Portfolio manager’s Letter December 2011
While it is apparent that the long cycles identified in last month’s letter certainly bring into question the efficiency and rationality of publicly traded asset prices, since there is no long cycles relationship between those long cycles and corporate profits. Financial markets may not be efficient at measuring long cycles value, but they are very good at measuring the current investor psychosis.
In the 83 years since 1929 for which we have records pre tax corporate profits have grown from $10.4 million to $1.6 billion, or at an average annual rate of 6.33%. During the long cycles bear market of 1966 – 1982 profits grew at 4.49% per year or slightly below the long cycles average. During the long cycles bull market from 1982 to 2000 corporate profits expanded on average of 7.66% or above the average rate for the 83 years. During our current bear market that began in 2000, profits have increased by an average of 8.89% per year.
These figures bring up several interesting points. First of all the rate of growth in pre tax corporate profits has been increasing since 1982. This can be explained by Globalism, outsourcing, and digital technology. Also it is interesting that corporate profits have not only been above the 83 year average, but that they have increased faster during the current bear than they did during the 1982 – 2000 bull market. Finally, and most interesting of all is the fact that the long cycles as we have identified them seem to be totally indifferent to trend in corporate profits.
In the Nineteenth Century, economic cycles were a good deal shorter than those experienced in the Twentieth Century, with panics appearing every ten to twenty years instead of the thirty to forty year cycles for most the twentieth century. The fact that central banks have become more ubiquitous and powerful, and that money is no longer backed by any hard asset may go a long way to explaining this lengthening of the business cycle. As long there are central banks that have the power to print money at their pleasure it has become fairly easy for domestic politics to prolong an economic expansion with administration of an occasional monetary upper.
This kind economic tinkering has been a great hit with politicians of all flavors, and the temptation to put off economic pain is particularly attractive if that pain can be delayed until after the next election. While the rise of the power of central banks has not allowed the political operators to eliminate the economic cycles, they have become experts at prolonging the expansionary cycles.
While this is politically popular it is definitely dangerous for investors because it allows little bubbles to become big bubbles. In prolonging the expansions, the central banks become bubble builders. While the FED has been able to prolong the economic cycle, there is little statistical evidence that this tinkering provides any real long cycles benefit to the economy as a whole, because prolonging growth cycle just seems to make the subsequent corrections proportionately more painful.
As a corollary, consider that the exaggerated contraction delays, and therefore, intensifies the subsequent market upswing, as improved earnings, and the retirement of permanently scarred investors, reach a tipping point with a new generation of fresh-faced innocents.
The bias of central banks toward expansionary economics seems to have created a situation where only way to end an economic cycle is to keep expanding the bubble till it blows up in your face.
While these behavioral long cycles have little day to day impact on stock prices, it is important to understand that interpretation of PE ratios will be continuously changing and that, in a long cycles trend, PE ratios will either be contracting or expanding irrespective of the trend in corporate earnings. In other words, in a secular Bull Market, the PE ratios will keep expanding till the bubble blows up.
The best time to buy stock is toward end of a secular bear market cycle. While it possible to find undervalued equities at almost any time they only appear in abundance when the market is very bearish. If you want to define the overall market as the S&P 500, and define “value” as single digits PE ratios then you can expect a good general buying opportunity every thirty or forty years, or for most people once in a career.
So when will this magic moment appear? Don’t we wish someone would sound a gong for us? But it is unlikely that the helpful headline will appear in the Wall Street Journal, as journalists tend to lag a bit. As I remember for most of the late eighties and early nineties, newspapers were saying that the market was overvalued and dangerous. If we look back at the forty year chart of the S&P 500 it is easy to identify the point in October of 1982 when the market broke out and that long cycles bear market ended and everything turned up roses for the next seventeen years.
So do we go to cash and wait three of four more years until the market starts making new highs? (This is not a prediction about the end of our secular bull market – I may not be the brightest bulb on the shelf, but know better than to make silly predictions). It certainly wasn’t the best plan for the 1965 – 82 bear market. If you look at thirty year charts that cover the 60’s 70’s and 80’s the vast majority of individual stocks made lows at the bottom of the 1974 bear market.
But at the bottom of each succeeding correction before the bear market ended, 1978, 1980, and 1982, the prices of the majority of individual stocks were higher at these bottoms than they were at the bottom in 1974. Granted, stocks where cheaper on a value basis in 1982 because stock prices were not keeping up with corporate earnings and PE ratios were lower in 1982 than they were in 1974.
But, for most good quality individual stocks, the price in 1974, and again at the bottom of the correction in 1978, was considerably cheaper than the bottom of early 1982, let alone when the Bear ended in October of 1982. So as usual, the investor was paying a hefty price for feeling comfortable.
For instance, let’s look at the price of good old Berkshire Hathaway “A” shares (of course, there were only “A” shares then). In 1974, the low was about $35. Three years later, in 1978 at the bottom of the first correction after the fearsome bear market of 1974, Berkshire Hathaway’s low was $150. At the bottom, in early 1982, the price was about $500. When the bear market ended in September of 1982 Berkshire Hathaway was about $750.
I am certainly not saying that Berkshire Hathaway was typical stock for this period, because Berkshire Hathaway was not typical then or for a long time after that. My purpose only is to try to quantify the premium investors pay for feeling comfortable. Except for the percentage extremes, the S&P 500 followed a similar pattern with 1982 lows being much at much higher price than 1978 or 1974. The bottom in 1974 was just below 450 (I am reading this off old long cycles chart so the figures are not exact). In 1978, the low was just above 600, and, in 1982, over 700. And the breakout that was the end of the secular bear came late in 1982 at 1000.
No, History does not repeat, and the facts, and fundamentals today are quite different, but human nature stays the same so psychological patterns repeat. Now seem to me to be very close to where we were in 1978. The song charges, but some melodies keep repeating, and the tune that we are hearing from Lower Manhattan and indeed the world at large now sounds a lot like the refrain that was playing 1978. If the pattern of the 70’s does repeat then we can assume that the lows (prices) for this generation have been put in (in March 2009), and there are a lot of good companies that will sell in this correction at lowest price that we will ever see again.
The news out of Omaha, that Buffet has been on a buying binge this year, reaching a crescendo in the last few months, speaks clearly to this idea. Of course there is no guarantee that any part of these patterns will repeat, but it does give us something to think about, does it not.
No matter how you look at it, 2011 investment year offered us little to be happy about. As you can see from your portfolio performance sheets our investment results were poor. We substantially under-performed the market averages (by double digits in most cases). The reason for our under-performance was the concentrated nature of Losch Management Company portfolios particularly in financial stocks and Berkshire Hathaway.
I do not consider Berkshire Hathaway a financial stock, but it appears that for particularly the last year, Mr. Market has decided to toss Berkshire Hathaway into that bucket. The math says that the areas where we now reside are the best place to find value in the current market, so that’s where we, investment company, have to concentrate our portfolios. The argument can be made that I was early, and this would be correct. Unfortunately, being early is a curse that the every value investor has to learn to deal with a lot.
But, the end of the year is not the end of the game, and the stocks Mr. Market hates one year he may learn to love in the next. Since we are playing for the long cycles we still have many years to go before the fat lady sings.
Just as you pay a high price for a cheery consensus, bad news presents opportunities and the more bad news the better. Consequently some of the values that are available in today’s market are the best that we have seen in a long time (maybe a generation). In the piece below about long cycles we compare the mood of the market today to the stock market in 1978. In 1978 we were about 13 years into the 1970’s bear market, not exactly where we are today with respect to the 2000’s bear market, but it’s close enough for government work.
The lows may or may not be in, but the values are very attractive. It is likely that it may be some time before we return to a long cycles bull market, and so the hardest part of being a successful investor for the next few years may be the ability to sit quietly with the positions we hold and wait. For a successful investor patience is more important the being smart.