Posted by David Tillson 2014 Second Quarter
For the past two quarters we wrote that our expectations for stocks’ 2014 performance would fall in the 8% to 10% range. With the more than respectable performance of 5% for the second quarter, we are now close to that full year target. The stock market has moved ahead despite persistent doubts about the strength and longevity of U.S. economic growth, numerous geopolitical problems, and the nearing of the end of the Fed’s support for low interest rates. More than a year ago the picture for investors was similar and many were wondering if it was time to get out of stocks. By April 2013 the S&P 500 had risen 330 points (+26%) in the prior 15 months through a very rocky 2012 and was trading at 14.5x estimated earnings. That month’s letter began with the statement that stocks were setting new highs and asked “So, now what? Opportunity or risk?” Our counsel was “stay invested.” That was 380 points ago (+24%) on the S&P 500 and it now trades closer to 16.5x estimated earnings. We, and others, ask again “So, now what?”
At the risk of sounding like “perma-bulls,” we do believe that investors should remain invested under most circumstances because we believe that ownership brings greater rewards. Without delving too deeply into economic theory, an economy is essentially trading goods and services among a group of people. Money is simply the tool that makes trading easier. Some people produce things that others want and others provide a service such as moving those goods. Some will consume all that they earn while others will save part of their earnings to consume later. Those people who have savings have only two choices of what to do with their savings: be a lender or be an owner. Being a lender is typically viewed as safer than being an owner because a lender receives interest plus a guarantee that their principal will be returned. An owner has no such guarantee; if the business fails, all the equity is lost. To compensate for this possibility, an owner expects a higher return. Otherwise, no rational person would assume ownership. An economy needs this equity investment in order to grow, else it will stagnate, and as we have just experienced in the housing crisis, too much debt with little or no equity leads to a very unstable economy. The U.S. has been among the leading economies in the world in terms of innovation, productivity gains, and creation of new companies. Whether we can maintain this leadership position in the long term in the face of growing regulation and higher taxes is open to question. But, in the near term, the U.S. is by far the most attractive economy in the world for businesses and workers. And we strongly believe that our clients should participate in the higher returns, vis-à-vis lending, that equity ownership should provide.
Today’s major worry for stocks is that prices are too high and that the market has not experienced a 10% correction for two years. The fear is that valuation is rich, earnings growth is not robust enough, and there are too many things that can go wrong. While we are certain that the market will sometime decline more than 10%, we don’t know when nor from what level. There are probably more than a few investors who have been waiting for a year or longer for that correction so that they could get fully invested. Stocks are volatile because prices partly reflect emotion and it is emotion that creates the large and sometimes violent swings in prices. Any news, good or bad, is cause for investors to trade a stock, but eventually, good news will turn to bad and vice versa.
While volatility is price movement both up and down, it is the declines that investors see as risk. No one likes to see the value of their assets decline, even on paper. However, if one does not sell, nothing is actually lost. Over time, the market values of quality companies have not only recovered from those paper losses, they have increased. Bonds are a less risky alternative to stocks because their price declines typically are not as fast or deep. When interest rates rise (and bond prices decline), investors don’t seem to mind their paper losses since they believe that eventually principal will be returned and interest will be collected in the meantime. Given the choice, where is someone better off? As with many things in life, it depends. If the time frame is short, invest in bonds. If it is long, stocks will likely provide a greater return and at the end of the day, having more wealth allows for the luxury of caring less about volatility. Temporary vacillations are not important if the trend is rising.
As we approach Eagle Ridge’s sixth year anniversary, which coincidentally was just before the 2008- 09 crash, we have been revisiting our past. During those early years our crystal ball was no brighter than others’, but our advice to clients relied heavily on history and behavioral economics – how people actually act instead of how they should in theory act. We did not know exactly how everything would turn out, but we were confident in the general direction and had faith that world economies would not completely collapse. We were contrarian in the face of seemingly overwhelming evidence that this time was worse than even the Great Depression. We had faith that calm would eventually return, that companies would survive, and that stock prices would actually recover. We pushed clients to at least remain invested or better yet, to invest even more in equities because it was fear that was setting stock prices, not fundamentals. Even during 2008 and 2009, the vast majority of companies in our portfolio not only continued to pay their dividends, they increased them. Only our financial holdings and General Electric cut their payouts to shareholders. This chart is a representative list of companies that we own or have owned in our portfolios during the past five years. Not all raised their dividends, but most did; and the median “pay raise” that their shareholders enjoyed was 70%. Furthermore, since the low in March 2009, the price of the S&P 500 Index has nearly tripled. At times, it was a terribly steep wall of worry that the market had to climb and our clients were probably quite nervous throughout. But, the result was that their wealth not only recovered, it has increased substantially. This fact is important because the more wealth that someone has, the more that it can change their perception of risk. Volatility is still noted, but it is better understood as a side show to what is truly important – long term growth in income and assets.
It is normal to remember what is most recent, but the most recent memories may not help people divine the future. Among many of Mark Twain’s quotes are “History doesn’t repeat itself, but it does rhyme” and “To succeed in life, you need two things: ignorance and confidence.” The first speaks to the fact that we probably have seen it all before and the second explains why. Mankind is in general optimistic, creative and competitive. Some of us are willing to take the risk that we can succeed where others have failed while others of us are not: the owner versus the lender. All economies need both to prosper. June 2014 is the five year anniversary of the end of the Great Recession that started in December 2007, and lasted 18 months, the longest of any recession since World War II. The recovery in the U.S. has been very subdued and the lack of growth has kept unemployment high, business activity well below normal, budget deficits high, and interest rates extremely low. The Federal Reserve’s monetary policy of keeping interest rates near zero to encourage growth has in large part offset the negative influences of greater government regulation and oversight, tax policies and low business confidence and capital spending. We believe that this “Goldilocks” economy of slow, but relatively steady growth is not a bad thing. No recession is on the horizon and we do see many indications of even better times ahead. Wage increases are becoming more prevalent, the unemployment rate continues its decline, the housing market is rising, capital spending and bank lending are both improving, and inflation is showing signs of rising to the Fed’s target rate.
What does worry us? The unexpected. To state the obvious: everyone knows what they know, and doesn’t know what they don’t know. Undoubtedly there will be some unexpected catastrophic event that catches people off guard. Fear will cause people to sell risk assets without considering longer term fundamentals. Those that do sell under these types of conditions typically wait until it is all clear before buying back in. By the time that fear has diminished, prices have usually more than recovered. The chart below highlights some of the eras and events of the past 35 years. As we look back, times can be turbulent and bad things do happen, but the resourcefulness of people, companies and our institutions have kept our economy and financial markets growing over the long term.