As usual, we read just about every year-end market review and 2012 outlook we could find over the past several weeks, and we thought we’d share some of them with you.  Unfortunately, some of what we reviewed is behind pay walls, but the ones offered below are available and provide a range of insightful commentary.

The Economy’s Not as Bad as You Think by Russell Pearlman (SmartMoney)

Commentary on The Oakmark International and International Small Cap Funds by David Herro

Commentary on the Oakmark and Oakmark Select Funds by Bill Nygren

PIMCO Cyclical Outlook: Deleveraging, Austerity and Europe’s Potential Minsky Moment by Saumil H. Parikh

This week brought some good news regarding Europe and the US economy, leading to a welcome rally in the stock market.  As a result, the S&P 500 is on track for its best week since March 2009.

The mood is certainly brighter now than in the previous few weeks, and we are pleased to see central banks’ action on the European debt situation and encouraging reports related to employment, retail sales, and consumer confidence.  Serious issues remain, of course, and it will take some time for us to see the ultimate resolution of the sovereign debt problems in Europe and any associated fallout.  While we wait, we are finding plenty of bargains in US stocks, which are trading at valuation levels (price/earnings ratios, etc.) last seen in the depths of the financial crisis of 2008-2009.

Wharton professor Jeremy Siegel recently gave an interview in which he makes the case for buying stocks now.  His primary reasons for believing that stocks are “extremely attractive” include strong growth in corporate earnings and very low interest rates, which make bonds less desirable alternatives.

In response to a question about the holding period likely to be required in order to realize good returns, Siegel responds:

[F]rom these valuations and under these interest rates, you are generally going to get good returns in three to five years…Basically, stock prices depend on earnings and interest rates.  That’s the fundamentals.  Right now they are even more favorable toward equities than last year.  Does this mean that in 12 months returns are going to be good?  No.  But does it mean three to five years returns are going to be good?  That’s a much higher probability.

His point is simple: when you are buying stocks at low valuations, you increase the chances of achieving favorable returns.  There is no way to know what is going to happen in the short term, including today amidst uncertainty regarding Europe and the global economy.  The market would likely jump on any good news, particularly relating to Europe; it could drop if the situation deteriorates; or it might bounce up and down for a while as these issues continue.  Buying today and patiently holding while these issues play out, however, is likely to be a winning strategy.

Click here to read the full interview.

In this latest installment of our quarterly report, my colleagues and I review the turbulent third quarter of 2011, offer our outlook for the economy and market, and discuss three of the securities we are currently buying: Novartis AG (NVS), Berkshire Hathaway (BRK.B), and BioMed Realty Trust Series A Preferred Shares (BMRPRA).

Click here to go to the full report on our website.  Following are a few highlights:

- The S&P 500 index fell hard in the third quarter and flirted with official bear market territory.  Foreign markets fared even worse.  The primary catalysts for the drop were sovereign debt concerns in Europe, slowing economic growth worldwide, and political stalemates in the United States.

- The European Central Bank, IMF, US Federal Reserve, and others are all working hard on a solution to the EU’s sovereign debt problems and have made some significant progress recently.  We think that an orderly Greek debt restructuring and stabilization of European banks is the best solution, and the sooner the better.

- US economic indicators were weak in August and September but have been improving recently.  We expect the US economy to continue along the path of slow, steady growth.

- Overall, we think the global economy and markets are in much better shape now than in 2008, and we do not expect a return to the depths of the financial crisis that brought on the “Great Recession.”  However, volatility is likely to remain high, testing the patience of investors.

- We continue to favor shares of high quality, well capitalized, multinational companies that pay dividends and trade at significant discounts to intrinsic value.

- We also prefer stocks over bonds.  The 6% gap between the earnings yield of the S&P 500 (8%) and the yield on the 10-year Treasury note (2%) is one of the widest yield differentials in history, a bullish signal for stocks.

As always, feel free to contact us if you have any questions or comments.  For more information, visit our website.

Jordan Smyth and the Edgemoor Investment Advisors Team

In our last blog post, written just after the downgrade of US government debt, we advised investors to stick with a proven strategy and avoid panic.  Stocks have bounced around since then, staying above the August low but remaining volatile.  More recently, concerns that the European debt situation might derail the global economy have risen, and investors have expressed their concerns by selling stocks and seeking safety in government bonds.  As a result, the yield on the 10-year Treasury is now near a record low (1.7%), the S&P 500 is threatening to fall back to the same level as in early August (1119), and the general mood is dour, despite the Fed’s announcement of yet another effort to buoy the US economy.

There is some good news amidst the bad.  For example, yesterday the Conference Board Leading Economic Index^® rose again, indicating a continuing, though slow, recovery, and the most recent claims for unemployment benefits came in lower than the prior week.  U.S. corporations continue to post strong earnings – 70% of S&P 500 companies beat expectations for the second quarter – and also hold record levels of cash.  However, the stream of negative news, including slowing manufacturing in China, has trumped these positive announcements, and markets have swooned.

Notwithstanding the negative news abroad and also at home, we still believe that investors should avoid making rash moves when their emotions are telling them, “Just do something!”  Our portfolio, in particular, is focused on well-capitalized, highly profitable, multinational firms that should hold up relatively well through these challenging times.  We own them at prices that are significantly below intrinsic value, even assuming the impact of a struggling economy, which gives us a margin of safety and the opportunity for gains when conditions improve.  These holdings are not immune to downward swings, but we think they will provide greater returns over time than cash, bonds, gold, or other holdings perceived to be more conservative.

Following are links to articles that we found particularly interesting over the past several weeks and that relate to the various issues affecting the markets.

Global Economy and Financial System:

Business Cycle Update: Europe Weighs on U.S. Economic Outlook Key points: U.S. economy most likely in a mid-cycle slowdown; consumers are still spending but sentiment is weak; “Most traditional indicators do not signal an imminent U.S. recession.  However, the sluggish pace of growth makes the economy more susceptible than usual to a downturn in sentiment or an external shock from abroad.”

Schwab Market Perspective: What’s Next? Key points: slow growth more likely than recession, European debt troubles threaten global economy but may help emerging markets.

The End of the Line: Eurozone Crisis Hits Tipping Point A detailed review of the European debt situation and the implications for investors.

Financial Turmoil Evokes Comparison the 2008 Crisis Key points: many risks are lower today than in 2008 (U.S. financial institutions hold much more capital now and have reduced leverage, for example), but there are still serious problems in the global economic and financial system.

Markets and Investment Strategy:

Don’t Let Fear Disrupt Your Investing Key points: don’t make hasty decisions driven by emotion that you may later regret; stick with a well-crafted strategy during turbulent times.

Jeremy Siegel: Stocks are a Strong Buy even if Economic Growth Grinds to Zero Key point: “Bottom line: stock prices and interest rates are now so low that we do not need economic growth to justify the purchase of equities.”

“Scared to Death”: Should I Move Into Cash? Key point: “[I]f you invest on the basis of hunches and speculation rather than setting a coherent long-term strategy and sticking to it, you’ll put yourself at risk of selling after prices have already fallen and buying back in when prices are already inflated.”

Will Danoff: A View from the Trenches Key points: earnings growth is slowing, margins are peaking, underlying fundamentals of corporate America remain strong, and large multinational companies are most attractive today.