Review & Outlook

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

Fourth Quarter Appraisal Letter

21 January, 2015 by Mark O'Brien in Quarterly Letters

performance 1-21

As we finish one year and start another, we have to remind ourselves that the stock and bond markets are on their own schedule.  They don’t appreciate a good year, such as we just had.  Even less do they recognize or give extra credit for a new theory or policy.  Neither do the stock and bond markets care about good intentions or pressing human need.  The markets play by their own rules, and when we try to make them play by ours, whether through The Federal Reserve Board’s “quantitative easing” or other forms of fiscal and monetary engineering, we tend to get big surprises.  This is what we had in 2014, a number of unexpected developments that now, in 2015, invite reaction and even correction.

We would identify three big and unexpected developments in 2014 that could roil markets in 2015. The first development was the American stock and bond markets reclaimed the territory as the world-wide haven of investor security. Whatever mistakes American policy makers have made in recent years, their counterparts in the developed world have made more. We are “the best house in a bad neighborhood,” as the expression goes.  Investors of the world have taken note, and foreign money is pouring into U.S. dollars (at an-eleven year high against other major currencies) and American stocks and bonds.

The second development was the collapse in commodity prices, most notably oil.  The latter fell about 50% in price over the second half of 2014.  No one saw it coming, and no one, it seems, was prepared for it.  The consequences, both good and bad, promise to be far reaching.  More on this later.

The third development was the drop in interest rates.  Again, almost no one saw it coming.  It was just the opposite.  The consensus was for interest rates to move sharply higher.  For instance, the vast majority of professional economists called for the yield of the 10-year Treasury note to end the year at 3.5% or higher.  Instead the year-end figure was 2.25%, in relative terms a move as significant as that of oil.  The result was that money, already cheap to borrow, became even cheaper, and companies and countries borrowed record amounts of it.

Typically, falling interest rates, lower energy costs, and a world-wide endorsement of U.S. capital markets would be harbingers of very good things for American stocks and bonds.  But too many good things can be as disruptive as not enough.  Overnight there’s been a reversal of winners and losers.  For instance, airline stocks and oil and gas exploration and production stocks have exchanged places.  To put the matter differently, the deck has been reshuffled and the risks, while not necessarily greater, are different from those we thought we understood.

What are the new risks?  The pace of change is one.  There would seem to be nothing to stop declining oil prices or interest rates or foreign investor sentiment from lurching in the opposite direction, which would have graver consequences. Then there are industry-specific issues.  The energy sector makes up about 16% of junk bonds.  That’s up from about 6% a few years ago before the so-called fracking revolution.  These energy start-ups need oil at $80 or higher to service the debt they have taken on, but oil is in the mid-$50s.  The squeeze affects the new energy companies and the funds that bought their debt. Many emerging market energy companies have an even worse problem. They borrowed in U.S. dollars, which have soared in price.  At the same time, the prices of the commodities these companies sell have plunged.  Thus emerging-market borrowers are being squeezed at both ends.

Numerous dictators around the globe depend on oil revenues to stay in power.  Now, with their income down 50%, these strong men (Russia’s Putin most notably among them) will have added incentive to roll the dice.  So we expect new geopolitical disruptions to accompany those  we already have.

Not everyone sees volatility and disruption in the year ahead.  Indeed, if the financial press is an indication, most don’t.  Typical is this headline from the December 29, 2014 Barron’s:  “Few see much to worry about for 2015.” The article pointed to low inflation, an accommodative Federal Reserve, rising employment and  strong 3rd quarter GDP growth of 5%. So there is a variety of opinion about the road ahead, which in itself gives a healthy stability to the markets. The commentary page of our website presents a number of voices in this debate.

Whatever one’s opinion about events in 2015, one wants to take this moment of relative calm to make sure long-term asset allocations can cover short-term income and liquidity requirements, and that diversification is appropriately broad.  Then one should move on and worry about something else besides the stock and bond markets.  The following chart, courtesy of Fidelity Investments, explains why:

 

Frequent Portfolio Evaluation Prompts Risk-Averse Behavior [1]

risk aversion

The chart shows that investors who look at their portfolio once a month appear to be overly risk averse, remaining largely on the sidelines, while those who check once a year are able to keep an asset allocation more appropriate for long-term investing. I might extend the observation into this rule of thumb.  The more one fiddles with one’s portfolio, the worse one does.  Everyone knows this, but still somehow it is forgotten that most investment wounds are self-inflicted during times of perceived crisis.

 

Sincerely,

 

Mark O’Brien

 

[1]  Thaler, R. H., A. Tversky, D. Kahneman, and A. Schwartz. “The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test.” The Quarterly Journal of Economics 112.2 (1997): pp. 647-61.