The Long Run Quarterly Letter: October 2011

"No passion so effectually robs the mind of all its powers of acting and reasoning as fear." — Edmund Burke

After two years of recovery from the disastrous lows struck in the climax of the initial credit crisis, fear has returned – driving global markets to swoon in the third quarter of 2011. Though much of the news has been centered on the sovereign debt issues in Europe, commodity prices have dropped precipitously – and emerging markets have cratered. The U.S. equity markets have been among the most resilient; and, surprising many pundits, the U.S. dollar has risen dramatically against most global currencies as nervous investors flee to the highest ground. Whether driven by fear of losing an election or fear of losing a currency, leadership paralysis in the developed world has pierced the confidence of the consumers, investors and businesses that drive global economic activity. Add the potential for a hard economic landing in China, and we now see pessimism at a full boil.

There are two primary issues driving the current volatility in the markets. First, the return of concern over solvency in the global banking system has sparked fear that a new contagion could lead to a second full-blown credit crisis. We read about sovereign debt problems in Greece, but the real problem is the potential for banks to fail under bad loans and then fail again as counter-parties to other banks on bad bets leading to larger systemic failures: The Lehman problem. Second, the sharp downward adjustments to U.S. GDP growth in July confirm that the U.S. is indeed experiencing slow growth and not enjoying the 3% to 4% annual growth rates that economists had – until the announcement – been affirming. Considering China’s tightening of credit, austerity in Europe and this adjusted U.S. reality, the hopes of seeing high growth rates in global GDP anytime soon have been dashed.

We have been asserting – since before the credit crisis began – that the deleveraging required to reset balance sheets that were warped by a multi-decade credit bubble would be a long, painful process. In April of 2007, we wrote, “We continue to believe that the primary nexus for market disruption here and abroad will be in the financial sector. Brokerages and banks are just beginning to rein in their lending, and we expect more blowups. The sub-prime lending crisis is a prelude.” This basic insight led us to avoid credit-sensitive areas in portfolios including money-center banks, insurance companies and other lenders. It also redoubled our focus on balance sheets as we recognized that companies that have ample cash and low debt have great advantages in times of tight credit when competitors falter. Our thinking has not changed, and we believe that what we are seeing today in Europe is the reality of deleveraging taking root. Hard decisions must be made and solvency will be tested. We continue to avoid investments in lenders and in companies with significant debt exposures in order to take solvency issues off the table.

Concerns over the sustainability of China’s growth and conviction that deleveraging would almost certainly slow the gears of economic growth in developed markets led us to conclude some time ago that we were likely going to endure a period of slow growth in the wake of the crisis. In April of 2010, we wrote, “So we begin to question whether we are facing a ‘bubble of certainty’ surrounding China and whether the dominant macro investment themes of the last decade – a broad dependence on vibrant emerging market GDP growth and expanded commitments to investments in industrial commodities – will succeed over the next decade. Expecting an extended period of deleveraging and moderating global growth ahead, we turn our attention to innovation once again as the critical driver of earnings expansion.”

Through the stimulus-induced market surge that carried us from 2009 lows to early 2011 highs, we have been rebalancing from investments dependent on a strong, coordinated macro-growth environment to companies that have the ability to thrive in a slower growth environment – trimming highly cyclical names, energy names and commodity-focused companies and investing in companies that have more ability to find sustainable growth independently or through innovations like genomics in medicine or mobility in technology. We have also added to cash holdings to maintain liquidity through times of volatility. These somewhat contrarian adjustments have served clients well through the recent market turmoil and position portfolios well for the road ahead.

As we look forward, we expect continued volatility beyond the historic norms for equity and credit markets. As is the case when a very large stone is hurled into a pond, current economic ripples will be more pronounced and will take more time to recede. But investors should note that volatility is not the same thing as risk. Many very attractive investments are on sale as panicked institutions and individuals have disregarded fundamentals to avoid the psychological pain that comes with violent swings in the market. Borrowing Warren Buffet’s famous words, “Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics is equally unpredictable, both as to duration and degree. Therefore we never try to anticipate the arrival or departure of either. We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." Just as we were disciplined about trimming holdings as the market rode up, we are likely to make modest purchases in equities and to continue rebalancing accounts in the depths of the market swoon. It is not an accident that Warren Buffet announced last month that he would be buying in shares of Berkshire Hathaway for the first time since he took over the company in 1965.

Caution is warranted in such an accident-prone world where moderating growth leaves us vulnerable to recession risks and no credible catalysts for change seem to be on the horizon. And yet, there are some signs to give investors hope. Don Hays of Hays Advisory service uses multiple data points to measure the prevailing conditions of psychology, monetary liquidity and equity market valuation. His approach has provided extraordinarily accurate insight over multiple market cycles leading to timely sales before bear markets and timely entries in advance of bull markets. The third quarter of 2011 drove dramatic changes in the Hays’ three-pronged asset allocation matrix: Equity market valuation dropped to “extremely undervalued” (the lowest of five measurement tiers), monetary liquidity dropped to the most accommodating of their six measurement tiers for liquidity, and psychology (measured as of August 9) was at the second lowest tier. All, extremely positive indicators. Psychology at this level has nearly always signaled that markets were near an eventual low point. Based on the historical record, these monetary and valuation levels give extremely high odds of long-term success. Hays shows average annualized returns of over 15% for both three- and five-year periods when these levels have been reached in the past. Hays also looks at the Rydex fund family money market holdings as a signal of opportunity. In September, Rydex traders held $1.57 in cash for every $1 in stocks. Every time this ratio has broken above 150% since 1997, without exception, equity prices have been higher three months, six months and one year later.

Of course – while market tea leaves might give comfort – there are exceptions to every rule, and history does not always provide a perfectly accurate roadmap. No one can measure the duration or amplitude of bull or bear markets with confidence. We can, however, judge when investments are reasonably valued and when they are not – and we can avoid the pitfalls of our human condition that compel us to sell at lows and to buy at the least opportune times. The allocation targets we establish with clients are designed not only to provide a powerful engine for long-term growth through carefully selected equity investments, but also to meet current liquidity needs and to mute volatility in difficult market environments. Maintaining a disciplined balance – particularly in volatile periods – has been and will always be a critical factor in assuring long-term investment success.

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In company news, we are very pleased to welcome Megan McGregor to our client service team and Jackson Bell to our research team. Megan joins us from Brown Brothers Harriman, and Jackson recently completed two years of teaching as a Teach for America corps member. We are fortunate to have such bright, young talent as a part of our firm.