It was a remarkable year, and it was a noteworthy decade—for the economy, for the markets, for geopolitics. As they say, that which doesn’t kill you only makes you stronger! Looking back at 2009, our clients not only survived, but they also benefited from the strength of the market’s significant rally off the lows set in March 2009. Even though anxiety was sky high a year ago, our confidence in the investment opportunity (plus the discipline to not fall prey to the fears expressed by the pundits) allowed us to maintain and enhance our portfolio allocations. It was a time for acting opportunistically in the face of a financial panic, and thankfully, the recovery has been substantial. We are obviously pleased to see the strong recent performance, and we are appreciative of clients who had the faith, time horizon and discipline to allow us to invest their funds at a time where our confidence and choices could provide such a consequential impact. Thank you.

But despite the building economic and market recovery, we continue to see a meaningful amount of skepticism among investors as they grapple with a decade most would rather forget. It was not only the worst decade for stocks ever, but it also contained two sizeable bear markets: the S&P 500 dropped 49% over 30 months starting March 2000, and it fell 57% over the 17 months leading up to March 2009. For the average investor, these sizeable declines have, understandably, created a great deal of cynicism about the benefits of seeking higher investment returns in any asset that carries more apparent risk than a 90-day CD. For some investors, in fact, the “mattress” has become the investment vehicle of choice while stocks seem to represent a mere game of chance. And so, as we first discussed three months ago—and despite a remarkable recovery over the past nine months—weekly outflows from domestic equity mutual funds continue, and many institutional investors remain wary of the U.S. equity market while embracing less volatile alternatives. Near-zero-yield money market fund assets are down from their peak in March, but the absolute and relative figures are still well-above historical averages. In brief, investors look back at the past decade and remain pretty scared.

Behavioral economists (who add a dose of psychology to better understand how economic decisions are made) would likely describe this phenomenon as “loss aversion”, a desire by individuals to avoid losses rather than seek good opportunities for gains. Loss aversion is simply a more extreme version of “risk aversion” (a desire for certainty over variability), and both conditions can help explain how actual economic decisions can depart from those predicted by more rational arguments. Examples of such behavior are all around us, for example the retiree who chooses a costly fixed annuity rather than take the risk of a variable (but potentially more rewarding) outcome. On a case-by-case basis, risk aversion is not irrational: as we often remark, clients "need to sleep at night", and a portfolio should reflect an individual's ability to accept various risks. But today it seems to us that we are seeing something more than simple risk aversion among investors: with the pain of the past decade fresh in their minds (an example of "anchoring", another behavioral observation), we are witnessing a broad-based phenomenon where even those who should be more willing to take on risk are reluctant to do so. The pile of cash in money market accounts, the rock-bottom yield on U.S. government bonds, and the outflows from domestic equity mutual funds all represent an extensive desire by investors to avoid any future painful losses. This strategy may allow for sweet dreams today, but it likely means missed opportunities and sleeplessness further down the road.

We all now know that historical trends don’t guarantee much of anything, but it’s worth acknowledging the robust long-term advantage of stocks over bonds. Our research group looked back at the results for the S&P 500 index versus those for 10-year Treasury bonds since 1928. Specifically, we looked at the 82 one-year periods, the 78 rolling five-year periods, and the 73 rolling ten-year periods. As you might have guessed, stocks outperformed bonds in:

61% of the one-year periods;
78% of the five-year periods;
84% of the ten-year periods

That is a pretty strong argument for stocks over the long haul, even more so when one considers the very low nominal yield (and strong recent performance) of bonds today. The data, plus all the arguments we’ve made in recent commentaries, continue to point to attractive opportunities in stocks versus bonds. Yet 2009 showed that most investors have adopted the “Won’t get fooled again” strategy articulated by rock and roll’s The Who. And so they have compiled a long list of reasons to avoid the U.S. equity market (and the possibility of any further losses). In our opinion, they are wrong, yet the excuses keep coming:

What about the risk of a double-dip recession?
The economic risks of a false recovery are real and cannot be dismissed. But it would be foolish to ignore the reported facts from recent months: a financial system meltdown was averted, credit spreads have returned to pre-crisis levels, inventory rebuilding has replaced liquidation, fiscal and monetary stimulus remain unprecedented (with more to come), employment trends seem to be improving (slowly), and even bargain-hunting has emerged in the most depressed housing markets. And perhaps most noteworthy of all: developing economies continue to grow, and U.S. exports to such emerging economies now exceed our exports to mature, developed nations. For sure, this has been the most painful—and scary—economic downturn since the 1930s, and so far the recovery feels sub par. But the system is in much better shape than it was a year ago, confidence is rising and we are confident that recovery—whenever it is confirmed—will support the long-run intrinsic values we see across most businesses.

The recent market rally is simply a bounce; it’s been led by low-quality stocks and is not real.
We disagree with those who see the market recovery since March as merely a "dead-cat bounce". As we have said for more than the past year, our portfolios have focused most prominently on robust, larger businesses with strong balance sheets and the ability to weather a prolonged economic downturn (which is another reason we worry less about a double-dip recession). While it's true that some of the greatest percentage gains in recent months have come from phoenix-like stocks that at one point seemed on the brink of extinction, it's worth noting these stocks dropped the most when the crisis hit in late 2008. In fact, since the market peaked in October 2007, both large stocks (S&P 500) and small (Russell 2000) are down by about the same amount (-25%). In any case, we are uninterested in pure speculation in lower-quality issues today simply because we can still find so many stronger businesses at wide discounts to value. Even after the recent market rally, the median stock on our Approved List trades at a large discount to intrinsic value and for about 12.5x our estimate of "trend" or normalized earnings, a level which can certainly produce acceptable—and above-average—gains.

What about gold? The weak dollar? Don’t they signal looming inflation?
We read the same stories everyone else does, and yet we still cannot get too wound up about gold prices, the level of the dollar or the threat of rising inflation. First, with high unemployment, low reported capacity utilization and plenty of competition across the globe, we aren't too concerned about any near-term inflation crisis. Second, the "signals" from gold and currencies have historically been fairly random and suspicious anyway: we're not sure anyone can easily explain why gold is much higher today than during the height of the crisis a year ago, or why the dollar has rallied recently even as the threat of rising deficit spending seems to have increased. We admittedly share the concerns of many regarding the implications of sharply higher government spending, but we also recognize that circumstances can change dramatically, rendering tactical investment moves speculative at best. Over the past few months we've fielded a lot of questions on this topic, which only reinforces our view that the weak dollar/rising gold price is a firmly entrenched consensus idea that is likely to be wrong. Given the wide swings in these related markets, it's very possible that speculators are driving prices regardless of fundamentals. At Harris Associates, rather than speculate on the random judgments spun by the prognosticators of commodity markets, we have always taken comfort in owning equity interests in real businesses that are managed by hard-working individuals we trust who are aligned with us in seeking growth, innovation, profit, cash flow and rising stock prices. In fact, even if inflation rises unexpectedly, we like our positioning in owning the equity of more dominant businesses—with greater ability to control pricing, profit margins and dividends—than owning low-yielding fixed obligations that would undoubtedly suffer real purchasing power loss.

In summary, we think many investors are outsmarting themselves once again. They are firmly focused on only the most recent data series for stocks, and they are thus positioned to avoid losing money rather than properly focused on the opportunity at hand. The economic and market crisis exacted a heavy toll on many, but those who understood the tendency of markets to overreact (and the associated valuation opportunity at the low) have seen meaningful, real recovery. Yes, fifteen months ago prices crashed and the economy suffered. But the real assets by and large survived—the businesses, the structures, the workers—offering the chance for real recovery and future wealth creation. Yes, stocks have rallied a great deal since the lows nine months ago, but in our opinion, those low prices reflected panic as much as crisis. Future gains are unlikely to annualize at the rate we've seen over the past few quarters, but we think the investment opportunity in equities still dwarfs that of bond funds, money market accounts and mattresses. As we have said in recent commentaries, despite wide economic and psychological swings (and despite mounting political challenges), we see only small changes to our own intrinsic value estimates. While fear may be in retreat as the worst of the crisis has now passed, we are convinced future investment opportunities are being dismissed too quickly by rearview mirror, loss-averse investors who are at risk of being fooled again.