From the June 2010 Letter to Tarpon Folio investors by portfolio manager Cale Smith. The rest of this series can be found here.

And the Market?

The stock market is down more than 15% from its peak earlier in the year. This sell-off began, you’ll recall, when those men in Greece reminded us that debt is bad. That brought back bad memories of the 08-09 stock market drop(s). Some stocks are very cheap again now, although risk is high, too. The probability of continued wild market moves is much higher than normal. But barring any other large shocks to the system, an improving economy and increasing credit will begin to show up as higher company earnings. That will cause the stock market to rise – all things being equal.

If I am wrong, then, again, we should have limited downside, both due to the mild nature of a second recession, and the margin of safety that exists in the securities we own. The price to fair value ratio of Tarpon is notably higher now than it was a year ago.

This next part may sound hopelessly optimistic, but it’s essential to understanding what I’m doing in the portfolio lately:

If the country manages to plod through these current economic headwinds, and I believe it will, then the next few weeks and months will be a terrific long-term buying opportunity. (By long-term, I mean years, not months.)

We can make quite a bit of money without impressive economic growth, and even in the face of stubbornly high unemployment. For one, we’re getting great prices on some wonderful businesses. Soon, macroeconomic factors could be a wind in our sails, too. Here’s what I mean:

The U.S. economy has over the long-term grown at about a 3% annual rate. This is due to 1% growth in employment and 2% growth in productivity. So even if employment growth struggles, the economy can still grow at an annual 2% rate due to productivity gains – meaning the ability to make more with less.

That 2% real economic growth might not sound like much, but given all the cost cutting done by businesses to survive the Great Recession, even modest gains in revenue will lead to outsized gains in profits. And when it comes to our already undervalued companies, any excessive earnings growth should cause the gap between their market prices and intrinsic values to close that much quicker. All things being equal, of course.

Recent history lends some support to this idea. In 2003, for instance, payrolls were basically flat all year, rising just 87,000 total, or about 7,000 per month. Nonetheless, the S&P 500 rose over 26% in 2003 as the economy recovered from the recession that began in 2001.

That doesn’t mean a similar rise going to happen – only that it is within the realm of possibilities.