STUDIO began on Thursday, August 4th. As most of you know, we hit a few bumps during the first week, but all issues were resolved quickly. We are happy to share that every family with which we previously worked followed us to STUDIO. Thanks to everyone for the fantastic support!
The financial world continues to provide more than its share of front-page news, and I offer our perspective on some of it below. Market volatility reached levels that surprised us. The already-much-discussed Greek debt crisis and larger European debt situation affect our near-term risk-taking approach. Our outlook for stocks remains lukewarm, yet we continue to emphasize a shift toward high-quality stocks, highlighted by our recent purchase of Nestle. And, lastly, we highlight our gradually increasing emphasis on emerging-market exposure.
The bumps of our first week extended to the stock market. On that first Thursday (8/4), the market declined nearly 5%. On Friday, Standard & Poor’s downgraded its credit rating of the U.S. Treasury from its highest AAA rating – most unwelcome news. On Monday, the market dropped nearly 7%. The market then jumped 5% on Tuesday, fell 5% on Wednesday, and climbed 5% on Thursday.
These six trading days, along with the middle weeks of October 2008, tied for the most volatile week in the U.S. stock market since World War II. And no week on recent record has exhibited such extreme price volatility coupled with such neat, and inexplicable, price reversals, one day after the next.
A normal distribution, or “bell curve”, indicates that the probability of a four-standard-deviation event is 1 in 17,000. Applying that frequency to the stock market, a daily move of 5% – four standard deviations from an average day’s result – would occur once every 46 years. In early August, five of six days saw this degree of volatility. One need not be a statistician to deduce that stock market movements don’t quite correspond to a bell curve (despite much of academic finance’s reliance on the assumption). Whatever mathematical interpretation one prefers, it was clearly a bumpy week.
Just days earlier, on August 2nd, President Obama signed into law the Budget Control Act of 2011, and raised the debt ceiling in doing so. Many believed the debt-ceiling issue was the fear that gripped the markets over the summer, and its resolution would be a calming influence. Clearly, the volatility that began just days later indicated otherwise.
The markets finally woke up to the real concern of the moment – the European debt crisis. And while our viewpoint is not likely to offer new insights, I believe the situation’s significance still warrants our perspective. To be sure, complicated politics will determine much of the outcome, and messages from Europe have been slow, weak, and inconsistent. As a result, the market seems to change its mind frequently, still today.
To recap, there are four key issues in Europe: 1) Greece can’t pay its debts, 2) many European banks have lent Greece money that will not be paid back, creating a potential shortage of money at the banks, 3) other European countries may not be able to pay their debts, creating still more risk for banks, and 4) there is much interconnected lending in Europe. Layer on the inherent complexities of a collection of 17 sovereign nations all (sort of) subject to the rules of a common currency, and you find a complex situation.
Even if some of its debt is forgiven, Greece may still have too much of it. Future economic growth will determine this, and the outlook is dicey. Growth is being impaired by forced spending cuts, and higher taxes, with no end in sight. Demographic and immigration trends are not promising. And banks have their own problems and therefore limit new loans, further impairing growth prospects.
The graphic below quickly makes Europe’s interconnectedness obvious. In addition, the Spanish and Italians have five to six times the debt that Greece does. Many are particularly worried about Italy’s ability to pay its debts, or at least to refinance its debts when they come due. If the world loses confidence in Italy’s financials, then the problems of Europe become extremely unpleasant. Italy might just be too big to bail out.
Source: Bill Marsh/New York Times
At the moment, Greece is the key domino. The enforcers of the Greek spending cuts are not Greek leaders, but instead those lending the new bailout funds – led by Germany. Not surprisingly, this forced austerity isn’t being well received by the Greek public. Rioting has grown violent, while striking has piled garbage head high. Worse yet, some extremist-Greek thinking has begun creeping into the mainstream, including claims of a German interest in re-occupation, and even Nazism. At the same time, Germans have signed up to absorb the largest percentage of the collective rescue of Greece. At best, it seems that resolution will come with strong resentment from both directions.
Europe’s issues extend well beyond Greece and Germany. As a result, there are many constituencies to satisfy, making the situation inherently volatile. I still believe the worst outcomes in Europe will be avoided, but the worst outcomes are ugly – uglier than most. As a result, I do not believe it prudent to be unusually aggressive in allocating assets. The downside risks are improbable, but their magnitudes are large – larger than most.
Furthermore, unusual aggression may not be well served even in the best case, as I do not think stocks are inexpensive, despite common claims to the contrary. Strangely, some point to past market levels as evidence. The U.S. stock market is 5% off of its 52-week high (July 7th), but it is also 17% above its 52-week low (October 3rd). The market is 17% off of its five-year high (October 2007), but it is also 87% above its five-year low (March 2009). If anything, recent price history would point to overvaluation rather than undervaluation. None of these frames are useful, however, because a stock’s underlying value is not dependent upon its past price.
Others point to the attractiveness of today’s prices relative to tomorrow’s expected corporate profits. Unfortunately, with the developed world awash in debt, I believe that profit expectations are abnormally high. The rampant growth in debt, over three decades, created false economic growth, and that growth helped produce false corporate profits. If corporate profits revert toward a more normal level, today’s stock prices will not look as cheap. Additionally, recent layoffs and their correspondingly lower corporate costs have provided yet another boost to corporate profit margins, but these benefits would not be maintained through a sustained growth phase.
So, while I still like stocks much better than bonds, and while I continue to prefer high-quality stocks to most every other investment class in the world, it is only a relative preference. On an absolute basis, the outlook, even for quality stocks, is merely acceptable. Today’s investing is a bit like voting for the candidate whom one dislikes the least.
Fortunately, there are individual opportunities for high-quality investments that occasionally arise, and our recent purchase of Nestle is an example. Nestle is the largest packaged-food and beverage company in the world, with 30 brands that generate over $1 billion in annual sales. Product areas include cereal, yogurt, coffee, water, ice cream, confectionary, pet care, and infant foods. The company did a mediocre job of allocating its substantial cash flow in the past, but this has improved nicely in recent years – a big positive. Economic sensitivity is low, reducing downside risk. Market shares are dominant, creating pricing power – that should exceed inflation. Growth prospects are solid, resulting in large part from emerging-market exposure. And the share price is attractive, emanating from the European debt crisis.
Nestle’s emerging market exposure – roughly one-third of revenue – is an important example of an increasing focus area for STUDIO. We hope to increase exposure to these faster-growing markets through relatively stable means. Often, this will come through ownership of shares in large, stable, multinational companies. In Nestle’s case, the growth differential is wide; in the most recent quarter, revenue growth was just 4% in developed markets, compared with 13% in emerging markets.
As the table above shows, the data are overwhelming. The population of the emerging markets is 82% of the world’s total, while the stock market value of the emerging markets is just 13% of the world’s total. As the emerging markets continue to benefit from global trade and mature into their capitalistic systems, and as the developed markets struggle with their weaker demographics and debt load, we expect the stock market valuation gap to converge.
The increase in emerging-market exposure will be gradual, but I believe it is a necessity. The numbers above are just too compelling. Of course, we still have to identify attractive entry points, because even great stories can be too expensive. But emerging-market growth will not come smoothly, so those opportunities will arise, and we will aim to take advantage of them.
After all, some bumps provide the best opportunities. Thanks again for your support in recent months. It will not be forgotten.