To Our Clients and Friends of Parthenon Capital Management
The stock market rallied sharply in the second quarter and most broad indices finished the first half of the year up over 10%, providing investors with a welcome respite after three years of relentless declines. The S&P 500 rose 11.78%, including dividends, for the first six months of 2003. Bond prices rose dramatically in a continuation of a long rally, with yields falling to the lowest levels since the 1950s. The yield on the 10-year Treasury bond reached a low of 3.07% in June, a level imagined by few until recently. The stock market advance was precipitated by the success of the war in Iraq, signs of a moderate acceleration in economic growth, improving corporate earnings reports, and continued low inflation. Our long-term expectations for stocks have not changed significantly from the outlook expressed in our year-end 2002 letter. We believe that the three-year market decline has driven stocks, in general, down to rational but not particularly undervalued levels. Consequently, we expect the overall market to roughly follow the increase in long-term underlying business values. If so, this should translate to total returns of 7% to 9% for the broad market. The rally this year has reduced stocks’ attractiveness modestly because business values have not, in our opinion, increased at the pace of most stock prices.
A forecast of long-term expected returns implicitly assumes an endpoint, though that endpoint may be somewhat fluid. Consequently, expectations could be incorporated into the forecast for the economy, geopolitical situation, and overall investment climate and investor psychology. These variables would influence both the overall corporate earnings level and the valuations placed on those earnings at that future date. Our approach to this exercise is relatively simple – we step back and punt. We assume the economic and political environment will evolve much as it always has. We will encounter periods of above-average growth, recessions, falling inflation, rising inflation, geopolitical turmoil and relative tranquility. But we do not hazard a guess as to the blend of these conditions that may prevail at a discrete point in the future. It is simply not possible to estimate with any useful precision these variables very far in advance. Our valuations and purchase decisions are made with the expectation that the businesses will be held through the changing economic climates. However, our agnosticism about these macro factors does not necessarily extend to agnosticism about a particular industry. We may, and often do, have strong opinions about the long-term future profitability of specific industries.
We observed the concurrent rallies in stocks and bonds in the second quarter with some bemusement. The primary reason for the stock rally, so the general mantra went, was an imminent and significant rebound in economic growth. This growth would translate into much better earnings growth for most companies. Concurrently, the rationale behind the huge rally in bonds was that growth was going to be anemic and the economy had a real potential to slip back into another recession. This would mean little risk of inflation and perhaps, it was surmised by some bond proponents, even deflation. Under this scenario bonds were attractive, even at already historically low rates. It seemed increasingly likely to us that, at the extremes, both could not be right and either the marginal stock buyer or the marginal bond buyer was likely to be disappointed in their long-term returns.
At least in the short-term, since the end of the second quarter, it has been the buyer of long-maturity bonds who has suffered.
Et tu Bond Market?
It appears the bond market is increasingly infected with the speculative fevers that are so familiar in the stock market. The last few weeks of the feverish rally in the market appeared driven as much by momentum and desperation as by a sober analysis of fundamentals. The desperation arises from the fear of not owning enough of the asset that is most popular. That fear overwhelms any concern about buying a historically overpriced (expensive) asset. Now in the first weeks of the third quarter the bond market has collapsed and yields have retraced all, and more, of the second quarter rally. Generally, we have observed somewhat less foolishness in the bond market than the stock market over the years. We neither predicted nor were we shocked by the sudden collapse in bond prices – we are not in the short-term prediction business. But the lesson for the buyer of long-maturity bonds near the top of the rally is an old but important one – all financial assets, even “safe” ones, have risk when purchased too dear.
The Thrill is Back?
We are far from hopeless curmudgeons who are skeptical of every advance in the stock market. We enjoy a good bull market as much as the next guy. Indeed, we have been buyers of stocks on balance over the past 12 months. But we recommend some modest caution about the excitement engendered in some quarters by the stock market advance. Although this is not March of 2000 it is most likely not March of 1990 either (to be followed by years of double-digit market returns).
The Only Sure Things – Death and Tax Changes
Perhaps the old aphorism about the certainty of taxes and mortality should be altered. When it comes to the Federal tax code it seems that politicians can never leave bad enough alone. Fortunately, for investors, there is a lot to like in the changes enacted this year. In particular, the long-term capital gains tax rate has been reduced from 20% to 15% and the top dividend rate has been reduced to 15% (dividends had been treated as ordinary income). Consequently, the price to be paid to diversify large low cost positions (if prudent) is now less onerous. In addition, the after-tax returns on dividends will be substantially greater for most taxable investors. Also, short-term capital gains (less than a one year holding period) will continue to be taxed as ordinary income. We will incorporate these changes in striving to achieve the goal we have always worked for – the highest long-term returns and income within the limits of acceptable and prudent risk.