Review & Outlook

Our take on the investing, financial, & economic themes of the day

Second Quarter

7 July, 2008 by admin in Quarterly Letters

Over the past few months I started jotting down my thoughts on the latest economic and investment developments. If you would like a more timely take than this quarterly letter can provide, please check out these comments, which appear on our website at Or call me up; I would love to hear from you.

I don’t like to burden clients with idle market chit-chat; there’s too much of that already. But recently I thought I should calm market jitters by calling a few new clients. The results were mixed. Thus one recent phone call elicited this response: “Why are you calling? Do I have to go back to work?”

I explained that everything was fine and apologized for any alarm my call might have caused. But this response is, I think, typical of how a lot of people feel right now. That is to say, people are scared about the economy. Should they be? The answer, I think, is that people should be concerned, but I really don’t see that they should be frightened – – although I understand why they might be.

Any casual reader of the financial press is familiar with the medium’s fondness for statistics that startle and amaze and especially those that frighten. Thus I recently saw June characterized in The Wall Street Journal as “the worst month for the stock market since 1930.” Such a characterization evokes the Great Depression and all the suffering of that time, but how accurate is it?

Ours is a big country and one can find a statistic to suggest anything. Business is absolutely booming in the farming regions of the country. The manufacturing and energy sectors are also doing well. Commodity prices have been in a 6 year up-trend. The export sector is especially strong. Retail sales and consumer spending are holding up despite low consumer confidence. Unemployment is relatively low and holding steady at 5.5%. Should one ignore these pockets of strength and focus on the financial sector, which is indeed in disarray? Home foreclosure rates are alarmingly high in some locations – – in portions of California, one in 75; but low in other portions of the country – – one in 1,500 in the farm states. Unemployment in Detroit is nearly 7%, but in Houston it is 3.9%. And so on. Internet competition has pushed the newspaper industry into its own Great Depression, and I think this has colored its economic reporting. But also the media has always loved the new and different. One must bear this in mind as one watches the parade of scary economic and investment news stream by. Most of it should be taken with a grain of salt.

It is not certain that we are entering a recession / bear stock market, but assuming we are, one can say that we have been here before, quite frequently in fact: about once every five years or so. Since World War II, there have been twelve bear markets. Stocks went down about 25% in the bear markets. That’s an average. In some bear markets stocks went down less, in others more. In recent times, the record was the 2000-2002 bear market, when stocks went down 55%.

As I write, the stock market has declined almost 20% from its October 2007 high. So we almost meet the technical definition of a bear market, which is down 20%. The reason I think we will not revisit the 55% record of the 2000 – 2002 period is that in October 2007, when this bear started, stocks were already half as expensive as they were in 2000. One could say that we are still in the great 2000-2 bear market. As the saying goes, you cannot hurt yourself falling out of a basement window.

No, the present danger is with the assets that investors like best. I am thinking of energy and commodities, which are now regarded with the same confidence and conviction that not long ago was reserved for residential real estate and before that for Internet and high tech stocks. Thus in the coming quarter we recommend patience with the poorly performing blue chips (stocks like GE and Procter & Gamble, Johnson & Johnson, 3M and Coca Cola), which are attractively priced on a historical basis at 17 times earnings. Also, we like better quality corporate and municipal bonds, which pay inflation-adjusted real returns that preserve the purchasing power of invested money. We would hold off buying short-term U.S. Treasury bonds, which pay a negative real or inflation-adjusted return. Certainly we would hold back from adding to energy and commodities. Six years ago oil was $20 a barrel and today it is $143. For the last 140 years the price of oil has been highly cyclical; that hasn’t changed.

Up to this point I have discussed how this market might resemble earlier markets. Let me close the letter by reflecting on how this market might be different in important ways. I am thinking of the recent proliferation of asset bubbles. One thinks immediately of the Internet and high tech bubbles in the late 1990s, then the housing bubble, which has been famously popping the last year or so. Now on its heels are bubbles forming in oil and commodities. What’s going on? Central bankers are pumping liquidity into the system to stave off recession. In the days before globalization and free trade and computer-generated productivity gains, excessive liquidity contributed to hyper-inflation, such as the 15% annual inflation in the early 1970s. Today loose money policies appear to be contributing to the formation of another kind of problem: serial asset bubbles. While perhaps an improvement over old style hyper-inflation, bubbles are extremely dangerous to portfolios. In normal times, buy-and-hold is an excellent strategy. But in a market inclined to bubbles, such as this market, one must be quick to identify risk and find ways to reduce it.


Mark O’Brien