Review & Outlook

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

First Quarter

12 April, 2012 by Mark O'Brien in Quarterly Letters

As you have heard by now, it was a wonderful quarter for stocks – – the best first quarter since 1998.  No doubt you have also heard many reasons why. (The financial media and Wall Street in general are very good at explaining markets after the fact.)  But really, does anyone know?  Forces beyond our control and understanding play as big a role in markets and economies as the things we do control and do understand.  That’s why government policymakers are having such a terrible time trying to get employment and personal incomes up.   But more on that later.  In terms of the quarter just ended, it seemed the riskier the asset the better it did.  Thus bank stocks were a standout performer after years of leading – – if that’s the right word – – the market as it headed in the other direction.  Even Greek stocks went up in price (+17%) last quarter.   Altogether stocks achieved the kind of return one hopes for from a good year, let alone a single quarter.

Speaking of years, it is probably too much to expect the stock market rally to go on for the rest of 2012.  Markets never go in one direction for long.  And in fact last year stocks as measured by the S&P 500 started out exactly the same way, with a strong first quarter before collapsing into a bear market decline of 20% in late summer. So it could happen again.  In fact some sort of a pullback is overdue.

But short-term correction or no, it is becoming clear how we will repair our fortunes – – again, I am not sure it’s the right word – – decimated by the Great Recession of 2007 and 2008. If it happens (repairing our fortunes), it will be because of stocks, not bonds.  Last quarter may well have been the end of a thirty-year long rally in bond prices.  Early in my career (I graduated from the Wharton Business School in 1975) high quality government bonds paid as much as 15% per annum.  As I write the two-year Treasury note pays a yield of .3%, the five-year Treasury note pays a yield of 1%.  Recently there have been government auctions when investors paid the government for the privilege of lending it money. In other words,   negative yields.  To find a comparable moment in history, at least in terms of bonds, one must turn to 1946, when the government started inflating away the bill for World War II, the Eisenhower system of interstate highways, the Great Society, the Vietnam War, and trips to the moon.  It took investors some thirty years to wise up and demand an inflation premium.  Now the cycle appears to be starting up again, and, as regards bond investing, it looks a lot like 1946.

I don’t want to dismiss bonds completely.  I think they can still contribute some income and price stability to a portfolio, but gone are the days from 1980 to 2011 when the investor weary of the volatility of stocks could retreat into the real, inflation-adjusted return of a money market fund or a ladder of bonds and be sure he was still protecting the purchasing power of his savings.  What makes the present time so difficult is that there is no place to hide, no certain “safe on base” any more, as bonds and money market funds were over the past thirty years.  Rather, policymakers at the Federal Reserve Bank (the Fed) have relegated savers to a permanent game of tag, and made them “It.”  Why?

The Fed is trying to induce individuals and business to take more risk with their money.  More risk-taking, the theory goes, will revive employment, consumption, and investment in new plant and equipment.  That’s the theory for near- zero percent interest rates: to force the investor’s hand.

The contrary point of view, of course, is that it will do none of these things and instead lead to speculation and asset bubbles.  So far the policymaker’s theory has not been borne out.  As for speculation and asset bubbles, there are troubling signs in oil and gold (not to mention Greek stocks).

The challenge for investors?   Don’t allow yourself to be manipulated into unintended and inappropriate risk-taking.  Individuals tend to be better judges than policy makers of how much risk they ought to take.  But with bonds, CDs, and money market funds pretty much off the table, people have fewer tools with which to work.

How to own more stocks and take less risk? Let me suggest two ways.  First, don’t get caught up in the quarter by quarter performance sweepstakes.  Last quarter, for instance, “junk” stocks did best.  Thus the financial media extols investment managers who had more junk in their portfolios than is in the S&P index.  But does one really want to be jumping in and out of different stock sectors in pursuit of this sort of short -term performance?  I think not.  Instead, look for ways to take less risk than the S&P 500.  It’s a more durable strategy.  For the risks are real.  Europe appears to be entering a recession and news from Spain and Italy suggests the sovereign debt crisis is far from over.  And China’s breakneck economic growth looks accident- prone to me.  As for the U.S. economy, truly massive stimulus and bailout spending has distorted key industries, like banking, to the point where no one knows the relationship between the price of goods and services and their real costs.  It could take years to straighten out the distortions in these important parts of the economy.

The second suggestion: try to time portfolio distributions, at least the discretionary ones, to coincide with good markets, and vice versa.   After a really good quarter, like the last one, that’s when you want to buy the new washing machine and dryer.  This sort of dynamic spending will serve you better than a flat distribution rate.  It will tend to result in more money on hand when the market takes off and less when it pulls back.  In a low-return environment, such as we appear to be in, one needs to pay attention to the little things.  They add up and make a difference.


Mark O’Brien