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January 2013 Investor Letter


Dear Investors,

 

2012 was a good year for the stock market, although that’s probably surprising news to many casual observers. The S&P 500 finished the year up 13.4% before dividends, which is a few percent better than the median return of the last 50 years. Last January I wrote that a double digit return from the market would not be surprising in 2012 based on cheap valuations and the timing of a typical economic cycle. Indeed that’s what ended up happening: stocks went from slightly cheap to slightly expensive and the economic cycle continued to provide a favorable tailwind.

The economy and markets continue to recover at a pace which is mostly consistent with past cycles. Nominal GDP grew at a robust 5.5% in the 3rd quarter and even unemployment is falling at a pace in line with historical averages. Likewise, since 2009 the S&P 500 has almost exactly tracked its rise from 2003 to 2007. Charts of the S&P from 2003, 2004, 2005 and 2006 look almost identical to charts from 2009, 2010, 2011 and 2012, and 2012 ended just 3 points from where 2006 did.

Assuming that the cycle continues to track historical norms, 2013 begins in an interesting spot. As I have written before, the average length of an economic expansion is 42 months overall and 59 months in the post-war era. The current expansion turned 42 as of the end of the year, so we’re just approaching the point where a recession would not be abnormal. Despite several scares in the past few years, the odds of a recession have actually been quite low up until now but are starting to increase. For the first time this cycle, I wouldn’t be surprised to see hints of a recession start to pop up in 2013. However I think it would be more likely to see these signs in the second half of the year if they come at all.

If we do start to get some hints of recession it’s likely that they will be faint at first and largely ignored by the broader markets—gradually building steam over time. Fixed income markets are most likely to be at the epicenter of any recession, because investors have poured money into “safe” assets and pushed interest rates to levels that are unpalatable to any rational investor. So for the fifth year in a row I will be predicting rising interest rates in 2013. Let’s see if I can maintain a perfect track record in this regard: 0/5.

Setting aside concerns of a future recession, I am actually starting 2013 as one of the more bullish people that I know. Recessions typically don’t happen when people are cautious, as they are today; they happen when caution is thrown to the wind and valuations become extreme. Although multiples have expanded, there is still precedent for them to go higher, especially when combined with an overwhelming amount of government stimulus. Whereas last year 1450 was the maximum level that I believed the market could reasonably bear, this year 1650 seems possible to me, and privately I would be willing to admit that I would not be surprised to see a number much higher than that. In 2013 caution, valuation and stimulus could create a potent cocktail for equities.

So, after reinvesting most of our cash in November, we continue to take a favorable view of equities generally. As always, we stand ready to sell at the margin when our individual holdings reach our price levels and are happy to buy where we find bargains. Cheers to a happy and healthy 2013!

Scott Krisiloff, CFA

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