Third Quarter 2009
ByQuarterly Review & Outlook
The debt and equity markets had one of the best quarters they have seen in years. In fact, since 1983 (when we started our firm), there have been only four quarters where S&P 500 returns exceeded the return of this past quarter. Mathematically, that equates to less than 5% of the occurrences. Surprisingly, (and disappointingly), the majority of the gains for the quarter came from finance-related companies (i.e., banks and brokers) that are of a more speculative nature. The high quality multinationals with strong balance sheets substantially underperformed the more speculative companies.
Benjamin Graham, the “Father” of modern security analysis, opined that in the short run, the market is a “voting” machine; while in the long run, it is a weighing machine. This means that the market is risky in the short run due to its wild price movements but it becomes more rational over time as market values reflect reasonable valuations.
We believe that this past quarter is reflective of the bounce back from last year and the massive injection of liquidity into the financial system by the federal government. The equity markets have recovered dramatically from the March lows (about 50% in the S&P 500). Whereas, the market, by our calculations, was very undervalued in March, we believe that it is now overvalued by between 10% to 25%. As was demonstrated during the 1995 – 2000 period, the markets can become and stay overvalued over a sustained period of time.
We exercise a risk averse process when managing portfolios. When valuations are attractive, we will ramp up the level of portfolio risk. When valuations are high, we reduce the level of portfolio risk. We reduced the level of portfolio risk earlier this summer as we thought equity valuations were at fair levels. With the benefit of hindsight, we were way too early in reducing portfolio exposure – a phenomenon we have frequently encountered in the past. We have yet to be able to figure how to play “musical chairs” until the very end without ending up standing when the music stops. Historically, we just leave the party early and let others have the last bit of “fun”.
The current consensus is that we have avoided a second “great depression” (probably true) and that the credit markets as well as the economy are healing. It is very likely that the GDP will be positive for the second half of the year. Much of the growth in the economy has come from government spending (cash for clunkers, 1st buyer home credit, etc.) which is unsustainable. The question is: will the economic boost by the government transition over to an economy that continues to grow due to continued increases in business and consumer demand?
As we have mentioned before, our economy faces some significant headwinds over the next few years. The de-leveraging of consumers and businesses still has a long way to play out. The increase in government regulations and direct government involvement in businesses has historically acted as a drag on economic growth. Additionally, the gigantic increase in the government borrowings and deficits are bound to have a negative impact at some point in the not too distant future. Additionally, the residential real estate problems are far from being resolved. We continue to feel that there is a significant risk of a “W” form of economic recovery where after a modest recovery, the economy slips back into a recession in a year or two.
We have modified the economic scenarios that we think will be the three most likely outcomes for 2009. (The old estimates are in parenthesis.)
1) The economy bottoms in the 3rd to 4th quarter (3rd to 4th) 2009. Credit markets stabilize over the next 6 months and the equity lows of November 2008 are tested but not violated. Equity markets move higher by year-end and GDP begins to grow in late 2009 at a below optimal rate. Life begins to return to normal. This scenario would be very positive for the debt markets as risk premiums move substantially lower and also positive for equities as confidence in the corporate profit outlook for 2010 improves.
Assigned probability = 75% (25%)
2) The economy bottoms in late ’09 early ’10 and the economy grows at an exceedingly slow rate for the following 1-3 years. Credit markets stabilize over the balance of 2009 with a higher than normal level of volatility in both the equity and debt markets. The equity markets do not exceed the March lows (establish a new low with the S&P falling to near the 700 level). The S&P finishes 2009 within a range of plus or minus 5% (loss in the 10% to 15% range).
Assigned probability = 20% (60%)
3) The economy continues to deteriorate well into 2010 and does not recover until late ’10 to early ’11. Credit markets do not improve and remain in this “semi-frozen” state for the balance of 2009. Volatility increases to levels seen in the October – November 2008 period. Corporate profits plummet, unemployment reaches 12%, government stimulus has little effect and we are in a worldwide mini-depression. Credit market returns would be coupon minus defaults. Equity markets suffer another steep decline with the S&P reaching the 600 level. Traditional “growth” assets (houses, stocks, private equity, business values, etc.) continue to experience substantial declines in market values.
Assigned probability = 5% (15%)
After assigning weighted probabilities to these scenarios, we project an outlook for the equity markets that places it around a trading range of about 10% – 15% of the 900 range of the S&P500. We continue to feel that in this environment, it is prudent to maintain a reasonable level of defensiveness. We continue to believe that the current rally is a bear market rally.
As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.
Sincerely,
James A. Martin, III