Greek crisis causes panic

It is easy to forget how quickly markets can adjust to changed perceptions of economic prospects and risks.  The S&P fell about 226 points, from 1345 to 1119, or 16.8%, in only ten trading days in late July and early August.  Since then, it has gyrated within a wide 90 point range.  This volatility has left people wondering if that near 17% decline was the panic or if The Big One still lies ahead.

It is mostly up to Europe, and very smart people have very different opinions about how that plays out.  Here is the best distillation I can do.  The market appears to have already discounted some sort of controlled default in Greece.  Its economy is too small to seriously jeopardize the financial health of any major bank.  Initial steps to stabilize both Ireland and Portugal appear to be successful.  The market seems to be slowly coming to the conclusion that the Spanish and Italian situations are also probably manageable with a TARP-like program in Europe.  But I didn’t say “likely”.  I’ve heard intelligent comment that there is perhaps a 1-in-5 chance that things spin out of control in Europe and cause a major financial crisis.  However, the more likely scenario is best described as a hangover – a period of years in which we stagger through modest economic growth while working off excess indebtedness.  With stocks as cheap as they are, the market can do quite well if the debt situation doesn’t reach a tipping point.  Market prices have already discounted much of what could go wrong absent major bank failures, and little of what could go right.  On the other hand, as we learned in 2008, cheap valuations are hardly a guarantee of rising stock prices.
Taking a moment to review results, your account….

The good news is that we are seeing some terrific values in stocks.  Despite the bickering in Washington and the mess in Europe, the private sector in the US is like The Little Engine That Could.  Short of major disaster in the world banking system, corporate profits should continue to be good.  And prices are cheap relative to those earnings.  Corporate earnings in general are estimated as stronger this year than they were in 2007, but most stock prices are better values today.  Let’s look at some examples with earnings taken from Value Line:

2007 2011e 07Price 30-Sep PEThen PENow Discount
AAPL 5.06 27.5 135.36 390.6 26.8 14.2 -46.9%
AXP 3.53 3.84 49.13 46.72 13.9 12.2 -12.6%
CVX 8.77 12.85 83.25 94.39 9.5 7.3 -22.6%
DD 3.28 3.88 45.18 41.35 13.8 10.7 -22.6%
DIS 2.14 2.5 29.84 30.65 13.9 12.3 -12.1%
EMC 0.7 1.49 15.83 21.33 22.6 14.3 -36.7%
GE 2.2 1.38 35.36 15.86 16.1 11.5 -28.5%
GOOG 13.29 35 564 527.5 42.4 15.1 -64.5%
GT 1.51 1.59 25.2 10.45 16.7 6.6 -60.6%
IBM 7.18 13.2 107.11 179.17 14.9 13.6 -9.0%
JNJ 4.13 4.95 63.14 63.9 15.3 12.9 -15.6%
MMM 5.6 6.21 79.65 74.53 14.2 12.0 -15.6%
ORCL 1.27 2.41 20.55 29.65 16.2 12.3 -24.0%
PNRA 1.79 4.55 37.78 107.68 21.1 23.7 12.1%
VLO 8.09 4.2 59.06 18.6 7.3 4.4 -39.3%
WLP 5.56 7.05 78.2 65.37 14.1 9.3 -34.1%

The “discount” is simplistic, and merely illustrative.  For example, Google should have a lower PE ratio today because its growth continues, but at a slower pace.  But many other companies are growing more rapidly than in 2007.  For instance, that is true of Panera and its PE ratio is indeed higher than in 2007.

When we consider valuations, it is worth remembering that the risks which played out in 2008 were coming into sharp focus by the end of 2007, so valuations then were relatively good.  Of course, stocks went down a lot even though they were cheap back then.  It can happen again.  But leaders in Europe and around the world know the stakes.

We are not suddenly throwing caution to the wind.  We did relatively well last quarter in part because we carried high cash balances and because we have owned stocks such as utilities that pay high dividends.  We still don’t own that many high beta stocks and we remain underweighted in bank stocks.  And I will still use stop-loss orders to protect against big down moves, even though we sometimes get stopped out of positions at just the wrong time.  This discipline is an insurance cost or opportunity cost of sorts, but in quarters like this past one, the overall results are better than most mutual funds produced in part because we maintained this discipline and limited losses.

It is never easy to identify an ultimate bottom; people have been trying to do that in the housing market for years.  But when my system projects a 20% annualized return on a stock based on current earnings projections, it is hard not to invest.  We are mindful that earnings, though a very useful guidepost, are yesterday’s news and earnings can plunge suddenly.  We’ve focused on the macro-economic picture in this letter because that is what has been driving daily market movements lately.  Needless to say, we track those developments closely but also continuously search for good companies at bargain prices.

Last year, almost all of the returns came in the fourth quarter.  It is possible that we’ll get a repeat performance, albeit for different reasons.  In any circumstance, we remain both vigilant and opportunistic and can only hope that our solid relative performance will persist when markets turn up!  Thank you for your continued confidence.  As you can appreciate, this letter is shorter than most but I’m happy to elaborate on current events with you at any time.

* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers include all actively managed equity accounts and reflect the reinvestment of dividends and deduction of all fees.

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