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“This ‘death of equity’ can no longer be seen as something a stock market rally – however strong – will check.  It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries and booms…For better or for worse, then, the U.S. economy probably has to regard the death of equities as a near-permanent condition – reversible some day, but not soon…. Says Alan B. Coleman, dean of Southern Methodist University’s business school: ‘We have entered a new financial age.  The old rules no longer apply.”

Looking at the above quote, one might think they were watching CNBC or reading today’s Los Angeles Times.  As eerily similar as this commentary is to our current day, the above quote is actually taken directly out of the August 13, 1979 edition of Business Week magazine.  The cover of that now infamous magazine was titled “The Death of Equities: How inflation is destroying the stock market:”  Despite seemingly dire circumstances at that time, the stock market bottomed on March 27, 1980 and was 37.09% higher by March 27, 1981.  While the market did give back approximately one-third of those gains by August of 1982, the market subsequently moved 58.33% higher by August of 1983 and ultimately enjoyed the greatest bull market run in U.S. history that lasted from 1982 through 2000.

“Already racked by a devastating double-digit inflation, the nation is now plunging deeper into a recession that seems sure to be the longest and could be the most severe since World War II.  Consumers who a few weeks ago worried mostly about rising prices now fear for their jobs and incomes as well…Federal Reserve Board Chairman Arthur Burns warned of a possible ‘permanent decline of our nation’s economic and political power’ unless the Administration takes more vigorous action to curb the flow of wealth into oil-country treasuries.”

If we substitute inflation concerns with deflation concerns and imagine Nouriel Roubini instead of Arthur Burns, the above quote smacks of the type of banter all too common in today’s media.  The above quote, however, is actually taken directly from the December 9, 1974 issue of Time magazine that was titled “Recession’s Greetings”.  While Time reminded readers how awful the economy was, the stock market had already bottomed on October 3, 1974 and was 38.01% higher by October 1975.  

Time did it again after the stock market crash of October 1987.  Their November 2, 1987 cover was titled “The Crash: After a wild week on Wall Street, the world is different.”  The stock market was actually able to muster slight gains for calendar 1987, was 22.78% higher one year later and 56.93% higher in two years. 

While the above examples reflect periods of pervasive doom and gloom, these now famous magazine cover moments also coincide when investors and the media are excessively optimistic.  The January 31, 2000 cover of Business Week magazine was titled “The New Economy: It works in America.  Will it go global?”  Then on February 14, 2000, Business Week ran a special report on “The Boom”.  The subtext to describe this issue offered the following: “Time to celebrate.  This month, the current economic expansion became the longest in U.S. history.  The boom has done more than create millions of new jobholders and stockowners.  It has also restored the public’s confidence and given more people than ever a shot at the American Dream.  We tell the story in how prosperity is reshaping the American economy.”

Despite the above euphoria, the stock market soon collapsed with the S&P 500 having dropped 49.15% by October 2002.  The NASDAQ peaked on March 10, 2000, less than one month after “The Boom” was published, and subsequently fell an amazing 78%. 

Given today’s consensus pessimism and fears of a second coming of the Great Depression, it is not surprising that Time pictured Depression-era soup kitchen lines in its “New Hard Times” edition published October 13, 2008.  And Time’s most recent March 9, 2009 cover is titled “Holding on for Dear Life”.  The article describes the economy as a “harrowing experience, tightrope walking over the financial abyss” with “American Dreamers optimistic, but few able to tread that wire now without looking down in panic”. 

Perhaps Time has now offered the current economic cycle a magazine cover moment that marks a potential inflection point.  Time and time again throughout history, the media jumps aboard a pervasive theme just as the theme has seemingly reached its peak.  In each of the above magazine cover moments, the magazine article accurately described the mood of the day, but failed miserably in offering any predictive value for future economic activity or stock market outcome.

The significance of emotions on investor behavior cannot be minimized.  Fear and pessimism are rampant today and strongly influencing investor behavior, with record outflows from equity investments even as the stock market hits new lows.  By the time these emotional impulses are featured on the cover of our national magazines, the “newsworthiness” or substance of the magazine pieces have already been priced in or discounted by the stock market. 

Meanwhile, there is an emerging group of respected investors bucking the magazine moodiness and offering their own rationale for a potential turn in the market.  For her part, Schwab’s Chief Investment Strategist Liz Ann Sonders recently published a report titled “Brighter Light at End of Housing Tunnel” and opines that “another 10%-15% drop is highly likely before a floor can find stability, but if the pace of inventory decline keeps up, that light at the end of the housing tunnel should appear”.

Fed Chairman Ben Bernanke recently testified that the recession should end later this year if the U.S. banking system stabilizes and expects fairly strong growth in 2010.  With Citigroup, J.P. Morgan and Bank of America all disclosing profitable months for January and February, bank stabilization may occur sooner than the market currently anticipates.  And Bloomberg now reports that Warren Buffett sees opportunities in the U.S. and suggests that the odds favor Berkshire Hathaway consummating a domestic deal.  Buffett seems to be demonstrating his knack for “becoming greedy when others are fearful”.    

Even previously bearish investors such as Jeremy Grantham and Doug Kass are finding valuations too attractive to pass up.  Grantham has been snapping up high quality U.S. stocks such as Johnson and Johnson and Kass was so bold as to predict that the market would hit a yearly bottom during the first week of March.  Kass’s analysis reveals that “equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income”.  Kass bases his opinion on the following analysis:

•    The risk premium, the market’s earnings yield less the risk-free rate of return, is substantially above the long-term reading.
•    Using reasonably conservative assumptions, the market has discounted 2009 S&P 500 earnings of $47.
•    Valuations are low vis-à-vis a decelerating (and near zero) rate of inflation, with the current market multiple consistent with a 6% rate of inflation.
•    Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
•    The market capitalization of U.S. stocks vs. stated GDP has dropped to about 80%, now at the long-term average.
•    The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below levels achieved in the late 1930s and mid 1970s.
•    A record percentage of companies have dividend yields that are greater than the yield on the 10-year Treasury note.  At 46% of the companies, that is over 4x higher than in 2002 and compares with only 5% on average over the last 30 years.

Kass’s arguments seem compelling to us.  While we have never claimed to be able to precisely predict market tops and bottoms, the current environment, rife with fear and magazine cover moments, sure feels to us like a potential inflection point.  With a revision to mark-to-market accounting and return of the “uptick rule” potentially in the cards, we are seeing early signs of fear turning to hope.  Meanwhile, the high quality companies that comprise the Osher core are selling at historically attractive valuations and possess the type of strong balance sheet and cash flow to thrive in the recovery that will eventually ensue.