Review & Outlook

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

Second Quarter

8 July, 2010 by Mark O'Brien in Quarterly Letters

The quarter just ended shook investors to the core not so much for what happened as for what was conjured up from the painful and all-too-recent past. I am speaking of memories of 2008 when markets collapsed and banks and brokerages failed and eight million or so workers joined the unemployment rolls. Are we heading back to those days? The second quarter 2010 raised the possibility. It threw into reverse the splendid stock and bond market recovery of the previous 12 months, and called into question the ability of government officials to administer monetary and fiscal tools, and, perhaps even scarier, whether these tools work at all, for anyone, regardless of political affiliation.

Whether we are headed back to 2008, no one, of course, knows. The future is always uncertain, but it’s probably a good idea to be prepared for that grim possibility. How? First, as they say in medicine, do no harm. I am thinking of how so many people sold out at the bottom of the market in 2009 and missed the 75% price rebound. A good way to avoid such a self-inflicted wound is to focus on portfolio cash flow (the income received from stocks and bonds) and not gyrating stock prices. Assuming high quality stocks and bonds – – and our portfolios only have high quality stocks and bonds – – portfolio income doesn’t change much from month to month, quarter to quarter, year to year. Thus this past May 10, when stock prices inexplicably dove 1,000 points in 2 or 3 minutes, dividends and interest payments were unchanged. Or, to return to 2008, when stocks ratcheted lower day after day, month after month, dividends and interest barely budged. So train your eyes on portfolio income. If we do go back to 2008, you’ll be comforted by the income metric, and less likely to sell out at the bottom.

A second point to remember: the private sector is in remarkably good health. Yes, the banking and brokerage and housing industries are struggling, but the rest of the economy is in fighting trim. An astounding surge in productivity has kept profit margins high even as overall demand has been lackluster. Companies have learned how to be ruthless cost- cutters. At the first sign of trouble, they are not hesitant to close foreign plants (outsourcing’s silver lining – – a real shock absorber for the domestic economy) and lay off employees. This cost-cutting ethic is not all good, of course, but it does speak to the ability and willingness of the private sector to adjust to changing business conditions. The result is that the vast majority of American companies are leaner and more competitive than they have been in decades, and they have record high amounts of cash and record low amounts of debt on their balance sheets. Companies are prepared for the very worst, which may be why they are doing surprisingly well. As I write three-fourths of companies in the S&P 500 are reporting earnings that beat estimates.

One thing more. When stocks get cheap, markets tend to go up, all the bad news to the contrary notwithstanding. Think of March 2009: just when there seemed no bottom to the market, stocks took off and climbed 75% in 12 months. Now, with this most recent pullback, stocks are cheap again. Great companies like Hewlett-Packard are trading under ten times earnings; the entire S&P 500 trades at a modest 12 times year-end 2010 earnings. Maybe stocks will become even cheaper; this is always possible. But on the basis of current values we would not be surprised to see the market go up in the near future. In the trade this is called a “relief rally” and it tends to follow bad news.

I need to say a few words on risk. In the last decade, investors went looking for risk. Well-credentialed experts said that quantitative financial tools could harness risk, like a dam against a raging river, to generate consistent and high investment returns. We know how that story ended. But today investors are mispricing risk in the other direction. Instructed by a different set of well-credentialed experts, investors are shunning every sort of risk. This attitude is as harmful as the first. The financial media have taken to calling stocks “risk assets.” It is a revealing choice of words that speaks to the current prejudice against stocks; one wonders why stocks weren’t called “risk assets” in 2000 when they were twice as expensive as they are today. But whatever you call stocks, it is not a bad time to own them in some proportion. They have appreciation potential, they pay dividends that approximate bond yields, and the dividends tend to increase year in and out. We would not use leverage, and of course we would not use capital we might need in six months.

What of unemployment, the BP oil spill, the European sovereign debt crisis, municipal, state and federal budget deficits, threats of inflation and deflation? These are real dangers. Their cumulative effect is to raise fears that the free enterprise system is no longer working. There may be something to this, although I might put it differently. What is not working, or at least in need of redefinition, is the role of government in the free enterprise system. Should it be a manager and owner of capital, or should it be the rule maker? In the United States the federal government’s take of GDP rose to 24% this fiscal year. In Europe it is even higher. Local and federal governments have committed to levels of spending that require boom times to sustain. The boom times have vanished. Now how to pay for the promises?

While we in the West are working out answers to this and other problems, the most populous nations in the world – – India, China, Indonesia, and Brazil – – are industrializing. The consequences are enormous. Whereas the American consumer used to drive the world economy, now these emerging markets are, but they are doing so with American capital equipment and technology. Flexibility and resilience are traditional American qualities, and they are presently demonstrated in the ability of companies to go anywhere in the world where enterprise is flourishing. America has thorny problems at the present time, but it has never been a good idea to bet against it.


Mark O’Brien