Review & Outlook

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

Fourth Quarter

24 January, 2012 by Mark O'Brien in Quarterly Letters

Despite a strong fourth-quarter finish, stock had a sub-par year. At this point in the cycle, stocks should be soaring. After a major recession like that of 2007-2008, there’s usually a big economic rebound that pulls markets along behind it. The big rebound hasn’t occurred, and apart from a handful of big dividend-paying blue chips like IBM, Coca-Cola and McDonalds, the stock market ended the year almost exactly where it began.

The other part of the performance equation is bonds.  Here the big surprise in 2011 was the U.S. Treasury market, where a meager yield of 2% and a much-publicized downgrade by rating agency Standard & Poor’s did not, to our amazement, diminish investor demand.   That investors would buy a taxable 10-year Treasury bond at a fixed rate in the 2% range, especially when reported inflation is 3.5%, shows how scared people are.  On a real or inflation-adjusted basis, Treasury bonds have a negative yield.  No matter: investors kept buying them anyway.   The price of the 10-year Treasury bond rose about 14% over the course of the year.  We avoided the Treasury market and bought tax-free municipal bonds instead. We even bought them in tax-free accounts.  They were higher-yielding and immune from the central bank manipulations (“Quantitative Easing” and “Operation Twist”) that are currently distorting the Treasury market.  Munis rose 10% last year, a bit less than Treasuries but respectable enough.

That was last year.  What of the future?  Good things can be said, and should be said.   But there are problems too.  Let me begin with the latter, so I can end on a positive note.  I want to point to the widespread and I would say unhealthy deference paid to financial/economic “quants.”  I am thinking of the heads of American International Group, Citigroup, Bank of America, Merrill Lynch, Lehman Brothers, Bear Stearns and other major banks, insurance companies and brokerage firms who recently compromised or even bankrupted their companies by giving free rein to twenty-something financial engineers with only a vague notion of what they (the financial engineers) were doing or what might possibly go wrong.  The movie Margin Call addresses this subject of quants on Wall Street.  The movie is worth seeing.  But the problem does not end with Wall Street.   National politicians seem equally credulous in deferring to the high-tech econometric model builders at the Federal Reserve and Treasury and at research universities.   Who, for instance, believes unemployment statistics to be accurate?  Or inflation statistics?  Or poverty statistics? Yet these are the metrics of government policy.  Small wonder there are unintended consequences.

Consider for instance the current wealth transfer from small-time savers to the banking sector.  The Federal Reserve’s theory is that near-zero percent CD rates and money-market rates will shore up the financial sector, and make it better able to lend money to businesses to create jobs.  Are zero-percent interest rates doing that?  No, not yet; but out of luck are all the wage-earners who saved money during their working years in order to support themselves in old age.   It’s quite a sacrifice to ask on the basis of theory.  Similarly, it is to put a very high value on theory to borrow a trillion dollars for stimulus spending. The theorists say it will work, but it is not clear it will.  Meanwhile the interest must be repaid and eventually the principal.

There is one last negative to consider, that of wild volatility.  Between August and November of 2011, the S&P 500 averaged an intraday swing of 270 points.  There was one stretch of 4 days when the market swung 400 points a day.  It cannot be good, but what does it mean? We don’t know, though we would take the lead of Warren Buffet, the greatest investor alive and perhaps of all time, who doesn’t worry about it.  He rarely sells a stock.  If you are a long-term investor, as nearly all our clients are, if you buy high quality stocks at a time when they are relatively attractive, as stocks now are,  and if the stock pays an attractive dividend, as many do at the present time, there is no need to worry about volatility, and we wouldn’t.

Let me turn to some good news:  the discovery that we have become “energy sufficient.”  It sort of snuck up on us; technology tends to do that.  But not so long ago, the country was convinced it was running out of fuel.  Now we have clean-burning natural gas as far as the eye can see.  The consequences are far-reaching and almost certainly positive for investors. For the first time in my career there are deep-seated stirrings in the manufacturing and industrial sectors, where a renewal appears underway, with exciting investment implications.

Elsewhere I have written of the remarkable financial strength in the corporate sector (apart from banking and housing-related).  Even as the pace of economic growth in the U.S. fell to 1.7% in 2011 from 3% in 2010, sales among the S&P 500 grew 10% and profits grew 16%.  Corporate debt levels are very low and profitability near record highs.  Companies are flush with cash, certainly enough to meet almost any contingency.  And if not used for emergencies, the cash can be used for dividends.  Thus S&P 500 dividends should grow at 10% plus in 2012.  Normally dividends on common stocks  amount to about 40% of the yield of a ten-year Treasury note; today they amount to a 100% plus, and should rise even higher.  Thus if corporate profit growth were to slow in 2012, we expect demand for dividend-paying stocks would continue to grow, because there are so few places to find yield.

Every week or two I post a market comment on (our website).  Ben and Sally have joined me as well.  We encourage you to check out the comments, and let us know what you think of these extraordinary times we find ourselves in.


Mark O’Brien