It’s the end of the world as we know it…and I feel fine!
June 30, 2009
Market Summary – 2nd Quarter, 2009
Maybe it is a sign of the times. When markets are struggling, we just can’t get some songs out of our heads. In a past newsletter, we referenced Joni Mitchell’s “Big Yellow Taxi” (“they paved paradise & put up a parking lot”). While the passing of Michael Jackson might have led you to expect titles like “Thriller” or “Bad” in the headline, we’ve been hearing a different song – one by R.E.M. whose title we borrowed for this quarter’s discussion. The point is simple – the end of the world, from an investment perspective seems to be on people’s minds these days. From our perspective, we’re much more optimistic. To be clear, we fully comprehend that the challenges facing the economy are real and significant. What we don’t buy into are the analyses that extrapolate today’s problems as the start of a “forever” trend.
A sense of history is always important, especially in times like these, when doomsayers are having a field day. We’ve confronted a number of “end of the world” challenges in our not so distant past, and yet, in each case, we always ended up feeling fine.
Newsweek columnist Fareed Zakaria (June 22, 2009 issue) cited a number of circumstances over the past couple of decades, where experts were convinced dire consequences would result from a negative turn of events.
• The 1987 stock market crash, when the Dow Jones Industrial Average dropped 23% in a single day (the largest one-day loss in history) was seen as a precursor to a severe recession, according to one of our nation’s most noted economists, John Kenneth Galbraith. Zakaria recalls Galbraith writing at the time that he hoped the coming recession would not be as painful as the Great Depression. Of course, the years that followed were among the most prosperous in the nation’s history.
During the 1997 East Asian Crisis, Zakaria notes that recent Nobel prize-winning economist Paul Krugman wrote “We could be looking at…the kind of slump that 60 years ago devastated societies, destabilized governments and eventually led to war.” Two years later the crisis was over, Asian economies prospered and no blood was shed.
The 1998 collapse of Long Term Capital Management, Zakaria reminds us, was considered to be the beginning of the end for hedge funds. In reality, hedge funds were entering a period where they became a dominant force in the industry.
We also acknowledge that the experts can be wrong on the upside. It was only a decade ago when many were convinced that “everything had changed.” We were in the midst of a new, information economy. Chairman Alan Greenspan was the “maestro” who masterfully, and without fail, would keep America’s economy growing. Recessions were a thing of the past. Of course, that was two recessions ago.
A major lesson of history is that today’s storm too shall pass. While many are talking of an entirely new environment for investors, we’re convinced that when all is said and done, stocks will return to their historical place as the best source for long-term wealth accumulation.
Why the continued faith in stocks? A point we think is worth remembering is that businesses can outlast even the worst governments and weakest currencies. In recent times, we saw it after the end of World War II. Germany and Japan may have lost and had their nations transformed by the outcome of the war, but it is notable that many companies in existence when the war started continued to operate during the war and found new paths to growth afterwards. German firms like Siemens and Daimler-Benz, and Japanese giants like Mitsubishi and Fuji are just a few examples.
The point here is that wealth is generated from businesses, not from governments. This has been the case throughout the history of capitalism, and even through some of the darkest hours, the capitalist model has prevailed. Today’s challenges, though serious, pale in comparison. Good businesses will continue to find ways to grow and build opportunities for wealth.
Downsizing the degree of risk in the market
The dual risks of a systemic meltdown of the financial system and an economic downturn comparable to the Great Depression, which seemed very real last fall, have clearly been averted. Led by Federal Reserve Chairman Ben Bernanke’s efforts, stability has returned to the financial marketplace. A number of firms that received the government’s TARP (bailout) payments last fall have paid the money back to Uncle Sam and many are returning to profitability (and sadly, even trying to resuscitate their outrageous executive bonus structures). There are flashes of other positive data as well. Real wages have increased 3.3% over the past year despite a weak job market. Employment in the ISM survey of non-manufacturing firms hit a nine-month high in June. Non-defense capital goods orders jumped 10% in May. All of these factors are signs that the economy has at least stemmed the bleeding.
This is not meant to downplay the current sorry state of the global economy. In late 2008 and the first half of 2009, things have been as bad as we’ve seen at least since the early 1980s. It could go down in history as the Great Recession. What’s more, it appears that patience is required to see this through. Those “green shoots” of marginally favorable news that economists saw sprouting through much of the spring may need a bit more Miracle Gro in order to really generate some excitement. In time, the environment will improve.
No matter how the market performs over the coming weeks and months, the sell-off that drove the major indexes down by more than 50% assure us of one thing – many businesses
are on sale. The S&P 500 now stands at the same level (around the 900 mark) that it first achieved 12 years ago! In the meantime, revenues of just the Fortune 100 companies have more than doubled – from $2.83 trillion in 1997 to $6.55 trillion in 2008.
On a very broad scale, this comparison of market perceptions and business realities demonstrates the case that stocks have become much more of a bargain in recent times.
Are you drinking the Kool-Aid?
This is a phrase often uttered in politics, referring to how either party recites its well-rehearsed views to support various agendas. The term has found its way into the financial industry as well. In the late 1990s, it was utter euphoria.
In 1999 alone, three different books were published with the following titles:
• Dow 36,000
• Dow 40,000
• Dow 100,000
Of course, all of these tomes are now available on the discount racks, and a different flavor of Kool-Aid is being served up today. For example, David Tice, head of the Prudent Bear Fund, which happens to profit from falling equity prices, has predicted the S&P 500 will drop to 325 (a more than 60% decline from today’s already depressed value). Of course, he made this prediction in April, just as the S&P was kicking off its best quarter of performance in a decade.
In our last two newsletters, we dealt with the subject of whether the sky was falling. When the very idea of capitalism is in question, it becomes difficult to value stocks on a fair basis. While the markets will likely remain volatile and the timing of the economy’s turnaround is uncertain, we are convinced that we have moved past the most serious risks that existed in the markets following last fall’s collapse of Lehman Brothers.
As we approach the “beginning of the end” of the current correction, the merits of individual companies will again take center stage. It will be less important to drink the Kool-Aid served up by the “big picture” bears and bulls. Given the current prices of many quality stocks, the more important matter is whether consumers and businesses are, in reality drinking the Kool-Aid, in other words, spending money again. When the economic cycle improves again, many businesses, particularly those which can capitalize on global demand, should be in a position to benefit.
Growth is busting out all over
Much of the trepidation we hear today is about how the future will be so different – that demand will be lower, the economic recovery will be slow, and business opportunities will be fewer than before.
In reality, this seems unlikely, because it isn’t just about America anymore. This is a global stage, and the world around us keeps growing. The rise of the middle class on a global scale, particularly in large developing countries like China and India, is for real.
If you are looking for evidence of areas where economic growth is inevitable, here are just a few examples of how the continued explosion of the global economy will affect demand:
A recent study by Goldman Sachs estimates that the size of the global middle class, already about 1.5 billion strong will rise to 3.6 billion people by 2030. The World Bank estimates by that time, 93% of the middle class will reside in developing countries.
• On the energy front, British Petroleum reports that energy consumption from “non-OECD” countries (that is, those developing nations not among the 30 members of the Organization of Economic Cooperation and Development) surpassed that of OECD nations in 2009. It is the first time in history this has occurred, and it seems likely that the trend will not change.
• Car sales in China for the first half of 2009 have surpassed those in the U.S. for the first time.
• CIBC world markets estimates that infrastructure needs worldwide will result in $35 trillion of spending on public works projects over the next 20 years.
• A report produced by Deutsche Bank and the University of Wisconsin predicts that the caloric needs of the planet will rise by 50% over the next 40 years. This will require new developments in agricultural production in order to meet the demand. Yet at this time, the United Nations estimates that food production could fall by 25% in the coming years. The just completed G-8 Summit in Italy included a commitment of $20 billion over three years as part of a food security initiative.
• The global consumption of fresh water is doubling every 20 years, yet the world has not discovered any new sources of water in the past 10,000 years.
These secular, long-term economic trends represent obvious opportunities for investors in key industries such as:
- Energy (fossil fuels and alternatives)
Rather than worrying about whether the economic recovery will occur in the second half of 2009 or the first half of 2010, the developments we’re talking about here have a lot more to do with positioning a portfolio for long-term growth. Timing is not a big issue. The key is to be invested in opportunities like these that will capitalize on long-term trends that seem, almost inevitably, will develop worldwide.
Living in parallel universes
In each of the areas we discussed above, there is tremendous potential for capital appreciation – owning businesses that are positioned to capitalize on the world’s booming demand. We happen to be living through one of those rare periods when an environment of excessive fear has driven down the prices of many good companies that should be well positioned for these opportunities.
In a sense, investors are confronted with parallel universes. Domestically, we continue to struggle with the deepest economic contraction in decades. This is part of the hangover from years of over-consumption and under-saving (the savings rate dropped from 11% in 1984 to 0% in 2007). We’ve reached a boiling point where the lack of fiscal discipline, by governments, businesses and individuals, is being realized.
At the same time, capitalism is flourishing around the world. As we’ve shown, the ranks of the middle class on a global scale are skyrocketing and more people are being pulled out of poverty through economic development.
This is a clear example of investors needing to step away from the trees (the day-to-day coverage of market and economic developments) to see the forest (the big picture of future global economic growth). Up close, we see the distress of our domestic economy, and hear the talk of how economic growth in America will be constrained even after the recession ends. It is hard to be encouraged when you are surrounded by that negative message.
As a result, a lot of money has flowed into cash equivalent vehicles and government bonds. This trend ignores the realities of our financial future, which dictate the need for higher returns than either bonds or cash are likely to deliver. When you think about it, most cash instruments pay only slightly more than the yield you get from sticking your money in a mattress. Investing in government bonds is essentially agreeing to lend money for a period of 10 to 30 years, but earning interest in the 3.5% to 4% range. It is not realistic to think of this as a way to build long-term wealth, particularly given the financial environment we are likely to see going forward:
Higher tax rates to account for the past and current glut of government spending. Tax efficiency is also important. The tax on interest has always been higher than on capital gains.
• Low earnings on fixed instruments in a low interest rate environment over the next few years given the modest rates of domestic economic growth that most anticipate
• A loss of purchasing power not because of a rapid increase in domestic demand, but due to the continuing weakness of the dollar. As the Federal Reserve ramps up the printing presses to put more currency into the economy the government takes on huge debt, the global market will question the validity of the dollar. We’ve seen some of that already with suggestions of forming a global reserve currency (a role currently played by the dollar, which helps keep demand for dollars high). It seems likely that our currency will face continued debasement going forward, which could result in a faster increase in living costs for Americans.
It is time to be realistic about what strategy will offer you the potential to rebuild your portfolio and secure your financial future. You need to earn the kind of returns that stocks have historically provided. Fortunately, that seems to be a viable option when we look at the big picture of the world around us.
We believe that, as many U.S. companies beef up their overseas operations and focus on the opportunities abroad, the markets will recognize the long-term growth story as well. The business world is not about to move backwards at the same time that demand for goods and services on a global scale is rising so dramatically. This is the most promising place to uncover future wealth potential. Stocks are still the answer for anybody thinking about the long run.
MPMG 4th Annual Speaker Series Event
Michael Mandelbaum: “Economic Turmoil, the Financial Crisis, & the Silver Lining: What Lies Ahead for America and the World”
We’ll gain further perspective on the global marketplace from our featured guest at the 4th annual MPMG Speaker Series event, Michael Mandelbaum. He is one of America’s leading authorities on international affairs, known for his ability to explain, in clear and accessible ways, the meaning and consequences of complicated global developments and trends. Dr. Mandelbaum is the Christian A. Herter Professor of American Foreign Policy at the Johns Hopkins University School of Advanced International Studies in Washington, D.C. His credentials include stints as a professor at Harvard, Columbia and the U.S. Naval Academy.
Mandelbaum’s opinion pieces have been published in The New York Times, The Wall Street Journal, The Washington Post, The Los Angeles Times and TIME Magazine. He has authored ten books and edited twelve more. Mandelbaum will share his expertise on world affairs and how they might impact investing in years to come.
The event takes place on August 27th. More information will be available soon.
MPMG In-House News
Laura Harvey, (soon to be Laura Friend) came to MPMG as an intern over five years ago. What was initially a temporary position quickly became permanent as we realized what a wonderful addition Laura was to MPMG. Recently, Laura passed the second part of a two-part exam to achieve the designation of CIPM (Certificate in Investment Performance Measurement). This rigorous exam administered by the CFA Institute requires in-depth knowledge of performance calculation, composite construction, attribution analysis and ethics to accomplish this certification. Congratulations to Ms. Harvey…we are all proud of you!
Their can only be one “low-handicapper” in the Grodnick family. Earlier this year (after decades of Phil holding this honor), Harrison claimed the “low-handicapper” title for the first time in family history from his father. Phil took this to heart, and has recently re-claimed his throne…and did so in emphatic fashion! On July 3rd, 2009, Phil sank his fifth hole-in-one of his career. On the 149-yard 11th hole at Golden Valley Golf Club, Phil hit a perfect shot and reminded Harrison that, “It is better to have loved and lost, than to never have loved at all”. Congratulation to Dad!!! (I promise not to break this hole-in-one trophy like the one I did when I was 8 years old).
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.