Notes, Views, and the Occasional Provocation March / April 2011 

In spring meetings with clients, perhaps the most common question I hear these days is, "With all the bad news out there, why have the markets continued to go up?"

It's a reasonable question, especially given all the disappointments investors suffered this past decade. But as the article below explains, the markets are not as upside-down as they seem. There are a number of good reasons why stocks have jumped more than 100% since the dark days of early 2009.


Warm regards,

Milo Benningfield


 
Why Has The Stock Market Continued to Rise?
It would seem that natural catastrophes, impending sovereign defaults, and chronic unemployment provide the very stuff that stock markets need to thrive. But looks are deceiving. more

BFA Media Quotes
Recent media quotes. more




Why Has The Stock Market Continued to Rise?
One of the oldest maxims on Wall Street is that bull markets climb a wall of worry. Naturally, as equity markets have risen more than 100% over the past two years, the proverbial wall of worry has never felt higher. Investors repeatedly ask, "How can the stock market be going up when the economy's so bad?"

There's no denying the alarming economic concerns on all fronts:

  • Japan earthquake, tsunami, and nuclear catastrophe;
  • Europe's continuing sovereign debt crisis;
  • Rising oil prices and threat of inflation;
  • $1.5 trillion U.S. budget deficit and threatened downgrade of AAA credit rating.

So how can the Russell 2000 small-company index have soared 150% since March 2009, hitting an all-time high yesterday?

In a market economy, prices are generally determined by one of two factors: supply and demand. The supply of outstanding shares on the U.S. market has not gone down the past two years; in fact, it's gone up slightly, which might normally depress stock prices.

Thus, stock prices must be rising because of demand. But who's been buying? Not individuals. Mutual-fund data indicates that most individuals have declined to participate in the market rally, moving money instead from stock funds to bonds and cash over most of the past two years.

This leaves institutions as the primary source of demand for stocks. But don't stock strategists and investment committees read the newspapers and see the economic clouds? Have they all gone mad?

We should pause and acknowledge that even with all their analytical firepower and investment muscle, institutions don't always make the smartest investment bets. Many university endowments went up in flames during the Credit Crisis, and some of Wall Street's most venerable firms suffered mass extinction.

Still, there's a fair amount of evidence that, despite all the negative headlines, institutions have been making prudent bets these last couple of years.

Corporate Health
Corporate earnings continue to come in ahead of projections. Companies have ample cash on their balance sheets, and one of their biggest inputs, labor costs, have remained reasonable, given the continued, but declining unemployment.

Stock Valuations
It's dangerous to bet the farm on any stock-valuation metric. But there's nevertheless been plenty of support for the argument that stocks became “cheap” after the crash. For example, one common valuation measure, the price-to-earnings ratio based on average inflation-adjusted earnings from the previous ten years – the so-called PE10 – suggests that stocks were oversold during the credit crisis and prices have simply been moving up closer to long-term trends:

Global Headlines, Regional Economic Events
While globalization has in many respects connected the world's communities, many of the world's headline events remain regional economic events. Japan's terrible triple blow of earthquake, tsunami, and nuclear catastrophe has affected global supply chains, yes. But most of the broad economic and market effects have been limited to Japan itself.

This feels counterintuitive to anyone who's been investing long enough to remember the Japanese equity markets of the 1980's. Back then, the size of the Japanese stock market surpassed the U.S. stock market in 1987 and by 1989 represented 41% of the global equity market. By contrast, last year, Japanese stocks had shrunk to only 8% of the global equity market, meaning that there was little direct impact in most global portfolios.

Markets Read Tomorrow's Headlines
Perhaps the biggest reason for the apparent disconnect between current economic and capital-market events is that the markets read tomorrow's headlines, not today's.

Equity-valuation models typically project corporate earnings out decades, not just years. Meanwhile, stock strategists factor rising interest rates into their models to create a margin of safety in their calculations. Current events will be factored in as they occur, but the long, forward-looking timeframes involved mean the effect of these events on valuations often remains muted.

This is why during the darkest hours of the Credit Crisis, Warren Buffet cautioned in an extraordinary New York Times editorial:

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. . . So . . . I've been buying American stocks. . . . I can't predict the short-term movements of the stock market. . . . What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.1

In other words, when it comes to the markets, today's economic conditions are often yesterday's news. Investors would do well to put down their newspapers and turn off their televisions before deciding how to deploy their long-term capital.

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BFA Media Quotes
Reuters, February 11, 2011
Milo was quoted in an article by Aaron Pressman, "Trade Idea: Advisers Suggest Lower Risk Muni Bonds," which discussed concerns about the municipal-bond market. Milo noted that while investors shouldn't abandon muni bonds, they should recognize the market structure has changed:

The municipal market is now much like the corporate bond market, with prices driven more by the individual characteristics of each issuer, San Francisco financial Milo Benningfield said. Risk awareness is the new theme, he said.

"I don't think all this means individual purchasers should abandon munis," Benningfield said. "They just need to recalibrate their expectations and be more sensitive to the risks going forward."

Read the article.

Wall Street Journal Online, January 14, 2011
Milo was quoted in Ian Salisbury's article, "Advisers Aren't Ignoring Muni Bond Problems," which addressed concerns about potential municipal defaults. Milo noted such concerns were likely misplaced:

"We're dealing with headline risk," says San Francisco-based adviser Milo Benningfield, who says investors often overlook constitutional guarantees California offers bondholders. "My expectation is that while prices fluctuate defaults will be infinitesimal."

Thank you for reading. Please look for our next newsletter in June.

Best regards,

Milo Benningfield




1 "Buy American. I Am.", Warren E. Buffett, The New York Times, October 16, 2008 (emphasis added).

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