Review & Outlook

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

Second Quarter

11 July, 2012 by Mark O'Brien in Quarterly Letters

It’s not surprising that, following the record-setting first quarter, stocks gave up ground in the second quarter. Indeed, the market could have trouble hanging onto the rest of that big first quarter gain given all that we have to get through before year end.

In terms of what’s straight ahead, we expect no big changes in the market before the election. Despite serious problems in Europe, which I will discuss, the excitement and expectations surrounding the American presidential election seem to have spilled over into investor psychology. I know, it’s not analytical or quantifiable, but I think the markets are fine up to the election.  But come November, when everyone will be fed up with politics, the market could easily succumb to the accumulated weight of bad economic news, and general fatigue. In the investment business a 10% drop is called a correction, a 20% drop a bear market.  Whether the one or the other, our system seems to require periodic corrections to wring out excesses and rationalize stock prices. They are more a sign of renewal than infirmity.

From March 2009 to the present time, stocks have risen over 100%.  The passage of time alone is not enough to trigger a pullback; neither is the 100% increase, which came on top of a depressed March 2009 starting point. Rather the problem is corporate earnings, which are slowing down. Just how much we will know in a few weeks, when companies report their second quarter earnings, but at this juncture it looks like corporate earnings have shifted from the double-digit growth rate of 2010 and 2011 to a 5% annual rate.  Five-percent growth may sound respectable, especially compared to the current (and historically low) returns on bonds and certificates of deposit, but it is the momentum that counts, and momentum is moving the wrong way.

So how sharp could a pullback be?  Not very. That’s because the stock market recovery from 2009 to the present has been subdued – -scarcely a trace of irrational exuberance, to borrow a term from an earlier era.  Indeed, if there has been any irrationality in recent years, it has been of the irrational “fearfulness” sort. The modern equivalent of hiding cash in the mattress is negative bond yields, and that’s what we have had on multiple occasions in the government bond market since 2009, when individuals started to flee stocks for the perceived safety of bonds. With unemployment stuck in the 8% range, individuals have not returned to stocks.  The Dow Jones industrial average is now one thousand points below its 2000 peak.  Markets become risky as prices rise.  But over the last 12 years, stock prices have fallen even as corporate earnings have steadily risen.  So any correction, if we get one, is likely to be muted.

How does one protect a portfolio in the face of these short-term uncertainties? With a heavy weighting in big dividend-paying American stocks in the consumer staples, railroad, health care, utility and telecom industries.  As long as interest rates remain at their current 300-year low, dividend-paying stocks are one of the few places to find current income.  The dividend rate for Intel is 3.2%, Pennsylvania Power & Light, 5.2%; Johnson & Johnson, 3.6%, Procter & Gamble, 3.7%; Verizon, 4.5%.  These dividend rates are not ironclad but they are dependable and, along with any appreciation potential, represent a refuge superior to the traditional retreats like bonds (the 10-year Treasury note pays 1.6% ) and money market funds, which pay close to zero.

Longer term, American stocks should be able to tap into global and domestic growth. In regard to the latter, the American economy appears to be undergoing a big, positive and multi-year transformation, starting with the recent phenomenon of energy self-sufficiency.  Its consequences are hard to overestimate.  For the first time in two generations America exported more energy last year than it imported. And this is a trend that analysts see continuing into the indefinite future.

The collateral benefits include a manufacturing renaissance.  Here I can offer an example very close to home.  For years I have watched Conshohocken-PA-based Quaker Chemical supply the steel, paper and auto industries with specialty greases and lubricants.  Always the question was, could Quaker have been in worse businesses? But today Quaker Chemical, like many small manufacturing firms, is prospering in the wake of cheap natural gas and rising global activity. Another bright spot, often overlooked because it is so familiar, is the American farming sector.  The global economy is growing 60% faster than it was 20 years ago, 500% faster than 30 years ago.  Global prosperity immediately translates into demand for more and better nutrition, where America dominates world markets like few other nations.

A final word on the crisis in Europe.  Certainly it is a wild card, though the stakes may not be as great as President Obama suggested when he publicly but erroneously described Europe as our largest trading partner. (In fact Canada, Mexico, China and Japan are, in that order).  Also, I think the story tends to be over-reported because the Continent is so accessible and familiar to the American media.  But clearly developments there are high on our worry list.  Could the EU story have a silver lining?  Perhaps.  In the great American debate over public sector debt, austerity and stimulus spending, the European experience seems to be influencing American voters judging from recent action in Wisconsin, California and New Jersey. And then there is the lesson of unintended consequences.  The central planners who put the EU together intended to enrich Europe, not impoverish it. But that’s not what happened.   Here I am reminded of my Mother’s shock (she was the ultimate central planner) when she learned that my brothers and I had opened all the doors and windows in the house to let bugs in.  She had the day before given us flyswatters and a promised bounty of a nickel for every corpse.  The plan was to get rid of the bugs in the house, not to let more in.  Alas, economic incentive programs tend to produce unexpected and undesirable outcomes.  It’s a lesson we need to remember when the times seem to cry out for a government solution.


Mark O’Brien