Quarterly Perspective for 3Q12

Summary

Markets were surprisingly strong last quarter as fairly lackluster economic numbers brought about global central bank intervention.  We have been in an unusual situation where “good is good” (meaning that good economic news leads to higher stock prices) and “bad is good” (bad economic news leads to the belief that the European Central Bank, U.S. Federal Reserve, and the Bank of China will add billions of dollars of stimulus to keep the rally going).  As it happened, the bad was good enough to prompt an influx of central bank liquidity.  This lifted both financial assets (stocks and bonds) and “real” assets (gold and real estate).  While that also increases the likelihood of future inflation, investors are generally more focused on the shorter term.  With the European debt crisis apparently pushed off for a few months and the U.S. budget situation on hold until 2013, the very short term appeared less dicey.  This had investors in a buying mood.

Overall, U.S. stocks rose 6.3% last quarter.  That brings the market’s gain to 16.3%[1] for the year.  Larger company stock generally performed better, with the S&P 500 (up 6.4% in 3Q12, 16.4% for the year) easily surpassing the midcap and small cap indices (both 5.4% in 3Q12 and 13.8% for the year, respectively).  I tend to think that graphs help put things in perspective so I inserted two charts from J.P. Morgan that illustrate the performance of the S&P 500 over several time periods.  Energy[2] was the leading sector with a 10.1% gain, followed by telecommunications and consumer discretionary (think cars and TVs).  Utilities and REITS were the worst performers.  These are seen as more defensive industries and often don’t perform well when investors are seeking to increase risk.

 

Source: Russell Investment Group, Standard and Poor’s, J.P. Morgan Asset Management as of 9/30/12

 

Source: Russell Investment Group, Standard and Poor’s, J.P. Morgan Asset Management as of 9/30/12

 

The actions by world central banks were even more beneficial for foreign stock investors.  The U.S. held up considerably better than Europe or Asia in the first half of 2012 because the U.S. was, as Bill Gross of PIMCO famously put it, “The cleanest dirty shirt in the hamper”.  Thus Europe and Asia had more to gain from the “cleansing” action of billions of dollars of credit.  Asian stocks rose 9.3%[3] on the quarter while European stocks tacked on 8.8%.  Once again, Japan was the place you really wanted to avoid.  Japanese shares gave up 0.8% last quarter.

The bond market rally continued.  Federal Reserve bond buying and investor demand for yield pushed bond prices up despite the increased risk of rising inflation.  Here too, the riskiest classes of debt instruments performed the best.  Emerging market debt soared 6.8% and high yield corporate debt rose 4.5%.  Bonds in whole, as measured by the Barclay’s Aggregate Bond Index, were up 1.6%[4].  That gives them a year-to-date return of 4.0%.  International bonds were helped by central bank activity, because it reversed the “flight-to-quality” buying of the U.S. dollar that had characterized the first half of the year.

 

Activity

When the central banks are actively easing, the only asset you really don’t want to have is cash (because the price of everything tends to be inflated).  We reduced our overall cash positions carefully where they were on the high side.  Most of the purchases were in global stocks (primarily the Artisan Global Value Investor fund) and large company stocks (BBH Core Select among others).  We did not do any major rebalancing because the overall investment environment (expansionary; risk-favoring within a context of below-average growth and an above-average risk of negative external shocks) did not change.

 

Outlook

The 16% year-to-date gain in stock prices is nice, but it is not justified given the lackluster growth in the economy.  In fact, in the absence of considerable central bank effort, the global economy would probably be contracting.  There is too much debt in developed nations (so their consumers cannot buy as much, and developing nations cannot export to them as much).  There is an excess world supply of labor, so wage growth is stagnant at best.  In “real” or inflation-adjusted terms, wages are falling.  There is no quick or easy solution.  Central banks are actively using monetary policy to fight deflation, but they cannot lift “real” growth.  As long as they continue to try, asset prices will perform better than they deserve to.  Which begs the question . . . . . . how long can this go on?  In another words, where would stock and bond prices be if governments were not indirectly supporting them?  The reason we have to ask this is that at some point in the future indirect government support will cease.  If we forget that today’s price levels are to some extent “artificial”, we are setting ourselves up for disappointment down the road.  The challenge for investors is to determine at what point (and how rapidly) the artificial prices and the true (unaided) prices begin to converge.  An aggressive investor would choose to be fully invested in order to take advantage of the price appreciation fueled by the excess liquidity.  A conservative investor would recognize the current market environment as a financial game of musical chairs, since political factors may force central banks to stop the music (in other words, end quantitative easing/outright monetary transactions) at any time.  Doing so would certainly hurt asset prices, so they probably elect to stay out of the market.   For most investors, pursuing a “middle of the road” strategy make the most sense.

 

Commentary – Valuation

If there is one thing that investors need to have a good sense of, it is valuation.  History has shown that when you invest at times when valuations are low, the probability of earning above long term average returns is high.  On the other hand, invest at the highest valuation points and long term below average returns are very likely.  The most common measure of market valuation is the price earnings ratio (P/E).  Stocks are said to be cheap when the price of a dollar of corporate earnings costs less than $12, and expensive when it cost more than $18.  Of course, there are other factors that influence this measure.  During periods of high inflation, for example, a dollar of future earnings is worth a lot less than a dollar of current earnings.  P/E ratios will typically be lower during those periods.  During periods when economic growth is especially strong (perhaps due to innovation or declining raw material costs) P/E ratios are often at the highest end of the range.  So where do we stand today?

That depends on how you look at it.  For example, much of the investment industry sees valuation today as being cheap.  Recently JP Morgan calculated the market’s current level is just 12.1 times “adjusted after-tax corporate profits”[5], placing it firmly in the lower end of its historical range.

Other market bulls cite the fact that the yield on the S&P 500 (2.24%) is lower than the yield on the 10-year Treasury (1.67%), a rare phenomenon over the last 60 years that has in each case been followed by strong stock performance.  See the inserted chart S&P 500 Earnings Yield vs. Baa Bond Yields.

 

Source: Standard & Poor’s, Moody’s, FactSet, J.P. Morgan Asset Management. As of 9/30/12

 

On the other hand, more than a few advisors (especially those without equity funds to promote) find the market rather expensive.  John Hussman, using Yale professor Robert Shiller’s price-to-last-10-years-average-earnings metric, says stock valuations are in the highest 1% of history[6].  See the inserted chart S&P 500 Shiller Cyclically Adjusted P/E.  His stats show that every time stocks are this expensive a significant decline is less than a year away.  Institutional money manager GMO isn’t that pessimistic, but they agree that future returns will be below average because after-tax profit margins are at record highs and must regress toward the mean.  At least one side is going to be very wrong.  But objectively, how do these arguments stack up?

 

Source: Russell Investment Group, Standard and Poor’s, J.P. Morgan Asset Management as of 9/30/12

 

First of all, since the S&P 500 is currently about 1440, a P/E of 12.1 implies earnings of $119 per share in 2013.  Past 12 month earnings are $101, so either future earnings are about to surge (not likely given recent CEO commentary) or JP Morgan is going by operating earnings (versus the more historically consistent reported earnings).  If we take a middle of the road estimate of 2013 reported earnings ($105), we get a P/E of 13.7.  Still modestly on the cheap side.

As for the argument that stocks are cheap relative to bonds, I wholeheartedly agree.  However, that discrepancy can just as easily be resolved by poor performance on the part of bonds as by strong stock returns.  The argument that P/Es should be higher today because inflation is low should also be rejected.  Historically, this relationship holds up during periods where inflation is stable but it works poorly when inflation is either volatile or negative (de-flation).  If the price of gold is any indication, the outlook for inflation is highly uncertain.  In any event, we do not afford Japanese stocks the highest P/Es today even though their inflation rate is clearly the lowest (-1%).  P/E ratios are more sensitive to the expectation of future growth – that’s why they were so high in the late 1990s.  With much of the globe expecting a prolonged period of sub-par growth, P/Es should be on the low side of average.

Now let’s look at the bearish arguments.  First of all, the Shiller P/E is not going to yield a useful result unless we factor out 2008, when earnings were essentially zero.  If we reduce the Shiller P/E by 10% (to adjust for the 2008 anomaly), we get a high P/E of 20.0.   The median historical Shiller P/E is about 19, so this is only modestly above average.  The GMO argument, that corporate profit margins have been unusually high at over 9% and will fall back toward the historical average of around 6.3%, also troubles me.[7] I don’t believe this will happen.

 

 

Source: Montier, James.  What Goes Up Must Come Down! www.GMO.com as of 9.30.11

 

There is plenty of surplus labor in the world, so labor costs won’t crimp margins.  Moreover, the political power of capital relative to that of labor is at its highest point since the 1920s.  Raw materials prices are set to fall.  They had surged in recent years because of the tremendous infrastructure growth of China as the Chinese built huge stocks of copper, aluminum, iron ore, timber, cement, etc.   Now China is slowing down just as raw material producers are adding capacity.  Moreover, the exploitation of vast natural gas reserves in the United States will also put downward pressure on production costs.  Finally, corporate taxes will either stay the same or be lowered, depending on the outcome of the election.  Rather than this (profit margin compression) being a negative for stocks, I foresee margins remaining elevated for a long time to come.

My conclusion is this – the path for the stock investor is neither decidedly uphill nor downhill.  In the end, neither the “boom” nor the “doom” arguments persuade me.  I expect that the relative difference in valuation between bonds (fairly expensive and over-owned by retail investors) and stocks (reasonably valued and under-owed by most people) will prove a long-term tailwind for stock investors.  Most of this will probably be realized beyond the next year or two.  By that time, bond investors will probably have become as dissatisfied with low returns as CD investors are today.

Trademark News

We are pleased to announce several new technology initiatives.  First, we are in the early stages of developing an iPhone, iPad and Android app that will allow you to review account valuation, performance and reporting information for your Trademark managed accounts.  The app should be available by the end of the year but we’ll let you know in our next newsletter.  Second, we now have the ability to email you your quarterly statement rather than mailing a paper copy.  Lastly, I want to remind everyone that I maintain a blog at www.trademarkfinancial.us/blog that I update once or twice a month.  It’s a good place for you to keep up with my current view of the market.  If you’re interested in either e-statement or being added to the blog update distribution email list please contact us.

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