Review & Outlook

Our take on the investing, financial, & economic themes of the day

Second Quarter

14 July, 2006 by admin in Quarterly Letters

After a strong start, the American stock market stumbled badly in the closing weeks of the quarter ending June 30, 2006. The reason the stock market sold-off probably had more to do with conditions abroad than at home. On balance the sell-off, however painful in the short run, will likely promote good health in the U.S. markets for the balance of the year.

Abnormally low interest rates in Japan – – short-term rates were actually 0% – – have encouraged aggressive investors to borrow as much as possible in Japan and then reinvest the proceeds in other markets around the world. Hedge funds have become particularly adept at this risky game, to the result that imitators have swollen their ranks. Speculative bubbles were forming in China, Brazil, India, and Russia, and in worldwide commodity markets like copper, timber and oil.

In mid-May, central bankers around the world, including U.S. Federal Reserve Chairman Ben Bernanke, became sufficiently uncomfortable with the situation to signal their intention to move against the speculation with the various monetary tools at their disposal. Their words of warning were enough to prick the bubble. Emerging markets, such as those in China, Brazil, India and Russia, fell the most, with some falling as much as 30%. Here at home small-cap stocks fell about 9% in price; energy-related stocks like Schumberger fell anywhere from 10 to 25%; blue-chip stocks like Procter & Gamble and GE and Citibank fell about 2 or 3%.

Where does this stock sell-off (or “correction”) leave us? In pretty good shape. What former Fed Reserve chief Alan Greenspan once called “irrational exuberance” has been wrung out of the system. (Indeed, the real danger would have been to let the bubble build, as occurred in the late 1990s.) Investors appear to have lost their appetite for risky stocks and bonds, whether here at home or in foreign markets in India, China, Brazil, Russia, Iceland, Greece. Meanwhile, the American economy is growing at a very strong rate of 4 to 5% a year; the rate of unemployment is at a five-year low of 4.6%; corporate profitability continues at roughly twice the rate of the 1990s’ boom; and federal tax receipts in 2006 are $250 billion more than expected. Inflation, which no one seems able to measure with precision, appears under control at annual rate somewhere between 2 and 4% a year.

We think investors will redirect their new-money purchases to our kind of stocks, that is to say, toward high-quality stocks like General Electric, Procter & Gamble, IBM, Home Depot, Medtronic, Cisco, and Microsoft. It is late in the economic cycle, when investors typically rotate toward the highest quality sectors of the stock market. The stock market does not have to follow the historical pattern, of course, but at some point blue-chip stocks are going to catch up with other classes of assets. The prices of residential and commercial real estate, small-cap stocks, foreign and emerging market stocks and commodity funds have enjoyed double-digit growth over the past five years; over the same period the prices of blue-chip stocks, as measured by the S&P 500-stock index, have been stagnant. Curiously, earnings among S&P 500 stocks have risen very strongly during this period, to the result that the S&P 500 is today about half as expensive as it was in the late 1990s, when stocks soared.

The risk of a surprise is always before us. While surprises can be of the pleasant sort (such as this year’s surprise collection of $250 billion in extra corporate and personal federal income taxes), they often are not. Fortunately the price of being cautious is going down. Let me explain. Today cash reserves held in money market funds are earning returns of 5%; several years ago, money market funds paid less than 1%, which, after taxes and inflation, was a high price indeed. Bonds also are beginning to be attractive on a real or inflation-adjusted basis. I will never forget trying to meet clients’ income needs several years ago when bonds paid in the 2% range (they pay around 5 to 6% today). Fortunately those days too are behind us.


Mark O’Brien