To Our Clients and Friends of Parthenon LLC
The weight of the challenges facing the U. S. economy took a heavy toll on the equity markets in the first half of the year. The S&P 500 fell 11.92%, the weakest first half since 2002. From its October 2007 high to the low reached in July, the S&P 500 declined over 20%, the classic definition of a bear market. There were few places to escape the damages in stocks, as indices tracking stocks of nearly all sizes and classes tumbled. The fear that had enveloped the housing and financial sectors spread to nearly all sectors and investors began to exhibit a more general distrust of stocks. The weakness was not confined to the U.S. markets, as many of the previously sacrosanct international markets tumbled as well. Many of the emerging markets, in particular, dropped after their recent dramatic spikes up. China’s market, for example, has fallen 50% from its peak. Growth and excitement are not enough if valuations become unhinged from underlying business values. Bond yields declined modestly, with the 10-year Treasury bond yield dropping to 3.97% from 4.03% at the beginning of the year. That slight change notwithstanding, the bond market was not without some excitement. The spread between interest rates on low risk treasuries and higher yielding bonds expanded, as investors sold not just stocks, but also bonds with perceived greater risk. While fear and risk avoidance have been predominate toward most financial assets, an exception has been the current “royalty” of investing – basic commodities such as oil, metals and agricultural products. How long commodities will hold the lofty status is uncertain. Recall that it was only a few years ago that residential real estate was the chic investment of choice. But, history is replete with examples of today’s financial “treasure” becoming tomorrow’s financial disaster.
Interestingly, amid all the real business problems and investor angst, the economy has yet to enter a recession, as measured by the government’s official reports on growth in Gross Domestic Product (GDP). Most economists think we will have growth, albeit modest, in the third quarter. Nevertheless, to many consumers, burdened with higher energy costs and lower home values, it has begun to feel like a recession.
The news headlines are dire, the markets have been sinking, and the economy teeters on the brink of recession. How bad is it? We would not diminish the seriousness of the challenges to the economy and the markets. The economy is being hit by a damaging triple play – a severe increase in energy costs; large, though uneven declines in residential real estate values; and, severely weakened financial institutions. The stunning, and seemingly relentless, jump in oil represents a huge tax on consumers. The drop in housing values, at unprecedented post war levels, is an extremely large wealth drain. And, the debilitated banking system is pulling back and
providing less growth fuel due to more stringent lending standards and capital weaknesses. Any one of these factors alone would almost certainly slow the economy. Together, they threaten to totally derail it. While the bulk of the economic indicators indicate contraction, not all the news is dismal. Interest rates are low and non-financial company balance sheets are strong. The current earnings reports from non-financial companies are generally positive and the outlooks, while weaker in some areas, have not been dismal. U.S. exports are strong, growing, and, we believe, under-appreciated. Finally, stock valuations, although not at the lowest levels reached in some prior downturns, are reasonable by historical standards, particularly so given the current low interest rate environment. It is even possible to find dividend yields of some high-quality, non-financial stocks that approach or exceed the ten-year Treasury bond yield. Although the balance of the data still leans toward the negative, the outlook is not unambiguously negative.
The above heading is a simple, succinct summation of the perspective one should have during all market declines. We remember well how we felt and recall vividly the palpably negative sentiment at the bottom of all the previous significant market declines we have had the “pleasure” to experience. Of course, we only knew it was the bottom well after the fact. The market’s healing process usually begins stealthily and amidst much doubt, with several false starts and head fakes. As for predictions on when and at what level the market will finally bottom, we think that those who ruminate on that question can be divided into two groups – those who know they don’t know, and those who don’t know they don’t know. We are in the former group, so we will not hazard a precise prediction as to the ultimate duration and depth of this downturn. The average bear market over the past 60 years has lasted 14 months, and the average recovery to regain the previous highs was 12 months. But, within the averages are widespread results, ranging from the extremely short downturn in the fall of 1987 that lasted less than four months, to the lengthy decline of 1973-74 that took over 20 months. While the recovery is inevitable, the timing is unpredictable. We are now nine months into this decline. While we cannot accurately predict the timing of the recovery, we think the market has discounted many of the current challenges. However, the healing and recovery, for the economy and the market, could take longer than average to come to fruition due to the intense pressure on consumers and financial institutions.
It is important to appreciate that long-term investment returns are comprised of a series of short-term “bursts” in valuation, the timing and degree of which can not be predicted with any consistent accuracy. We do not believe investors can hope to dance in and out of the stock market successfully. An investor must remain in the investing arena to gain the long-term benefits of equity ownership, even with the short-term dislocations.
These are the times when it can be extremely difficult to take an optimistic view. Some would argue that there is nothing rational about optimism now and, more importantly, it is even hazardous to your financial health. But, with an emphasis on rational, with a healthy dose of wariness and an acute awareness of the need for a considerable margin of safety, we think it is the correct attitude. We stated this before and still believe it – the rational optimist will win over the long-term. Our investment philosophy has not, and will not, change with the current fads. We are long-term investors who look to purchase high quality companies selling below a conservative estimate of intrinsic value. It has worked for us for over two decades, although not without occasional “hitches.” We believe that a long-term investor must have a permanent philosophy that is not prone to the latest fashions and whims, not unlike the line in a song we heard – “you’ve got stand for something, or you’ll fall for anything.” Adhering to our philosophy has helped us avoid the worst of the investment problems over the past twenty years. We are seeing opportunities to add to holdings where we feel the gap between intrinsic value and market value has increased, and we are looking, with intense discrimination, to add new positions. Excessive long-term returns are made during periods of market weakness, but that will only be apparent after we have come through the valley.