To Our Clients and Friends of Parthenon LLC
The first six months of 2009 provided investors with an exhilarating ride as the S&P 500 plunged over 25% by March, to the lowest level in over a decade, then roared back 40% by the end of the second quarter. After the excitement ended, the net result was a relatively placid total return for the S&P 500 of 3.16% for the first half of the year. Bond yields rose but remain extremely low by historical standards. The ten year Treasury bond yielded 3.53% on June 30, up from 2.25% at the start of 2009. The Federal Reserve continues to battle the financial crisis by maintaining short interest rates at a near zero yield. The economy continued to contract in the first quarter, with Gross Domestic Product falling 5.5%. GDP is expected to have fallen again in the second quarter though at a much slower pace.
The huge rally off the panic lows in March begs the question – could stocks still be attractive after such a move? Before answering consider this – would the average investor view current stock valuations differently, and would market commentary and overall perspective on stock values be altered, if the stock market had not fallen dramatically in the spring and then rallied, but instead simply meandered along to the slight gain for the year? We suspect so since after seeing, and buying, stocks at lower prices, it can be difficult to think that some may still be values at higher prices. Although we acknowledge that many stocks are not the values they were at the bottom, long-term value is not determined by where a stock price has been, but instead by its valuation relative to current estimated intrinsic value.
We are often asked if the economy and the stock market are “out of the woods.” Our response to those inquirers has been that we believe the economy and the equity markets are “out of the mouth of the beast, but not yet out of the woods.” The risk of financial and economic Armageddon appears to have passed, but no definitive and strong turnaround is yet apparent. The recent economic statistics have been moribund, but we are seeing some more hopeful, though hardly robust, data. While we follow the macroeconomic statistics and economic reports, we also listen closely to the managements of the companies we follow. They are battling it out on the front lines. The latest reports from the front show some stability, and some companies have reported modest improvement, though few have yet reported concrete evidence of a significant and sustainable upturn and few managers are predicting much improvement in the second half of the year. Earnings have been better than the very weak expectations but well below year ago levels for most companies. Nevertheless, while it is undeniable that the economy in general, and many businesses in particular, have lost a measure of economic wealth, that does not mean that stocks are not attractive, relative to history and other asset classes, as long-term investments. Many stocks, we think, have fallen in value enough to more than compensate for the economic wealth destruction and lower earnings levels. We believe stocks, broadly, are priced at least to provide average historical returns. However, while we caution against any expectation of a robust new bull market with returns well above historical averages given the wealth damage to consumers, and the likelihood of growth-retarding tax increases, we are positive on the long-term prospects for our businesses.
We think it would be useful, and interesting, to examine several of the more common kernels of “wisdom” floating around Wall Street and the financial media today. If you have watched financial news channels or read any financial publications, you almost certainly have been exposed to some variation of the following.
“Avoid stocks, it will take the market at least (X) more years to reach old highs”
This is one we find particularly dubious on at least two counts. First, we feel it is not possible with any meaningful precision to know when the market will reach previous highs and, depending on the number of years the “forecaster” uses, the comment is often “mathematically challenged.” It is usually announced in dire tones and is designed to turn one away from equity ownership, but the effect, for anyone who did not fail basic math, should often be just the opposite. Consider that if the stock market does return to its old highs within seven years, a not uncommon period we have seen used, the total annualized return, including dividends, will exceed 10% from current levels. That seems pretty attractive to us. It is not relevant to today’s purchase decision where the market was in 2007.
“Buy and hold is dead”
This one is routinely, and triumphantly, offered up by the “buy in the morning and sell in the afternoon” crowd, for whom action always trumps analysis. You can find them daily on your favorite financial news channel. As always with Wall Street, if something has not worked recently, it will, of course, never work again. Some equate buy and hold with buy and ignore. We have never purchased a stock with a required holding period in mind, and we have no dogmatic and ideological aversion to selling after a short period of ownership if the facts, such as a significant price move or new business information, warrant such a decision. Frenetic trading while trying to guess short term moves in stocks may work for some for some periods, but we believe the best approach to long-term wealth creation for most investors remains long-term investing, not market timing or trading.
“Burned investors will never return to stocks, so a sustained market move up is not likely”
We always find this one kind of silly, or at least historically ignorant. The market recovered after 1932, 1974, 1987, and other less dramatic declines. Somebody clearly “returned.” The marginal buyer will come back – markets do recover. But, ultimately it does not matter if some do not come back – it only matters if earnings and the economy do, then a more than adequate number of buyers will follow. In short, pay no attention to this “forecast,” it has little logic and no historical supporting evidence.
“Much higher inflation is inevitable”
There are some reasons to think this may have merit, though the certainty with which the statement is often couched seems overdone to us. The Federal Government is printing money at an alarming rate, the federal deficit is soaring, and the dollar may be teetering on the brink of a significant devaluation.
Yet, inflation seems a distant risk today. Slack demand, extremely low factory utilization rates, very weak labor markets, and very competitive retail markets all argue against a near term acceleration in price increases. The arguments for higher inflation, while worthy of respect, are clearly “early” but serious enough to warrant concern and some planning.
“We have entered the ‘New Normal’ – the economy must ‘reset’ and then grow from a new, lower level at only a modest pace”
This is one we have pondered, and generally agreed with, for the past year. These are unprecedented times, and an unprecedented recession. Differentiating between permanent and temporary wealth and valuation damage is extraordinarily challenging in this environment. Determining “normalized” earnings for companies is extremely difficult today and many companies have suspended external earnings and sales guidance due to an inability to reliably gauge near term sales and order patterns. In previous post-war recessions, one could expect a “catch-up” period for GDP growth and corporate earnings, with above-average growth in both. We are not so sure that is in the cards now. If the U. S. economy was powered along over the past decade by a huge increase in debt and housing values, then it may be that we borrowed growth from the future. Our natural contrarianism makes us a little queasy agreeing with a phrase that has become so ubiquitous and nearly universally accepted, even if we were early adopters. But, we feel most comfortable planning for modest economic and earnings growth in this recovery, and we are content to be pleasantly surprised if things are much better.
The past year has been an excruciatingly difficult one for investors. Maintaining a long term perspective is often challenging, but has been extremely so amid such extraordinary volatility and painful stock price declines. However, the market volatility and the extreme fear, while emotionally challenging, also presented numerous compelling investment opportunities. Where appropriate, we added new equity positions and increased our existing equity holdings selectively at very attractive prices, and purchased high quality municipal and corporate bonds. We believe the returns from these new purchases will be quite satisfactory over the long-term.