08 Mar 2010 Clipper - Q4 2009 Report ( Portfolio )
Less than a year ago, many investors were concerned about a new Great Depression. Prices of all asset classes, except Treasuries, were collapsing. Unemployment was surging and liquidity was evaporating. The combined market capitalization of our nation’s financial institutions fell 80% on average and most of the largest were taken over, forced to raise capital or filed for bankruptcy. To make matters worse, the combination of overextended consumers, undercapitalized financial institutions, excess manufacturing capacity, and an underemployed workforce made it difficult to see what engine could pull the economy out of its nosedive. From the highs reached in 2007 through the trough in March 2009, the stock market fell more than 55% and Clipper Fund almost 66%.

In response to this free fall, the U.S. government and Federal Reserve pulled out all the stops, pouring liquidity into the system through near zero interest rates, huge increases in government spending, unprecedented capital investments in financial and industrial institutions, the direct purchase or guarantees of less liquid loans and securities, a ballooning of the Federal Reserve’s balance sheet, and expanded access to its discount window. While some of these individual actions may be questioned and the long-term consequences of soaring government deficits have yet to be faced, there is no doubt that drastic action was required.

As time passed, these actions took hold and though the economic news has not gotten much better, it has stopped getting worse. Although such important indicators as home prices and unemployment are still significantly worse than they were a year ago, they seem to have stabilized, albeit at depressed levels. Because we were in the midst of a financial panic, stabilization or a decline in the rate of decline was viewed with enormous relief, setting off an explosive rally in global stocks. As strange as this might sound, the news that we are in the midst of one of the worst downturns in more than 50 years was welcomed simply because it was better than Armageddon. As a result, despite a shrinking economy, high unemployment and soaring deficits, the S&P 500® Index surged a staggering 68% and Clipper Fund jumped more than 92% from their March lows through the end of the year.2

While such huge increases in so short a time are almost unprecedented, they are as much a consequence of how far markets had fallen as they are a reflection of new optimism. As suggested at the beginning of this report, an occasionally forgotten piece of math is that a 50% decline requires a 100% increase just to break even. Thus, having fallen more than 55% before recovering 68%, the S&P 500® Index still trades almost 30% below its starting point. The math is worse for Clipper, which after falling almost 66% and rising more than 92%, is still about 35% behind its starting point.

From a longer term perspective, even after this recent rally the S&P 500® Index is still well below where it was 10 years ago. Although the market has fallen during this decade, the companies that make up the S&P 500® Index are earning more and are thus more valuable. Specifically, at the end of 1999, the S&P 500® Index traded for 1,469 and earned about $48, implying an earnings yield of about 3%. Today, the S&P 500® Index trades for 1,115 and should earn $55-$75 this year, implying an arnings yield of 5%-7% on fairly depressed earnings.3 More important, when we look at the individual companies that we hold in Clipper Fund, many now have earnings yields of 7%-10% and intrinsic values significantly above today’s prices.

Although valuations still seem reasonable, many investors are anxious that the market’s steep recovery means that it must be ahead of itself and that they would do better to wait for a correction. However, there is an old saying that “the market doesn’t know where it’s been.” In other words, the returns investors earn have nothing to do with where a specific stock or the market in general was trading a year before they invested. It is also not uncommon or a sign of overvaluation when the market bounces from depressed levels. For example, after falling more than 40% in less than two years and bottoming in October of 1974, the market soared 55% in the next nine months making 1975 one of the strongest years for the S&P 500® Index in the last 40 years. Given that the market was up more than 50% and the economy was still weak, with inflation and unemployment rising and the energy crisis looming, investors who missed 1975’s strong advance might have felt it would be prudent to wait for a better time to invest. If they waited, in one sense they were correct as many economic indicators continued to worsen, only reaching their nadir in the 1980-1981 recession with double-digit inflation, interest rates and unemployment. However, as is generally the case, the market recovered long before the economy, advancing another 24% the following year. In fact, in the five years following 1975’s 37% gain, the market almost doubled. Clearly, those who waited until investing “felt” better paid a big price. As Warren Buffett wrote in a prescient article that almost rang the bell at the end of the bear market in August 1979:

[The] argument is made that there are just too many question marks about the near future; wouldn't it be better to wait until things clear up a bit? You know the prose: Maintain buying reserves until current uncertainties are resolved, etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.

We do not use this example of the 1970s market recovery as a forecast. We simply do not know what the market will do in the next year or two. Rather we use it to point out that stock market returns in any one year do not help predict what returns might be the following year. If investors have learned anything over the last several years, it should be the futility of short-term market forecasts.