With deference to the late, great Rodney Dangerfield:
“I tell ya, this market – it don’t get no respect.”

It’s been an astounding run for the equity market since early March, one of the strongest in history and one, like all the others, which has caught most of the pundits flat-footed. The market’s collapse one year ago created a self-reinforcing atmosphere of fear and panic among not only retail investors but also many professionals (who, by now, should know better). As we at Harris Associates surveyed the panic-driven wreckage weeks before the ultimate market bottom, however, we expressed plenty of confidence, albeit with some tactical question marks:

We recognize the path to recovery is unlikely to be straight, but we also know that to ignore the current set of facts [dirt-cheap valuations, pervasive pessimism] guarantees low returns…as well as a lost chance to rebuild portfolios once confidence and trust invariably return. (January 2009)

It has been gratifying and encouraging for our clients to see the magnitude and speed of the market recovery itself, as well as the obvious related benefits of less turbulence and building evidence of economic stabilization. An important aspect, too, has been the positive feedback that comes from being rewarded for sticking to the disciplined investment philosophy that has served our clients and us so well for more than three decades. This episode also has helped to reinforce some important principles that have assisted us through other volatile periods: 1) valuation and quality are, ultimately, paramount; 2) tactical portfolio moves in anticipation of changing macroeconomic conditions (i.e. sell at the top and run to cash) are not only difficult to pull off once, they are nearly impossible to do well twice (i.e. re-enter the market at the bottom); and 3) market prices fluctuate a great deal more than underlying fundamentals, creating outstanding investment opportunities for disciplined, patient investors willing to position against the prevailing winds.

The current economic and market environment remains complex, for sure, and we humbly recognize the challenge of deciphering a deeply bruised financial system, unprecedented fiscal/monetary stimulus and a rapidly recovering market. Nonetheless, our own outlook remains essentially unchanged from the statements we’ve made in the past several commentaries: like all previous cycles, we expect economic recovery, and despite the strength of the recent market rally, we still see great investment opportunities in strong businesses that trade well below the intrinsic values we estimate. As value investors, we certainly understand the temptation to nervously doubt a market in full sprint, but as the title of this note suggests, we think too many spooked investors are still on the sidelines, filled with disbelief and skepticism that the healing could come at all, let alone so quickly.

Notwithstanding an encouraging past few months of economic data – GDP declining less than 1% in 2Q, home prices stabilizing, productivity and profits rising – investors 1) remain wary of an economic double-dip; 2) seem to believe the market rise is nothing more than a “sucker’s rally”; and 3) are positioning their portfolios for more bloodshed: prepared for yesterday’s unprecedented turmoil and invested in yesterday’s safe-havens. Translation – the vast majority of investors seem unwilling to accept reasonable risks that continue to offer some of the best investment opportunities in a generation. Rear-view mirrors certainly show you where you’ve been, but they were never designed to tell you where you’ll go. And remember this: investors hated stocks in the late 1930s and the late 1970s, and the late 1990s represented an ill-timed lovefest with equities. In each episode, public sentiment proved to be a wonderful contrary indicator as market performance severely disappointed the prevailing mood.

Today, investor disengagement is striking. Despite a near-60% return in the S&P 500 since the March low, U.S. stocks remain decidedly out of favor. According to industry data, while investors have finally started to pull money out of record-sized (and infinitesimal yield) money market funds, just a trickle of those dollars have landed in the U.S. equity market (following huge, panicked outflows from equities in 2008); in fact, the trend for equity funds has actually worsened in recent weeks with modest net outflows. Instead of reversing their exit from stocks during the panic, investors increasingly direct the vast majority of their cash toward taxable and municipal bond funds, admittedly safe vehicles yet destined to struggle to keep up with even moderate (and inevitable) increases in the cost-of-living.

While it’s encouraging to see investors begin to tiptoe away from the absolute safest asset class – cash – the rush into basic bond funds appears to represent a continuing desire by most retail investors to “hunker down”. With two of the worst equity bear markets on record hitting investors within the past ten years, perhaps we should not be surprised. Investors, it seems, have (literally) tuned out: even with the rally, ratings at uber-channel CNBC are off nearly 40% from a year ago. This lack of interest – while undoubtedly a positive step forward for mankind! – seems to be an almost clinical response to recent painful experiences. Well, CNN’s ratings declined after Hurricane Katrina, too!

Anecdotally, we can also report that institutional investors and their intermediaries seem to have their minds elsewhere, too. With the explosion of “alternative investments” in the past decade – commodities, real estate, private equity, hedge funds – plain old equities represent a shrinking asset class for many pension plans, endowment funds and the like. In fact, this trend actually accelerated in late 2008 as the need for immediate liquidity during the crisis drove many of these big funds to sell the one thing they reliably could (stocks), albeit at panic-driven prices. And today, these same investors grapple with outside pressures to reduce risk – as well as the contractual obligations they previously made to pour cash into their alternative investments – by limiting their allocations to equities. The great irony is that despite the promises of diversification into these less-liquid (and higher expense) alternatives, many of these investments proved to perform no better during the crunch than publicly-traded equities. In 2008 – as in the mini-panics of 1998 and 2002 – the only true refuge from the panic-driven selling from risky assets was cash and Treasurys. And while there are always exceptions, the evidence so far in 2009 shows actively managed stock portfolios like ours outperforming many other asset classes.

Even given an environment where we think investors will increasingly need to reconsider their recent shift away from equities, we recognize that economic news over the next few quarters is likely to have a meaningful impact on short-term market moves. From our vantage point we see a number of positives: in addition to the GDP, housing and productivity/profits data cited above, we would also note the consistency of these improving factors across an increasingly interconnected globe. Risks seem to have dropped, too, as credit spreads have returned to pre-crisis levels, acquisition activity has exploded in recent weeks and the IPO window has reopened after a long drought; in short, financial conditions have improved markedly. If the recession has indeed ended (as Bernanke seemed to say a few weeks ago), the decline in GDP from peak to trough is likely to be near 4%, significantly worse that the slowdowns of 1990-91 and 2001 yet comparable to the 1981-82 recession (and nowhere near the 27% decline from the 1930s). From our perspective, the odds of recovery are high. We certainly expect the market to gyrate on the ebb and flow of all this anticipated data, but we don’t expect it to meaningfully alter our long-term optimism.

One data series that is surely to remain stubbornly negative for quite a while is unemployment. Over the past ten recessions (dating back to 1948), our research staff found that the rate of unemployment kept rising for about 10 months after the official end of the recession. A similar experience this time would not shock us, and while it shouldn’t surprise anyone given the historical record, this factor seems to be a prime candidate for inviting an excess of anxiety and discussion among investors, economists and of course politicians. The implications of sustained, high unemployment are serious, and the skeptics have painted a compelling negative case for the economy in this regard. But given the unprecedented fiscal and monetary stimulus, and all the economic and market repair that has already occurred, it seems unwarranted to bet against job growth within a normal time horizon (and it could even occur sooner, given the magnitude of the stimulus). Yes, there are still some important questions to be answered about the U.S. economy. But the skeptics are running out of arguments to justify their overly risk-averse posture.

The S&P 500 closed almost exactly two years ago at 1565, and despite a huge rally the index is still 1/3 below that peak. We are impressed with the strength and trends in corporate profits, the healing across all financial markets, and the unmistakable stabilization in a wide variety of economic statistics. But for those with their eyes transfixed on that rear-view mirror, the equity market remains very risky and no longer suitable for investment: “This must surely be a sucker’s rally”, they repeat. Others rationalize that the quick snapback in recent months doesn’t feel right simply because the market hasn’t been sufficiently penitent for all its sins! And then there are the economic doomsayers. We’ve heard all these stories before, and while the Bear case always seems to be argued elegantly and convincingly, we believe it is rarely right for long, particularly when the trade seems so crowded.