The Peloton Position / 2nd Quarter 2012

Summer Heat

Summer officially began June 21, but for much of the country, it has been summer-like since the end of February. In Indianapolis, when temperatures stretched into the mid-80’s in early March, one of my children asked, “Daddy, is it summer?” I had to think about it for a second, “Technically, honey, it’s not even spring yet.” Plenty of CEOs, politicians, and policy makers have also been feeling the heat for a while. For some, it is only going to get hotter.

A number of CEOs have been sweating the heat lately. Chesapeake Energy CEO Aubrey McClendon stepped down as chairman of the company he founded after a number of personal financing conflicts came to light. Scott Thompson resigned as CEO of Yahoo! following the discovery of a minor discrepancy on his resume—it seems that Thompson’s alma mater did not actually offer computer science degrees at the time he attended. Green Mountain Coffee Roasters founder and CEO Robert Stiller was ousted for violating the company’s stock sale rules. The CEOs of NASDAQ and Morgan Stanley have taken fire for the Facebook IPO debacle. And most recently, JP Morgan CEO Jamie Dimon endured hours of mind-numbing pontification and uninformed questioning from members of both the Senate and House banking committees regarding his bank’s recent $2.0 billion trading loss.

Wall Street is not the only hot spot. Washington DC is also in the midst of a heat wave. Fed Chairman Ben Bernanke is walking a tightrope over a witch’s boiling cauldron. The slow growth economy (or “Plowhorse Economy” according to Brian Wesbury1) makes it incredibly tricky for the Fed to move decisively in either direction. Extremely loose (accommodative) monetary policy, including extraordinary programs like QE1, QE2, and Operation Twist, cannot persist indefinitely. However, stubbornly high unemployment statistics preclude Bernanke from allowing interest rates to find equilibrium at higher levels. Dr. Bernanke, to his credit, has made the most of his predicament by doing the only sensible thing in Washington lately—he turned up the heat on members of Congress themselves to fix their looming “fiscal cliff.”

In an election year with so many uncertainties and crosscurrents, there is perhaps no hotter seat than the one behind the desk in the Oval Office. With unemployment high and economic growth barely room-temperature (and decelerating), President Obama has lost the ability to campaign on any suggestion that massive spending programs have rescued the economy. Instead, he has sharpened his attack on wealthy Americans with a “tax fairness” message, enlisted college students and recent graduates as combatants in “class warfare,” and mischaracterized Governor Romney’s success in private equity (while vilifying the entire PE industry in the process). One thing is certain. The long, hot summer that began in March will last until Election Day in November, at least.

ICYMI (IN CASE YOU MISSED IT)

The news is awful. Anyone with a TV, radio, newspaper subscription, or Twitter account can recite a long list of challenges facing investors: Europe, China, Congress, the housing market, stingy banks, unemployment, greedy corporations, high oil prices… And so on… These nagging concerns, together with the turn of the calendar, have led many to surmise that stocks will inevitably decline again throughout this summer. Admittedly, the pattern so far is eerily similar to 2010 and 2011. Nevertheless, we think there are plenty of good arguments against a “three-peat” in ‘12. In a recent blog post2, we included the table below to support our case. The point is that on many fronts, things are much better than they were 12 and 24 months ago when stocks withered in the summer heat.

Summer Heat Comparison Chart

Despite year-to-year improvements, economic indicators have weakened very recently, and employment trends have turned mixed. Stocks again have consolidated after a strong first quarter. We at Peloton believe the current economic soft patch has much more to do with uncertainty about future regulation and tax policy than renewed fears of European systemic financial risk or a Chinese economic hard landing. The European machinations certainly bolster Americans’ confidence, but it makes sense that domestic growth is stalling 6-9 months ahead of the date on which trillions of effectual tax hikes may hit businesses and households. The fact is, corporations and households are simply unwilling to make significant investments or purchase big-ticket items without the ability to assess how taxes or regulations will impact their operations. Similarly, financial markets are currently handicapping, in advance, the odds of a wide range of possible outcomes. When the range of uncertainty is this broad, the markets (initially) assume the worst. (For instance, depending on Congressional action—or not—future dividend tax rates could range from 15%-43%!)

In addition to the empirical data in our table, we believe there are other reasons to question the inevitable summer swoon. For one, the world is still grossly over-allocated within “safe” investments like bonds and cash. This could be tremendous fuel for stock prices as uncertainties are clarified throughout the year. History has demonstrated that stocks quickly price-in a worst-case scenario, and then climb “walls of worry” as issues are resolved. Three years ago we witnessed this in the depths of the global credit crisis. Two years ago the phenomenon played out after early reports predicted the BP Macondo oil spill would turn the Gulf of Mexico into a dead sea and close the Gulf Coast for decades. Last year the debt-ceiling impasse and impending credit downgrade threatened massively higher borrowing costs for America and a potential default – none of which materialized. And this year? Well, at this point, the consensus of opinion is again bleak for stocks. Most assume: 1) that Congress will remain deadlocked and drive us over the fiscal cliff; 2) that Obama will be re-elected and fail to address tax reform and entitlement programs; and 3) that Europe will blow up, leading to a global recession and significantly lower corporate profits. If forced to bet on any of these issues individually, we’d take the odds that they won’t materialize either.

SO WHY DO WE DO IT…?

Investors are tired of roller coasters. The past 10 years have been so volatile and frustrating that an entire generation of would-be investors has perhaps irreparably abandoned stocks. It has been a long, tough slog that naturally raises the question, “why bother?”

So why do we do it? Intuitively, it seems foolish to own risk assets like stocks during uncertain times. However, time and again, markets prove that for stock buyers, good bargains and good news don’t happen at the same time. We don’t know what is going to happen in Europe or with the election or taxes, but we do know that investing does not have binary outcomes. Just like there is a range of economic activity (virtually any percentage rate of growth or contraction) or a range of potential future tax rates on corporations, individuals, capital gains, dividends, etc., there are ranges of future returns for distinctive investments. A recession or bad news from Europe does not mean that all stocks will become worthless or that one’s financial goals are suddenly beyond reach. Likewise, generally bad fiscal or economic news may not prove specifically bad for the stock prices of particular companies.

Our information-overload society has created a false sense of black or white in investing—“risk-on” or “risk-off” in trader’s parlance. There are thousands of discrete data points and nuances that converge to influence any company’s operating performance and stock price. Unfortunately, investors have been trained to fret about every incremental data point reported—whether it is a specific quarterly earnings announcement or a macroeconomic report on consumer price inflation (CPI). And worse yet, investors are being encouraged to make all-in or all-out decisions based on every next piece of info available. It doesn’t work that way; it just doesn’t.

We do not build portfolios out of macroeconomic data points or earnings releases from random companies from tangentially-pertinent industries. We invest clients’ capital in real pieces of real businesses that we understand. These investments are backed by cash flows, profits, high-quality management teams, established brands, strong market positions, pricing power, and many other things that do not go away simply because, for example, the CPI index was 0.1% higher or lower than expected last month.

A solid approach can generate solid long-term returns even in difficult environments, and it has for Peloton’s clients. The definition of successful investing (or portfolio management) should revert to the idea of “achieving reasonable financial goals” rather than “avoiding every downturn and being all-in on good days.” The past decade has been a grind for equity investors but, at Peloton, we continue to stick with our investing discipline. Why do we do it? Because it works.

1 Chief Economist at First Trust Advisors (@wesbury)
2 pelotonwealth.com/blog “Summer 2012: 3-Peat? Not so Fast. “ May 10, 2012
 
 

The Peloton Position is a compilation of original insights and writings by Peloton Wealth Strategists. This issue features articles by Matthew K. Bradley, Executive Director and Chief Investment Officer.