Review & Outlook

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

Third Quarter

10 October, 2011 by Mark O'Brien in Quarterly Letters

We just endured the worst quarter in the stock market in three years.  But not all asset classes were down. To use the standard Wall Street expression, some made money.  Which were they? More to the point, since they worked last quarter, can we recommend buying them in the quarter just beginning?

In terms of which made money, only two major assets did: gold and the 30-year Treasury bond (A.K.A. the Long Bond).  Gold rose from $1,487 to $1,624, a 9% increase.  The yield of the Long Bond fell to 2.92% from 4.40% (bond yields and prices move in opposite directions, thus falling bond yields must mean rising bond prices).  Other major asset classes – – domestic and foreign common equity, commercial and residential real estate, oil and gas – – lost ground last quarter.

That gold and the Long Bond did well, and did well at the same time, provides useful commentary about the current state of the markets. People buy gold as an insurance policy against hyper inflation; and people buy the Long Bond as an insurance policy against deflation.  Insofar as inflation and deflation are opposite and mutually exclusive outcomes, gold and bond prices should logically move in opposite directions.  That they both moved up in price means the market is preoccupied with catastrophic events.  In other words, investors are lurching from one doomsday scenario to its polar opposite.  There is no coherent economic vision, only fear.

To be sure, buying gold and the Long bond offers the consolation of having lots of company; gold is the reflexive response to fear of inflation and the Long Bond is the reflexive response to fear of deflation, and investors are crowding into these trades.  But there are problems with them.  The biggest of which is that, in the case of gold, the precious metal pays no income at all; and, in the case of the Long bond, only a relatively small income of 2.85% a year for 30 years.  Thus you had better be right about your apocalyptic vision, or it’s a long wait.

There are better ways to insure against deflation and inflation. Let me suggest just a few.  Last week Microsoft increased its dividend 25%. The stock now yields 3.5%. The company has an 8-year history of dividend increases and it has $53 billion in cash and short term investments.   Johnson & Johnson is another way to deal with both inflation and deflation fears.  It pays a 3.5% dividend, and a history of increasing it, and thanks to a new acquisition (Synthes – – hip knee, spine and trauma equipment) and the reintroduction of Tylenol, business is growing.  McDonalds is another stock that provides inflation and deflation protection, and pays you while you wait. In terms of deflation, it just increased its dividend 15% so that presently it yields 3.5% a year.  In terms of inflation, it’s easy to raise the price of a hamburger. In the commercial real estate sector, professional managed REITs offer yields in the 4 to 6% range with the potential of appreciation and inflation protection.  In the natural resource sector, Plumb Creek Timber yields over 4%.  Master limited partnerships, like Tortoise Energy Infrastructure, yield even more.

I could go on in this vein with General Mills (dividend of 3.5%), Wal-Mart (dividend of 3%), Chevron (dividend of 3.5%) – – all these yield more than a 10-year Treasury bond and all have the potential to raise their dividends, and along with their stock prices.  As to the safety or creditworthiness of these stocks, I can report a remarkable piece of news.  Credit default swaps, which are a kind of insurance policy against default, for the debt of blue chip companies cost less than the credit default swaps on U.S. government bonds.  Many blue chip corporations (though not all) have become “the new sovereigns.”

It is a matter of fact and not opinion that stocks are inexpensive.  They trade at 13 times earnings, compared to their historical average of 16 times earnings.  Their average dividend exceeds the yield of a 10-year Treasury note.  But there are a couple of problems that make people hesitate. The market is roiled by extreme volatility.  It is difficult to commit new money if stocks can suddenly dip 3 to 5% from one day to the next.  Another problem is that we appear to be entering a bear market, which is defined as a drop of 20% from recent highs.  Moreover we may even be entering a so-called double-dip recession, when corporate earnings may well lose their current momentum.  In all likelihood, bad news will continue, and get even worse as the European Union goes through death throes.  Are all bets off in such a setting? I don’t think so.

There is an expression in the investment business that may rise to the level of a joke; I don’t know.  But the expression/joke runs this way: “What are the most dangerous words in investing?” Answer: “It is different this time.”  Usually we think of the expression after some bullish mania, like New Economy Internet stocks in the 1990s.  How, we ask, could people have been so gullible?  But the other half of the joke, the half that concerns us here, describes investors in times of fear and uncertainty, like the present, when people are prepared to believe that bear markets and recessions are a permanent condition.  They aren’t.

The median length of the average bull market leading up to a correction is 50 weeks.  The length of time leading up to the current sell off was 112 weeks. So we are overdue for a sell-off.  How long could it last?  Between 6 months and a year.  How far could stocks fall before recovering? Around 30% from the high, so another 10% from here, is my guess.   Bear markets and recessions are part of the system, and always have been.


Mark O’Brien