The S&P 500 index turned in the worst quarterly performance in over two years, losing 13.9% in the third quarter.¹ Materials and Financials were the worst performing sectors this quarter, losing 25% and 23% respectively.  Stocks in those two sectors have now declined about 25% from the beginning of 2011 and account for the largest losses in the overall index so far this year.  The defensive sectors in general and high-quality stocks specifically have held up relatively well as macroeconomic fears have come to dominate the investment landscape again this year.

The culmination of events that began with the debt ceiling debate in Congress and ended with the U.S. downgrade from Standard and Poor’s lead to a 17% drop in the S&P 500 index in the span of two weeks from the end of July into early August.  The speed of this decline has roiled capital markets across the globe and shoved a tepid economic recovery onto even less solid ground.  The United States is in a better position than Europe to withstand this setback and will most likely do so without the requisite two quarters of negative GDP growth that officially marks a recession, but it will probably feel like a recession to most of us.  In Europe, the political leaders of the various EU member nations are repeatedly making their problems worse because they lack an understanding of how the system they designed was fundamentally flawed from inception.  Greece, Portugal, Italy and Spain are all symptoms of an underlying problem and are not themselves the root cause, per se.  The seeds of today’s financial problems in the EU were planted more than 10 years ago when the common currency of the Euro was created without an accompanying political union capable of supranational debt issuance, taxation and spending authority.  The analogy would be the United States with all 50 states using the dollar and only the Federal Reserve to regulate the economy at the national level.  This would be politically untenable, as Europe now knows.

Some public companies are more suited than others to deliver an acceptable return in an environment of ongoing macroeconomic turbulence and low GDP growth with valuations that are not terribly cheap.  The caveat is that the holding period becomes the critical factor even for companies that can thrive in these adverse conditions.  High-quality companies share a set of characteristics that reflect an ability to grow and return profits to shareholders over a wide variety of economic conditions, but the reward for identifying and owning these stocks is only realized over a multi year time horizon.

Try as they might, stock prices for even the best, most profitable companies in the world cannot withstand the crosscurrents currently blowing all over the globe.  There are too many variables working against them to deliver consistent above-average returns in the short run, despite a consistent increase in dividends and profits that should attract buyers at these prices.  Trying to time the ups and downs of a stock market that changes direction with the speed and intensity that we have witnessed over the last few years is a near impossible game that will likely lead to below-average performance in the long run with a great deal of frustration along the way.  The alternative is to look past the daily, weekly and quarterly returns to a time horizon more likely to reward the patient and diligent investor with a return that is compensatory for bearing the short-term volatility.  High-quality stocks outperformed the S&P 500 index by 8% on an average annual basis over the last 7 years with the U.S. economy growing slower than at any comparable period in our post WWII history.^2,3 This was accomplished with a 12% average annual increase in earnings and cash dividends returned to shareholders and includes a 20% price decline in 2008.  Not a bad deal for those with the ability to see the forest for the trees.

Sources:  1 – Standard & Poor’s: standardandpoors.com, 2 – Value Line Investment Research: valueline.com, 3 – U.S. Bureau of Economic Analysis: bea.gov

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