“Confidence and Markets”

Sydney M. Williams

Thought of the Day

“Confidence and Markets”

June 22, 2012

In 2008, Warren Buffett and John Bogle warned investors to expect modest equity returns going forward. Around the same time, Bill Gross, chief investment officer of PIMCO, wrote of a new normal – slow economic growth, persistent high unemployment and gradual deleveraging. In such an environment one could only expect modest investment returns. Nevertheless, most pension funds, public and private, continue to use actuarial returns of seven to eight percent.

In 1997, the great bull market had three years to run, yet the compounded return to the S&P 500 over the past fifteen years has been a modest 2.9%, with, roughly, another 175 basis points of dividend yield, producing annual returns of less than 5%, in line with Mr. Buffett’s and Mr. Bogle’s “modest returns.” James Paulsen, chief investment strategist at Wells Capital Management and who is considered by some to be a “perma-bull”, in a recent Fortune interview, was quoted: “We look back at the dotcom era as a ridiculous mania of optimism. I would argue that the past few years we’ve been living through a mania of pessimism.”

Pension funds that model seven or eight percent annual returns when 30-Year Treasury Bonds are yielding under 2.8%, and when stocks have been providing total returns of less than 5%, are being self-deceptive. Such decisions (and promises) are also dangerous to our national financial health, as we witness the problems states’ have with tax funded employee retirement accounts. Nevertheless, the ability to forecast markets is a fool’s game. The best anyone can do is study the past and make certain assumptions about the future. We do know that over long periods of time markets tend to track earnings. We also know that markets have years during which price appreciation exceed profit returns, and that they also have equally long time periods in which price returns are less than earnings growth. A reversion to the norm is how market gurus refer to such action, though most people (like me) are incapable of defining “norm.” Historical multiples are difficult benchmarks, as future growth prospects vary, along with interest rates and productivity.

Certainly, the 1980s and ‘90s were a time when the appreciation of stocks far surpassed the growth in earnings, and the reverse has been true since March of 2000. One question: has this period of correction created real value? A second question: Does the relative low volatility we are now experiencing, both in terms of the VIX and in daily volatility (although yesterday showed some real volatility!), suggest complacency on the part of investors? Have the macro challenges facing Europe today along with our own debt and deficit problems, combined with the rapidly approaching financial cliff been factored in? A third concern asks: What are prospects for growth? These questions and more have challenged America’s natural optimism, and they raise the question as to how confidence will be raised and how long it will take.

The first question is almost impossible to answer, other than to say, in wise guy fashion, that stocks are less expensive than they were in 2000, yet not as cheap as they were in 1982. However, macro conditions are very different. In 1982, the interest rates on Thirty-Year Treasury bonds reached 15% and inflation was running in double digits. We entered a bull market in bonds that is still underway. In 2000, expectations were so bullish that internet stocks were priced on the basis of “eyeballs.” It was a “silly season” with many stocks trading at several multiples of revenues, as there were no earnings. Today, investors are far more sober. And there can no longer be an extended bull market in bonds that helps drive equity prices, unless we believe that interest rates can go below zero. Unfortunately there is no crystal ball and there is no historical precedence.

The second question is something I worry about, but I also know I have plenty of company. In Berkshire Hathaway’s 2008 annual report, Warren Buffet wrote: “When investing, pessimism is your friend, euphoria the enemy.” With the mounting problems in the euro zone, a slow down in China, burgeoning balance sheets on global banks “too big to fail,” ballooning federal deficits and debt at home, persistent high unemployment and sluggish economic growth, euphoria is certainly not our problem; but are we pessimistic enough? It’s hard to tell; though we are assuredly leaning in that direction.

The third question, in some respects, is the most interesting. It is made so because of the fact that we are in an election year, and the choices we are offered are stark in their contrasts. On the one hand, the President offers more of the same – an emphasis on the public sector to drive economic growth, with higher taxes and more public projects. On the other, Mr. Romney proposes to let the private economy take the lead, with a lessening of regulation and tax reform that should encourage investment in both capital and labor, which ultimately would provide more cash to federal coffers, thereby helping both debt and deficits.

This rising tide of pessimism threatens to sweep us away. Politicians are held in very low esteem. Surveys show increasing numbers of people do not expect to be able to live as well as their parents, the notable exception being immigrants who still view this country as a land of opportunity. The Administration appears to have a vendetta against capitalism, yet they smilingly wallow in the dollars we send them. Everyone is concerned about consumption, while no one seems concerned about a lack savings and investments. The Federal Reserve has kept interest rates at exceptionally low levels for more than three years, damaging savers and the elderly, while purportedly driving consumption and asset prices. Does the Fed truly believe people cannot see through their scheme? Investment is what drives capitalism, allowing economies to grow. On January 1st the tax rate on dividends will rise from 15% to 42.5%, for those in the highest tax brackets. Is that any way to encourage investment, or to raise confidence on the part of investors? At hearings on Wednesday regarding the definition of high frequency trading, Duncan Niederhauer, chief executive of NYSE Euronext, speaking of the stock exchange, stated: “The public has never been more disconnected and has never had less confidence in the underlying mechanism.”

When I look at the market, it seems to me, to use a restaurant analogy that the ingredients are in the kitchen, the wait staff is ready, and there are customers in the dining room. The problem is the chef.