Review & Outlook

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

Third Quarter

6 October, 2006 by admin in Quarterly Letters

This past May the outlook brightened considerably for our brand of high-quality stocks. Central bankers in Japan, Europe and the United States signaled their intention to end easy-money policies that had long fueled speculation and created valuation bubbles in commodities and emerging markets like Brazil, Russia, India and China. In the aftermath of the central bankers’ tough talk, one could almost feel investors shift from these areas to blue chip American stocks. These trends that began in May accelerated in the third quarter 2006. That is to say, commodities, emerging markets, and lesser-quality American stocks continued to wilt, while blue chip American stocks rose 5 to 6% in price, their best July-to-September period in eleven years. Market leadership clearly passed to blue chip stocks, which finally came to life after six long years of waiting.

A news story on page six of Sunday’s New York Times (October 1, 2006) causes one to wonder why it took blue chip stocks so long to resume market leadership. For the first time ever, reported The Times, corporate profits amount to 8.6% of gross domestic profit; corporate profits have never been so high. They have been growing at double-digit rates for an unprecedented thirteen straight quarters, a trend that is expected to continue as companies report earnings for the third quarter of 2006. A survey of analysts by Thomson Financial suggests earnings growth close to 14% for companies in the S&P 500 during the quarter. Corporations have used the record profits to pay down debt, shore up cash reserves, increase dividends, and develop or acquire new product lines.

While corporate earnings are about twice as high as they were six years ago, stock prices are unchanged, making stocks half as expensive as they were six years ago in terms of price-earnings ratios (the famous “PE” in the investment business). How do current price-earnings ratios compare to historical averages? On the scale of relative expensiveness, stocks now are about at the average point, so stocks are still not particularly cheap. But then again, stocks should not be cheap, because the economy in general and corporations in particular, are in above average shape.

Unemployment is 4.7%, which implies employment of 95.3 %. When I studied economics in the 1970s, anything over 94% was considered full employment. Despite full employment conditions, the pressure on inflation appears to be easing. In recent weeks, the price of oil has fallen from a high of $78 in July to $58 a barrel. Prices of other commodities like gasoline, food and metals have similarly fallen. Though lower gas prices offer relief to consumers, falling home prices are cause for concern. In August, the national median price fell, year over year, for the first time in eleven years. The big question, as yet unanswered, is whether falling gasoline and commodity prices will offset a weak housing market in consumers’ calculation of their financial well-being.

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October 6, 2006

There is another problem that bears watching. The herd of “independent-minded” money managers at elite educational and cultural institutions like Harvard, Yale and Princeton and at state and private pension plans around the country has thrown record amounts of money into leverage buyout and private equity funds. The result is that an alarming amount of money has poured into some very sketchy areas of the economy. For the last few years, while blue chips marked time, these “alternative investments” worked out beautifully; but a good investment idea, even the best idea in the world, can be turned into a disastrous investment if too many people buy into it. Thus I expect that private equity and leverage buyout funds, after years of stellar performance, are destined to go through a period of wealth destruction, just as Internet stocks did in 2000. The fallout will make some ugly background noise, but on balance be a healthy corrective.

As far as our particular brand of stocks and bonds is concerned, I think we are in the sweet spot right now. Barring a surprise of some sort, which by definition is unknowable, record-high productivity, profitability, and employment should carry the third quarter trend of higher blue chip stock and bond prices into the fourth quarter and beyond.

Sincerely,

Mark O’Brien