Newsletters 2010 Newsletters The Known-Unknowns
Monday, 12 July 2010 19:49
Shortly after sending out invitations for our recent luncheon presentation on “Portfolio Navigation in a Post-Crisis World”, we were asked by a client, only half-jokingly, whether “Portfolio Navigation in a Perma-Crisis World” might be a more appropriate topic. This seems to be an increasingly common line of thinking with investors – the glass seems more “half-empty” than “half-full” of late.
We too are stuck somewhere between “half-empty” and “half-full” and have positioned portfolios accordingly. We don’t recall an environment for investors where there were so many “known-unknowns”. If “known-knowns” are already known and “unknown-unknowns” are unknowable, “known-unknowns” represent nagging concerns that we do know about, but cannot precisely predict outcome for. This idea of a seemingly ever-increasing list of “known-unknowns” is the source of our present caution – a neutral outlook, neither overly optimistic nor terribly pessimistic. In addition to the recently held client luncheon, we thought it would be instructive to use this framework for our newsletter as well.
The known-knowns are the empirical data points that bulls and bears alike can use to make their argument, either for optimism or for pessimism. Today, we find as many known-knowns in the favorable or “bullish” camp as we do in the unfavorable or “bearish” camp. Let’s start with the favorable, glass half-full, known-knowns that might influence a more constructive view of the equity markets:
After suffering one of the worst recessions of the last century, the U.S. economy is clearly on the mend, albeit at a pace that is likely sustainable below historical trend. GDP grew 2.7% in the first quarter of this year and a Wall Street Journal survey of 53 economists predicts that the economy will grow between 2% and 3% in the second half of 2010 and continue at that pace in 2011. Industrial production, durable goods, factory orders, ISM Manufacturing and ISM Services have all shown remarkable V-shaped recoveries. And productivity growth has been the strongest on record since the 1960s.
The super-tanker $14 trillion U.S. economy has turned the corner and it is unlikely that an imminent, “double-dip” recession is in the cards. That said, we are believers in the idea of a post-crisis “new normal” for the U.S. economy characterized by below-trend growth, growth that is weighed down by increased regulation, higher taxes and consumer deleveraging. The recovery now underway has been characterized by especially strong manufacturing and exports, while the consumer continues to clean up his collective balance sheet. Since 70% of U.S. GDP has recently come from personal consumption, it will be difficult for the U.S. to reach historic levels of growth as the consumer retrenches.
Emerging markets are strong. Expectations that China’s GDP growth could be sustained near 10% seem to be validated by a recent report that Chinese exports surged by 48.5% in the 12-month period through May, leading to a trade surplus of $19.53 billion for the month. India’s most recent GDP registered in at 8.6%. And Brazil’s GDP growth for the first quarter of 2010 came in at 9%, its fastest growth since 1996. The International Monetary Fund (IMF) expects average 2010 GDP growth of 6% for emerging economies, with 2% average growth expected for advanced economies. Total global GDP is expected at 4% for the year.
Emerging nations, especially China, are more vital than ever to the global economy. China’s very recent announcement to allow the Yuan to gradually adjust to market conditions is mostly bullish, as it takes the potential for a trade war with China off the table. Further, U.S. exports which have been instrumental to the current recovery will get a welcome boost as the dollar weakens relative to the Yuan. A stronger Yuan and increasing wages in China will gradually increase the importance of the Chinese consumer to China’s and indeed the global economy. The baton is being handed off from the American consumer to the Chinese consumer – this is a very bullish, secular trend for multinational companies that already have a strong presence in China.
Inflation is low. The Consumer Price Index (CPI) for May provided further affirmation that the Fed will be on hold for some time yet as the trend in both total CPI and core CPI is clearly one of disinflation. Consumer prices declined 0.2% in May, slightly lower than the 0.1% decline in April. Total CPI is up 2.0% year-over-year versus a 2.2% increase in April. Core prices, which exclude food and energy, increased 0.1% in May. The year-over-year core CPI growth rate has fallen to 0.9%, well below the Fed's target level of between 2.0% to 2.5%.
Interest rates remain low, yet the yield curve remains steep. The steepness of the yield curve seems to signal continued economic expansion, while the historically low level of rates seems to indicate that bond investors are unfazed by prospects for rising inflation. And vis a vis equity earnings and dividend yields, bonds simply do not offer compelling value. The current dividend yield of the S&P 500 at 2.2% is greater than the 1.814% yield on 5-year Treasury notes. And the earnings yield for the S&P 500 at between 7% and 8% is considerably higher than the 3.029% yield on ten-year Treasuries. The earnings yield valuation model suggests that the earnings yield for stocks should be roughly proximate to the yield on 10-year Treasuries. So, in today’s case, either stock prices or bond yields must move materially higher for the model to be at parity. We believe stock prices and bond yields will move higher over the intermediate term and meet somewhere in the middle at parity.
Mortgage rates remain at historic lows. After the Federal Reserve disengaged from buying mortgage securities in March, there was much debate as to whether mortgage rates would drift higher. Today, a conventional 30-year mortgage is set at 4.77% and a 15-year mortgage is 4.26%. Jumbo rates are down to 5.7%. Low mortgage rates are necessary to help stabilize the housing market and offer consumers an historic opportunity to refinance, a once in a lifetime chance for Americans to improve their cash flow and clean up their balance sheet.
Corporate America is rock-solid. Having already retrenched in the aftermath of the dot-com bubble, Corporate America is “lean and mean” and balance sheets are in Fort Knox condition. Cash, as a percentage of assets on balance sheets for the S&P 500, stands at 11%, a sixty year high, making this a ripe environment for dividend increases, stock buybacks and acquisitions.
Corporate earnings have been better than expected and valuations look reasonable. According to Thomson Reuters, the consensus earnings estimate for the S&P 500 is $85.26 for 2010 and $96.61 for 2011, implying a PE ratio of roughly 12 for 2010 and a forward PE of 11, with the S&P currently hovering near 1,100. Even if these estimates prove too generous, a reasonable PE of 15 on a potentially lower range of earnings, say between $80 and $90, implies a target range of between 1,200 to 1,350 for the S&P 500.
Excessive pessimism is often a very good contrary indicator for the stock market. While measures of consumer confidence have been higher than expected in recent weeks, investors continue to plow money into bond funds. Flow of funds into bonds and away from stocks continues to indicate that there is no euphoria in the stock market. While the absence of excessive optimism or “irrational exuberance” does not necessarily imply the presence of downright pessimism, we would argue that the proverbial “wall of worry” for stocks to climb has rarely been this high. Anecdotally, judging by what we read in newspapers, see on TV and hear from friends and clients, fear and pessimism remain steadily higher than usual, though far from the levels of panic we observed in the Fall 2008 into the Spring of 2009.
The dollar has strengthened considerably of late. While the dollar’s strength has coincided with the collapse in the Euro, the fact is that the dollar continues to enjoy its status as a safe haven and the world’s dominant reserve currency.
There was a time not long ago when the combination of low interest rates, strong dollar, benign inflation and moderate growth came to be known as the “Goldilocks” economy – not too hot and not too cold. These otherwise favorable conditions could be counted on historically to deliver premium valuations for stocks and worthwhile returns for equity investors. While it seems clear that the economy is “not too hot”, investors are presently uncertain as to just how “cold” the economy may prove to be.
This leads us to our unfavorable, glass half-empty, known-knowns that might influence a more cautious view of the equity markets.
Just when investors were beginning to gain confidence in the sustainability of the global economic recovery, the European debt crisis emerged and spoiled the party. In addition to Greece, Euro nations with the most significant exposure to this crisis include Spain, Portugal and Ireland. Together, these countries – the so-called PIGS - account for 20% of euro zone GDP. The IMF estimates that GDP for these countries will contract by 6%, implying an overall hit to euro zone GDP at roughly 1%. Potentially offsetting weakness in these overleveraged countries, Germany and France might actually benefit from the weak euro. Since European sales account for only approximately 9% of S&P 500 revenues, we think a potential “double dip” in Europe is manageable for the United States, but it is an overhang nevertheless.
The silver lining in Europe’s sovereign debt crisis is that it has given the Federal Reserve yet another reason to continue its easy money policy, giving banks and consumers still more time to recoup. Another glimmer of hope is that euro member countries are being forced to take the fiscal medicine necessary to keep their currency union intact. In that regard, Europe may emerge over time with stronger growth than pre-crisis levels. There remains an outlying possibility, however, that the euro union collapses, a potentially disruptive blow to the global economy.
While the strong dollar is again very positive for the United States, it will inevitably lead to currency translation headwinds for multinational corporations that derive substantial earnings overseas. As a result, we would not be surprised to see companies trim their 2010 earnings guidance based on the dynamics of the soft euro-strong dollar. China’s recent decision to float its currency will help offset this dynamic going forward.
Unemployment remains stubbornly high at 9.5%. High unemployment compounds the process of consumer deleveraging and increases the likelihood for a prolonged bout of “new normal” growth. While we remain concerned with the prospects for a “jobless recovery”, there is good news for the approximate 90% of Americans that are employed. Real disposable income increased by 0.2% in March after two consecutive months of little or no growth. In fact, this was the first month of year over year wage growth since the beginning of the Great Recession. A sustained trend of rising wages would help offset the economic vacuum created by such high unemployment.
As already pointed out during our discussion of the favorable “known-knowns”, U.S. economic growth now hovers near 3% - yet it seems difficult to imagine an environment that would support higher GDP growth, especially with deficits rising, the Bush tax cuts set to expire and government stimulus waning. It will be a Herculean task for the economy to create enough new jobs to substantially reduce unemployment if we are indeed in for a prolonged period of below-trend, “new normal” growth. As such, we would not be surprised to see imminent Congressional debate on the merits of additional stimulus, reinstating successful stimulus programs such as the tax credit for first-time home buyers or even (dare we say) extending the Bush tax cuts.
While we do not see any imminent rise in interest rates, we are convinced that rise they must…eventually. With the Federal Reserve effectively at 0% for Fed Funds, the Fed must be itching internally to bring rates back to at least something resembling normal. The most important trends to watch that would foster a growing urgency at the Fed are unemployment and inflation. Unemployment must move materially lower or inflation materially higher to stir the Fed’s hawkish tendencies.
However, the wake-up call echoing from Europe, for those that might listen, is that unsustainable deficit spending is just that…unsustainable. Greece ultimately had no choice but to accept “savage austerity” measures in order to avoid default and maintain its place in the euro union. The so-called “bond vigilantes” served Greece and other euro nations with immediate notice that rising deficits would not be tolerated, driving Greek interest rates to punitively high levels.
The lesson here is that the Fed does not control bond traders. Bill Clinton learned this valuable lesson early on in his Presidency, prompting the President to “pivot” to the middle and his close advisor James Carville to quip that if reincarnated, he would like to come back as the bond market, because “you can intimidate everybody”. It is not beyond the realm of possibility to potentially see a sharp, vigilante-induced rise in U.S. interest rates if we do not take the measures necessary to bring fiscal restraint back to Washington.
With memories of the stock market panic still fresh, investors are rightfully anxious about periods of excessive volatility. The early May “flash crash” was a painful reminder of how difficult it is to be a long-term investor in a world filled with such short-term nonsense. The fact that this “flash crash” seems to have been caused by computers, computers that generate as much as 70% of average daily trading volume, leaves investors feeling that the deck is stacked against them.
While we agree that the forces that seem to have caused the flash crash are alarming and potentially disruptive, we would argue that they can and should be used to our advantage. The flash crash was such a brief episode that it was virtually impossible to take any meaningful action. However, the lesson here is that market volatility brings opportunity for patient investors. As Warren Buffet has so famously stated, we should “buy when others are fearful and sell when others are greedy”. We presently have an ample cash cushion and intend to deploy at least some of this cash should this kind of unique opportunity again arise.
Finally, in the unfavorable camp of known-knowns, headline risk as it relates to the economy in general and companies specifically has further influenced heightened volatility. Toyota, Goldman Sachs and BP have all seen their share price collapse under the weight of incidents that could lead to irreparable damage to their respective brands. Headline risk has always been present in market dynamics, yet it is magnified greatly in periods of excessive market volatility.
As for the “known-unknowns”, we list a great number of these nagging concerns but have no way of precisely knowing what the outcome for each might be. An outcome one way might be quite bullish and an outcome another way might be entirely bearish. Among these concerns, consider the following:
• Can the United States growth reach economic escape velocity, even as stimulus wanes and taxes and deficits rise?
• When will unemployment decline?
• Will the November elections usher in renewed fiscal restraint in Washington?
• When will the consumer have reached a level of deleveraging that finally subdues present deflationary impulses?
• Is the United States headed for an inevitable bout of hyper-inflation?
• Will the U.S. government have the courage to tackle entitlement reform?
• What will the ultimate cost be for new healthcare reform legislation?
• What will happen with Fannie Mae and Freddie Mac?
• When will the Federal Reserve raise interest rates? And will the bond vigilantes beat them to the punch?
• Will Congress simply let the Bush tax cuts expire?
• What are the odds for a double dip in Europe? How about a potential double dip in U.S. real estate?
• Are current earnings estimates too high?
• Will the euro union survive?
• Can China successfully engineer a soft landing?
• What stand might be taken against Iran’s nuclear ambitions?
• Will we pull out of Afghanistan according to schedule?
Together, the known-knowns and known-unknowns influence a more cautious investment posture. It was much easier for us to be optimistic and bullish when the S&P 500 was closer to 700. Now that the market has recovered substantially from those lows, we will demand a higher margin of safety to commit additional capital to equities. We have consistently and opportunistically raised cash throughout 2010 and now have a firmwide allocation of approximately 60% stocks, 25% short-term corporate and municipal bonds and 15% cash. Obviously, each client’s portfolio is managed to reflect their specific circumstances, so this allocation varies widely across our client base.
We remain focused on high-quality blue chip companies with consistent records of earnings growth, persistent dividend increases, strong balance sheets with little, if any, debt, and well-defined prospects in foreign markets. It is rare that this type of company can be owned at such discounts to the overall market, yet that is what we find today. These are precisely the kind of companies that will not only survive, but thrive in the new normal environment. They do not need leverage to successfully grow their business, instead relying on cash flow to invest in new markets, buy competitors, increase their dividend and repurchase their own shares. We remain convinced that high-quality equities will outperform both bonds and cash over the long-term, even if they suffer periodically from seemingly ridiculous bouts of volatility.
We expect the stock market to remain in a prolonged sideways or trading range, as the known-unknowns are worked through, and anticipate ample opportunities to boost returns.
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