In the investment business, we are constantly amazed at how drastically things can change in so little time. It’s almost as if there’s something awry with the space-time continuum. A mere three months ago, we were licking our wounds and praising the entire pantheon of investment gods for sparing us from what seemed like certain and utter destruction. From then until now, the stock market (true to form) has climbed the proverbial “wall of worry” while the doom and gloom crew continued to tell us the economy is structurally damaged and will require years to recover. Did the economy really improve overnight? No. Was the stimulus package some kind of “silver bullet” that instantly made everything better? No. The simple answer as to why stocks rose from the March lows is that investors once again were willing to take on a little more risk after having shunned it for many months. In an open economy, capital tends to run to where it thinks the best returns can be achieved. Will the rally continue? Will the economy recover? Read on…
Second Quarter Review
During the second quarter of 2009 the S&P 500 rose 15%. This was the first positive quarterly return for the market in nearly two years. Although all three months of the quarter posted positive returns, the biggest gains were achieved in April, with the S&P 500 up 9.4%. As early as March, we were seeing a dramatic decline in market volatility and some of the economic data was beginning to look “less bad.” The reasons for the turn in the market in early March are, even at this point in time, hard to pin down. There was no obvious event coincident with the turn. The March employment report was as bad as could be expected. The tone of commentary from nearly everyone ranged from gloomy to apocalyptic. It appears that global pessimism and the selling pressure associated with it simply had reached its psychological peak – sentiment simply could not get any worse, so it started to improve. And the stock market went along for the ride.
For us, one key driver to this rally was the first quarter earnings season which began in early April. As you may recall, when companies reported fourth quarter results (in January), the impacts of the credit crisis and recession were for the most part absent in the fourth quarter numbers. But by January, many companies had begun to see a precipitous slowdown in their businesses. Because of this, fourth quarter results were mostly in line with expectations, but most company managements presented a very worried tone about the outlook for 2009. Many companies chose not to give guidance for the coming year; those who did admitted very low confidence in their numbers. Such was the great uncertainty of that time.
However, the first quarter earnings season (which began in April), showed a marked shift in tone about the outlook. For most companies the first quarter results were horrendous, with earnings falling as much as 80% in some cases. Yet, many firms were able to affirm the guidance for 2009, which had looked so shaky back in January. The market loved this modest vote of confidence and in many instances pushed up the share prices after what looked to be, at face value, a very bad result. Such are the perverse ways of the stock market.
The logical extension of this progression may be seen in the second quarter earnings results where, if indeed the worst of the recession is behind us, companies may begin to raise their outlook for either 2009 and/or 2010. Ultimately, stocks need earnings growth to move higher, and the prospect for higher EPS growth for 2010 could be a key driver for stocks moving forward.
The bond market continues to show improvement – corporate spreads have narrowed dramatically since the worst days of the credit crunch, but still offer attractive potential returns vis-à-vis US Treasuries. The US dollar appears to have stabilized near the middle of its one-year range. The bond market and the dollar exchange rates are trying to assess the longer-term impact the massive US government stimulus spending and monetary easing will have on inflation. The commentary on this topic is decidedly mixed. Although most are less worried about deflation than they were a few months ago (and the prospects of the US replaying Japan’s “Lost Decade” appear less and less likely), not everyone is jumping on the hyper-inflation fear band wagon. Our best guess is that as long as we see slack in the job market, inflation is unlikely to become a major systemic problem. The consensus seems to suggest that higher inflation, if it becomes a big issue, will not do so before 2011.
Here’s what the second quarter looked like by the numbers:
|Index||2nd Qtr 2009||Year to Date||Trailing Twelve Months|
|Dow Jones Industrial Average||11.0%||-3.8%||-25.6%|
|MSCI EAFE Small Cap||32.5%||16.6%||-31.8%|
|MSCI Emerging Markets||29.9%||29.1%||-28.7%|
|Barclays Aggregate Bond||0.7%||-2.0%||1.7%|
|Barclays Municipal Bond||-0.4%||2.8%||1.5%|
|Dow Jones Commodities||15.0%||7.7%||-45.8%|
Albert is Smart, He’s a Genius
Amidst our nation’s obsession with pop celebrities, reality TV “stars” and those who are famous simply for being famous, we wish to briefly focus on someone truly worthy of the respect, adoration and media attention lavished on others – Albert Einstein. Granted, he left this mortal existence over 50 years ago and to our knowledge never sold a hit record, yet his theories about the nature of energy, light, matter and, indeed, the entire universe continue to profoundly impact our world. For example, the recent discussion between President Obama and Russian President Medvedev about reducing their nations’ stockpiles of nuclear weapons has at its heart a paper Einstein published in 1905.
He is known as a theoretical physicist. Those of us who struggled through high school physics may remember that physics is the study of how things work – from the sub-atomic level up to the interaction among the stars and galaxies which populate the universe. A theoretical physicist would try to explain how things work with theories, formulas and ideas, rather than measurements and observations. This makes this kind of physics even harder for the average person to understand. This suggests that Einstein was not only incredibly smart, but super smart in a very challenging field.
He’ll Be Scribbling Things, Genius Things
Einstein published his first paper in 1902, trying to prove that atoms exist and that they have a finite, non-zero size (something that was still uncertain in the physics world at the time). Although his work did not receive immediate praise, this early work did show the promise which was to blossom in a spectacular fashion within the next few years. For Einstein, 1905 is considered his Annus Mirabilis (extraordinary year) and his work in this year propelled him into the elite circle of great scientific minds where the likes of Newton, Galileo and Aristotle reside. He also won a Nobel Peace Price for his efforts.
In 1905, Einstein published four major papers which revolutionized the physics community and ultimately led to the development of nuclear energy. A brief review of basic findings of these papers can provide some valuable insights into the physics of the investment world.
Photoelectric Effect. – Light, the “stuff” that makes our crops grow, allows us to see colors and most importantly, makes life itself possible on our planet, seems pretty straightforward. Any child can tell you what light is, why it’s good and what it’s good for. But to an early 20th century physicist, light was an enigma. Many thought that light traveled in waves, like sound. Some, like Einstein, thought that light was actually made up of some kind of particles. His paper on the photoelectric effect “proved” (at least in a theoretical way) that light is comprised of discrete packages which he called “quanta.” Modern physicists have refined Einstein’s pioneering work here, and we now know that light is comprised of things called “photons,” but light also continues to display wave-like properties. Einstein was able to prove something that no one could see.
Investment implications. Some things in the investment world are ubiquitous and simple to observe, like stock prices. Anyone, at any time, can measure the price of a stock. But what a stock price really, truly represents; what forces are impacting a stock price at any given time; or why a stock trades as it does are issues much more complicated than the casual observer can truly understand. And understanding these complex forces and their impact on stock prices is the most basic and important step to understanding how to invest. Without this understanding, stock investing becomes nothing less than an exercise in randomness.
Brownian Motion. – Atoms are very small; invisible to the naked eye. Yet, their existence was posited by Indian and Greek philosophers as early as 2,000 years ago. In Einstein’s day, the grand atomic debate centered on whether atoms were real or simply a nice idea, something which helped explain lots of things physicists care about. Einstein was able to prove their existence by postulating what the motion of an atom that had a non-zero finite size would look like and then actually measuring and showing that exact motion. He also devised an experiment whereby one could see this effect (and thus “see” atoms) under a microscope.
Investment Implications. Some important factors which impact our investment decision are hard to see (monetary policy or investor sentiment, for example), but can be measured in one way or another. By accurately measuring and understanding them, one can gain better insight on how the markets operate. Just because something seems small and hard to grasp does not mean it cannot have a big impact on the price of a security or the capital markets at large.
Special Relativity – This theory is a little more complicated, but in simple terms it suggests that all uniform motion is relative and that there is no well-defined state of rest. A simple way to explain this is to consider a person bouncing a tennis ball on a train. To a person in the train, the ball goes down and then comes right back up. To someone watching this from a distance (assuming this person could indeed see the ball), the ball’s trajectory would look like a wide “V” pattern, the horizon movement of the ball being a function of the train’s movement. So what is the “real” motion of the ball? Einstein proved that it would be relative to the point of view of the observer. Another important result of this paper was the notion that the speed of light is constant in all frames of reference.
Investment Implications. Often a person’s point of reference can influence his or her opinion on a security. Consider Person A, who bought stock XYZ at $10, and Person B, who bought the same stock (at a different time of course) at $30. The stock now trades at $20. Person A is feeling pretty good about XYZ, given the 100% gain Person A has in the stock. Person B on the other hand considers XYZ a “dog,” having lost 50% in it. Yet, XYZ has a valuation, outlook and potential irrespective of where one might have bought it. This concept is at the heart of our equity research – we try to assess value and potential regardless of perspective. Not every stock we buy will appreciate. All along the stock’s trajectory, we try to measure its value and potential. Like the speed of light, some investment principles, like valuation and reducing risk by diversification, are fixed, constant, and independent of point of reference.
Matter and Energy Equivalence. E=mc2 . This simple little formula was perhaps Einstein’s greatest achievement. He was able to show (theoretically, of course) that the energy of an object at rest (E) is equal to its mass (m) times the speed of light squared (which, by the way, is a really big number = 8.98755 x 1016 m2 s2 ). The brilliance of this theory was shown (in very dramatic fashion, by the way) at the scene of the first atomic explosion (July 16, 1945), where a very small amount of plutonium (less than 2 pounds) created an explosion with the power equal to 20 kilotons of TNT. Einstein was right; mass can be converted into energy.
Investment Implications. Other than some weak joke about one’s portfolio “blowing up,” we would suggest that sometimes we see an event or a data point that seems small and inconsequential by itself, but can have a profound impact because of the circumstances in which this event occurs. Sometimes we will see a stock move down a large amount simply by missing its earnings expectation by a penny. A specific example would be the Lehman Brothers bankruptcy. Many companies go bankrupt each year without damaging the economy or the capital markets. Lehman’s failure, on the other hand, led to a near total seizing up of the capital markets and led to much of the angst and trauma all investors experienced last year. In the markets, some little things can have a huge impact.
While the debate over the length and severity of the recession continues to play out in the media, most thoughtful and credible economists are calling for positive economic growth in the third quarter of this year. The second quarter (just passed) is likely to show negative growth, but a smaller decline than that of the first quarter. The consensus is suggesting that GDP growth in 2010 could be around 3%. Although we would be the first ones to suggest that the correlation between the overall economy and the stock market is less than perfect, rising GDP does imply rising corporate earnings, which is a key driver of the stock market. We find it hard to believe that the stock market would go down in the face of a steadily improving economy (something suggested by the consensus economic forecasts). Thus, we would not be surprised to see higher stock prices into 2010.
Another way to look at the current situation may be to recall the stock market’s action in 2003. By early 2003, the bear market was over 2 years old and large numbers of widely-held stocks were down over 50%. The economy had also been struggling for a few years, following the tech bubble of the late 1990s. Global tensions were high in the wake of 9/11, and ironically the stock market bottomed in early March, the day US troops invaded Iraq. The market rallied well from there, but by July many were suggesting the market had run out of steam. Because early signs of improvement were starting to emerge, many suggested to “buy on weakness.” The market never really corrected, but did flatten out for a few months. The rally resumed by autumn and the stock market return for 2003 came in at +28% or so, the best year in a long time.
We know that every market and cycle is different, but we see important parallels here. This year the market bottomed in the middle of nothing but bad news. As it rallied, many were calling for caution. Now, many are calling for a pull back, something that would allow investors to buy stocks at better prices. And the consensus outlook is for an improving economy. We do not make forecasts, but we would not be surprised if the market does not pull back as expected. As so often happens in the early stages of a market recovery, those looking to buy at lower prices may be disappointed. Concern and skepticism about the market right now are two factors that could help propel it higher to the end of the year.
One of our favorite Einstein quotations is “Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.” As we do our work each day (which, by the way, usually involves lots of numbers and counting – after a fashion), we occasionally stop and reflect on the things which count the most. As maudlin as it might sound, we genuinely believe that helping our clients identify, understand and reach their long-term goals is our greatest work. The markets, the numbers and the returns are, at some level, really just the means to these much more important ends.
As most of you know, identifying goals for the long term and putting a dollar value on them can be as challenging as evaluating markets and securities. It requires each of us to step away from the hectic, non-stop activity in our daily lives and consider what is truly important to us. Some choose not to do this because it is either too difficult or because they do not think that they can achieve their true goals. We believe that not planning for these longer term goals can leave a person less in control and may create near-term anxiety as the person relies on luck or fate to determine how they live their lives. We can assist in the process of both developing the goals and measuring whether you are on the path to achieving the goals. The benefit of this process is that you will be able to determine when you stray from the path and make corrections to your strategy. We encourage you to speak with us about how we may be able to help.
One final point — our Chief Investment Officer, Mike Goodson, is still populating his financial blog, “Persuasion Time” (http://persuasiontime.blogspot.com), with comments pithy, topical, sometimes humorous and usually optimistic. This blog represents another way we can share our current views and ideas with our clients. A recent post entitled “Are You Being Served” discusses the dangers of free investment advice abundantly available in the media. Please take a look and let us know what you think.
As always, your current portfolio holdings are listed in the enclosed Quarterly Portfolio Statement and your portfolio’s rates of return for the most recent quarter, year-to-date and past twelve months can be found in the Portfolio Performance Summary.
RDL Financial, L.C.