January 2005: “It’s The Economy, ---------!”
This quarterly letter covers a number of topics we feel investors need to keep in mind as they assess results for the year just ended and attempt to anticipate the possibilities for 2005. As in the past, we will leave the “summing up” of world events to the media, instead focusing on what strikes us as the essential investment fundamentals. In our view, the central issues are and will remain: (1) prospects for the global economy; (2) comparative valuations in the world’s financial markets; (3) the status of the U.S. dollar relative to other foreign currencies, and (4) how all this relates to future portfolio realignment strategies.
It’s the Economy, - - - - - -!
Despite all the political posturing, media-generated concern about job growth and the wailing about American business competitiveness in the global marketplace, our “sluggish” economy continues to grow at an enviable pace (i.e., GDP + 4.0% in 2004, 3.5% in 2005). Old Europe is still taxing its workforce excessively to pay for its lavish social benefits. At 5.4%, our unemployment rate is roughly half that of Germany and France (which still has a mandated maximum workweek of 35 hours). Over the past 25 years our entrepreneurial economy has added 40 million new jobs, 2.2 million in 2004.
Today virtually one half of the U.S. population, 140 million citizens, is gainfully employed. Declining income tax rates have encouraged businesses to invest heavily in capital improvements, increasing worker productivity 67% since 1980. Government programs do not “grow the economy,” but constructive public policy fostering entrepreneurial development does, and is the answer to how in the years ahead we will meet the competitive challenges posed by China, India, and other low-labor-cost producers.
Problems abound, of course, and receive disproportionate media attention. We are fighting a war, but as Winston Churchill once observed, “Except for brief and precarious interludes there has never been peace in the world; and before history began, murderous strife was universal and unending.” The long term solution to much of today’s terrorist-generated turmoil lies in the gradual liberation of the world’s under-utilized creative human capital. This includes equal rights for women, a more tolerant pluralistic social structure and closing the wealth/income gaps. To quote another worthy, J. Danforth Quayle, who may have been paraphrasing his mentor, Yogi Berra, “I believe we are in an irreversible trend toward more freedom and democracy – but that could change.” Out of the mouths of _ _ _ _ _.
Financial markets, for the most part, discount the soon-to-become obvious and what eventually emerges as conventional wisdom. In the year 2004 we experienced world-wide real GDP growth near multi-decade highs, partially stimulated by a strong U.S. recovery. 2005 promises to be a year of more normal expansion, a decelerating pattern, not a recession. Some economists today are even hazarding the prediction that 2006 will be surprisingly strong, possibly on an accelerating slope when compared with 2005. Collectively, investors at the moment seem to view the global economic outlook with guarded optimism, as do we.
Equity Markets in 2004 – Funds Outperform Indexes in a Period of Declining Price Volatility
U.S. stock market price volatility increased considerably in the late 1990’s, and during the gyrating period of 2000-2003, spawning a passel of hedge funds which by definition thrive on financial market valuation inefficiencies and price fluctuation. Stock prices in 2004, on the other hand, reverted to a narrow band of volatility, roughly one third the historical pattern of annual variation. Today, with nearly 9,000 (vs. 1,500 in 1990) hedge funds hunting for arbitrage opportunities and superior returns in an ever-more crowded bog of declining market volatility, these sophisticates may in fact, like the plot in a Greek tragedy, be hastening their own demise. Real time computerized hedging techniques jumping on unfolding security price anomalies tend to moderate the very imbalances such hedge fund managers live off, eroding the chances of providing clients with extraordinary returns.
2004 ended as a reasonably good year for many equity investors with well diversified portfolios. Despite the Iraqi conflict, periods of mid-$50s oil, a shift in FED policy clearly foreshadowing rising short-term interest rates and a presidential election which was too close to call until all the ballots were counted, stock markets around the world rose in relative unison. It was also a year in which active managers (i.e., those who try to beat the market through proprietary stock selection techniques) out-distanced their benchmark indexes, but the essential call in the end still turned out to be an investor’s portfolio asset class weightings. Value strategies, small company over-weighting and, for American investors, unhedged international stock market participation, yielded greater returns than did the domestic U.S. broad market averages. In 2004, these strategies outperformed the S&P 500 index by a margin of between five to nine percentage points, or 500 to 900 basis points, as shown in the neighboring chart. (For further detail, see “Fund and Benchmark Total Returns” which is included with this letter).
As might be expected, this uneven asset sector performance in the year just ended (especially comparing U.S. small companies to domestic large “growth” companies), has created portfolio imbalances requiring realignment to original asset mix policy settings. For taxable investors, in a rising market this rebalancing discipline inevitably means long-term capital gains taxes, but the investment imperatives, in our opinion, should drive the equation, not tax considerations. More about this later.
Whither the Dollar? Does it Matter?
One of the games politicians play, as do we all to some degree, is to borrow money today for projects (infrastructure, social services, pork, etc.), saddle some unsuspecting holder with the corresponding debt, allow the issuer’s currency to inflate and pay back the obligation at maturity in dollars of diminished purchasing power. This game works well for all players as long as the debt-issuing country’s financials (cash flow and balance sheet) remain in relative balance and, as in our country’s case, the world is willing to consider the dollar as the reserve currency of choice. However, when the U.S. Trade Deficit approaches 5% of GDP, the Federal Government’s annual budget is in the red by $400 billion and the American individual savings rate near zero, foreign dollar holders cannot be blamed if they begin to consider other currencies (e.g., the Euro) as a parking place for surplus savings. Further, official U.S. government policy seems to be “talk a strong dollar, but let it slide”… without intervention in foreign currency markets – hardly comforting to non-dollar investors attempting to optimize the value of individual or institutional reserves. Nor is the potential of weak dollar-induced inflation reassuring for such investors.
In the last analysis, the value of a country’s currency depends on many more variables than those stated above, including the structure of interest rates world-wide, a country’s perceived internal political stability, not to mention the expected relative GDP and corporate earnings growth of competing economies. Given the enormous structural imbalances in the global economy – especially those driven by the twin engines of U.S. consumption and Chinese production – and the major role played by currencies in relieving global economic pressures, further declines in the dollar in the months ahead would not surprise many. Periods of dollar weakness are not uncommon, as illustrated in the chart above. Indeed, history suggests that the current slide – a decline of 25% since early 2002 – is not over and that we may have several years of dollar weakness ahead.
The question remaining is whether this ongoing global rebalancing through currency adjustment will remain gradual and orderly. We are watching closely to monitor whether foreign buyers, especially Asian central banks, continue to willingly purchase additional U.S. government debt, thereby financing our trade deficit. It is a delicate balancing act, requiring many of our trading partners to swallow hard and endure reflation in the U.S., domestic inflation in China, as well as deflationary pressures in Europe. Presently, foreign buyers are making investments denominated in a depreciating currency, ultimately hoping that U.S. politicians will deal with the United States’ long-term entitlement payout-revenue gap (e.g., Social Security, Medicare, etc.). The November U.S. election seems to have set the stage for the resolution of some of these long festering structural problems. The battleground now shifts to Congress.
Growing countries, like growth companies, often are in need of borrowed capital to finance long-term projects. Currently, the U.S. economy, is the only developed country where capital can freely participate in a demonstrably expanding environment. For the moment, the game can continue, but we are approaching the last innings of the seventh game in the series.
Rebalancing Equity Portfolio Positions: A Global View
In the global sense, viewed from 30,000 feet, adjustments in the world’s currency markets are slowly rebalancing the world economy. However, on the portfolio level, there have been imbalances created by the investment out-performance of U.S. small companies and international equities, as well as value funds, relative to the broader equity market. These imbalances generate a need for a course correction.
Small has been beautiful in U.S. equity markets – 2004 marked the sixth year of small cap outperformance, as measured by the major indexes. Since the end of 1998, the total returns of the large-cap S&P 500 have been modestly positive (+8%), while those of the small-cap Russell 2000 are up a strong 67% over the same six-year period. While market history tells us, over the long-run, that small company stocks outperform those of large companies, the annual difference is on the order of 2% per year (12.7% vs. 10.4% per year, from 1926-2003, according to Ibbotson). Mean reversion – another market history axiom – suggests that a seventh year of major small cap outperformance seems unlikely.
Fundamental analysis supports a similar conclusion. Increases in stock values can be described as a combination of changes in two factors – earnings-per-share (EPS) and valuation (P/E) multiples. The charts at right compare the current P/E multiples of the Russell 2000 small-cap index and the S&P 500 large-cap index with historical ranges. In basic terms, at today’s levels, investors are paying $28.50 for every $1.00 of 2004 small-cap earnings, while they are paying $18.80 for each $1.00 of 2004 large-cap earnings.
While small company earnings are projected to grow more rapidly than those of large companies, the current valuation premium of over 50% already reflects that higher expected growth. Consequently, small cap stocks are no longer “cheap” relative to large caps and compelling valuations do not provide a tailwind to the small cap asset class. As a result, in spite of the unpleasant [mostly long-term] capital gains tax consequences, investment considerations lead us to reduce our overweighted positions in small-cap companies and use the proceeds to add to large-cap domestic equity allocations.
The case for rebalancing of domestic “value” stocks is similar. In the six years since the end of 1998, the total returns of the large-cap Russell 1000 Value index have trounced those of its sibling large-cap Russell 1000 Growth index by a cumulative 57%, or almost 8% per year. Style-based differences in small cap have been even more dramatic, with the total return of the small cap Russell 2000 Value index beating that of the Russell 2000 Growth index by almost 100% in the same six-year period. While academic research has shown that value stocks outperform growth stocks over the long-run, we are also aware of mean reversion in this context as well. This implies that a near-term continuation of the value style’s dominance in U.S. equities seems unlikely. Hence, we will also be rebalancing portfolios by style.
In international equities, however, we are staying the course with meaningful allocations to non-U.S. equities. Abetted by a weak dollar, international equity outperformance for American investors has been a more recent phenomenon, with the greatest divergence of returns in the past two years. More fundamentally, we continue to see relative value in international equities. P/E ratios of stocks in developed countries average 10-15% less than U.S. stocks, while stocks in more volatile emerging markets trade at a 25-35% discount to the U.S. Meanwhile, forecast earnings growth of international companies is comparable to (or higher than) U.S. companies. Moreover, the effects of a depreciating dollar amplify unhedged returns from international equities for U.S. investors. In summary, even though our economy may grow relatively more rapidly, we see better value and a more attractive risk-return profile in international stocks. These fundamental factors, together with the prospect of further weakness in the dollar, support our conviction in international equities.
Finally our commitment to natural resources continues unabated. The long-term investment case remains intact. First, global raw materials demand is robust, even as China orchestrates its “soft landing.” Second, the hard assets of commodity-producing companies offer a useful inflation hedge for long-term investors. This latter feature will help portfolios withstand any adverse inflationary consequences of the depreciating dollar.
In the weeks ahead, adjustments to portfolio structure will be undertaken to compensate for these disparities. You will be receiving transaction notices from your custodian as the changes occur.
Last summer, we initiated a new quarterly billing and report mailing process aimed at getting all this material into your hands in a more timely manner. We understand some have encountered problems with these mailings. Please let us know if difficulties arise and we will work to resolve them.
As always, we welcome your questions and comments.
Sincerely,
James L. Joslin
President