Review & Outlook

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

Third Quarter

22 October, 2012 by Mark O'Brien in Quarterly Letters

In summary form, the price changes in the broader stock and bond markets in the quarter appear below:


I normally try not to predict the next twist or turn in stock prices, but in my last appraisal letter, at the end of June, I strayed from that practice and made a prediction that proved accurate.   Which brings me to the first point I want to make: you only hear about the predictions that work out.  But I get ahead of myself.  To return to my end-of-June prediction:  I predicted that even in the face of bad economic news at home (national debt, deficits, housing starts, home sales, employment, consumer sentiment, personal income, corporate income all going the wrong way) and even worse economic news abroad (slowing global growth, Chinese housing bubble, collapsing economies in Spain, Greece, Italy), the next three months would turn out all right.  These were my words: “the excitement and expectation surrounding the American presidential election seem to have spilled over into investor psychology … and the markets (should do) fine up to the election.”

And so they have; the markets did fine last quarter.   The Dow Jones Industrial Average has returned to its all-time height last established in 2007. Perhaps it was the distraction of the presidential election, as I suggested, or maybe it was the decision of central banks around the world to print money (probably the better answer).  Whatever the reason, stocks surged across the board.  Even European stocks rose; the Euro Stoxx index was up 8.4% on the quarter.

But now what?  Am I going to make another prediction about how the so-called Fiscal Cliff will play out next year?  No, I don’t think so.  I can say that these appear to be unusually risky times but—and this is my second point—there are too many problems with too many variables to make concrete predictions, especially ones that might serve as the basis for jumping into or out of different kinds of investments.  Rather I would think about reducing the greatest risk and forget about predictions.  Reducing risk is hard enough.  Which brings me to my third point: what used to increase portfolio risk in more ordinary times may now actually decrease it, and vice versa.

Two kinds of risk threaten our savings: equity risk (stock prices fall) and inflation risk (devaluation of the dollar).  Of the two, in my judgment, inflation risk poses the graver and longer-term problem.  But most people don’t see this.  Unfortunately the financial media are not helping.  They have taken to calling common stock, even stock of the highest caliber, a “risk asset” on the basis that it has no fixed and certain nominal dollar value and therefore is more risky than bonds and money market funds.  The latter do have a fixed and certain nominal dollar value and are therefore, presumably, riskless. But, of course, it’s the purchasing power of an asset, that is, its real or inflation-adjusted return that counts, not nominal value, and here stocks offer more protection than bonds, a lot more.

In this business of real versus nominal returns, there is a lot to worry about.  Our own government is playing games. What the individual investor has to worry about is the mountain of debt that the federal  government  has created (up 151% in the last 10 years) and then sold to itself in  money-printing programs called Quantitative Easing 1, 2, and 3.  The last time the government had this much debt, at the end of World War II, the government inflated it away from 1950 to 1980. And that appears to be the plan now: to inflate the debt away.  What’s the best defense?   High quality stocks appear to be the best, if not the only, defense at the present time.

Priced reasonably, companies like McDonalds and IBM pay dividends that exceed bond yields and, if inflation heats up, can raise the price of a hamburger or computer services to preserve profit margins.  There is precious little out there that works as well.

But isn’t the stock market overdue for a pullback?  Isn’t the global economy slowing down?  Aren’t American companies running out of steam and their earnings starting to fall?  Yes, all this is true, but these cyclical pressures are always going on, whereas current federal debt levels are of historic proportions.  And there are game-changing economic forces abroad in the land that could postpone a short-term stock-market correction.  Consider that in the last four years domestic energy production has taken off.  Four years ago we imported 60% of what we used and pundits wrung their hands over our unbreakable dependency on foreign oil. Today that figure is 40%, and it is coming down fast. Over a million new jobs have been created in the energy sector alone. The collateral benefits could prove to be the very stimulus that has eluded Washington policy makers and their various quantitative easing (money printing) programs. And remember, nobody predicted the domestic energy boom four years ago.

What about commodities as a way to defend oneself from the tidal wave of debt and risk of inflation?  Yes, to some degree it’s a good idea, but rather than own the actual gold, silver, oil or other commodities, individuals are better served owning companies that produce and use them and whose stock pay dividends.  Also, one has to be very careful.  Wall Street has rushed to market with some very sketchy new products; these funds use cash flows from pipeline companies, and a good deal of leverage, to create high octane yields reminiscent of those in the  pre-crash mortgage derivative securities market.

In sum, these are difficult times to be an investor, and they could get tougher.  The rules are changing.  Adjustments in thinking and expectation are in order.  But that’s the way it always is.  The price of wealth is vigilance.  Always has been.

We have started to add more comments on the economy and the markets to our website (  I hope you will take a look.  If anything sparks your interest, feel free to call and talk about it.   Also, there have been a number of big changes at the firm in the last quarter, most significantly the passing of our dear friend Dave Greene; enclosed in this packet are some reflections.




Mark O’Brien