A roller coaster ride ends where it begins, in relative calm and at full stop, in sharp contrast to the wild ride in between.
The same could be said for stocks during the first quarter. A chart of the major indices bears surprising resemblance to a typical rollercoaster ride, starting with a long ascent through mid February, followed by a sudden and dramatic decline, another rise, another fall, a sharp rise and then a final coast down into the quarter-end. After a wild ride that roiled the global markets, the major indices ended up, near where they began, with a few notable exceptions.
Of course, most people who get on a roller coaster are expecting thrills and chills. By contrast, many investors were caught by surprise by the sudden and violent downdraft that hit the market just after Valentine’s Day.
Led by a sharp sell-off in Chinese stocks, a melt-down in the sub-prime mortgage sector, and a partial unwinding of the Yen-carry trade, the markets showed how quickly they can change their nature.
Ironically, the Chinese Shanghai Index, which triggered the global sell-off still ended the quarter up 19%, outpacing every other major market index except for Peru.
Outside the U.S. most developed markets had low single digit returns. Here at home, the S&P 500 gained .2%, the Dow Jones Industrial Average lost .9%, the tech heavy NASDAQ gained a meager .3%. Mid and small capitalization stocks outperformed large and very large stocks, with the Russell Midcap and Russell 2000 indices returning 4.0% and 1.7% respectively, in contrast to the Russell 200 and Russell Top 50 indices which returned -0.5% and -2.5% respectively. Finally, with the exception of mid-capitalization stocks, growth edged out value.
Underneath the covers of the broad averages there were pronounced winners and losers, with commodities the most dramatic winner and anything connected with homebuilding and sub-prime mortgages the biggest loser. The dramas of the quarter unfolded against a growing backdrop of mergers and acquisitions, including bigger deals and the announcement that Blackstone Group, a premier private equity firm, plans to go public.
So what does it all mean and what happens next?
We believe that we are in the early stages of a significant recalibration of growth expectations and a revaluation of risk in stocks, bonds and other asset classes. In our last commentary we mentioned the virtual non-existence of any rational risk premia in stocks and bonds as measured by the volatility index (VIX) and high-yield bond spreads. After the past quarter, investors are certainly more conscious of risk and volatility, but that has yet to be fully or rationally reflected in asset prices.
A major driver of current valuations is the ever abundant supply of cheap and easy capital. There is a lot of money chasing opportunity, especially in the world of private equity and hedge-funds. Hundreds of billions of dollars investing in similar trades at the same time, such as borrowing Yen to buy commodities, also support distortions in valuations that are not likely to be sustained when the trades unwind.
Cheap capital allows for greater amounts of leverage in deals and supports higher valuations. High expectations combined with high levels of compensation for taking risk and doing deals creates an incentive to take greater risk in the pursuit of greater rewards, especially with increased competition. A high level of M&A activity across the markets results in more companies being valued as potential takeover candidates rather than on fundamentals. We believe this is especially true in the realm of small and mid-capitalization stocks and accounts for their continued outperformance relative to their larger cap brethren.
The extensive use of ETFs, index funds, and derivative instruments, often in conjunction with leverage also can create structural distortions in valuation unrelated to fundamentals. For example, S&P index funds and ETF’s cause the underlying securities to be bought and sold as a function of their composition in the index rather than their relative valuation. There are more tools than ever before available for investors to slice and dice the market, but these tools still ultimately reflect the same underlying economies and businesses.
We continue to believe that global growth is a major story that will play out over the coming decades, with a far greater impact than most people imagine today. The global middle class will likely double in the next ten to fifteen years, opening vast new markets for products and services and creating enormous demand for energy, basic materials, food and clean water. Over time, currencies and interest rates should reflect the changing balance of economic power between and among the global economies and we would expect higher levels of overall inflation and higher interest rates as economies compete for limited goods, services, and capital.
The current woes in the housing market are considerable and may get worse, but we do not believe that they will cause a major and lasting disruption in domestic or global growth. The U.S. economy is a lot bigger than the housing market, and the global economy is now three times the size of the U.S. economy and growing.
Much of what happens in the domestic markets next quarter will be driven by the strength of first quarter earnings and the guidance for the balance of 2007 and on into 2008.
It would also not surprise us to see another sell-off in stocks between now and mid summer. This is not an unconventional wisdom, yet it is not one reflected in current market valuations. The sell-off could be spurred by lackluster earnings especially relative to unrealistic expectations, worries about inflation and rising rates, or continued saber rattling in the Middle East or elsewhere.
As a general rule, we invest in businesses rather than economies or markets and apply a simple rule of buying great businesses at good prices and good businesses at great prices. Valuation provides a floor and a margin of safety in turbulent markets and volatility provides an opportunity to buy good assets on the cheap.
Given our outlook, we continue to be drawn towards larger, multinational companies with strong business franchises, a significant international sales component, and very healthy balance sheets.
Chart 1 above shows the relative performance of large, small and mid cap companies relative to the broad market as measured by the Russell 3000 index.
Mid and small capitalization companies have outperformed large capitalization companies over the past five years. They also sell at significantly higher valuation levels than their larger brethren reflecting fairly aggressive expectations for revenue and earnings growth. It would not surprise us at all to see results and guidance disappoint expectations.
Conversely, many large capitalization companies offer the benefit of inexpensive valuation, significant exposure to emerging and developing markets, and fortress-like balance sheets. In any major market downturn, these large companies, are natural buyers of their own stock which provides additional valuation support.
We are also drawn towards classic growth companies versus “value” companies. This is a thesis we have written about since last summer.
As Chart 2 shows, “value” has outperformed “growth” for more than five years, largely on the back of the boom in oil and energy related stocks, as well as financial services. Meanwhile former growth darlings like Microsoft, Cisco, Johnson & Johnson, American Express and Pfizer are inexpensive relative to the quality and health of their businesses. Today, in our opinion, growth is a value and value is expensive.
We have seen these cycles before and they always reverse, although they can persist far longer than anyone would expect. Much of the current value cycle is tied to energy and other commodities which have already more than tripled in price over recent years, so profits may be peaking.
By contrast, many larger growth companies are selling at trough valuations and expectations for them are low. In our experience, the greatest opportunities are usually found where the expectations and valuations are low, especially if the businesses are of exceptionally high quality.
Jurika, Mills & Keifer