A few of our friends and clients have been asking specific questions on our views of the market in recent days. We thought we’d share our responses.
1.) Given the market correction, do you perceive securities and other market instruments are at bargain prices? If so, where are the bargains?
We believe many areas of the market remain bargains in spite of the recent recovery. In hindsight, the 666 level on the S&P 500 was likely discounting an environment of rampant bankruptcies. Now, after a strong run, it’s merely discounting a “less bad” scenario.
From a statistical point of view, the market doesn’t look cheap, but that assessment is based on cyclical lows in earnings estimates, which we believe will work their way higher over time. There are bargains, especially if you’re willing to look out two to three years, where gains could still be significant.
Right now, we’re most interested in later stage cyclical stocks in the materials, energy and industrial sectors. As the recovery gains traction, the recent out performance of early cycle plays in the financials and consumer discretionary sectors should begin to fade as these later stage names begin to shine.
Consumer staples stocks also look like incredible bargains, but theory suggests the area may face performance headwinds as money flows into areas more leveraged to economic improvement. We believe, however, that this theory may be tested this time around as consumer staples stocks may be unique beneficiaries of a weakening dollar, or alternatively put, greater relative strength from emerging economies.
2.) Given the significant impact of the economic outlook (perceived or real) on the markets, what is your perspective on the state of the economy?
We believe we’re seeing signs that things have stabilized, a sentiment shared by many corporate managements during this earnings season. Of course, at some point the markets will need to see more than “less bad” results to make additional progress. But “less bad” is an important first step. Having been through a hurricane, companies can now assess the damage and begin the rebuilding process on firmer ground rather than still shifting sand.
Sentiment plays a huge role in determining the actual state of the economy in the extreme short run. After a nice bounce, moods are understandably better across many measures of consumer sentiment, but it also remains fragile. Investor sentiment, on the other hand, remains bearish even by historical standards rivaling lows only seen once in the last forty years. While a 10-20% pullback from here wouldn’t be unprecedented, it is doubtful that we’ll revisit the old lows in the face of such bearish sentiment. Bull markets invariably climb a wall of worry and we still have far more worry than jubilee.
On the political front, conservatives are up in arms over the rise of big government, but liberals aren’t entirely to blame as the trend clearly got started during President Bush’s last year in office. While I am a conservative, I believe the minority party is beginning to sound fatalistic, which has dangers of its own. Things aren’t likely to be nearly as bad as the extremes of either party might suggest, even though these voices will always be the loudest. We’ll get through this, we always do.
3.) What is your recovery plan to address these historically low returns?
Ten year rolling average rates of returns on large cap stocks have never been as low as they are today, even going back to the Great Depression. Unless this is really the end of the world, current levels suggest that forward ten year rates of return could have significant upside. This may be an incredibly compelling buying opportunity for today’s long term investors.
I would also note that “buy and hold” is now disdained worldwide. Often, whenever an investing style or economic sector becomes universally despised or loved, an impending inflection point may be close at hand. Even Warren Buffet has taken shots lately. Ditto with the “it’s different this time mantra”. I hear alot of that these days.
History has repeatedly taught that it pays to go against the grain during points of maximum pessimism and maximum greed. The key, of course, lies in finding one’s courage to act. There are no free lunches, after all.
4.) What single most significant change have you made to your own personal investment philosophy and how have you incorporated this change, or will you incorporate this change, in your personal investments?
After the tech wreck earlier in the decade, we adopted a selling discipline which we compared to caring for a garden. Regular pruning, weeding and transplanting of investment holdings based on relative performance criteria and changing economic seasons has served us well over the last few years.
More recently, we’ve also recognized that the greatest gains in the portfolio have tended to come from the names that are most universally out of favor, a characteristic that may be unique to extreme environments. This has caused us to take a closer look at similar areas of opportunity, not only within the portfolio, but outside of it as well. Every morning, we review the performance of our holdings year to date and off the lows in both November and March. We’ve been more quick to prune gains, but have also been more eager to hold or add to names under significant pressure.
Historically, we’ve only invested in bonds where clients need income or would like to achieve some downside protection. I’ve never been a personal fan of corporate bonds as a diversification source in downside environments, preferring, the risk return profile of equities instead. Where a fixed component is needed or desired, I’ve tended to only invest in government debt.
Given the recent downturn, I’d say I’m more inclined to have a fixed income component in almost any portfolio, including my own. Hundred year floods do occur and you have to make sure the liquidity exists for near term survival. You also can’t take advantage of buying low, if you have nothing to sell.
While it may be true that “less bad” isn’t the same as “better” earnings, it is still an important first step. As mentioned in our answer to question two, First Call earnings estimates have been trending up for the first time in quite awhile. Remember that the market discounts improvements in earnings ahead of their actual occurrence, just as it discounts deteriorating earnings ahead of their actual occurrence. There are certainly false positives on both sides, but in all cases, stocks end up moving up or down in advance of the fundamentals.
In our last update, we closed with the comment that religious faith is defined as being sure of what one hopes for and certain of what one cannot see. The greatest blessings often come to those who move ahead of the crowd, when the evidence for such belief isn’t always readily apparent. Investing may be similar.