Review & Outlook

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

Second Quarter

30 July, 2013 by Mark O'Brien in Quarterly Letters


The quarter just ended was a so-so one for stocks, collectively up about 2% in price.  The real stock story was that stocks managed to hang onto the big gains of the quarter before, when prices soared in contradiction of fears over Cyprus, Greece, the EU and especially the Fiscal Cliff (remember the Fiscal Cliff?).

As for bonds in the quarter just ended, they suffered a sharp price reversal at the end of the quarter. The Federal Reserve Board, which is the American central bank, said it intends to slow the pace and/or the size of the $85 billion it is spending each month on government bonds and mortgage-backed securities in support of bond prices.  This could be start of a long string of bad news for bonds.  More on this later.

And in the big-news-if-we-only-knew-what-it-means department, gold suffered its biggest one-quarter drop “since the start of modern gold trading” (WSJ, 6.29-30.13, p. B-1).   People who bought gold last year as a hedge against financial collapse in Europe and inflation at home have lost about 25% of their investment.  When one lines gold up against the news, its price behavior is hard to explain and even harder to predict.  We have stayed away from the precious metal in our portfolios.  We would even draw an investment conclusion from the recent price action: gold is not a safe haven where one can hide wealth, as many people used to think and many still do.  There is no substitute for vigilance and diversification in the business of preserving wealth, not even gold.

In these quarterly appraisal letters we customarily spend most time on stocks.  That’s because stocks provide, over time, the biggest and most consistent price appreciation, and they are more entertaining, at least compared to bonds.   But this time we must give pride of place to bonds, because historic changes appear to be afoot.  Why does the bond market matter so much? The price of money is set (in the form of yields) in the bond market, and nothing in a market-based economy like ours is more important than the price of money.  But in recent years massive government bond-buying, referenced above, has distorted yields so they send inaccurate signals about what things are worth and the financial risks of different courses of action.  These inaccurate signals may be one reason why businessmen are reluctant to invest in new plants, why unemployment is high, and why, more broadly, this is the most anemic economic recovery in modern times.

We take it as a good development that the Federal Reserve is looking for ways to end and even reverse its $85 billion monthly bond-buying program, so markets can set interest rates and not academic economists with an untested theory, as is the case now. But unwinding the Fed’s massive bond buying programs is likely to send big and frequent shock waves through the bond market, as the mere suggestion did near the end of last month.  We think bond investors are likely to see a good deal of bad news in the months and even years ahead.

So are we going to get rid of all our bonds? I don’t think so.  Let me say why we intend to continue to hold individual bonds, with fixed and intermediate maturity dates, even if their market prices are likely to fall in the months and years ahead. Over the years I have found that bonds tend to keep investors sane during times of maximum stress, like 2008-9.  Put another way, bonds tend to give investors the mental fortitude to hang onto perfectly fine stocks they might otherwise sell in the face of horrible news about the EU, terrorist attacks, wars, earthquakes, Fiscal Cliffs. And of course, bonds still provide a fixed amount of income over a certain term.  They also at maturity pay their face amount to the holder, who gets a return of principal even if in the meantime not having gotten much of a return on principal.

We can be more sanguine about stocks, even though they are, as we are often told in the press, at an “all-time high.”  Yes, stock prices as measured by the Dow Jones Industrial Average and the S&P 500 index are about where they were in 2000 and 2007; so these measures are revisiting the “all-time highs” (always a scary description) made in those years.  But now the underlying companies in the Dow and the S&P are making more profits and paying higher dividends than they were in those earlier years.  Moreover American stocks have no competition from bond yields, as they did then.  Altogether stocks are a much better value now, and one should not be distracted by headline grabbing phrases like “all-time high,” which is a misleading and incomplete notion.

As for the economy itself, there’s enough underlying strength to withstand the assaults of the normal business cycle, not to mention the policy errors of central bankers, politicians and regulators.  Those underlying strengths include restrained labor costs, abundant energy ($4 natural gas in the U.S. as compared to $10 in Germany, $14 in China, $17 in Korea), favorable demographics, and political stability.  These strengths are not forecasts, but are real drivers of the economy right now.

A last point needs to be made. We are overdue for a stock pullback and/or an economic slowdown, as I wrote in recent appraisal letters.  Stock pullbacks and business slowdown are not a refutation of the strengths mentioned above.  We had a 16% stock pullback in 2010, a 19% pullback in 2011 and a 10% pullback in 2012 –and still managed respectable performances for the full 12 month periods. And as for recessions, they happen about 25% of the time.  They appear to be an inevitable and even beneficial part of the system. I mention this because the financial media, central bankers and politicians seem to expect expansion all the time, and even try to engineer it with programs like “quantitative easing.” It doesn’t work that way, and never has.

In conclusion let me suggest a few stocks that my research team (Sally, Ben and Matthew) is studying.  The Walt Disney Company knows how to entertain America. Think of ESPN, which is owned by Disney, or the new movie The Lone Ranger, which I have not seen yet, or the theme parks here and abroad.  Disney pays a 1.2% dividend while one waits for earnings and the stock price to grow.  Express Scripts makes money by reducing health care costs, which is probably the most certain way to make money these days in that sector.  And EMC stores data; the amount of data that has to be stored is expanding so fast that it is hard to come up with the right word for it.  “Exponentially?”   Is there a stock we don’t like? Tesla Motors, the new electric car company. Matthew recently posted a research report on our website.  While the stock price has surged, he explains why he would be reluctant to recommend it.  Take a look at our website and let us know if you agree.



Mark O’Brien