyed. It was very unclear how jobs would be created for returning veterans, whether the next recession would be as bad as the 1930’s, and how to cope with rising interest rates with the enormous debt incurred for the war. Investing in stocks was the last thing that most people wanted to do with their savings since the greed-fear pendulum had swung so far toward fear. However, as shown in the chart, equity investors did very well throughout this 20 year period despite recessions, rising inflation, various political crises, and social unrest. Contrary to the belief that rising interest rates hurt stocks, observe that P/E’s vacillated between 15x and 19x while 10-year US Treasury rates rose from about 2% to 6%. Today’s P/E ratio of 14x is below the level experienced at any time from 1955 to 1969. Our belief is that while a full solution to our fiscal problems is not probable, movement toward a solution is. This change of direction should put us on a path not dissimilar to the 1950’s where recessions occur, interest rates rise, and investors become more comfortable with owning stocks. When this happens, P/E’s will likely move higher and could very well match the 17x average experienced in this past period. What this means to owners is that a move in the P/E from 14x to 17x will drive prices 22% higher with no change in earnings. 


So far this year equity investors have enjoyed a 15% increase in their wealth, as long as they did not try to time the market. Worrying less about what someone will pay them for their shares and more about owning solid companies with the capacity to grow has paid off. Just maybe this is the beginning of a long lasting period such as the 1950’s and 1960’s where patience and low expectations were handsomely rewarded. Disbelief and fear will keep many from participating in the early stages of this period. Most people wait for the outlook to be clear before venturing forth, but by the time that happens, the market will be much higher. If we have learned anything from the last 15 years, the outlook is always anything but clear.