Review & Outlook

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

Second Quarter 2017 Appraisal Letter

11 July, 2017 by Ben O'Brien in Quarterly Letters

Yet another quarter of good stock market performance!

Close readers of this report will note that I used the same words to begin my last appraisal letter to clients, that for the period ending March 31, 2017.  And in the appraisal letter for the quarter before that, the one ending December 31, 2016, I tried to convey the same sense of surprise, even astonishment, with these opening words:   “Whoa! the 4th quarter (of 2016) was something, but then the whole year was something.”

To continue that string of surprises, the good performance last quarter was accompanied by exceptionally low volatility.  According to the Wall Street Journal (June 28, 2017, p.B-1), the quarter was one of the quietest periods in market history.  The sub-caption to the Journal article described the markets in general as “A World of Calm.”

And it is not just the U.S. stock and bond markets that are calm.  The entire American economy is too, and so are economies everywhere else in the world.  Altogether, said the Journal, “global GDP is exhibiting the lowest volatility in history.”

Why should investors care if markets and economies are calm, even unusually so?  In the language of markets and finance, volatility is a synonym for fear.  Indeed, the Chicago Board Options Exchange (CBOE) Volatility Index goes by the nick name “The Fear Index.”  Fear generally drives markets in unhealthy ways.  Most investors would take confidence any day, though there are those who prefer to see a Goldilocks balance of fear and confidence, with not too much, or too little, of either one. But the current measurement suggests a surfeit of confidence.  In the immediate term, that is comforting, as in “Phew, at least we’re all right for now.” Longer term, however, it is a little worrisome.  That’s when one hears the word “complacency” along with comparisons to pre-crash conditions in 1987, 1999 and 2007.

My take is that the markets and economy may not be as calm as the low reading on the Fear Index would indicate.  Using nothing more systematic than the seat of my pants, I would say that people, especially investors, are plenty fearful.  What’s unusual about this time is that investors do not know how to act on their fear.  That’s because central banks in the United States and abroad, using stimulus programs composed of near-zero interest rates and quantitative easing, have taken away the safe harbors (CDs, money market funds and bonds) where investors used to be able to hide.

Investors are especially upset about risk, because central banks have taken deliberate action to confuse them.   I could give examples from the U.S., Asia and Europe, but let me take one from Europe.  Central banks are propping up junk bonds there, so much so that their yields, which move in the opposite direction from their prices, are lower than the yields of European stocks.  This report, courtesy of Bank of America’s Merrill Lynch, may sound like typical Wall Street double talk, but it is worth thinking about for a moment.  It highlights the extraordinary reversal of a normal risk-reward relationship and, in my opinion at least, the heart of the problem facing Europe, America and Asia.  The so-called price mechanism is broken. That is to say,  If an economic actor (a businessman, investor, whoever) cannot figure out the risk of an asset, he cannot put a correct price on it.  And when people cannot assess the right price of an asset, or a course of action, they tend to withdraw, and wait until they can.

That’s how I would explain the current calm: it is more a withdrawal from normal economic activity than an assessment of future prospects.  It is more a sign of stagnation than complacency, and it explains why economies in the developed world have been unresponsive, in terms of labor force participation rate, income growth and capital spending, to unprecedented levels of government stimulus spending. If GDP growth is normally in the 3% range, ours is about a third of that. How long can the economy stay anemic? A long time. In the U.S. interest rates have been near zero for nine years and there’s no reason they won’t stay there for another nine.  This is the experience of Japan, where ultra-low interest rates designed to stimulate the economy have had the opposite effect.

One last example might give some perspective to the problem. In the late 1920s the farming sector lobbied the federal government to help it get through a post-war recession.  Congress and the president responded with a big new program of federal farm banks that allowed farmers to borrow up to 50% of the value of their farms at artificially low rates of interest.  (Sound familiar?) Despite the easy credit and huge expansion in the money supply that followed, prices fell even further.  That’s because farmers used the subsidized credit to buy more land, which they farmed intensively to repay the debt.  Along the way they produced bigger surpluses of wheat, corn, hog bellies, you name it, to send prices into total collapse. Instead of inflation, all the new money resulted in deflation and stagnation.

The point is this: when government tries to do too much, the bold action can set unintended forces into motion. In the U.S. 2008 to the present, the Federal Reserve quintupled its balance sheet to buy bonds for “quantitative easing,” and the federal government doubled the national debt for stimulus-spending programs. At the very least, unwinding these programs will take time.

Let me turn to the stock market.  Notwithstanding the calm markets and anemic economy, a few sectors are caught up in speculation.  Well known are Amazon and Netflix, which have astronomical valuations of 153 and 287 times trailing earnings, respectively.  Most stocks, however, while not cheap, are not particularly expensive either, trading at about 23 times trailing earnings and 18 times forward earnings.  This is where investors should be.  If there is a pullback, they will not fall as far as Amazon and Netflix.

Usually money market funds and bonds are a big part of diversification.  But with their yields close to zero, where they are likely to remain for the foreseeable future, the lion’s share of diversification and risk reduction should go to ordinary companies at reasonable valuations and  sustainable dividends. Like what?  Recent additions to our list of stocks have been in the much maligned retail sector, reeling from competition with Amazon.  Here we think that U-Haul parent Amerco, Tanger Factory Outlet Centers, and Dollar Tree will survive and prosper in this time of slow economic growth in which we find ourselves. They are good businesses at reasonable valuations.

So much happening and so little space.  For more commentary on the markets and the economy, visit our website, or call me or associates Matthew, Stephen and Sally on the phone.  We would love to hear from you.


Mark O’Brien