Wednesday, October 10, 2012

“What, Me Worry?”

Sydney M. Williams

Thought of the Day
“What, Me Worry?”
October 10, 2012

For the forty-five years I have been in the market, both the S&P 500 and the DJIA have compounded annual returns at 6.2%, excluding dividends. The last dozen years, though, have seen a gyrating market that first had to digest the collapse of the greatest bull market in the history of the exchanges – August 1982 to March 2000 – and then respond to the greatest credit crisis America and the world has faced since the Great Depression. For many, the last several years have been a “lost decade”, with markets lower than they were a dozen years ago. The ten year CAGR for the S&P 500 has been 5.1%, while the fifteen year CAGR has been a dismal 3.1%. If we go back a dozen years, the S&P 500 is now selling at the same level it then was. People far smarter and more intuitive than me are paid to make sense of a market that, as usual, defies analysis. I feel conflicted.

The market collapse in 2000-2002 wiped out an estimated $6 trillion in equity value. Much, but not all, was made back by October 2007, as the economy was entering both a recession and credit crisis; the S&P 500 subsequently fell 57% before bottoming on March 9, 2009. (The NASDAQ, however, is still 40% below where it was twelve and a half years ago, suggesting that the total value of U.S. equities is probably still lower than it was a dozen years ago.) For the past three and a half years stocks have irregularly bulled their way back; so that the S&P 500 is now down a mere 7.7% from its all-time high. Despite the market’s recovery and in spite of a VIX that is not far off multi-year lows, there does not appear to be a lot of conviction about stocks being a long-term store of value. That can be seen most obviously in a chart depicting New York Stock Exchange composite volume, which shows a decline of roughly 60% over the past four years. What makes those numbers even more compelling is that the same period has seen a rise in high frequency trading. It all suggests that investors, as opposed to traders, have, to a great extent, abandoned the market.

It may be that investor’s apparent lack of interest is the consequence of rational thinking. The world certainly looks uncertain. China’s growth has slowed. Europe is disintegrating, putting band-aids on gaping, open wounds. The Middle East is more, not less dangerous than it was four years ago. The IMF recently lowered their estimate for 2013 world GDP growth to 3.5% from 3.9%. The United States’ economy has been slowing for the past two years and there are suggestions it could be stalling. Third quarter earnings for the S&P 500 are forecast to be down 1.4% year-over-year and about 4% below the second quarter. Margin debt is up 5.4% year-over-year. We are facing a fiscal cliff, which everybody expects we will avoid, but ultimately it is a roadblock we cannot avoid, with debt and deficits sapping our strength. Despite a death-defying credit experience four years ago, regulators have allowed banks to become even bigger, and the Federal Reserve, in one of history’s most egregious examples of price fixing, has kept interest rates at record low levels for a record long time. Crony capitalism is alive and well in Washington and New York. Congress is in hibernation and the President, having given up governing, is campaigning when not appearing on The View.

The consequence has been a spurt in asset prices over the past four years, with the yield on the Ten-Year falling from 3.83% to 1.62% – below the rate of inflation. High grade corporate bonds are today yielding less than what the Ten-Year did three years ago. The yield on High-Yield Bonds has declined from over 25% at the end of November 2008 to 6.7% today. Copper is up by a third; gold prices are up 100%, and silver has almost tripled. Stocks are 132% higher than their low in March 2009. Ironically, since the credit crisis in 2008 the rich have become richer, the middle class, according to Joe Biden, have been buried and poverty has increased. It is not a scenario that lends itself to the confidence that economies need and bull markets rely on.

Efficient pricing theorists argue that markets always reflect and discount all available information. The argument is made by those who argue that it is virtually impossible to beat the market consistently over time. Purveyors of index products use such arguments to peddle their own products. But, it has been my experience that things are never that easy. There are times when markets are more volatile than the news; and there are times like the present when they seem to ignore indications of possible trouble. Over time, multiples, interest rates and equity performance tend to revert to the mean. At roughly 14X current year earnings, the multiple on the S&P 500 is in line with its long term average. The compounded average annual ten-year price return is 5.1%, slightly below the longer term average, while interest rates have been fixed at abnormally low levels.

Fundamental analysis, which largely drove prices during my first three decades, seems to have given way to short term traders looking for an edge in a company’s next quarter’s report (will they or will they not beat consensus?) and quant-driven high frequency traders. I recognize that is an exaggeration. There are exceptional investors who, through diligence, perseverance and savvy find nuggets in what seems a largely unfriendly landscape. Nevertheless, the increase in the buying of ETFs and various index funds suggest a willingness to make geographical, sector or industry bets, but the lack of volume suggests investors are reluctant to bet on specific companies. Additionally, since we inhabit an attention deficit disordered world, requiring instant gratification, patience is no longer considered the virtue it once was.

A confluence of myriad conflicting events confronts investors. On the positive side we can note strong corporate balance sheets, little or no return on “safe” assets, low interest rates and, despite recent market strength, little confidence that stocks, the economy or government are well positioned. On the negative side we see market complacency in a low-priced VIX, corporate margins at peak levels, concerns about a slowing economy, worries about Europe, China and the Middle East, uncertainty regarding the “fiscal cliff” and the election, and what both might mean for future taxes. The combination has created a pushmi-pullyu market that only a Dr. Doolittle could interpret. Should I be worried? I am uncertain.

I am, however, a firm believer that the best way to participate in the long term growth of the U.S. is through equities. At certain points, bonds serve to protect capital, but given the current level of interest rates, they afford, in my opinion, little protection and – when interest rates go up, as they surely will – the risk of sizeable losses. Commodities are either a bet on a declining dollar, or an outright speculation, except where they are tied to economic demand. Given the size of the national debt, and the apparent willingness of the Fed to monetize it, it seems a reasonably safe bet that the dollar will continue to be weak. I am negative on the dollar and neutral on commodities, given their rise over the past decade. That leaves equities. While I worry about the direction of the country (and that complacency isn’t entirely unknown) and the potential for a nasty surprise from the Middle East, Europe or China, it seems to me they represent the best value – not great, but OK, especially if one can find companies paying reasonable dividends with the opportunity to increase them over time. It looks to me like a stock-pickers market.

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