The Cash Bubble

Following the worst trailing ten year returns in more than 180 years, the past three months have given us a classic roller coaster ride – down a fast 27% for the S&P 500 Index, followed by a substantial recovery. Our clients’ portfolios finished the quarter down about 4%, significantly better than S&P 500 Index, which fell approximately 11%. As I write this letter, clients’ portfolios are now up for the year and outperformance of the S&P 500 Index continues to improve as well. The key question we are all asking is: Have we just seen a bear market rally or is it finally the start of a longer-term bull market? Currently huge cash reserves could provide the fuel for an extended bull market. In this letter I’ll try to put that prospect in perspective.

There are few on the planet who have not been inundated and concerned by the flood of negative economic news in the past year. Fear, which is a significantly stronger emotion than greed, has helped to develop the largest financial bubble of our times – the multi-trillion dollar cash bubble I described in my last letter. In January, household cash on hand in CDs, T bills and money market funds exceeded the value of the entire S&P 500. That number is probably higher now. Cash, which yields next to nothing today, became the investment of choice. Relative to the Wilshire 5000, one of the broadest stock market indices, cash reserves are now at least as high as they were at the start of the last huge bull market in the mid-eighties. These points can clearly be seen in the two charts shown below.

Source: ISI Group

Source: ISI Group

The other side of the cash bubble has been investors’ demand for extraordinary risk premiums for both equities and less than pristine bonds. This has been reflected in low P/E ratios and high bond yields. As I noted in my January letter, earnings quality and interest rates considered, shares in great growth companies have recently been as cheaply priced as I can recall.

Certainly the economic situation is dire – as bad as most of us have ever seen. But I still think gradually growing pent-up demand, a heavy dose of creative destruction and dramatic government intervention in the credit markets should improve the situation within a year. We are, in fact, seeing just a few positive straws in the wind where we most need them - in consumer spending patterns. As markets often anticipate economic change by six months or more, I’ve been inclined to take up the positions I want to hold for the next cycle while their prices are low rather than trying to figure out just where the ultimate bottom will be.

The most important action taken in the States was the Federal Reserve and the Treasury Department’s decision to get interest rates down to a level where buying homes and refinancing mortgages make sense. Lower interest rates support higher present values for homes and a broad range of businesses, not to mention stocks and bonds. Furthermore, a mechanism is now in place that should remove many of the so-called toxic loans from bank balance sheets, permitting them to start lending again. This is an exceptionally complex challenge, but a good start has been made.

Another vitally important factor is the stock market itself. As I’ve pointed out before, the US is a consumer society with about 2/3 of GDP generated in that sector. Consumers’ activity is significantly influenced by changes in their net worth, which is in turn heavily impacted by the value of their homes and investment portfolios. Those values have been seriously depressed over the past two years, and a significant and lasting recovery will be vital to sustained domestic economic improvement. Lower interest rates are likely to be among the most important contributors to that recovery. Other things being equal, lower rates drive higher share values, which can play a vital role in reversing the negative feedback loop we’ve lived with for the past 18 months. Keeping rates down once the economy turns for the better might become a chore, but it’s not a concern now.

I made the point in my last letter that our firm is all about buying clients a steadily growing stream of earnings power and dividends behind their portfolios. We aim to see those profits grow by 15% a year over time and we’ve had only one year in the last 34 years when earnings power grew by less than 10%. Portfolio “look through” earnings power rose by about 11% last year when S&P 500 profits fell about 40%.

I never thought we’d see an economy weak enough to interrupt the steady earnings growth we strive to put behind clients’ portfolios. But, it now seems there is a chance that “look through” earnings will not advance in 2009 and could, in fact, have their first slightly down year, while S&P 500 earnings may fall another 20% or so. Today’s global head wind may be just that strong.

We’ve made a conscious decision not to “throw the baby out with the bath water” just to retain consistency. Our clients’ holdings should prosper in even a modestly healthy economy. In fact, most will have improved their competitive position during the recession. We expect profits behind clients’ portfolios to more or less double over the next half decade, albeit, from a slightly depressed base in 2009. Each holding is a leader in its field, has a strong balance sheet and excellent, in-depth management. Most are global firms and growth outside the States should be an important driver over time. We still hope to end 2009 with our 35th consecutive increase in “look through” earning power behind our clients’ portfolios, though we accept the possibility that we may not make it this year.

Cautiously assuming it will take several years to rebuild a solid financial foundation under global markets, I won’t project a near-term return to historical price to earnings or cash flow ratios in the next five years. On the other hand, it is already clear that some investors are just starting to move out of their cash hoards. Industrial quality corporate and municipal bonds have been moving steadily ahead in price for several weeks and depressed equities have clearly been finding buyers more recently, despite the deepening recession. Notwithstanding this early shift, however, most of the cash bubble built up over the past few years remains firmly on the sidelines.

A rising stock market in itself can provide an economic stimulus as it improves consumer confidence and net worth. Impatient cash on the sidelines can drive a market higher well before corporate earnings power turns up. It will be a while before we’ll know if the many participants in the global cash bubble will, in fact, become impatient. Meanwhile, there is
plenty of value to be had while we wait. Once the cash bubble really bursts, that value, and our profit opportunity, will be diminished.
A conservative assumption of only 10% annual earnings growth from today’s already subnormal base and a return to a P/E ratio of just 15 times estimated earnings, well below the 17-31 range for the decades before last year’s meltdown, will double the current value of our clients’ portfolios in five years.

It is certainly possible that the market could test its recent lows again. But once our clients have set aside their sleep-at-night reserves, our most important concern is to position their equity portfolios to make a lot of money over the next several years rather than trying to call the market bottom – which has proven over the years to be a fool’s errand. On a simple risk/reward basis, investing for a possible 100 percent upside during the next five years versus the risk of perhaps making little or nothing in a continuing recession, which would have to be worse than anything we’ve seen before, seems to me like a sensible way to invest.

Based on the chart below, showing the 10-year moving average returns for large US companies going back to 1825, the highest returns one can expect from the broad market averages are about 20% per annum for 10 consecutive years. The worst returns are approximately zero percent for the same period, which is where we are today. Looking ahead, if history provides guidance, it seems pretty clear that returns could improve dramatically in the coming decade.

10-Year Moving Average US Large Cap Common Stock Nominal Total Return, 1825-2008

As always, please call or email me with any questions or suggestions.

Regards,
Bill Stewart

Please contact one of our offices if you would like to discuss our investment opportunities or to receive more detailed information.

Issued by W.P. Stewart & Co., Ltd. This document is prepared solely for information purposes and does not constitute an offer to buy or sell or a solicitation of an offer to buy or sell any security mentioned in this document. Statements about any particular issuer or security are included solely for the purpose of illustrating the way W.P. Stewart has made prior investment decisions in managing its clients’ portfolios; such statements are not intended to be given as advice for the basis of future investment decisions by others. With respect to any views expressed herein regarding a particular issuer or security, the W.P. Stewart analyst primarily responsible for researching such issuer or security certifies that (1) such views accurately reflect the analyst’s personal views and (2) such analyst’s compensation was not, is not and will not be tied to specific views expressed herein. Prospective investors should conduct such investigations as the investor deems necessary and should seek their own legal, accounting and tax advice in order to make an independent determination of the suitability and consequences of an investment with W.P. Stewart & Co., Ltd., its subsidiaries and affiliates.