During the quarter, the S&P 500 reached an intraday high of $1370.58 on May 2, 2011. Despite the fact that this price remains 13% below its previous intraday high of $1576.09 reached on October 11, 2007, we would argue that the general market is back to pushing new all-time highs. This becomes particularly apparent when you look at another index such as the Russell 2000 (primarily a small-cap index) where last quarter the price level surpassed prior highs from 2007 by 1.4%. But this phenomenon is not only reserved for small cap stocks – the same holds true amongst several individual sectors within the S&P 500 itself. For example, ETFs that track the separate sectors also reached new all-time highs or were very near to them when adjusted for dividends, including Consumer Discretionary (XLY), Consumer Staples (XLP), Health Care (XLV), Technology (XLK), Industrials (XLI), Materials (XLB) and Energy (XLE).
The one sector that is the main culprit holding everything back is Financials (XLF), which has lost more than half its value from prior peaks, even when adjusting for dividends. This stems from the permanent losses that took place during the credit crisis amongst firms such as Fannie Mae, Freddie Mac, Bear Sterns, Lehman Brothers, AIG, Wachovia, Washington Mutual, Citigroup, Bank of America, etc. – losses that are never to be recouped again. In other words, the losses in the financial sector have created a false illusion that the stock market still has plenty of upside to return to prior peaks, when in reality we have actually attained new highs amongst the majority of individual stocks.
This would not be so troubling if there were earnings to back these prices up. However, mean-reverting operating margins are also back to elevated levels as a result of vicious cost cutting. When you normalize these earnings, and when you take into account the recurring “non-recurring charges,” the market does not appear cheap by historical standards. In fact, we are trading at valuations that have preceded prior market collapses.
The point of this discussion is not to scare our investors, rather, we hope you can take comfort in knowing we recognize the forces at play and have taken them into consideration. Some investors may be inclined to attempt to time the market and move completely into cash. Not only has this proven to be a losing strategy, it is important to highlight that this can be more detrimental in the event of serious inflation. We could potentially have a situation where the nominal prices of equities continue to rise creating the false impression of positive returns; but in real terms, when you account for inflation, investors have actually experienced a loss. In this situation, sitting purely in cash would create an even steeper loss because your dollars would not stretch as far as they used to – your purchasing power would be declining as your dollars are rapidly losing value.
Additionally, individual stocks can appreciate in a falling market. This is why we have been able to generate positive returns over time periods when the general market has struggled. And even if the market were to experience a sweeping collapse where prices of all asset classes are unable to escape, it is important to remember that you own shares of businesses that continue to compound their earnings. What other people tell you your shares are worth (ticker quotations) is irrelevant until the moment you choose to sell. Benjamin Graham advised “man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment” (The Intelligent Investor, 1973, p. 107). Speculators are “instructed” by the market as to what the value of a stock should be, whereas investors are “served” by the market which conveniently offers them attractive buying and selling opportunities.
So, as long as we successfully purchase businesses at prices below their worth, then in the long run you will not experience permanent losses of capital. In other words, losses in the short run would be what we call “temporary paper losses,” or a deferral of future performance because the earnings per share in the underlying business would continue to grow and the value would eventually be recognized again.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.