Review & Outlook

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

Fourth Quarter

17 January, 2014 by Mark O'Brien in Quarterly Letters

The best account of 2013, and the outlook for 2014, may come from the late mutual fund pioneer and philanthropist Sir John Templeton:

Great bull markets are born in pessimism, grow on skepticism, mature on optimism, and die in euphoria.

Along with colleagues Sally Sulcove, Ben O’Brien, Matthew O’Brien, and Paul Devine, I spend untold hours this time of year reading investment and economic research on the capital markets.  This plethora of research literature, which is appropriately academic and obscure and, I might add, expensive, is essential to the craft; one cannot manage investment portfolios by adages. But in terms of explaining what happened last year, and what may happen next, this comment of Sir John gets 2013 (and maybe 2014) about right.

As regards the first clause, about pessimism, I will move quickly on because previous letters discussed how the media had hyped fiscal cliffs, massive tax hikes, federal spending cuts, problems in Cyprus, Greece, Spain and Portugal into fear that spooked much of the investing public out of stocks. The apocalyptic predictions that ended 2012 and began 2013 show the hazards, if not the folly, of taking investment cues from the short-term, event-driven financial media. One feels for the poor souls who took the predictions to heart and sold stocks for the false security of “fear assets” like gold, which was down some 30% in 2013.

We come to the second clause of Sir John’s sentence, about skepticism.  On this account 2014 looks like it might be another good year, because, heaven knows, the market is full of skepticism. I am speaking of the vast investing public, those who lost their shirts in the Great Bear Market 2007-2008.  From the financial crisis through 2012 investors withdrew $451 billion from stock mutual funds. Compared to that the stock inflows of 2013 were a trickle, even smaller than the $126 billion that left stocks just the year before.  Yes, some speculators struck it rich in 2013. Beneficiaries of the government’s easy-money policy, they gambled in IPOs and highly leveraged companies with weak balance sheets, and drove these valuations to lofty levels. But they are froth above the waves, and not typical of the investing public more generally.

As for optimism and euphoria, the terminal stages in Templeton’s market life cycle, it is safe to say we are not there yet. Here I am reminded of words from the Sermon on the Mount: Sufficient unto the Day are the problems thereof.  We can worry about optimism and euphoria later, but right now investor sentiment is restrained and valuations, at least for high quality stocks, are reasonable.

To be sure, high-quality companies like Coca Cola, Chevron, Apple, Sysco, McDonalds, Nestle, Coach, Amgen and JP Morgan are not bargain basement as they were in March 2009, but neither are they expensive at 15 times forward earnings or less, which is about average when compared to historical levels.  And many of these high-quality companies have dividend rates that exceed the yield on their bonds, which has never happened before in my career. What about soaring stock prices last year? Doesn’t that invite correction? Perhaps, but this fact alone doesn’t justify trying to time the market and go to cash.  2013’s stock rally was disproportionately due to surging low-quality stocks—smaller companies with high debt, no dividends, negative earnings, etc.—which rose twice as fast as high-quality stocks.  Any correction is likely to be suffered disproportionately by low-quality companies as well.  High-quality stocks are the best, and indeed only, real stores of value right now. Compared to money market funds and Treasury bonds and their microscopic yields, well, there is just no comparison.

The economy is getting better. Despite some problems, which I will mention below, the United States is in an enviable position relative the rest of the world.  Our demographics are the strongest in the developed world.  U.S. energy production recently passed Russia to become the largest in the world.  And most important, entrepreneurial spirit drives innovation in every sector of the economy. We tend to take this entrepreneurial spirit for granted.  We shouldn’t. A Swiss business friend described it this way: “I don’t understand American entrepreneurial spirit, I cannot explain it, but I can smell it in the air as soon as I get off the plane, and it is amazing.”

I mentioned problems.  I don’t know whether to call it a problem or a concern about an open-ended situation with unknown consequences, but I am thinking of the Federal Reserve’s massive bond-buying program called “quantitative easing.”  Critics claim it is just sophisticated money printing and that it will be no more successful than earlier such efforts.  Fed officials disagree. The president’s nominee as Fed chairman, Janet Yellen, is a big fan of quantitative easing, so we may see more of it. Its use, along with the already large national debt, demonstrates a new willingness on the part of the Fed to experiment with an absolutely essential part of economic life as we know it.  And that is concerning.

In addition to our worries, at the end of what was a very good year in the market, it is also fitting to express our gratitude.  Many clients have been with us for decades now; some are new, but all have had the fortitude to stay invested through some difficult times.  We appreciate your commitment to long-term investing and are gratified that the market has rewarded your discipline.  We wish you a prosperous and healthy new year.




Mark O’Brien