No two ways about it – the third quarter of 2011 was difficult. The stock market declined all three months. July was the month of the U.S. debt ceiling struggle. Both stocks and bonds meandered most of that month as politicians tried to work things out. As we got close to the August 2nd deadline, however, public confidence plunged. Bonds soared and stocks plummeted. In August the European sovereign debt crisis returned to center stage. The Euro sold off as some speculated as to whether or not it would survive. Nervous global investors sought the relatively safer dollar and yen. Of course, this just made the alarming decline in European and emerging market stocks even greater in dollar and yen terms. Gold soared 16.6%[i] in the first three weeks of August, only to give every bit of it back by the end of September. By September, economic reports covering August began to roll in and they showed a sharp drop in economic activity. Investors knocked stocks down even further fearing that the economy had slipped back into recession. Interestingly, the bond market began to slump late in the quarter suggesting bond investors did not believe the economy was slowing as much as stock investors seemed to think. (This feeling has been borne out through the first week of October).
The bottom line was an average decline for U.S. stocks of over -15%.[ii] Large companies fared better as the S&P 500 lost -13.9% during the quarter and is now down -8.7% on the year.[iii] Small and mid-size companies each lost close to -20%.[iv] Developed international markets lost -19% and emerging markets dropped over -22%.[v]
Bonds performed much better–if you stuck to high credit quality. The BarCap Aggregate Bond Index rose 3.8%, but most bond funds hold shorter average maturities and as a result gained closer to 2.5%. On the other hand, high yield corporate bonds were slammed by the same economic concerns plaguing the stock market; they sank over -6%.[vi] T-Bills, the safest fixed income investment and the staple of most money market funds, rose just 0.01%.
Our focus last quarter was on replacing funds that were outliers to the downside with better performing alternatives. We also reduced international exposure, and upgraded the credit quality of the bond portfolio. Since we had started the fund replacement effort back in the second quarter, we were pretty well positioned in terms of stocks. On the other hand, the sell-off in credit sensitive bonds was greater than we expected, and given the strength of corporate balance sheets, unwarranted. High volatility favors active management, so we are making changes more frequently now.
At some point, prices get to a level when you just have to hold your nose and buy. We still have a dysfunctional political system in the U.S. The European sovereign debt crisis is, if anything, closer to its ultimate resolution due to the fact that those still supporting Greece can’t hold on much longer. The global economy continues slowing and China doesn’t appear to have the wherewithal to flood it with money as it did three years ago. There are plenty of reasons to want to sit on the sidelines and wait things out. That said, as investors you do not get paid for doing what is easy. The question isn’t whether or not things are bad. The question is whether investors have discounted the right amount of bad news, too much, or too little. Stock prices on September 30th reflected too much fear, I believe, and present an opportunity.
Because stocks have already declined so much, I am actually more nervous about bonds. Investors have flocked to bonds because they have outperformed stocks by a large margin over the past decade. The risk-reward equation for bonds going forward is not very attractive, however. At some point investors won’t be as negative on stocks as they are right now, and at that point the prospect of earning less than 2% on their short term bond fund is going to seem awfully unappealing. We are in an environment where the Federal Reserve is manipulating the yield curve in order to stimulate the economy. If the Fed was not in the market, almost certainly long term Treasury rates would be higher. At some point, therefore, they will be.
Commentary – The Least Worst Choice
First Eagle, a well-respected value-oriented mutual fund manager, recently stated that “Equities remain the least worst choice for a long term investor.”[vii] I want to discuss what they mean and why I agree with that statement.
Last quarter I tried to illustrate the difference between losses due to market fluctuation (those that can easily be recovered) and losses that stem from a fundamental mispricing of an asset (which may never be recovered). I did that to illustrate that sometimes prices fall for reasons unrelated to the success of the issuer. There is a fundamental understanding of investment markets that you MUST understand in order to be a successful investor. The more expensive (cheaper) the asset is, the less (more) return it will provide over the long term. This is so important that I want to de-construct it so we can understand it better.
The first part of the sentence refers to how much one has to pay for the benefit (meaning yield or appreciation potential) one is getting. For example, the stocks of many medical device companies were expensively priced at over 20 times annual earnings per share a decade ago because investors believed they would rapidly grow earnings. As it happened, in almost all cases those companies did double or triple their earnings. Unfortunately, investors came to see those companies less as innovative technology companies and more as boring manufacturing firms. Many of those firms now trade at 11 times earnings or less, meaning investors made little or nothing on those stocks even though the companies performed as expected. At the wrong price, even a good company is a bad investment.
The second part of the sentence refers to time, specifically the long term. In the short term, there is very little to contain the fear and greed of investors. It seems absurd to think that investors would pay over 100 times annual earnings back in January 2000 for a semiconductor equipment company that earned just over a dollar per share, but they did.[viii] Sometimes you can buy an investment that is expensive only to see it get more expensive. However, investors cannot maintain a climate of extreme greed or extreme fear indefinitely. At multiple points in time, prices move through fair value.[ix] We can project fair value in the future by using historical median interest rates, price-earnings ratios, and earnings growth rates. There is no guarantee those figures will be correct, but we are at least removing our current bias from them. For example, today’s estimates of future economic growth tend to be conservative because we are in a weak economic environment and have been for many years. There is no guarantee, however, that this will still be the case ten years from now. Bottom line: if we only buy assets when they are in favor, our long term returns will not be very good. If, on the other hand, we can buy good assets when sentiment is bad, long terms returns can be surprisingly good.
Broadly speaking investors have four asset classes with which to work. One is cash, or money market instruments such as T-bills. They currently yield 0.01% (and if you own a money market fund inside a variable annuity, after insurance expenses their annual yield is closer to -1.6%). Since the cost of living is rising at a higher rate than 0.01%, cash is not an attractive place to invest for the long term right now. A second option is the bond market. For sake of argument we will restrict the discussion of bonds to higher quality bonds since lower quality bonds correlate much better with the stock market. The ten-year Treasury bond yields a little over 2% today. High quality corporate 10-year bonds might yield as much as 4%. These yields reflect conditions in which inflation is low and the Federal Reserve is buying long term bonds to keep interest rates down as a means to encourage mortgage refinancing and stimulate the economy. If we assume that ten years from now Fed policy is neither restrictive nor accommodative, bond yields would almost certainly be higher. Therefore, bond prices would be lower. Investors buying a long term Treasury bond fund would earn a return of less than 2% annualized. High grade corporates and municipals might do a percent or two better, but we are still looking at annual returns of less than 4% best case. A third asset class an investor might choose is commodities. This wide ranging group includes oil & gas, timber, grains & livestock, and both base and precious metals. Generalization of such a disparate class is very difficult because each commodity has its own fundamentals (some are scarce while others are plentiful). Over the long term, however, the rate of growth of most commodities tends to grow with the rate of population growth. The only way it can do better is if its scarcity or its usage increase. There is no reliable way to know how much more or less scarce or in demand gold or natural gas or cotton or soybeans or niobium will be ten years from now. That brings us to stocks.
The historical return for U.S. stocks is around 9.8% according to CNNMoney.[x] Stock returns are comprised of appreciation (which is tied to the rate of profit growth), dividend yield, and net change in investor sentiment. The long term growth rate of profits has been surprisingly steady at around 6% over time. Dividends have fluctuated from over 6% in the late 1970s to under 1.5% in 1999; today they yield about 2.3%. It is the changes in investor sentiment that give markets the volatility we all know and love. If we estimate stock returns ten years out, we should probably adjust the 6% annual profit figure downward to allow for the fact that corporate profit margins have been at record levels recently and almost certainly will be lower in the future. Dividend yields are lower than average today as well, so the 9.8% annual return we otherwise would have expected might well be closer to 7%. That leaves us with the net change in investor sentiment. How might that change in the next ten years?
Stocks today trade at earnings multiples below their historical averages.[xi] We attribute this to the fact that investors have a lot of fears. Europe might break apart. Our politicians seem incompetent at best and corrupt at worst. Wall Street is run for the benefit of large trading firms instead of small investors. Add to this the national debt, China, oil, weather, the list is seemingly endless. To be sure, all of these fears seem very rational. But will things really be this bad or worse ten years from now or will we have addressed at least some of them? For example, in ten years Greece (and Portugal and Ireland) either will have defaulted or the Europeans will have come up with a better system to replace the current one. If we assume no improvement in price-earnings ratios, stocks would project to a 7% annual return, which would beat bonds by at least 3%. If P/Es returned to their post-war average, stock would gain double digits annually.
First Eagle was saying in its “least worst” commentary that all asset classes look bad right now but that for the long term investor, stocks are the best option. I firmly agree with that assertion. The caveat I would make is that if you cannot be a long term investor (either because you need to take withdrawals or you cannot stomach the volatility that comes with being a stock investor) then you should own primarily bonds and cash and accept the very modest returns that these investments provide. You will probably be far better off earning 3% than selling every time the stock market drops and buying every time it rises. If, however, you have the time horizon and the fortitude for stocks I believe you will be well rewarded on a ten year and longer basis. Just know that the road will continue to be bumpy as global financial markets sort through a variety of challenges. It may very well be that the first half of the decade is less profitable than the second half.
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[i] As measured by GLD
[ii] Wilshire 5000 per Morningstar
[iii] Source: JP Morgan 3Q11 Guide to the Markets
[iv] S&P 400 Midcap and S&P 600 Smallcap Indices
[v] MSCI EAFE and EM Indices, dollar-based
[vi] Barcap Corporate High Yield Index
[vii] First Eagle Update, 10/7/2011
[viii] PMC-Sierra actually reached $255 per share, or 250 times earnings. It trades at less than $7 today.
[ix] Fair value being the subjective price in which all material knowledge about a company is known and fear and greed are in equilibrium.
[x] CNNMoney.com, 1926-2010
[xi] Source: JP Morgan 3Q11 Guide to the Markets