To Our Clients and Friends of Parthenon LLC
The S&P 500 rose 9.5% in the first half, effectively delivering an average year’s total return in only six months though investor’s displayed little exuberance over the positive results. The beginning of 2012 was one of the most uncomfortable and angst- filled strong periods we can recall. The dark shadow of European economic uncertainty, coupled with weakening domestic job growth, overshadowed any pleasure from a strong first half for stocks. Bonds yields (you may have heard this before) remained stunningly low as high quality bonds continue to be the refuge of choice for investors fleeing from any impending economic storms. The ten year Treasury bond yield was 1.65% on June 30th. In popularity, and relative historical valuation, bonds show some similarity to technology stocks in early 2000, though we suspect any reversal of fortune will be less abrupt and dramatic. However, we believe holders of predominantly very long maturity bonds and long maturity bond mutual funds may, when the bond fever breaks, feel nearly as blue as tech investors did after the bursting of that bubble. We saw some data recently that illustrated the popularity of bonds. Over the past five years, over $350 billion has been taken out of stock mutual funds and nearly $1 trillion has moved into bond funds. This measures only mutual funds but we are confident the trends are the same with individual investors’ direct investments. Success begets popularity in the investment world, and the higher the prices rise the more investors clamor to buy. We will continue to be cautious with our fixed income investments, while recognizing the need in many portfolios for reliable current income and portfolio stability.
Fear and anxiety over economic and political concerns foments stock market volatility, and the volatility creates more anxiety and fear – a non-virtuous circle. We understand the fear, but we are not so concerned about the volatility. Suppose the broad market returns 7% annualized over the next decade. Would you choose a smooth, relatively placid annual return of 7%, or a rocky, volatile 7% annualized return? The smooth return might be more soothing and less nerve wracking. But would that be better? The outcome is clearly the same for the overall market, but the opportunities may be superior in a more volatile environment for the patient investor as the stock price volatility creates mispricing of individual securities.
Whither the stock market? Economic data and reports and outlooks from the companies we follow show a marked slowdown in the economy, though not a complete stall. Consequently, earnings growth is slowing and the near term outlook for stocks is problematic. Our focus is primarily long-term and over a longer time horizon cyclical events, positive and negative, will tend to even out. Making a judgment on whether stocks are cheap, expensive, or somewhere in between depends, in large measure, on the long-term sustainability of current profit margins. The argument put forth by some pundits is that current profit levels are not “normalized,” but are benefiting from a confluence of positive factors that cannot endure. In the near term, an economic recession would, at least temporarily, depress overall profit margins, as recessions always do. The bigger question concerns whether the long -term secular level of profit margins is significantly below current levels. Do companies today enjoy an unsustainable tailwind and are there meaningful business expenses that inevitably must rise from temporarily low levels? Without going into all the details, we are not as skeptical about the long-term profit margins as some market commentators and find stocks generally to be reasonable on current and expected future earnings. We continue to believe that, due to government fiscal constraints and consumer debt, economic growth and overall corporate earnings growth will be restrained below historical levels for the foreseeable future. This combination of reasonable stocks prices but modest economic growth leads us to our slightly below average, though still acceptable, outlook for stocks long-term.
Odds are that you are very aware (only too aware) that this is an election year, and a pretty important election year as well. The undersigned all have our individual political preferences and plan to vote accordingly. There are many reasons to vote for, or against, a presidential candidate and some of those reasons have little or nothing to do with the economy or the stock market. However, we have had many conversations with clients and others this year expressing deep concern about the impact of this election on the market and their investment holdings. The crux of the issue is simple – will a victory by one candidate insure good times ahead, and perhaps more importantly, will a victory by the other candidate lead to certain investment purgatory? The brief, and honest, answer is that we cannot know, though it is more nuanced than that. Take a look back at two elections and the stock market results that followed. In 1980, Reagan was elected and, though time and Reagan’s success has obscured it, his victory was hardly to universal acclaim. Even the chief opponent in his own party referred to Reagan’s economic plans as “voodoo economics.” If an investor agreed, and did not vote for Reagan, and sold his/her investments, that investor may well have missed out on a subsequent huge market rally. Now fast forward to another election twelve years later. Most of those who voted for Reagan probably did not vote for Clinton in 1992. If those investors, in disappointment and with the belief that the ascendancy of a different political party spelled economic and investment doom, sold stocks and waited for the inevitable collapse, they too missed a remarkable stock rally. Two rallies, two Presidents, two political parties, two different political philosophies. What is the point of this historical review? To make the point that may seem obvious but bears remembering- there are many variables that impact and determine the fate of financial markets. Many of those variables are not directly determined by political decisions, and even those that are may not be predictable. Make no mistake – the decisions made by our political leaders over the next decade will be important determinates of our country’s economic fate, and we are far from agnostic in our beliefs regarding the policies and political decisions that are best for the country. Nevertheless, we are wary of being “one-issue” investors, and not certain that we, or anyone, can accurately predict those future political decisions and policies, nor the ultimate impact of this election on the markets.
Go away, come back again another day
The other dominant topic of interest we hear is straightforward and rarely goes out of style. Given all the undeniable short- and long- term economic and political problems would it not be wise to exit the market altogether – sell all stocks – and wait until the problems are resolved and the coast is clear? Should we go to the bunker and wait for the inevitable? Underlying the argument is the belief that moving out of all “risky” assets, such as stocks, and into cash is a risk-free move. That is a comfortable myth, but it is a myth nonetheless. An investor has traded the risks of volatility and a temporary loss of capital, for another risk, the gradual loss of purchasing power due to inflation.
Charlie Munger, Warren Buffett’s brilliant and blunt partner, had this to say on market timing (he is never subtle): “there’s no system to avoid bad markets. You can’t do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go.” Not all investors would agree with Mr. Munger. However, we are aware of few investors with long-term exceptional investment records who have successfully, and consistently, timed the stock market. Our unwillingness to attempt to time the market is not a prediction that we will not endure another bad market in the next few years. That could happen, and sometime over the next decade seems almost certain to happen. We just think it would be extraordinarily difficult to predict when a downturn will occur, how bad it will be, and the correct time to get back in the market. Our approach is to hold high quality investments at attractive long-term valuations. We structure each portfolio with an asset blend that appropriately reflects the current and expected future needs for income and stability so that we can ride out, and take advantage of, any downturns that do occur.