Third Quarter Commentary

Posted Oct 12, 2009 | Calvin Brown

As we come to the end of the third quarter of 2009, I want to take a look back to where we have been, suggest where we might be going and assess the much-discussed “New Normal.”

Anyone with access to a television or the internet has a very good idea of where we have been over the past year. Anyone with a 401(k) or any other type of an investment account has intimate knowledge of where we have been. September of 2008 began what would become one of the most calamitous periods in our Nation’s economic history. Lehman Brothers, the venerable investment firm founded in our own State of Alabama, collapsed. Other time-honored firms like Merrill Lynch, Bear Stearns and Wachovia disappeared into the arms of government-led suitors—shotgun weddings, if you will. Thus began what has been termed “The Great Recession;” a period in which markets around the world collapsed in short order.

In my twenty-six years in the investment business, I have never witnessed such sheer panic. Chaos ruled the day and Armageddon scenarios were being trumpeted by even the most seasoned and respected commentators. We all learned of the horror that had been wrought by the collapse of the housing bubble, the evils of sub prime mortgages and the supposed dastardly nature of all those working on Wall Street. Many of us even learned of things most had never heard of—credit default swaps and all manner of exotic derivatives whose unwinding was wreaking havoc on our global financial system. Perhaps Warren Buffett was prophetic some time ago when he referred to derivatives as “weapons of mass destruction.”

Despite the dark days and dire forecasts, at the time of this writing it appears that we are indeed emerging from the depths of the recession. Stock prices have recovered a great deal—up over 50% since their lows of early March. Investors bold enough to stay the course have seen their portfolios begin to recover by a significant measure. Industrial production is improving, GDP growth is trending positive, consumer spending, while still anemic, is improving and even housing is showing signs of life. The one vital economic statistic that remains a stubborn negative is unemployment. While it will take time for this lagging economic indicator to improve, it is at least trending in a positive direction. At the height of the recession, the domestic economy was losing an average of 750,000 jobs per month. Currently that figure is in the mid-200,000 range.

We must always remember that the equity market is a predictive, or discounting, mechanism. Share prices began telling us in mid-March that the economy would begin the healing process later in the year. That has transpired as predicted. Yet the skeptics argue that we are merely experiencing a bear market rally and the markets are expecting too much from the economy. From a contrarian standpoint, this bodes well for future returns. Stocks are climbing the proverbial “Wall of Worry.” I will become skeptical and nervous when optimism reigns and everyone hops on the bull bandwagon.

However, the market is likely overbought on a short-term basis, and a period of consolidation is probably in order. I would welcome a “pause that refreshes” as healthy and feel that it would prolong the duration and magnitude of the current bull market. I am certainly not in the camp that believes stocks will retrace recent gains and retest the lows. On a valuation basis, the S&P 500 is currently priced at 14.1 times the 2010 earnings estimate. Its fifty year average, based on forward earnings, is 16.54 times, which would imply a fair value of 1,240, 17.5% higher than its current level. While this is not a prediction of future returns, it certainly disabuses the notion that the market is somehow wildly overvalued.

I want to close by briefly discussing the popular thesis of “The New Normal.” Undoubtedly you have heard that we must adjust our expectations to this period that will usher in years of slow economic growth and subpar investment returns. Many forecasting such a climate talk of “weak” economic growth of 2%-3% per year. They conclude that this environment can only result in meager gains, if any, for stocks. I would suggest otherwise. In fact, I would suggest that the past several years—highlighted by enormous speculative bubbles and their subsequent, spectacular busts, terrorists attacks and the like—have been anything but normal. Given the luxury of hindsight and lots of gray hair, I remember long periods of 2%-3% GDP growth accompanied by low interest rates and low inflation that painted a perfect backdrop for solid investment gains. I believe that monetary policy will remain accommodative for quite some time. Interest rates will remain near historic lows and inflation will be subdued for an extended period. This scenario may well set the stage for steady economic recovery and expansion. Indeed, given the massive government stimulus and the subsequent flood of liquidity injected into our financial system, inflation could become a problem down the road, but I think that day is some time off. In the meantime, I believe the end of our financial nightmare is ending and better days lie ahead.

I will leave you with a quote from one of the world’s greatest investors, the late Sir John Templeton, made in his 94th year on this earth. I believe it is highly instructive to all of us during times like these.

“Throughout history, people have focused too little on the opportunities that problems present in investing and in life in general. The 21st Century offers great hope and glorious promise, perhaps a new golden age of opportunity.”

As always, we appreciate the trust and confidence our clients place in BlueCreek Investment Partners. We look forward to serving you and your families for many years to come.