Review & Outlook

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

First Quarter

15 April, 2014 by Mark O'Brien in Quarterly Letters

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It was a seemingly uneventful quarter for investors.  The stock market went up, then down, then up to where it started, in a pattern that people who work in the industry call “range-bound.”  Compared to last year, the first quarter 2014 was disappointing if not just boring.  But healthy markets need time to catch their breath.  The first quarter gave investors a chance to absorb the assumptions and trends of the extraordinary stock market of 2013 and, we would submit, to see the way forward with greater clarity. Was the historic surge in biotech and Internet stocks in 2013 a harbinger of a new era or a revisiting of the late 1990s high-tech bubble? Does the so-called manufacturing renaissance have legs?  Does, indeed, cheap natural gas in the U.S. change everything?  Is the economy really strengthening or is financial engineering by the government and corporations propping markets up?  The first quarter 2014 provided some clues to the big questions raised during 2013.

The quarter was also noteworthy for what it said about the ability of economists to administer the economy on the basis of expert knowledge of interest rates.  A Bloomberg survey at the beginning of the year scored 65 out of 65 economists as certain interest rates would trend up in 2014.  Wrong.  Interest rates fell.  The yield of the bellwether 10-year Treasury bond fell from about 3% to 2.75% during the quarter, with the result that bonds, whose prices move in the opposite direction from their yields, were the best performing segment among all financial assets.  The best-performing stocks were utilities, then health care, and then banks.  These sectors were among the worst performing in 2013.

Biotech and Internet stock prices surged in 2013 but suffered a real correction (something less than a crash) in 2014.  How much longer it takes to unwind the extravagant expectations in these sectors is anyone’s guess, though in all likelihood it may be a long time, because there is still much loose thinking about them. Consider, for instance, one of our own stocks, Google. It is with some unease that I would note that it has 3 separate classes of stock. There is a voting class, a non-voting class, and (a new one for me) a non-public class.  If an oil company or a bank or an old-fashioned drug company tried that, their boards would be hauled before Congress.

The darlings of Wall Street right now (one also thinks of electric car companies and social media companies and selected biotech companies) enjoy the privileges of a double standard. No need to go into that here except to say that privilege can make management sloppy and, ultimately, accident prone. Thus we would be nervous about Facebook’s $2 billion purchase last week of Oculus, a company without products or revenues let alone profits.  And this followed its $19 billion acquisition of WhatsApp, another profitless company.  We’ve seen this kind of arrogance before, and it seldom ends well.  We would look elsewhere for less risky investment opportunity.

But just because there are double standards and pockets of extreme optimism doesn’t mean the whole market is that way.  Rather the stock market as a whole trades at about 17 times earnings, which puts it on the high side of normal, which seems about right to us.  After all, there is nothing else out there to invest in. Bond yields are nearly invisible.

What about the charges of financial engineering? At the corporate level, some bearish investors charge that corporate earnings are phony, the result of cost cutting and stock buybacks designed to boost nominal earnings per share without really adding value. This critique is probably accurate in many individual cases, which is why we think it is important to read balance sheets and invest in stocks individually, rather than “buy the market” willy nilly.

And then there is the financial engineering at the national level. Here the charge is that the entire bull stock market is courtesy of the government. If you compare the timeline of the government Quantitative Easing programs (I, II, III) with those of surging stock prices, you see that the correlation is over 90%.  When the government unwinds these programs, runs the argument, stock prices will necessarily fall.  Here we are inclined to agree.  It is one reason to be cautious, and avoid companies with a lot of debt and/or obscure finances.

Investment analysts are debating the possibility of oil falling from the range of a $100 a barrel to $75 a barrel.  We need not run through the merits of the respective arguments here, except to note that the debate itself would not have been possible 10 years ago.  Our economy is changing and change at once destroys wealth and creates it.  Investors must be vigilant to be on the right side of that dynamic. That’s our job.

 

Sincerely,

Mark O’Brien