As we reflect and try to make sense of one of the stranger years we can recall, we are captivated by the striking contrast between the financial and political markets in 2011.

On the one hand, the financial markets were incredibly volatile, as trigger-happy investors reacted daily to natural disasters, debt downgrades, sovereign debt crises, political uprisings and some very confusing economic signals. For most investors, time horizons continued to shrink and the perceived need to trade feverishly seemed to grow each week.

By contrast, the political markets seemed to be paralyzed, with elected officials unable to act in the face of these same fiscal and sovereign threats, both at home and abroad. The lack of meaningful progress on a wide range of issues served to undermine already depressed confidence levels in our political leaders.

Ironically, at least for most U.S. equity investors, the year-end scoreboard for both markets and politics was nearly the same: no meaningful progress and lots of frustration. Broad U.S. equity market returns, though, looked pretty good compared to those posted by most aggressive traders and hedge fund managers, where returns lagged quite a bit. By our reckoning, the market volatility and multiple course corrections throughout the year served to confound and perhaps even humble fevered traders who may have overpromised steady, positive returns in all environments. For those folks, 2011 was certainly a year to forget.

While the range of outcomes for investors was wide, our client portfolios were helped by our focus on the underlying fundamentals (which were fine despite all the headlines), plentiful dividends and share repurchases (helpful in a flat market), and the investment discipline to avoid panic when the headlines seemed to promote hysteria (e.g., the Japanese earthquake, the U.S. debt downgrade, and rising political rhetoric and confusion in Europe). Our admonition to stay patiently focused on the fundamentals and valuations may seem overdone at times, but it remains a key feature of our long-term record and a vital core philosophy for us and our clients, particularly in frustrating macro environments such as we see today.

While we admit there is no guarantee of stability in Europe or legislative progress here, the stock market is currently priced as if current profitability is on the verge of collapse while current balance-sheet strength, excess liquidity and recent profit trends argue strongly against such an outcome.

The crisis in Europe, of course, continues to dominate any economic or political discussion. The past few quarters have offered us a real-life version of the movie Groundhog Day: Are we doomed to spend eternity listening to the daily rhetoric of European politicians, only to awaken to the following morning’s headlines with no real solution to the crisis (and then repeat this cycle indefinitely)? The Euro Crisis itself bears a strong resemblance to the U.S. subprime mortgage meltdown. Just as ratings agencies, politicians and lending standards failed to differentiate between the good and bad credits in the housing market here (thereby encouraging too many subprime loans), the various structures supporting the euro and the European Union failed to account for wildly divergent fiscal policies between countries like Greece and Germany (thereby encouraging too much lending to Greece, Ireland, Italy, etc.).

Ultimately, a debt crisis requires a certain degree of fiscal rectitude, and in that sense, Europe still has a long way to go. When we read that a vastly oversized Greek government has yet to engage in serious belt-tightening, or that an unemployed family in Ireland will receive $41,000 tax-free annually for the rest of their lives, it’s easy to roll one’s eyes. And we are now well aware of how much more difficult it is to manage 17 disparate economies without a comparable “federal” fiscal model that has worked reasonably well among our 50 states for more than two centuries. In fact, bond-market pricing implies sovereign default risk at elevated levels throughout the Continent; even seemingly rock-solid Germany trades no better than an A-rated corporate credit here in the U.S.

We have no particular insight as to how the crisis will ultimately be solved, but we still expect it will be surmounted, just as we’ve seen throughout history. There have been some important encouraging signs recently, including new “technocrat” governments in Greece and Italy, new fiscal rules for all member states, and also a more muscular, convincing effort by the European Central Bank to provide credit for an extended period. Moreover, with rising financial market pressure (rising yields, capital flight) to find a solution, needed fiscal reforms are more likely than ever. We also recognize that Germany – with 39% of its GDP tied to exports and the financial wherewithal to help craft and lead a solution – has a huge stake in avoiding a worst-case outcome. To be clear: We expect more turmoil, economic weakness and brinksmanship in Europe in the coming months. But ultimately, the intense pressure will lead to improved stability and certainty. Whether that surprises already pessimistic investors is another story.

Compared to Europe, the U.S. looks almost immaculate. Almost. Of course the political paralysis is nearly as acute here as across the Atlantic, most recently confirmed by last month’s debate over extension of the payroll tax cut. Frustratingly, this was another example of how an awful policy outcome (a mere two-month extension, more uncertainty for employers and workers, difficult to implement) can easily arise even when the answer should be easy. Is this some cruel Groundhog Day sequel? As we’ve commented recently, there is a strong argument that high levels of political and legislative uncertainty have turned off investors and lowered valuations across many markets.¹

Yet even with political uncertainty likely to remain high at least until the November elections, the U.S. market held up better than most in 2011. Why? In broad terms, fundamental profit performance remained exceptionally strong, even after a big scare surrounding the U.S. credit-rating downgrade in late July. Profit margins are at record levels, driven by rising productivity (manufacturing, supply chain and technology efficiencies), growing exports, moderating commodity costs, and low interest rates and inflation. These factors have even led to some moderate improvements in the job and housing markets, albeit from depressed levels. Housing may not be the economy’s engine it was a decade ago, but it definitely exerts less of a drag than it did just a few years ago.

Importantly, balance sheets across the U.S. economy are also strong, with half of the S&P 500 lowering their debt ratios in the past year. Our portfolios, as our clients know, have emphasized this important strength for several years, which has allowed for recent incremental profits to be directed increasingly toward shareholders. Within our own core group of holdings, we have seen more than 85% of the companies increase dividends or repurchase stock (or both) over the past year. This is a tangible benefit to shareholders at a time when many have little confidence in risk-taking or equity exposure.

The valuation part of the story has been (and continues to be) compelling – wide discounts to our estimates of intrinsic value, 12x our estimate for 2012 earnings, undeniable long-term advantages versus bonds. But, unfortunately, these relative advantages continue to be overshadowed by the intense volatility mentioned earlier. By almost any measure, price volatility has reached record levels recently, assisted by growing use of passive indexes and ETFs, as well as a decision by global asset managers to manage their daily risk appetite (i.e. “risk on/risk off”) through these vehicles. Much of the trading in recent months seems to have been driven by seemingly trivial political rhetoric or imagined threats, particularly frustrating diversions at a time when corporate fundamentals have generally exceeded most everyone’s expectations.

The result has been a relentless rush to the exits from equity mutual funds (net outflows in 34 of the past 35 weeks). The exodus has rivaled that seen during the dark days of 2008/2009 despite a much improved economic environment. Despite a solid market recovery over the past three years, investors continue to try to shed any perceived risk from their portfolios, an effort we continue to question given current yields and spreads in the bond market. We’ve been through periods like this before, and we know that such high levels of market correlation and anxiety provide our clients with an important long-term advantage.

Our long-term optimism is not based on any immediate relief on the political or macroeconomic fronts. In fact, like Bill Murray’s character in our referenced movie title, we have come to expect more frustration from politicians both here and abroad, and more volatility from impatient traders. But while the equity market appears priced for this state of affairs to continue indefinitely, we don’t think it’s unreasonable to imagine a different, better market result in 2012 and beyond.

The challenge today is for investors to differentiate between the relentless frustrations and foibles of outside political and market forces, and the improved underlying reality of the businesses in which they own a share of future distributed and retained earnings. The day-to-day gridlock and frustration can be mighty, but the opportunity to own great businesses at depressed prices can also be highly rewarding in the long run.

 

Edward S. Loeb
quarterlynews@harrisassoc.com

¹Empirical Research Partners recently estimated that political gridlock has subtracted about four points off the P/E multiple of the U.S. equity market.