July 27, 2009
Dow Jones Average: 9,093
S & P 500 Index: 979
Lower Ceiling
A persistent rally in stock prices has lifted the major market indices some forty percent
from the depths that were plumbed last winter. The S&P 500 index stands at 979 as of
this writing, well down from its highs of 1550, but up substantially from the 670 level
touched in early March 2009. The Dow Jones Industrial index now stands at 9,093 which
is thousands of points from its high of 14,000, but considerably higher than the mid- 6000
level of a few months ago. When a market index falls by fifty percent or more, it can
stage an impressive rally in percentage terms and still be miles from its all-time high.
The rebound and seeming stability of the market is giving investors newfound
courage. The panic selling of last winter has disappeared and has been replaced by a
desire to join the rally. While investor emotions dictate shorter-term trends, it is cold,
hard mathematics that sets the longer-term level of the market. When one considers the
damage that has been done to the economy, to corporations, and to the stock indices that
reflect the value of those corporations, it seems highly probable that the stock market
will remain significantly below its former highs for many years to come.
The Standard and Poor’s 500 index is the most commonly used measure or
benchmark of aggregate U.S. stock market value. Almost every major, public company
headquartered in the United States is a member of the S&P 500 index, along with
hundreds of companies that may not be household names, but are still large and
significant by most measures. While there are thousands of small and medium size
companies in the U.S. that have publicly traded shares, the 500 companies in the S&P 500
Index represent almost seventy five percent of all value in U.S. domiciled stocks.
The meltdown of the financial group, and weakness in many other sectors, has
lowered the value of companies included in the S&P 500 index. There has been
considerable turnover in the index as mergers and bankruptcies have forced a revision
of the companies that constitute the index. Major corporations, such as GM, Fannie Mae,
Washington Mutual, Wachovia, Lehman Brothers, Merrill lynch, Bear Stearns, etc. have
either gone bankrupt, been forced to merge at a low price, or fallen so low in value that
they no longer qualify for inclusion in the S&P 500 Index of leading companies. When a
company is removed from the S&P 500, another company is chosen to fill the empty slot
in the index, keeping the number of companies in the index at a constant five hundred.
Since almost all the big companies in America are long standing members of the
S&P 500 index, the replacement candidates are usually smaller companies that did not
previously make the cut. On September 12, 2008 Fannie Mae, the largest mortgage
holder in the country, fell to about 50 cents per share and was booted from the S&P 500
index. The company that took Fannie Mae’s place in the index was Fastenal, a relatively
unknown company. Washington Mutual, a large bank, was kicked out on October 1,
2008 after a collapse of its share price, and its place in the index was taken by Flowserve.
Merrill Lynch, a company once valued in the index at 95 billion dollars, dropped by about
90% in price and was forced to merge with Bank America. As Merrill Lynch no longer
exists, its place in the S&P 500 index was taken by SCANA, a relatively small South
Carolina utility company. The decline in the major market indices accurately reflects the
shrinking number of highly valued companies.
In October 2007 the combined value of all the companies in the S&P 500 index was
13.42 trillion dollars. More recently the aggregate value of the 500 companies was only
7.6 trillion dollars, a decline of some 40 percent. The decline in value reflects the demise
of some former S&P 500 members, such as GM and Lehman Brothers, the removal from
the index of Fannie Mae, Merrill Lynch, etc., and the sharply reduced value of companies
such as AIG and Citigroup that are down 95 percent or more in value but still qualify for
inclusion in the index. The bottom line is that the market indices, and the majority of
mutual funds that typically mirror the performance of the indices, are not likely to fully
recover for years to come.
The broad market, as reflected by the S&P 500 index, could go up by 20 percent from
current levels, if the less damaged companies in the index all surged back simultaneously
to their 2007 highs. This highly optimistic, unlikely scenario would still leave the market
well short of the highs reached in 2000 and 2007. A more substantial recovery, back
toward the all-time highs reached in those two years is just not mathematically possible
anytime soon. Many of the companies that were once part of that higher market either
do not exist anymore or have been irreparably damaged. In our opinion, investors will be
more successful and less frustrated if they recognize that the market is constrained, has a
lower ceiling, and is currently closer to the ceiling than the floor.
Current Strategy
The great stock market collapse of 2008 and early 2009, that took the S&P 500 index from
1550 to 670, set the stage for an impressive rally. After a decline of 57% it is typical to
experience some kind of rebound. During the second quarter of 2009 the market did
surge by about 40 percent from the March 2009 bottom, which still left the averages some
40 percent lower than the all-time highs reached in 2000 and 2007. We see the market in
a middle zone with just slightly more downside than upside potential at this point.
We have taken advantage of the recent market rally, selling a number of positions at
prices substantially higher than the going price at the March bottom. For twenty-seven
years we have been sellers into market rallies and buyers on major declines. Market rallies
give investors a chance to clean up portfolios by selling, for gains or lesser losses, holdings
that are overvalued or have become less attractive from an operating perspective. We
have used the market rally to reduce and improve the mix of stocks in portfolios.
Markets are driven by investor psychology and fundamental, company specific news.
When psychology is extreme, i.e., the giddiness of 2007 or pure panic last winter, investors
largely ignore fundamental business news. Now that markets have settled down,
investors are re-focusing on business results. Success in the current market environment
will depend more on research and analysis of individual companies and less on predicting
seismic shifts in the market. We are finding some companies still worth buying even after
the rally and others that are closer to an exit price.
The fixed income portion of accounts presents us with a dilemma at this moment. The
money we have invested in TIPS (treasury inflation protected securities) and municipals
looks good, as the rates we secured for clients are no longer available. It is the cash
reserve holdings that are problematic and challenging. Money market funds yield next
to nothing, while the return on ten-year (not inflation protected) treasuries has climbed
to 3.7 percent. We are nervous about committing client money for ten years or even five
years to lock in a higher rate, when financial conditions and interest rates may change
dramatically over those time periods. Inflation is the big concern for Warren Buffett and
many others, given the trillions of dollars being printed by governments around the
world. If inflation takes hold during a period of economic recovery, interest rates could
shoot higher. Cash will have been a better choice than fixed rate bonds if that happens.
We are considering a number of alternatives to cash, including dividend-paying
stocks, foreign bonds in countries that may benefit from commodity inflation, and
corporate bonds issued by companies that have solid prospects. Our preferred bond
categories, TIPS and municipals, are just too high for any more buys at this time.
