Review & Outlook

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

Third Quarter

6 October, 2010 by Mark O'Brien in Quarterly Letters

One hears “sotto voce” that the quarter just ended was great for financial assets, especially stocks.  The latter returned more than 10%, which is a good return for a full year let alone a single quarter.  As for the last month in the quarter, typically a so-so month for stocks, it was the best September in 71 years.  Corporate bonds were good too, returning about 5% for the quarter, junk bonds were up 6.5%; Treasury notes and bonds rose about 3% in price over the period.  Why the sotto voce (which my New Oxford Dictionary defines as “in a quiet voice, as if not to be overheard”) if everything was up, and some things, like stocks, were up a lot?  The answer is that everyone, and I mean everyone, is scared for his future and the country’s.

The fear finds specific and precise expression in the government bond market.  There last week investors accepted a yield of 1.8% at the 7-year Treasury note auction.  At the other end of the maturity scale, the 2-year note pays a 0.4% yield (as in less than one-half of 1%), Treasury bills pay next to nothing.  In the financial markets, where actions and not words are what count, these yields reflect fear not seen since the Depression, or foreign acts of war. These yields do not remotely compensate investors for the risk of inflation, but the yields don’t matter. Investors want absolute security of principal now, and are prepared to let inflation or the future take care of itself.  Against such foreboding, investors don’t care if stocks go up 10%. In fact investors have been pulling hundreds of billions out of the stock market.  Last quarter alone they took some $45 billion out of stocks and put it into bonds.

It is reasonable for investors to be alarmed.  Quite apart from the (usual) threat of terrorist attack, we are looking at sharply higher federal taxes, trade war with China, protracted housing sector collapse, spiraling state and federal deficits, and a stalled economic recovery, following the worst recession in three generations.  And that’s only part of it. We are sixteen months into a recovery (the recession ended in June 2009), a time when the economy should be (if history were the guide) zipping along at a growth rate in the 6% range, and the unemployment rate falling. Instead the economy is limping along at 2% growth, if that, and unemployment is stuck at deep recessionary levels.  If one counts recent college graduates, the underemployed and the poor souls who have given up looking for a job, unemployment is in the 15 to 20% range.

Most ominous of all, the Treasury in conjunction with the Federal Reserve Board have started printing money (though the procedure is now called “quantitative easing”) to stimulate job growth. Whatever you call this printing of money, it risks the debasement of the currency.  Over the weekend I came across these words of a 30-year old Abraham Lincoln:  “No duty is more imperative on government than the duty it owes people of furnishing them a sound and uniform currency.”  Policy makers appear to have broken trust with this first principle of government. That’s what I find particularly scary.

Curiously, the one bright spot in the picture comes from the engine room: the corporate business sector.  Businesses learned how to control inventory and labor expenses in the 1980s, and in the 1990s they finally learned how to integrate computers into their operations.  The result has been a startling and unprecedented productivity.  As for demand, which typically plummets in hard times likes these, the companies in the S&P 500 (which is where we invest) have found it abroad.  Today companies are getting as much as 50% of their revenues from outside the United States, with an ever-increasing share coming from emerging markets.  Thus we have a corporate sector that is flush with profits and cash.  Here, as regards all this cash, corporations are acting just like individuals.  They are afraid to take action lest business conditions suddenly worsen.  So they sit on their record-high stashes, trying to decide whether to increase dividends or do something else with the money.

What are we recommending amid all this uncertainty?  Gold?  Last week Barron’s Magazine ran a headline with this question:  If you had to go 100 years into the future, which asset would you take with you?  The answer which the authors were looking for was, of course, gold.  But it is not an answer for our clients, who have bills to pay, now.   We prefer productive assets that generate dividends and interest.  Presently we can recommend selected investment-grade-rated corporate and municipal bonds that pay in the 3 to 5% range; otherwise bonds (which recently have acquired the moniker of “fear assets”) look toppy.

Big-cap blue chip stocks look like a good place to wait out this time of political uncertainty. Companies like Hewlett-Packard, Procter & Gamble, VF Corp, Sysco, Intel, Coca-Cola, McDonalds have dividends that equal and in some cases exceed their bond yields, and of course they have appreciation potential.  These companies sell about 12 times 2010 earnings, less than half the price of a few years ago.  They have earnings yields (dividends plus retained earnings) in the 8% range, which is about as cheap as I have seen since I got out of business school in 1975.

Let me keep this note short – – and relatively upbeat.  In the way our government is always up for grabs (generally a very good thing), it can always make a wrong turn.  I think this is what happened in recent years.  Government at the state, local and federal levels tried to do too much, whether by fighting two wars or promoting widespread home-ownership.  So long as the economy was booming, these things were possible.

Ours is a political economy, and next month we have an election.  Depending on what happens in the election, the stock market could rocket up, or it could continue to muddle along.  We will be watching this one closely.


Mark O’Brien