So far, 2011 is shaping to up to be one for the history books. Tunisians caused the first revolution in the Middle East since 1979. Egypt soon followed as protesters forced Hosni Mubarak, the Egyptian President since 1981, to step down. There’s a high probability that Libya and Yemen will have new leaders by 2012. Civil unrest is occurring in Syria, Bahrain, Iran and Saudi Arabia but the markets’ perception is that leaders of these countries are less threatened.
Earthquake in Japan
On March 11th, the market was catching up to the uncertainty in the Mideast when a 9.0 earthquake struck Japan. The Tohuku earthquake is the 4th strongest since 1900. But, the horror of the earthquake paled next to the impact of the tsunami and the confusion surrounding the state of the nuclear reactors at Fukushima. Global markets took their cues from the latest success or failure of the containment efforts.
In some ways, the crisis paralleled the British Petroleum oil spill from 2010. As traumatizing and threatening as these events appear, the scale of the global economy is of such a great magnitude that revolutions, wars, natural disasters and man-made disasters rarely alter the trajectory of the economic cycle. Most often, global economic activity recovers to pre-crisis levels within six months of the crisis.
Higher Oil Prices
The economic impact of the instability in the Middle East was immediate. The price of oil is up about 25% since protests in Egypt broke out. Fortunately, higher oil prices do not create the same economic headwind today as they did in the 1970s. In spite of higher oil prices, most economic indicators showed stronger than expected growth. Unemployment receded to the lowest levels in two years, and corporate earnings exceeded fairly optimistic expectations. Final economic growth statistics were only held back by a drop in government spending at the local and state level.
Europe’s Debt Crisis
Europe is still battling the debt crises of Ireland, Portugal, Greece and potentially Spain. The European Union and European Central Bank appears to have successfully bought some time but a permanent solution is still missing. Until Europe definitively decides whether to abandon their smaller “peripheral” countries or become a co-signer on all of their debts, it will continue to stumble from one stop-gap measure to another while hoping that the economic recovery matures enough for the dependent states to grow their way out of their insolvency.
Eventually, Europe will attempt to strengthen the bonds of the member states. If Europe were to abandon Greece, Portugal and Ireland, it would call into question the entire meaning of the European Union. Since the end of WWII, Europe has continually pursued more unification and integration. The will to continue the process will likely overcome the current sovereign debt crises.
Robust First Quarter Performance
In spite of the extreme turbulence of the last few months, the Dow Jones was up 6.4%, the best first quarter since 1998. The S&P 500 was up 5.4% before dividends. International stocks lagged as the MSCI All-Cap World benchmark was only up 2.5% for the quarter.
For the quarter, Barden Capital’s Growth portfolios achieved outperformance relative to the S&P 500. After fees, most growth accounts were up about 7% while the balanced accounts were up as much as the S&P 500–5.4% on average. I’m especially pleased that our balanced accounts, which on average are approximately 60% invested in stocks and 40% in bonds, were able to match the performance of the S&P 500.
The Stock Market Appears Modestly Undervalued
As of today, April 7th, the S&P 500 is at 1,333. This is exactly 100% higher than the value on March 9th, 2009, but we’re still 18% below the all-time high set in the fall of 2007. By the second quarter of this year, earnings should fully surpass the prior peak from 2007. Astonishingly, this will be the fastest earnings recovery since at least 1900, according to Yale University’s Robert Shiller, author of Irrational Exuberance. In spite of this being the best stock market rally since 1937, the market is still undervalued relative to the 2007 peak of 1,576.
1,576 on the S&P 500 was 17.5 times peak earnings of $90. Today, the S&P 500 is priced at 14.8 times present earnings. Analysts estimate that the S&P 500’s 2012 earnings will be $110. At 17.5x $110, the S&P 500 would trade at 1,926, 45% higher than today.
Fundamentals like earnings and profit margins drive the market over the long-term. Short-term market moves are the providence of emotion and sentiment. It’s impossible to know when the market will exceed its previous all-time of 1,576, but earnings and profit margins suggest that it should be sooner rather than later.
Strategic Adjustment to Bond Portfolio
Stocks are still trading below pre-Y2K prices, while bonds appear to be in the final stages of a multi-decade bear market. Fixed income allocations helped protect assets during the credit crisis, but for the last year, they have been a substantial drag on overall investment performance.
As the economic recovery matures, resources become scarcer. This drives up demand for financing, leading to an increase in interest rates. Higher interest rates equate to lower prices for fixed income investments. In response to higher interest rate expectations, we have shifted the bond strategies towards low risk short-term credits which behave similarly to money markets and CDs and short-term high yielding corporate bonds.
The Pace Will Slow, but the Recovery Should Continue
We’re not going to see stocks increase 100 percent in a 24 month period again anytime soon. But stock prices should continue higher. The Federal Reserve will not suddenly increase interest rates, and inflation is not an immediate problem. Even government deficits will be stable for the next three years or so.
We have major issues that need addressing, but we are unlikely to face the consequences of any of these issues in the next twelve months. In the meantime, stocks should continue to grind higher along with earnings growth through the duration of the current economic expansion. With any luck, that expiration date on this expansion is still years away.
