Letter – 2012 Q1

Late on Friday March 9, Greece effectively defaulted. On the following Monday, the stock market yawned. One day later, it closed up nearly 2 percent. Who’d have imagined that? In retrospect, the best part of my last letter stated: “history has shown that previous debt crises have been great buying opportunities if properly timed. Most notably, the Mexican debt crisis gave rise to the start of the 1982 bull market.” I’m not suggesting that we get carried away in thinking that a default by Portugal or Spain would therefore be terrific for stocks. But financial markets are doing their best to discount adversity and to reflect improving domestic economic data. Stocks remain a good value relative to fixed income investments, and the US economy is showing improvement particularly in the financial and technology sectors.

We’ve managed to take advantage of the recent uptrend. The S&P 500 Index provided a total return of 12.55% for the quarter. Your account gained 12.2%. On a risk-adjusted basis, returns are even better as the market volatility we discussed in our last letter has gone from high to low.

There are mutual funds that have done better in 2012, but most of those funds were down by double digit margins last year. We would have done better in the first quarter if I had traded out of all of the utility stocks that did so well for us last year. These stocks have lagged in 2012 and some are down for the year. So selling would have been a good tactical move. But from the standpoint of tax efficiency and turnover, I still think these stocks are worth holding as they have good yields and will likely outperform if and when we hit turbulent patches later this year. I don’t want to try to trade every wiggle.

So is this rally sustainable? Our view is yes – but in a more irregular fashion rather than this quarter. There are many encouraging signs.

* Stocks remain cheap relative to bonds. Goldman Sachs came out in late March and opined that the prospect for future stock returns relative to bonds is at a generational high. Stocks can rise even with increases in interest rates because at this stage both are consistent with a strengthening economy. After the tech crash a decade ago, the S&P 500 rallied from about 1000 to 1100 between June 2003 and May 2004 even as ten year Treasuries rose from 3.2% to 4.8%.

* The financial stocks have been leaders in this rally, and financial institutions are the lifeblood of the economy. When they are not healthy, neither is the economy. When they are healthy, that does not guarantee a period of great prosperity but it is a precondition for one. Even Citigroup, which failed the latest stress test, rallied 39% in the first quarter.

* The housing stocks have also been market leaders. We are long this sector for the first time in quite awhile, and there is some chance that we’ve caught a major market bottom. Even stabilization in housing prices would be a major plus for the economy.

* Despite higher gasoline prices, the long-term energy picture has brightened considerably as huge deposits of natural gas move the United States closer to self-sufficiency and reposition the gas rich industrial heartland for energy intensive manufacturing.

* American companies have plenty of cash to invest; there is now over $3 trillion of cash on the balance sheets of US corporations. But about half of this cash is held overseas as a stalemate between Washington and private enterprise continues over taxation of this money if it is brought home for domestic investment.

* The market closed above its 200 day moving average on the first trading day of the year, and has not looked back. While I have stressed that a moving average has no predictive value, it is useful as a marker of trend, and it remains in bullish territory.

Let’s take a step back and see where we stand in the longer term picture. What follows has no use as a market timing device but provides valuable long-term perspective. We looked at the level of the S&P 500 at the start of each postwar decade and compared it to the level of GDP for each period. Here is the raw data:

Year GDP GDP GR SPX SPX % Comment
1950  293.7 16.66  5.67% Stocks cheap to GDP – great decade followed, market gains 3-fold
1960 526.4 79.2% 59.89 11.38% Stocks not cheap, but GDP growth led to 50 pct gain for stocks
1970 1,038.3 97.2%  92.06  8.87% Inflation hurt real returns
1980 2,788.1 168.5% 107.94  3.87% Stocks cheap to GDP – great decade followed
1990  5,800.5 108.0% 353.40 6.09% Stocks still had room to run
2000 9,884.2 70.4% 1469.25 14.86% Stocks rich to GDP – bad decade followed
2010 14,551.8 47.2% 1115.10 7.66% Valuation slightly better than mean
MEAN  8.34%
NOW 15320.8 1397.11  9.12%

What can we observe? First of all, this is not a PhD quality presentation; eg, we’ve used the index level as a proxy for market capitalization. But we can see that the market has risen in every decade except the most recent one. In very general terms, it has done best when the S&P 500 Index is at a low number relative to the level of GDP (last column). The market rose more than 3-fold in the 1950s, which made stocks pretty rich relative to GDP at the onset of the 1960s. Even though GDP grew rapidly in the 1960s, the stock market cooled off (but still rose by 50% during the decade). GDP growth in the Seventies was distorted by high inflation. Although the market had nominal gains, real returns were negative due to inflation. Thus the market was very cheap relative to GDP at the start of the 1980s, and the decade gave great returns. The market was still reasonably priced relative to GDP at the start of the 1990s, and that turned out to be a good decade as well. But by 2000, the market was very rich relative to GDP (the 14.86% figure above) and we know what happened then. By the 2009 lows, the valuation was pretty compelling once again. Given the market’s gains since then, the valuation is back to a bit above the average.

This suggests positive but not stellar returns. It reinforces a commonly held view that we should experience total returns in the single digits on average for the next few years. The positive twist is the cheapness of stocks relative to bonds. But that is a technical factor of sorts; ie, it relates to liquidity rather than growth. More fundamentally, we also see that GDP is not growing as fast as it did in earlier decades. As a consequence, we should not expect rapid increases in corporate earnings either. That will ultimately limit the rate of increase in stocks.

There is in fact a bit of a slowdown in corporate earnings, or more precisely, in the rate of increase in corporate earnings. The consensus estimate for the year is now about $104. This compares to $96.50 in 2011, so we are looking at a deceleration to only a 7.7% gain. The PE ratio for the market is now 1408 / 104 = 13.5. This is certainly reasonable, especially in light of interest rates, but it is not exceptionally cheap. It is also true that Apple has accounted for an usually high share of the overall earnings increase. Analyst Henry Blodgett noted that once you remove AAPL, the S&P 500’s year-over-year earnings growth drops from 7.7% to 2.7%.

The economic picture is part of the reason that we have committed some portion of your funds to Asian-related equities. GDP growth is considerably higher there than in the US. Those markets can be quite volatile, so we calibrate our exposure. But valuations in most of Asia are pretty reasonable now. At the very least, this allocation provides useful diversification. We also believe that over time, this approach will enhance returns.

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There is one other comment from last quarter’s letter that bears repeating. I noted that: “I may have jumped the gun on owning at least some bank stocks; we’ll see.” Actually, the bank stocks have done exceedingly well this year. The results from the Fed’s most recent round of stress tests indicate that most banks are very healthy and could withstand severe shocks to the economy. In retrospect, although we continued to buy bank stocks during this quarter, I wish that I had bought more sooner. It just reinforces the notion that it is often, but not always, time to buy is when things seem the most frightening.

The tech sector is the other market leader. Apple returned 48% for the quarter and just instituted a dividend. Priceline gained 53%. We also have a good size position in Seagate Technology. They make hard disks that are ever more in demand for data storage. The stock ended the quarter at just under $27, which is up 66% for the year. Earnings estimates are for $6.28 in 2012 and $8.60 in 2013. My system projects a 40% compound annual return on the stock, but this is a very cyclical industry so stocks in this area can be quite volatile.

As usual, we have had some disappointments. For instance, Google is fractionally lower for the year. Although it is reasonably valued, Google has invested too much money in collateral ventures unrelated to their core search capabilities with little return (eg, Google +). Their misadventures in China have probably also hurt the stock.

There are some other laggards. While I think Exxon is trading below where it belongs based on my regressions versus oil prices, this has been true for some time. The stock has returned only 2.9% this year despite higher oil prices, and I am gradually shifting some money from Exxon to more promising investments. One might argue that Exxon’s large investment in natural gas has penalized it but comparable stocks such as Chevron have lagged the market just as much.

Needless to say, we continue to monitor the globe both for good investment opportunities and for potential negative surprises. We could get shocks from Iran or Syria or some unexpected corner of the globe (eg, the earthquake in Japan last year). But the skies have brightened considerably since last quarter, and spring has come early to Wall Street. We appreciate your continued confidence and are pleased to report good results for the year to date. Please don’t hesitate to contact us with anything at all that you’d care to discuss.


* 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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