Ten years from today, the CEA and Federal Reserve chairman will again celebrate a decade of unexpected strong growth. This time the credit will go to countrywide gains from the very low energy prices found only in the US. Low-cost energy will have spawned an export surge in all sorts of goods, from chemicals to tyres. Fracking and the other technologies that gave us low natural gas prices will have added more than 1 per cent a year to US growth, repeating the 2000 surprise. Today, few realise that the US stands on the cusp of significant economic gains stimulated by low energy costs. … As a result of these circumstances, the benefits of low-cost energy supplies will spread throughout the US economy, stimulating exports of goods and services and creating millions of jobs.

Another piece in the New York Times tells a similar story and details how the gas boom is revitalizing U.S. manufacturing:

The rapid development of shale gas technology has helped reduce energy imports and, in some cases, encouraged companies producing petrochemicals, steel, fertilizers and other products to return to the United States after relocating overseas. Natural gas exports are growing and terminals built to hold imported supplies are being repurposed for international sales. The American petrochemical industry, for example, uses natural gas as both its primary raw material, in the form of liquid ethane, and as an energy fuel. And cheaper prices have led to a major expansion of capacity in the United States.

While these developments are highly encouraging, it poses difficult investment questions. A major shift like the shale gas drilling boom is easy to identify, but it is more difficult to participate in it as an investor. This is because the drilling boom has created a supply glut that has driven down the price of natural gas. The low price of the gas has taken its toll on the profit of the very companies driving the boom, the natural gas producers. It’s also a long term process. Factories and vehicles cannot switch fuels over night. New pipelines and fueling stations must be built and factories and vehicles refitted.

Despite the fact that natural gas prices have dropped 80% in the last four years, there have been other ways to participate in the boom than investing in natural gas producers. One way in has been natural gas drilling services companies that have profited from the increase in drilling activity without being hurt as much by the drop in prices. Another has been investing in gas pipeline companies that get paid based on the volume of gas that goes through the pipelines and not on the price of the commodity.

We’ve also seen the benefits of natural gas spread to other sectors as the above articles mention. One small cap company we follow was primarily involved in servicing water and sewer pipes. They are now expanding their business by working to maintain the increasing number of pipelines being built to transport natural gas. Another company that makes nutritional supplements found that one of the chemicals it was already producing could be used in “fracking”, part of the natural gas extraction process. This provided a new, unexpected source of revenue.

The sudden, unexpected rise of shale gas drilling is an exciting development. It shows that the conventional wisdom about the economy—such as the impending threat of “peak oil”—is often wrong. It also shows the hazards of acting (and investing) on the basis of long-term forecasts. Things happen, and sometimes they are so big that they change everything. One thinks of the collapse of the Soviet Union in the political sphere. In the economic sphere such a development appears to be the sudden and unexpected rise of natural gas. Alas the cost of wealth is always vigilance. That never changes.

Speaking of years, it is probably too much to expect the stock market rally to go on for the rest of 2012.  Markets never go in one direction for long.  And in fact last year stocks as measured by the S&P 500 started out exactly the same way, with a strong first quarter before collapsing into a bear market decline of 20% in late summer. So it could happen again.  In fact some sort of a pullback is overdue.

But short-term correction or no, it is becoming clear how we will repair our fortunes – - again, I am not sure it’s the right word – - decimated by the Great Recession of 2007 and 2008. If it happens (repairing our fortunes), it will be because of stocks, not bonds.  Last quarter may well have been the end of a thirty-year long rally in bond prices.  Early in my career (I graduated from the Wharton Business School in 1975) high quality government bonds paid as much as 15% per annum.  As I write the two-year Treasury note pays a yield of .3%, the five-year Treasury note pays a yield of 1%.  Recently there have been government auctions when investors paid the government for the privilege of lending it money. In other words,   negative yields.  To find a comparable moment in history, at least in terms of bonds, one must turn to 1946, when the government started inflating away the bill for World War II, the Eisenhower system of interstate highways, the Great Society, the Vietnam War, and trips to the moon.  It took investors some thirty years to wise up and demand an inflation premium.  Now the cycle appears to be starting up again, and, as regards bond investing, it looks a lot like 1946.

I don’t want to dismiss bonds completely.  I think they can still contribute some income and price stability to a portfolio, but gone are the days from 1980 to 2011 when the investor weary of the volatility of stocks could retreat into the real, inflation-adjusted return of a money market fund or a ladder of bonds and be sure he was still protecting the purchasing power of his savings.  What makes the present time so difficult is that there is no place to hide, no certain “safe on base” any more, as bonds and money market funds were over the past thirty years.  Rather, policymakers at the Federal Reserve Bank (the Fed) have relegated savers to a permanent game of tag, and made them “It.”  Why?

The Fed is trying to induce individuals and business to take more risk with their money.  More risk-taking, the theory goes, will revive employment, consumption, and investment in new plant and equipment.  That’s the theory for near- zero percent interest rates: to force the investor’s hand.

The contrary point of view, of course, is that it will do none of these things and instead lead to speculation and asset bubbles.  So far the policymaker’s theory has not been borne out.  As for speculation and asset bubbles, there are troubling signs in oil and gold (not to mention Greek stocks).

The challenge for investors?   Don’t allow yourself to be manipulated into unintended and inappropriate risk-taking.  Individuals tend to be better judges than policy makers of how much risk they ought to take.  But with bonds, CDs, and money market funds pretty much off the table, people have fewer tools with which to work.

How to own more stocks and take less risk? Let me suggest two ways.  First, don’t get caught up in the quarter by quarter performance sweepstakes.  Last quarter, for instance, “junk” stocks did best.  Thus the financial media extols investment managers who had more junk in their portfolios than is in the S&P index.  But does one really want to be jumping in and out of different stock sectors in pursuit of this sort of short -term performance?  I think not.  Instead, look for ways to take less risk than the S&P 500.  It’s a more durable strategy.  For the risks are real.  Europe appears to be entering a recession and news from Spain and Italy suggests the sovereign debt crisis is far from over.  And China’s breakneck economic growth looks accident- prone to me.  As for the U.S. economy, truly massive stimulus and bailout spending has distorted key industries, like banking, to the point where no one knows the relationship between the price of goods and services and their real costs.  It could take years to straighten out the distortions in these important parts of the economy.

The second suggestion: try to time portfolio distributions, at least the discretionary ones, to coincide with good markets, and vice versa.   After a really good quarter, like the last one, that’s when you want to buy the new washing machine and dryer.  This sort of dynamic spending will serve you better than a flat distribution rate.  It will tend to result in more money on hand when the market takes off and less when it pulls back.  In a low-return environment, such as we appear to be in, one needs to pay attention to the little things.  They add up and make a difference.

Sincerely,

Mark O’Brien

First the good news. With the earnings season now ending, the results generally came in better than expected and earnings of the companies in the S&P 500 grew on average 5.64% and sales 5.53% when compared with the fourth quarter of 2010. This was the ninth consecutive quarter of earnings growth as companies have bounced back strongly from the depths of the Great Recession in 2009. Of the S&P 500 companies, 65% reported earnings above the average estimate issued by the big Wall Street banks and brokerage firms.  Apple (AAPL), Intuitive Surgical (ISRG), Intel (INTC) and McDonalds (MCD) all announced earnings and sales higher than analysts expected and higher than the previous year, just to name a few standouts in our clients portfolios.

Now for the not-so-good news. While earnings have been increasing over the last several quarters, they have been doing so at a decreasing rate. The 5.53% average earnings growth of the S&P 500 was a sharp slowdown from the third quarter of 2011 growth of 14.89%. The 65% of companies that beat estimates sounds impressive, but actually this is below the average percentage of companies that beat estimates.

To make matters worse, if you take out the two biggest contributors to this quarter’s earnings, AIG and Apple, earnings growth for S&P 500 companies slows from nearly 6% to 1.2%. Apple reported earnings more than double the previous year’s, and the troubled insurance giant AIG benefited from weak comparisons from the year before.

What is the cause of this mediocre earnings season? Part of this slowdown of growth is simply the result of tougher comparisons. In the first quarter of 2011 when earnings grew more than 50%, the numbers were being compared to the recession lows of 2009. Now we are looking at the fourth quarter of 2010 for comparison, when the economy was well out of recession. But in addition to tougher comparisons, companies are now facing a deeply troubled economic environment in Europe and a slowdown in the rapid growth of developing countries in addition to the lackluster domestic economy.  In numerous earnings reports this quarter we read about the effect of higher costs, weak demand in Europe and slowing emerging markets. Looking ahead to this quarter, if these trends continue we could very well have a decline in total earnings for the first quarter of 2012.

But what is remarkable is how well companies have fared in this difficult environment.  We also saw in this quarter’s earnings reports extremely high profit margins, record cash holdings and increasing dividends. Companies are in good shape even with earnings slowing down. Historical valuations are also low, given the long rally. The Price-to-earnings ratio based on forward earnings of the S&P 500 is at 12.5 compared to a historical average P/E of 14.6. By comparison the market P/E during the internet bubble of the late 1990’s reached as high as 40. While there is always the possibility of a market correction after a long rally, the current valuation suggests that stocks could still have some room to run.

The weakening earnings trends means that earnings growth is less likely now to fuel a continued rally in the near-term, but there could be other things that push stocks upwards, like more signs of an improving US jobs or housing market, or a partial resolution of the European debt crisis. This week the positive results from the Fed’s recent round of stress tests of big banks drove the market up. What’s really striking about the current market is how so many investors, scarred by the financial crisis, are remaining on the sidelines. As more people take note of the tremendous rally and become dissatisfied with record low yields of bonds, they may start to put their money back into stocks and mutual funds and ETFs and push the market higher.

From a mechanical point of view, it’s a lot easier to be informed than it used to be. The author of popular finance blog “Abnormal Returns”, Tadas Viskanta argues, “There has never been a better time to be an individual investor.” His blog post on the subject set off a firestorm of debate. According to his argument technology has transformed investing. Despite the many looming macroeconomic worries, investing is cheaper, easier and more transparent than ever. Viskanta writes, “Never before have investors had access to data, analysis, opinion and social tools that are commonplace today.”  He goes on to list the financial innovations, from exchange-traded funds to new social media tools that have made investing increasingly inexpensive and accessible to amateurs.

Jason Zweig, the prominent Wall Street Journal columnist, weighed in on the debate with a story of his first stock purchase as a teenager in the 1970’s. Then, the only source of information on the company was writing away in the mail for the company annual report or else a trip to the public library to wade through large, dusty investment guides. Once he bought a stock, he faced commissions of up to 50% of his earnings, and was so disgusted by the whole process he didn’t but another share for years.

Zweig’s anecdote pretty well settles the debate. Leaving the state of the market aside for the moment, things are pretty good for investors these days. The internet offers vast amounts of free information that only recently was available only at great cost to professionals.

The ease of making trades with a few clicks and the enormous amount of free information out there, however, comes with its own threats. As Viskanta warns, many innovations are a “double-edged sword” and should be avoided. Despite the technological advances, we still have “innate behavioral biases” that give us a tendency go with the crowd and to buy high and sell low. As Zweig puts it, “Yes, Wall Street is still a dangerous place. But it used to be worse.”

Ben O’Brien

A recent article in the New York Times Magazine “Why Do We Still Care about the Dow?” goes a step further and makes the case the Dow itself is an outdated measure of market and the economy:

In the postwar boom of the 1950s, the economy was growing so fast, and the benefits were so widely shared, that following 30 large American companies was a solid measure of most everyone’s personal economy. Back then, the U.S. was a largely self-sufficient country, so Asian or European economic troubles didn’t matter much. … [Now] rather than being a useful indicator, [the index] is an anxiety-amplification device. It reflects investors’ own reactions, and often hysterical overreactions, as they progress through the turmoil.

Any index will have limitations, and the Dow is certainly not perfect. The real problem, however, is not so much the indices as the way the media tends to abuse them, announcing their fluctuations with great hype hundreds of times a day. The Times says that Charles Dow, who founded the index in 1896, believed that the index should be checked and studied on a quarterly basis. This sounds about right. While it’s hard to avoid following the indices more frequently these days, investors shouldn’t attach too much importance to them except over quarters and years. Nor should they get too worked up about the index reaching a round number.

Ben O’Brien

My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).

Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety — but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.

Whether or not you attribute it to the January Effect, there has been an abrupt shift in market behavior that coincided with the beginning of 2012. One big change this year has been a drop off in volatility. One measure of volatility is how many “all-or-nothing” days there are in the market. These are defined as days when at least 400 of the 500 companies in the S&P 500 moved up or down together. In 2011, according to Bespoke Investment Group, there were 70 all-or-nothing days, the most in recent memory. In 2012 so far there have been none.

Volatility tends to go along with correlation—when stocks swing wildly up and down it tends to be in reaction to large-scale macroeconomic forces that move all stocks together regardless of their individual characteristics. This was the case for much of 2011. To the frustration of stock pickers, everything moved up and down together. This too has changed in 2012. Correlations between different types of stocks swung from record highs in 2011 to record lows so far in 2012. Materials, tech, and financial stocks have soared, for example, while utilities and consumer staples stocks have sunk.

In the new year there has also been an abrupt shift in leadership from large cap stocks to small caps. In 2011 large caps rose 5% while small caps fell 5% as investors focused on the safety of large dividend-paying stocks, but now as investors have become somewhat less risk-averse small caps are up more than 11% compared to 5% for large caps. The tech-heavy Nasdaq Composite which lagged in 2011 is now in the lead, up more than 13% year-to-date. Similarly the lead has shifted from the U.S., which outpaced all major stock markets in 2011, to emerging markets where Brazil is up 18% and Singapore 17% so far this year.

With the strong market performance and the economy showing some signs of strength investors are beginning to feel optimistic again. According to the American Association of Individual Investors survey, bulls now outnumber bears by 51.6% compared to 28.3%, the highest measure in over a year. Whether the market will follow the pattern of last year (when a strong first quarter was followed by a large correction) or whether the market will continue on its present course is still unclear. Certainly there are plenty of headwinds in Europe, China, and the Middle East that could sink the current rally. Either way, the abrupt change in market behavior confirms the wisdom of owning a diversified portfolio of high quality stocks across different sectors and economies, market capitalizations and asset classes, and holding on to them for the long run. This year the market has shown once again that jumping on the bandwagon of the latest trend is a losing strategy.

Ben O’Brien

The other part of the performance equation is bonds.  Here the big surprise in 2011 was the U.S. Treasury market, where a meager yield of 2% and a much-publicized downgrade by rating agency Standard & Poor’s did not, to our amazement, diminish investor demand.   That investors would buy a taxable 10-year Treasury bond at a fixed rate in the 2% range, especially when reported inflation is 3.5%, shows how scared people are.  On a real or inflation-adjusted basis, Treasury bonds have a negative yield.  No matter: investors kept buying them anyway.   The price of the 10-year Treasury bond rose about 14% over the course of the year.  We avoided the Treasury market and bought tax-free municipal bonds instead. We even bought them in tax-free accounts.  They were higher-yielding and immune from the central bank manipulations (“Quantitative Easing” and “Operation Twist”) that are currently distorting the Treasury market.  Munis rose 10% last year, a bit less than Treasuries but respectable enough.

That was last year.  What of the future?  Good things can be said, and should be said.   But there are problems too.  Let me begin with the latter, so I can end on a positive note.  I want to point to the widespread and I would say unhealthy deference paid to financial/economic “quants.”  I am thinking of the heads of American International Group, Citigroup, Bank of America, Merrill Lynch, Lehman Brothers, Bear Stearns and other major banks, insurance companies and brokerage firms who recently compromised or even bankrupted their companies by giving free rein to twenty-something financial engineers with only a vague notion of what they (the financial engineers) were doing or what might possibly go wrong.  The movie Margin Call addresses this subject of quants on Wall Street.  The movie is worth seeing.  But the problem does not end with Wall Street.   National politicians seem equally credulous in deferring to the high-tech econometric model builders at the Federal Reserve and Treasury and at research universities.   Who, for instance, believes unemployment statistics to be accurate?  Or inflation statistics?  Or poverty statistics? Yet these are the metrics of government policy.  Small wonder there are unintended consequences.

Consider for instance the current wealth transfer from small-time savers to the banking sector.  The Federal Reserve’s theory is that near-zero percent CD rates and money-market rates will shore up the financial sector, and make it better able to lend money to businesses to create jobs.  Are zero-percent interest rates doing that?  No, not yet; but out of luck are all the wage-earners who saved money during their working years in order to support themselves in old age.   It’s quite a sacrifice to ask on the basis of theory.  Similarly, it is to put a very high value on theory to borrow a trillion dollars for stimulus spending. The theorists say it will work, but it is not clear it will.  Meanwhile the interest must be repaid and eventually the principal.

There is one last negative to consider, that of wild volatility.  Between August and November of 2011, the S&P 500 averaged an intraday swing of 270 points.  There was one stretch of 4 days when the market swung 400 points a day.  It cannot be good, but what does it mean? We don’t know, though we would take the lead of Warren Buffet, the greatest investor alive and perhaps of all time, who doesn’t worry about it.  He rarely sells a stock.  If you are a long-term investor, as nearly all our clients are, if you buy high quality stocks at a time when they are relatively attractive, as stocks now are,  and if the stock pays an attractive dividend, as many do at the present time, there is no need to worry about volatility, and we wouldn’t.

Let me turn to some good news:  the discovery that we have become “energy sufficient.”  It sort of snuck up on us; technology tends to do that.  But not so long ago, the country was convinced it was running out of fuel.  Now we have clean-burning natural gas as far as the eye can see.  The consequences are far-reaching and almost certainly positive for investors. For the first time in my career there are deep-seated stirrings in the manufacturing and industrial sectors, where a renewal appears underway, with exciting investment implications.

Elsewhere I have written of the remarkable financial strength in the corporate sector (apart from banking and housing-related).  Even as the pace of economic growth in the U.S. fell to 1.7% in 2011 from 3% in 2010, sales among the S&P 500 grew 10% and profits grew 16%.  Corporate debt levels are very low and profitability near record highs.  Companies are flush with cash, certainly enough to meet almost any contingency.  And if not used for emergencies, the cash can be used for dividends.  Thus S&P 500 dividends should grow at 10% plus in 2012.  Normally dividends on common stocks  amount to about 40% of the yield of a ten-year Treasury note; today they amount to a 100% plus, and should rise even higher.  Thus if corporate profit growth were to slow in 2012, we expect demand for dividend-paying stocks would continue to grow, because there are so few places to find yield.

Every week or two I post a market comment on obriengreene.com (our website).  Ben and Sally have joined me as well.  We encourage you to check out the comments, and let us know what you think of these extraordinary times we find ourselves in.

Sincerely,

Mark O’Brien

In the article Malkiel writes:

For years, investors have been urged to diversify their investments by including asset classes in their portfolios that may be relatively uncorrelated with the stock market. Over the 2000s, bonds have been an excellent diversifier by performing particularly well when the stock market declined and providing stability to an investor’s overall returns. But bond yields today are unusually low. Are we in an era now when many bondholders are likely to experience very unsatisfactory investment results? I think the answer is “yes” for many types of bonds—and that this will remain true for some time to come.

The gist of Malkiel’s argument is that things look a lot like 1946 in terms of debt levels and GDP. Back then debt was 126% of GDP; today it’s in the range of 100% and moving higher. The government inflated its way out of the debt in the period 1946 – 1979 at the expense of bond holders.

Today, says Malkiel, the US government (as well as governments around the world) is likely to work down the debt the same way. In response, he says, lower credit quality a bit when buying corporates, buy munis(we did last year when they were cheap), buy dividend-paying stocks, be very cautious about US government bonds. Just what I have been saying. Maybe he should change my grade.

Mark O’Brien

• Total earnings growth for the S&P 500 was 14.9% over last year’s third quarter and 17.8% if you leave out the troubled financial sector.
• Sales grew 11.89%. This is important because it shows that earnings are coming from companies doing more business and not only from cutting costs.
• 64.9% of companies beat the official earnings estimates published  by Wall Street brokerage firms. 58.3% beat revenue estimates.
• Net margins expanded to 9.36% from 9.06% a year ago. This shows companies are adapting and cutting costs to become more profitable.

These results reflect the relatively healthy condition of the corporate sector, despite our many economic challenges. As earnings grow and the market remains relatively flat (despite its many fluctuations) for the year, stocks look increasingly attractive, especially in comparison to bonds which have record low yields. Taking third quarter earnings into account puts P/E ratios for the S&P 500 at 13.05 for 2011 and only 11.87 for 2012.

As we get down to the homestretch for the year there are some big questions outstanding. What will be the effect of the European crisis on fourth quarter earnings? What is the effect of the slight slowdown in emerging markets?