Review & Outlook

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

First Quarter Appraisal Letter

10 April, 2015 by Mark O'Brien in Quarterly Letters

alThe first quarter of 2015 saw stock prices rise in January and February (with several new record highs) only to stall out in March.  The Dow Jones Industrial Average closed on March 31st at 17,776.12, down less than 1% for the quarter.

Treasury bond yields notched lower over the quarter into the range just below 2%.  As low as U.S. interest rates are, Japanese, German, French and Italian rates are lower.  The difference between us and them contributed to the euro going on sale.  At the start of the quarter a euro cost $1.22; at the end of the quarter one cost $1.06. That’s trouble for U.S. exporters to the Eurozone. The story is much the same in Japan, where the effect of historically low interest rates has put the yen on sale when compared to the dollar.

The first calendar quarter of 2015 seems to have something to disappoint everyone.  For bears and Preppers (those preparing for the worst with hand-cranked flashlights and radios and survival food), the global meltdown didn’t happen, again. For bulls expecting six years’ worth of massive government stimulus to kick in, finally, that didn’t happen either.  And for those on the sidelines waiting for “greater clarity” before committing to stocks or bonds, they were disappointed too, because the economic and investment outlook is as murky as ever.

What is becoming clearer, though, is that the great economic models like Keynesianism, monetarism and rational expectations that failed to predict, explain or correct the 2008 financial collapse are no more adept today, some seven years later.  Whether or not these models ever helped policy makers increase employment or lower inflation–and there is considerable doubt they ever did–they are not helping now, and may be hurting.  Why?  There’s a line going around the Internet (we cannot find the source) that offers an explanation as good as any we have heard:

 In 2015 Uber, the world’s largest taxi company, owns no vehicles.  Facebook, the world’s most popular media owner, creates no content.  Alibaba, the most valuable retailer has no inventory, and Airbnb, the world’s largest accommodation provider, owns no real estate.

Manifestly, the economy has changed, and so have the markets.  Just as it was once easy to prepare one’s own federal income tax form, so was it once easy, relatively, to manage money.  Not anymore.  In fact I don’t think it has ever been harder.  Take the matter of the risk-free rate of return, which used to be the starting point of investment analysis.  Well, the risk-free rate of return doesn’t exist anymore.  After fees, inflation, and taxes, domestic money market funds and CDs have a negative yield, and many European countries actually charge investors for the privilege of lending them money.  Thus the risk-free rate of return has been replaced, as one wag put it, with return-free risk.  Everything now has imbedded risk, and often the risks are big and hidden.  One has to be a forensic accountant to identify the snare in much of the new financial

“product” created by Wall Street in response to this situation.  Particularly risky are stocks that look like bonds, and bonds that look like stocks.  Designed by financial engineers to generate income in the wake of the Fed’s zero interest rate policy, they create bigger problems elsewhere.

If a stock has a dividend higher than 4% in today’s environment, it usually means there is a problem.  Verizon (4.4% yield), Duke Energy (4.1%), General Electric (3.7%), and McDonald’s (3.5%) have above-average dividends, with average being about 1.5%.  They also have well- known problems, like heavy exposure to out-of-favor sectors like energy and banking, and/or tired products in a mature or highly competitive industry.  These grizzled and hardened corporate operators will in all likelihood overcome their problems and reward their shareholders, and one can own them in moderation in a balanced portfolio.  They aren’t the problem.  What is problem, though, is new Wall Street “equity product” that mimics them, and then some, with yields of 6-7%.  For instance, UBS ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend Index ETN (symbol: DVYL) pays a dividend of 6.6%.  Though called an equity product, these are in effect bonds, with the inherent limitations and disabilities of bonds, but with none of the protections.  Whether owned individually or in exchange traded funds (ETFs) or in mutual funds, such high-yielding equity products are accidents waiting to happen.

As for the other Wall Street product enticing the unwary, that is, bonds that look like stocks, they too solve the income problem, but also at unacceptable risk.  With the 30-year Treasury bond yielding just 2.5%, the investor has a clear marker, as one says in the trade, of where the bond market is.  Here the monikers alone should be enough to warn investors.  Consider the Pimco “Unconstrained Bond Fund” (PFIUX) which promises to go anywhere, do anything (including leverage) to enhance yield.  In sum, then, if the yield of a junk bond, a limited partnership, a master limited partnership (MLP), real estate investment trust (REIT), an ETF, or a mutual fund made up of these, is 7 or 8%, you know there’s a lot of leverage and risk inside.  These hybrid securities have no fixed, final maturity date and no earning potential.  They combine the riskiest features of stocks with the riskiest features of bonds.

If nothing changes–that is to say, if inflation, investor sentiment, economic growth, employment, personal income and corporate profitability stay the same–these new high-yielding financial products will work out.  But if economic conditions deteriorate, these new products will start to fall apart.

What’s the bottom line?  Be suspicious of anything with an above-average yield, whether stock or bond. We are relatively late in the investment cycle and the likelihood of a government policy error seems high.  In times like these it is best to stay in high-quality and simple-to-understand stocks and bonds, which have proven they can ride out just about any storm.




Mark O’Brien