OR HOW I LEARNED TO STOP WORRYING AND LOVE THE MUDDLE-THROUGH SCENARIO1
I suppose love is too strong a word, but I could not help the reference to Dr. Strangelove. Finding humor in looming catastrophe is not a new idea, and might ease our pain a bit as we end a tumultuous 2011 and look forward to a lot of uncertainty in 2012.
As we all know, and as we mentioned in a previous letter referencing the protest song “Eve of Destruction,” the feared worst case of nuclear holocaust was not inevitable, despite the many strident forecasts of doom, and this offers some parallels to our current situation. Many prominent economists and analysts are earning fame and fortune proclaiming the end of the good life as we know it, and do so in some cases with excellent analysis and arguments (others not so much, needless to say). And we are seeing serious problems, no question. To summarize the two biggest:
1. Europe and the euro are in crisis, have been for several years now, reeling from one problem to another. The inelegantly nicknamed PIIGS – Portugal, Italy, Ireland, Greece and Spain – are all still grappling with almost overwhelming debt, weak economies and angry citizens, far too many of whom are unemployed. No easy answer is in sight; this is going to be very tough, no doubt. And it could still cause major trouble.
2. The U.S. has a combination of a huge government budget deficit/record debt on the one hand, and high and unyielding unemployment on the other. We are employing fewer workers than we did in 2000; we are setting records for low levels of participation in the workforce and job creation. We have had a few glimmers of hope recently (including today’s initial unemployment claims release—down 50,000 to 352,000).23Let’s hope this trend continues.
The muddle-through scenario
So why would we invest in the equity markets with so much going wrong? A related question was put to me recently, why would we buy something that doesn’t go up? Good question! Specifically, as an example, we are looking at 10 years of S&P 500 returns of about zero, with a lot of fluctuation in between. Not very attractive. So with a recent history of lousy returns, and danger looming almost everywhere, what are we doing in the market?
There are good reasons to be in the market, very good ones. Looking back with 20/20 hindsight, we see the S&P 500 on a tear from 1982 to 1999. The last five of those years saw a 28.6% compound annual return, a new record that may well stand forever.4And by 1999, the press was full of admonitions to invest by simply “putting it all in the S&P 500.” Seriously. Really. Hard to imagine now, but that was the received wisdom at the time.
Needless to say (but that never stopped us saying it before) the next ten years saw the S&P 500 lose money, for 10 full years! Another record. And a very bad place to “put it all.” Every other class of equity made at least decent returns, and some did extremely well. And bonds, almost forgotten by the late nineties, had just a superb decade.
So, in 2000, the question was “why not put it 100% into equity, which always goes up? And why not all in the S&P 500, which does best?” The past was great, and the future looked bright. As it turns out, those are often the points of maximum risk, just when you feel the best. Conversely, if you pore over books of statistics and past market returns, as some of us do (we even like it, some of us!), you find that the points where markets were doing badly, and market sentiment was worst, often turned out to be the best opportunities.
So why might this be such a time, an opportunity despite all our troubles?
As we have discussed in several previous letters, market valuations (e.g., price/earnings ratios) are quite low by historical standards, and that is especially the case if you account for record low interest rates; normally a low interest rate environment would support higher multiples of earnings, which creates a lower return on equity to match the low return offered by bonds. Even dividend yields are better than treasury yields these days!5What created this situation? Well, while the governments of the world have really bungled matters this time, and unemployment remains very high, companies have made their adjustments and returned to profitability and strong balance sheets and growth. Business is very good, but equity markets have not responded to this. Driven by fear, equity prices have remained depressed. Thus, the opportunity for those bold enough to buy solid profitable businesses at bargain prices despite the apparent risks.
In short, we do not need a miracle to survive, and we are not likely to get one soon anyway. The good news is that we don’t need a miracle. As we discussed in our recent letter reviewing the survey of the euro from The Economist, we believe the most likely outcome is muddling through, neither solving all the problems in spectacular fashion nor enduring the kind of disastrous outcome so many pundits enjoy forecasting. The fear suppressing today’s equity prices could dissipate in such a scenario, allowing for some appreciation. Just remember, no one rings a bell to tell you it’s OK to buy now– these things usually happen rapidly and unexpectedly.
We are likely to have a tough slog, make no mistake; in Europe and America we have our work cut out for us. The debt is a disaster and unemployment just as bad, and neither will yield quickly. We do have problems, and people are suffering and will suffer some more. And we do have the very real possibility of substantial setbacks, which is the reason the market is so fearful. But a muddle-through scenario could work out pretty well for today’s investor, should it develop that way. As long-term investors we cannot afford to miss it.