Review & Outlook

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

First Quarter 2016 Appraisal Letter

28 April, 2016 by Ben O'Brien in Quarterly Letters

What to say about the first quarter, when stock-market happenings bordered on the bizarre?   With two weeks left to the end, the March 18 edition of The Wall Street Journal ran this front-page headline: Dow Industrials Turn Positive for 2016 as Oil Rises and the Dollar Falls.

A large graph beneath the headline plotted out the extraordinary price action of the Dow Industrial average.  A perfectly-shaped “V” showed stock prices plunging 10% in the first half of the quarter, then rebounding 10% in the second half, to finish the quarter about where they started.  In a good year stocks might go up 10%, or, in a bad year down 10%.  But to do both in the space of a single quarter, a mere 12 weeks, suggests tectonic forces in precarious balance.  The headline mentioned two such forces, the dollar and oil.

A falling dollar may not sound like a powerful force.  Currencies always seem to be falling, or rising, and the news doesn’t swing markets.  But this time the falling dollar is freighted with significance.  Central bankers around the globe are trying to weaken their currencies against the dollar to stimulate their economies.  None more so than the Bank of Japan, which pushed down its currency to “jump-start its economy” (that over-used expression) with negative interest rates. Think about it.   Negative interest rates means that corporations and other debtors are paid to borrow money.  Think of the mischief this could cause, including more asset bubbles. This monetary policy is powerful, new, and untested. And it is not working.  No, not even close. The yen is up 8% this year against the dollar, which means Japanese products are that much less competitive in world markets.

Other central banks, including the U.S. Federal Reserve, are having similar problems with their policies.  It seems all the central banks are using more or less the same tools and they are not working, or at least not as intended.  Why?  The March 18 Wall Street Journal blames the long stretch of zero and near-zero interest rates (2008 to the present) for distorting markets and economies, and the fact that all the central banks are using the same tools, largely offsetting each others’ efforts.  Whatever the reason, those tools are not doing what they are supposed to do, and the proof of this is that efforts to stimulate economies are having the opposite effect.

The headline also referred to soaring oil prices, up some 50% in February and March. That big percentage increase is a bit misleading, because it comes off an exceedingly low base.  But even so, one sees how fast the price of oil can change when supply and demand fall out of balance, and it explains why oil giants Exxon Mobil and Chevron were up 8.4% and 5.9% in price last quarter, after cratering in 2015.

On a long-range and absolute basis, energy prices are still very, very low.  This may be good for consumers driving cars and heating homes, but still hurts energy companies trying to pay their bills. The major companies like Exxon, BP, and Chevron are replacing in inventory only about 75% of what they are selling, because the exploration and production costs far exceed the price at which they can sell the oil.  As a result, their reserves are falling or, to put it in different terms, their shelves are growing bare. As for little energy companies, those that exploded onto the energy scene earlier in the decade, they are going out of business.  The Journal reported on March 25 that over 50% of bank loans to new oil producers are in danger of default.   With further decreases in supply, energy prices could snap back again, with big disruption to the economy.

In sum, then, the first quarter of 2016 leaves us with a legacy which is also a forecast for the period up to the November presidential election: stock price volatility without clear direction; the energy sector looking increasingly accident-prone; policy makers at home and abroad trying out powerful new tools (negative interest rates, quantitative easing) which they, manifestly, don’t know how to use. Altogether we don’t think central bankers can avert major economic ills like inflation and deflation.  Central bankers around the globe have repeatedly said they are trying to get businesses and investors to take more risk, but it is not clear that even this is an appropriate goal.  Bottom line, investors are on their own.  But this is the way it always is.

In one very important respect, however, investors should be grateful for the first quarter of 2016. The 10% drop in stock prices during the first half of the quarter amounted to a lifeboat drill, and you can never have enough of them.  Especially now.  The memory of 2008-2009 has faded after six years of higher asset prices, and the temptation is to expect the future to look like the immediate past. It doesn’t work that way.  The big lesson, then, is this:  If you had trouble getting through the period January to mid-February 2016, when stocks fell 10%, then you probably need to lighten your stock allocation.  For the next time stocks go down, it will likely be more than 10%, and it will likely take longer than six weeks for them to come back.

Going forward we may have to get through turbulent times.  We’ve had six years of up markets, and we are overdue for something.  Through the presidential election, my hunch is that the markets should be all right; people are distracted by the election.  But after that it’s questionable.  The first year of a new administration is typically not a good one for the markets, although no one knows why.  And on the global stage things look unsettled.

But investors can still be optimistic about the long-term outlook.  A recent Bain & Company study found that 60% of high-net-worth Chinese have applied for or are considering emigration to the West.  Along with this there is a Chinese corporate buying binge of enormous proportions.  In 2015 Chinese companies spent $107 billion buying every sort of U.S. company; in 2016, reports The Wall Street Journal, they spent that much again, and it’s only the first quarter. And they are paying cash. Close to home, the Philadelphia Inquirer reported a curious fact.  The Archdiocese of Philadelphia is renting out empty rectories to Chinese boarding students sent here to attend parish schools.  All this says that, on a relative basis, the outlook must be awfully bad in China or awfully good in the United States.




Mark O’Brien