Review & Outlook

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

Third Quarter

11 October, 2013 by Mark O'Brien in Quarterly Letters

If 2013 could only end now! Then our report for the year would tell a happy tale of Chicken Little warnings proved wrong, of the prices of “fear assets” like gold and government bonds plummeting in response to the good times, and the prices of growth  assets like stocks registering solid price gains, in percentage terms in the mid- to high teens. But, alas, we have another three months to go in 2013, which is more than enough time for government policy errors and economic mishaps and heaven knows what else to unravel the happy narrative and, maybe, even prove Chicken Little right about stocks, at least in 2013.

This longing for an early end to 2013 brings me to my first observation: finish lines, as in the end of a time period, don’t have much meaning in the investment process and should not be given any meaning by those who need their savings to last a long time.  In the present investment climate, even the retiree is a long-term investor.  Increases in longevity and bond yields close to zero means that a retiree has to stretch out his or her portfolio to cover a not inconsiderable span of years.  The best way to do this is to maintain one’s long-term stock holdings, even when the short-term outlook is clouded with scary headlines, as it is now.

Speaking of artificial finish lines and false deadlines, we must address the national government’s October 1 budget deadline and the October 17 debt ceiling deadline. These events are culminating in the federal government shutdown, which is unfolding as I write this letter. Talk about scary headlines.

 My associate here at O’Brien Greene, Paul Devine, has uncovered some statistics on the subject of government shutdowns and the stock market. The research shows that since 1976 there have been sixteen government shutdowns including two especially big ones in November and December 1995. What happened then was not much of anything. In the relatively major shutdowns (November and December 1995) the stock market went up prior to the shutdowns and then up some more when they were over. It is always possible that this time will be different, though in recent days the stock market has gone up, then down, then up again. Hardly a pattern, hardly a catastrophe.

As for what we think about the whole spectacle of government shutdown, we are of the school that this is the way our system of checks and balances is supposed to work. That is to say, no one is meant to have his way without compromise. The result is sloppy at times, but it has always been so. Rather than a sign of the democracy being broken, we see the opposite. Maybe this is why the stock market has tended to hold up well during these episodes. Certainly we would not go to fear assets (gold and government bonds) on the basis of a continued government shutdown.  We would hang in there. This would seem to be the verdict of history.

 Congress will probably jury rig some end to the government shutdown just in time to raise its borrowing limit. In this regard, for Congress to ignore its ballooning debt really would be a dereliction of duty—unlike the faux crisis of the government shutdown.  If Congress fails to meet the obligations of its creditors by failing to raise the debt ceiling, or if it extends its borrowing without making any cuts in spending, then this would be a genuine problem.

How are things otherwise? Market news, as always, is mixed. Equity analyst Ben O’Brien reports that Internet stocks have come rocketing back, again, and we must confess that this is rather disquieting. Left for dead in 2000, and then again in 2003, and yet again in 2008-9, they have this year managed to lead a very fast-paced parade up Wall Street. The NASDAQ Internet stock index (QNET) is up about 50%, more than twice the rest of the market. In the mode of Internet stocks, though not itself an Internet stock, electric motor car company Tesla Motors is up 470% this year. This despite some pretty flimsy fundamentals, at least in our opinion, and without consideration of last Friday’s spectacular network evening news footage of a Tesla sedan rolling down an off-ramp and bursting into flames as its ion batteries malfunctioned. So are Tesla and the Internet stocks a sign of market excess, crying out for correction, and threatening higher quality stocks along the way? We do not think so. We would indeed be worried about owning companies without earnings and sales and strong balance sheets (like Internet stocks and Tesla). They are the beneficiaries of the government’s easy money largesse and appear vulnerable, to put it mildly, to the so-called tapering off of easy money, which sooner or later is going to happen. But we are not worried about the rest of the stock market, which at 15 times earnings is neither particularly cheap nor expensive but altogether reasonable, in our opinion. As for Internet stocks crashing and burning, as they have done in the past, they did not take higher quality equities along with them over the cliff. We expect the same thing would happen now. As long as you don’t ride the escalator up with them, you won’t ride the elevator down with them, or so the expression goes.

 Let me say a word about the really big picture: about the Federal Reserve Board and our so-called managed economy. The modern profession of economics is not delivering on its promise (we would say extravagant promise) to increase employment, maintain price stability and spread prosperity. This is true in theUnited Statesand the European Union and elsewhere in the developed world. Even the effort to measure inflation and unemployment has been shown to be incomplete and inaccurate, with the result that flawed data is the basis for fiscal and monetary policies. No wonder the policies are not working as promised. So, in such a state of affairs, how can we be optimistic about the future—as we are optimistic— if neither we nor the fiscal and monetary authorities or anyone else knows the economy as well as we thought we knew it?  The answer is that you don’t have to be able to operate the economy like a piece of machinery, precisely, to appreciate its properties.

The U.S. demographic profile, our spirit of entrepreneurialism, the reformed state of our labor relations, and the newly revitalized energy sector are all cause for optimism. They are moving the economy in the right direction, certainly when compared to our competition around the world. So that is the good news and we think it is for real. Moving the economy in the other direction, that is, holding the economy back, are current tax and debt policies. These could prove intractable, though on balance we don’t see them as powerful enough to offset the strengths mentioned above. In terms of stocks and bonds, our belief is that we are at the start of a period like the late Forties and the Fifties when the country was similarly situated in terms of debt, taxes, and competitive advantage relative to the rest of the world. In the Truman and Eisenhower years, stocks significantly outperformed bonds.  Bonds did poorly, as their fixed rates of return were diminished by the steady and deliberate erosion of inflation, which was used to reduce the size of public-sector debt run up during the World War II. We see the same dynamic playing out now, and the last few years have so far borne this view out.



Mark O’Brien