The Great Recession Rotation
December 31, 2012
Market Summary – 4th Quarter, 2012
“Never argue with a man who buys ink by the barrel,” we asserted in our first quarter of 2009 newsletter. Written during the darkest period of the Great Recession, we observed that the trillions of dollars being deployed by Federal Reserve Chairman Ben Bernanke in order to contain the worst economic contraction since the Great Depression would serve as an unstoppable catalyst for economic growth. Mr. Bernanke’s efforts were successful in saving the banking system from collapse and for lifting our economy out of the Great Recession.
Fast-forward four years to today. The Fed has continued to unleash trillions of dollars into the financial system in an effort to jumpstart our economy’s tepid recovery. Mr. Bernanke, however, is not the only central banker that owns a printing press and a seemingly unlimited supply of ink. The Fed has been joined by the central banks from the world’s largest economies, including the European Central Bank, Bank of England, Bank of Japan and the People’s Bank of China in an aggressive quantitative easing monetary platform. Collectively, the world’s central banks are expected to have brought $9 trillion of liquidity into the market by the end of 2013 in order to stimulate economic growth¹. To put this number in perspective, if the world’s central banks were a country unto themselves they would be the second largest economy in the world – behind the United States ($15 trillion), but ahead of China ($7 trillion), Japan ($6 trillion) and Germany ($4 trillion)².
In 2009, we cautioned investors that those who ignored the implications of the Fed’s measures would miss out on a tremendous investment opportunity. Now that the world’s central banks have adopted similarly loose monetary policies to the Fed’s, this warning is even more relevant. The creation of all of this money isn’t a temporary trading catalyst; it is a long-term tectonic shift that will transform the investment landscape for an entire generation.
While the printing of money lifts the economy, it reduces the value of the currency, causing many necessities of life to cost more. Note the 7.1% inflation in food prices over the past year³. The consequence of printing $9 trillion is that it must go somewhere. Capital is ultimately directed to its highest, most productive and profitable use (per unit of risk). With this in mind, and to protect against inflation, we believe that it is wise to own productive assets (equities, real estate) that create wealth and that benefit from stimulus dollars, rather than be a lender (bonds, annuities) in an environment that is already awash in liquidity.
We remain steadfast in our belief that equities, even after a 16% total return in the S&P 500 Index last year, continue to offer the greatest risk-adjusted return given the current macroeconomic backdrop. The tidal wave of liquidity being pumped into our financial system is an overwhelming influence that we believe will usher in a 25 year bear market for bonds (the approximate length of an interest rate cycle). We believe that the flow of funds out of the bond market and into the equities market will accelerate due to improving fundamentals of companies that create wealth out of this stimulus and improved investor sentiment. We also believe that this mass migration of funds out of bonds and into equities, the “Great Rotation” as we are calling it, will serve as a powerful lever driving stock prices to new highs.
The Great Rotation
This isn’t simply conjecture. As we predicted throughout the year, the proverbial canary in the coalmine signals are emerging. For starters, the high dividend/low growth stocks that were all the rage for the past two years have reversed course. By year’s end, the bellwether sector of income-oriented stocks (utilities) was the worst performing sector among the major industry groups tracked by S&P Dow Jones Indices. In a year when the price return of the S&P 500 Index was up 13.41%, the price return of the Utilities sector was down 2.91%. More recently, for the week ended January 9th, equity mutual funds and exchange-traded funds experienced the second greatest inflow of funds on record. The foundation for a significant economic expansion has been laid. The Great Rotation has already begun.
Most of the market chatter towards the end of 2012 was focused on the looming “fiscal cliff.” The over-dramatized consequences were more about high cable news ratings than high probability outcomes. Meanwhile, far less publicized but more meaningful developments were (and remain) underway. The Great Rotation encapsulates many of the themes that we have been discussing over the past few years, and offers a road map for the coming sequence of events. We believe that the Great Rotation will ultimately create tremendous wealth for investors who can see through interesting (but unimportant) headlines and become owners of wonderful businesses at attractive prices.
The first stage of the Great Rotation, central banks for the world’s largest economies printing extraordinary amounts of money, is already underway. This government stimulus, coupled with more pro-growth legislation (seen recently in the states of Wisconsin and Michigan), signal that government will provide enough stimulus in order to generate meaningful economic growth.
Now that central banks have flooded the market with liquidity and restored confidence in the banking sector, a housing recovery is underway. Home prices are up 5% this year and housing starts are 22% higher than last year. It is our opinion that a recovery in housing will drive a recovery in consumer confidence. As people’s homes increase in value, their personal net worth will expand. We anticipate that people will respond by looking to grow their wealth, rather than simply to preserve it.
What makes a housing recovery so important to a robust economy is the fact that it possesses a unique “multiplier effect” that, in our opinion, is unrivaled by other industries. Consider what other transactions happen when you buy a home: you go to the bank for a mortgage, pay a realtor, pay movers, you may do some renovations, buy new furniture and appliances, etc. In the case of new construction, the spill-over benefits are even more profound. This growth will necessitate that new jobs be added to the economy. It is no wonder that the weak improvement in the job market has been referred to by some as the “Tool Belt Recession.” Of the estimated 8 million jobs lost during the Great Recession, approximately 25% of them were in the construction industry⁴. As the housing recovery continues, the positive “multiplier-effect” benefits will spread to other industries, and more jobs will be created.
The wealth generated by housing and related industries, coupled with stronger employment, will soon find its way into other industries as discretionary spending increases. Consequently, our anemic post-Great Recession GDP growth has the ability to break out of its recent 1.5-2.5% range and approach the 3.0–4.5% range that we experienced before the Great Recession. Furthermore, there exist several paradigm-shifting opportunities (natural gas drilling and transportation, U.S. multinational corporations repatriating billions of dollars from overseas to support domestic manufacturing) that, if realized, could push GDP growth to levels rarely seen in a developed economy.
As GDP growth improves, investor sentiment will likely also improve. Both individual investors and pension funds have been conspicuously absent from the rally in stocks. These segments of the investment community have likely been reluctant to participate in the equity rally because of the overarching theme of fear in the markets. Strong economic growth and robust corporate earnings will not only drive stock prices higher, but will also quell the fear that has permeated the market for the past several years. Against the backdrop of strong corporate earnings growth and a stable/growing global economy, we suspect that investor emotion will shift from fear to greed, and investor sentiment will improve. Pension funds and individual investors, tired of the low single-digit or even negative returns that they are getting in the bond market, will begin to rotate their fund allocations to the equity market that offers them significantly higher returns.
This newly arrived positive investor sentiment will be facilitated by the stronger economy. However, a fast growing economy in a developed nation is quickly followed by higher interest rates in order to moderate the growth and proactively combat inflation. With higher interest rates, bonds will decline in price. Bond investors will likely respond by sharply increasing the speed of their rotation out of bonds in favor of higher-returning equity investments.
The rotation out of bonds and into equities will have an incredibly powerful impact on the markets. Those who recall the aftermath of the dotcom and housing bubbles can attest to the fact that bubbles do not pop gently. We continue to believe that there exists a bubble in bond prices. When the bubble ultimately pops, the billions of dollars that we believe will rotate out of bonds and into equities will drive substantial multiple expansion in equities. Current equity multiples of 13x next year’s earnings are below the 50 year average P/E multiple of 15x and considerably below the 19x average P/E ratio during low interest rate periods. The Great Rotation, therefore, will ultimately deliver the two things that lead to the greatest returns for investors: multiple expansion coupled with stronger corporate earnings. Given the amount of funds being created by central banks and the sequence of events that we anticipate playing out, we believe that the beneficiaries of the Great Rotation have the opportunity to build significant wealth.
Prelude to the rotation – a look back at 2012
A review of the past year’s newsletters shows that we were building the case for the Great Rotation in each issue:
In our 1st quarter letter (“A Momentary Lapse of Reason”), we talked about the risk that bonds and their low yields presented. We reminded readers that the greatest risks come when an asset is expensively priced, and that bond valuations were excessive. This is still true today. We also emphasized that investors can’t overlook an even bigger risk – the loss of purchasing power being brought about by loose monetary policy. Assets that can keep pace with inflation, like equities, offer a strong defense against such a risk.
In the 2nd quarter (“Why Am I Here?”), we focused on the anxieties that investors have in regards to investing in equities. This was reflected by the fact that investors took money out of equity funds and put them into fixed-income assets in 2012 even in the face of double-digit equity returns. We noted that this “flight to safety” was likely to be counterproductive. Perceived “safe” assets like bonds and high dividend-paying stocks would, we suspected, turn out to be disappointing investments. As we noted above, this appears to be materializing.
In our 3rd quarter newsletter (“The Wizard of Wharton Foretells a Promising Future”), we recounted the key case for equity investing made by Professor Jeremy Siegel, the guest speaker at our annual MPMG Speaker Series. Siegel expressed his belief that stocks, which have lagged bonds since 2000, offered tremendous long-term value. Siegel is a big proponent of the idea that growth opportunities are particularly pronounced in developing countries across the globe due to the rise of an emerging middle class.
In November, we provided a brief perspective on how the entire fiscal cliff issue should be viewed in the context of investing (“The Fiscal Cliff: Another Brick in the Wall of Worry”). Our view was that once the headline-grabbing concerns of the day faded away, fear and anxiety would quickly turn to optimism. This was validated on the first trading day of 2013, with a 300-point bump in the Dow Jones Industrial Average following the fiscal cliff resolution. We first introduced the “Great Rotation” concept in this letter, and suggested that as the focus shifted away from headline issues, the advantage for equities would become clearer.
Tactical steps to maximize gains
Those of you familiar with MPMG and our investment philosophy know us to be company driven, opportunistic value investors – not economists. While this newsletter, along with our letters throughout 2012 have focused on big picture macroeconomic events, it is our belief that we are in the early stages of what we believe will be a rarely before seen opportunity for investors. Those that are first, able to understand these macroeconomic tectonic shifts ahead of the crowd, and second, (and more importantly) position their portfolios ahead of the crowd to own unique business with solid balance sheets and strong, long-term growth potential at reasonable valuations, have the opportunity, in our view, to experience significant wealth accumulation.
We are deeply honored that you have entrusted us to help manage your wealth. We wish you and your loved ones a happy and prosperous 2013.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.