Review & Outlook

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

First Quarter

31 March, 2013 by Mark O'Brien in Quarterly Letters

Yes, stocks were up 10% for the quarter and, yes, the S&P 500 reached an all-time high.  The latter peak was scaled the last trading day of the quarter, which added to the aura of improbability about the period.

From the very first day of the quarter there was mounting disbelief that a stock market rally was really happening.  That’s because investors could not forget the litany of horribles that cycled through the media last year.  I am referring to the incessant drum-beat over “the fiscal cliff” of massive tax hikes and spending cuts here at home; the imminent collapse of the Euro and maybe even the economies of Greece, Spain and Italy;   governments’ (especially our own government’s) printing and spending money like never before; ballooning municipal, state and federal debt and budget deficits; and most recently, the peril with the weird name – –  sequestration.  It seemed no matter where you stood on the political spectrum, there was a disaster just for you.

Shouldn’t someone be apologizing?  In any event, one of the problems today is how financial news is presented.  The presumption is that every piece of bad news requires a response.  This approach is murder for retirees and ordinary investors who have been manipulated by government policymakers to try to preserve their savings in the stock market.   No sooner were they lured into stocks than they were scared out of them.  These people, hunkered down in bonds, had nothing to show for the quarter but flat to down bond prices and the lowest yields in memory, courtesy of the Federal Reserve Bank policy.

Small investors have been singled out to make big sacrifices.  It is as though government monetary policy has decreed that there may be no risk-averse investors.    It is a lot to ask.

But now what?  Are stocks going to go up another 10% in the new quarter?  The stock market is overdue for some sort of pull back. In the last three years the market has traced out the same pattern:  a strong first quarter, such as we just had, is followed by a piece of bad news – – a political upheaval in the Mideast, an environmental disaster in Asia, an economic disappointment at home – – which sends stocks into decline.  This triggers strong government money-printing which pumps up the price of financial assets, like stocks and bonds, and the cycle repeats itself.  The role of government is cited by some as a reason to own stocks.  They point to the “Bernanke Put”.  It means that the Federal Reserve has put a floor under stock prices.   Stocks can fall only so much before the government starts printing money.

This gives us little comfort.  We would not buy stocks on the promise of more government help.   But fortunately there is another argument for buying stocks: many individual companies are reasonably priced.  Technology stocks, as represented by the Nasdaq, are still 50% below their 2000 peak.  Consider that while Apple has shed a third of its value in recent months, it still has a price-earnings ratio (PE ) of 10, a dividend of 2.5%, and a 5-year annual earnings growth rate of 65%.  It certainly looks attractive to me.

It is best to consider stocks on the basis of their earnings.  Stock prices have risen to new heights, but stock earnings have gone up faster.  Taken together stocks trade at about 15 times earnings, which is a little bit below the long-term historical average of 16.  Not a steal, but still a good value.

And there may be no better value anywhere else.  The financial press has coined a new expression to describe the American stock market: T.I.N.A.  It stands for “there is no alternative.”  What about Canada, Finland, Australia?  Yes, these economies are prospering, but their markets are too small, so they can take only so much new money.  In many ways this moment is like that following the end of World War II, when savers around the world regarded the United States as the only stable and safe place to invest.  Interest rates then were also repressed to levels that were not remunerative, forcing investors into stocks, as they are now.  And stocks were relatively inexpensive then, as they are now.  Altogether stocks did well in the post-war period, and they could do well now for a period of years for many of the same reasons.

What are we worried about most?  Curiously, what happens when the economy really gets going, when the housing sector, employment and consumer spending really pick up.  Right now hundreds of billions of dollars sit in bank reserves, like vast lakes of gasoline, volatile and dangerous.  In a more robust economy, this easy money will then have to be drained off.  If it is not, it will fuel hyper- inflation.  This draining off is a very tricky operation, and monetary officials will likely postpone it for as long as they can. That’s why we tend to think the economy will remain sluggish for a good while longer.

The economy may remain sluggish, but some sectors are booming. In regard to the latter, let me conclude this first quarter letter with a few words on transport-related stocks.  My entire career the sector has been assigned to the bone-yard of investing, because it was capital-intensive and embroiled in labor disputes, and burdened, in the case of the railroads, with punitive and outdated regulations.  Transportation always lagged the more glamorous sectors like pharmaceuticals, computer software, and consumer discretionary.  In this vein I remember attending an analysts’ meeting with the management of Norfolk Southern in the 1970s when the president of the company asked why in the world any of us would ever recommend a railroad stock.  And this was from the president of the company!

Well, that attitude is changing and in a hurry.  The country is awash in cheap and plentiful natural gas and this is bringing collateral benefits throughout the economy but nowhere more than in pipelines, barges, rails, trucks and heavy-duty engines.  Close to the beginning of his investing career, Matthew O’Brien, Ph.D., has written a very nice piece of research on the subject summarized in the commentary section of our website (



Mark O’Brien