Review & Outlook

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

First Quarter 2017 Appraisal Letter

Another quarter of good stock-market performance!  It is still with a little wonder that I report this, for no one saw this rally coming, its size or duration.  Yet here it is: stocks up 5.5% for the quarter, making that up 11% for the five months since the presidential election.  The latter is what one hopes for in a full year, and a good one at that.

And the news seems to be getting better, at least as regards earnings for the companies in the S& P 500.  First quarter 2017 corporate earnings are expected to be 9% higher than the year ago period. Yes, President Trump has been talking about cutting regulations and taxes and building walls and infrastructure, and that’s got investors excited.  But talk and excitement are one thing, the reality of higher corporate earnings is another.  More than anything else, corporate earnings drive stock prices. Another positive statistic is new job creation. This aging bull market may just be getting a second wind.

Thus investors are reminded that it is not time that kills a bull market.  Other things, yes; but not time. That’s fortunate, since if it were about the passage of time, this bull market would be long dead.  It started in March 2009, and now at eight years and counting its age is twice the historical average and the second longest bull market since 1928.   But even so the age of the bull market ought to raise concerns.  That’s because rising stock prices can often mask problems that can turn into bigger problems down the road.  Let me discuss several problems masked by the last eight years of rising stock prices.

The balance of power between capital and labor has shifted in recent years and not, we think, in a healthy way.  The move has been decidedly in favor of labor.  Not any kind of labor, certainly not the traditional muscular sort.  Rather I am speaking of the high-tech labor that came up with the technological innovations behind companies like Google, Facebook and Alibaba, to name a few.  Heretofore capital called the shots because there never was enough of it. But now the world is awash in capital, and high-tech labor is taking advantage of surplus capital, and the relative shortage of break-through entrepreneurial tech skills, to change the rules of investing in its favor.  We saw this last quarter with Snap Inc.’s initial public offering.  Its founders “sold” the company to the public for $26 billion.  That  price valued the company at about 60 times revenue.  To get a sense of how sky-high that is, consider that Amazon is currently trading at about three times revenue.  At any rate, “sold” is in scare quotes because Snap’s IPO wasn’t really a sale. For the first time in this history of US initial public offerings, a company issued shares with no voting rights, allowing the founders to retain complete control of the company.  How can Snap sell itself but not really?  Because it can.  That’s what happens in an aging bull market. We are surprised government regulators allow it.

Ownership and control have different interests and they can be in conflict, especially in difficult times.  No one washes a rented car. Traditional shareholder protections have grown up out of experience.  We don’t like to see companies abandon them without suitable replacements.

The last eight years have brought other developments that have us a little uneasy.  Over this period the nation’s central bank (the Fed) committed its full resources to inflating prices of financial assets.  No surprise, then, that an investing strategy committed to owning all financial assets without regard to their quality, earnings, risk management or anything else, has flourished.  What’s that strategy?  “Passive investing,” also knowing as “indexing,” is buying or selling the entire market without regard to the individual securities in the market.  Whereas an active investor like O’Brien Greene tries to own the 25 or so best companies in the S&P 500, as it understands them, the passive investor, through the miracle of computers, owns them all, the good, the bad and the in-between.

Index funds have a proper place in many investor portfolios; we buy them for our clients for a number of limited, strategic reasons.  However, if an investor has sufficient assets to diversify between 20-30 individual stocks, we believe it is superior for the bulk of his or her portfolio to consist in directly owned stocks.

In 2016 passive index investment strategies outperformed all but 30% of active  It’s been that way since 2009, when the Fed’s monetary policy became the tide that lifts all boats.  And investors have taken note.  In January 2017 $48 billion dollars fled active management for the passive strategies of Vanguard; in February $33 billion poured into Vanguard from active managers.  That’s just Vanguard.  Individuals and institutions of every stripe are flocking out of actively-managed accounts into passively-managed index funds.

Could indexing be the next bubble? Yes.  Here an anecdote is in order.  Last week the roofer working on my neighbor’s house sidled over to suggest that perhaps I too ought to have a new roof.  In the course of conversation, my roofer friend boasted of his success as a passive index investor.  In recent months I have heard several versions of the same boast from a variety of unlikely sources.  The last time roofers and auto mechanics were talking about successful investment strategies—the Internet craze in the late 1990s or the housing bubble in 2007—the trouble was about to start.  There are useful lessons to be learned from passive investing, like the impossibility of market-timing and the importance of diversification, but there are hazards too, and these are generally being ignored. It will take a bear market, sadly, to reveal them.  Snap’s IPO is a preview, because it shows the degree to which index investing has habituated the investing public into buying whatever stocks are served up by Wall Street’s bankers; the structure of a company and the integrity of its business don’t matter, so long as it meets the relatively low standards of index inclusion for S&P, Russell, MSCI, and so on.

Warren Buffet has famously said:  “Only when the tide goes out do you discover who’s been swimming naked.”  Quality still matters and you see that more clearly in down markets.  But this can be seen in the retail sector even now.  Passive investing in the retail space would mean owning trouble stocks like JC Penney and Sears, along with the change agent that’s punishing them, Amazon.

One last anecdote, also close to home, about this peculiar time in which we find ourselves.  Recently the government told O’Brien Greene & Co. to hire an independent auditor (the last 48 years the firm didn’t need one).  Hiring an independent auditor, especially one you don’t need, is an expensive undertaking, but we complied.  More recently the government told us to hire a second independent auditor to watch the first one.  We are not being singled out; this regulation is nationwide.  The regulation doesn’t work; the number of Ponzi schemes continues at the same pace as always.  The regulation can perhaps be paid for in prosperous times like these, but when the good times end, as they will, such practices will deepen and extend the hardships.

The business of managing money is often a matter of leaning against the wind.  And so we do now.  It’s our job to be a little guarded in this time of rising corporate earnings, rallying stock market, stable bonds and low inflation.

Sincerely,

Mark O’Brien