Sunday, April 4, 2010
The bulls continue to get the benefit of the doubt as we respect the tape (long-term positive), but stay aware of market risks (short-term negative).
- Trends for earnings, economic recovery, inflation, and interest rates do not typically get much better for equities. The bull market continues to deserve the benefit of the doubt, but we are also prepared to cut back quickly if the stock market fails to meet the Q2 2010 challenges and thus deteriorates more than might be reasonably expected.
- “The perfect is the enemy of the good.” – Voltaire. Berkshire Money Management makes it a practice to participate in the big advances and to get defensive during big pullbacks (crashes, recessions). There are no perfect tools for consistently and reliably timing regular and ordinary five-to-ten percent stock market corrections. Instead, stock market corrections should be used as opportune times to upgrade your portfolio from positions of weakness to positions of strength.
- Such a five-to-ten percent stock market correction is likely to occur in Q2/Q3 of 2010. While a correction of such magnitude is regular and ordinary and simply what the stock market does, this one will be unique to the last year in so much that the subsequent rally will be defined by more clearly demarking leaders and laggards. It will be a phase that is different from the previous year where there was widespread participation from all stock market sectors and asset classes.
- Wall Street analysts have begun to see the light in regard to improving corporate earnings. Because analysts are notorious for missing turning points in corporate profitability it is important to consider not just what might happen, but what has happened.
- Based on the P/E10, stocks potentially have more room to run to the upside, but valuations are stretched. At best, the stock market is fairly valued, and when the stock market is fairly valued its rate of growth can mimic the rate of corporate profit growth.
- The U.S. stock market remains in a long-term bear market. The average for such declines is 17.6 years, and we are ten years into this one. What Berkshire Money Management has done for clients over the last decade will likely continue to be what needs to be done for much of the next decade. The old rules no longer apply, and it’s Berkshire Money Management that has successfully written the new playbook.
In our Economic Outlook for 2010 we wrote a page and presented a graph representing the PE10, which is the price-to-earnings ratio of the stock market based on an average of ten years’ worth of earnings. In this, the update to the Economic Outlook for 2010, we present an update of that chart. Not that three months’ time has done much to change the landscape of the previous decade, but consensus forecast for earnings are booming (in part due to easier year-ago comparisons) so it seemed appropriate to update our PE10 conversation given much better future expectations.
Optimism (rightly or wrongly) does beget optimism. And earnings for the fourth-quarter of 2009 were great, compared to expectations. There really isn’t any debate on that. Nearly three-quarters of the companies in the Standard & Poor’s 500 index beat analyst estimates. Of course the important question is, “what happens next?” Likely the coming earnings will not be nearly as impressive in terms of beating analyst estimates, if only because these same analysts have begun to feel optimistic enough to bump up estimates in response to missing them by so much last quarter. Still though, the improvement will continue.
Analysts are notorious for being slow. Or more precisely, in the aggregate, they are notorious for reacting and not predicting. And for them, just as optimism begets optimism, pessimism begets pessimism. And, in the aggregate, analysts get the calls wrong at important turns. It is often when analysts give up and begin expecting that the bad can only become worse that things will actually begin to improve. It turns out that consensus earnings estimates don’t have any history of accuracy at turning points, unless you bet against them.
The point to this is that while it is important to forecast earnings, even the alleged best and brightest in the field get it wrong – often on both the upside and the downside. We at Berkshire Money Management tend to get our market calls correct more often than wrong because we actually understand how those psychological mistakes are made, and we try to avoid them. So to come up with a valuation statement on the stock market, we must be careful of the mistake of relying too heavily on what might happen and thus try to show appropriate homage to what has happened. After all, when it comes to investing, the people who miss the biggest opportunities and get exposed to the biggest risks are those that say “this time it’s different.”
Because it’s not different this time. There are a lot of reasons to consider the P/E10 over the traditional P/E ratio, but instead of getting into the geekiness behind it, let’s just say that it was devised by the legendary economists and value investors Benjamin Graham and David Dodd (aka Graham & Dodd).
Not yet impressed? If those names are unfamiliar to you and thus don’t conjure up as much confidence in this tool as we would like for it to, then 1) telephone us on it, and/or 2) ask Warren Buffet about it because he is a disciple of Benjamin Graham (that’s right – the co-creator of the P/E10 is the Master’s Master!).
Some things to know about the P/E 10: the historic P/E10 is 16.3 and it currently stands at about 21.5 (up from 20.0 as we published the Economic Outlook for 2010) after dropping to 13.4 in March 2009. The chart below (courtesy of DShort.com) gives us a historical context for these numbers.
The good news is that the current P/E10 isn’t as stretched as many other instances. At 1,150 points on the S&P 500, the “E” of the P/E10 represents about $53.49 worth of S&P 500 company aggregate earnings. Moving from a P/E10 multiple of 21.5 to the 24.1 multiple achieved in 1966 puts the S&P 500 at 1,350 points (that number of 1,350 points on the S&P 500 was highlighted in the Risks & Rewards section of the 2010 Economic Outlook).
Beyond the companies that comprise the S&P 500 Index, according to the Commerce Department a broader tally of US corporate earnings also saw profits grow robustly in the last quarter of 2009. Pretax profits rose 8% to $1.468 trillion in the fourth quarter, up 8% from the third quarter (or 30.6% from year-ago fourth quarter 2008). Keep in mind that the recovery in profits is just beginning – the first half of 2009 was horrible. For the full year of 2009, profits were actually down 3.8% from 2008. Growth is expected to continue in the first quarter, albeit at a much more modest 2.8% rate compared to last quarter. That moderation should be expected after such a spectacular surge. But profitability continues to advance, and it has been a healthy mix between both financial and nonfinancial companies. Corporate profits will continue to rebound as the economy expands, and the economy is expanding (see Economic Recovery below).
Now, the bad news. Doug Short’s chart is a great graphical tool to point out where we might stand on whether or not we have embarked on a new secular (i.e. long-term) bull market, or if this current rally is simply a cyclical (i.e. short-term) bull market occurring within the context of secular bear market. Over the last 130 years, long-term bull markets have begun when the P/E10 was in its 5th quintile and in single digits. Doug references a couple of ominous points. First, that “every time the P/E10 has fallen from the first quintile to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits.” For example, in 1966 (like in 2000), the P/E10 reached the 1st quintile, dropped considerably in 1974 (similar to 2009), and then rebounded (like now) only to fall back to single-digits in 1982 (a few years from now?).
Seeing how secular declines last about 17.6 years, on average, this cycle’s “1982” (the end of a great bear and the beginning of a great bull) could occur about 2016-2017. That doesn’t necessarily mean that the stock market will go straight down for the next six or seven years. But it does mean that what Berkshire Money Management has done for clients over the last decade will likely continue to be what needs to be done for much of the next decade. The old rules no longer apply, and it’s Berkshire Money Management that has successfully written the new playbook.
But this is just one way to value the stock market. Anyone, including us, can pull together as much statistical data as is necessary to support their case. Using Standard & Poor’s 12-month trailing “As Reported” earnings (similar to using Generally Accepted Accounting Principles, or GAAP), the P/E ratio based on trailing 12-months earnings is about 17.2. And the P/E ratio using Standard & Poor’s expected 12-month earning is about 16.0. For optimistic bulls, both of those numbers show the stock market’s valuation in a slightly better light. Still, even the bulls will acknowledge that stocks typically trade at an average of about 16 times annual corporate profits. So that makes the stock market “fairly valued.” And when the stock market is fairly valued its rate of growth can mimic the rate of corporate profit growth (hence my instance of starting this report with commentary on the recent optimism pertaining to profit growth.). That’s not to say that the stock market cannot grow faster than earnings – it often has. But it doesn’t leave a lot of room for what we in the industry call “multiple expansion” where the stock market rises faster than earnings do.
Historically, when the P/E ratio has gotten above 20 it has signaled that the market was expensive and may be due to experience a stretch of subpar returns (note: valuations are good long-term indicators only; in the short-term valuation metrics are ridiculously awful timing tools). Going from a 17.2 P/E (using trailing earnings) to a 20 P/E puts the S&P 500 at 1,350 points (remember, 1,350 points was the Reward Level that was defined in the 2010 Economic Outlook). That’s not a bad place for the stock market to be, but the valuations do suggest that getting there is more likely a function of time coupled with earnings growth, as opposed to a surge in buying that exceeds the profit growth.
Again, I must reiterate that valuation metrics are ridiculously horrible timing tools. For Berkshire Money Management, the most frequent use of valuation tools is to determine whether or not we remain in a secular (i.e. long-term) bear market. Let’s go back to the P/E10. To us, the problem is not just that the P/E10 is very expensive at 21.5. The bigger problem is that since 1991 the P/E10 has spent only seven months, in late 2008 and early 2009, below the average level of 16.3. The stock market should spend a good portion of its time trading below its average to match the amount of time it spent above its average. Remember when we shunned the notion of accepting “this time it’s different?” Stock market cycles, like business cycles, always revert to the mean.
Similarly, valuations can be useful as sentiment indicators telling us where the crowd is at a psychological extreme, either extreme pessimism or extreme optimism. The P/E10 chart shows that we have rallied from near “extreme pessimism” (undervaluation) to mildly “excessive optimism” (mild overvaluation). Our other sentiment indicators also show that optimism is rising, but there is room for it to rise further. And sentiment indicators can be early – they won’t tell us that a correction is imminent.
None of this means that the stock market needs to go into a bear market right away, (note the late 1990s and 2004-2007), but our analysis shows that risks have risen, and that upside potential over the next twelve months will moderate compared to the previous twelve months.
Year Number Two
- Bull markets that extend past the one-year mark almost always last two years or more. Since 1926, the average stock market advance in its second year has been nine percent.
- Trends for earnings, economic recovery, inflation, and interest rates do not typically get much better for equities. The bull market continues to deserve the benefit of the doubt, but we are also prepared to cut back quickly if the stock market fails to meet the Q2 2010 challenges and thus deteriorates more than might be reasonably expected.
Two important milestones have been reached:
1. The secular bear market in U.S. equities has now been intact for more than 10 years.
2. The cyclical bull market in U.S. equities has now been intact for more than a year.
Recently we celebrated the one-year anniversary of the global markets hitting bottom and turning for the better. The first year was better than anyone could have reasonably expected. So what’s to expect for year number two? Historians will note that the second year of a stock market recovery also stacks up favorably. The average price advance for the S&P 500 since 1926, from a bear market low, during the second year was nine percent. A nine percent advance from 1,140 points (the S&P’s level on March 9, 2010) would put the S&P 500 at 1,242 points.
Keeping with the exercise of tracking history, it is important to note that the survival rate of a bull market actually increases after it surpasses the one year mark. The 13 bull markets since 1930 that have lasted more than a year have averaged a total gain of 153% and a total length of 4.4-years (in this case, a “bull market” is defined as an advance greater than 20 percent that follows a decline in excess of 20%). Bull markets that pass the one year mark have almost always lasted two years or more. The exception was in 1948 when the rally ended after 393 days. But that rally only saw a gain of 24%, so (for better or for worse) it is not a lot like this rally.
Why is one year an important milestone? We only have a theory and, admittedly, it is not a very impressive one. First, we Americans pay attention to annual anniversaries. Second, as discussed earlier, optimism begets optimism. And it takes that somewhat arbitrary and somewhat lengthy timeframe for the stock market to convince stubborn and scared investors alike that it’s o.k. to get back into the market. (For now we’ll shelf the conversation about how it makes little sense for investors to ignore buying low and to instead wait for prices to go up meaningfully – let’s just agree that it happens and acknowledge it.).
While we are making acknowledgements, let me also point out that the use of statistics can make heroes or devils out of anyone, depending on how the numbers are used. Remember that conversation we had earlier regarding price-to-earnings ratios and the P/E10 in particular? And how valuation tools are horrible timing tools, but they do a good job assessing whether we are in a secular bull or a secular bear market? And we argued that we continue to be in a secular bear market? Well, we told you that to tell you this: The average lifespan of a cyclical bull market within the context of a secular bear market is only about two years.
The average length of all bull market rallies is 4.4 years, some last longer and some die sooner. So that a cyclical rally occurring during a secular bear lasts only about half that duration makes sense – there are more (and longer) 20% rallies during secular bull markets than there are 20% rallies during secular bear markets.
First-year bulls tend to recover an average of 84% of what they lost in the entire bear market, and this one has so far recovered about 57% of its losses (re-attaining a level first reached in 1998 and still below where the market collapsed after Lehman Brothers failed), so you could certainly argue that the there is more room to run to carry this rally into the second year.
Had enough of history and valuations? Let’s talk about current fundamentals. Take into consideration that 1) the economy is recovering nicely (Yes, yes, we have some concerns, too. But that fact is that the growth in GDP for the first two quarters has been stronger than the previous two recessions. Similarly, the retreat from the peak of the unemployment rate has been faster than the previous two recessions.), 2) monetary policy is extremely expansive, 3) there is still about two-thirds of a $787 billion stimulus package to be spent over the next few years (Yes, yes, we have some concerns about the deficit, too. But that’s another conversation.).
We believe that the cyclical bull market remains well intact. But that doesn’t mean the stock market will progress upwards in a linear fashion – it never does. We acknowledged the aforementioned concerns, and let’s add excessive optimism, interest rate pressures, and weakening internals. As indicated in our 2010 Economic Outlook there could be a drawnout correction in the second and third quarters of 2010. But do not overly focus on the prediction of that or any other correction. Corrections are ordinary and regular during bull markets. For all except the shortest-term players and index-futures scalpers, the important question isn’t whether the market retrenches a bit but whether that retrenchment would segue into a renewed bear market. What is important is not the correction, but that we monitor it so as to determine whether or not it is merely a disruption in what we consider to be the primary trend for the markets, or if it will manifest into something more stark. Currently, the primary trend continues to be up – not down.
Memories from Economic Outlook for 2010
In our Economic Outlook for 2010 “we anticipate[d] a continued stock market advance for 2010” but that we had some concerns regarding a stiff correction.
In that same Economic Outlook for 2010 report we noted that:
Should a correction occur in 2010 that would not be unexpected. In our February 10, 2007 article “Charts & Graphs (Indicators & Interpretations for 2007)”, [we presented that] there is a ten percent stock market correction about once per year (each such correction lasting about 114 days). Coming up with the timing of when we might expect that correction to begin is a little more difficult than just admitting the obvious. Nonetheless, it is our job to go through that exercise. In the context of an established and on-going bull market, it is common for traders and value investors alike to look for a pullback toward the 200-day moving average, since that is often a technical entry point for new stock purchases. But what may have been frustrating for those particular investors, those sitting on the sidelines in cash, is that such a pullback has not yet occurred since the S&P 500 crossed its 200-day moving average on July 10, 2009. And, as shown in the table below, investors waiting in cash may have to wait a few more months.
In that December 30, 2009 white paper we continued to report that:
After another quarter or two of the stock market rallying (Spring/Summer) the advance will become vulnerable to corrections of more than the 4-7% nature we have experienced since the March 2009 bottom. A probable worst-case scenario would be a 1977-like decline of about 21% after “only” reaching 1,200 points on the S&P 500 (which would rival the 1975 advance) in April of 2010 (bringing the market down to our Risk-Level of 950 points sometime in September of 2010).
Granted, the 9.2% pullback in the S&P 500 we had in the first quarter (it occurred over just fourteen trading days, so you are certainly excused if you blinked and missed it) diminishes the likelihood of the worst case scenario (Why? The proverbial “weaker hands” already did their selling.) Additionally, the sample table above (Hypothetical 2009-2010 Pullbacks) defines the stock market pullback down to the 200-day moving average. (The 200-day moving average is an important technical level. Its value is arrived at by taking the closing price of the index for the past 200 days, and adding these up, then dividing by 200. Every day we drop the ‘oldest’ price, and add today’s price. This keeps the average ‘moving’.) Currently, the 200-day moving average for the S&P 500 is just about 1,050 points – right where the index found resistance for the most recent pullback.
Upgrading from Weakness to Strength
• “The perfect is the enemy of the good.” – Voltaire. Berkshire Money Management makes it a practice to participate in the big advances and to get defensive during big pullbacks (crashes, recessions). There are no perfect tools for consistently and reliably timing regular and ordinary five-ten percent stock market corrections. Instead, stock market corrections should be used as opportune times to upgrade your portfolio from positions of weakness to positions of strength.
• Strong positions can remain invested so long as the primary trend is bullish.
• Both fundamentals as well as technicals argue that the primary trend continues to remain bullish.
As you might suspect, some stock market conditions are more difficult to navigate than others. Now may be one of those times, when the longer-term outlook is positive but the shorter-term is challenged by the expectation of a likely correction. The easy answer is that if you are in a strong portfolio then remain invested during corrections (not crashes) so long as the primary trend continues to be bullish. But what if the positions in your portfolio are cash and/or weaker positions?
For those holding cash, the consideration is whether to defer new buying but risk missing a further rally. Or buy in spite of the apparent warnings signs and risk being exposed to a pullback that may be deeper than anticipated.
For those holding weaker positions (including stocks or funds that may represent certain sectors or asset classes Berkshire Money Management likes, although the specific investments themselves are not those that we would select), corrections are opportunities to upgrade your portfolio. A longer-term positive outlook, coupled with the potential for a short-term pullback (Weeks? Months?), can offer favorable conditions for upgrading a portfolio. Either a continued advance or the beginning of a decline could be used to cull the weakest investments from a portfolio. At the same time, stronger replacements could be either introduced immediately, or after the market pulls back more.
What is it that convinces us that the continued primary trend is bullish? We shall address the fundamentals in the “Economic Recovery” section below, but technically speaking, we take some solace in the following bullish indicators:
- According to the metrics we follow, Buying Pressure is at a near high and Selling Pressure is at a near low, indicating expanding Demand (i.e. buying of stocks) and contracting Supply (i.e. selling of stocks). This is consistent with a healthy uptrend.
- Advance-decline lines (An advance-decline line is a technical tool that measures the number of stocks rising divided by the number of stocks falling.) continue to make new highs. Since the 1937 stock market top, advance-decline lines have begun to diverge from new rally highs in their underlying price indexes by an average of seven months. This suggests that any major market top is still many months away.
- Both the NYSE as well as a subset of operating companies (stripping out closed-end bond funds and the like which also trade on the NYSE) recently recorded peak readings of New Highs. Since 1960, peak readings in New Highs have occurred, on average, 10 months prior to major market tops. Again, this suggests that any major market top is still months away.
None of this at all mitigates the chances of a correction. But it does compel us not to do what we did in 2001 and 2002 (pretty much sell all equity in managed portfolios) or in 2007-2009 (pretty much sell all equity in managed portfolios plus short the market).
So why not jump out of the market during the squiggles that are 5-10% corrections? It was Voltaire who famously said that the perfect is the enemy of the good. Take the last correction for as an example. The fourteen-day, 9.2% pullback was over before it began. That is not reason by itself, but we do have to consider that the tools to time major tops and bottoms, while extremely blunt, are more consistent and reliable than those tools that may be applied to those squiggles.
Here’s the fact that most investors don’t want to hear: The stock market is going to go through corrections on a regular basis. If you can’t deal with that then you shouldn’t be in the stock market – ever. But clients of Berkshire Money Management know this to be true, otherwise we wouldn’t have been hired to invest in the capital markets.
Here’s the fact that 99% of other money managers don’t get: The stock market is going to crash twenty percent, on average, every three-and-a-half years. And it is the job of hired money managers, like Berkshire Money Management, not only to identify those cycles but to protect clients’ portfolios from them. As clients of ours know from our actions in 2001-2002 as well as in 2007-2009, we are quick to go to cash if we believe that the primary trend is turning bearish.
So why do we bother to go through the exercise of attempting to identify when those squiggles may occur? Those little squiggles of corrections can sometimes become much bigger problems.
Signs of a longer-than typical correction
- For the previous twelve months, there has been widespread participation in the global stock market advance.
- A correction could be looming as the rally over the last couple months has seen an increase in selective buying and deteriorating upside momentum. Additionally, and also worrisome, this has occurred against an apparent backdrop of investor complacency (for contrarians, that is bearish).
- Buying will become less widespread and more selective. The stock market can continue to advance during this phase, but it is also prone to a series of setbacks as investors unload laggards.
- While the primary uptrend of the overall market would remain up in this phase, the stock market can shift back and forth between these two zones, or phases, multiple times and for many months before a major top is reached.
Even the strongest primary uptrend is interrupted from time to time by short-term pullbacks. At this point, even in the face of a pullback, reward is favored over risk at these levels.
The aforementioned 9.2% correction occurred over just fourteen trading days. That is unusual. On average, there is one ten-percent correction per year. And, on average, that ten-percent correction occurs over 114 days (shy of four months). Too, on average there is one fifteen-percent correction every two years (those last closer to seven months).
It is not unusual to have a ten-percent correction. It is unusual for it to be over before most people even realized it occurred. So, besides corrections being normal market activity, what are we seeing now that suggest a four-month ten-percent correction could start in the months to come?
The gains in the stock market indices have continued as Buying Power has increased (increasing Buying Power is bullish as stocks are being bought) at a greater rate than the increase in Selling Pressure (increasing Selling Pressure is bearish as stocks are being sold). In other words, the breadth is diminishing (wide breadth is bullish) and the buying is becoming more selective.
In the November 9, 2009 website White Paper titled “Holding and Upgrading” we wrote:
“In the coming months (if not sooner) we expect to embark upon a new stage, the Holding & Upgrading stage. This new stage will be a period where the original, or Primary, stage begins to mature. Demand continues to outpace Supply from an overall perspective, but Selling Pressure will begin to grow (not necessarily overwhelm, but grow) for certain stocks, sectors, and asset classes even as overall Demand continues to increase. In other words, buying becomes more selective, rallies will be less dynamic, and sellers will be quicker to take profits. The easy part of the bull run is over.”
In this case, the increase in Selling Pressure may serve as a warning of a possible shift from a broad advance to something more narrow, a second phase we can call the “Holding and Upgrading Zone.” While the primary uptrend of the overall market would remain up in this phase, the stock market can shift back and forth between these two zones, or phases, multiple times before a major top is reached.
Because during this period Buying is more selective and profit-taking is more prevalent, the markets can vacillate between going nowhere and going down (think correction of a 5-10% magnitude). It is worth emphasizing that this second phase can persist for an extended period of time (think 3-7 months). Thus, the shift from the first to second phase does not typically serve as a warning of an approaching market top. The shift does, however, suggest that a premium be placed on selective, rather than broad-based, buying and that cash should be recycled from the weakest investments to stronger positions.
On balance then, and what suggests to us that a correction could be looming, the rally over the last couple months has seen an increase in selective buying and deteriorating upside momentum. Additionally, and also worrisome, this has occurred against an apparent backdrop of investor complacency (for contrarians, that is bearish). The Chicago Board of Exchange (CBOE) put/call ratio remains low, indicating heavy interest in calls (bulls) over puts (bears). And with the exception of the survey from the American Association of Individual Investors (AAII), who have been generally bearish from the March 2009 low, most sentiment surveys of individual investors show a high level of optimism (again, for contrarians that is bearish).
The bottom line is that while the weight of evidence suggests the market’s primary uptrend appears a long way from any major top, the short-term shows signs of deterioration consistent with an approaching pullback. Forecasts are nothing more than guesses (educated as they may be), and our best guess is a 6-7 week correction to the tune of 6-7% (down to about 1,085-points on the S&P 500). Allowing room for error, we certainly would not be surprised to experience the average once-per-year, four-month, ten-percent correction. (It is again worth noting, these types of moves occur on average once per year – it’s nothing spectacular or out of the ordinary.)
We have written a lot about 90% Days, and March 5th was a 90% Up Day. Historically, the market has not produced any major gains immediately follow a 90% Up Day that occurs well after a significant market low (such as the low made on February 8th), as opposed to a few days after such a low. Rather, when such 90% Up Days have occurred, gains have been subdued. And that pattern has apparently continued following the March 5th 90% Up Day. Since then the stock market has gone up, but hardly showing gains that would qualify as dynamic. But of more importance to the topic at hand, each of those prior subdued rallies (subsequent to the 90% Up Day that occurred well after a significant market low) was then followed by a correction. The duration of those corrections varied from the very short-term of a few days to 6-7 weeks. However, none were what we would consider to be severe, with the worst declines in the range of 6-7%.
This brief history lesson seems pertinent given the signs of weakness that have developed as the market has worked higher over the past few months.
- On June 30, 2009 Berkshire Money Management forecasted that the recession in US economic output would be over before the end of the summer. Gross Domestic Product (GDP) for the second half of 2009 saw a 2.2% bump in Q3, followed by a 5.6% jump in Q4 (better than the previous two recoveries – twice the growth rate of the last recovery, and one-and-a-half times the early 1990’s recovery).
- There will be no double-dip recession this time as the recovery is sustainable.
We ruled out a double-dip recession long ago. But we certainly are not dismissive of the problems that exist. We have often said that the business cycle is a powerful force that is capable of eating up any of those problems. There are always problems that remain in the headlines as the economy shrugs off recession and moves into recovery – always. And the economic tailwinds always overwhelm those headwinds. If they didn’t we’d always be in recession and never in recovery or expansion.
But is it different this time? A February feature story in the Wall Street Journal reminds us that “many economists say the U.S. may be moving toward recovery, but they figure the chances are one in four or five that the fragile upturn could be snuffed out by certain problems.” One of those “problems” discussed in the Journal story was “high unemployment, [which] creates a ‘fright factor’ that inhibits spending by those who are employed.” By the way, that February article did not run in February 2010, but rather February 1983. Back then the unemployment rate was 10.4% (versus the recent peak of 10.1%, and 9.7% currently). It turned out that the “fragile recovery” of 1983 was anything but. The recovery from the deep 1981-1982 recession pumped out a 5.1% Gross Domestic Product (GDP) figure in the first quarter of 1983, then 9.3% in the second quarter. Then GDP grew at 8% or better for the next three quarters in a row. It was amazing.
We don’t expect anywhere near that sort of growth in 2010. Still, the growth rate for the second half of 2009 saw a 2.2% bump in Q3, followed by a 5.6% jump in Q4 (better than the previous two recoveries – twice the growth rate of the last recovery, and one-and-a-half times the early 1990’s recovery).
With trending improvements in consumption, capital investment, and net exports we see no reasonable chance of another recession occurring soon enough to be considered a “double-dip.” If you are waiting for the proverbial shoe to drop, you are going to be waiting for a long time – the shoe already dropped.
The point is that while you shouldn’t dismiss problems, the business cycle should be paid its proper respect. It works both ways. In 2008 the Economic Stimulus Act of 2008 pumped $152 billion into the U.S. economy but was swallowed by the downward business cycle at that point. Fiscal stimulus works best when it is injected into the economy during the “fragile” stages of a recovery. The $787 billion American Recover and Reinvestment Act of 2009 will see the bulk of that stimulus spent over the next couple of years during a recovery – perhaps when it is no longer needed. It will be powerful.
Beyond a continued stream of monetary and fiscal stimulus, there are a couple reasons why deep recessions generally are followed by strong recoveries. First, recessions correct the unwise investments that were badly allocated due to artificially low cost of credit and an unsustainable increase in money supply. Second, and more directly, deep declines in production and consumption creates a pent-up demand that becomes replaced. The recovery has slowly been gaining traction since mid-2009, and, as Berkshire Money Management predicted months ago, job growth is set to resume on a sustained and material basis by mid-to-late-2010. Businesses should get their groove back in coming months as the financial panic and Great Recession recede into the past. While the transition from recovery to a self-sustaining expansion faces a number of significant impediments, policymakers appear willing to provide enough monetary and fiscal support to overcome them. Over the course of the next eighteen months, the expansion should be in full swing – in large part due to policymakers erring on the side of providing too much stimulus, rather than too little, to ensure that the expansion takes hold.
Worries about the already-swollen federal budget deficit are well justified, but it is prudent keep the accelerator on at this moment. And with underlying inflation low and inflation expectations tethered, policymakers should be able to deflect what will surely be mounting criticism of continued easy-money policies.
- Inflation is low and inflation expectations are tethered. Core inflation (CPI minus food and energy) is at one of its lowest rates on record.
- Inflation trends are closely watched by the Fed, and this gives the FOMC the credibility to keep rates low for, as they put it, “an extended period.” This is good news for investors.
Inflation, as measured by the latest Consumer Price Index (CPI) number, is up 2.2% versus last year. Judging by the “break even” rate of inflation, the point at which inflation-linked bonds would make the same pay-out as the fixed-interest bonds over the next ten years, the market is currently expecting continued 2.2% inflation in the US. While views are likely to change over time, for now those subdued expectations make sense given that unemployment remains high and any increases in wholesale prices will be difficult to pass along to consumers. Too, the vast economic slack left from the recession leaves companies and workers with little leeway to ask for price or wage increases.
Inflation will likely be a problem in years to come, but it is important to note that in the intermediate-term, while inflation expectations remain at these manageable levels, the pressure on central banks to raise interest rates is not too intense – which is what the markets want to hear. Inflation trends are closely watched by the Fed, which has said it will keep short-term interest rates near zero for an “extended period”, meaning at least several more months. And while this balance holds, this, of course, has important implications for fueling the economic recovery as well as the primary bullish trend for the stock market.
Yet looking at today’s inflation numbers, while important for considering the next twelve-months or so, could be short-sighted. The current U.S. policy stance has moved the economy out of recession, but under different circumstances it could also lead to overheating and rapidly rising prices. Yet the Fed’s and the Treasury Department’s intervention did not cause the economy to overheat. This is because much of the cash it pumped into the nation’s banks stayed there, rather than circulating among businesses and consumers. Without an expansion in credit, the surge in the money supply has not led to a turnover of dollars – in other words spending, while improving, has been mild. Thus there has not yet been the type of explosion in prices we might have otherwise expected at this point.
As the recovery continues, demand for credit will grow, and banks will be able to turn their current reserves into loans. The good news is that the economic recovery will continue. The bad news is that, in the long-term, inflation is going to be a problem. But for now, low inflation is an aid to capital market investors.
It is at least worth mentioning that while the Fed can raise interest rates to dampen the expansion, and thus inflation, it is at least theoretically possible that they might choose to tolerate relatively high inflation – as it did in the late 1960s and early 1970s – out of fear of the recession’s return.
The Bottom Line: When Berkshire Money Management opened its doors nine years ago in April 2001, we wrote a White Paper titled “18-Years of Pain” (or something like that, it was a long time ago). That report was used to describe what U.S. stock market investors could expect for nearly the next two decades – a bear market.
Such a proclamation at that time was not widely accepted. But now that we are ten years into the bear market we find that we have a more receptive audience as to the historical lessons of stock prices. Through over a century of stock market history there have been periods where, from Point A to Point B, stock prices do absolute nothing. On average those stretches last 17.6 years. And while stock prices may have gone nowhere from start to finish during those stretches, in the interim there is huge – huge – volatility on both the upside and the downside.
Currently we are enjoying the upside volatility. And while we expect that upside volatility to continue for the next twelve-months (granted, at a much more moderate pace than the previous twelve-months), Berkshire Money Management recognizes that to profit and to protect we must continue to acknowledge not just the potential reward of buying investments, but the very real risk of holding investments.
Clients of Berkshire Money Management during 2001-2002 as well as during 2007-2009 know that we get out of the market and into cash during crashes/recessions. It’s what we do and it’s what separates us from other money managers.
Clients of Berkshire Money Management during 2003-2007 as well as during March 2009-March 2010 know that we get back into the market during recoveries. However, at the risk of sounding cavalier, we do not worry about decreases in portfolio values due to regular and ordinary stock market corrections (note that there is a world of difference between a correction and a crash).
That’s not to say that we do ignore such corrections – we are laser focused on such pullbacks. In fact, much of this Second Quarter Update for the Economic Outlook for 2010 has been focused (perhaps overly focused) on a correction that we expect to occur. Why? While we are comfortable with portfolio value fluctuations and stock market swings, we also know that stock market crashes often begin from what appear to be something a little more regular and ordinary.
Berkshire Money Management is not like other financial advisers that sign on clients, plug them into a portfolio, and then walk away leaving you sold on the mantra “invest for the long run.” After all, as John Maynard Keynes said, “in the long run we’re all dead.”
Those same “other” financial advisers are also famous for saying “you can’t time the market.” Berkshire Money Management argues that if a financial adviser doesn’t try to protect their client’s portfolios and disguises their lack of talent and attention by demonizing smart and intuitive active portfolio management, then they aren’t working hard enough to keep your business.
The bottom line is a correction is coming, but it’s not a crash. The primary bullish trend remains intact.