A Year for Nothing (Not Quite)

Audited figures for our reference account (1) won’t be available for a while, but our best estimate is that it closed the year 2004 with a gain of 10.1% against 10.9% for the S&P 500. The small-cap and gold components of the portfolio held back the overall performance somewhat, but this was not unexpected after their stellar performances in 2003, which contributed significantly to that year’s overall gain of 43.1%. In addition, we held somewhat greater liquidity reserves through most of the year, both for prudent reasons and because we found few compelling new investments. This, however, was mitigated by the fact that a portion of these reserves was invested in foreign currencies, principally the Euro, which appreciated against the dollar.

This performance explains the “Not Quite” part of our title. Admittedly, 2004 was not a great year, but our returns (and the markets’) were in line with the long-term average for equities, so that it was not quite “a year for nothing” after all. More importantly, we preserved the precious cushion built during the bear market. Over the five years since the end of 1999 (the peak of the stock market bubble), our reference account has appreciated more than 62% while the S&P 500 has lost almost 11%. Of course, one may recall that our returns during the bubble, while honorable, paled in comparison with those of the leading indexes, particularly the NASDAQ. But over 28 years, we have managed to eke out the returns of the S&P 500, while avoiding that index’s most extreme fluctuations. This is the kind of performance we aim for, on behalf of our conservative clients (1).

1. We measure our investment performance using a reference account that, throughout the last twenty-eight years, has represented a significant (though thankfully declining) percentage of the assets under our management. It presents the added advantage of having had its performance figures audited without interruption since 1976. Finally, we believe that it fairly reflects our contrarian value investment style. Returns are presented after deduction of our fees and, for the S&P 500, include the re-investment of dividends.

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The first part of our title -- “A Year for Nothing” -- refers to the fact that, despite a seemingly eventful year and decent financial market returns, the world’s economy faces the same basic challenges as it did a year ago – and so do investors.

From a purely economic point of view, the only step toward correcting the world system’s major imbalances has been the downward adjustment of the US dollar against other major currencies.

Source: Prof. Werner Antweiler, University of British Columbia.

Significantly, however, there has been no adjustment of the US dollar against the currency of the country with which America has the worst trade imbalance: the Chinese renminbi. But, as I have argued before, even a significant revaluation of the renminbi would be unlikely to slash the bilateral trade imbalance between the two countries. Chinese wages are a fraction of American ones and, more importantly, the United States no longer manufactures many of the products it imports from China. So, the US trade balance will improve in response to the dollar’s decline against the euro and the yen, but only moderately overall. Unless, that is, US consumers go onto a spending strike, which indeed would drastically reduce American imports but could create problems for other economies.

In any case, trade figures are less relevant today than in the past. In fact, they seem to have become a mere derivative effect of massive international capital flows, which are now large enough to boost or curtail demand in individual economies. This kind of dependency on international capital used to be the curse of the smaller and weaker economies, but now even the United States is vulnerable to it.

Today’s paradox is that the world is awash in liquidity but that this liquidity is ill-distributed, requiring a massive recycling between high-saving countries and high-spending ones. This situation is not altogether different from the one that prevailed after the 1973 oil shock, when oil producing nations accumulated huge dollar reserves, which they could not physically spend – at least immediately. A huge recycling of reserves was needed, whereby consuming nations (particularly the United States) borrowed back the liquid reserves accumulated by OPEC. Note, however, that the growth of America’s real GDP, which had reached more than 53% between the end of 1962 and the end of 1972, was more than cut in half (to less than 24%) in the following decade.

In an ideal world, it is the developing countries that should import more than they export, in order to invest in infrastructure and boost development. More mature economies should be chronic savers and lenders/investors abroad. Today, the mature economies of Europe and Japan are net savers, but the developing countries of Asia (partly because of undervalued currencies and mercantilist policies) are even higher savers. America has filled the gap by absorbing these savings – earlier in the form of equity or direct investments and more recently by borrowing from foreign central banks.

There is nothing inherently virtuous or reckless about countries saving or borrowing to spend. Everyone has benefited from America’s role as the world’s “spender of last resort” and, for a time, almost every other country enthusiastically endorsed that self-assigned role. However, imbalances cannot keep growing forever. Already, there are signs of stress in the financial system: a huge amount of bad loans in China and the high level of debt of American consumers, for example. In America, while some traditional high-cost borrowing channels such as credit cards do not seem overextended, new ones like home-equity loans have been rising at an ominous rate.

Furthermore, the absence of stress at this very moment is not necessarily comforting, because a twenty-five year decline in borrowing rates has kept debt-carrying costs low despite ever-rising levels of debt.

Source: economy.com

One may therefore wonder what will happen when interest rates begin to trend up again, which is bound to happen sooner or later. However it unfolds, this development is bound to surprise many analysts and consumers who have never lived in a world of rising interest rates.

At a very general level, I would say that the environment of the last decade, reflected in a rising dollar, has been one where international capital flew massively into the United States, allowing the American economy to grow faster than it would otherwise have. Now, there are signs that the former eagerness of foreign investors to pour money into the US economy has abated. Aggressive private investors have had to be replaced by defensive central bankers, who buy US bonds with their growing reserves only to slow the appreciation of their currencies against the dollar.

It is likely that the coming decade, in many ways, will look like a mirror image of the one just ended. To me, this can only mean one thing: the US economy, after being boosted by foreign capital inflows, will have to grow more slowly than its domestic fundamentals alone would justify. While the timing of the slowdown is hard to pinpoint, it is not a question of if but of when – and this has important implications for investors.

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One of the characteristics of today’s financial markets (principally in the United States but, really, almost everywhere) is that everything is, more or less, selling at the same price. Investors seem unwilling to pay a premium or to demand a discount for considerations of quality, size or growth. This is evident, for example, in the fact that in December US junk bonds yielded only 6.76%, a rather complacent premium over the 4.22% yield of 10-year Treasury bonds. This trend is observable across the quality spectrum, as illustrated below:

Source: Economy.com

In terms of stock prices, the same phenomenon is evident. Since 1973, the Leuthold Group has regularly monitored the valuation of the 99 stocks most widely owned by large institutions. It then compares the median price-earnings ratio of the 33 most expensive among these institutional favorites with that of the 33 cheapest. The ratio of the expensive tier to the cheap tier reached an all-time high of 4.35 in September 2000, shortly after the peak of the stock market bubble. Last month it had fallen to 1.73, barely above its all-time low of 1.65 in September 1993. Seldom, in the last thirty years, have valuation multiples been so compressed.

Leuthold also compares size deciles among 3000 US companies. In December 1999, the 300 largest companies had a median price-earnings ratio of 28.2 – almost twice the median ratio of 14.5 for the 300 smallest companies. Now, the largest companies have a median ratio of 16.8 – under the median of 17.8 for the smallest ones.

Finally, ISI Group recently published weighted averages of price-earnings ratios and dividend yields of the 30 companies in the US Dow Jones Industrial Average and the 30 companies in the European “Dow Industrials”. In spite of our feeling that Europe, today, is cheaper than the United States, European price-earnings were only a bit lower (16.5 vs. 17.7) and dividend yields a bit higher (2.73% vs. 2.06%). This is one more indication that the compression in valuations has been a global phenomenon.

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Thus, as we enter 2005, the economic horizon remains clouded by the need to ultimately correct imbalances in the world trade and financial system. One of the consequences is that US economic growth will slow down from the pace of recent years, with possible ripple effects on economies dependent on exports to America.

At the same time, stock valuations are compressed within a very narrow range, with premiums for individual companies’ financial strength and growth potential historically very low.

The challenge, for the value contrarians that we are, will be to identify value among companies in the traditional realm of growth investors, because today, that is where the best risk-reward ratios seem to be.

François Sicart

January 17, 2005
^©Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.