June 2011’s conclusion marked two years since Black Cypress’s inception. Over this period, our portfolios, while more-conservatively positioned, were able to slightly outpace their benchmarks despite the broad markets’ rapid appreciation. Our portfolios also significantly outperformed our clients’ required and desired returns.
As we have remarked in past letters, our value-oriented strategy should perform best during market turmoil, better during market rationality, but underperform during bouts of investor euphoria and overvaluation. This has certainly been the case when one looks at the returns to our clients over each of the last two years.
From July 2009 to June 2010, the S&P 500 returned 14.4% and the MSCI EAFE returned 6.6%. The combined returns were slightly higher than historical averages, but not exceptionally so. Our portfolios outperformed their benchmarks by nearly 2% in our first year. From July 2010 to June 2011, the S&P 500 and the MSCI EAFE each returned 30.7%, despite already elevated equity valuations, amidst rampant speculation due in part to the Fed’s quantitative easing programs. Our portfolios rose handily, but underperformed their benchmarks by an average 1.8% in our second year. Over the two year period, our clients remain ahead of their benchmarks.
Conditions continue to point to a soft, but still growing economy. Weekly unemployment claims have been trending down for the last several weeks, retail sales continue to expand, housing inventories have declined year-over-year for five consecutive months (which is ultimately supportive of pricing), corporate earnings are strong, monetary policy remains accommodative and borrowing costs are low for consumers and businesses. But there have also been renewed signs of weakness.
Real total income earned, a Black Cypress proprietary metric, has decelerated to a level of growth that has historically led recessions. The unemployment rate has begun to move higher and if it were to move up one more tenth of a percentage point, four of our five employment-based leading indicators would signal an approaching recession. Real retail sales growth, while still positive, has decelerated considerably. Rail traffic in the U.S. has been softening and fell during the most recent week. Regional manufacturing has been mixed, with a few reports of actual contraction. And housing, which typically represents an individual’s single largest asset, remains in a depression. The economic landscape is clearly mixed, but there isn’t yet enough persistent, pervasive and pronounced negative data to alter our economic viewpoint. We expect continued, albeit tepid, growth ahead.
There are of course numerous bearish opinions at this time, each of which has the air of reasonableness and cleverness. But remember that the bear case always seems more intelligent. The best investors are contrarians at heart and take pride in having an opinion contrary to the typical brokerage-house research. Therefore, it is useful to remind ourselves that for the most part, the bulls are right. After all, the market has risen an average of over 9% per year for over a hundred years. Being bearish doesn’t pay over the long-term, as the ingenuity of the human spirit coupled with capitalism ultimately prevails. At Black Cypress, we maintain no bullish or bearish biases–we labor to go only where the data takes us. With that being said, we’d like to address the two currently most discussed and feared headlines: the U.S. debt ceiling negotiations and the Euro zone debt and deficit crisis.
Our congress and Presidents have proven themselves inept to make unpopular decisions, two of which are raising taxes and cutting or limiting entitlement spending. They are, however, rather adept at getting reelected. It is for this latter reason that we fully expect a debt-ceiling deal of some sort despite the political theater. We also expect it to more or less kick the proverbial ‘can’ down the road once more.
Troubles in the Euro zone, on the other hand, represent the potential for catastrophe. Interest rates have risen from one periphery country to the next, threatening contagion. The European banking system has capitalized itself with the debt of its Euro zone sovereigns and if one periphery was to default, it would deplete banking capital and could potentially lead to the collapse of the entire banking system. This fact isn’t unknown to the ECB, IMF, and Fed, each of which is seeking a resolution that limits market turmoil. All we can do is watch and wait, but we expect some resolution that buys the world economy more time to heal.
Broad equity markets remain overvalued and credit markets have low absolute yields and tight spreads. Many commodities and precious metals trade near all-time highs. Cash and cash equivalents are nearly yield-less. This limited opportunity set of ample margin-of-safety investment options is in spite of widespread economic and political uncertainty. However, our portfolios trade with valuations below historical averages with higher-than-market dividend yields.