Review & Outlook

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

Third Quarter 2016 Appraisal Letter

19 October, 2016 by Mark O'Brien in Quarterly Letters

October 14, 2016


Stocks performed strongly in the third quarter of 2016.  In addition to the S&P 500 Index (+3.31) the Dow Jones Industrial Average rose 2.2% in the quarter, the technology-oriented NASDAQ rose 9.7%, and the Russell 2000, a measure of small-capitalization domestic stocks, rose 8.7% in the period.  Bonds were generally off, with the  U.S. Treasury (1.625% due 05/15/26) down 1.11%.

These stock indices are of course averages, which mean that within each some stocks went down in price while others went up.  In examining the internal mechanics of what went up and what went down last quarter, one finds the news is even better than it appears, for the stocks that went up were not “fear stocks,” the bond substitutes like utilities, that the quarter before surged because investors regarded them as a place to hide from the fallout over Brexit or terrorist attacks.  Rather the best performing stocks in the 3rd quarter belonged to companies with new products and higher earnings, like Apple, which released a new iPhone in September.  Its shares rose a robust 18% in the quarter.

The upshot is that investors were looking at the right things again.  In the first half of the year they weren’t; they were looking for high dividends at the expense of all else. Thus stocks with relatively big but unsustainable dividends were driving the market higher.  This obsession with current income, even unsustainable current income, appears to have abated, fortunately. I say “fortunately” because the clamor for income looked like a bubble, which can do real damage.  But now investor attention is focused more on corporate earnings and less on high dividends.  In a normal and healthy economy, this is how it should be: stocks are the appreciation vehicle and earnings are the fuel that powers it.

If the good news is investors are looking at corporate earnings again, the bad news is that corporate earnings in the aggregate are not looking very good.  They are expected to fall in the third quarter 2016, and they have already fallen about 3% over the previous four quarters.  When corporate earnings fall, but stock prices don’t, the commonly-used measure called the price-earnings ratio (PE) expands, and stocks get more expensive, even if prices are unchanged. It is not a healthy development.

Stock prices are still up nearly 200% since the 2009 low.  But the economy has not grown with them.  Altogether it has been the weakest economic recovery since the 1930s.  Personal income grew five times faster in the Clinton recovery of the 1990s, seven times faster in the Reagan recovery of the 1980s, and ten times faster in the Kennedy recovery of the 1960s (WSJ, Gramm 8.4.16).  What’s the problem today? Fiscal and monetary tools are not working.  In terms of fiscal programs, the Obama $836 billion spending package, larger than all other stimulus programs combined, had little positive effect, though the debt incurred still has to be paid back. In terms of monetary programs, the Federal Reserve has injected $3 trillion of new reserves into the banking system to generate record low interest rates in the hope that that might stimulate the economy.  It manifestly is not working either.

Where does this leave us? The story of markets, if not entire economies, is one of challenges and responses to challenges.  Not long ago our country was running out of oil, and the fear, if not the forecast, was something akin to freezing in the dark.  Now we are awash in cheap oil. The present economic challenge is getting rid of, or at least reconfiguring, government policy that is over-stimulating, over-taxing, and over-regulating the private sector into 1930s-style stagnation.  It would be nice not to have such challenges, but the thing to remember is that every challenge brings a set of new opportunities.  That was true in the 1930s, and it is true today.

In terms of the appropriate investment response, let me start with what not to do.  The one-decision remedy like “buy gold” or “buy real estate investment trusts” or “buy high-dividend-paying stocks” or “put everything into cash” is almost certainly a mistake.   As with trying to time markets, one cannot be lucky enough, especially over the long term.  I am reminded that the Sage of Baltimore, H.L. Mencken, famously said: “Every complex problem has a simple answer, and it is invariably wrong.”

In a similar vein, I often hear salesmen on the radio promising to “crash-proof”  retirement portfolios.  It, too, is a simple solution to a complex problem that is invariably wrong for reasons of the high cost, illiquidity and inflexibility embedded in annuities and other so-called crash-proof products.  No, the better course is to maintain flexibility through a diversified and balanced portfolio of multiple asset classes, including individual bonds, stocks and money market funds.

The presidential election is just weeks away and a few concluding words on the outcome are appropriate.  In earlier letters I have predicted that the markets would hold up until the election.  I still think that. Then, if Hillary Clinton wins, which appears likely, I expect a short period of stock market elation.  She is, after all, the candidate of Wall Street. But I doubt the elation will last.  There is the nasty business of declining corporate earnings and then the first year of a new presidency has historically been bad for stocks.  That’s not so much a reason as just an observation.  Finally it has been an unusually long time (seven years) since we had a real stock market correction.  We are overdue for one.  What If Trump wins which, we are told, is more likely than the polls would suggest?  The result could be a bit like the aftermath of the Brexit vote:  a sharp selloff, and then a rebound as investors rediscover that the president is part of a much larger system of overlapping and competing majorities, and that he alone is not all that powerful.  Speaking of federalism, the stock market prefers the president and Congress to be from different parties, which is, the polls say, what we will get.


Mark O’Brien