Rewind
Last year, at this time, the stock market was struggling under the weight of worsening economic news. On August 27th 2010, Ben Bernanke, Chairman of the Federal Reserve, gave a speech at an annual central bank symposium in Jackson Hole, Wyoming, hinting at his willingness to initiate what we have referred to in this blog as “The Bernanke Playbook”. (Recall that this refers to a paper he wrote as an academic, criticizing the monetary policy of the Japanese during the 1990s and providing his own policy prescriptions.) His speech introduced what became known as QE2 (the second round of quantitative easing) in which the Fed would buy $600 Billion of long-term US Treasury Bonds in an attempt to stimulate the economy.
Three days later the stock market embarked on a furious rally that topped out on April 29th of this year. The market took the bait and gambled that QE2 would spark a sustainable recovery in the economy.
Last week we found out that the annualized growth rate in the economy for the first 6 months of 2011 was 0.8%. By some economists’ estimates, this is less than half of what is required to simply maintain current employment levels. Other very recent economic reports show that the economy is weaker than many would have expected. Needless to say, QE2 has fallen short of expectations. Today the market closed below where it started the year.
The silver lining here is that corporate profits have remained quite strong, due largely to productivity gains. Of course, productivity means doing more with relatively less (i.e. fewer employees). And there’s the rub. How long can corporate profitability withstand the effects of a weak job market? Given the recent economic data, we may soon find out. Importantly, even with the amount of discord among policy makers in Washington, corporate managers are performing exceedingly well in creating value for shareholders.
As for our portfolio strategy, back when Bernanke embarked on QE2 last fall, we maintained our conservative position (as we wrote in this blog in December). We did not believe that QE2 would really fix what ails the economy and lead to a sustainable recovery. What seemed like a very contrarian position then, appears to be the consensus now, as the market recoils from recent economic news. Our efforts have been to invest in lower risk, high-quality companies, with good dividends that, as always, generate EVA. We have conserved cash to be ready when opportunity arises and protect capital. In a volatile world, we have tried to be stable and consistent.
Another Leap of Faith?
While the Fed may distort asset prices, (like making the stock market go up just by saying they will print money) we are not taking issue with the Fed’s willingness to help; they are using every tool made available to them. Without their initial response in 2008, things would have been far worse. Even Bernanke has learned to sympathize with his own plight. At a recent press conference, a Japanese reporter specifically asked him whether he still agreed with the paper he wrote criticizing Japanese monetary policy, while still a professor at Princeton. Bernanke’s answer: “Well, I’m a bit more sympathetic to central bankers now than I was 10 years ago.”
Add this to President Obama’s recent comments about last year’s stimulus package that “shovel-ready wasn’t as shovel-ready as we expected” and you get the sense that policy makers are disoriented. Washington has lately been caught up in talking points and ideology with complete disregard for the tremendous risks they are adding to the economic recovery. However, this doesn’t come as a complete surprise. The country is divided, as demonstrated by the last election. In a way, they are doing what they were elected to do.
We do, however, take issue with investors blindly assuming that our economic problems can simply be overcome by government policy. Every new policy prescription from Washington appears only to be a red herring, diverting attention from the issues and giving investors hope without justification. Just look at the jubilant response of the stock market after the Fed committed to QE2. Or after the elections when the Bush Tax cuts were extended and payroll taxes were reduced. As if one more round of printing money is the solution. As if tax cuts will suddenly invigorate growth. As if spending cuts will put us on the path to stability. As if more government spending will create jobs. As if raising the debt ceiling will create more certainty. While several policies may be necessary at different times, investors have seemed intent on believing the solution is simply a matter of the next policy fix.
In what feels like a scene from the movie Groundhog Day, traders and investors are again anxiously awaiting Bernanke’s upcoming appearance at Jackson Hole later this month for hints of QE3, as the economy weakens. As if…well you get the picture.
Working Through It
We continue to think the world is upside down for policy makers, making them ineffective in overcoming the historic deleveraging occurring in many developed countries of the world. It takes cooperation, coordination, and communication. We have very little of that right now, which is a startling parallel to the 1930s. In Europe it is even more complicated.
There simply is no easy fix. In their landmark book, “This Time is Different”, Carmen Reinhart and Kenneth Rogoff describe the history of financial panic induced recessions (or depressions). Given history, one could expect a seven year period, or “tail”, after the initial shock, until a sustainable recovery begins. During those years, a multitude of policy risks exist with growth taking place in fits and starts. We are almost halfway there.
The irony of the title, and stated purpose of the book, is that it really is no different now than it ever was. Simply, our lifetime experience in relation to a much longer economic history is different. Rogoff and Reinhart show us that this has been happening for 800 years. We can only accept where we are and work through it.
While our politicians fail to inspire us, corporate managers have been brilliant. Dealing with vast political and economic uncertainties coming from Europe, China, and the U.S., they continue to do their part to create value for shareholders. While some pundits, and even members of Congress, proclaim that the U.S. is bankrupt, they fail to recognize the real value that exists in the private sector, regardless of how broken government has become. There is no doubt that policy risk will remain a drag on economic growth and missteps at the government level could have profound consequences. Business owners and managers are very well aware of these issues, yet they continue to look for ways to grow and prosper. We hear this from the management of companies we invest in and we hear it from our own clients, most of whom are making their own business decisions every day. This is what keeps us optimistic and what generally gives the equity market underlying support. The U.S. economy, built on free-market principles and entrepreneurial aspiration, is very much a going concern.
Repeating Ourselves
For investors it takes patience and a dedicated strategy. We have been consistent in our message for the last several years, avoiding the impulse to anticipate every up or down move in the market based on the next government policy. We are working very hard to remain alert to potential downside risks while prudently investing our clients in the best, low-risk, wealth producing companies we can find. We continue to invest in EVA-producing companies with strong balance sheets and good dividends. We are being extremely careful to protect our client assets and continue to provide thoughtful insight via our fiduciary duty as investment advisors.
Our basic goal during this period of elevated uncertainty is to earn a more consistent and predictable return than the market. We believe this is in the best interest of our clients’ ability to preserve and grow their wealth.
Thank you for your continued trust.
Peter and Jack Falker
August 2, 2011
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