Review & Outlook

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

Third Quarter

8 October, 2009 by Mark O'Brien in Quarterly Letters

The quarter just ended was the best for stocks since 1998. The Wall Street Journal managed to put it even more dramatically, calling the period ending September 30, 2009 “the best third quarter since 1939.”

However the Journal might sensationalize the quarter, we are hardly back to the “excessive optimism,” let alone the “irrational exuberance” of earlier times. The tyranny of arithmetic requires something that has fallen 50% to rise 100% before it is back even. Thus the price action of the quarter just completed, and the quarter before that, have lifted the stock market very nicely, but it still has a long way to go to reach the October 2007 level of 14,000 on the Dow, the point at which the mortgage and banking sectors began their painful collapse, dragging down the rest of the economy along behind.

To be sure our clients are relieved to see prices of financial assets recover from their March 09 depths, but more fundamentally they remain deeply fearful that this so-called return to normality is temporary, that it is built on sentiment, that federal authorities have worked hard to make things look better without, as one client put it to me, really making them that way. Several clients have called concerned, not knowing what to make of all the money the federal government is spending, and printing, and borrowing, and whether these policies will drive away essential foreign investors, like the Chinese, and contribute to 1930s-style deflation or, conversely, 1970s-style inflation. It is not clear that fiscal and monetary authorities are doing any good; many responsible observers think they are prolonging the crisis, even making it worse. Certainly many of their bold policies have unknown consequences. Then there is the geo-political situation with Iran, Iraq and Korea, which I needn’t go into here. There is a lot to be gloomy about.

So yes, the stock market may have rebounded, but investors, especially the most cautious of investors, are still suffering. Money market funds pay an interest rate of 0.1% (no, that’s not a typo). Entire incomes have been wiped out. Monetary authorities at the Federal Reserve and Treasury Department are engineering interest rates to subsidize the bailouts of plans for banks, auto companies and other distressed sectors. Savers did not create the nation’s debt problems, but they are the ones being punished. Could this savers’ deflation get worse? It could, and we think one has to be prepared for it, though we think it more likely that the next major problem will be hyper-inflation, which erodes the spending power of savings.

In the two-step dynamic of putting money into circulation and then getting it back out, the easy part is putting it into circulation. It is always easy spending money, which our government is doing with real gusto. The hard part of course is getting it back, back out of circulation, after things calm down, without throwing the whole system into recession, or worse. This latter step democratic governments have no taste for, including our current government. While the two ills of deflation and inflation are mutually exclusive, that is to say, they cannot both happen at the same time, we think it prudent to plan as though they could both happen at once. In any event that’s what we are planning for, both inflation and deflation. To commit just to inflation (a portfolio full of stocks and commodities) or just to deflation (a portfolio full of long government bonds) is too big a bet to make. No doubt there are money managers who will bet one way or another and win big; in years to come we will read how smart they were. But in our portfolios we are trying to take what we think is the prudent middle course.

Certainly diversification is more important than ever. General Electric’s February 28, 2009 dividend cut (a whopping 66% cut) haunts us still. It was a punishing reminder why one wants plenty of diversification even among the bluest of the blue chips. GE falls under the heading “too big to fail.” We ourselves thought that if GE cut its dividend, which management said it would not do, then nothing is safe. Alas, as events played out, we have been forced to face the “nothing is safe” conclusion. Diversification is even more important with bonds. Consider the effective bankruptcies of CIT, AIG, Lehman, Fannie Mae, Freddie Mac, Merrill Lynch, to name just a few of the disasters in the last twelve months. In bond land, a triple-A credit rating is, manifestly, not enough; neither is an insured bond a certain thing (insured by whom?). There is no such thing as a riskless course of action, but plenty of diversification can offset much of the risk posed from any one holding.

Is gold part of our diversification scheme? Generally not. Portfolios are starved for income, and gold does not pay interest or dividends, which is true of commodities in general. Instead of pure raw commodities, we prefer companies that deal in commodities, like BHP, that also pay dividends, that do business with China, India and other fast-growth economies. Among American stocks we like big, multi-national corporations such as Exxon, 3M, Procter & Gamble, Johnson & Johnson, and IBM; they have ready access to capital or can operate without having to tap the capital markets.

What about annuities? Aren’t they are a sure thing? We don’t like them. These insurance-based products are low-yielding, inflexible, complex and illiquid, and carry high fees. They are just not a good product. No, we would rely on traditional income-paying (stress the income part) stocks and bonds. We understand from a reliable source that Yale, having gone the private equity route to disastrous consequences, is now re-evaluating a return to traditional portfolio strategies.

Lastly, let me say that investors can help their own cause in these unsettled times by coordinating purchases with markets. Rather than taking a fixed dollar remittance every month, or quarter, and then funding big purchases out of these fixed remittances, companies or individuals might make purchases after the market has had a big run up, such as right now. Alternatively, after the market has been poor, as it was last March, they might consider postponing big purchases. This timing of remittances and purchases can make a surprisingly big difference over time. It is something I would invite clients to discuss with me or my associate Sally Sulcove. But on this or any other matter, never hesitate to call.


Mark O’Brien