As they often say, two steps forward, one step back...

Actually, it's been much better than that over the past 15 months: four consecutive up quarters for the S&P 500, against the most recent period's 10% pullback. A rough past few months, for sure, but let's not get carried away: the market is still more than 50% above the March 2009 lows, a remarkable effort following the most jarring economic recession and market panic since the Depression. Our portfolios also suffered during the most recent three month period, although by most any measure since the bottom – and even going back pre-crisis – our clients have fared better than the indices by a comfortable margin.

We readily admit our own tendency to see the glass as half-full, but it's very clear most investors increasingly see nothing but a mere drop at the bottom of the goblet. Disengaged is the latest adjective we'll use to describe a public that is not only skeptical of stocks, but also progressively oblivious to the fundamental structure and attractiveness of the asset class itself. Investors continue to shift substantial funds into fixed income despite near-microscopic yields, spurning equities that not only offer in many cases a current dividend yield equal to or greater than bonds, but also an astonishing special offer: an actual ownership stake in a strong, seasoned, growing business! Don't get too excited, but it's even possible that the business might generate additional profits someday that would lead to higher dividends for shareholders, or even the chance that the ownership stake might rise in value. But don't worry: unlike other amazing offers, this one is still good after midnight tonight...

On a more serious note, and as we've admitted in recent commentaries, we certainly comprehend the public's skepticism of riskier assets like stocks. It was a rotten past decade for anyone invested in the S&P 500, and two serious bear markets have sapped investor enthusiasm. But while the value proposition for equities versus bonds continues to improve (as coupon and interest rates fall, and as earnings recover and equity valuations look more and more attractive), the flight to bonds has reaccelerated. The PIMCO Total Return Fund – today's zeitgeist – is now over $225 billion in size, double its level of late 2007, and larger than the GDP of countries like Israel or Ireland. The rush for fixed income is, in our opinion, a mistaken flight to perceived safety, reinforced by a slew of geopolitical threats that have mounted in recent months: the Eurozone crisis; the oil spill in the Gulf; new uncertainties in the Mideast; unexplained daily volatility in the stock market; and rising legislative/regulatory wrangling in Washington. Investors are overwhelmed by the rushing flow of dispiriting news, easily susceptible to the negative spin and seemingly most comforted by the warm embrace of sub-3% Treasurys. There's nothing quite like a three-decade bull market in bonds to make even today's token bond yields seem like a hot cup of cocoa, right?

The tendency to embrace the pessimistic is a curious trait of homo sapiens. We all know by now that a gloomy headline tends to sells more papers, but there may be an actual anthropological basis in this: a few hundred thousand years ago, the happy-go-lucky caveman tended to get eaten by predators, thus encouraging the development of paranoid, danger-sensitive brains. Thankfully for us, starvation, illness and attack are less likely today, but our minds are still most excited by perceived threats around us. It's perhaps why a recent Businessweek proudly trotted out all the economic doomsayers from the 2008 economic crisis: we understand the subscription and ad revenue enhancing aspects of continuing to interview recently-accurate economic sages like Nouriel Roubini, Nassim Taleb, Stephen Roach and Meredith Whitney, but their insight today is somewhat undercut by the fact that many were perma-bears for years pre-crisis (if only we could have identified their prescience among thousands of conflicting voices back in 2007!). Note to self: find out what happened to Elaine Garzarelli after her prediction of the '87 Crash...

While some might be tempted to characterize our current positive outlook as merely contrarian, the fact is our own confidence is driven most significantly by two basic elements: 1) solid fundamentals among the businesses we follow; and 2) increasingly attractive equity valuations. In recent months, and over scores of earnings reports and management commentaries, we have been impressed by recovering revenues, healthy profit margins, and unexpectedly robust cash flows alongside fortress-like balance sheets. Early and significant cost-cutting and low interest rates have positioned Corporate America to generate record profits in the current up-cycle, and we think this corporate strength is likely to endure – there is now $2 trillion of cash in business coffers – even if the trajectory of the economic recovery slows. Granted, there are more indications today of a slower economy: volatile retail sales, a stalled housing market, persistent high unemployment and, of course, a worsening fiscal deficit. And the unrelenting and depressing oil spill has also given consumer confidence a hard punch to the gut. The headlines are dominated by these factors, but there are also important offsetting elements that tend to get glossed over in the daily news flow: rising productivity, strength in manufacturing/exports, low mortgage rates, declining credit card delinquencies and consumer spending already achieving new highs. Given how far we’ve come in the past 15 months – the economy and the financial markets – we view the odds of a sharp economic reversal as low.

Most importantly (and regardless of whether one views the economic glass as half full or half empty) investor pessimism and disengagement has driven stocks to levels cheap enough to deliver strong absolute returns from current levels. Our own portfolios now trade at a price/earnings multiple of about 11x our conservative estimates for 2011, a low figure both historically (for a recovery) and when compared to bond alternatives¹. For the broader S&P 500, Wall Street analysts (an admittedly fickle bunch) are using estimates for 2011 that bracket the P/E between 10x and 13x; again, low figures even if the pessimists of the group are closest to the mark. At Harris Associates, our clients know we speak more often of the gap between the current price and our estimate of intrinsic value (we prefer to pay less than 60-70% of that estimate). While stocks were certainly cheaper at the March 2009 bottom, today's figure for our portfolios (near 55%) represents, in our opinion, a well-above-average opportunity when considered against our 35-year experience.

One other point on valuation and fundamentals: many folks who were invested directly in the S&P 500 over the past decade suffered real losses (the cumulative total return was -14%), and so they are the toughest to convince that the future is likely to be brighter. But these investors often forget that those 10-year trailing returns were very much influenced by the sky-high valuation at the start date. S&P 500 EPS actually grew at a 4% annual rate during the period – near the 5% long-run trend – but returns failed to match that increase because the P/E ratio in mid-2000 was above 20x, inflated by the enthusiasm for large cap growth stocks; as we correctly said back then, big cap valuations were unsustainably high and would ultimately decline. Today, the situation is substantially different: P/Es are below-average and are more likely to rise than fall. In our view, this means there is a much greater likelihood in the next decade that stock prices appreciate at least as fast as earnings growth. Even if one wants to assume future earnings growth is slower than the long-run average, investors – who also receive dividends as a part of their total investment return – should do a lot better in stocks than bonds.

Before we conclude, it's important to make a few points about the Eurozone crisis and its implications. First, we do not think the crisis threatens the world economy: the most troubled countries (particularly Greece and Portugal) do indeed face serious solvency issues, but their size in relation to the region is small. While neighbors Spain, Italy, Ireland and a few others face some related liquidity problems, we fully expect stronger nations – with significant exposure to these weaker economies – to ultimately step up to the funding task, as they have essentially done so far. Second, while a significant slowdown in the region is likely, the impact on the U.S. is likely to be muted: U.S. companies have little direct exposure to the countries in question (well below 5% of our exports), and overall, Europe accounts for only about 10% of the revenues for S&P 500 companies. If U.S. businesses were less healthy, we would be more worried about a painful outcome but, as we said earlier, balance sheet strength and liquidity are near all-time highs. Third, the crisis has, for the first time in our memory, forced many countries to address both short and long-term deficit issues. Not only are budgets being cut at an unprecedented rate, but we are seeing honest efforts to reduce long-term state liabilities by raising the retirement age and freezing or reducing retirement benefits.

Every day we read of comparisons to the fiscal situation here at home, and this has encouraged feverish political debate on a host of related issues. This is all good. While the immediate fiscal threat to the U.S. is small – our relative deficit is smaller, we can implement fiscal and monetary fixes much easier, the dollar's reserve currency status provides us with a unique borrowing advantage – there are important issues to deal with in order to avoid the fate of our friends across the Atlantic. Clearly, entitlement reform must be addressed in order to reduce burgeoning structural deficits. As Europe shows, there are physical limits to the promises that government can make – ultimately, creditors need to be confident they can and will be repaid. Growth is also important – Europe's problems have been exacerbated because its economy has grown at slower rate over time due to a less flexible labor force, high regulation/taxes and lofty levels of government spending.

It's clear that we are all grappling with these issues and uncertainties, and the current deficit of confidence has contributed to the disengagement from equities: investors are surely concerned that we are destined to follow Europe's example, and that tomorrow may be worse than today. Confidence is further sapped when politicians of both parties find it politically expedient to denigrate the economy – and business in general – in order to achieve their own policy goals. With Europe firmly on everyone's mind, from our vantage point the best "stimulus" for the economy and markets would be an honest attempt to reduce the threat of long-term fiscal insolvency. It can be done; it’s just that our leaders need to demonstrate the will to make difficult choices while recognizing the inherent structural advantages of a flexible and growth-oriented economy.

Nonetheless, we are convinced that our portfolios can weather a wide range of outcomes, and we have high expectations for performance given current valuations and the robustness of the businesses we follow. Uncertainty and pessimism weigh heavily; but at current prices, we think the market already assumes very negative outcomes for Europe and other macro threats, results we view as unlikely. Furthermore, as long-time investors we have instinctive trust in the capabilities of companies to innovate, grow and deliver value to shareholders and the economy in general; but admittedly, our confidence in government in such endeavors is less assured. Simply stated, that's another reason we'd rather own strong, growing businesses with solid dividend yields rather than sub-3% Treasurys. The opportunities for patient, long-term equity investors are, we believe, substantial.

Edward S. Loeb
quarterlynews@harrisassoc.com

¹One way to calculate a comparable “P/E ratio” on bonds is to take the inverse of the current yield; for 10-year Treasurys, the P/E would thus be the inverse of 3%, or a whopping 33x.