Ramblings of a Portfolio Manager

Let it Snow, Let it Snow, Let it Snow!

The US equity markets just completed their first positive week in five, a welcome relief to most investors but to the dismay of our TV repairman, who was Bentley shopping after we put a series of Diet Coke cans through the screen in vain assassination attempts on the” gurus” postulating that the market is selling off simply because we are 60-70% off the March lows, which we now need to retest according to their detailed analyses (assuming they are holding the chart correct side up). After a strong start followed by much volatility, the indexes are now slightly in positive territory for the month. The recent rally, which began Tuesday after the Dow closed below 10,000 for the first time since November, startled many market watchers who had no idea whence it emanated. Was it the prospect of a resolution to the Greek debt crisis? The strong US economic data hitting the tape daily? A benign CPI in China? Toyota finally recalling their Camry and Prius models? Yes. A more compelling argument, however, is that Washington was deep under two successive snow storms, which had the effect of suppressing any and all toxic rhetoric on the airwaves. No news is good news!

So where are we now? After our “well deserved” sell-off the major US equity averages are all down about 3% year to date. From their January 19th closing high to their February 8th closing low, most indexes lost about 8% or more. Only the Russell 2000 came close to the “classic correction” number of 10%, having fallen 9.7% between those dates. When one looks at the intraday highs and lows, however, the numbers are a little more drastic and in line with guru expectations, with the Russell correcting nearly 11%, the Dow and S&P dropping about 9% and the NASDAQ losing about 10%. So there you go! Correction meted out, weathered and now over, right? Frankly, in our opinion, this is all just number manipulation. Take the Shanghai Composite, for instance--that index was up over 90% from its November ’08 bottom yet it is down in line with US equity indexes during its “correction,” which began at the same time. Is that enough, too little or too much? Heck if we know. Stocks have no memory of their historical trading prices--just ask anyone who owned Cisco Systems or Nortel in 1999--and, collectively, these indexes are comprised of stocks. So, just as it is nonsense to preach the need for a correction after some random amount of upside from a bottom, it is irrational to suggest that any pre-determined percentage move to the downside during that correction is appropriate and to be expected.

We like to think like the fundamental portfolio managers we are and look at the indexes as individual securities, with financial performance expectations and multiples placed by the market on those expectations. Like a stock, the price of an index is determined by a multiple—e.g. price/earnings-- and that what the multiple is measuring—e.g. earnings, sales, book value and cash flow. For portfolio managers, the denominator--earnings, sales, book value, etc.--is fairly easy to calculate and even forecast. The numerator or Price, however, is what we all want to know so it is the multiple (of earnings, book value, etc.) that fundamental portfolio managers spend most of their time trying to solve.

In the case of the S&P 500, the current Price/Book Value multiple is 2.1x , the Price/Sales is 1.14 and the Price/Cash Flow is 10.0x. All of these are well below their pre-2008 10-year averages and near the lows hit over that same period. The Price/Earnings multiple on 12-month trailing earnings is 18.1x, near the high for the pre-2008 decade, but it is only 14.2x on forward (2010) expected earnings, at the lower end seen during that same period. What’s going on? Market multiples are all about sentiment and sentiment is based on expectations of growth. The higher the expected growth (in earnings, book value, etc.), the more the Market is willing to pay for the future in today’s dollars and, thus, the higher the P/E, P/B, etc. In 2009 S&P earnings per share dropped to $68.6, and for 2010 they are expected to be about $75.8, a level last seen at the end of 2005, when the index was trading over 200 points (19%) higher than it is now. The Market, always looking ahead, is willing to pay a higher multiple on what it perceives as “trough” earnings in 2009, expecting higher growth in 2010 and beyond, yet the S&P is not even at the multiples or level where it began 2005. Why not?

In 2011 S&P 500 companies are projected to earn $87.6 per share, roughly equal to what they earned in 2006, their highest level ever. The index at that time was trading over 350 points higher than today. Obviously, the Market saw something in2005- 2006 that gave it more reason to be optimistic and assign higher multiples than it is now. Was it higher expected near-term earnings growth? Not if you believe 2011 numbers. Was it a lower interest rate environment than we have now? Doubtful, given that we are at zero for the foreseeable future and even a series of rate hikes wouldn’t get us to where we were in 2005 or 2006. So why was the Market willing to pay more then for the future than today? There are multiple (pun intended) factors. To be sure there is the uncertainty discount that the current administration carries with it. Whatever history thinks of Bush/Greenspan the truth is that they were seen then as infinitely more business friendly than Obama/Bernanke are now. Then there is the fear factor, carried over from the near meltdown of 2008, which we did not have in 2005 and which recent sovereign events have rekindled. Like someone who has jumped into an icy pool once, investors will be slow to renter the same water as quickly the second time around. Also to be considered is the diminution of the Pax Americana premium, something that will continue as sovereign entities like China and the EU (don’t laugh!) assert their ascendancy in the world. Finally, there is the enormous debt that the Obama administration is piling on, raising the risk level of the US economy vis-à-vis its competitors. This last one is ironic as the Market is almost always willing to pay more for unlevered vs. levered companies due to their lower risk, yet as the Obama administration swaps private debt for public the Market is ascribing the same, if not higher, level of risk to the now less-levered companies in the S&P as it did before—all due to the leveraging up of the US government.

For stocks to go higher in the near term we will need multiple expansion and for that to occur some of the above concerns need to be alleviated in investors’ minds. We believe that the fear factor will dissipate over time and that the American premium will wax and wane with our perceived relative position in the world. The risk discount from the current administration and government borrowing, however, can only diminish if we get perceived stability and fiscal control out of Washington. The Bush administration spent like drunken sailors and Obama, despite his proclivity to blame everything on that policy, is only ramping it up. Perhaps, if we are lucky, the mid-term elections will do more than reduce the power of the anti-business lobby—hopefully, voters will send a message that they have learned their lesson with debt and now it’s Congress’ turn to learn as well. If that happens, then S&P 1400 and Dow 14000 will not be far away.