The “new normal” – an expensive distraction
December 31, 2010
Market Summary – 4th Quarter, 2010
A popular investment theme during the “great” recession of 2007-2009 centered on the idea of the “new normal.” It suggested that investors needed to be prepared for:
• slower economic growth in the U.S. and other developed nations;
• lower investment returns in bonds and equities; and,
• the need to look outside of the U.S., particularly to emerging markets, for opportunities.
Perhaps worst of all, the “new normal” was a shot across the bow of America’s spirit of optimism. This ideology is rooted in a belief that economic and investment hopelessness is in our future. The purveyors of the “new normal” implied that American exceptionalism is no longer.
Because the creators and key proponents of the new normal manage large sums of money, and have a great media presence, their theory was given instant credibility and received significant ink and airtime. Unfortunately, investors who signed onto the theory talked themselves out of a great investment opportunity. The “new normal” phrase was first uttered in March 2009, ironically the same month as the beginning of the stock market turnaround. Since then, the S&P 500 has risen 86%.
We point this out as yet another example of how existing conditions in the market or economy are often extrapolated out into the future as if they will continue forever. Those who fall into this trap tend to be “living in the moment.” They overlook something that many in our government actually recognize – the source of America’s economic strength is business. When the economy struggles, policies are usually implemented to stimulate and incentivize business, setting into motion the natural cycle of free market forces. Understanding this reality was the key to recognizing the opportunity that existed in March 2009 when the equity market reached its low point.
Other wrong calls that led investors off track
2010 could be called the “year of skepticism.” A number of pundits cast a shadow over investors and convinced many to mistakenly stay on the sidelines.
Contrary to expectations, by the end of 2010, the economy actually gained strength. Growth was still far from vibrant. Millions remained out of work and millions more faced foreclosure on overleveraged homes. But for the approximately 85% of working-age Americans who were fully employed and those who continued to invest as before, a sense of normalcy returned. A number of encouraging signs have emerged, including:
• a dramatic drop in new weekly jobless claims (for the week ending Dec. 25th);
• a record month of private sector hiring, up to almost 300,000 jobs in December (according to ADP);
• a jump in the Chicago Purchasing Managers Index to 68.6 in December, up nearly 10% from November and well in excess of its historical average (from 1970 to 2009) of 55.1; and
• the growing realization that, as James Paulsen, chief investment officer of Wells Capital Management recently stated in Bloomberg Businessweek (“The New Normal Is So Normal,” Dec. 16, 2010), “Characterizing this as the New Normal is a misnomer and misdirection.” Paulsen points out that the current economic recovery is stronger than the previous two (in 2001 and 1991) in terms of profits, real growth in the Gross Domestic Product (GDP) and job creation.
Stocks responded accordingly in the second half of the year. Yet many investors remained on the sidelines or, if investing at all, directed most of those assets towards fixed income. Cash flows into bond mutual funds were strong for most of 2010, while money poured out of domestic equity mutual funds for most of the year.
A different perspective
Throughout the year, our own position has been quite different from the new normal crowd:
• In our newsletter issued a year ago (titled “All I really need to know I learned in the last decade”), we first took issue with the “new normal,” pointing out then how pessimists were “betting against America.” We demonstrated that lengthy periods of strong equity returns tend to occur in the wake of extended weak periods for the market. The market’s recovery over the past two years is an indication that we’re in the midst of a similar rebound.
• Our April letter (“Seek not comfort, but opportunity”) acknowledged that the market remained volatile, but suggested rather than seeking the “comfort” of traditionally more stable investments like bonds and cash, investors would be better served capitalizing on the opportunities still available in stocks. Our message, which is still valid today – don’t just sit there, buy something!
• In July (“The summer of vuvuzelas and other incessant whines”), we took on the skeptics again, comparing their endless negative slant to the sounds of the traditional African horn that constantly emanated from the telecasts of the world cup soccer matches. Specifically, we railed against the role of quantitative analysts and traders who were driving much of the stock market’s volatility. At the time, the Dow Jones Industrial Average stood at the 10,000 mark. We pointed out that the opportunity in the stock market, then mired in a temporary slump, had actually improved for investors. The market has since gained another 15%.
• Three months ago (“Bonds – the next lost decade”), we encouraged investors to steer away from their overreliance on bonds. Fixed income performed well for the past decade, but we pointed out the significant risks that lie ahead, including unfavorable valuations for bonds and the government’s need to issue more debt (likely to push interest rates higher). The risks were real and we pointed out that equities appeared to be the asset class offering the greatest potential. Bond yields have taken a sudden turn upward. The yield on the benchmark 10-year Treasury note hit its 2010 low of 2.39 on October 7th, then proceeded to increase to 3.49% at the end of December.
If our theme for 2010 (and for that matter, 2009) could be summed up in one word – “opportunity.” The real opportunity for investors, as we saw it, was in equities. The market’s weakness and the lack of conviction investors had in the staying power of stocks aligned perfectly with one of Warren Buffet’s famous philosophies – “be greedy when others are fearful.”
Results lived up to our expectations. By the end of 2010, the stock market recovered all of the ground it lost after the financial crisis kicked into full gear in September 2008 when Lehman Brothers collapsed. At the same time, it is important to note that the market remains below its all-time peak reached in October 2007. However, our key theme of 2009 and 2010 – that the opportunity was in equities, has proven to be true.
What matters to investors now is the potential opportunity for 2011 and beyond.
Reasons for optimism
The favorable scenario that began to emerge late in the year is poised to continue. Economist Donald Luskin writes in his Trend Macro newsletter (Dec. 28, 2010) that our current economic recovery was tracking right in line with the economic path of 1936-37, a time when America was fighting to escape the Great Depression. Economic historians have pointed out the policy mistakes that occurred at that time, including tax increases and a cutback in stimulus efforts. As a result, the economy fell back into recession. Many feared it would happen again in 2010 and 2011. Government stimulus programs were expiring, as were the tax cuts first implemented in 2001 and 2003.
Instead, today’s policymakers have demonstrated an ability to learn from history. Two recent actions should be encouraging to investors:
1. The Federal Reserve’s second round of Quantitative Easing (QE2). The Fed added liquidity to the system, a spur to ongoing economic growth. Some have expressed concern that the Fed’s actions will drive interest rates higher and boost inflation risks. But Wharton Professor Jeremy Siegel points out that an increase in long-term rates is indicative that QE2 is working. The bigger risk Ben Bernanke was trying to address was an economy growing too slowly and the short-term risk of deflation. Siegel says higher rates mean the market is anticipating a stronger economy and higher inflation. In other words, if rates rise over time, it can only mean the economy is strengthening, and hence, Bernanke’s plan worked.
2. The post-election tax bill compromise. Republicans and President Obama agreed to extend the Bush-era tax cuts for at least two more years and allow some individuals access to additional unemployment benefits (typically a very effective stimulus in hard times). Additional tax cuts and spending programs included in the package (such as the 2% payroll tax holiday) should further boost the recovery.
Both actions avoid what would potentially slow economic growth. The fact that the two parties could agree to compromise legislation was another reminder that despite the political rhetoric of election season, when push comes to shove, policymakers will take whatever actions are necessary to encourage businesses to perform.
Those who did recognize the opportunity in the markets back in March 2009 and since then understood an important reality – ultimately, private enterprise is the fuel of economic resurgence. Government has played a role in propping up the economy through difficult times, but this was nothing more than a stopgap. The key was building confidence and removing some of the uncertainty related to the business, regulatory and tax environment going forward. To a large extent, this has occurred. With the changeover in Congress, additional actions designed to incentivize new business investment are likely to be implemented.
Better days ahead
If you were to listen to the new normal crowd, particularly those who love to point out that the stock market is virtually unchanged since the start of the 21st century, you’d think America was standing still. Yet we remain a very innovative culture. Just consider how the world has changed over the past ten years:
• Less than half a billion people had access to the Internet ten years ago, and broadband access essentially didn’t exist. Now, nearly 2 billion people are on the net worldwide. While the stock market’s Internet “boom” may have happened in the 1990s, the real impact the Internet has on the world has occurred since then.
• The iPod and its offshoots, including today’s iPhone and iPad are commonplace. Notably, Sony* recently ended production of the predecessor to this technology, the Walkman.
• The first popular hybrid car hit the market. It was a sign of a new focus on energy efficiency. While U.S. population grew by 10%, total power consumption in our country actually declined over the past decade, a feat that could only be accomplished through new technological initiatives.
• The human genome was decoded, an advance affecting nearly every form of medical research.
• Amazing new microsurgery techniques have become commonplace, turning once complex and invasive procedures into ones that often require no in-patient care.
• In 2000, 8 out of every 100 people around the world had a cell phone. Today that number is 76 out of 100.
• 3M* is the perfect example of an old-line company that continues to move forward. 30% of the company’s 2010 revenues of $23 billion came from products that are less than five years old.
• Johnson & Johnson* is investing in a new technology designed to detect and even help treat cancer based on a simple blood draw rather than much more expensive biopsies or image scans.
Despite the overall market’s relatively flat performance over the past decade, the world did not stand still. During this time, many companies thrived, and their values grew. Population worldwide is growing dramatically and the consumer class continues to expand, particularly in developing countries. There continue to be tremendous opportunities for well-positioned companies. New businesses continue to be invented to meet new challenges.
The world economy is in a period of transition. Times like these create a great deal of uncertainty and pain. The year ahead will not be without its challenges. As pointed out earlier, the U.S. continues to suffer from lingering home foreclosures and high unemployment.
Yet like the difficult times in the past, we can expect leaders to step forward. Problems identified by some will be recognized by others as opportunities. The free market system is alive and well and doing better than ever on a global scale. Investors who have an ownership position in well-managed companies that are poised to create solutions to meet the world’s challenges have a chance to profit from on the opportunities that are created.
Confidence is clearly on the rise, and even some of the most pessimistic are beginning to admit that the environment is showing more life than they expected. This nation’s economy proved its resiliency through the hardest times and is now ready to move forward. As is almost always the case, the path for stocks won’t be a straight line up. There will be plenty of bumps and corrections along the way. But investors should be convinced by now that any short-term weakness demonstrated by stocks creates a long-term opportunity.
It appears to us that the new normal may have run its course. A case can be made as to whether it really existed in the first place. Those convinced to follow it missed an 86% recovery in the S&P 500 since March 2009. The New Year presents a new opportunity to avoid making the same mistake again.
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.
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