The following is an excerpt of Kirr Marbach’s third-quarter client letter, which can be found at www.kirrmar.com.
What a difference a year makes. Last October, we wrote of the U.S. stock market’s dismal third-quarter performance. We thought in the midst of the panic selling, the seeds of the next market recovery were being sown. Expectations were low and there was a lot of future bad news reflected in stock prices.
Fast forwarding 12 months, we are glad we stayed the course. For the one-year period ending Sept. 30, 2012, the S&P 500 had a total return of 30.2 percent.
As contrarians, we are cheered that most investors seem to be dismissing the market’s strength as either unwarranted by the fundamentals or unsustainable. According to the Investment Company Institute, mutual fund investors “celebrated” stocks’ strong performance by redeeming a net $109.8 billion from domestic equity funds through Sept. 26.
We think the overall U.S. stock market is still attractively valued, particularly given the historically low level of interest rates. With its strong recovery from the March 2009 bottom, the S&P 500 closed the third quarter of 2012 within 8 percent of the high reached in early October 2007. However, corporate profits are about 30 percent higher than they were at the business cycle peak in 2007.
The European Central Bank pledged to do “whatever it takes” to save the euro and launched a program allowing it to buy an unlimited amount of sovereign debt of countries that have accepted a bailout and are in compliance with its terms.
The Federal Reserve announced a third round of quantitative easing (QE3), planning to buy large quantities of mortgage bonds. Unlike past actions, the Fed specifically tied the duration of the program to its economic objective of generating more jobs.
We are encouraged the housing sector is showing renewed vigor, even before QE3 kicks in. The S&P/Case-Shiller Index gained 5.9 percent year-to-date through July 2012—the largest increase since the same period in 2005 (and a huge improvement over the 10.1-percent loss for the same period in 2008). As of June, 12 percent of mortgages that were underwater at the beginning of the year were no longer so. An additional 5-percent price increase will lift another 12 percent of them to the surface.
Rising home prices combined with QE3 could lead to a virtuous circle. Higher home values enable previously underwater borrowers to refinance and take advantage of historically low rates, putting more money in their pockets. Similarly, rising prices make homeowners feel wealthier.
Howard Marks of Oaktree Capital says, “The best response when seas are choppy is to focus on completing the long-term voyage and not think about whether the next wave is going to push the nose of the boat up or down.
“Our investment destination is best reached by accurately valuing assets, assessing the relationship between price and that value, and acting resolutely and unemotionally when mispricings are detected.
“That’s still the best—I think the only—reliable path to investment success. Nothing about the current environment alters that one bit.”
We couldn’t agree more.•
Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or [email protected]