Review & Outlook

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

Second Quarter 2016 Appraisal Letter

The performance statistics shown above appear tame and even ordinary, and do not begin to describe the distorted condition of the capital markets in which investors find themselves today.  I have never seen anything like it, and I have seen a lot, including 20% interest rates in the 1970s, Portfolio Insurance and the 1987 stock market crash, the Internet and high-tech bubble in the late 1990s, and the housing bubble and Great Recession of 2008-9.

Unique about the present time is the role reversal between stocks and bonds.  Stocks have always been the price-appreciation vehicle, and bonds have always been the income vehicle.  Institutions, practices, expectations – – everything about investing – – have been ordered to these two archetypes. That is, until now, when stocks are acting like bonds and bonds are acting like stocks.  It is not just nomenclature that is at stake but long-held and long-shared understandings.  Change them and you change the culture.

The role reversal is most complete in the government bond markets of the developed world.   For instance, the 30-year U.S. Treasury bond, which has a yield to maturity a bit in excess of 2%, rose 17% in price in the first half of 2016.  The story is pretty much the same in the rest of the developed world, including France, Germany, Spain, Italy, the United Kingdom and Japan.  The 40-year Japanese government bond rose 96% in the first half of the year, as measured in pounds sterling.  The bond looked like an Internet stock in the high tech bubble of 1999.

Meanwhile, prices of the traditional appreciation vehicle, common stocks, plod along in the way bonds used to.  In the United States, where stock dividends actually exceed government bond yields, the stock market is barely positive on the year. To the extent a stock group has done well, like utilities, it is because it has dividend income.  The fact that it has little or no earnings growth doesn’t seem to matter.  As long as it acts like a bond, that is enough for this market.

Why have stocks and bonds reversed roles?  I think the Federal Reserve and other central banks in the developed world are at fault.  Some two hundred years ago Alexander Hamilton set the standard for central bankers when he reconfigured a mountain of near-worthless state and national Revolutionary War debt into the U.S. government bond market, and a miracle of prosperity ensued.  In the hands of genius, monetary intervention can achieve desired outcomes.  But in the hands of people who are not geniuses, strange and unintended things start to happen, like the Japanese government bond doubling in price in 6 months.

Politicians share the blame too. They have encouraged monetary authorities to figure out a way for their respective nations to continue to live beyond their means.  The central banks have responded with clever monetary experiments, like quantitative easing and zero and even negative interest rates, in the hope they might increase employment, wage growth and national income.  The experiments have not achieved these objectives, but they have managed to turn the world of investing upside down.

Businesses and investors are waiting on the sidelines for things to return to normal.  Companies are not investing in new plant and equipment, and people are buying gold, that non-productive asset, expensive to keep, but in times of uncertainty a store of value.  In the first half of 2016, its price jumped from $1077 to $1320 an ounce.

What should individual investors do in the upside- down world in which they find themselves?   For starters, forget about the risk-free rate of return available until recently in the government bond market.  Monetary authorities, who want investors to take more risk, have put an end to that.  Now the closest substitutes are corporate bonds, preferred stocks (which is a form of bond), municipal bonds and, maybe, utility stocks, although the latter are on the cusp of being too expensive. These groups pay yields in the 3% and 4% range. And as long as one stays with high quality issues, their credit risk is minimal. Reach for a little extra yield, however, say something in the 6% or 7% range, and there could be a credit problem.  This is the rule of thumb in a low-return environment:  a little extra yield usually means a lot of extra risk, and it’s not worth it.

Earning assets like farmland and second-tier commercial and residential real estate, away from major metropolitan areas, may be a very good investment, although they do have a downside: they tend to be illiquid and labor intensive.  Who wants to spend one’s free time collecting rents, mowing hay, fixing faucets?  Sometimes available in financial assets like REITS (real estate investment trusts), they have to be evaluated on a case-by-case basis, because their fine print can hide excessive risk.

We have come across an acronym that describes the appeal of common stocks: “TINA.”  It stands for “There Is No Alternative.” High-quality stocks, while not cheap, are a bargain compared to CD’s and bonds, which are the most expensive they have been  in history.  And stocks, over the medium to long term, tend to have growing earnings.  If you buy a high quality stock at what at first appears too high a price, growing earnings will, eventually, bail you out.

At the start of the current quarter / the end of the last one, U.S. stocks demonstrated encouraging resilience in the face of the Brexit.  After the initial 5.6% drop, stock prices bounced back to where they were before the vote.  In the trade, this is called “support” and it is a good sign. There are other encouraging signs. The price of oil is rallying and energy companies are resuming the exploration and production of petroleum products, which helps a host of other industries. At the same time, gasoline remains low enough on an absolute basis, which puts disposable spending money in consumer pockets. Employment is up, too, adding further support to the TINA thesis.

The Brexit vote seems to be the Rorschach test of the present moment, and a few words are appropriate.  In terms of what happens next, we are reminded of another highly controversial referendum, Proposition 8, and the definition of marriage in the State of California. Also passed in referendum, it had no supporters in high government office.  With no one to enforce it, Proposition 8 eventually died at the hands of unfriendly judges. Something similar may be in store for Brexit: twilight membership in the EU, lingering longer than anyone expects, with much bitterness and political wrangling but not a lot of substantive economic change.  More interesting than the outcome, however, may be issues raised about governance in modern and complex democracies in the developed world.  Who should decide?



Mark O’Brien