Back To (Old) School

We hope you enjoyed your Labor Day weekend.

A while back, I was thumbing through my bookshelf copy of Graham & Dodd’s classic text, Security Analysis, first authored in the 1930’s.  Coincidentally, this was just before the recent Wall Street Journal article declaring the “Decline of the P/E Ratio,” among other articles that occasionally allude to their work.  Strangely, the two seem to be most readily acknowledged either in times when they’ve been dismissed as passé, out-of-step with cutting-edge quantitative techniques, or, conversely, their traditional and straightforward ways of looking at the world have been “rediscovered” by investors discouraged by complicated modern methods.

It used to be required reading “back in the day,” but now you only tend to see the text referenced in passing and usually only examined thoroughly by contrarian investing diehards and academics.  What we were reminded of most is the timelessness of the material.  The jargon has changed a bit with the times:  what were “popular” stocks in the 1930’s became the “Nifty Fifty” in the 1960’s-70’s, and later transformed into what we call “growth” equities today.  A preference for “out-of-favor stocks with unbecoming prospects,” considered to be a common-sense way to seek out potentially underpriced businesses, refers to “value” investing today.  Obscure and not so well-tracked “smallish companies” became today’s much more highly developed small- and mid-cap markets.  REITs and foreign assets, especially those from the emerging and frontier markets, were not even on the radar.  This era pre-dated Modern Portfolio Theory by a few years, so “portfolio construction” consisted of simple approaches, such as buying different types of stocks, from different industries, that behaved differently from each other at different times in the business cycle—the aim being to provide some protection from possible losses if/when some of these ideas went wrong.  This was coupled with buying a few bonds that varied by issuer and maturity, adjusting the types you owned based on where interest rates currently sat, as well as where you thought they were likely headed in the near future.  Sounds like common-sense diversification to us.

In many respects, it is encouraging how little has changed since the book was written.  Not that the world hasn’t evolved; it could be argued that the world has undergone the most dramatic changes in its history during the last century.  What hasn’t changed, and this becomes more apparent through its matter-of-fact treatment in the text, are basic human nature and risk-taking tendencies.  At that time, definitions seemed a bit clearer than today—market participants could be categorized as momentum-focused “enterprising” or “speculator” types, fundamental research-oriented “investors,” or “savers,” at the lowest end of the risk aversion scale.  We have gravitated toward more lengthy questionnaires and other evaluations in recent years, but these general personality characteristics seem to still be the output.  A “saver” will probably not feel comfortable in an aggressive portfolio, unless properly educated as to how important time horizon is to one’s perspective, as well as the type of volatility to expect (or realizing the opportunity cost of not reaching one’s goals by being too conservative).  “Speculators” of the day should have been prepared for frequent strikeouts in return for the occasional home run.  Whatever the current story is (technology, gold, global depression), change the details a little bit and projected thesis from present to future is often quite similar from era to era.

What strikes us most though these reminders are today’s short-term focus and information overload, not to mention minute-by-minute quotes and dirt-cheap commissions.  Well-documented are the tendencies of investor confidence and perception of better control to grow in line with the volume of available information (although returns are often no better from the excess of information).  Regardless of the period, though, the paths tend lead to excessive greed or excessive fear.  Unfortunately, as we experience from our vantage point of exposure to all types of investors, actions in response to emotions tend to be the wrong ones, and are made at the wrong time.  This is both a bull- and bear-market lesson.  It is almost irrelevant as to what’s occurring in the outside world (the book was written at the outset of the Second World War, prior to Pearl Harbor and the American entry into the war; nevertheless, a time of great global uncertainty and concern).  Markets react now, as they always have, to continually changing expectations, hopes and dreams of tomorrow’s reality, not reality as it stands today or stood yesterday.  The fear of what could happen is often far worse than what actually does happen—the most dramatic events of the past have often been surprises. 

That said, it is not unusual for our interpretations to be colored much more strongly by what happened yesterday than what occurred five years ago.  No wonder so many are scarred by 2008’s events as opposed to what we intellectually know about long-term market behavior—that stocks have tended to return 8-10% per year, bonds 4-6%, and cash a shade more than long-run inflation, etc.  These averages have held true for several hundred years, through global military and environmental catastrophes and political upheavals, as well as through good times.  Challenging cycles are often followed by good cycles, and vice versa, as the vacillation always overshoots that rational middle ground we seek.

People on TV keep telling us we have a lot to worry about.  The negative sentiment out there echoes that.  The most recent Investors Intelligence Poll showed “bulls” at below 30%, which is the first time since late March 2009 this has happened.  What we find interesting is how the magnitude has changed of what we’re supposed to worry about.  In the fall of 2008, nearly two years ago now, it was the potential systemic failure of our financial system—up to the point of a well-publicized investor or two actually wondering whether bank ATM’s would function for a few days.  That didn’t happen, of course, and we’re well past that point of immediate crisis. 

Now, our worries have shifted to whether or not seasonal adjustment factors in the employment market have either helped or hurt “real” employment; and, despite rebounding revenue and earnings growth numbers that have been nothing short of very strong in many cases, focusing on cautious/realistic words from management as a reason to cast an entire report in a negative light (the question of why a CEO would ever be overly optimistic in the first place and subject themselves to likely future disappointment is another matter entirely).  It may help to put these concerns in perspective.  Despite the fact that economic recoveries are not a straight-up process, but rather a two-steps-forward, one-step-back type of thing, we are in better shape than we were two years ago.  Then again, if we were too optimistic (think late 1990’s or so) when nothing could go wrong, then we probably would have something to worry about. 

Muddling through does not sound as dramatic as the high and low extremes, but it is the base case with a high probability chance of occurring.  History tells us this is the correct road.


Economic News

On Monday, reports showed that July Personal Income rose less than expected at +0.2%, while Consumption was slightly better than expected at +0.4%.  One important part about consumption is the inverse—it dropped the savings rate down 0.3% to 5.9%.  Perhaps the temporary culture of frugality has waned as income prospects have improved slightly.  The Core PCE number was up +0.11% for July, which equates to a year-over-year number of +1.38%…a within-target figure.

The Case-Shiller Home Price Index of 20 major U.S. metro areas rose +0.28% for June, which was a little better than forecast, and resulted in a +4.2% rise for the year-over-year period.  Note the small monthly rise was seasonally-adjusted; the non-adjusted (“real”) number was +1.02%.  As pricing is done with multi-month averages, transactions from the tax credit period were still reflected for the most part. 

We’re always interested in the individual metro area data, which are reflections of both the microeconomies in each region and their own individual price bubbles (or lack thereof).  The biggest month-to-month gains took place the rust belt cities of Detroit, Chicago and Minneapolis, while the biggest drops were out west:  Denver, Las Vegas and Seattle.  Year-over-year, the major California markets and Minneapolis were all up over 10%, while Las Vegas, Seattle and Charlotte (the latter two being pillars of strength early in the downturn) performed the worst—with price declines. 

Consumer Confidence rose 2.5 points to 53.5, a moderate positive and mostly due to rising expectations (except for labor market expectations, which measured slightly worse than the prior result); consumer assessments of current conditions slightly deteriorated.

The ISM rose 0.8 to 56.3 for August, which was a bit of a surprise for many—stronger production and employment indexes led the upward move, but was tempered by slightly weaker results in new orders and supplier deliveries.  A majority of managers reported current inventories as being “about right” for conditions.  However, Friday’s ISM Non-Manufacturing Survey fell a bit more than expected, to 51.5.

Construction outlays fell in July by a more than forecast; May/June numbers were also revised downward, led by weak results on the residential end.  There is no doubt that residential construction is still in a difficult state.

On Thursday, Initial Jobless Claims fell for previous week (down 6,000 to 472,000), which was obviously taken as a positive.  Continuing claims also fell (by 23,000 to 4.456 million), but a portion of this was offset by prior revisions upward.  Unfortunately, the fact that numbers are still “high” left room for additional pessimism by some. 

Productivity for Q2 was revised lower, along with GDP.  Labor costs rose +1.1% for the quarter (a greater rate than expected), but are still below levels of a year ago.  If inflation becomes a concern down the road, labor costs will be an important component to watch.

Pending Home Sales from the National Association of Realtors rose +5.2% for July, better than expected, and represented a bit of a bounce following a terrible May number and slightly negative June report (post-tax incentive).  The Western U.S. reported the highest gains at +11.6%. 

The “big” number of the week was Friday’s unemployment report.  We had a feeling this might make for a somewhat dramatic day, and sure enough, it did… on the positive end.  The results were much better than expected, with nonfarm payrolls down -54,000 vs. the expected -125,000 consensus number (inclusive of 114,000 Census job layoffs), while private payrolls added 67,000 jobs compared to the forecast 40,000.  Hours worked jumped at a 3.5% annual rate, the fastest since the first quarter of 2006.

This may not seem like much, but it’s the directional component we view as important, especially if it ends up signifying a “troughing” of the trend and stokes a turnaround.  Even the most bearish of economists seemed pleasantly surprised by the positive numbers Friday.

Note that the unemployment rate ticked up one notch from 9.5% to 9.6%.  No surprise that some in the media picked up on this and highlighted it as a negative, but the reality is that it’s a by-product of other employment numbers (details from the recent release confirm some of this).  When employment hits its worst point, job-seekers essentially “drop out” of the potential labor pool and are no longer counted as unemployed.  They’re referred to as “discouraged workers,” which is probably a bit of an understatement.  Conversely, when the job picture improves, many of them begin actively looking once again, and “re-enter” the labor pool… when they’re once again counted, it changes the ratios and drives the unemployment number up temporarily.  This is nothing new. 

As it stands now, the job recovery situation has been slow and follows the progression of “jobless recoveries” we’ve seen in the last few decades.  The current recovery has underperformed the pre-1982 recoveries dramatically, yet it has outperformed both 1991 and 2001 thus far at this time in the cycle.


Market Highlights

Market results at this stage of the economic recovery appear to have been largely driven by shorter-term economic releases, as investors have been looking for signs of direction.  Mixed results and low expectations at times don’t often give you much to go on, unfortunately, in that end.  The broader theme from the past few weeks is that economic growth has slowed, but this week saw a bit of a jump in the numbers (see above).  M&A deals have also picked up (over $200 billion worth announced in Aug.) which tends to affect names in the mid-cap area.  For better or worse, Burger King will no longer be a public company, which may or may not affect its fans in our home office.

U.S. equities were up just over 3% on the week, mainly in line with the stronger-than-expected economic reports noted in more detail above.  Financials and consumer discretionary stocks led the way last week, while health care and utilities underperformed with smaller gains.

Foreign stocks, similarly, moved higher in Europe, at 5%, and by a lesser amount in Japan, which didn’t quite reach 1%.  Emerging markets were on par with the U.S. markets with a 3% gain for the week.

In fixed income, bonds suffered in their usual opposite response to stronger economic data, as 10-year Treasury yields moved upward from 2.65% to 2.71%.  Corporate bonds performed slightly better, particularly in high yield.  International bonds were largely flat.

U.S. REITs gained 6%, roughly line with domestic equities, while the international REIT market earned 3%.  Commodities were up about 1%—the small price drop in crude oil was offset by strength in metals and natural gas—not surprising considering the East Coast hurricane situation.  Grain contracts have continued to see higher volatility in response to speculation about Russia’s wheat export situation.


Until Next Time

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.