Review & Outlook

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Third Quarter Appraisal Letter

24 October, 2014 by Mark O'Brien in Quarterly Letters


The feel of the market has changed.  To use a Wall Street term, investor sentiment has swung from complacency at the beginning of the quarter to an emotion bordering on fear at the end of the period.  Thus a piece of routine bad news that would have made little impression on stock prices in July could – – and did – – trigger big sell-offs at the start of October. A case in point was the 238 point drop on October 1.  There was no real news, yet the size of the stock sell-off recalled to mind stock market collapses in Octobers 2008, 1998, 1987 and, of course, October 1929, though I wasn’t around yet to witness that one.

Why the change in investor sentiment, and what does it mean?   Investor sentiment is notoriously fickle.  It tends to change in the twinkling of an eye, and often for no apparent reason.  But one might well ask if something more lasting, and more important, is behind the gyrating stock prices.  We are inclined to point to commodity prices, which have fallen sharply. The price of oil began the 3rd quarter at about $106 a barrel and ended the quarter at $92 a barrel.  As I write this letter, oil is $87 a barrel.  That is a big move, especially for such a widely-used commodity.  And it is not alone. Precious metals like gold and silver and agricultural and industrial are also falling in price.  One’s first inclination is to say great, we have no inflation.  But there appears to be a bigger problem at work.  Economies in China, India and Europe are manifestly slowing down, and therefore using less, and demanding less, materials and equipment from the rest of the world, including the United States.  So it is that their slowdown threatens to become our slowdown.  This would appear to be the problem the market sees.

The other thing going on, or more accurately not going on, is the serial monetary stimulus program called quantitative easing (QE).  October 2014 marks the official end of it.  Understand, also, the significance of this.  Month in and month out for the past four years, the Federal Reserve Board bought billions and billions of dollars of mortgage-backed securities and government bonds.  In three massive waves of buying (called in turn QE1, 2 and 3) the government shored up bond prices and along with them the prices of stocks and other “risk assets.” That buying program is over, at least for the time-being.

I say for the time-being because, at the first sign of trouble, say the stock market falls 10% in price, we bet a new quantitative easing problem (QE4?) will spring to life.  This, after all, is how QE2 came into being and after it, QE3.  Public officials don’t have a stomach for what in polite company is called a correction and what the rest of us know as a bear market.  So, if we have a bear market/recession (and we are overdue for at least one), the Federal Reserve is unlikely to allow a real purging of weak companies.  With the lowest interest rates in history, and the serial quantitative easing programs, the government is committed in effect to maintaining a floor under stock and bond prices and providing marginal businesses, which should be allowed to go out of business, with low-cost money to borrow.  A lot to do.

Is it good policy to try?  We don’t think so, but we appear to be in the minority.  Countries in the European Union have embraced an even more aggressive form of quantitative easy, and they too are keeping interest rates at even lower levels than the U.S.  in an effort to prop up exhausted and inefficient borrowers and protect them from recession. The result of this government administration is slow growth.   In such a climate businesses are waiting and watching.  They are not reinvesting in themselves. This happened in the U.S. during the Great Depression, in Japan over the last 30 years, in Europe now, and threatens to happen in the United States.

Growth becomes increasingly difficult to find, that is, at a reasonable price.  Various cloud and biotech stocks promise growth but at excessive valuations.  One place to find growth is domestic small-cap stocks.  The small-cap stock market, as measured by the Russell 2000, fell nearly 8% in the third quarter.  So this appears to be a good entry point.  We also like small-cap stocks because they don’t rely on Europe and Asia to the same extent large cap stocks do.  They get 14% of their profits abroad, as compared to 30% for the big companies in the S&P 500.

In addition to small-cap stocks, some very fine large-cap stocks have had big pull-backs recently.  Schlumberger, the great oil service company, fell 14% in the quarter. Exxon, whose creditworthiness exceeds that of the United States government, fell 7% in the period.  EOG, the beneficiary of the natural gas revolution in the United States, fell 15% in the quarter.  Chevron fell 9% over the same period.  Macy’s seems to have struck the right balance between brick and on-line retailing; its earnings are growing at a double-digit rate.  The on-line travel and restaurant agent Priceline also has double-digit growth at a reasonable valuation.  We would not hesitate to buy any of these.  With the exception of Priceline, which pays no dividend, these companies pay bond-like dividends while one is waiting for stock price appreciation to occur, and the great democracies to get their fiscal and monetary policies in order.

On a slightly different note: the process of writing this quarterly letter has always been a big help to me.  I have always thought that the act of writing tends to clarify thinking by pointing out holes in logic and thinness in evidence. Along these lines, the commentary page of our website ( is a useful discipline for us as well as a good way for clients to stay up on the great investment issues of the day.  Please visit the site and let us know what you think.



Mark O’Brien