Overview & Outlook
The first quarter of 2010 was one of extremes and started things out with a bang. The S&P 500 began the year at 1116 and quickly rose to 1150 before undergoing a 9.2% selloff (the steepest since the recovery began in March of 2009) down to 1044. Investors (such as myself) took advantage of the “sale” on stocks during the selloff and used it as an opportunity to add to positions. The ensuing buying pressure caused a 12% rally and the S&P 500 ended the quarter up at 1169.
Optimism abounded during the first quarter as corporate earnings continued to meet or beat expectations; auto sales maintained their upward trend and 4th quarter U.S. Gross Domestic Product (GDP) registered growth at an annual rate of 5.6% (the strongest growth since 2004). The jobs picture also improved in the first quarter with a drop in the unemployment rate down to 9.7% from 10% in December. March was especially strong as the economy added 162,000 jobs, the biggest monthly gain in over three years. Unfortunately, over 40,000 of those jobs were temporary Government hires for the Census and, after dropping to 9.7% in January, the unemployment rate has not fallen any further.
The signing of the health care reform bill by President Obama eliminated some uncertainty in the markets; influencing performance positively. Although the long term effects of this legislation are not yet clear, companies can now move forward with a solid understanding of what the rules of the game will be. Economists had been arguing that until the bill was either signed (or killed) it would be very difficult for companies to hire new employees because they wouldn’t know the true cost of employment.
Credit markets also continued to improve with the spread between corporate and government bond yields falling back to historically normal levels. Inflation was beginning to be a concern for investors towards the end of 2009 but the Consumer Price Index (CPI) data from the first quarter of 2010 allayed those fears by showing very muted gains. This maintains the foundation that the Federal Reserve needs to maintain its “exceptionally low levels of the federal funds rate for an extended period” while also providing financially strapped consumers with lower prices for their everyday items.
Despite the good news, there continue to be significant caveats and reasons for caution:
- Unsustainable GDP Growth
The blistering 5.6% GDP growth rate from the fourth quarter is not likely to be repeated because it was primarily driven by companies stocking up their inventories for the holiday season. Inventory stocking is typical in the fourth quarter but its effects were magnified in this case because companies were being cautious last year and maintained especially low inventories during 2009. To provide some context, we would need three more quarters of 5%+ GDP growth to drive unemployment down just 1%.
- Weak Jobs Market
Although the unemployment rate has fallen from its peak, it is still at historically elevated levels. U-6 Unemployment (a broader and more complete picture of unemployment) had been slowly declining but has now been ticking upward since February and registered at 16.9% in March. The picture gets even worse when you look at the details. Out of all the unemployed Americans, 44.1% have been unemployed for more than six months (almost double the worst level seen in our last recession). Also, many people who have been unemployed for more than a year are no longer being counted in the official statistics. This trend has only been getting worse and could mean that a lot of the jobs that have been lost are not coming back (particularly in construction, manufacturing and financial services). Unemployment rose in 24 states, while California, Florida, Nevada and Georgia all set new records for joblessness in March.
- Rising Oil and Commodities Prices
Over the past couple of years, oil companies have drastically cut their capital expenditure budgets for building new capacity because global demand had significantly slowed. Following strong stimulus programs from around the world – most notably China’s – demand for commodities and oil has been rising and global demand for oil is expected to set all time records in 2011. This strong demand combined with a diminished supply of oil could cause another sustained run-up in oil prices, which would severely dampen the economic recovery taking place.
- Interest Rate Policy and Bank Lending
A key driver of this recovery has been the strength of banks and their ability to keep credit flowing throughout the economy so that consumers can spend (even when they shouldn’t) and companies can expand. The more money banks make, the more credit they can provide. With the Federal Reserve holding their overnight lending rate at effectively zero, it has been extremely easy for banks to make money by borrowing from the Fed (AKA U.S. taxpayers) at a rate of 0% and then lending it out to companies at a rate of 5% or more; essentially providing the banks with windfall profits. Eventually the Fed will need to raise rates to stave off inflation, which will severely crimp the margins of banks, limiting their ability to continue contributing to growth.
- Continued Uncertainty Around Financial Regulation
Now that health care legislation has been passed, the administration and congress can turn their attention toward regulating of the financial services industry There is strong political and popular will to ensure that a financial crises of the magnitude that we saw in 2008 does not repeat but it is still unclear whether it will be done in a way that would impair the ability of banks to provide credit. Major banks made themselves easy targets by taking taxpayer money (whether they claimed to need it or not) and then spent lavishly on employee compensation stoking outrage that continues to smolder.
- The U.S. Budget Deficit and Tax Increases
In combating the recession and reforming the healthcare industry, the U.S. budget deficit has grown to unprecedented levels. This has been exacerbated by falling tax revenues due to lower corporate profits and consumer income. President Obama has already said that taxes will need to be raised for upper class Americans but it is not unreasonable to assume that lower income levels could also see higher taxes. Of particular concern for the stock market is that taxes on capital gains and dividends may also be raised, which would most likely be perceived negatively by the market.The elephant in the room however is looming social security and Medicare expenses that will continue to balloon as the baby boomers retire. Any reform will most likely require a mixture or higher taxes, reduced benefits and tougher eligibility requirements. Faced with the prospect of higher tax rates and decreased social benefits, investor sentiment is likely to wane.
Despite my caution, I am hopeful and optimistic that economic data will continue to improve. I would like to believe the market cheerleaders on CNBC who say that we are in a new long-term bull market but unfortunately, the facts of the situation do not yet support that assertion. After selling off a large portion of my portfolio in December and early January, I have been gradually increasing my exposure to certain areas of the market with a defensive posturing.
During times like this when hope and optimism outweigh the raw data, it’s important to maintain perspective and discipline. Warren Buffett said it best in a letter he wrote to his investors during the stock market frenzy of 1969:
It is possible for and old, overweight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.
Although very volatile, the S&P 500 continued its upward march, gaining 5.39% in the first quarter of 2010 and bringing its return for the trailing twelve months to 49.76%. However, it is still down more almost 19% from the October 2007 market highs.
The MSCI EAFE (European, Asian & Far East) index continued to underperform U.S. equity markets with a gain of only 0.94% in the first quarter, bringing its’ total return for the past year to 55.19%, slightly above the S&P 500. We feel that the MSCI EAFE is still being held back by a strengthening U.S. Dollar as well as concerns over sovereign debt in countries such as Greece, Ireland and Portugal. Despite these concerns, we maintain a favorable view on foreign/emerging markets as a whole because of their stronger fundamental growth prospects and lower consumer debt to income ratios.
The Barclays Capital U.S. Aggregate Bond Index underperformed equities during the first quarter of 2010 with a gain of 1.78%. The index is now up 7.70% over the past year and yields approximately 3.8% as of the close on March 31. The recent underperformance of bonds is likely due to investors shifting money from bonds (which are relatively safe) into riskier assets such as stocks (which offer greater returns). Another downward force on the price of bonds is speculation regarding when the Federal Reserve will begin to raise interest rates (higher rates tend to depress the price of bonds) and by how much.
We are either at the end of a Great Depression style “fools” rally or entering the second stage of a longer term bull market but it is very difficult to tell which it will be. The market is longer “cheap” by almost any definition with the P/S ratio now solidly over 1.0 and the dividend yield of the S&P 500 back to normal levels below 2%. However, with a forward P/E ratio of 16.95 (as of market close on 4/23/10) the market is not exactly overpriced either. We are now in a valuation limbo of sorts.
The main reason for this is that there is currently an unprecedentedly large divergence in the corporate earnings estimates of top down macroeconomic analysts and bottom up security analysts. Historically, bottom up security analysts have predicted operating earnings 19.25% higher than those predicted by top down macroeconomic analysts. For 2010 and 2011, the difference has widened to over 28%.
It the optimistic bottom up analysts are correct and the S&P 500 has operating earnings of ~$95 in 2011 (up from ~$57 in 2009), then the market is certainly undervalued and could easily run up into the 1,400’s assuming a modest P/E ratio of 16. However, if the top down analysts are closer to the mark and the S&P 500 earns only $70, then using the same P/E of 16 would imply a market correction down into the low 1,100’s.
This being said, I remain long the market and do not see any strong technical resistance other than 1,229 (the 61.8% Fibonacci retracement from 2007 highs to 2009 lows). However, until we break above that line, I am keeping my mind very open to the idea of a deep decline for two reasons. 1.) Selloffs bring lower prices and opportunities to buy great companies that might have been missed earlier during the rally and 2.) The public and political will for strong financial reform (which I feel is absolutely necessary in some areas) has been dwindling with each new month that the market continues to rally. The impetus for reform would be greatly strengthened if the market begins another dramatic selloff and stories continue coming out about issues similar to what went on between Goldman Sachs & Co. (GS) and Paulson & Co.
Bottom Line: Don’t short a market that wants to rally. I’m staying net long until technical long setups start breaking down and if short setups start working before we break above 1,229 then I’ll have to reevaluate and strongly consider going short.
Warren Buffett has picked up one of the stocks I have championed before on this blog, railroad stock Burlington Northern Santa Fe (BNI). Berkshire Hathaway (BRK.A, BRK.B) had previously acquired a sizable minority position in BNI, and Mr. Buffett must have liked it a lot because he decided to buy the rest of the company at a price of $100 per share (about a 30% premium from the previous days close).
In addition to the announcement of his largest acquisition ever, Buffet announced a 50-to-1 split of the Baby Berkshire shares, his class B tranche (BRK.B). This announcement, he said, was so that he could offer the small investors some BRK shares, whereas before they couldn’t afford the high prices (somewhat of a contradiction to what he said a few years ago about how a stock split was stupid and would allow inferior investors to own its’ stock…).
This puts BRKB on the radar of both Mike and myself. Previously, we both had looked at BRK as a favorable investment, especially during March when it had reached such a low level, however, the price was cos prohibitive. Now, Warren has offered me the chance to either accept $100 in cash for my shares of BNI, or some of his new, cut price, BRK.B shares. And I am unsure how to act.
On the one hand, BRK is a one stop diversification stop. It has exposure to banks, insurers, manufacturing, transportation, and a host of others. It has a proven track record of providing its investors with outsized gains, and excellent capital preservation. And it is the best way to ride the coattails of the one who is considered the world’s greatest investor.
On the other hand, Mr. Buffett is not a young man anymore. I am aware that there are several remarkably smart people waiting in the wings at Berkshire, but it is a huge risk to assume that the company can continue its remarkable run without its point man at the helm. His deal with Goldman Sachs (GS) during the height of the financial crisis was inspired and hugely profitable, but his similar timing with a similar deal with General Electric (GE) was less so, with the warrants he acquired remaining worthless. Finally, BRK is highly leveraged to the US economy. With this deal, Warren openly admits that he is taking a huge risk on the future of America, which he is undyingly positive about. Add to this his other positions and you have a company which is leveraged to a country with anemic growth, a declining currency, and a government with a huge debt load.
During the course of writing that last paragraph, I have convinced myself that I will take Warren’s offer of cash to the bank. There are too many variables involved in Berkshire, especially as Mr. Buffett gets older. I respect him hugely as an investor, I just think I can achieve a superior Sharpe ratio investing elsewhere.
Disclosure: Long GE, GS and BNI (pending the buyout)