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Newsletter 3rd Quarter 2011
Quarterly Investment Commentary: A Glass Half Full or Half Empty?
When the quarter starts with our nation’s legislative leaders bickering endlessly about raising
the debt ceiling, segues into an unprecedented downgrade of U.S. Treasury debt, and concludes with worries about the fiscal soundness of numerous European countries and concerns
about flagging growth in the global economy, it’s bound to be a challenging time for the markets. Indeed, the Dow Industrial Average experienced its worst decline since the first quarter
of 2009, dropping 12%, while the broader S&P 500 lost 14%. Market segments that normally
account for more robust growth fared far worse than the Dow with the Russell 2000 (small
company stocks) down 22%; and MSCI EAFE (International stocks) down 19.60%. High volatility was a constant companion as the Dow swung more than 200 points eighteen times, further unnerving investors. The only bright spot amongst all this turmoil was the bond market,
where yields plummeted to extraordinarily low levels (prices move inversely to yields). The
benchmark 10-year Treasury dropped more than 1.2% for the quarter, yielding 1.929% by
quarter’s end. The 30-year dropped 1.4%, ending September at a meager 2.921%.
The Federal Reserve responded to concerns about persistent weakness with two unexpected
and unprecedented moves. The first was a commitment to keep short-term rates low for two
years. The second endeavors to bring long-term rates even lower with the Fed selling its shortmaturity Treasuries and buying longer-term Treasuries – a move dubbed “Operation Twist”.
While I’m sure Chubby Checker is pleased, I suspect his infamous dance has left a more profound mark on society than will the Feds’ action. Paul McCulley, former managing director at
bond giant Pimco, voiced his skepticism in a recent interview (my underlining added):
A liquidity trap is simply defined as when the private sector is in a deleveraging mode, or a de-risking
mode, or an increasing savings mode — all of which you can also call deleveraging phenomena — because of enduring negative animal spirits caused by legacy issues associated with bubbles. In that
scenario, the animal spirits of the private sector are not going to be revived by a reduction in interest
rates because there is no demand. It's not the price of credit driving the deleveraging. It's "I took on too
much debt during the bubble. I have negative equity in my home. I don't care what the price of credit is,
I already have too much outstanding. I am paying down credit!"
Federal Reserve Chairman Ben Bernanke has been quite vocal of late in stating the need for fiscal
reforms, as it appears the Fed may be running out of bullets; or, as McCulley alleges, the bullets it’s
firing are blanks. The reality of persistently high unemployment, anemic economic growth and
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lingering stagnation in housing strongly suggest Mr. McCulley may be on the right track. We
have had very low rates for some time now, but the economic effects have been decidedly underwhelming.
The growing groundswell of social unease and protest we’ve witnessed of late suggests citizens
are beyond weary with Washington’s empty rhetoric, endless bickering and persistent finger
pointing. What effect this will have on election year politics remains to be seen, but surely
elected officials of all stripes must feel more tenuous about their job security. Perhaps job insecurity will goad them into actually doing something constructive.
Valuations & the Long View
Normally at this juncture I would wax poetic about current valuations and themes relevant to
the quarter recently transpired. However, if someone else can say it better, they should be
heard. With sentiment so negative and pessimism so prevalent, the contrarian in me finds
these selected insights from the quarterly newsletter of Neel Kashkari, head of global equities
at Pimco, a thought-provoking counterpoint to those currently fleeing the equity markets:
If this extended New Normal period of slow growth and deleveraging is unavoidable, does it mean equity markets will languish for the next decade? We don’t think that has to be so.
Let’s consider how equities offer returns to investors and see what markets today are telling us:
1) Multiple expansion: today, trailing twelve month earnings multiples for the MSCI World are at
12.2x compared with an average of 14.3x for the past year and 19.5x for the past 10 years.
Emerging markets, as designated by the MSCI Emerging Markets Index, are cheaper yet, at
9.7x. While we aren’t forecasting strong multiple expansion from here, valuations today don’t
seem excessive as long as the U.S. and global economy avoid recession.
2) Earnings growth: Corporations have enjoyed very strong earnings in the past couple of years
due to aggressive cost cutting, continued adoption of efficiency-enhancing technologies, as well
as exports to higher growth markets. MSCI World earnings grew approximately 4% per year the
last three years, with significant earnings growth coming from outside global developed economies. While a slow developed economy won’t help corporate earnings grow quickly, many companies can generate faster growth by continuing to export to higher growth markets. The New
Normal does not necessarily doom corporate earnings – and careful stock selection can help.
3) Dividends: In an extended period of slow economic growth and deleveraging, interest rates are
likely to remain low, with the real return on bonds low or even negative. No longer having a
debt-induced rising tide to continue lifting asset prices endlessly higher, actual income generation from investments is important. The MSCI World today offers a dividend yield of 2.9% which
compares favorably to nominal 10-year Treasury yields at around 2%. Whereas the Treasury
coupon is fixed, dividends on stocks tend to grow over time. Emerging markets are also offering
yields of around 3.3% today.
Based on all three factors -- reasonable valuations, healthy earnings growth and attractive dividends -we believe with careful stock selection investors can earn attractive returns during this extended period
of slow economic growth.
But we must stress one additional aspect of the New Normal that is likely here to stay: heightened volatility. We have all experienced it watching equity markets rally and plummet on an almost daily basis, in
part due to economic factors and in part due to a lack of confidence in political processes on both side
of the Atlantic.
Valuations are quite compelling, as Mr. Kashkari points out. Global stock markets have
“priced-in” most, if not all, of the negative news and sentiment so prevalent today, and investors are currently overlooking a host of positives. Unlike three years ago, after the Lehman
Brothers debacle, most domestic banks are well capitalized and liquid. Commodity prices
have recently declined, reducing inflationary concerns. Corporate earnings have remained
positive and corporate coffers hold record levels of cash.
The investing public sees a glass half empty, while a more measured view indicates a glass
half full. Expectations are so low and sentiment so pervasively negative that it would take
very little good news to spark a rally. Market history has shown that protracted periods of
market weakness, such as the present one, are frequently followed by pleasant surprises.
While it is impossible to time when such a turnabout will come, Wall Street repeatedly validates the oft stated adage that “it is always darkest before the dawn.” “The optimist sees the rose
and not its thorns; the pessimist stares at the thorns, oblivious to the rose.” – Kahlil Gibran 1883-1931
Paul Vermilya
Compass Investment Advisers LLC