COMMENTARY - 1ST QUARTER 2009

“The best way out of a difficulty is through it. ”
                  – Will Rogers

Glimmers of Hope

Our current investment outlook is guided by our firm belief—supported by much historical precedent—that the market will move higher long before we see reassuring headlines about the economy. Ironically, we are encouraged by recent economic news that is “less bad” than what we had faced over the latter half of 2008. These glimmers of hope include the progress our government has made in executing a fiscal stimulus package, in adding needed liquidity to the credit markets, in creating a vehicle for acquiring bad assets from financial institutions, and in pushing toward a solution for the American auto industry. Other glimmers of hope include the resurgence of real estate transaction activity and housing starts, the return of corporate mergers and acquisitions, and the flood of corporate debt underwritings, signaling a healthier credit market environment. One key missing ingredient is consumer and investor confidence, but even there we may be at an inflection point, as the University of Michigan, ABC and Rasmussen surveys of consumer confidence have all shown positive ticks in recent weeks.
Prior to the most recent up-ticks in sentiment, the survey results of many of these weekly polls were extremely negative, in some cases registering historically low readings. Indeed, one weekly poll of individual investors conducted by the American Association of Individual Investors (AAII) indicated that more than 70 percent of individual investors were bearish on the market and just 19 percent were bullish—the most pessimistic reading ever in the poll’s existence. Of course, this reading immediately preceded the market’s recent rally in March. It furthermore reminds us of the psychology of human behavior that influences the stock market and the tendency of individual investors to act in mass at the same point in time; more specifically, the massive and extreme capitulation we experienced in the final quarter of 2008 that continued into this quarter.
Despite the negative sentiment and headline doom and gloom, the stock market has responded to “less bad” information with the highest monthly return since April, 2003. As of March 31st, the S&P 500 had recovered 17% from the 12-year lows it reached on March 9th. Underneath the surface lie other encouraging signs as well. From a technical standpoint, various technical indicators are beginning to show signs of improvement, as some of the market’s “internals,” such as volume and breadth, have turned incrementally positive.

Return to Normalcy

Generally speaking, stock markets as well as individual stocks are priced according to two key inputs: (1) corporate earnings, and (2) price-to-earnings (“P/E”) multiples. We think we will have good news on both fronts.

First, as our economy recovers, so too will corporate earnings. Wall Street analysts project that the S&P 500 will earn $62 from operations (excluding one-time charges) for 2009, in the midst of a severe global recession. S&P 500 earnings peaked at $92 in 2007. It may take a few years to recover to those levels, but it is inevitable that someday they will.

Second, as we return to a more normal business environment no longer characterized by extreme fear, we expect the stock market will gravitate toward P/E multiples more in line with historical averages. We base this expectation on the interplay between P/E multiples, inflation and interest rates. As a general rule, in times of high inflation and high interest rates, P/E multiples contract. Conversely, in times of low inflation and low interest rates, P/E multiples expand. For example, during the relatively high inflation periods of the 1970’s and 1980’s, the average P/E multiple on the S&P 500 was 12.0x. As we entered a period of lower inflation and lower interest rates in the 1990s, the average multiple on the S&P over the decade gravitated upward to 20.2x. Our belief, based on an assessment of the competitive nature of global economies, is that inflation and interest rates will be relatively subdued over the next several years. Consequently, as the fear that currently grips investors subsides, we expect P/E multiples to recover to levels that are more normal for such an environment. The chart below, which presents long-term average P/E multiples in various inflationary environments, suggests that a return to multiples in the mid-teens would be reasonable.

As an example, if one were to connect the dots and assume a recovery of S&P 500 earnings to $80 from the current level of $62, and a return to an environment where investors value those earnings at 15x, then the implied value for the S&P 500 index would be 1200. This would constitute a 50% increase from the current market level.


New Developments

Many of you will notice a few new securities in the fixed income portion of your account statements. We recently began purchasing Exchange Traded Funds (ETFs) to satisfy the fixed income allocations in your retirement accounts. We believe these ETFs—which hold bonds issued by corporations, the U.S. government, and government-sponsored agencies—offer many benefits. Not only do they provide significant diversification and minimize the impact of issuer-specific credit risks, but they are also lower-cost than individual bonds, which can have very high transaction costs, and—consistent with our own investment approach—are managed in a tax-efficient manner. As a further benefit to those of our clients receiving income distributions from their portfolios, they provide monthly cash distributions, whereas most individual bonds only make semi-annual coupon payments. All told, we believe these fixed income ETFs will help us serve you better, as we will continue to actively manage your allocation to high-quality fixed income securities, but with greater flexibility and lower risk. (Please note that, where appropriate, we will continue to purchase individual municipal bonds in taxable accounts, as the ETF offerings serving that segment of the bond market are not yet well developed).

With best regards,

The Golub Group

Disclaimer: All opinions presented in this commentary are strictly those of the Golub Group.  You should not construe any implied or expressed conclusions presented as a promise of future returns.