At its annual Partners Dinner the late Leon Levy, Senior Partner of Oppenheimer & Company, always welcomed those newly admitted with the words, "You don't know how lucky you are to become an owner of a business in which the higher the price of the product, the more people want to buy it." We recall those words every day as we encounter the trauma among wealthy investors, whose real estate and stock portfolios have plunged by an aggregate of $14 trillion over the past two years. That loss has been unparalleled in human history. This has been a "Rich Man's Recession and Bear Market" unlike all previous post-war contractions. Of course, a 10% unemployment rate (15% if one counts the discouraged and the underemployed) has exacted considerable pain on the middle class in America. This is reflected in a jump in the personal savings rate from virtually zero up to a current range of 5%-6% and is likely headed higher as people struggle to whittle down their debt while enduring a torrent of residential mortgage foreclosures.
However, the wealth loss among the rich has been staggering, and many to whom we have spoken in recent months, particularly those past middle age, are frozen into inaction. We are often complimented on our track record over the past seven years, including 2008, and those whom we approach seeking new clients for our firm tell us over and over again, "We are holding on to our cash right now, but we will certainly consider your firm when we decide to get back into investing." Since the first week in March, the Standard & Poors 500 has risen 50% from its cycle low of 666 to 1000 at this writing. Since the low, which occurred amidst a wave of capitulation selling by individual investors, including those redeeming mutual funds, the rise has been almost without interruption. Yet, virtually everyone to whom we speak is sure that there is no good reason for this recovery.
They are all ignoring a growing body of evidence that shows the U.S. economy has bottomed out and is in the early stages of an upturn which is unlikely to be cut short by rising inflation any time in the next few years. Instead, those to whom we speak are focused only on those factors which are likely to be headwinds for the recovery but will not by themselves prevent it. These include tight credit conditions, a rising household savings rate, the sorry condition of state and local finances, the pressure of continuing mortgage foreclosures and the risks inherent in refinancing commercial mortgages. These are all real concerns, but in the aggregate they pale beside the beneficial effects of an imminent upturn in inventory accumulation, the stimulus provided through our growing exports, particularly to the emerging economies, and the Administration's stimulus package, among others. Moreover, in the wake of the credit freeze that followed the Lehman bankruptcy, every business cut employment and other operating costs to levels appropriate for a 1930s style depression. Before too long, many of those lost jobs will begin to come back. More importantly, corporate profits will greatly exceed today's consensus expectations for at least the first several quarters of a recovery, as profit margins widen dramatically on even modest increases in revenues. Particularly strong profit gains will be achieved by those firms with strong market positions in the emerging economies.
This brings us to the second group of doubters and skeptics, namely the securities analysts at the brokerage firms. For many years now, their work has been a sham. Indeed, ever since Regulation FD was enacted by the SEC most analysts have been quick to accept the guidance for Earnings Per Share that corporate managements put forth in their quarterly conference calls. They build their earnings models from the bottom up. Few have the courage even to surmise what level of earning power might be possible for the companies under their coverage if the economy were to achieve a sustainable improvement, albeit at a modest pace. Corporate managements, too, have been traumatized by the events of the past two years and in this age of Sarbanes-Oxley they are notably unwilling to stick their necks out and suggest what their earning power could be in an economic recovery. As a result, the next several quarters are likely to witness corporate profits that greatly surprise the consensus of securities analysts. Hence, even after a 50% rise from the March low, today's stock market is not looking very far ahead. Moreover, the sideline cash that might in time find its way back into U.S. equities has never been greater. Counting Money Market Funds, Bank Deposits and holdings of short-term bonds, as well as cash assets held by foreigners, there is probably sideline cash equal to today's $10 trillion of U.S. equity values, which is down from $14 trillion at the peak, at which time most equities were fully valued, but not absurdly overvalued. By our reckoning, the S&P at 1000 today is probably selling at only about 12 times mid-cycle earnings of $85, give or take. There is plenty of upside headroom for an expansion of valuations. Finally, our analysis of the market's technical position suggests that there is little overhead supply between 1000 and 1200 on the S&P 500. As long as skepticism and doubt persist on such a large scale there is little risk that stocks will become overvalued.
"LATE COMERS PORTFOLIO" As of 8/4/09 - S&P 500: 1000.24
SPW 55 MRK 30 FCX 64 FXI 43
EMR 35 SNY 34 TCK 28 EWZ 61
RIG 81 ABT 45 RTI 18 GLD 95
BTU 36 DSX 14 CSCO 22 AAPL 166
DVN 60 UNP 60 LLL 76 ARW 26
COP 45 SYT 46 TRN 15 APD 74
OXY 72 MOS 54 UTX 55 USB 21
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