June 30, 2011

Market Summary – 2nd Quarter, 2011

The poem by Emma Lazarus inscribed on the Statue of Liberty says “Give me your tired, your poor, your huddled masses yearning to breathe free…” It speaks to a sense of mutual opportunity. Those viewed as “the wretched refuse” by other nations had an open door to America’s land of freedom. Our country invested in the downtrodden. Individuals rejected elsewhere provided the foundation of our America’s ultimate prosperity.

The downtrodden can be found far and wide in today’s economy. There are millions of unemployed and underemployed Americans, struggling businesses and foreclosed homeowners.

Many investors suffered for more than a decade in a market that has experienced two 50%+ drops in prices, followed by recoveries. Since the 2008 financial crisis, investors experienced numerous “black swan” events. Today’s headlines are continually filled with disconcerting news, be it the U.S. economic slowdown, Middle East uprisings unsettling the oil markets, lingering problems plaguing Japan in the wake of the tragic earthquake and tsunami, sovereign debt problems from Greece to Washington and even a lockout of pro football players.

The picture creates a gloomy environment even though the economy is still in recovery mode. Despite the flood of negative news, our best companies have better balance sheets than at any time in history – in excess of $2 trillion in available cash. Firms that make up the S&P 500 Index are on pace to generate record earnings (profits) this year. Yet one could make the strong argument that equities (specifically those of well-managed, multinational corporations that create products and services to meet the world’s challenges) are now the unloved, the overlooked, the forgotten. The predominant mentality of the market is to “sell first and figure it out later” whenever bad news arises. Fear remains the driving emotion as many investors sense that every problem has sinister and wide-reaching tentacles that will ultimately result in another economic pandemic.

Investors are uncomfortable and many don’t trust the stock market. This has created the investment world’s version of the “wretched refuse” – under-appreciated stocks that offer a dynamic opportunity for individuals to generate wealth in the years ahead.

Down so long it looks like up
Beginning with the closing days of April through mid-June, the market soured and the S&P 500 lost more than 7% of its value. The current environment is scarred by weak job reports, political paralysis over budgets and a housing slump. Investors have become accustomed to dramatic, day-to-day price swings as the market reacts to every headline. Despite this bitter mood, the market continues to demonstrate resilience.

Bloomberg News reports that through all of this, earnings for S&P 500 companies continue to grow and are back in line with their historical average annual increase of nearly 7% over the last 51 years. They also report that this is not yet reflected in stock prices, suggesting that equity valuations are “stuck near credit-crisis levels.”

One indicator to demonstrate how stocks became the “wretched refuse” of the investing world is known as the equity risk premium. It is a measure of the excess return that is theoretically demanded by investors as compensation for “taking the chance” of owning stocks rather than putting their money to work in a “risk-free” alternative, namely long-term government bonds.

The equity risk premium historically (dating back to the mid-1980s) fluctuates within 1% of the so-called “risk-free rate” – the yield on 30-year U.S. Treasury bonds. In fact, the moving average of the equity risk premium over that time has hovered between 0% and 1%. In other words, equity investors’ enthusiasm for stocks is generally high enough that they don’t perceive a significant risk factor compared to owning bonds.

The attitude of investors has changed dramatically since 2003. Money has not flowed freely into equities. This is evident by the equity risk premium climbing to more than 5%. It averaged about 3% during the last eight years. In mid-2011, it stood at 3.66%, nearly three full percentage points higher than its moving average over the past 27 years of 0.70%.

Today’s high equity risk premium indicates that investor confidence in equities is low. On the face of it, that might not seem to be something to celebrate. But in reality, the number is a contrary indicator. Historically, when the equity risk premium is high, stocks tend to perform well in the subsequent months or years. It is a sign that equities offer real value.

This too shall pass
The media’s presentation of news, particularly on the negative side, tends to add to a sense of fatalism for many who have become cautious about the benefits of investing in equities. It is important to remember that even the worst events in our history reach a low point, and things get better from there. In many cases, it is the part of the story missed by the headlines that has more bearing on our economic fortunes. Examples related to the recent spate of bad news include:

• 139 million workers – The media’s focus is on the 9.2% unemployment rate, not the 139 million Americans who are employed as of June 2011.
• Post-earthquake Japan – A long, $300 billion rebuilding process is underway in Japan. Industrial production rose by a record 5.7% in May. Japan’s stock market has regained half of its lost ground. (Note – the supply interruption from temporarily shut down Japanese manufacturers may have contributed to recent job weakness in the U.S. Most of those factories are back on line today.)
• Moderating oil prices – Just as it looked that we might have to endure $4.00/gallon gasoline prices throughout the summer, the oil price spike that developed in the spring subsided.
• Debt-saddled European nations are not the next Lehman – The market may briefly react to daily news coming from Europe, but probably won’t be blindsided by debt problems in Greece, Spain and elsewhere as it was with the Lehman Brothers collapse. The problem has festered, and Europe will have time to come to the rescue.
• Government spending on the block in Washington – The politics of the debt negotiations in Washington may be ugly, but at least policymakers across the board are putting an emphasis on controlling spending rather than raising revenues. Some improvement in our own debt problems and better controls on spending will be an encouraging development in this country.

The king of negative sentiment – the housing market
While many are baffled at the flat, jobless recovery, the main suspect isn’t hard to locate – the housing market. Since the recession ended in June 2009, hiring in most industries increased. By contrast, during two years of this recovery, an additional 490,000 construction jobs were lost (on top of previous large losses). That alone represents nearly 4% of the unemployed.

Much of the weakness is attributed to the collapse in new home construction. Between 1960 and 2007 the number of new private housing units authorized by building permits rarely dropped below one million on an annualized basis. The last three years have been the worst in over a half-century for new home construction.

This trend will change. Residential investment – the amount of money spent on housing – was too high in the middle of the last decade, about $300 billion more than required to meet housing needs. Now, residential investment is more than $1 trillion below trend to meet growing housing needs. At some point, new construction will have to make up for that underinvestment.

Additionally, the rental vacancy rate has shrunk from a peak of 8% to a normalized level of 5.5%. Demand for single family and multi-family housing is likely to grow. At that point, supply won’t meet demand.

Add to this scenario the fact that we’re approaching a point where the so-called “echo boomers,” (children of the baby boom generation) are ready to buy their first home. It is estimated that there are 75 million of these young adults born between 1979 and 1995. Many felt priced out of the market before the bubble burst. Housing prices have dropped dramatically since 2007 and mortgage rates are still extremely attractive. This market is ripe for a rebound.

The timing of any recovery is unpredictable. Markets will rebound and construction of new housing will improve. Warren Buffet stated on CNBC in March, in commenting on his firm’s purchase of a brick producer, that the firm will lose money “this month…next month…the month after,” but “one year, two years, five years from now, people are going to be using a lot of brick in new houses.”

This industry alone is likely to be huge contributor to economic growth when it inevitably recovers.

Staying focused on the facts, not the commentary
To those who fear that the black swans are flocking to create a repeat of the 2008 scenario (financial crisis, a deep recession, the global economy on the brink…) here are a few facts that have emerged lately that seem to contradict that gloomy vision:

By early July, the S&P 500 had recovered nearly all of the ground lost from its 2011 peak reached on April 29
Looking deeper into the broader market, the S&P Transportation Index has reached a record high in July, a key indicator of solid business activity.

Markets from Germany to Korea are back to reaching their highs for the current cycle. Developing markets like Malaysia, Chile, Indonesia and Thailand are at or close to all-time record highs.

Laying the foundation for future opportunity
When the tired and poor were landing on our shores in the formative years of this country, it might not have seemed obvious that our nation would derive any value from their presence. We know of course that over time, they contributed greatly to our prosperity. A similar idea seems to permeate individual investors’ psyche today, wondering if those stocks that were tossed and turned over the past decade can be the engines of growth for tomorrow.

It is important to acknowledge that clear headwinds remain and markets will undoubtedly go through challenging periods in the months and years to come.

The preponderance of negative news, aided by the more than occasional black swan event in recent times, has only made investors more skeptical of the value of owning stocks. The discomfort in the short-term is not pleasant and can be downright frustrating, but it has resulted in more attractively priced stocks that offer great reward potential.

Among the key points to keep in mind when trying to look past the current wave of negative headlines are:

• Despite the world’s vast challenges, free markets are more prevalent than at any time in the history of the earth. This can only mean more opportunity for investors.
• There are well-managed corporations headed by capable leaders who understand how to grow their businesses profitably over time. This has been the case in the history of our nation’s rise as an economic power and continues to be the case in an expanded global market. The record earnings U.S. companies are generating is a testament to continued business excellence.
• The world is still growing demographically and economically, a fact that will benefit companies positioned to benefit from that growth.
• Stocks of many of these quality companies are very attractively priced, offering a generational opportunity for long-term investors.

To the extent it helps to create opportunities to find downtrodden stocks with long-term values, short visits from black swans are welcomed here.

~MPMG

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.