The following is an excerpt of KM’s Q3-2012 Client Letter, which can be found at kirrmar.com.
What a difference a year makes. Last October we wrote of the U.S. stock market’s dismal performance in Q3-2011. We thought in the midst of the panic selling, the seeds of the next market recovery were being sown. Expectations were low and there was a lot of future bad news reflected in stock prices.
Fast forwarding 12 months, we are glad we endured the pain and stayed the course. For the one-year period ending Sept. 30, the S&P 500 had a total return of 30.2 percent. We are obviously pleased by the recovery. As contrarians, we are also cheered that it seems like the majority of investors are dismissing the market’s strength as either unwarranted by the fundamentals or unsustainable. According to the ICI, for the year-to-date through Sept. 26, mutual fund investors “celebrated” stocks’ strong performance by redeeming a net $109.8 billion from domestic equity funds.
We think the overall U.S. stock market is still attractively valued, particularly given the historically low level of interest rates. With its strong recovery from the March 2009 bottom, the S&P 500 closed the third quarter of 2012 within 8 percent of its high reached in early October 2007. However, corporate profits are about 30 percent higher than they were at the business cycle peak in 2007.
The European Central Bank (ECB) pledged to do “whatever it takes” to save the Euro and launched a program allowing it to buy an unlimited amount of sovereign debt of countries that have accepted a bailout and are in compliance with terms of the bailout.
The Fed announced a third round of quantitative easing (QE3) whereby it planned to buy large quantities of mortgage bonds. Unlike past actions, the Fed specifically tied the duration of the program to its economic objective of generating more jobs.
Taken together, these actions may indicate the ECB and Fed have determined their incremental approaches to date have been ineffective.
We are encouraged the housing sector is showing renewed vigor, even before QE3 kicks-in. The S&P/Case-Shiller index gained 5.9 percent in the year-to-date through July, the largest since the same period in 2005 (and a huge improvement over the -10.1 percent reading for the same period in 2008). As of June, 12 percent of the underwater mortgages at the beginning of the year were no longer so. Another 5 percent price increase will lift an additional 12 percent of the underwater mortgages to the surface.
Rising home prices combined with QE3 could lead to a virtuous circle. Rising home prices enable previously underwater borrowers to refinance and take advantage of historically low rates, putting more money in their pockets. Rising prices may also entice potential buyers who were afraid of further declines. Similarly, rising prices make homeowners feel wealthier, which can spur spending.
Howard Marks of Oaktree Capital said, “The best response when seas are choppy is to focus on completing the long-term voyage and not think about whether the next wave is going to push the nose of the boat up or down. Our investment destination is best reached by accurately valuing assets, assessing the relationship between price and that value, and acting resolutely and unemotionally when mispricings are detected. That’s still the best — I think the only — reliable path to investment success. Nothing about the current environment alters that one bit.”
We couldn’t agree more.
Mickey Kim is the chief operating officer and chief compliance officer of Columbus-based investment adviser Kirr Marbach & Co. He can be reached at 376-9444 or firstname.lastname@example.org.
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