In this appraisal letter, as with earlier ones, we identify what happened in the capital markets in the quarter just ended. The underlying assumption is that we cannot predict the next turn in the market (nor can anyone else), but that we can spot trends and then decide if we want to join them or, more likely, run away from them. The writing of this quarterly letter is the culmination of a process that occurs all quarter long in daily conferences here at O’Brien Greene & Co. Another expression of that process appears on our website (obriengreene.com) under the tab entitled Commentary. If you are a high-volume consumer of investment news and opinion, or just a casual browser, you might check it out. Credit for putting the material together goes to Ben O’Brien. The credit for the opinion, or the blame, goes largely to me and long-time colleague Sally Sulcove CFA.
Now, let me turn to the markets at the end of the second quarter 2014. With all the bad news at home and around the world, you would expect more investor fear, as expressed in wide price swings in the stock and bond markets. Instead, stock and bond prices were remarkably stable in the quarter, rarely rising or falling more than 1% in a given day. Altogether the volatility index (VIX index) , which is a frequently cited gauge of fear among investors, was two-thirds its normal level, a record for such an extended period of time.
So the investment result were good, as measured in rising prices and record-low volatility, but the news was not. Before explaining how that could happen, let me say a few words about the nature of the bad news. First was Russia’s move into the Ukraine, which has unnerved Europe. It brings to mind the Cold War, the invasions of Hungary and Czechoslovakia in the 1950s and 1960s, and the prospect of higher defense spending, which the social democracies of the West, including the United States, cannot afford. Raising similar concerns was the sudden and unexpected collapse of Iraq late in the quarter, which is on-going. The potential for another war in the region (even one in which the U.S. does not have troops on the ground) raises economic anxiety (particularly regarding energy costs) and the possibility of the region’s population becoming militantly and lastingly anti-Western (whether for religious or nationalistic reasons). Closer to home was a surprisingly bad economic report. Toward the end of the second quarter, the estimate of gross domestic product (GDP) for the previous quarter (there is a lag in reporting) was revised downward from a mildly disappointing number to a terrible number of a negative 2.9%. Such a negative GDP number points more toward recession and bear market than new stock market highs and low price volatility. The terrible GDP number would normally trump all other reported statistics. Yet the markets appeared unfazed. How could this be?
The answer to the question explains one of the big and enduring advantages America enjoys over the rest of the world. I am speaking of the world-wide phenomenon whereby bad news, like the geo-political shocks last quarter, triggers a capital flight into the security of American markets. For the foreigner investor political stability may be this nation’s greatest attraction. Certainly it, along with the dollar’s status as the world’s reserve currency (the currency in which business is conducted around the globe), is our ace in the hole, silver bullet, life preserver, you name it. Whether this advantage works to the long-term health of the nation is another question. But in the short term, one can hardly exaggerate the benefit.
Let me turn briefly to a less attractive feature of our markets, though initially it might not look that way. Last quarter the price of everything went up, even prices of assets that are supposed to move in opposite directions. Why would the prices of speculative stocks, so-called “greed assets,” rise at the same time as the price of “fear assets” like gold? Here the answer is not so encouraging. It matters how and why prices go up, not just that they go up. Central banks in the United States and around the world have expanded their respective money supplies in a great experiment of stimulus spending and Quantitative Easing that they hope will end in new investment in plants and capital equipment and in new employment. But these things are not happening. Instead asset prices have started behaving in weird and unexpected ways. These distortions of the so-called pricing mechanism in certain key markets are bad news for economies around the world, for without logical and consistent prices, business people cannot allocate capital among competing investments. So they do nothing. Their capital sits idle, which is the case today, especially among American corporations.
The biggest asset price distortions may be occurring in the bond market. For instance, the current yield of a so-called junk bond is about 20 basis points lower than the historical average yield of the one-year Treasury bill, which is the safest bond investors can buy. That’s a mouthful, but what it means is that junk bonds, which by definition are risky, pay little yield in return for risk. Not so long ago investors would speak of the riskless return of bonds; now they would more aptly speak of the return-less risk of bonds. Stocks, however, are another matter. By our reckoning, the rank and file of the S&P 500-stock index still offers reasonable value, though not the initial public offering (IPO) market and selected cloud computer and drug stocks. These are too hot to handle, at least for us.
How investors navigate in this upside down world is no simple matter, and most investors are not equipped to know when risk is mispriced, as it is now. There is a huge wealth transfer going on today from CD investors and other small-time savers to the financial sector. The savers are being paid next to nothing so that banks might repair balance sheets damaged in the recent mortgage crisis. This monetary policy requires small-time savers to give up their investment return so that banks can have it. It does not seem wise or just to us, and the sooner we are done with the zero interest rate policy, the better.