The first quarter of 2013 ended at record highs for the Dow Jones Industrials and the S&P 500. This brought the market higher than at its peak in October, 2007. Despite this, most investors today are skeptical. This is typical, since most bull markets climb “a wall of worry.”

In contrast, at the peak of the high-tech boom in the year 2000, investors were overly euphoric. That period of euphoria swiftly shifted to panic as the laws of finance and economics asserted themselves and punished investors who had overreached. Investors certainly do not feel optimistic today. To give you an understanding of why we are not worried about today’s market levels, please look at the following statistics for the S&P 500.

The above table shows that Blue Chip stocks are much cheaper today than they were at the 2007 stock market peak. Relative to 2007, therefore, stocks represent great value. When we are offered Blue Chip businesses at sale prices, as they are today, we buy.

Frankly, most investors should be optimistic. In addition to Blue Chips being bargains today, the U.S. is at an advantage to the rest of the world because we have cleaned up our banking system, our housing recovery continues, and we are experiencing a long-term energy production boom.

During the quarter we made two changes to the portfolio. We sold out of our position in Charles Schwab (“Schwab”) and initiated a position in in American International Group (“AIG”). Please keep in mind, these commentaries should not be construed as a recommendation to buy or sell the securities discussed. Such decisions are made only within the context of the market environment as we perceive it at the time of the decisions and the structure of the diversified portfolio of which the securities are a component.

In 2012, when we began purchasing shares of Charles Schwab, their earnings were being depressed by the Fed’s low interest rate policy. Specifically, low interest rates force Schwab to waive fees on its money market funds and suppress the spread income Schwab earns on its loan book. Our feeling was that the eventual rise in interest rates and, thus, earnings would drive the stock higher. 

As interest rates rose to begin the year, investors began to view Schwab similarly. Importantly though, we have yet to see any improvement in company earnings. To use a common expression, we believe “the stock has gotten ahead of itself.” Fundamentally-speaking, without an improvement in earnings there is little to support the stock; therefore, we concluded a major decline in price from current levels is quite possible. 

Since our primary goal at Golub Group is to protect your capital, we decided to sell Schwab out of your portfolio with the hope that we’ll have the opportunity to reinvest in the company on more favorable terms in the future.

AIG is our most recent addition to the portfolio. Those of us who follow the news are well-aware of the government bailout provided to the company during the financial crises. What many individuals fail to realize, however, is that AIG’s insurance operations did not cause the company’s demise; in actuality, a unit that managed a large derivatives portfolio, called AIG Financial Products, was primarily to blame.

The company has made enormous progress since the dark days of 2009. New management has sold off non-core businesses, all government bailout proceeds have been repaid, and, most importantly, the complex derivatives portfolio that necessitated the government bailout has been wound down by more than 95%. 

Despite all of this favorable progress, investor sentiment toward AIG remains poor, and the stock continues to trade at depressed levels. According to our calculations, AIG trades at a P/E multiple of just 6.5x our estimate of “normalized” earnings. Therefore, as sentiment improves over time, we expect to see a material reevaluation of the share price.