Review & Outlook

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

Second Quarter

13 July, 2011 by Mark O'Brien in Quarterly Letters

We are two years into “the worst economic recovery since the Great Depression.” The expression in quotation marks, which came from a recent Wall Street Journal article, reveals the dark mood in America. That is to say, even a good development, like an economic recovery, is cast in negative terms. The Journal also dredges up the so-called Misery Index, adding together unemployment and inflation rates, and reports that it is at a 28-year high, hitting 12.7 in May. Though not quite as colorful as the Misery Index, the consumer confidence index, prepared by the Conference Board, also bears out a widely-held foreboding. The index slid to a score of 58 last month; a decade ago it was customarily in the mid-90s, sometimes even higher.

The dark mood seems to envelope everything in its path. Depressed and not spending, in relative terms, are the American consumer, who accounts for 70% of spending in the economy, and the corporate sector, which sits on $1.5 trillion in idle capital. Also suffering from negative sentiment is the stock market, the particular subject of this letter. In regard to the latter, last quarter the companies that make up the Standard & Poor’s 500-stock index reported profits 16% higher than in the year-ago period, yet even this robust report could not dislodge the mood that grips investors. So while earnings soared, stock prices ended the period largely unchanged from the quarter before (see above performance numbers for the S&P 500).

Here we should pause for a moment and ask the question, what happens when corporate earnings churn higher and stock prices remain flat? The answer is that stocks get cheaper. And that is precisely what has been happening. As I write, stocks now are on average the cheapest they have been in 20 years. I am referring to the familiar stocks in the Standard & Poor’s 500-stock index; I am not referring to a few, glamorous new pockets of over-valuation. Into this frothy category I would put those social networking and cloud-computing stocks whose valuations recall those of the Internet bubble. Rather it is in the rank and file of the S&P 500 where the patient investor finds good dividend-paying stocks with strong growth prospects, trading at 13 times earnings (about half as expensive as they were ten years ago). In many cases these stocks pay dividends that exceed bond yields. (One doesn’t see this too often.) Established technology stocks (Apple, IBM, Intel) and health care and consumer stocks (Johnson & Johnson, Medtronic, Procter & Gamble) appear particularly attractive. Formerly revered as “growth” stocks, they could now be called “growth plus value” stocks: altogether a nice package.

Things could always go wrong. High on the worry list is China. Its real estate sector is on fire, as ours was a few years ago. Can this be stable? China owns huge amounts of our debt. What if it starts selling the debt or just stops buying it? And then there are Chinese politics, which are simply an enigma to westerners. But no one can doubt that China is a powerful and beneficial force that helps our economy, as do the other emerging market nations. Their irrepressible economies soften the effect of disarray in Europe.

The weak dollar contributes to higher energy costs. Who knows how long that dynamic will continue to break against us? New business formation, where real job growth occurs, is dead in the water. Whether it is so because banks are not making loans, or for some other reason, no one seems to know. It is also unclear if the housing sector has stabilized or is still getting worse.

The news from the public sector is no better. The federal government is printing money to pay its bills, and policymakers (the same crowd that tax-credited, regulated and incentivized the banking sector into ruin) are anxious to do something but are at a loss as to what it should be. Indeed the role and limits of government seem to be up for grabs at the state, local and federal levels. On and on the worries go; no wonder stocks are cheap.

But when stocks are cheap, as they appear now to be, and when there is a lot of fear, as there is now, and when bonds offer nothing in the way of current income, as is the case now, then stocks tend to do all right – – regardless of all the other things you can worry about. How do you quantify “do all right?” A return of at least 5% looks very doable for the next year. Stocks have dividends on average of 2%. If stock prices go up a mere 3%, roughly the rate of economic growth, then one gets a total return of 5%. Not great but it is almost twice the return of a 10-year Treasury note.

A metaphor I read in the financial press is that stocks in the S&P 500 are “the best house in a bad neighborhood.” I like the expression. The asset classes where one traditionally waits out the economic storms – – in real estate, money market funds, gold, municipal bonds, Treasury notes, bonds and bills – – don’t appear up to the task. They appear vulnerable to inflation and errors in government policy in ways that stocks appear not to be vulnerable. This is not to say that stocks, and only stocks, belong in a prudently managed portfolio. Rather, it is to say that stocks, the ultimate “risk asset”, may be the least risky of assets at this time for the patient, long-term investor.


Mark O’Brien