To Our Clients and Friends of Parthenon LLC
The stock market surpassed the all-time high reached in 2007, those halcyon pre-crisis days, and kept on rising. The S&P 500 delivered the highest annual total return since 1997, up 32.4%. Only a short five years ago the world financial and economic systems were in total turmoil, the stock market was crashing, and stocks were pariahs to be run from at the risk of financial ruin. Not so now, as enthusiasm for stocks has returned. That scary time offered at least one redeeming quality to investors – stocks were extremely cheap. We will discuss in this letter whether, as a long-term investor, one should be more or less enthused about stocks after the more than 100% jump from the 2009 bottom. If you have read any of our previous letters, you can probably guess where we come out on that question.
Bond yields rose significantly though yields remain low by historic standards. The 10-year Treasury bond ended the year at 3.03%, up from only 1.76% at the start. That was a huge move in relative percentage terms, though the yield still remains well below long-term averages. The Federal Reserve eased back ever so slightly on the economic accelerator at year end as economic growth picked up some steam. Inflation, even after years of Fed stimulus, continues to be quiescent. An interesting “circularity” is in play with bonds and was a source of investor concern throughout the year. It goes something like this: A stronger economy (good) will force yields higher (bad). In turn, higher rates will slow down, perhaps even derail, the economic expansion (also bad). Maybe, though we think if rates rise at a moderate clip due to economic growth, it is more likely to be good than bad. We do not fear moderately rising rates pushed higher by accelerating economic growth. The alternative, rates at or below current levels with a stagnating economy, would be much more worrisome.
What went so right last year to propel the market higher? We wrote at the beginning of the year a brief summation of things that could go right, though our focus was longer-term. Many variables impact the market in the brief period of one year and the market can go higher for no compelling fundamental reason. Corporate earnings were generally solid, coming in as expected or better. Europe did not implode, and economic tensions eased. The domestic economy began to accelerate as the year progressed, and the Federal Reserve continued to stimulate throughout the year. In addition, stocks continue to find favor as most alternative investments, such as bonds, remain relatively unattractive and cash yields are near zero.
As we look ahead and consider the market’s prospects, it is important to understand that the intrinsic value of an individual stock can be estimated but never precisely pinpointed. Even the valuation of the most mundane and consistent business can be only approximated. The intrinsic value of the market, comprised of thousands of stocks, is hence much more difficult to determine. We recommend never assuming greater precision than possible in an arena fraught with uncertainty. In that context, we think the market’s valuation is within a broad zone of reasonable valuation based on historical parameters, current and sustainable earning power, and interest rates. However, we feel it has reached the upper end of that zone, and expectations for future long-term returns should be tempered.
Stocks – Then and Now
In the summer of 2010, we articulated a case for the attractiveness of equities by describing the market valuation accorded to a group of high-quality, large companies. As you no doubt can surmise, these “generic” companies were representative of many stocks we owned, and were buying, at the time. They were valued at 11-13 times earnings (the p/e), with dividend yields of 3%-4%. Our thesis was simple, straightforward, and extremely conservative. These businesses had historically grown earnings approximately 10% annually and were valued near the bottom of their historical range, with yields at the highest levels in a generation. No heroic assumptions were needed to envision solid investment returns with a portfolio of these securities. Indeed, we wrote that with earnings growth of only half the historic average, and an ending valuation no higher than the current low level, the total annualized return from owning this basket of stocks would be at least 8.5%, which is near the long-term average for the stock market. Our recommendation then was to buy and own these stocks, and we did. Seems quaint now, but at the time the air was thick with pessimism and the lingering trauma of the financial crisis. Needless to say, our rationale proved more than conservative as stocks have far outperformed that meager expectation.
Three and one half years later, let’s take a look at those same stocks. They are now 15-17 times earnings, with yields down to 2% -3%. The assumptions and estimates needed to envision solid returns, while still not grandiose, are no longer quite so conservative. We have seen much higher valuations in our career, most notably the late 90s. On valuation alone this is hardly 1999. At that time stocks of companies of all stripes – high, low, and no quality – were valued at unprecedented levels. We do not think current valuations are the prelude to another lost decade. However, unless one envisions valuations rising to excessive heights, returns will be much closer to business value growth and well-below the past several years.
Higher Prices, More Buyers
The prices are higher, so the buyers are swarming back. Few things are more reliable than the influx of more investors from the sidelines as the market hits new highs. After over four years of fleeing equity funds, individual investors are coming back. Net cash flows to stock mutual funds were negative for each year from 2008 through 2012 before turning positive in 2013. We have seen estimates that the investment in-flows alone to equity mutual funds in 2013 exceeded the total from the previous four years combined. It is not just individual investors who behave thus; institutional investors are likely to increase their commitment to domestic equities as they feel pressure to “keep up.” We are not predicting this late-charging herd will be wrong. Indeed, of three broad asset classes – cash, bonds and stocks – we expect stocks to outperform over the long-term. However, those investors returning from the wilderness lured by visions of returns similar to the recent past are likely to be disappointed.
Be Prepared Not Surprised
In the preceding paragraphs, we may have thrown a little cold water on any untoward exuberance you may have felt about stocks after the big gains of the past two years. Any long-time readers of our letters (we know there are a couple) are well-aware that we avoid short-term market predictions with as much effort as we can. Ask us how the market will fare this year and watch us dance around and provide a suitable non-answer. Unfortunately, the myriad variables that impact short-term market moves are, we think, simply too capricious and unpredictable for anyone to reliably predict. Our thinking toward short-term market gurus is akin to an exchange from an old radio skit we heard recently: “Hey, can you see anything under that blindfold? Well, on a clear day I can see the blindfold”. The short-term investment “blindfold” is too opaque to see though and renders in our opinion short-term market prognostications so unreliable as to be little more than random guesses. We recently read that the average Wall Street market strategist prediction for 2013 called for a gain of 8% in the S&P 500. As the saying goes, “missed it by that much.” We know a lot of people get paid to make those guesses and with hundreds doing it every year you can be certain some will get it right and be celebrated for their prescience until they flame out in the next round. We recommend paying them little heed.
Nevertheless, it has now been over two years without even a 10% correction in the market. No financial law requires there be a correction, no stock exchange mandate exists to force one. Though as prices rise and valuations become more stretched, the catalysts that may precipitate a decline generally become more abundant. We would, if we could, dance nimbly out of the market before any correction, and then jump back in. We cannot. Many of the “dancers” have completely missed the music over the past four years trying to avoid the next downturn.
Event risk is unpredictable so it is imperative to have an appropriate long-term asset blend. Understand and accept that investing is a marathon and focus on the process, not on the daily market score. Do not assume precision and accuracy that it is not possible to possess and accept the inevitable and unavoidable short-term uncertainty. By maintaining a long-term focus, when much of the world cares only about next week, an investor can avoid the emotional swings that plague so many and cause them to make imprudent and rash financial decisions. An investor focused on the long-term process can profit from the market’s short-term myopia. The two single most important things for an individual investor never change – an asset blend appropriate for their needs and situation, and a long-term focus. Do not be thrown off your focus should 2014 bring a temporary decline. We will not be.