Third Quarter 2011 Letter to Clients


The four most dangerous words in investing are: “This time it’s different.”

- Legendary investor Sir John Templeton (1912-2008)


Consider the above quote from one of the most successful investors in history, who experienced nearly every major historical event of the 20th century. He died in 2008 at the age of 96, just as we entered the worst economic crisis he had seen since his teenage years. Yet, despite all the crises he had weathered as an investor – depressions and recessions, war and terror, impeachments and resignations – and all he saw coming in the financial crisis that was brewing at the time of his passing, John Templeton knew the biggest mistake investors made over and over again was based on an underlying, erroneous assumption:

“This time it’s different.”

Really, though, the flaw is the assumption that is one step beyond that: “This time it’s different and so we must do something different. We must react. We must protect. We must abandon the long-term plan in an effort to save ourselves from the short-term catastrophe that is so clearly at hand.”

In times of crisis, it becomes exceedingly easy to leap to such a conclusion. The facts are right there before us, and we are bombarded with them on a daily basis. This time, we are told, is different. And not just different, not just worse, but worst. Broken beyond repair. Don’t just sit there, they tell us; do something!

Certainly this is much of the mindset we hear in the conventional wisdom today, and it’s not hard to leap to dire conclusions looking at current events. At the time of this writing in early October, large U.S. stocks have moved into official bear-market territory, joining their small cap and international stock counterparts that hit that threshold in mid-August. As we look back on the Third Quarter, we see a spate of dramatic events that sent stocks into their tailspin: a protracted, bitterly partisan debate over the debt ceiling, the subsequent downgrade in the U.S. bond rating, and the never-ending Eurozone economic crisis. All of these events sent stocks reeling and ramped up volatility to levels not seen since the fall of 2008. And there is still yet plenty of drama to be played out in the weeks and months ahead.

So there is, indeed, much to fret over, and it is easy to believe that this time really is different. There is no definitive answer in this regard; outcomes are unknowable, and that is the uncertainty of equity investing. On the other hand, when we look back at the historical timeline and see where the traps for investors have been, it is plainly evident that the traps were the bumps along the way in which investors fell victim to just the mindset Lord Templeton warned us about.

Investors (and their advisors) must therefore beware the temptation to extrapolate today’s crisis into tomorrow’s apocalypse, because it is that mindset that causes most people to experience failure instead of success in their investing efforts. In times of maximum stress, our deep-seated need for safety and security wells up inside us and drives us to make panicky, emotional reactions with our money that always turn out, in hindsight, to have been hasty and ill advised.

Surely one day in the not too distant future we will look at one of those chronological timelines that tracks the stock market’s growth over time while noting major events along the way, and we will see notations in 2011 for “U.S. debt ceiling crisis” and “S&P downgrades U.S. AAA rating.” Perhaps we will also see “Greece defaults” and “European Union dissolves.” Who knows?

There may be a notable downturn in the market’s trajectory at that point, but in the grand scheme of the market’s history it likely won’t amount to much. It likely won’t amount to much for investors either – at least not those who kept the faith. But for those investors who blink, that blip on the timeline will mark yet another point in which they panicked and bailed out and failed to participate in the recovery that inevitably followed.

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We won’t be so immodest as to predict how today’s Crises Du Jour will play out over the short term, but since the media seems to have the lock on the doom-and-gloom angle, we thought we would raise a few points that show that, despite all the prevailing negativity, there are a number of reasons to be encouraged about the future of stock returns:

Stocks are a relative bargain right now: With price-to-earnings ratios back close to single digits for large-cap U.S. stocks, there is tremendous upside potential for equities going forward. This is not just our opinion; two recent articles in the Wall Street Journal featuring Vanguard founder John Bogle (“Why A Legendary Market Skeptic Is Upbeat About Stocks,” September 10, 2011) and esteemed market historian Richard Sylla (“A Long-Term Case For Stocks,” September 12, 2011) echoed these sentiments.

Meanwhile, the corporations that comprise the S&P 500 just logged their most profitable quarter ever and are sitting on more than $1.25 trillion in cash – money that is waiting to be put to work once confidence is restored. So while there are a number of short-term risks to stocks that the media continues to obsess about, the long-term prospects for stocks are actually very encouraging.

Individual investors are panicking. And they are almost always wrong: The four months ending in August saw individual investors pull more than $75 billion from U.S. stock funds. Incredibly, this is more than flowed out of U.S. stock funds in the five months following the collapse of Lehman Brothers! Small investors have an uncanny, and unfortunate, knack for buying high and selling low, and many of those investors who are bailing out of the market now have only recently gotten back in the market, after the dramatic gains that occurred in 2009 and 2010.

Keep in mind also that there is $2.35 trillion sitting in taxable money market funds – money that is earning nothing in today’s low-interest rate environment. At some point, when the panic selling has abated, that cash will flood back into the market.

The dividend yield of the S&P 500 now exceeds the yield on the 10-year Treasury: In the Third Quarter, the dividend yield of the S&P 500 index exceeded the yield of the 10-year U.S. Treasury note – only the 20th quarter in the last 58 years in which this has happened. This occurred as investors ran to the “safety” of government bonds (bond yields fall when investors flood the market and bid up prices). At the same time, the dividend yield on the S&P 500 climbed as the average share price of S&P companies plunged and the dividends remained steady. The net effect of this shift is that an investor could own an S&P 500 index fund, reap a dividend yield that was greater than that of the 10-year Treasury, and still have all the upside that comes from owning 500 of the world’s largest, most innovative companies. Such deals don’t come along very often!

A resumption of economic growth will solve our debt problems in a hurry: John Steele Gordon, the foremost historian on our national debt, authored an informative column in the August 29 issue of The Wall Street Journal titled, “A Short Primer On The National Debt.” In this column, Mr. Gordon raised the point that we can return the debt-to-GDP ratio (which he considers far more important than the total amount of debt) to the 2000 level of 56.7% in just a decade if we can experience GDP growth equal to that of the 1990s. He also pointed out that Congress can shave trillions from the national debt in an instant just by adjusting the cost-of-living assumptions in Social Security and Medicare.

Granted, these are hardly givens. But they do show that there are realistic ways in which our national debt crisis can become a non-crisis much faster than many people imagine. And with the amount of pressure on Washington being applied by market forces, doing nothing is not going to be an option.

Deep drops in the stock market are usually followed by gains: As we have seen over the past few weeks, stock declines often come quickly and unexpectedly. But those who head for the exits after such declines run a very high likelihood of missing out on the gains that historically come on the other side of a big selloff in stocks.

The chart below illustrates this. The two red bars reveal that market downturns are not as rare as investors often believe. The light red bar at left shows that nearly one-in-three quarters in the market is negative, averaging to about one such quarter a year. And about once every three or four years the market experiences a major downturn of 10% or more in a single quarter.

Now for the good news. The light green bar in the chart reveals that 70% of the subsequent one-year time periods following a decline of 10% or more have been positive, while nearly 90% of the following five-year time periods have been positive.
This is why so many investors get “whipsawed”, as the saying goes in the investment industry – they catch the downturns, which come quickly and unexpectedly. They run for the exits. And then they miss the inevitable recovery.

The financial markets are forcing change: It’s easy to look at the volatility in the global financial markets as a sign that things are irretrievably broken. But there is another way to look at this as well: By shifting capital away from countries and governments that are, in the market’s opinion, doing things the wrong way, investors are forcing the very changes that need to be made to resolve those problems.

As one German trader noted recently as Eurozone leaders met to rethink their efforts on how to tame their debt crisis, “It’s got to be something radical. Otherwise the financial markets won’t accept it.”

There is another side to this coin as well. Where risk is perceived to be greater, markets will demand a higher return.

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Much has been made of the fact that the Dow today is hovering around the same level it first attained back in 1999, when the index crossed the 11,000 threshold for the first time. We won't quibble about the fact this is strictly a price comparison and not a total return figure that includes reinvestment of dividends (historically nearly half of total return). We also won’t mention the fact that many other equity asset classes have enjoyed significant gains since 1999.

Instead, let's examine what the market fundamentals looked like at Dow 11,000 back in 1999 and compare them to Dow 11,000 today.

The 1999 version of Dow 11,000 was attained at the very height of what then-Fed Chairman Alan Greenspan termed “Irrational Exuberance”, a phrase that came to be the hallmark of that era. The Dow had more than doubled in just a few short years, and investors were pulling all the money they had out of bonds and cash and piling it into the riskiest sectors of the market. Optimism among individual investors -- always a bearish indicator -- was at an all-time high, with the American Association of Independent Investors' (AAII) "Sentiment Index" registering a record high 75% of its members as bullish by the end of 1999, with only 13% bearish. When surveyed, the average investor believed that annual stock market returns of 20% to 30% were “reasonable.” And why not? This was a fraction of the 200% to 300% returns that many investors were enjoying in their dot.com stocks.

Suffice it to say, caution was not the word of the day in 1999, and the Dow’s pricing at that time reflected it, with a price-to-earnings ratio north of 25 – a level that was nearly 50% above its historical P/E ratio of 18. The 1999 version of Dow 11,000 was priced on the conventional wisdom of the day, the supposed “New Era” in which earnings didn’t matter anymore; all valuations were based on “upside potential.” (Sounds quaint now, doesn’t it?)

Now contrast this with the environment we find ourselves in today. The Dow’s current P/E ratio hovers near single digits – nearly 50% below its long-term average. Individual investors are about as far from being bullish as you can get, with the AAII sentiment index showing only 25% of its members being bullish. Billions of dollars are flowing out of equity mutual funds every month, and the media is full of reports that investors are focused on “not getting burned” again in stocks.

The following chart of the Dow’s historical P/E ratio over the past decade tells the story of market forces ultimately bringing the Dow’s valuation back in line with its fundamentals:

In short, the 2011 version of Dow 11,000 has a great deal more upside potential than did the 1999 version, and investor optimism is about as low as it has been in forty years. Both of these factors are extremely bullish indicators for large cap stocks going forward.