After spending the first three quarters of 2010 bouncing up and down in a wide trading range, the stock market broke out to the upside during the fourth quarter without looking back. The S&P 500 ended the year up 15.07%, with about 75% of the gains taking place during the final quarter. This compares to a yearly gain of 8.2% for the MSCI EAFE Index (returning 6.65% in Q4) and 6.55% for the Barclays Capital Aggregate Bond Index (which lost 1.3% in Q4). Global stocks have now rallied over 20% (even more for riskier small and mid-cap stocks) since Ben Bernanke, Chairman of the Federal Reserve, first started talking about a second round of quantitative easing (QE2) to support asset prices (which include stocks), however, this is not the only factor contributing to higher prices.
In addition to the massive monetary stimulus coming from the Federal Reserve, stocks have also benefitted from an even larger $858B fiscal stimulus in the form of the extended Bush tax cuts and temporary payroll tax reductions. Regulatory uncertainty has subsided with a deadlocked Congress and investors have cheered the more business-friendly attitude coming out of Washington as shown by appointing William Daley (former Vice Chairman of J.P. Morgan Chase) to Chief of Staff and replacing Paul Volcker with Jeffrey Immelt (CEO of General Electric) as the new head of his economic advisor panel.
On the non-political side of things, the U.S. economy experienced improvements in capacity utilization rates (although still not anywhere near levels that would pressure companies to hire and expand), part-time hiring and the lowest unemployment claims in two years going into the holidays. GDP growth also ticked up to 1.7% in the fourth quarter, which is not very impressive because if you subtract the effect of government stimulus programs and QE2, our GDP would still be in contraction. Inventory buildup (not consumer demand) has continued to be a large contributor to growth.
Many emerging market economies are showing signs of overheating with inflation rising into the double digits in some areas, however, their Central Banks have been quick to raise rates but it is still uncertain if these strategies will continue to be effective. Debt fears in Europe have calmed down for the moment due in large part to China and the European Central Bank (ECB) stepping in to purchase euro zone government bonds, especially in peripheral areas such as Portugal, Ireland, Greece and Spain. We view these actions as a temporary band aid and will be watching their respective government bond yields (see below) going forward for signs that their structural solvency issues are being resolved. In the meantime, we are maintaining relatively low exposures to these areas.
Despite the improving economic data and news, the extreme level of euphoria in the stock market at the moment is worrisome.
Bullish sentiment has been at very elevated levels over the past couple of months, similar to how it was in 2007 before things started to crumble. Back then, people knew that there were serious risks to the market but they were comforted by the Fed’s reassuring words that they had everything under control. This is also similar to today where market commentators are making statements that there is no way equities and risk assets won’t go up because if the economy doesn’t improve on its own, the Fed will print money to continue supporting prices. The 2010 Barron’s Roundtable for 2011 concluded that:
“America’s structural problems, including a gargantuan deficit, and the policies that perpetuate them, just might bring the country to ruin – but not before the stock market rallies another 5%, or 10% or 20%…”
Do investors really believe they are getting good long-term VALUE for their investments with a macro outlook like that?
Another measure of market exuberance is also flashing warning signs, the Shiller 10 year P/E ratio. This measure takes the average inflation adjusted price/earnings ratio for the S&P 500 over a 10 year period so that it can accurately measure the growth of earnings over multiple business cycles. A high P/E ratio means that investors are willing to pay a high price for each dollar of earnings and vice versa. Many stock market bulls tout the one year forward P/E ratio for the S&P 500 at under 14 and say that it is below average and therefore, the market is cheap. However, if you look at the cyclically adjusted P/E ratio, we are near the high end of a 100+ year range which does not bode well for future longer term returns from this level (see chart below).
Along with the P/E ratio, corporate profit margins are also near all time highs. This is also concerning because high profit margins attract competition which lowers prices and margins back to a more normal level. P/E ratio’s should therefore be highest when profit margins are low, and vice versa. It seems hard to imagine how investors are going to achieve above average long term returns when they are paying an above average price for above average profit margins that are likely to revert back to the mean.
Aside from market sentiment, there continue to be three major headwinds to the global recovery:
Although sales of new and previously owned homes has been on the rise of late, the more important metric of home prices has continued to flounder. Price is a much more important variable to watch than the number of sales because price is what drives the “wealth effect”, lets homeowners tap into their equity, and spurs new construction (see chart below to see how dead the construction market remains), which in terms drives employment.
History is riddled with economic bubbles from Tulip Mania in the 1630’s, to the South Sea Bubble in the early 1700’s, to the British railroads in the middle 1800’s, to the Internet Bubble in 2000 and now the housing bubble. The only similarity between them all is that they involved large amounts of price speculation and that they all saw price declines of over 75% from their peaks after adjusting for inflation to their bottoms. Although we doubt that home prices will tumble that far – at some point, inflation, population demographics as well as principals of supply and demand will start to play a large role in supporting prices – we are skeptical that the current decline of approximately 16% is all that will happen (see chart below of the multi-decade home price bubble).
The details of the past year are even more concerning, especially considering that television and the newspapers are all talking about how much housing is improving. Average home prices for the S&P/Case-Shiller 20 City Composite have fallen 3.38% over the last 4 months (about 10% annualized contraction) and 14 of the 20 regions are setting new lows or are on their way back down and within a couple percent of new lows. Only one region reported price gains in November but it was 0.1% and is within the range of statistical error and over the past twelve months, the 10 and 20-City Composites has declined 0.4% and 1.6% respectively.
Whether we like it or not, the future of both the housing and job markets are dependent on each other. Construction (especially residential) is one of the biggest sources of jobs in the U.S. and the amount of jobs lost during the recession in that sector alone is staggering. This leaves us with the paradox that improving home prices will spur new construction and jobs, however, prices will face downward pressure so long as the unemployment rate is at elevated levels.
While it is good news that part-time hirings have picked up lately, we do not necessarily view it as a precursor to increased full time hires and instead believe that it is representative of a broad shift in America’s labor market in which a greater share of the workforce will be composed of part-time employees. We view this as a negative development because part-time workers make less total income on average, do not get medical benefits and are not eligible for sick days or maternity leave. The issue of lower income is especially important because it means that a higher percentage of take home pay will need to be used for essential expenses, and the remainder is more likely to be saved than spent on luxuries since their job is not stable.
In terms of full time jobs, the market is still not looking very encouraging. Although normally we would cheer a 0.4% one month drop in the unemployment rate such as we had in December, it was a hollow victory for the job market because about half of the drop was the result of 260,000 more workers dropping out of the labor force (after 99 weeks, people without jobs but want one are no longer counted as unemployed) and joining the ever growing army of discouraged workers (see below).
The labor force is now smaller than it was before we entered the recession, even though it would have needed to grow by more than four million just to keep up with population growth and our civilian labor force participation rate is now down at a 26 year low of 64.3%. Lastly, the graph below compares growth in the job market during The Great Recession to other post-war American recessions and it is chilling reminder that although we’re not seeing mass layoffs, contracting GDP and falling stock prices anymore thanks to unprecedented support from the Federal Reserve and Government, we still are nowhere close to seeing the kind of improvements needed to promote a self-sustaining recovery that leads to organic (not debt-fueled) growth.
Developed Market Growth & Emerging Market Inflation
Our final major concern is the contrasting growth and inflation dynamics between developed market economies, which are suffering from heavy debt loads requiring deflationary austerity measures, and emerging market economies, which are struggling to rein in inflation due to soaring commodity prices. In an effort to calm fears about ballooning deficits in Europe, many Governments such as Ireland and the UK instituted austerity measures to cut costs. The ensuing protests have died down, but it’s possible that the budget cuts are already eating into economic growth as evidenced by the resumed GDP contraction in both of those areas. We are concerned how long public support for the fiscal restraint will last if their economies continue to contract in 2011.
The issue of emerging market inflation is of particular importance right now because the high food and energy costs in these areas are beginning to spur social unrest. The Government of Tunisia has already been toppled and there are currently protests taking place over high unemployment and rising commodity prices in Algeria, Mauritania, Yemen and most importantly, Egypt, a key ally to the U.S. and stabilizing influence in the Middle East. While none of these events by themselves are particularly serious, the situation could quickly spiral out of control if we were to see similar events take place in more economically important emerging economies such as China, India, Pakistan and Saudi Arabia. All of these countries play crucial roles in the global food and energy supply chain and any disruptions could cause a price shock to the global economy. In fact, this may already be happening with the price of oil. If you look at the chart below, you will notice that there has only been one time in the past four decades where the U.S. didn’t end up in recession when the price of oil increased by more than 50% over a two year period. We are crossing our fingers that “this time will be different” but we will watch this closely moving forward.
Although our composite client performance was neck and neck with the stock market through 2010 at the end of Q3, our conservative positioning held back our performance during the end of year melt up where stocks with poor balance sheets and high levels of cyclical economic exposure performed the best. As a result, our composite performance trailed the S&P 500 in the fourth quarter with a gain of 2.18%, bringing the year end return to a 5.82%. While such short-term underperformance is certainly unwelcome, it is an unavoidable result of the absolute-return, value-driven investment philosophy at Pacific Mountain Advisors that has helped us deliver such solidly market-beating returns since our inception and we see no reason to change that any time soon.
Our equity and commodities/precious metals were the strongest performers during the fourth, riding on the back of inflationary expectations arising from QE2. Unfortunately, these same inflationary expectations put pressure on our fixed income holdings which detracted slightly from overall performance. Another detractor from our performance was our above average holdings of foreign equities, which underperformed the S&P 500. This recent underperformance is not worrying at the moment because a period of consolidation is typical following prolonged upward swings like our holdings have.
We continue to be positive on gold, despite a recent pullback in prices, because of the pervasive money printing taking place in the developed world and the inflationary pressures that are building in emerging markets. We are also positive on commodities over the long term because there is simply not enough viable farmland on this planet to produce enough food for the growing population (especially as consumers in developing markets add meat to their diets as their incomes grow). Climate change is also exacerbating the situation as crop yields fall due to fires in Russia as well as floods in Pakistan and across Southeast Asia.
We made two changes to client portfolios during the fourth quarter:
We changed our equity hedge in the beginning of the quarter from ProShares UltraShort S&P500 ETF (SDS) to PIMCO StocksPLUS TR Short Strategy (PSSDX) to achieve the same directional market protection, but without the performance divergences that result from an ETF recalculating its net asset value every day. While this action saved clients money during the quarter relative to the performance of SDS, the gradual improvements in economic conditions, coupled with the asset price boosting policies of the Fed, caused us to reconsider our position and we sold PSSDX for a loss (or hedged it by buying the Schwab US Broad Market ETF (SCHB) in client accounts where short term redemption fees prohibited us from selling). We always prefer to sell positions for gains but cutting losses is just as important as locking in gains. John Maynard Keynes may have said it best when a critic accused him of flip-flopping on policy recommendations during The Great Depression when he said “When the facts change, I change my mind. What do you do sir?”.
The other significant change involved client portfolio’s that were holding the iShares S&P California Municipal Bond ETF (CMF). We have had a cautious eye on the municipal bond market for the last year but it wasn’t until the end of Q3 that we really started to get worried. Municipal bonds had been on a multi-year rally and CMF was hitting new all time highs. These new highs meant that the yield on CMF was falling and we began to question whether yields that low would be enough to compensate bond holders for the increasing threat of municipal defaults. Municipal bond investors have always enjoyed the presumption that the Federal Government would bail out the states if things became bad enough, but the new Republican Senate is less likely to allow this. The final straw for us came when we began hearing chatter in Congress about amending laws so that states and cities could declare bankruptcy. While this would help the states to get out of their tremendous debt burden, it would also be disastrous for bond holders. These concerns led us to sell all holdings of CMF in early November at $108.48 per share and protected our clients from the ensuing 10%+ drop that erased almost two years of gains.
Moving forward, we will be looking for pullbacks in the market to boost our equity exposure with an emphasis on high-margin sectors that are benefitting from demand based fundamentals such as global technology and energy.
In general, our equity holdings are higher quality and more conservative relative to the overall stock market, which includes many smaller companies that are dependent on a fast growing economy. These smaller companies may have done well since the rally in risk assets began (outperforming large-cap by a wide margin), but they do not offer the same degree of protection for investors if the economy falters because of their lower average dividend yields, inferior access to capital and weaker fundamental cash flow generation. These issues are important to us as value investors because as they say in the industry: “In the short-term, the stock market is a voting machine, but in the long-run, it’s a weighing machine”. Therefore, we would expect to underperform (although less so than in Q4) the S&P 500 if the current trend of ignoring fundamentals in favor of momentum continues but we are confident that the positioning of our portfolio’s will reward our clients over the next few years as it has done in the past.
Heads, they win; tails, you lose has returned to the markets and some money managers are feeling pressure to fill client portfolios with high levels of equities in an effort to beat their benchmarks (which is the basis for how many of them are compensated). If the market keeps going up, they get extra bonuses and their clients make money so everybody is happy. However, if the rally loses momentum (which is one of the key drivers of the market at the moment), their clients lose their shirts like they did in from 2000-2002 and from 2007-2009. In this case, the client is the only one that really loses because the money manager will keep his job since he/she performed in-line with their benchmark (even though the benchmark fell).
At Pacific Mountain Advisors, we are very proud of what differentiates us from that mentality. We don’t get extra bonuses for beating benchmarks and when our clients lose money, we lose money – regardless of what our benchmarks did. Giving up potential additional gains when the stock market is racing blindly towards the sky can be emotionally trying, but we are not here to feel comfortable. We are here to make decisions that often feel very difficult at the time but are aimed at safeguarding and growing the life savings of our clients – not just over the next three to six months, but over the next three to ten years – and as we said earlier, we don’t plan on changing that any time soon.
Word of Wisdom for 2011
“Beware of silent dogs and still waters”
~ Old Portuguese Proverb