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June 30, 2010 Market Commentary

Posted by: STEVE ARNETT

Posted on: July 6, 2010

“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”  Winston Churchill

The last 2 ½ years have been particularly tough for investors, and we aren’t yet out of the woods.  The road to this recovery will likely be slow.  Opinions vary widely; most offer little hope because they see no reasons for optimism.  George Soros, a renowned hedge fund investor, observes, “Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.”  In this vein, one might bet that the developing markets will rebound more quickly than predicted.  In the past, developing markets would be discounted because of their relative size, yet today they approach 50% of global Gross Domestic Product.  This should favor U.S. multi-national corporations (MNC) like McDonald’s and Coca-Cola, who derive an amazing 75% and 66%, respectively, of their revenue from outside the U.S.  How does that help us?  According to McKinsey & Co., although MNCs account for less than 1% of all U.S. companies, they represent more than 23% of the U.S. private sector portion of our GDP (2007).  Since 1990, MNCs have accounted for 31% of our GDP growth and over 40% of our productivity gain.  Their foreign sales account for over half of our exports and one-third of our imports.  Thus, as the global economy improves, these companies should be positioned to experience significant gains in revenue, which in turn will buoy U.S. GDP.

The U.S. has a population of just over 300 million people; the potential markets for cars, computers, and cell phones have reached 81%, 81%, and 87%, respectively. Contrast this with India, whose population is 1.2 billion, but whose potential markets for cars, computers and cell phones have only reached 1.2%, 3.3%, and 29.4%, respectively.  In the case of China, with a population of 1.3 billion, numbers are 2.8%, 5.7% and 48%, respectively.  The U.S. is reaching a much slower growth rate domestically, but should benefit globally  as the developing markets begin to see their demand for these types of products explode.

As the above points out, there are large underserved populations in developing countries for American goods.  The economic potential in these countries are enormous; all that needs to happen is for their standard of living to increase. To illustrate this point, let’s examine what China’s and India’s current standard of living is relative to the US.  Someone working fulltime in the U.S. making minimum wage would expect to earn approximately $15,080 annually.  Earning the equivalent amount in India or China, one would have to work 24.33 years and 8.83 years, respectively.  This gives  an idea of the enormous potential increase in their standard of living.  As an exporter and a provider of high value added products and services, the U.S.  will benefit significantly.

Beyond the potential to grow existing markets, the U.S. is at the top of the class when it comes to being innovators of technology and other products, which can create industries where none existed a few years before.  A perfect example is the music business, where advances in technology have taken us from vinyl records (peaked in 1977), to eight track tapes (1978), to cassette tapes (1990), to CD’s (1999) and now to a digital platform to listen to music. (Recording Industry Association of America). 

Who knows where we go from here? The big player in the case of the latter is Apple, who has built on the concept of an iPod and leveraged it into the iPhone and now the iPad.  As Apple has grown, businesses that created ancillary products for them have emerged.  In 1890, Charles H. Duell, who was Commissioner of the U.S. Patent Office said, “Everything that can be invented has been invented”.  How wrong he was!

Technology and innovation can be tremendous catalysts for economic growth.  In the two recent studies by Bloomberg/BusinessWeek, they selected the top 50 Most Innovative Companies and 100 Top Tech Companies in the world.  In the case of the former, U.S. companies made up 22 of the top 50 and 6 of the top 10.  In the case of the latter, U.S. Companies made up 42 of the 100 and 5 of the top 10. 

The rally that began on March 9, 2009 has seen the S&P 500 increase over 84% by April 23^rd of this year. Since that time, it has declined almost 15% bringing the return to 56%. We have been telling our clients that at some point the market would have a pullback of between 10 – 20% because it couldn’t continue to go straight up. Is the pullback a result of stocks being overvalued? One measure of whether stocks are undervalued or overvalued is the ratio of total market cap to US GDP, which is the method that Warren Buffett prefers to use. Using the Wilshire 5000 Total Market Index and the most recent reported GDP (Gross National Product),the ratio is currently at 81%. The ratio has been as low as the 35% during the deep recession of 1982 and reached a high of 148% during the tech bubble of 2000. On a relative basis this puts the market at modestly undervalued which would translate into an average annual return of 7.5% into the future. Jack Bogle, the former head of Vanguard commented that he thought that returns for the next decade would be between 7-8%. Historically from 1926-2009 the S&P 500 has had an annual average return of 9.9%. During that 84-year period, there were only 6 periods when actual returns fell within plus/minus two percentage points of the historical average.

In prior commentaries we have talked about fund flows, which refer to how much money is coming in and going out of different types of mutual funds. The numbers are incredible. Over the last 17 months   (ending 5/10), there have been $34.8 billion that have flown out of U.S. stock funds, while at the same time international stock funds have taken in over $45.4 billion dollars.  The most amazing statistic is that fixed income funds have taken in over $475.7 billion dollars and that indicates that investors are still very risk adverse. 

The road ahead of us is going to be bumpy and the market will go up and down but we believe the trend is up, and like Winston Churchill,  we choose to be optimists and look for the opportunities in this crisis. As Peter Lynch, the former manager of the Fidelity Magellan fund once said, “unless you're a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.”

For the quarter ending June 30, 2010, returns for the S&P 500, NASDAQ, Russell 2000, MCSI EAFE, and Barclays U.S. Aggregate Bond indexes were <6.66%>, <6.60%>, <1.95%>, <13.25%> and 5.33%, respectively.  For the same period, our Stock, Aggressive Stock, Balanced and Fixed portfolio returns were <7.85%>, <6.93%>, <1.88%> and 4.09%, respectively.