Widespread equity pullbacks often represent excellent opportunities to add to secular investments

At the time of this posting, October 9th, 2013, the Dow is priced at 14,802.98 and the S&P 500 is priced at 1656.40. From the 52 week highs achieved by the Dow (15,676.94) and the S&P 500 (1725.52) on September 28th 2013, this represents a pullback 5.9% and 4.2% respectively.

Fundamental investors typically look to add to existing positions in bull market selloffs. The only two reasons not to buy are either of a timing nature: “perhaps the markets will fall further and create a better short term entry point?”, or alternatively are of a cyclical nature, “does this pullback signal the end of a 55 month bull market that started March 3rd 2009?”

Let us explore both possibilities without getting bogged down in the minutiae.

“Will the markets fall further and create a better entry point?” The broadly based American index pullback is presently tied to uncertainty in the United States on a budgetary front. An impasse over the debt ceiling, posturing over the Patient Protection and Affordable Care Act (ACA), nicknamed “Obamacare”, and a growing sense that the US Federal Reserve’s asset-buying program will end soon; all of this has produced an increased degree of uncertainty. Markets abhor uncertainty.

To be sure, the current risk of a US government default is minimal. A more likely scenario; American democrats and republicans will reach a temporary funding accommodation. This will lead to further confrontation some months out. As to the ACA, there are certainly issues that give pause for reflection on both sides of the house. However, legislative and implementation problems tend to get hammered out behind closed doors, via series of amendments, over time. In wide ranging legislation, every contingency cannot be predetermined. The nature of an unforeseen problem is that it is, unforeseen. I don’t doubt that the ACA is here to stay. I also don’t doubt that the act will be modified slightly in the years to come. Finally, the inevitable end to Federal Reserve quantitative easing program is keenly important to bond holders but may be less important to equity holders; tapering is a logical outcome when domestic economic growth is determined to be self-sustaining. All of this is simply business as usual.

The question that overrides the short term machinations of the market is this; “Does this pullback signal the end of a 55 month bull market that started March 3rd, 2009?”

According to data published by the World Bank, 2013 global GDP, on a purchasing power parity basis, is forecast to touch $88 trillion US. For 2007, which coincided with the previous top in equity valuations, global GDP touched $66.0 trillion. On an absolute basis, the global economy may have grown by more than 33% since the prior equity peak.

Compare this GDP data to equity valuations. The S&P 500 peaked at 1561.70 in October 2007. At the current level of 1656.44, the index is up about 6% from previous equity top.

A comparison of global economic growth to equity valuations suggests that a mispricing may still exist. Stock prices in general have improved rather strongly since 2009, without a doubt. That improvement must be appraised against the absolute increase in the size of the global economy since the prior peak.

In politics, appropriate policy solutions are seldom elegant and clean; messy and protracted outcomes are status quo. The view of this author is that all of the political issues currently on the fore are little more than business as usual. The investment world is equally polarized. With so many competing opinions and agendas, there can often be a tendency to overthink a problem, to overstate a problem or even to create a problem when none truly exist. Maybe this pullback is much ado about nothing.

And to answer the more important strategic question, this author feels that we are some ways off from a market top. Tops are generally spectacular and are feted by all and sundry. Nurses abandon their jobs to become day traders, Joe the Plumbers are minting coin with hot IPOs. People get angry, not based at how much they are losing, but at how much opportunity cost they are missing. THAT is a market peak. This bull market, in contrast, seems to be a particularly sullen and grouchy sort. It is encouraging.

As all know, this author is neither a market timer nor a cyclical investor. The model portfolio is overwhelmingly comprised of monopolistic equities designed to fully capture the profit potential of notable secular trends. Secular trends often persist for periods of a quarter century or more; the correct allocation of capital in that trend can produce returns, over time, which greatly surpass indexes. In the author’s portfolio, dividends are accumulated and invested periodically; occasional takeovers or going-private transaction free up substantial cash for new equity purchases. The recent capital received from dividends and the proceeds from the tender of Provida SA (PVD-NYSE) are, today, being reinvested in the model portfolio.

 

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