Review & Outlook

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

First Quarter

8 April, 2011 by Mark O'Brien in Quarterly Letters

This may be a good time for clients to raise the most fundamental of investment questions: What goal do you have in mind as regards your investment portfolio?  Is the goal to beat the Standard & Poor’s 500-stock index – – the time-honored method of building wealth among institutional and “professional” investors?  Or, is the goal something more basic, like hanging onto the money you already have, through all eventualities, including “Black Swan” surprises (accidents which by definition cannot be avoided), inflation, stagflation, deflation?

What’s special about the moment?  The 5 % climb in stock prices last quarter made it the best quarter in the last 13 years; on top of that stocks rose 11 to 13% in 2010 and over 20% in 2009.  In relatively short order the stock market has recovered the losses of the great 2008 crash, which was the worst in some 80 years.  Are we better able to set goals now than we were then?  For at the bottom of that crash, investors tended to see their goals with startling clarity, judging from their conversations with me at the time, and that was to hang onto the money anyway you can.   But now, after two years and one quarter of big stock gains, and something approaching normal market psychology, that clear statement of purpose seems to be morphing into  “let’s beat the S&P 500.”  Should it?

I don’t think so.  We appear to be in a dangerous period in investing history and the emphasis should still be on preservation of assets, with a twist.  That twist is to consider high quality stocks as a necessary tool of capital preservation, because the old standards are no longer working or are no longer available.  Defined benefit pensions – – the kind of pension that one’s grandfather had – – used to guarantee a fixed and certain annual income.  But they are long gone.   For all but government workers and public school teachers, defined pension plans have been replaced by defined contribution pension plans, which guarantee nothing.  Social Security is iffy as well, insofar as this New Deal era entitlement program is broken; it  must be cut at least in part if the nation’s finances are ever to be put into order, or indeed, if Social Security is even  to continue to exist.  Same for Medicare, the health care program for the elderly.

Other things you can’t count on any more: Income from money market funds and certificates of deposit. These so-called riskless assets not so long ago paid yields in the 6 and 7% range; you could live on that.  But now their yields are nearly non-existent (a money market yield of 0.2% on $1million generates $2,000 a year; try to live on that).  Federal Reserve / Treasury officials are trying to help the banks, but at the expense of savers.  So much for the little guy.   One’s house was the traditional store of individual wealth, but even that is uncertain, to put it mildly.   The government struggles to prop up real estate values, but month after month home prices ratchet lower.  Most lamentable of all, to my way of thinking at least, the government is printing money in a bold gamble that the ensuing inflation will revive a sluggish economy and lessen the weight of federal debt.

In sum there are fewer institutions and practices one can count on, and with the government actually planning inflation, bonds aren’t sufficient either.  People are coming to see this.  Consider that on March 16 the news was very bad, and had been for a period of some weeks. The so-called Sovereign Debt Crisis in Portugal, Ireland, Spain and Greece threatened to pitch all of the European Union into default; widespread upheaval in North Africa opened the possibility of a third armed conflict for American forces (after wars in Afghanistan and Iraq); the price of oil soared 25% in 13 days; a huge earthquake and tidal wave in Japan triggered a nuclear accident in that economy, the world’s third largest, and, oh yes, U.S. housing prices slumped another 3%.  In the face of the terrible news, the stock market held its value.  Then it started to climb, up about 700 points in the second half of March.  As I write in early April, it is still heading up.

What is going on here? I think we may be seeing a massive shift in asset allocation on the part of individual investors.  Ever since the market low in March 2009, individual investors were content to sit on the sidelines in bonds and money market funds.  Even as hedge funds and institutional investors poured money into stocks, and repaired their tattered fortunes, individual investors withdrew money from the stock market to salt away in bonds.  But yields of 1 and 2% eventually got old, and people lost patience.  They passed a tipping point, and money is starting to flow back into stocks.

Are individual investors ill-advised?  I don’t think so.  Stocks are indeed cheap.  Or, to put it differently, they are less risky than so-called riskless assets like government bonds.  The dividends alone of high quality stocks like Johnson & Johnson, Intel and Abbott Labs, to cite just a few blue chip stocks, exceed the yield of the 10-year Treasury note.  And investors aren’t looking for home runs; their expectations are realistic.  People describe this as “stocks climbing the wall of worry,” and it is a prescription for slow but steady appreciation.

But stocks are called risk assets for a reason, and the fact that they are the course of least risk speaks volumes about these times and this economy. In owning stocks one must temper them with the intent to reduce risk at every opportunity.  In owning stocks at this time, one’s plan should be to participate in an upward moving market, but not to lead it.  In this way, when the stock market falls, as from time to time it will, one’s portfolio will fall less.  This attitude helps one stay the course in difficult times.

A final note.  In recent months we have begun writing a weekly comment on our website (  In recent weeks I have written about Gold, Momentum Investing, On the Merits of Doing Nothing.  Colleagues Ben and Sally have written on other topics.  If any of the website comments triggers a response, please don’t hesitate to call or email.  We would profit from hearing your ideas.


Mark O’Brien