Review & Outlook

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

Fourth Quarter Letter

31 December, 2012 by Mark O'Brien in Quarterly Letters

I am of course delighted that stocks and bonds made money last year.  I thought they would, though I must confess there were times when I had my doubts.  But I am not altogether happy how the markets made money.  Politics took charge of the stock and bond markets.  By “politics” I mean government in the manipulation of interest rates and the money supply, the licensing of hospitals, the construction of pipelines, etc., and not just the election of a president, senators, representatives and local officials, which also happened last year.  Reliance on things political poses a particular set of risks that investors should recognize and generally try to avoid, because the government is a notoriously unreliable investment partner.

Consider that Citigroup common stock rose over 50% in price in 2012.  Bank of America rose over 110% in price.  All banks taken together rose over 25%.  Banks were the best-performing group in the domestic stock market.  The Standard & Poor’s 500 index and the Dow Jones Industrial Average returned 13% and 7%, respectively, in 2012.  To put the matter in personal terms, if your portfolio beat the Dow Jones average or the S&P 500 average last year, then in all likelihood it was because your portfolio was heavy in the financial sector.  So what was it that was so good about banks last year?

The Federal Reserve Board in cooperation with the Department of The Treasury and Congress is maintaining the soaring profitability of banks by depressing short-term interest rates.  Banks enjoy close to a “zero cost of funds,” which in the banking trade means that their raw material (money) is close to free, courtesy of the Federal Reserve Board.  What business can’t prosper when it gets its merchandise for free?  That’s why banks went up 25% last year.  But one must ask who is paying for the free use of money.  The answer is savers and retirees are paying.  Indeed, there is an enormous wealth transfer going on from savers and retirees to the banking sector.  For instance, when my mother sold the farm, she put the proceeds into a money market fund and earned $60,000 a year in interest, which she lived on.  Today she would earn $600 a year, which is not enough to live on.  The current practice seems unjust.   One wonders if average Americans will catch on and, if they do, how long they will put up with it.  The situation is all the more curious for what is going on at the same time.  While one part of the federal government is subsidizing the banking sector, other federal agencies are prosecuting, fining and in other ways punishing banks for mortgage underwriting practices, foreclosure abuses, inappropriate currency speculation and security price (Libor) manipulation.

The lesson?  If you have to own a lot of banks to beat the market averages, maybe you shouldn’t try to beat the market averages. Everyone knows that what the government gives the government can take away, and often does. One is reminded of government-sponsored entities Fannie Mae and Freddie Mac.   Their stocks soared, for years, until the government changed its mind over the nature of its support, and overnight wiped out the common and preferred stockholders.

We are not suggesting that clients should bet against the government.  We would not, for instance, start shorting bank stocks.  Nor are we saying government is not necessary.  What we are saying is that, fortunately, there are sectors in the domestic economy relatively free of political influences where good things are happening right now. We would focus on these instead of piggybacking on government schemes to stimulate the economy.   To cite just a few such areas that did not exist a few years ago, there is the explosion of smart phones and tablets, data storage, cloud computing, and shale oil and gas.  As regards shale and energy self-sufficiency, I just saw an item in Bloomberg News that caught my eye.  A story on January 3, 2013 reported that Union Pacific railroad shipped 140,000 carloads of shale oil in 2012, up from 2,400 carloads in 2010.  This is real.

What is not for real, or at least not in the same way, are bonds whose yields are set by government planners.  A one-year Treasury note pays 0.10%; the ten-year U.S. Treasury note pays an annual coupon of 1.8%. Inflation is higher than that.  These bonds are guaranteed losers, and promises from the Treasury Secretary and the Federal Reserve Board Chairman that they know how to contain inflation are just not credible in light of government spending and “quantitative easing,” and other money-printing programs.

Also not for real is the constant litany in the media of phony deadlines and fake showdowns surrounding the fiscal cliff, debt ceiling, tax hikes, spending cuts and so forth.  One does not want to make investment decisions based on media-hyped negotiating tactics.  Many clients ask me if they should get out of stocks in anticipation of one of these catastrophes occurring.  My answer is no, because these hypothetical events are not real in the way that, for instance, retrofitting oil-drilling rigs to be powered by cheap and clean-burning natural gas is for real.  Thus Cummins Engine is a for real investment that makes money, pays a dividend and has a credible prospect of future growth.  We would buy it now, and are buying it now, when we would not buy a Treasury note paying 0.10% or a government shutdown story that calls for gold, survival food, and hand-cranked flashlights and radios.

In calling attention to stocks like Cummins Engine, with attractive dividends and growth prospects, I must admit the possibility of stock market correction and even a recession in the year ahead.  We are overdue for some sort of stock-market pull-back.  They happen from time to time (most recently four years ago) and seem a necessary though unpleasant part of the system adjusting to new taxes and other changes.  But for the first time in my business career, which has been a long one, people are building steel mills and fertilizer plants in Pennsylvania and Ohio.  Now what I would like to see is the end of quantitative easing subsidies every time the correction of recession threatens. The market doesn’t need them and society cannot afford them.


Mark O’Brien