October 20, 2008
Why Warren Buffett is Right (and Why Nobody Cares)
The best way to begin this comment is to reiterate that U.S. stocks are now undervalued. I realize how unusual that might sound, given my persistent assertions during the past decade that stocks were strenuously overvalued (with a brief exception in 2003). Still, it is important to understand that a price decline of over 40% (and even more in some indices) completely changes the game. Last week, we also observed early indications of an improvement in the quality of market action, and an easing of the upward pressure on risk premiums.
In 2000, we could confidently assert that stocks would most probably deliver negative total returns over the following 10-year period. Today, we can comfortably expect 8-10% total returns even without assuming any material increase in price-to-normalized-earnings multiples. Given a modest expansion in multiples, a passive investment in the S&P 500 can be expected to achieve total returns well in excess of 10% annually.
None of this is an argument that the market has necessarily registered either a near-term or a final bear market low. Regardless of whether or not the market has established a short-term trough, one would generally expect that a decline of the magnitude we've observed would be followed several months later by a secondary decline (which may or may not take stocks to lower levels). It is also not an argument for establishing an aggressive investment stance. We continue to hold index put option coverage under about 90% of our stockholdings, though primarily as a "stop loss" against any major continuation, rather than a defense against moderate declines. What is clear, however, is that after more than a decade of strenuous overvaluation, stocks are finally priced to deliver acceptably high long-term returns.
While it's true that the market established even deeper valuation troughs in 1974 and 1982 (near 7 times prior peak earnings, compared with the current multiple of about 11), it is important to remember that long-term Treasury yields were 8% in 1974, and 14% in 1982, compared with about 4% at present. While I've frequently argued that stock and bond yields are not related in anything near the 1-to-1 manner that the "Fed Model" suggests, it is already clear that a long-term investment in stocks here is likely to substantially outperform a long-term investment in Treasury securities over time. Even with very little adjustment for risk, U.S. stocks are likely to provide stronger long-term returns than the yields available on most corporate bonds as well.
This point is so important that I am again presenting our 10-year total return projections for the S&P 500 Index ( standard methodology ). The heavy line tracks actual 10-year total returns since 1950 (that line ends a decade ago for obvious reasons). The green, orange, yellow, and red lines represent the projected total returns for the S&P 500 assuming terminal valuation multiples of 20, 14 (average), 11 (median) and 7 times normalized earnings.
The reason we use a variety of methods to "normalize" earnings is that reported earnings are actually more volatile than stock prices themselves. In recessions, both earnings and stock prices decline, but stock prices nearly always bottom first. Year-over-year changes in reported earnings have virtually no correlation with year-over-year changes in stock prices. Despite all of that earnings volatility, long-term S&P 500 earnings can be nicely contained by a 6% growth trend connecting earnings peaks across economic cycles as far back as you care to look. Interestingly, even the enormous short-run variation in U.S. inflation rates over time has had very little impact on that long-term dynamic.
As for individual stocks (at least the stable, quality businesses), you don't liquidate just because a recession may depress earnings next quarter, or even for a few years. The main use of quarterly earnings reports is as an information signal for businesses whose future can't be adequately assessed otherwise. The better the business, the less attention you place on quarter-to-quarter earnings.
Why Warren Buffett is right, and why nobody cares
On Friday, Warren Buffett published an editorial in the New York Times titled "Buy American. I Am." In that piece, Buffett noted " I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: ‘I skate to where the puck is going to be, not to where it has been.'"
The most interesting thing about that op-ed piece wasn't Buffett's opinion about stock valuations. He's absolutely right, in my view. Rather, it was fascinating how quick many investors were to dismiss Buffett's advice, saying either that he didn't understand how bad the economy was going to get, that he preferred to "get in early," or that he was "talking his book" and trying to bid up the value of his own investments.
Look. Buffett doesn't need the money. Virtually everything he has is now or will ultimately be committed to philanthropy. My impression is that Buffett honestly doesn't like to see investors making decisions that will damage their financial security over time. Also, a good part of his own self-concept centers on being a good allocator of capital. If he didn't like his investment positions, he wouldn't try to talk them up. He would liquidate them. If he thought he could postpone his purchases without a high probability of missed returns from waiting, he would have waited. My guess is that Buffett is very excited about the values he has been buying up, but doesn't get wrapped up in the day-to-day fluctuations that weaken the judgment of less disciplined investors.
The most expensive resource on Wall Street is short-term comfort. Investors who constantly seek comfort over the short-term ultimately give up a fortune over the long-term. In a market economy, the most reliable source of long-term gains is to provide scarce and useful resources to others when those resources are most in demand. At present, the most probable source of long-term returns is the willingness to provide liquidity (holding out willing bids at depressed prices in a panicked market), risk-bearing (taking on the market risk being liquidated by fearful or distressed sellers), and information (through the proper assessment of value). In my view, Buffett's willingness (and our own) to accept market risk here does all three.
Though Buffett doesn't easily show his hand regarding individual purchases or the details of his calculations, he has always been very clear about what drives his assessment of value: stocks should be valued as if you were purchasing the whole business. The way you (properly) value a business is to weigh the price against the long-term stream of cash flows that you expect that business to deliver into your hands over time.
I'll say that again. The real object of interest is the long-term stream of cash flows that the company will deliver into the hands of shareholders over time (beware of companies that quietly dispose of their reported earnings through grants of stock and options to management and employees). Nearly all of the value of a stock is loaded into the "tail" of that stream - 5, 10, 20 years out and beyond. As Buffett notes "fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."
The rush to dismiss Buffett's advice underscores the extreme level of bearishness among investors here. According to Investors Intelligence, just 22.4% of investment advisors are presently bullish. This matches the lowest extremes we've seen in decades. Extreme negativity of investors has generally been a useful contrary indicator of stock market prospects. That doesn't ensure that stocks have registered their final lows, but it contributes to a set of historically favorable conditions here.
At present, we observe not only undervaluation coupled with negative sentiment, but also extreme volatility that has historically accompanied important market troughs. Similar spikes in actual (e.g. 44-day) volatility were observed in July 1962, June 1970, October 1974, December 1982, December 1987, October 1998, and September 2002, all which were associated with important market lows.
The argument for gradually increasing our stock market exposure in the past couple of weeks is not that some flag has gone up that provides certainty about a bottom. Rather, our investment discipline is to gradually increase our investment exposure in proportion to the expected return/risk profile associated with prevailing conditions of valuation and market action. Scaling our positions in proportion to the market's expected return/risk profile, based on prevailing conditions (rather than trying to forecast market turns), is the essential practice.
Buffett notes, "Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."
I have no idea whether the market will be higher or lower a month or a year from now either, but I think I differ from Buffett on the reasons for this. Buffett's reason is that he largely disregards short-term fluctuations, understanding that the market will improve before visible fundamentals do. My reason is that our market allocation is proportionate to the favorable expected return/risk profile of the prevailing Market Climate, and I have no way of knowing when that Climate will shift. When it does, we'll change our allocation. As I've said before, you don't have to forecast the future direction of the wind - you just need to regularly adjust the sails as the evidence changes.
Early measures of market action turn favorable
Notably, last week we observed a measurable reversal in risk premium pressures, coupled with a clear "breadth reversal" across a wide range of industries. As I've stated frequently over the years, the most important feature of market action is not the extent or duration of market movements, but their quality and uniformity. These measures can change very quickly, and long before "trend following" signals such as moving-average crossings occur. Last week, our most sensitive measures of market action clearly reversed to a favorable condition. These don't "whipsaw" very often because they come into consideration only when market action is unusually compressed. Presently, in addition to undervaluation and extreme sentiment, we already have the beginnings of favorable market action.
That said, we don't yet have enough evidence to simply remove our hedges. The prevailing evidence is consistent with a high expected return/risk profile for stocks, but the still "early" improvement in market action and the unusual nature of the current downturn suggest that we maintain something of a "stop loss" in the form of continued put option coverage, with strike prices within a few percent below current levels. That is the position that we have established here.
The recent panic is frequently described as the "worst" since the Great Depression, but this does not imply that the outlook is similar. One of the clearest contributors to the Depression was the failure of the monetary base to expand at anywhere near the demand for base money. At present, governments have made a concerted effort to put the world awash in base money.
Neither the crisis in financials or the current recession are surprising, but Depression talk is hyperbole. About the only surprise in recent weeks was that the broad recognition of a U.S. recession emerged at the same time as the peak of the financial crisis. That compressed what should have been two separate down-legs of a bear market into a single swan-dive. This downturn is certainly extreme, but the conditions that amplified the downward spiral in the Great Depression are largely absent here. Both at market peaks and at market troughs, investors allow their imaginations to run, almost always to their detriment.
I'll repeat what I wrote during the 2000-2002 bear market: at meaningful market lows, "the tenor of news reports has always been something to the effect that 'conditions are bad, expected to get worse, and there is no end in sight.' When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, that is when the market is likely to register its low."
This is also a good time to reiterate our standard "anti-marketing" message: The Strategic Growth Fund is not a "market timing" fund. Nor is it a "bear" fund or a "market neutral" fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave "buy signals" and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate.
My opinion is that while there is still risk that the market will decline even further, investors may be underestimating the potential for a rapid 20-25% spike higher in U.S. stocks as risk aversion collapses. That opinion doesn't drive our investment stance. Rather, both my opinion and our investment stance are driven by the objective evidence we have in hand about valuations and market action. At present, the evidence indicates that it is appropriate to accept market risk, but with something of a "stop" in the form of put option coverage close to (or a few percent below) current levels.
I won't sugar-coat the fact that we are accepting some amount of market risk here, and that this exposes us to some amount of potential loss if the market continues lower. Again, however, we continue to have a put option defense below about 90% of our stock holdings with strike prices within a few percent of current levels, which should relieve any concern about unacceptably large downside exposure. Equally important, in the event that stocks were to decline from here, I expect that there would be a strong likelihood of recovering at least to current levels on a subsequent advance. From that perspective, I expect that whatever downside we might experience as a result of a further market selloff would probably be temporary.
With the Strategic Growth Fund less than 10% below its record high, we now observe a loss of 40% or more in the major indices, extreme bearish sentiment and volatility consistent with important market lows, and a clear though still "early" improvement in our measures of market internals. It is impossible to be a successful equity investor without the willingness to accept some amount of market risk when conditions appear frightening. If anything should be clear from the bubbles of recent years, the greatest risks are not when prices are depressed, the economy is weak, and investors are frightened, but rather when prices are elevated and an unendingly positive outlook for technology, or housing, or global growth, or private equity, or emerging markets, or commodities seems all but certain.
Treasury gets it right
Last week, the Treasury finally got it right, announcing that it would directly provide capital to troubled financial institutions by purchasing senior preferred equity stakes. As I argued in An Open Letter to Congress Regarding the Current Financial Crisis and You Can't Rescue the Financial System if You Can't Read a Balance Sheet, this is exactly the right approach, since it operates on the liability (capital) side of the balance sheet, which is where the trouble has been. I would have preferred the Treasury to follow Bagehot's Rule (lend freely but at a high rate of interest) as opposed to the "favorable" terms that were offered. This would have encouraged these financial companies to get off of the public's dime as soon as possible. Even so, as long as the yield on the preferred is higher than the Treasury's funding costs, the favorable terms will represent an insufficient risk premium but not a loss to the public.
Still, some amount of patience is needed, lest investors frighten themselves that this capital infusion is not working. As I wrote in a note to shareholders in the Fund News section of the website on October 15, "Investors appear frantic to observe a reduction in LIBOR and other measures of credit strain, but such impatience is not reasonable given that the Treasury has not yet actually executed the announced transactions to provide capital to U.S. financials. Sellers at these levels may find themselves scrambling to repurchase stock as that occurs, particularly in view of current valuations (even adjusted for the impact of an ongoing recession). On nearly every measure - sentiment, valuation, volatility, oversold conditions, and others, we are observing extremes associated with strong expected return/risk profiles, on average."
With respect to the economy as a whole, I continue to believe that allowing what I've called a "property appreciation right" (PAR) would be the single best legislative change to decouple the mortgage crisis from the broader economy:
Congress can efficiently mute the impact of the mortgage crisis on "Main Street" by allowing a small change in foreclosure law. Specifically, in foreclosure proceedings, judges should have the ability to reduce the amount of principal on a mortgage loan, provided that the original mortgage lender receives a "Property Appreciation Right" or "PAR" from the homeowner. The PAR would be an obligation to repay the mortgage lender out of future appreciation on the home (including property subsequently purchased, until the obligation was relieved). Payment would occur either when the home was sold, or through an equity-extraction refinancing at some later date. In that way, homeowners would surrender some amount of future appreciation in return for an equivalent reduction in the mortgage principal. This would result in an immediate lowering of mortgage payments, yet the original mortgage lender would still stand to be made whole. To account for time-value, the amount of the PAR obligation could be allowed to increase at a small rate of interest. The homeowner would be able to keep the house. Importantly, there would be no need to continue major write-downs on mortgage securities, since only the character of the payments, not the value of the mortgage obligation itself, would change.
(Readers who believe this approach should be included in discussion are encouraged to forward the above paragraph to their representatives in Congress.)
As of last week, the Market Climate for stocks was characterized by favorable valuations and early evidence of favorable market action. The improved character of market action is not evident from standard "trend following" evidence such as moving-average crossings and so forth. Rather, last week we observed a very broad reversal in breadth and risk premiums. When this has occurred in the context of favorable valuations, compressed price trends, and bearish sentiment, such early reversals have often resulted in double-digit market gains over a period of weeks. At the same time, we are maintaining something of a "stop loss" a few percent below current levels in the form of put option coverage for about 90% of our stock holdings. In doing so, we are balancing the improvement in our quantitative measures, as well as our qualitative analysis, against our tolerance for risk (we prefer investment positions that allow us to be dead wrong about everything and still not experience intolerable losses). I expect that we'll maintain some amount of put coverage at least until we observe confirming evidence from high trading volume and improvement of more conventional market internals.
Generally speaking, an intolerable loss is one that requires a heroic recovery simply to break even. From my perspective, the S&P 500 has experienced an intolerable loss, since a 42% loss requires a 70% gain just to recover. The typical market loss of about 32% in an average bear market requires a 47% gain in order to break even, leaving only bull market returns beyond that amount to contribute toward long-term progress. Downside risk should always be assessed in relation to upside potential: a 10% loss is recovered by an 11% gain, a 15% loss is recovered by an 18% gain, and a painful 20% loss is recovered by a 25% gain. Such losses in say, a short-term money market fund, would be cause for panic because gains of 18%-25% are indeed heroic propositions. In the equity markets - particularly for strategies that can be partially or fully exposed to market fluctuations - such recoveries are reasonable and even commonplace (within a matter of weeks or months) once the market has become deeply depressed.
In bonds, the fear about Depression gripping the markets had a striking result last week, as investors priced inflation-protected bonds as if the rate of inflation would be essentially zero for the next 5 years or more. Now, from the standpoint of immediate inflation risk, I have long argued that widening credit spreads have a very strong effect in suppressing inflation. At the same time, however, the enormous increase in government liabilities stemming from an ongoing budget deficit and huge financial rescue efforts is likely to result in normal if not elevated levels of inflation as the economy recovers.
As investors suddenly adopted a "deflation mindset," they dumped their inflation-protected securities with little regard to price or longer-term inflation prospects. TIPS yields soared to over 3%. From a historical perspective, it has been rare for U.S. Treasury securities to provide real yields much over about 2% annually. In the Strategic Total Return Fund, we shifted about 25% of the Fund into Treasury Inflation Protected Securities with a variety of maturities. We may accumulate more if real yields press even higher. As always, you scale in proportionately as the expected return/risk profile becomes favorable.
Back in April, when commodities were still advancing to new highs, I noted that "at the point where real interest rates become positive and trend higher, we may observe a softening in commodities. Presently, we don't observe that, but it is important to keep in mind that the strength in commodities largely mirrors a persistent decline in U.S. real interest rates, and in the value of the U.S. dollar. As the downward pressure on real interest rates abates, so most probably will the upward pressure on commodity prices." Having closed our TIPS positions when real interest rates fell to negative levels, we closed the bulk of our precious metals positions shortly thereafter when gold soared over $1000 an ounce. It is not typical for the Fund to have the majority of its assets in Treasury bills, but that was the case through much of the summer.
The weakness in commodities now having largely played itself out, the entire analysis above could now be reversed. Specifically, at the point where real interest rates stabilize or trend lower, we may observe a strengthening in commodities. The weakness in commodities we've seen lately mirrors the surge in U.S. real interest rates and in the value of the U.S. dollar. As that upward pressure on real interest rates abates, so most probably will the downward pressure on commodity prices (as well as the upward pressure on the U.S. dollar). In addition to the Total Return Fund's positions in TIPS and short-dated Treasury securities, the Fund continues to hold about 30% of assets in a diversified group of precious metals shares, utility shares, and foreign currencies. With these markets sharply down from their highs, I believe it is appropriate for the Strategic Total Return Fund to again hold a moderate, diversified portfolio of TIPS, short-dated Treasury securities (awaiting higher real or nominal yields to invest in longer-dated securities), precious metals shares, utilities, and foreign currencies.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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