Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
The second anniversary of the stock market’s nadir during the financial crisis-induced crash passed almost unnoticed during a tumultuous period in March, after which stocks advanced with renewed vigor, reaching levels not seen since the months prior to the collapse of Lehman Brothers in September of 2008. Judging by the action on Wall Street you would never know that much of the oil-rich Middle East is in revolt; the world’s third-largest economy, Japan, is suffering through the after-shocks of a natural catastrophe; parts of Europe are going through the throes of a debt contraction; and political instability in the U.S. is threatening a shutdown of the federal government. Indeed, the popular equity-market averages reflected surprising investor stoicism in the face of bad news, gaining 5.5-6.5% in the first quarter of 2011, the best result for that time period since 1999 (as readers with long memories may recall, the NASDAQ index gained 85% that year; the S&P a less impressive 21% — no predictions intended). Stocks’ gains coincided with signs of an improving economy, including better numbers with respect to jobs, income and spending, and industrial production. Corporate earnings reports have also been quite strong coming out of a recession-weakened business environment, posting the biggest percentage gains in profitability since 1900, according to Bloomberg. This has prompted increasing numbers of companies to increase dividends and buy back more of their own shares. The markets’ positive reaction to the news implies optimism over further improvement in such measures of business health.
While it may seem puzzling to the casual observer, it is not unusual to see markets gain in the face of adversity. Stock values multiplied by four or five times from 1932 to 1937, in the depths of the Great Depression; in the early 1980s they rose sharply despite concerns about inflation, high interest rates, and oil prices. There is always something amiss in the world, and somehow or another markets always seem to climb these “walls of worry” sooner or later.
Sharp market rebounds are also common after big declines like the one in 2008-2009, or following long periods of weakness: the upwards leap in 1982 that proved to be the beginning of one of the greatest bull markets in history occurred after a full 16 years of flatlined stock barometers. Understandably, the rapid advances so far in this cycle have led some observers to voice concerns that stock prices have “gotten ahead of themselves.” It is unclear to us whether this is truly the case (and we are known for being quite attuned to valuations). On a “normalized” basis — adjusting for more or less temporary economic and earnings weakness — valuations for the market overall appear full, but not overinflated, as they often become when bullish conditions persist the way this current upswing has (since 2009). Furthermore, the stock prices of many large and important companies remain well below their previous highwater marks. We are by no means advocating the wholesale purchase of stocks — the bargain status reached by many issues two years ago has long since ceased to be — but if you are already a stock owner, things might not be so bad going forward, as long as you expect and can tolerate the usual ups and downs. There appears to be room for significant upward movement in stock prices before they would reach rich valuations, and many stocks would not need to return to their former highs in order to produce attractive returns for their holders.
As we have repeated many times over the last few years, the same sanguine remarks cannot be made about the market for fixed-income assets, which, in our view, is a ticking time bomb, with the ticking getting louder. As the memories of the 2008-2009 debacle fade away, the unusual, historically-low yields available on good quality investments are driving some market participants back to low-rated, ostensibly higher-yielding junk, including mortgage-backed paper, subprime loans, and securitizations. Thanks to recent history, all are now familiar to the general public, including the taxpayers who helped shore up the financial system after it was threatened by those who overindulged in these products the first time around. It is interesting to note that the average yield on junk bonds—currently at a record low of just under 7%—is not much different than the long-term average yields on intermediate-term treasuries, which carry no credit risk (historically, at least). This is indicative of the incredible speculation in these issues at a time when normal market yields and relationships among securities of varying quality and duration are extremely distorted.
It is also interesting to note who the sellers are this time. When the subprime market began to implode a few years ago, some of the surviving hedge funds and other “vulture” players swooped in and bought speculative debt instruments at prices which proved calamitous for the original owners. The carrion feeders are now selling paper for which they paid twenty or thirty cents for as much as sixty cents on the dollar. Even the U.S. Treasury is getting into the act. $142 billion of mortgage-backed securities acquired during the 2008-2009 panic (in a successful effort to stabilize the financial system) are being unloaded as the markets return to health. The old Wall Street adage, “Don’t fight the FED,” may come to have new meaning.
Crude oil prices rose 17% in the first quarter to over $100 per barrel, although they remain well below 2008's high of approximately $140, and apparently are not yet high enough to impact the U.S. economy or American driving habits. Still, the increase in energy costs represents a kind of consumer tax and is not helpful given that other commodities, from grains to metals and coal, have also risen sharply owing to poor crops, low inventories, Chinese demand, Middle East turmoil, and, at least to some extent, speculation. Not to worry, however. While these items find their way into most consumer products, according to Chairman Bernanke and the Federal Reserve their prices are “volatile” and, hence not really inflationary! Underlying inflation excluding the volatile elements remains tame.
Monsters From the LLC
Long-time readers may remember that one of our favorite films is Forbidden Planet, a 1956 sci-fi movie whose story is occasionally a source of insight for our commentaries. An expedition is sent into deep space to rescue a group of explorers from a previous mission to the planet Altair, most of whom, it turns out, have been killed by a machine built in the distant past by an advanced alien race. The ultimate labor-saving device, the machine caused objects to materialize at will with a mere thought. Unfortunately, so advanced were its creators that they had forgotten that thoughts also arise in the subconscious mind, home to the “mindless primitive,” the “savage beast” that our superegos keep in check. The machine, however, lacked such inhibitions and with access to a vast source of energy proceeded to create “monsters from the id” that wiped out the race and their advanced civilization.
We do not think it too much of a stretch to view the great machine of Altair as a metaphor for the corporation in our own modern economic and business culture. Like the machine, the purposes of the corporation are laudatory: it exists to pool resources and harness productive energies in order to create products that are needed and wanted by society. The key to this system is limited liability — the owners contribute capital, but have little say in running the business, the tradeoff being that they are at risk only to the extent of their contribution. This arrangement permits the collection of huge sums of capital from sources that might not otherwise be able to handle the risk entailed in a business venture. Yet limited liability also has a downside, especially when it applies to those who manage the businesses. Managements control the levers of power, and the unscrupulous among them have ample opportunity for self-aggrandizement. Importantly, they carry no personal liability for mistakes and often gargantuan compensation awards free them from most of life’s troubles. Thus freed from capitalism’s punitive mechanisms, they are able to roll the dice with other people’s money.
Freedom from ultimate responsibility by individuals, access to enormous financial resources, and growing political influence relieve corporations, like that out-of-control machine of cinema fame, of an important limiting influence, freeing them to create their own “monsters” and wreak havoc. The role that certain banking practices played in the extremely destructive financial crisis is clear. As we recently learned following the disaster in Japan, recklessness at a Japanese company responsible for running nuclear power installations had cost workers their lives long before the devastating earthquake. One also suspects that a certain oil company executive, had he to fear the loss of his sailboat, might have been more attentive to what was happening on a certain drilling platform in the Gulf of Mexico last year. (Executives at one company involved in the Gulf disaster were awarded bonuses for their “safety” record in 2010.) At least Japanese managers are subject to being shamed in their culture. In this country executives are decidedly shameless.
As investors who frequently interact with corporations and their managements, we have very mixed feelings about the flaws in this system, and virtually no hope of their ever being corrected, due to politics and legal issues. In an attempt to introduce some of capitalism’s limiting influences into the process, we vote our shares in such a way to favor owners over managements, but with little hope of any real impact. It is distressing that few people other than Warren Buffett and a few letter writers to the Financial Times have discussed this issue. Meanwhile, some businesses remain “too big to fail,” and perverse incentives for personal aggrandizement are still the norm.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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© Copyright 2011 Dennis C. Butler, All Rights Reserved
Revised: April 11, 2011 TAF
© Copyright 2011 Dennis C. Butler, All Rights Reserved