February 11, 2010Beginning in early March 2009, the stock market staged a powerful rally. As a result, the market rose 26.5% for the year, as measured by the total return of the S&P 500 Index. From its March low, the total return of the S&P 500 was 67.8%. Despite this impressive gain, the market had a cumulative loss of 24.9% from its October 2007 high. Moreover, returns for the decade ended 12/31/09 were extremely disappointing. For that period, the cumulative total return for the S&P 500 was -9.1%, making the decade from 12/31/99 to 12/31/09 the single worst decade in nearly 200 years! 1
Obviously a good deal of the decade’s under-performance can be explained by the fact that it suffered a three year bear market at the beginning (2000 – 2002) and another vicious bear market in 2008 and early 2009. The first bear was a reaction to the high-tech bubble of the 1990s and the second a reaction to the recent housing bubble and orgy of wanton credit.
The following table puts the past decade in context. Note that while stocks did poorly, bonds performed rather well.
All returns as of 12/31/2009 * Bank of America Merrill Lynch U.S. High Yield Master II Index ** Bank of America Merrill Lynch Current 10-Year U.S. Treasury Index
We have written extensively about both the tech and housing manias and their subsequent panics, so we won’t dwell on them here. We do, however, want to make the assertion that following such a disastrous decade, stocks may do reasonably well going forward.
Equity valuations today are reasonable, but not dirt cheap. The price/earnings (P/E) ratio on forward earnings is around 15x which is roughly in line with its long-term average. Given the fact that interest rates are unusually low now, and could rise over the next few years, we believe it is unlikely that P/E ratios will expand much if at all. Therefore, stock market returns may be driven by earnings growth and dividend pay outs. Earnings growth could be in the mid-single digits over the next three to five years, and the dividend yield should approximate 2%. If these conditions come to pass, we believe stocks could potentially generate a total return of 7% to 8% over the next three to five years. While this is not a spectacular return, it would be acceptable in a low inflation environment.
Economic Outlook
The outlook for the economy is clouded by several factors related to the housing bubble and its aftermath. Although economists debate about the strength of further recovery, most observers believe the economy began to recover in the third quarter of 2009 and may be poised for further gains. We are squarely in the camp that forecasts a weaker than average rebound. Our thoughts on this subject are little changed from what they were three and six months ago.
Consumer spending, which accounts for about 70% of GDP, cannot rebound strongly if unemployment continues to hover around 10% and then only slowly improves. Consumers took on too much debt over the past decade and now need to rebuild their balance sheets. As a result, the savings rate has risen from less than 1% in early 2005 to just under 5% today, further detracting from consumer spending.
Some 23% of all mortgages in this country are underwater. While house prices have recently showed signs of stabilizing they are not likely to rise sharply. In fact many analysts are expecting another wave of foreclosures which would dump a new supply of houses on the market further depressing housing prices.
Despite the best efforts of the government to create liquidity and stimulate the economy, banks are reluctant to lend. They are more concerned with rebuilding their own balance sheet strength and still face a mountain of rotting credit card and commercial real estate loans. Hardest hit are the local and regional banks, many of which are expected to fail over the next 12 to 24 months. As a result, credit for consumers and small businesses remains severely constrained.
State and local budgets are in shambles, resulting in spending cut-backs across the nation. It is unlikely that state and local budgets will improve dramatically or quickly. We would expect many states to raise taxes. This would have a dampening effect on local economies.
Throughout the past year the Federal government has pulled out all the stops in order to stabilize the financial system and stimulate the economy. The Federal Reserve flooded the system with liquidity and Congress spent vast sums to jump start the economy. The results of these efforts were (1) the financial system has indeed stabilized and (2) economic activity has rebounded. Both of these results are, of course, salutary. They are, however, not without serious costs.
While the stimulus is working, it will not be permanent. Therefore, what happens when it is taken away? Will the recovery be on a self-sustaining path or will it sink back into recession? Moreover, what are the long-term implications of this massive federal spending? Clearly one answer is an exploding federal deficit. While consumers and businesses generally are deleveraging, the federal government is leveraging. How long it can do so is an open question.
How long will investors – both domestic and foreign – continue to buy U.S. government debt? At what point will they demand a higher interest rate to lend to the U.S.? What will be the effect on the dollar? These are not insignificant questions. In looking for the next financial crisis, one need only look for the current financial excess. The last cycle it was in the housing sector. Now it is government. We believe the next crisis will concern government debt. The only unknowns are how extensive and how severe the crisis will be and when it will happen. The Federal government is running massive deficits occasioned by the need to stimulate the economy, while simultaneously waging two active wars in Iraq and Afghanistan, and struggling to deal with the structural imbalances derived from an aging population. While the deficit spending associated with fiscal stimulus programs is ultimately a temporary problem that should recede as the economy picks up a momentum of its own, the other two issues are of a more permanent nature.
In and of themselves the wars in Iraq and Afghanistan could be viewed as voluntary. That is, we did not have to invade Iraq, and history may conclude that we did so based more on ideology and false intelligence rather than on any real strategic necessity. Afghanistan may enjoy a somewhat greater justification. But, the rise of radical Islamism and its use of terrorism to achieve its ends, does necessitate a response on our part, a kind of permanent step-up in our defense and national security budget. Because the goal of the radical Islamists is basically ideological and not economic, there seems little hope that we can sit down and negotiate a truce. This battle will probably be with us a long time.
The structural problem of an aging population could soon result in a crisis of Medicare and Social Security expenses with fewer younger workers available to support the cadre of aging retirees. A significant consequence of an older population is an inexorable growth in health care expenses, made worse by growth in medical technology, which seems to add to costs when looked at in aggregate. Sadly, Congress and the administration failed to address the issue of health care costs when drafting recent health care reform legislation. Rather than health care reform, their “solution” is really little more than insurance reform in which 30 million more people would gain insurance coverage and be added to our dysfunctional health care system. This rather cynical attempt at reform will certainly add to our long-term structural deficits for years to come.
Ultimately taxes will have to be raised to pay for all of this. Whether they will go up so far as to kill the golden goose is an open question. Our guess is that tax increases will not prove draconian, but will exert a modest dampening effect on long-term economic growth.
The other issue associated with the current monetary easing and fiscal stimulus is whether these actions will spark inflation. Because of high unemployment levels, and the continued impact of globalization, we doubt that inflation can move beyond an increase in commodity prices and trigger a wage-price spiral. In other words, an economic recovery coupled with growth in emerging markets may result in higher demand and prices for commodities. Relatively weak consumer demand, however, will not allow manufacturers to pass on these commodity costs. Wages are also likely to be constrained by surplus in labor markets. Therefore, while the economy may experience some commodity inflation, it is not likely to see much increase in consumer prices or in wage rates.
Conclusion
Looking out over the next year, we would expect the economy to continue expanding, but in the face of some severe headwinds, including a possible double dip in the housing markets and the unwinding in the commercial real estate sector. The stock market has recovered sharply in anticipation of further economic gains and hence profit recovery. If the economy falters and profits disappoint, the stock market could suffer a temporary setback, especially as it is no longer dirt cheap. We are, therefore, keeping some dry powder in the form of cash in order to cushion any downturn and also to have buying power to take advantage of bargains should they occur.
As we said earlier, we are constructive on the market over a three to five year horizon. Given that the last decade was the worst for the stock market in nearly 200 years, it seems reasonable to expect that the new decade could be a good deal better. Nonetheless we remain cautious near term because of the possibility of a double dip in housing and general economic activity, and are concerned longer term by the structural problems contributing to the federal deficit.
In choosing investments we are, therefore, focusing on strong companies with stable business outlooks and in many cases stable and rising dividends. We are also interested in companies undergoing significant improvement not widely appreciated by other investors. Thirdly, we are attracted to companies, both domestic and foreign, which derive a large portion of their revenues from more rapidly growing emerging markets. In short, despite our concerns, we believe we are able to identify attractive investment opportunities that in our view have the potential to produce favorable returns over time. ________________________
1 Tom Lauricella, Investors Hope the ‘10s Beat the ‘00s, wsj.com, 12/20/09. ________________________
To receive Outlooks quarterly from Osterweis Capital Management please send us an email. Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The Price to Earnings (P/E) Ratio is a common tool for comparing the prices of different common stocks and is calculated by dividing the current market price of a stock by the earnings per share.
The S&P 500 is a market-capitalization weighted index of five hundred unmanaged common stocks and is widely recognized as representative of the equity market in general. The Dow Jones Industrial Average is a price-weighted index historically regarded as a barometer of stock market performance. It is comprised of 30 selected blue chip stocks. The NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on the NASDAQ Stock Market. The Bank of America Merrill Lynch U.S. High Yield Master II Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S domestic market. The Bank of America Merrill Lynch Current 10-Year U.S. Treasury Index is a one-security index comprised of the most recently issued 10-year U.S. Treasury note. The indexes do not incur expenses and are not available for investment. Index returns reflect the reinvestment of dividends and interest.
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(c) Osterweis Capital Management
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