Where Do We Go From Here?

03/18/2010 05:12 am ET | Updated May 25, 2011
  • Alan Schram Managing Partner of Wellcap Partners, LA-based hedge fund

The economy is most likely not out of the woods yet. Credit remains tight, unemployment is rising, retailers are struggling and both commercial and residential real estate are still reeling. Yet, the country is much better off now than it was a year ago, during the crisis in the fall of 2008. Many of our fundamental problems have been fixed, leverage has been removed from the system, foolish exposures to risk have been expunged, and most of the weak companies have been washed out. Blood is no longer gushing on Wall Street.

As always early on in a recovery, people fear the fiscal and monetary stimuli are not sufficient. Then when the markets start going higher, people fear that the economy may stall. Once the economy begins to improve in earnest, they fear profits will not recover enough to justify stock prices. When profits recover, they fear a jobless recovery, and when the employment situation improves they say it will not be sustained for long.

That pattern holds true this time around. Other patterns emerge as well. Some investors have compared the market behavior in the last decade to that of the 1930's. I believe the peak of the tech bubble in March 2000 could be compared to the 1929 market top. Both "easy money" bubbles ended suddenly, and brought on a long period of decline. Back then, from the bottom of 1932, the market had a 300% "hope" rally, which peaked in 1937 and went into a five-year, 50% decline, until finally making a generational bottom in 1942.

March 2003 may have been the temporary-bottom corresponding to that of 1932. Buoyed by an unprecedented credit bubble, the indices commenced a hope rally that actually exceeded the previous top. In the summer of 2007, the chickens came home to roost, and the S&P 500 began a sickening 57% slide that lasted 18 months. We made our generational low in March 2009, and that will not be breached even if the economy "double dips."

It may be years before we see Dow 14,000 again, but we are on our way higher from that generational bottom last March. The major stock indices may well spend the next few years flat, but it will be a good environment for stock pickers, who can outperform. Large cap companies have lagged in the recent rally, and many of them are still down for the year. They present an opportunity, especially those that are high quality businesses with little net debt and strong cash flows.

And historical precedent happens to be on our side. If you examine the table below, you will see that in the past, recessions have been a good time for long term investors to buy stocks. I believe this time will be no different.

S&P 500 returns during and after recessions:
Recessions # of months During R 1 year 3 year 10 year
Jul 1953 - May 1954 10 17.94% 25% 100% 179%
Aug 1957 - Apr1958 8 -3.94% 6% 26% 107%
Apri1960 - Feb 1961 10 16.68% 20% 28% 50%
Dec 1969 - Nov 1970 12 -5.28% 0% 28% 17%
Nov 1973 - Mar 1975 16 -13.13% -27% 6% 73%
Jan 1980 - Jul 1980 6 6.58% 13% 27% 188%
Jul 1981 - Nov 1982 16 5.81% -18% 15% 196%
Jul 1990 - Mar 1991 8 5.35% 9% 26% 302%
Mar 2001 - Nov 2001 8 -1.80% -1% -3% N/A
Average 10 3.14% 2.95% 28.20% 139.16%
*from Michael Zhuang's internet blog, "The Investment Fiduciary" 20, August 8th, 2009.

Nevertheless, in light of the large amount of fiscal stimulus, monetary easing and credit creation in the form of new dollars that have all taken place recently, you have every reason to be concerned about the buying power of the dollar and the inevitable spike in interest rates that will be necessary to entice people to buy Treasury bonds in the future.

You will hear people advise you to hedge these risks by buying gold. Gold does not generate cash flow and does not have any intrinsic value, and therefore I do not like it as a long term investment. I believe currency and interest rate risks are best hedged by owning shares of high quality businesses that have a durable competitive advantage and pricing power, and will be able to weather a bout of inflation.

While ignoring the macro economy is naïve, predicting it is arrogant. Few people can successfully predict macro trends over time. It is much preferable to focus on bottoms-up analysis of individual companies. The only sensible approach to investing is to buy into well-understood businesses when they are offered substantially below what they are worth, and to sell them as they approach intrinsic value.