To Our Clients and Friends of Parthenon LLC
This would not seem to be a flavorful investment recipe: combine a “fiscal cliff” with a heated presidential election, and then add a pinch of tepid job growth and a large dash of economic uncertainty. Finally, top it off with a huge government deficit. Although that brew hardly sounds appetizing, investors got a tasty double digit return in equities from the mix (or in spite of it). The market rarely waits for the all clear to sound before climbing, and this year demonstrated again the hazard of remaining on the sidelines hoping for the ever-allusive investment certainty. The S&P 500 was up an above-average 16% with dividends in 2012. That is nearly double the long-term annual average for the broad market.
Bond yields remained near historic lows, with the 10-year Treasury bond finishing the year with a 1.76% yield after beginning at 1.88%. The extraordinary has become the mundane with bond yields after years of declines to levels hardly imagined only a few years ago. We continue to caution that future bond returns are likely to be very modest, while recognizing the need for the current income and stability that high-quality fixed income securities provide in appropriate portfolios.
Stocks outperformed our long-term annual expectations in 2012 and, generally, our estimate of growth in underlying corporate intrinsic values. We remain positively pre-disposed toward stocks relative to other assets classes, but our enthusiasm has waned modestly as valuations have expanded. We anticipate returns below long-term annual averages but the risk /reward ratio for our stock holdings, we believe, remains attractive, though less compelling than this time last year.
What could go right?
Unless you never watch TV, log on the Internet, read a newspaper, or turn on a radio, you are no doubt aware of nearly everything that is wrong, will go wrong, should go wrong, and could go wrong with our economy, political system, capitalism, and, for good measure, the weather. We would like to take a moment to present the oft-neglected other side – what is right, and could go right economically and politically (we will skip the weather). As investors, we try to be neither optimists nor pessimists if being either means placing sentiment above hard analysis and rational thought. So, do not mistake the following as an “optimist’s credo.” We see it as a realist’s view of current conditions and potential positive events. As we have written in past letters, we believe our economy, and investors, face at least a moderate net “headwind” for the next 5-7 years. However, the following explains why we think that headwind need not grind economic activity to a halt. So read on for some “good” news.
The housing market continues to rebound, improving conditions throughout the housing food chain, which is vast. The uncertainty is how long and how strong the recovery will be. Housing impacts our economy in a huge manner with enormous implications. For those with fond memories of the housing market in 2006, today’s rebound may seem paltry. Nevertheless, the relative improvement from the disastrous conditions post the financial crisis is already providing an economic lift, and may be quite significant and meaningful if it accelerates.
North American energy independence – does anything sound more like a contradiction in terms? We are not energy experts nor do we claim to have an intimate knowledge of the intermediate and long-term supply/demand equation in energy. However, consider that only a few years ago America seemed trapped in an ever-spiraling energy cost escalation, wholly dependent on unstable foreign sources for oil. Now we are awash in low cost natural gas, and production technology is improving yields from older oil fields, while new technologies have made it economical to extract more oil at reasonable costs from shale and other non-conventional sources. In addition, modest conservation efforts have reduced the growth in energy usage domestically.
The growth in energy production creates more stability in energy costs and, just as importantly, the production itself creates well-paying jobs. Make no mistake, a disruption in the Middle East oil markets would still impact prices at the pump, at least temporarily, and the growing demand in emerging markets may still exceed new world-wide production growth long-term. However, it is impossible to deny that our energy concerns have diminished (for now, at least).
In a “man bites dog” story, some manufacturing jobs may be moving back to the US as domestic manufacturing competitiveness allows companies to consider sourcing domestically or cancelling plans to move production offshore. While we would expect any positive labor impact from increased domestic sourcing to be modest, all jobs are welcome.
Growth in emerging market economies, though uneven, continues at a healthy pace. Wealthier developing countries will provide a larger market for American products and greater world-wide prosperity. A wealthier world is better, not worse, for our economy, all things considered.
Corporations are flush with cash, and bank balance sheets are in much better shape than at any time in the past five years. The slow economy and limited investment opportunities have created cash-heavy corporate balance sheets. The cash on the balance sheets, according to an estimate we recently saw, is approaching $2 trillion. While that cash is symptomatic of a dearth of recent investment and expansion opportunities, it also shows that companies have the wherewithal to invest in capital projects if, and when, confidence returns and conditions warrant renewed capital investment.
Finally, our dysfunctional politicians may actually agree on a long-term strategy, sometime in the next five years, to deal with the structural deficit spending and underfunded/over-promised entitlement programs (pause for laughter and cynical comments). We understand that little we have seen over the past year would provide much hope for this eventuality. However, a looming disaster has a way of focusing one’s thoughts. The problems are huge, the numbers enormous, but putting the federal government on a fiscal “glide path” to solvency can be done if changes are made now, years before the worst problems start. Nearly all politicians of both major parties understand the math, and, ultimately, doing nothing indefinitely will not be an option. It is inevitable that something will be done. It is not inevitable that what is done will be sufficient, but neither is it inevitable that it will be totally inadequate.
A Quarter Century of Prosperity?
In a moment of personal introspection recently, one of the undersigned reflected on the fact that he began his professional investment career slightly more than a quarter century ago, in the summer of 1987. The stock market was riding high that summer, five years into a bull market. The market peaked shortly after, and then started a decline which culminated in a stunning 22% one day drop in October (think about that the next time the market suffers a “harrowing” 3%-4% decline in one day). The total market decline from the summer peak was 40%.
Let us take a quick glance back at the highlights (and lowlights) of those 25 years. We experienced a war, bear market, and recession in 1990-91 followed by a few years of slow growth, and little market progress. Then the strongest stock market rally in a generation began in 1995, culminating in the “tech bubble” of the late 90s, and its collapse in 2000. That was followed by the terrorist attacks of 9/11, a recession and a near 40% decline in the broad stock market by 2002. An economic recovery ensued and the stock market moved up to the previous levels. Then arguably the worst recession in fifty years hit in 2008, a financial panic ensued along with a 50% decline in the stock market which bottomed in 2009. That has been followed by a slow, grinding economic recovery coupled with massive government deficits.
Now take a deep breath and consider whether you would have put a penny in stocks in July 1987 had you known all that would occur economically, militarily, and politically? It might have seemed quite rational, and wise, to just skip that opportunity. Through it all, the stock market, measured by the S&P 500 has produced an annualized return of 8.7%.
We recognize that 25 years is a time horizon beyond that of most investor’s currently anticipated needs and visions. Examining the market’s progress for that time span will naturally smooth out most peaks and valleys that otherwise may significantly impact an investor’s objectives, financial condition and wealth. Nevertheless, the progress demonstrates our economy’s ability to overcome daunting obstacles and challenges, and march upward. As one considers the future, contemplate whether we will face any more, or more challenging, hurdles than we have encountered over the past 25 years. In the meantime, we will continue to position portfolios with the appropriate asset blends to meet more immediate needs, while also being invested to gain from long-term market growth.