The stock market fought, and barely won, the battle in 2005 against dramatically rising energy costs and relentless Federal Reserve interest rate increases. For the year, the S&P 500 with dividends was up a modest 4.9%. The Dow Jones Industrial average was down fractionally before dividends, but up 1.7% including dividends. During the year oil prices rose over 40% and natural gas prices increased even more. The Fed has increased short-term rates for thirteen straight meetings over the past eighteen months, from 1% to 4.25%. In addition to the economic hurdles of rising energy prices and increasing interest rates, the economy was hit by the worst natural disaster, in financial terms, in history. In spite of these daunting hurdles, the U.S. economy still managed to add a respectable two million jobs in 2005. The unemployment rate at year-end was only 4.9%. Also, growth in Gross Domestic Product is expected to have exceeded 3% for the year. We have recited these economic statistics not solely because of their importance and interest, but also to illustrate the extraordinary contrast that can occur between the economic inputs and the ultimate output. It is interesting to contemplate what the consensus economic forecast at the beginning of the year might have been had the eventual energy price rise and interest rates been known with certainty. It is highly likely that it would have been well below the actual result.
We may not have felt the full impact from soaring energy costs and interest rate increases. It seems likely that higher winter heating bills will cut consumer discretionary spending. Plus, short-term interest rate increases will increase costs for adjustable mortgages, among other things. Nevertheless, we are certainly much nearer the end than the beginning of the rate increases. Although we will not hazard a guess as to the fate of energy prices over the next several years, history has shown commodity prices to be at least somewhat self-correcting as forces act to bring supply and demand into balance. Geopolitical uncertainties and weather risks make forecasting near-term energy prices a highly unreliable venture, in our opinion. The increase in short-term interest rates has not been followed by a corresponding increase in market driven long-term rates. Consequently, short rates have reached, and at times exceeded, long-term rates over the past several months. An “inverted” yield curve has historically been a harbinger of an impending slowdown. Perhaps, but this inversion may instead reflect the extraordinary amount of cash looking for a safe home. There are other challenges to the economy and the markets, including a maturing earnings cycle and a weakening housing market. Earnings for the S&P 500 have increased at a double-digit pace for the past ten quarters. If that pace continues for the next three quarters the streak will be the longest in over forty years. Earnings growth seems nearly certain to slow but we have not yet seen strong evidence that it will halt or slow dramatically. The housing market has slowed but still remains fairly robust. However, the boost to consumer spending from residential home value growth seems certain to diminish considerably.
The foregoing has been a long-winded economic discussion by our standards. It is not a prelude to a prediction about the economy for this year. It does seem that it is always more “chic” to be negative, even apocalyptic, about the outlook for the economy and the markets. Only the boring, unimaginative types are generally optimistic. At the risk of being boring, we have always been generally optimistic about the long-term wealth creating prospects of the economy, even if not always so sanguine about stock market returns. The past year showed anew that it is difficult to win consistently betting against the resiliency of the American economy. Most importantly to us, the significant rise in earnings over the past five years, coupled with little stock price movement, has left overall equity valuations at levels not seen since the mid 90’s. Although we do not
anticipate extraordinary equity returns, we think current prices should result in long-term results near historic levels of 7% to 9% annually.
From Small To Large?
Over the past three years, stocks of small- and mid-sized companies have outperformed the stocks of large companies. Numerous pundits have predicted an imminent shift back to larger companies, particularly high-quality, high-return companies. While we search for long-term value wherever we can find it, we have normally had a predominant exposure to larger companies. Consequently, we would benefit from a rotation away from smaller companies. While we have no opinion on the probability or timing of a wholesale shift in market sentiment, we do believe that a growing number of large, high quality companies are selling at reasonable discounts to intrinsic value, and ultimately will provide solid total returns from current prices.
Looking Inward
The decade thus far has not been particularly kind to equity investors. For the past six years the annualized return for the S&P 500 has been a negative 1.1%. We are generally pleased with our overall relative results for the decade thus far, and also for longer periods. But we are far from totally satisfied. As we have said (and proven) many times, we do not try to replicate an index of stocks. Hence, we are not terribly concerned with, and fully expect, periods of relative underperformance. When a single sector, or subset, of stocks dominates the market, and we are not significantly represented, we can find ourselves swimming against a powerful current.
We have examined carefully our methodology and habits, and considered whether it is desirable to attempt to reduce our relative performance variability at the risk of diminishing long-term results. We are certain the answer is “no” if it entails buying stocks in particular sectors simply to achieve representation in the event that particular sector becomes the next “hot” area. Buying stocks for that reason holds no appeal for us and, we believe, ultimately reduces long-term returns (though it does position a portfolio closer to the index, for better or worse). We are wary of “tweaking” our style solely to attempt to address any short-term shortfalls. The habits that contribute to short-term variability are often the very habits that have created long-term success with modest risk. We prefer a variable, yet superior, long-term return, to a more consistent, though inferior return. We have examined two areas that require particular diligence. While price is paramount in any investment decision, we continue to strive to not set our price filters too tight, and consequently pass on some otherwise wonderful opportunities. In addition, we must be careful to avoid staying with success too long. To paraphrase a famous politician, extremism in the pursuit of liberty may not be a vice, but extremism in the pursuit of long-term investment results may be. Any business, no matter the quality, can be priced at a level that too highly values all the probable future cash flows. Finally, if we can match our relative results of the past decade over the next five to ten years, we will be quite pleased. We will continue to focus, as always, on generating solid long-term returns with moderate risk.
