“A wise man makes his own decisions; an ignorant man follows public opinion.” Chinese proverb
As we write this on July 28, 2009 the Dow Jones Industrials average closed the prior day over 9,100 and the S&P 500 closed over 980. Compare these levels to the March 9th close for the Dow of 6,547 and for the S&P 500 of 676 and you can see that U. S. equity prices are up approximately 40% from those March lows. Stocks in the U.S. (as measured by the S&P 500) have increased approximately 7% so far in July alone and approximately 10% for YTD 2009. Investors who sold at those low levels in March have missed out on a very significant upward move in prices.
One of the key reasons for the July gains were positive surprises on corporate profits for the quarter ended June 30, 2009. A good example of such a positive surprise is the report from Apple that showed a 15% jump in quarterly profit and even more meaningfully reported a 12% increase in quarterly revenue from a year earlier. This means consumers were willing to increase purchases of Apple products despite the challenging economy and the market seems to interpret this as an indication that consumers may not be as stingy as expected. According to Thomson Reuters, 77% of companies reporting have exceeded profit estimates and this has also supported recent market gains.
All of this has many market experts revising upward their earnings estimates and market targets. Goldman Sachs has raised its estimate of S&P 500 earnings for 2010 to $75 and has raised their year-end target for the index to 1,060 (from prior target of 940). If the $75 earnings prediction proves accurate, it equates to a price earnings ratio of 14 on the new 1,060 target.
International stocks have done well also, with the MSCI-EAFE index up 15% in dollar terms YTD through July 24, 2009 (5% of this increase came from dollar declines). Emerging markets (especially those in Asia) have done exceedingly well, with Asia ex-Japan up 43% in dollar terms through July 24.
Corporate bonds have also done well, as the very high spreads of investment grade issues as compared to U.S. Treasury securities have now returned almost to the levels that existed before the September 15, 2008 Lehman Brothers bankruptcy. Quality corporate bond spreads that were 600 bps over Treasury securities in March of this year are now less than 300 bps. Likewise, high-yield spreads of almost 1900 bps in March are now under 1000 bps (100 bps = 1%).
We believe our client portfolios were well positioned to participate in the 2009 gains of U.S. stocks, international stocks (including emerging markets) and corporate bonds (particularly high-yield bonds). This was possible because we did not follow public opinion and sell in early March when there were broad worries about deflation and possible depression. Instead, we worked to keep client portfolios invested consistent with their written Investment Policy.
Going forward we think there are still many economic challenges. One key challenge is what could happen with home foreclosures. Home prices (per the 20-city Case-Shiller index) are down 32% from their mid-2006 peak. As a result 15 million homeowners- one in five of those with a 1st mortgage- are under water (their home market value is less than their mortgage). If these homeowners run into any significant financial difficulty (lose a job, medical claim, etc.) they are at severe risk of walking away from their mortgage. This could spiral home prices down further as these foreclosed homes are sold at low prices. The Obama administration has advanced plans for helping homeowners, but these programs are unwieldy and to date have helped relatively few.
As we write this on July 28, 2009 the Dow Jones Industrials average closed the prior day over 9,100 and the S&P 500 closed over 980. Compare these levels to the March 9th close for the Dow of 6,547 and for the S&P 500 of 676 and you can see that U. S. equity prices are up approximately 40% from those March lows. Stocks in the U.S. (as measured by the S&P 500) have increased approximately 7% so far in July alone and approximately 10% for YTD 2009. Investors who sold at those low levels in March have missed out on a very significant upward move in prices.
One of the key reasons for the July gains were positive surprises on corporate profits for the quarter ended June 30, 2009. A good example of such a positive surprise is the report from Apple that showed a 15% jump in quarterly profit and even more meaningfully reported a 12% increase in quarterly revenue from a year earlier. This means consumers were willing to increase purchases of Apple products despite the challenging economy and the market seems to interpret this as an indication that consumers may not be as stingy as expected. According to Thomson Reuters, 77% of companies reporting have exceeded profit estimates and this has also supported recent market gains.
All of this has many market experts revising upward their earnings estimates and market targets. Goldman Sachs has raised its estimate of S&P 500 earnings for 2010 to $75 and has raised their year-end target for the index to 1,060 (from prior target of 940). If the $75 earnings prediction proves accurate, it equates to a price earnings ratio of 14 on the new 1,060 target.
International stocks have done well also, with the MSCI-EAFE index up 15% in dollar terms YTD through July 24, 2009 (5% of this increase came from dollar declines). Emerging markets (especially those in Asia) have done exceedingly well, with Asia ex-Japan up 43% in dollar terms through July 24.
Corporate bonds have also done well, as the very high spreads of investment grade issues as compared to U.S. Treasury securities have now returned almost to the levels that existed before the September 15, 2008 Lehman Brothers bankruptcy. Quality corporate bond spreads that were 600 bps over Treasury securities in March of this year are now less than 300 bps. Likewise, high-yield spreads of almost 1900 bps in March are now under 1000 bps (100 bps = 1%).
We believe our client portfolios were well positioned to participate in the 2009 gains of U.S. stocks, international stocks (including emerging markets) and corporate bonds (particularly high-yield bonds). This was possible because we did not follow public opinion and sell in early March when there were broad worries about deflation and possible depression. Instead, we worked to keep client portfolios invested consistent with their written Investment Policy.
Going forward we think there are still many economic challenges. One key challenge is what could happen with home foreclosures. Home prices (per the 20-city Case-Shiller index) are down 32% from their mid-2006 peak. As a result 15 million homeowners- one in five of those with a 1st mortgage- are under water (their home market value is less than their mortgage). If these homeowners run into any significant financial difficulty (lose a job, medical claim, etc.) they are at severe risk of walking away from their mortgage. This could spiral home prices down further as these foreclosed homes are sold at low prices. The Obama administration has advanced plans for helping homeowners, but these programs are unwieldy and to date have helped relatively few.
A retrenching consumer in developed countries, particularly the U.S., is another significant risk. No one yet knows what level of past consumption will be redirected toward savings to replace wealth lost with declining home prices and shrunken investment portfolios. All such reduced consumption translates into reduced corporate sales and reduced corporate profits which would challenge stock prices.
We continue to follow the themes expressed in past reports. Those themes for how we invest client money include:
We continue to follow the themes expressed in past reports. Those themes for how we invest client money include:
- Developed countries will be faced with weak consumption as consumers deleverage and increase their savings rate to help restore lost wealth.
- Emerging countries have a growth advantage with an emerging middle class, high savings rates (that can be redirected towards consumption) and low government debt.
High budget deficits will lead to increasing levels of government debt compared to GDP, resulting in a weaker U.S. dollar (and weaker currencies of most other developed countries). - There is an increasing possibility of significantly higher levels of interest rates on government bonds in the U.S. and other countries where government debt to GDP increases materially over the next decade or more.
- There is a risk of much higher inflation (although time is needed to clear excess capacity) if governments worldwide don’t skillfully remove monetary stimulus.
- It is important to understand that human behavior results in markets that overdo things on both the upside and downside.
We are not recommending any changes to client portfolios at this time, but we do continue to consider a number of possible investment themes and strategies. Also, we are periodically rebalancing portfolios to their Investment Policy, as we always have.
