Bill Nygren Market Commentary | 4Q11

Theme and Background

This chapter discusses the peculiar phenomenon of high volatility but lack of direction in the 2011 market, as well as the strategies for long-term value investors in such an environment. The author notes that although the S&P 500's volatility exceeded 30% (more than triple the level five years earlier), the market closed the year nearly flat, with individual stocks moving in high correlation, limiting arbitrage opportunities from stock swaps.

Core Thesis

The author's core investment argument is: Stocks are significantly undervalued relative to bonds, presenting a generational asset allocation opportunity, but many investors, misled by bonds outperforming stocks over the past decade, have mistakenly reduced stock holdings and increased bond holdings. Counterintuitive judgments include: although stocks were also deemed cheap a year ago, corporate earnings are now higher, share counts are lower, dividends are higher, and cash reserves are larger, making the average stock more valuable than a year ago; meanwhile, bond yields are even lower, making them even more overvalued.

Key Arguments and Data

1. 2011 Volatility Characteristics:

• The S&P 500's full-year high-low range was only 24%, below the 20-year average of 31%
• In the second half of 2011, the number of days when 90% of S&P 500 components moved in the same direction exceeded the total for the five-year period from 2002 to 2006
• Despite high volatility, the lack of direction limited arbitrage opportunities

2. Stock vs. Bond Valuation Comparison:

Metric	One Year Ago	Current
Corporate Earnings	Lower	Higher
Shares Outstanding	More	Fewer (EPS growth exceeds earnings growth)
Dividends	Lower	Higher
Cash Reserves	Smaller	Larger
10-Year Treasury Yield	Lower (already deemed insufficient)	Even Lower (<2%)
Stock Prices	Same Level	Same Level

3. Mathematical Limitations of Bond Returns:

• Over the past decade, the 10-year zero-coupon Treasury returned 74%, but with current yields below 2%, even if rates fall to zero, the total return over the bond's life cannot exceed 20%
• The author believes extrapolating past bond returns into the next decade is a major mistake

4. Logic for Future Stock Returns:

• Stocks performed poorly over the past decade, but corporate earnings grew well, offset by a decline in P/E ratios from well above the historical average to slightly below it
• Over the next decade, earnings growth is expected to continue, and P/E ratios are more likely to revert to the historical mean than to continue declining

Companies/Assets Involved

• S&P 500 Index: Represents U.S. blue-chip stocks, used to illustrate overall market volatility and valuation characteristics
• 10-Year U.S. Treasury Bond: Represents bond assets, with current yields below 2%; the author considers it overvalued with limited future returns
• Zero-Coupon Treasury Bonds: Used to illustrate the non-replicability of high bond returns over the past decade

Investment Implications

• Individual investors should ignore daily fluctuations, avoiding anxiety from frequent portfolio checks that could lead to irrational actions
• Now is the time to sell bonds and buy stocks to restore target asset allocation. The author believes that, from current price levels, stocks will offer far higher long-term returns than bonds
• Do not linearly extrapolate the past decade's strong bond performance; current bond yields are too low to replicate historical returns, while stock valuations are more attractive