Letter – 2010 Q4

The S&P 500 Index began the year at 1115.10 and ended it at 1257.64, for a price gain of 12.8% and a total return of 15.1%. Your account gained 16.4% for the year. Notably, when the S&P 500 declined 16% between April 23 and July 2, your account did not fall nearly as much, while we tracked more closely on the upswing. The bottom line: we captured a lot of return per unit of risk, thereby reducing volatility and limiting losses while still augmenting performance.

The market’s big rally began in early September, right at the time that many pundits said the market tended to be “seasonally weak”. It’s hard to believe that several months ago, a few widely-followed market pundits went even further – calling for a horrific bear market. Although we got more aggressive as the year went on, we still maintained a bias toward high dividend or other value stocks at a time when growth stocks such as consumer cyclicals did considerably better. That cost us in relative performance terms in the fourth quarter. But we generated solid returns overall.

The bottom line for 2010 was a growing confidence, especially later in the year, that the Fed would succeed in providing enough runway for the US economy to take off on its own, despite frightening levels of debt in Europe and the US. Our economy will probably grow at a sub-par rate of 2-3%, while economies in emerging markets will probably grow at annual rates of 5% or more. Many of these overseas markets may well offer better returns in the years ahead, and are at the very least a sensible diversification. How things change! A dozen years ago, it was the Asian currency crisis that concerned investors and now financial worries now are centered on certain countries in Europe. China and the Pacific Rim are not without risk, and their markets can be quite speculative and can thus get ahead of themselves. Ironically, those markets generally lagged the US equity market in the last quarter and contributed to us lagging the S&P 500 Index in the fourth quarter.

Prospects for the overall market in 2011 seem reasonably bright. Some commentators now believe that the greater risk is in missing an upside burst. Corporate earnings are likely to set a new record this year in the $90 – $95 range. The previous peak for the S&P 500 was $88.12 in 2006 before the financial crisis . Interest rates are lower now than in 2006, which justifies higher PE ratios (all else equal). For one frame of reference, a PE of 15 with $93 in earnings would take the S&P 500 to 1395. That would be an 11% gain for the year. At an index level of 1395 with earnings of $93, the earnings yield on the S&P would be 6.66% – well above current bond yields. At market peaks, the earnings yield is often less than these bond yields. (http://in.reuters.com/article/idINIndia-53714920101225)

Earnings momentum provides a slightly different perspective. It has slowed somewhat but is still good: $59.65 in 2009, probable $84.75 in 2010, and an estimated $90 to $95 in 2011. Although this would set a new record, it also indicates a deceleration of earnings growth from 24% to less than 10%. Clearly, accelerating momentum would be better, but the rising absolute level of earnings should matter the most.

Experts on asset allocation look at historical relationships between stocks, bonds and their relative valuations. I listened to one expert on asset allocation say that normally he would expect stocks to outperform bonds 70% of the time over the course of a decade. His probability as of September 30 had risen to 89% in favor of stocks. Of course, this could mean that stocks return 3% while bonds return 2%.

Asset allocation is critical in deciding allotments to stocks and bonds, and is also critical in deciding among segments in the stock market. There was a wide range of performance among industry groups as you can see from Morningstar:

Will the same groups be strong in 2011? We expect certain trends to continue. As growth continues in China and elsewhere, demand for industrial and agricultural materials should remain strong. A separate source of strength in the world of materials is precious metals. We will not re-state the case for gold here (see previous letters), but the fiat currency concerns both here and in Europe have not abated. We own the gold ETF and also have a great gain in Nova Gold (NG), which has impressive proven reserves.

Although other sectors did better than energy in 2010, we believe that the demand for oil will continue to rise. The OECD estimates that worldwide demand for oil will increase by 1.5% to 87.9 million barrels per day, with that growth almost wholly coming from Asia. A small shift in the supply-demand balance can lead to substantial price changes because people will pay up for energy usage. As with any sector, there are sub-categories. The biggest sector is exploration and production, represented by the “majors” such as Exxon and Chevron. Natural gas has underperformed crude oil for a long time, even though it is a source of cleaner energy. Both Exxon and Chevron have made major investments in natural gas recently. The refining stocks such as Valero and Tesoro are a separate breed from the majors, and refining margins have been very low recently. Given stronger economic growth and cold winter weather in the US and Europe, there is a good chance that refining margins grow. Accordingly, we have bought Valero – which seems cheap based on a number of metrics such as our earnings payback measure and its price regressed versus refining margins.

The consumer sector has been strong, but vexing. Much of the strength has been concentrated in luxury goods, casinos, and online merchants. We have been underweighted in this sector because valuations have not seemed compelling. We also underestimated the strength of holiday sales; retail sales in fact grew at an impressive annualized pace of 13% in the last quarter. We did have success in Apple, Amazon, Priceline, Coach, and JC Penney. Although Ford rose 68% for the year, it was extremely volatile and tough to hold a lot of it without a very bullish view on the auto industry (where I still have some hesitation).

The financial sector has been buffeted. Banks had been hurt for much of the year by a flat yield curve, which means that they cannot make good margins by borrowing short (ie, paying interest on deposits) and lending long (charging rates that are higher for longer terms). The yield curve has steepened this quarter. Ironically, longer term yields went up despite the Fed strategy of buying long term notes and bonds in an effort to lower rates. Bond investors began to worry about the inflationary impact of a strategy that boiled down to printing more money. But stock investors decided that at least for now, this strategy would indeed stimulate the economy. Thus financial stocks and other economically sensitive stocks rallied. There is still an overhang of bad commercial and residential real estate loans, and it is hard to judge when that overhang clears. Housing stocks have remained subdued, while some REITs that invest in commercial real estate have done well. We have looked for some specialty plays in the financial sector. We have a solid gain in The Blackstone Group (BX) which is a savvy player in private equity and real estate. We have done less well in Greenlight Re (GLRE), which has generated some impressive portfolio returns in previous years.

Returns in the health care sector have been muted. Despite their great dividend yields, it is getting harder and harder to own the major pharmaceuticals. Many patents on major drugs are running out, and it is getting more expensive to develop and produce new drugs (and often for smaller target groups). Although these dynamics would theoretically support generic pharmaceutical companies, we have had disappointing results from Teva this year as well. The most promise (and the most risk) is found in the biotech field. Since it is difficult to predict where the next huge success will be, we own the biotech ETF (symbol IBB) for exposure to the field. We also own Celgene, which is a leader in cancer research.

The utilities we owned performed much better than the Morningstar index of utility stocks. Total returns were 20% for Southern Company, 14.3% for Con Ed, and 12.1% for Progress Energy. PSE&G did worse with a return of negative 0.2% for the year.
Let’s turn back to the big picture. As discussed, valuation is reasonable. There are other positive signs. From a technical perspective, the market has been above its 200 day moving average since mid-September. The employment picture is gradually improving. Household savings have increased from about 2% to 6% over the past few years. There is still probably too much cash on the sidelines. The current value of all S&P 500 stocks is about $9.9 trillion. Money market funds hold about $2.8 trillion. Historically, this high a proportion in cash equivalents has been bullish for stocks.

There are always risks. We cannot adjust a portfolio rapidly enough to respond to a sudden event such as a terrorist attack. However, we can use stop-loss orders and other techniques to limit our risk profile if market conditions change for the worse. Meanwhile, it makes sense to invest for a continuing economic recovery.

Is it too late? After the S&P 500 returned 26.5% in 2009, many people were nervous about whether all the good news had played out. We addressed that issue in our letter of a year ago as follows:

“Everybody wants to know whether 2010 will be as good in the financial markets as 2009. After an earthquake, the seismograph tends to have smaller oscillations up and down. A calmer market and regression toward more normal returns strikes me as the highest probability scenario in 2010.”

That is pretty much what happened. The trend toward normalization will probably continue. It is possible that this may mean a year of high single digit returns. That would still be quite good, especially relative to fixed income. And as noted earlier, the surprises now may be to the upside.

We will continue to work hard to try to provide an edge by monitoring macro conditions, company earnings, relative valuations, and many other things. We are slowly getting back to normal. We appreciate your continued confidence and are ready to help in any way we can.

With our very best wishes for a happy, healthy and prosperous New Year,

* 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.