Inflation expectations continue to rock the market

The market had a surprisingly good third quarter, and so did we. I say “surprisingly” because there has been widespread fear of another autumn selloff, so the market did what it does best and confounded people – this time on the upside. Despite the good news, there are two key conflicts in the market today. One is that stocks are predicting somewhat better economic conditions, but the rally in the bond market suggests otherwise. The other conflict is between those predicting inflation and those predicting deflation. These conflicts may continue to make the stock market a bit erratic: up a lot in July, down almost as much in August, up even more in September. For the quarter, the S&P 500 Index returned 11.3%.

So far this year, we have been somewhat defensively postured and more focused than usual on dividend yield. We have been less aggressive in growth stocks, which is rational given the sub-par growth in GDP. We also kept reasonable cash balances while the S&P 500 Index was below its 200 day moving average. This has made your account less volatile than the overall market, and has kept us well ahead of the S&P 500 so far this year. However, this approach caused us to lag during the July and September rallies. Your account gained 9.57% for the quarter. While I would like to report a better quarter, I indicated in the last letter that I felt no need to get more aggressive until the market had shown some signs of sustained strength.*

Where to from here? The tension between bonds and stocks cannot last forever. Usually a decline in interest rates is associated with a slowing economy. In sluggish times, there is less demand for credit and so the cost of money (as measured by interest rates) declines. Axiomatically, that means that bond prices go up. That has happened, and thus our fixed income portfolios are doing well. Remarkably, the rate on five year Treasury notes has fallen in half this year, from about 2.69% to a mere 1.27%. But while the bond market is predicting a slower economy, the stock market seems to be sending a more positive message. How do we reconcile this?

Stocks can go up for multiple reasons. Obviously, a feeling of better economic prospects ahead is good for stocks. Another major factor is relative valuation. For discussion’s sake, let’s limit our investment choices to either Treasury notes or some conservative stocks. We can settle for the 1.3% yield on five year Treasuries. Or we can decide that Kimberly Clark (Kleenex, etc) and Heinz (ketchup, etc) are reasonable alternatives. These stocks each have a dividend yield of nearly 4%. People are likely to use tissues and ketchup even during a recession. Needless to say, these stocks can go down. But the gap between their dividend yield and the yield on Treasuries is far wider than usual, and that should provide some cushion. Moreover, their valuations are low relative to where they have been in the past 10-20 years. So these stocks seem like reasonable investments. We feel that we can own them without necessarily having any strongly bullish view on the economy.

We are invested in other high-yielding securities, such as the pipelines. They tend to be less sensitive to economic cycles as well. The same is largely true of utilities. Next, we are invested in the stocks of major energy companies such as Exxon. As outlined in previous letters, these stocks have lower valuations than at any time in the past decade. But they have been disappointing. Exxon’s total return for the year is -8.4%. Even so, we collect a 2.8% dividend while we wait for energy markets to improve. Growth in demand from Asia alone should spur the energy markets, and they should gain ground even more quickly if Western economies revive. In short, there are good relative values in consumer staple, energy and utility stocks.

Meanwhile, we also look for stocks that are likely to do well even if the economy remains in the doldrums. Apple is one such stock, for pretty obvious reasons. The main thing holding me back from owning even more Apple is the “key man” risk around Steve Jobs. There are other stocks that seem attractive in this environment. DuPont is one. To quote Value Line: “The company seems well positioned to benefit from several megatrends. Increasing global population and a rising middle class in developing economies ought to drive demand for greater food production, alternative energy and environmental solutions, and products that enhance personal safety.” DuPont’s revenues rose 26% and earnings more than doubled in the most recent quarter.

So what about growth stocks in general? Proponents say that growth stocks are trading at PE ratios that are on average only 77% of the norm, which theoretically makes them a good relative value. If these analysts could assure me that this measure would never go below 75%, I’d jump in aggressively. But if the economy is only growing at 77% (or less!) of the post-recession average, then perhaps growth stocks aren’t quite the relative value that some see. We’ve been cautious and quite selective to date. For instance, Google still seems fairly cheap relative to its growth prospects. Although the stock returned 18% for the quarter, it remains a frustrating hold over the longer term with a negative 15% return so far this year.

There is reason to be cautious in the growth stock sector. Adobe plunged 19% in a day when management simply said that growth might slow very slightly. I’m glad that we didn’t own Adobe, though I bought some for our more risk-tolerant accounts after that plunge. It is only one example of the risk associated with growth stocks. Many consumer stocks fell by 40% or so in 2007, even though their earnings were about flat in 2008. There can be great reward in growth stocks, but timing and careful selection is critical, especially if the bond market is accurate in foreshadowing more economic weakness.

However, the bond market may in fact be wrong this time. Interest rates are so low because the Fed is doing all in its power to keep them low. Many smart investors believe that bonds are the new bubble, and that there is risk of a severe price decline in the fixed income markets over time. Our fixed income portfolios are conservatively postured. If interest rates simply stop falling, it will be taken as a signal that the economy is no longer weakening.

Now let’s turn to the tension between those who are predicting inflation due to soaring deficits versus those who are predicting deflation due to a slowing economy and the consequent reduced demand for goods and services. Who is right? I’ll offer the politician’s answer – you’re both right! Different sectors of the economy can be affected in different ways – unfortunately, probably to the detriment of the American middle class.

Not all prices move in lockstep. The prices of aluminum or wheat can go up while the wages of an auto assembly line worker or a cook go down. So there are both inflationary and deflationary forces at work. Deflationary forces may push down wages in the West even as wages rise in China and other parts of the developing world. China’s economy has surpassed Japan’s to become the world’s second largest. They want more minerals for steel, cars, airplanes, buildings and other development. So the prices of many metals and materials have gone up. The price of wheat has also gone up due in part to the exogenous variable of vast fires in Russia. Yet domestic wages fall due to both worldwide competition and internal recessionary forces. In sum, framing the question as inflation versus deflation is overly simplistic.

Gold is a separate issue. How does gold go up if the bond markets are predicting deflation? Look at gold as an alternative currency, a store of wealth. Since the dollar is no longer backed by gold, one can only wonder what the clearing price of gold would have to be if we chose to return to the gold standard. The price needed to allow all holders of dollar bills to convert their holdings to gold is around $3500 (though a return to the gold standard is not in our near future). Although the example is hypothetical, it is a calculation that is in the back of the minds of many. Another reference point is the relationship between the amount of money in circulation and the price of gold. The country’s monetary base (currency in circulation plus bank reserves) has gone up about 2.5-fold since the end of 2007. In that time frame, gold has risen a more modest 50%. This suggests more upside for gold. But if it were this simple, gold would quickly go to its “proper” price. Some argue that because broader measures of money supply (such as M-2) are not growing very quickly, the bullish arguments for gold are overstated. The bottom line is that fears of debased currencies, both here and in Europe, are causing some conversion of liquid assets to gold. Since part of our job is wealth preservation, we own gold as a hedge against currency debasement.

The stock market can go up during a period of a slowly declining currency. In fact, many would argue that this would stimulate exports and thus prop up sales, profits, and stock prices. So it is not inconsistent to own both gold and stocks.

Currently, we are about fully invested, though many of our stocks are fairly conservative holdings; i.e. high quality stocks with good dividends that tend to fluctuate less than the overall market. Fears of a double dip are receding, thanks in part to re-assurances from respected investors such as Warren Buffet and his talk of the natural “regenerative capacity” of the American economy. The market has confounded those who held back because September is “seasonally weak”. Our foreign wars are winding down. The Basel Accords are seen as strengthening banks without causing economic disruptions. Many large cap companies derive much of their profit from growing markets in Asia. So while unemployment remains very troublesome, there is good news out there. Moreover, there is a growing conventional wisdom that the November elections will be good for the stock market in much the same way that the 1994 election helped to produce a surge in the Dow.

Back then, Newt Gingrich took control of the House from the Democrats. A similar change may be in the offing, even if the Republicans do not gain control of both houses of Congress. The logic is that an anti-business agenda will be halted, and that is good for capitalism. But the aftermath may not be the same. Here is why. Distasteful though it was, the TARP program made the government the buyer of last resort for certain financial institutions and auto companies. So there was a safety net for capitalism. That safety net will probably not be available, should it ever be necessary, after the November elections. That absence of support in any future periods of fragility could well have a self-fulfilling aspect at some point. But this does not seem likely to be an immediate problem.

My last letter talked about the debt problems in Europe and the deficit fears here. Despite the recent headlines about Ireland and the downgrading of Spain’s debt, the markets seem persuaded that Europe has the will and capacity to deal with these debt problems. Nevertheless, there is the old saying that where there is smoke, there is fire – so we remain watchful with respect to Europe. Meanwhile, we’ll do our best to take advantage of the opportunities that the market presents

Thanks as always for your confidence; don’t hesitate to get in touch whenever you want to discuss something. Best wishes for an enjoyable autumn.

* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.

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