Quarterly Investment Commentary

October 2010

In The Clear earnings dropped, how quickly they dropped,

and how long it took for earnings to recover to
Readers will be elated to know that the recession new highs. Certainly the 1929 plunge (blue line)
is over. Actually, it has been over for some time. was the steepest and most protracted decline,
If you believe the National Bureau of Economic requiring 18 years (72 quarters) to reclaim the -
Research (NBER), it officially ended June 2009, 75% that was lost in the crash.
18 months after it began. It was the worst
contraction since the Great Depression as In 2007 (purple line) as earnings traced an
measured by drop in GDP, jobs lost, and eerily similar decline as in 1929, many investors
duration of time. The government matched the wondered with good reason whether we were in
magnitude of the economic malady with an for a repeat experience. After suffering a near -
equally aggressive monetary and fiscal stimulus. 60% decline, earnings have regained all but 15%
of their prior highs. That is a very different
Funny thing is, it sure does not feel like the outcome from 1929 so far. In fact, based on their
recession is over to us. There is perpetual talk of current trajectory, earnings are on track to
a double dip. The recover a little
Fed continues to faster than the
hold interest four years it took
rates at 0%. The after the internet
Treasury bubble of 2000
continues to (green line).
backstop Fannie’s
and Freddie’s But earnings are
mortgage losses. only part of the
Unemployment story. Stock
remains above prices, too, are
9.5%. Housing demonstrating
continues to that investors
languish. This believe the
post-recession recovery will
recovery has been continue to
called the weakest since World War II. At the progress. The chart on the next page compares
same time, the stock market has been recovering the price changes of the stock market (as
nicely the last year and a half. Let’s take a look measured by the S&P 500) during the
at this downturn from both the perspectives of aforementioned market declines.
stocks and their earnings to see if we can see
what the NBER does. Notice that the 2007 price decline of stocks
(purple line) has been very comparable to what
First up, corporate earnings. We charted we witnessed in 1972 (red line) and 2000 (green
corporate earnings during the largest market line) even though earnings dropped significantly
declines of the past 85 years to see how we are more this time around. Both of those pullbacks
progressing this time around versus prior took 30 quarters (7½ years) to rediscover new
periods. The graph above shows how far price highs. Currently, the stock market is 12
quarters into the decline and is still about 25% smooth wild earnings fluctuations shorter-term,
off of fresh highs. [Note: for purposes of our and to help determine the appropriate value of
simple study here, dividends are not included in the stock market. For you math types, the R-
these numbers and will serve to shorten investor squared of our regression line is 96%. For you
recovery times.] math-haters, that means this method has done a
really good job of helping us determine where
Some readers may notice a challenge here earnings will go over the next few years; so we
synthesizing have a lot of
these two confidence in
charts. If this metric.
earnings still
have to recover The chart below
15% of old highs compares our
but the stock estimated long-
market has to term earnings
recover 25% of trend to actual
old highs, then earnings over
either earnings the last several
have to travel an years. Actual
extra 10% earnings per
through their share traveled
old highs or p/e from around
multiples have $91 in 2007 to
to make up for that extra 10% to get stocks back $40 in 2009 and then back to $73 in June 2010.
to where they used to be. In other words, either It just so happens that $74 was our June
corporations must realize particularly robust estimate of earnings per share. So, earnings
earnings growth in the face of high have gone from above trend, to below trend, and
unemployment and lower leverage or investors then back pretty closely to in-line with our trend
have to become more confident in the future estimate.
such that they
become willing Now look at the
to pay 10% more red dotted line
for each dollar of that extends
earnings than from the current
today. If neither quarter into the
of those two future above the
things happens, trendline. That
stocks will take a line represents
longer time to analysts’
recover fully. estimates of
Allow us to earnings growth
briefly look a over the next
little closer at the year. By this time
possibility of in 2011 analysts
each of those expect that
scenarios—that earnings will be
is, earnings growth and p/e multiple expansion. back to $91/share. That $91 estimate is
important because it states a conviction that
Earnings Growth corporations will have fully recovered
everything earnings-wise they gave up a little
As a reminder, we use long-term earnings over four years prior. That earnings trajectory
trends as our sanity check on earnings, to could add about +16% price appreciation to
stocks over the next year if p/e’s hold steady.
That would place the S&P 500 at almost 1350
(versus 1141 on 9/30/10) and earnings would be
at 115% of their long-term trendline.
From a valuation perspective, it is not unusual
or disconcerting that earnings would go above
their long-term trendline. At the same time,
earnings can only oscillate so far north of trend
before growth slows to the long-term trend.
Typically that limit is close to 125% of trend,
although it has been as high as 150% back in
2007 (refer to the chart on this page).
For stocks to reach higher prices at current
multiples would imply that earnings would need
to get to over $104/share. That is 130% of next
year’s trend
earnings or, if you
are patient, 100%
of trend earnings
out in the year
2016.
P/E Multiple
Expansion
Of course, the
other way to get
market gains is by
convincing
investors that the
future is brighter
than they
currently expect it to be so that they are willing
to pay more for earnings. This is called p/e
multiple expansion and is especially challenging
to obtain in the current environment given that
stocks have experienced a contraction in p/e
multiples. At the highs in 2007 stocks traded at
24.4x trendline earnings. Currently they trade at
15.3x. This contraction in multiples has been the
principle culprit in deterioration of stocks
prices. If analysts are correct and earnings go to
$91 next year, p/e’s would need to go to 17x in
order to reclaim old heights—a bold valuation in
this timid environment.
Our point is that without the economic
fundamentals and investor enthusiasm in place,
we do not expect that the stock market could
logically make fresh highs anytime within the
next few years. If it does, due to an artificial
monetary stimulus for instance, then it will have
likely moved ahead of its fair valuation and
become a candidate for trimming in portfolios.
At the same time, the upward slope of the
earnings trendline means that with every
passing calendar quarter the odds of stocks
breaking down to the March 2009 low of 666
becomes less probable.
So, if highs are constrained and lows are
contained, where does that leave the stock
market? Well, range bound for now. If that
conclusion sounds hopelessly consensus, then
let us add that if stocks do break out of their
trading range we would be buyers at p/e’s close
to 10x trend earnings and sellers near 18x.
Outlook For
Stocks
Stocks are long-
term investments
and therefore
should be
evaluated on a
long time
horizon. While
that simple fact
may sound
pedestrian and
redundant, we
believe the
overwhelming
majority of investors struggle profoundly with
its implications.
It is by first forming a view of what stocks could
return over say, 10 years, that we establish a
baseline to know whether the investment is
worth the risk. Second, once that long-term view
is fixed, then the investor can understand how
the inherent volatility can be used as a tool to
buy stocks cheaper or sell them dearer along the
way. It is the layering of short-term
opportunity behind the long-term view
that leads to satisfactory returns.
Investors too often replace the long-term
view with the short-term view and lose
their perspective in the process.
We frequently delineate what we believe stocks hang on through volatile times are eligible for
and bonds are priced to return and like to these returns.
approach those estimates using different
methods to check for consistency. Let’s take yet Now let’s compare how this historical data
another look at what stocks could return to squares with what we are seeing prospectively
investors over the next decade. On this page is a by creating a projection of 10-year returns and
chart of 10-year nominal stock returns putting it beside the historical range of returns.
(including dividends) covering quarterly periods We will use the same basic equation we have
from 1925 through the end of third quarter used in past writings. That is, stock returns are
2010. The graph compares the beginning p/e to equal to:
the following 10-year total return for stocks. The
red square marks the intersection of the current Earnings Growth
p/e (i.e., 15.3x) and the ensuing 10-year +
arithmetic average return for all of the data (i.e., Change in P/E
9.3%). Note that because these are nominal +
returns, inflation is included in returns. Dividends
Therefore, during inflationary times, the real
returns will actually be lower than observed on First off, earnings have grown a predictable
the chart and vice versa during disinflationary +5.9% annually for over 90 years. Given any 10-
times. year time frame, a majority of earnings growth
rates fall between +3.7% on the low side and
The principal observation to draw from the +8.9% on the high side.
chart is that
there is clearly Second,
an inverse regarding p/e,
relationship for our exercise,
between p/e’s we can assume
and the that from the
subsequent 10- current 15.3x,
year returns of the p/e can go
stocks. In to one of three
general, as places: to
investors’ extremely
willingness to undervalued
pay more for levels (8x), to
earnings overvalued
increases, levels (18x) or
stock returns to the long-
decrease. Keep term average
that in mind (14x). The
should stocks get cheaper. effects these repricings would have on returns
would be -6.3% annually, +1.6% annually, and -
Take a look at the black oval. It highlights that 0.9% annually, respectively.
every 10-year return we have observed that
began with a p/e of 15x has been in the range of Finally, the dividend yield of stocks is about 2%.
+5% and +17% per year. This brings us to our While that could rise, assume it does not for
second observation. The worst 10-year returns conservativeness.
ever from these levels are still double the
current yield on the 10-year Treasury bond Putting it all together we get the following range
before any possible/probable future dividend of annual stock returns:
increases. But only investors who are willing to

Look at the chart below. Compared with
historical stock returns our prospective model
suggests lower lows are possible (i.e., -0.6% vs
5%). At the same time, the historical data
suggests higher highs are possible than does the
prospective model (i.e., 17% vs 12.5%). Using the
green lines on the chart we highlight the
common return areas and thus narrow a likely
range of returns to
between 5% and
12.5% annually. The
median estimated
return falls between
+7% and +8% per
year.
Gold
The price of gold
has been steadily
rising—up 20% this
year—and many
investors are
interested in hearing our view on the metal at
these higher levels. Let’s lead off with some
words from former Fed Chairman Alan
Greenspan. He wrote a paper in 1966 called
“Gold and Economic Freedom.” In it he made
the following statements (emphasis is mine):
“Stripped of its academic jargon, the welfare
state is nothing more than a mechanism by
which governments confiscate the wealth of the
productive members of a society to support a
wide variety of welfare schemes. A substantial
part of the confiscation is effected by taxation.
But the welfare statists were quick to recognize
that if they wished to retain political power, the
amount of taxation had to be limited and they
had to resort to programs of massive deficit
spending, i.e., they had to borrow money, by
issuing government bonds, to finance welfare
expenditures on a large scale.
In the absence of the gold standard, there is no
way to protect savings from confiscation
through inflation. There is no safe store of
value. If there were, the government would
have to make its holding illegal, as was done in
the case of gold. If everyone decided, for
example, to convert all his bank deposits to
silver or copper or any other good, and
thereafter declined to accept checks as payment
for goods, bank deposits would lose their
purchasing power and government-created
bank credit would be worthless as a claim on
goods. The financial policy of the welfare state
requires that there be no way for the owners of
wealth to protect themselves.
This is the shabby secret of the welfare statists’
tirades against
gold. Deficit
spending is
simply a scheme
for the
confiscation of
wealth. Gold
stands in the
way of this
insidious
process. It stands
as a protector of
property rights. If
one grasps this,
one has no
difficulty in understanding the statists’
antagonism toward the gold standard.”
This year Greenspan addressed the Council on
Foreign Relations with this (again emphasis is
mine):
“Fiat money has no place to go but gold.
If all currencies are moving up or down
together, the question is: relative to what? Gold
is the canary in the coal mine. It signals
problems with respect to currency markets.
Central banks should pay attention to it.”
In case you are wondering, yes, this is the same
Alan Greenspan whose monetary policy has
been blamed principally for its contribution to
the falling dollar over the last two and a half
decades. Regardless of Greenspan’s role in the
whole program, his ideas are apropos here. Our
nation finds itself at the present time barreling
headlong into a debt trap with declining
consumption and anemic investment. As we
have postulated before, we must do the painful
thing, that is to instill fiscal discipline and pay
down our debts, or else we kick the can down
the road by printing money to service our
growing debts (i.e., quantitative easing) until we
are forced to change direction. For the record,
we prefer the former to the latter; so too,
Germany. As Europe wrestles with its own
problems, the real contrarian amongst the
sovereigns has been Germany who has worked
very hard to restrain its debt. Maybe this
dogmatic stance arises from the fact that it has
actually experienced firsthand the ill effects of
hyperinflation and is not interested in going
back there anytime soon. The U.S. government
seems to be acting as if it can avert just such an
outcome.
Yet every day the
rumblings grow
louder about the
efficacy of our
nation’s fiat
currency. Barely
four decades old
and already this
latest fiat
experiment
seems to be
showing signs of
cracking. Mr.
Greenspan’s
comments both
then and now bookend the subject ominously.
Competitive currency devaluation is heating up.
Last month Japan is reported to have sold about
$25 billion worth of yen in exchange for U.S.
dollars in an effort to hold the value of their
currency down vis-à-vis ours. The last time their
central bank intervened in the foreign exchange
markets in this manner was 2004. Meanwhile,
the U.S. continues to ramp up protectionist
measures in an effort to induce China to let its
currency revalue against the U.S. dollar. The
U.S. administration is suggesting that the
renminbi could be undervalued by as much as
20% against the dollar.
Mind you, since early June, the dollar index has
fallen some -13% versus other currencies. As
such, we have seen virtually all other asset
classes rise during the last quarter, from stocks
to bonds to commodities. We should mention
that these investments have gained in nominal
terms. However, those returns are not as
attractive when measured in dollar terms.
Gold is the insurance we have been
recommending against the currency wars. But
just because we recommend purchasing
insurance does not mean we want to see our
house burn down. Nevertheless, it is worth
spending a little to hedge some larger risks. We
are not talking about inflation risks. We are
talking about the risk of a coordinated
worldwide currency debasement where the
arsonists are the central bankers themselves.
We said a good
deal about the
subject in our first
quarter’s
commentary if you
would like further
reading.
The difficulty, of
course, comes in
valuing gold. The
most common
investor hesitation
we hear is that gold
has already run
and it is
overvalued—both
of which are valid concerns. Believe us, as value-
oriented managers, if there are two things that
do not sit well with us, they are chasing an
investment that has already run and not being
able to value an asset’s cash flows. Gold appears
to fall victim to both concerns. Therefore, even if
it is not an easy question to answer, we believe it
is necessary to put some handles on gold’s
valuation.
We in the U.S. have experience with a gold-
backed currency. Recall Bretton Woods where
our currency was a fixed value based on the
government’s total units of gold holdings.
Today, the U.S. monetary base is approximately
$2.2 trillion. The U.S. gold stock is about 8,100
metric tons or 261 million ounces. Given these
inputs, the U.S. government could, as before, fix
the value of a dollar to an ounce of gold at about
$8,400 currently (i.e., $2.2 trillion divided by
261 million ounces). If the Fed chooses this
route, the dollar/gold ratio would become the
primary target for the central bank to manage
money supply. To stimulate the economy the
Fed would offer to buy gold at the targeted ratio
(in this case $8,400), thereby expanding the
monetary base by that same amount. To slow
the economy the Fed would sell gold at the same
rate. This strategy would effectively cover the
monetary inflation engineered thus far by the
Fed. Simply put, the Fed would have unilaterally
revalued gold on its books without directly
affecting the money supply. Of course, this
action would serve as a windfall to U.S. gold
investors and a source of angst to lenders.
If I were the Fed,
here is potentially
the pecking order
of my options as
we see it. First, I
am hoping the
economy starts
growing soon so
that we can shrink
the money base
again and start
paying off debts.
Then, if that
growth does not
happen, then I am
going to wait as
long as I can to devalue the dollar against my
gold holdings because that is the point where
austerity begins. Finally, if all else has failed and
rates start rising because my country has
become an international credit risk and inflation
becomes too onerous, I would devalue my
currency against gold through a fixed exchange
rate.
Gold, in our view, competes with fiat currency.
Therefore, the reason gold has been in a 10-year
bull market is because investors around the
world increasingly view gold as a more stable
currency than their own local currencies.
Observe the track record of gold versus the
dollar. The Bloomberg chart on the prior page
shows the path of the dollar over the last 90
years. Pick any inception point you want; the
dollar has not maintained any assemblance of
its value. It has lost over 90% of its value since
Bretton Woods just 66 years ago. Conversely,
gold has been relatively stable with the
exception of the secular decline in the ‘80s and
‘90s which can be tied to an expansion of credit
that masked the failing dollar (see the chart on
this page). Investors must not ignore that the
monetary base continues to expand. The supply
of gold only expands marginally. All of the gold
ever mined in the world could fit into one
Olympic size swimming pool. We cannot say
that about dollars.
Given the current set of facts, we believe it
requires more faith to believe that the U.S.
dollar is a safe
investment than to
believe that gold
is. Think about
where the real risk
is.
In his comments
Alan Greenspan is
essentially
verifying the idea
that the main
objective of U.S.
policymakers since
1971 (when the
U.S. suspended
the convertibility
of dollars to gold) has been to maintain the
supremacy of the U.S. dollar in order to allow
our country to extend its influence over global
pricing and resource distribution. To do this,
policymakers have had to marginalize the one
currency capable of replacing it—gold. It is hard
to deride gold though when you are the largest
sovereign holder of gold reserves in the world.
Maybe that is one reason why the carrying price
on the government’s balance sheet is only
$42.22/oz—1/30th the current $1,300 market
price.
Conclusion
Suffice it to say that we would still advise
holding gold in portfolios until such a time
central bankers can prove to us that they have
righted the ship. For that matter (and for similar
reasons) we believe real assets in general are a
good store of value during a period of
debasement. We recommend maintaining
commodities, timberland, and real estate
exposure.
It is likely the dollar could rally near term after
its recent decline. If it does, stocks and
commodities could suffer drawbacks for a time.
We still believe the longer-term path of the
dollar is downward and would use weakness as
an opportunity to add to real assets.
We continue to maintain our stock positions.
Long-term returns seem reasonable, but not
outstanding. Valuations have not moved
substantially all year. Given the uncertainty of
the current economic environment, any
unexpected event could react with inherent
stock volatility to create opportunities for
investors. For that reason we are interested in
broad diversification across asset classes in
order to have resources from which to pull.
Although potential dollar strength could
temporarily buoy returns, U.S. bonds remain
unattractive on a secular basis. Investor cash
flows into bonds have been +$591 billion for
2009 and 2010 year-to-date, compared with
stocks for the same time period, which have
been -$24 billion. Investors have clearly
preferred bonds over the last two years.
Nevertheless, we are waiting for this 30-year
bull market in bonds to top out in the next
couple of years. Sixty percent of U.S. sovereign
debt outstanding is set to roll over in three years
and 80% will mature within seven years.
Compare this with the U.K. where 45% of their
bonds are due further out than 10 years.
Voisard Asset Management Group • 146 Monroe Center NW, Suite 820, Grand Rapids, Michigan 49503
800.343.9041 • www.voisardgroup.com • dvoisard@voisardgroup.com
Shrinking maturities on U.S. bonds is one
expression of investor cautiousness. At some
point, foreign buyers of U.S. bonds will not be
there to re-up their support. We do not know
when that will happen, but we believe that is the
course that our nation is currently on. As such,
we prefer non-dollar denominated international
bonds, particularly in commodity-based
currencies where there are low debts and fiscal
surpluses.
The tone of this letter may sound rather somber,
but understand that we are keenly interested in
trying to make sense of a very uncertain time.
Our world is at a crossroads of economic policy.
No one knows how the transitions and shifts will
play out. We are endeavoring to protect our
clients during this phase. But it is still a ‘phase’
and that is exactly how we view it. We profess a
very sanguine long-term global view. We firmly
believe that there will be remarkable
opportunities on the other side of this transition
period. The combination of productivity
improvements, a burgeoning middle class, and
increasing global connectivity will, in our
opinion, bring tremendous and unexpected
opportunities for investors.
Your Investment Team,
Douglas E. Voisard, CFP®
Brian McClard, CFA