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THE BROYHILL LETTER
The old saw reminds us never to confuse genius with a bull market. Anyone can become “expert” at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don’t always compliantly rally. Sometimes minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, “buy the dips” can drift mindlessly into “buy anything”; a rising tide that is lifting all boats often proves irresistible. - Seth Klarman’s 2006 Baupost Annual Letter

Executive Summary
Wikipedia defines Confirmation Bias as a tendency for people to prefer information that confirms their preconceptions or hypotheses, independently of whether they are true. We are all guilty of this behavioral pitfall, but investors ignore it at their peril. Research shows that we are twice as likely to look for information that agrees with us than we are to seek out information that does not. Charles Darwin understood this and looked for disconfirming evidence. While researching his theory of evolution, he kept two notebooks: one that confirmed his hypothesis and another that disproved it. Self awareness is perhaps the most powerful defense against a long list of behavioral biases. Rather than looking for all the evidence that everything is going well, investors would be well served by more closely examining the potential for errors in judgment. By spending more time questioning the consensus and looking at ways things may go wrong, investors are more likely to be positively surprised by the upside, rather than caught skinny dipping when the tide recedes.

Bull Fighting
The Investment Team at Broyhill recently spent several days with an outside consultant reviewing the potential for behavioral biases to enter our investment discipline. While it is impossible to completely eliminate such biases, an effective process should aim for ongoing improvement in awareness and draw upon various methods for minimizing behavioral risks. The best way to counter Confirmation Bias is to spend more time with the people who disagree with us most, so that we fully understand the opposite side of the argument. If we can’t find logical flaws in their reasoning, we have no business holding onto our view so strongly. Other helpful tools include playing a game of Devil’s Advocate or conducting a Pre-Mortem where the thesis is assumed to be wrong, and potential sources of failure are brainstormed. After a 5.9% first quarter return in the S&P 500, led by lower quality cyclical stocks, we’ve spent a considerable amount of time speaking with equity market bulls and reviewing as many positive research reports as we could get our hands on. We even turned BubbleVision (CNBC) back on in our offices to hear what our favorite market cheerleaders had to say! Our efforts to more fully appreciate the bull case for owning equities today confirms our concerns that the potential returns from owning stocks at current prices do not compensate investors for the risks being taken. All of the Wall Street research we came across suggesting that “stocks have further to run” can essentially be summarized by the five points outlined below.

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A Sustainable Economic Recovery?
By far the most common argument we came across was the strength of the economic rebound currently underway. Analysts point to a number of coincident indicators of economic growth - improving employment trends, rebounding retail sales, surging manufacturing indices, and the notorious “inventory building” - as reason for optimism. Importantly, we do not disagree that current economic data points are a substantial improvement upon year-ago levels. Where most fail to connect the dots however is what impact this data has on future stock prices. The sharp rise in Leading Economic Indicators last year foreshadowed stronger economic growth this year. And while we are likely to see continued improvement in economic data near term, the same leading indicators which painted a very bullish backdrop one year ago are now raising the caution flag. Note that equity markets have historically traded lower six months after a peak in leading indicators, as shown in the charts below from Morgan Stanley Research. In short, last year’s monster rally in stock markets was a leading indicator of current economic strength - not the other way around. What concerns us is the recent deterioration in the index, which is likely a precursor to weaker stock market returns and a slowing economy in 2011. Consequently, this would also be consistent with economic history which warns that historic deleveraging episodes have been painful, and on average have lasted six to seven years. Research from McKinsey Global Institute suggests that if today’s economies were to follow this path, deleveraging would only just begin two years after the start of the crisis, and GDP would contract for the first two to three years of deleveraging before growing again. But the global nature of today’s crisis, coupled with large projected increases in government debt, could easily delay the start of the deleveraging process and result in a much longer period of debt reduction.

source: OeCD, isM, iFO, eCri, NBer, Morgan stanley research

source: Morgan stanley research

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New & Improved Corporate Profit Growth
Wall Street’s love affair with corporate profit growth and rising earnings estimates is almost as strong as analysts’ belief in a “sustainable economic recovery.” Without exception, every portfolio manager we spoke with cited the strength in corporate profits as reason for optimism. Once again, we find it difficult to argue that last year’s aggressive reductions in capital spending won’t result in dramatic year-over-year earnings growth. But given how fast expectations have risen, it’s important to understand exactly what analysts are pricing into projected results. The graph below, by Hussman Fund’s Bill Hester, plots long term S&P operating margins in blue. Operating margins currently being forecasted by Wall Street, in red, show that analysts are pricing in a speedy return to the record profit margins seen only at the lofty peak of 2007. Let’s ignore for a moment Wall Street’s miserable track record of actually predicting earnings. Even giving “the street” the benefit of the doubt, investors should tread very carefully when expectations are this high under any circumstances. If the consensus already expects earnings to soar over the next year, then the consensus should already be invested ahead of this news, leaving little room for upside. Research source: Hussman Funds from Ned Davis supports this thesis, indicating that the average gain on the market when earnings expectations have been as high as they are now has been (3.4)% annually. This is quite a turn when compared to the 17.2% average gains in the S&P 500, when expected earnings growth has been below 4.2%. For the record, analyst estimates for forward earnings were less than (20)% at last year’s bear market lows . . . and not a bad time to buy stocks. The sentiment of equity mutual fund managers (shown left) clearly illustrates that the consensus is fully invested today. After our own “lost decade” and two merciless bear markets, portfolio managers are even more fully invested than they were in 2000 and 2007. Retail participation in stocks is much higher than generally perceived. Kenneth Gailbrath, the astute Canadian-American Keynesian, had it right when he surmised, “There can be few fields of human endeavor in which history counts for so little as in the world of finance.”

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Don’t Ask a Barber If You Need a Haircut
The majority of research we came across classifies stocks in one of two buckets: cheap or “fairly” valued. While optimism may be entrenched in the human (and portfolio manager) psyche, assumed prosperity is not synonymous with safety. Coincidently, psychologists have often documented a self-serving bias whereas people are prone to act in a manner that is supportive of their interests. Unfortunately for us, simply by virtue of an expert’s apparent confidence (we’ll resist the urge to mention Cramer), investors are likely to blindly follow poor advice from supposed “authorities.” Since our brain actually turns off our natural defenses when we are told a person is an expert, allow us to separate valuation fact from fiction. First and foremost, valuations based upon forward earnings estimates are heavily dependent upon the level of operating margins implied in those estimates. Even assuming today’s forecasts for a quick return to record profit margins are accurate, valuations based on forward operating earnings are not attractive. And from a risk management standpoint, there is little margin of safety in current estimates, given that even a minor reduction in profit margins would cause the scale of overvaluation to widen materially. Second, we strongly suggest that anytime you hear an alleged “expert” use the phrase “stocks are cheap relative to the alternatives” that you ignore anything that follows this statement (and probably most of what you might have heard leading up to it). Valuation is an absolute concept, not a relative one. Arguing that stocks are attractive because they are cheaper than bonds (or any other asset class) is equivalent to arguing that a $75 case of Budweiser is attractively priced since a single bottle of Bud costs $5. We’d note that both are outrageously expensive, and suggest beer drinkers look for a $.50 bottle of Miller Light.

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Since forward earnings are not reliable and relative valuations have little predictive ability, investors would be well served to use a method which 1) normalizes profits and 2) covers a long enough time period in order to assess the model’s predictive ability. The Cyclically Adjusted PE (CAPE) is one method which accomplishes both by averaging earnings over ten year periods. The validity of this approach has been tested and is robust (projected returns are displayed above). Despite this, the CAPE is habitually ignored as it naturally shows that the market has been cheap about half the time, which shouldn’t be a surprise to anyone (except Wall Street) since an “average” consists of both below average and above average readings! Alas, to limit claims that “stocks are cheap” to only half of the total occurrences would reduce commissions on Wall Street by . . . about half. With the market trading at a CAPE of 22 today, equity investors find themselves back in a familiar position – in “Group Five,” the most expensive quintile of historic valuations where expected ten year returns are lackluster at best, and quite often negative.

Awash in Liquidity
Hands down our favorite justification for optimism, this one is actually a “sell side” catch-all which covers: low inflation, disinflation, cash on the sidelines, expansionary fiscal and/or monetary policy, low interest rates, etc. All are rumored drivers of higher stock prices, except for one minor problem – the phrase “awash with liquidity” was also in vogue in the ‘70s, in ‘87, in ’99 and repeatedly from ’05 through ’07. Investors may wish to respond to this phrase in the same manner as other “expert testimony” discussed above. Put simply, while low inflation may help explain why stocks are currently overpriced, it does not alter the long term consequences associated with that overpricing. High valuations produce low long-term returns, while low valuations generally produce attractive long-term returns. Please take a second look at the chart above if you are still questioning this. It really is that simple. To be sure, we firmly believe that monetary policy exerts a strong influence on leading indicators. One of the earliest signs of stimulus in 2008 was a pickup in money supply growth. That being said, roughly a year has passed without additional rate cuts from the world’s major central banks and money supply growth has been slowing dramatically. The period of broad money growth is over. In fact, several central banks have begun to raise rates in recent months, providing a further drag on money supply growth and a likely headwind for leading indicators. So much for all that liquidity!

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Simple Is As Simple Does
The more mathematically challenged investors we spoke with prefer to hang their hats on the truism that every prior decade of poor stock market performance has been followed by a decade of strong performance. While this may hold true, investors who blindly follow such shallow recommendations may find themselves thoroughly disappointed in ten years. Past performance is not indicative of future results . . . but starting valuations are as good an indication as any. Bad decades have historically been followed by good decades because ten years of poor performance had always resulted in cheap stock markets, in the past. This is emphatically not the case, when the starting point is 44x cyclically adjusted earnings as it was in 2000! As shown below, the past ten years of poor performance has simply brought us from those nose-bleed levels back to valuations consistent with prior bubble peaks.

Bottom Line
Investors have a clear tendency to extrapolate recent trends into the future. Our strategy for the past year has been built largely on the belief that investors would shift from Discounting a Depression to Relying on The Rebound at precisely the wrong time. Sometimes, even we are surprised by how Predictably Irrational consensus behavior really is. Nonetheless, we’ll go out on a limb here and say, “Now is the wrong time.” We’ll refrain from using “precisely” since we would have said the same three months ago. Can markets continue to ignore elevated valuations and forge higher in the short term? Sure. But in buying stocks today, investors are purely speculating that they will be able to sell them to a greater fool at some time in the future. There is simply no investment merit in buying stocks when they are trading at prices as high as today, only speculative merit - not unlike buying a home worth $250 for $500K, expecting to sell it for $1MM in six months. Volatility has recently reached levels last seen in July of 2007. Sentiment Trader reports that “speculation in the options market has spiked to its highest levels since the spring of 2000.” And the last time the put-call ratio was this low was in early 2004. Needless to say, there are some inconsistencies between today’s total disregard for risk and the near unlimited uncertainties that cloud the global economic outlook. While the opportunity cost of earning next to nothing on cash appears painful, the real pain has always been felt by those who extrapolate current trends too far and overpay for low-quality securities. An old saw reminds us never to confuse genius with a bull market.
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