Third Quarter 2010
ByQuarterly Review & Outlook
Not to repeat our 2nd quarter letter but the equity markets for the third quarter were almost a mirror image of the second quarter. Equity markets across the board were up rather sharply roughly offsetting the losses that occurred in the second quarter. As anticipated, our defensive approach restrained some of the potential gains during the third quarter, the inverse of the help these holdings had in mitigating the losses of the second quarter. The equity markets have essentially eked out minimal gains for the year but with a lot of volatility. We find this environment to be embedded with greater risks than usual and we believe it calls for an abundance of caution.
There are a number of conflicting economic signals that contribute to the level of uncertainty regarding the outlook for the economy. On the positive side, the Federal Reserve has provided tons of liquidity, held interest rates to almost zero, corporate earnings are higher than anticipated and corporations are sitting on almost one trillion dollars. However, corporations are reluctant to spend these funds on capital expenditures due to a weak economy, sub-par growth and persistent high unemployment. Additionally, the rate of growth in the economy is declining and the ECRI index has been declining for 20 consecutive weeks. This index is indicating a significant decline of economic activity and should it continue to decline, increases the odds of a double dip recession.
In the short run, there are more positive attributes to the equity markets than negative ones. There is ample liquidity, positive momentum, positive earnings surprises, positive money flows and a likely election outcome that is expected to be positive for equities. We are not traders and as such do not try to catch the various swings in the markets. Trading is a game best played by hedge funds that have the talent and resources to jump in and out of the markets to pick up nickels and dimes from each trade. Our approach is more strategic in nature, oriented toward seeking gains from the markets while always focusing on lessening risk. With that in mind, we thought it might be helpful to share with you our current “view of the world”.
One of the strongest factors in the markets is mean reversion. Mean reversion is a phenomenon similar to the weather. Whenever markets experience a period of over performance, there is a strong tendency to underperform in subsequent periods. It may be hot during the summer and cold in winter, but the average temperature is relatively constant over the years. Markets have a similar tendency to fluctuate around a long-term trend. They will experience cycles of over and under performance, but in the long run, they tend to “regress toward the mean” or move toward the long-term average. We see a number of areas where we think the prospect of mean reversion is likely to happen over the intermediate time horizon (3 – 5 years). Most importantly in the area of U.S. debt, equity valuations, corporate profit margins and interest rates.
We have talked many times about the debt problems with the U.S. and developed world economies. The U.S. Government has added an exponential level of debt in an effort to stimulate the economy. High levels of debt tend to act as a drag on the economy and eventually will have to be reduced to more normal levels. Currently, the Federal Reserve has all but stated that they will pursue another round of stimulus in an attempt to “goose” the economy. Now referred to as QE2 (quantitative easing version 2), the Fed will be buying mortgage securities essentially by printing money. There are a number of concerns regarding the efficacy of this approach and many concerns regarding the intended consequences stemming from QE2, principally future inflation and a lower dollar. We think (as do many others) that QE2 is a bad idea. It will contribute only modestly, if at all, to stimulating the economy and the potential risks far outweigh the benefits. Using debt (whether public or private) to stimulate the economy has become progressively less effective over the past 30 years. Our public debt is already at excessive levels and we do not now need to add to the problem. It is only a matter of time before mean reversion kicks in and the aggregate level of debt declines (it already is in the private sector). Paying down debt is a good thing except it is a short term negative for the economy as funds are diverted from consumption which results in lower demand for goods and services.
Equity markets have rebounded strongly since the June lows and have pushed valuation levels above normal (the Shiller P/E index is now above 21 vs. its long term average of 16). There is nothing to prevent the PE multiple from going higher (it was over 30 at the peak of the Tech Bubble) but the higher it goes, the greater the risk. Additionally, corporate profit margins are near all time peaks and are likely to move downward in the not too distant future. Lower margins translate into less profit growth and could put further pressure on P/E multiples. One of the factors contributing to high margins is low interest rates. Creditworthy companies are able to borrow at historically low rates. IBM recently borrowed $1.5 billion for three years at a rate of 1%, an all-time record for low rates. The real question is how long will rates stay this low?
This leads us to our last (for now) mean reversion issue – interest rates. As you well know, short term rates are near zero and long term rates are at historically low levels. The Fed uses short term rates as a monetary tool and is currently holding rates at so low a level that they effectively can’t go lower. The real rate of interest (interest rates minus the inflation rate) is at negative levels. Negative real rates are not a sustainable condition; either inflation turns to deflation (a possibility) or rates go up. Neither outcome would be viewed as a positive for the equity markets. Remember when the Prime Rate was 21.5% in December of 1980? Interest rates have been on a secular decline for the past 30 years and can’t go much lower as zero is the lowest possible interest rate. Should inflation start to pick up or should creditors demand better yields (i.e. lending money to the U.S. Government) interest rates are likely to increase. Again, it is impossible to know when but there is a high probability that over the intermediate term (3-5 years) interest rates will rise.
We don’t mean to always cast a dour light on our economic outlook but we do need to look at the weight of the evidence which leads us to our current risk assessment. We believe that half the battle of achieving good long term returns is to minimize losses during hostile market environments. This is an effective approach that Sterling has practiced for over 27 years: protect principal first! On a positive note, we do believe in the resiliency of the U.S. economy and are optimistic that we will work our way through these problems, it will just take some time. Eventually there will be an opportunity to acquire equities at reasonable to cheap valuations and enjoy periods of above average returns. For now, we expect to continue our defensive approach in the management of client portfolios.
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