Review & Outlook

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

Third Quarter 2017 Appraisal Letter

19 October, 2017 by Mark O'Brien in Quarterly Letters

In early 1987 I quit my job at the private bank of Brown Brothers Harriman & Co., where I had learned the money management trade, to go out on my own. Somewhat in the Whig tradition of Alexander Hamilton, Henry Clay and Abraham Lincoln, I was progressing from day laborer to business owner. It was an exhilarating time in life, though the exhilaration would not last. I did not know it at the time, of course, but I had stepped out just in time for the great stock market crash of October 19, 1987.

I bring the subject up now for a very practical investment reason. The investment climate in which we find ourselves today, in early October 2017, is remarkably similar to the investment climate in early October 1987, to the result that the attitudes and practices understood to have worked, or not worked, then can probably be counted on to do the same now.

Readers will remember that the stock market lost 23% of its value on that day. In contemporary terms that translates into 5,000 points on the Dow Jones Industrial Average. A fall of this magnitude is not uncommon over the course of an entire bear market, which might be a year or even longer. But for such an event to occur in a single day was unprecedented. Indeed, the crash and the accompanying panic, both institutional and individual, remain the great financial catastrophe of the modern era. For the nation as a whole, it was the great crash that did not end in depression, as opposed to another famous crash in 1929. And much good reform followed in its wake. For individual and institutional investors, however, it was another story. Whether one survived the crash or didn’t depended in large part on what one did, or didn’t do. Luck played a role too, as it always does. But investment philosophy made the critical difference.

In the weeks and months leading up to October 19, 1987, a sense of “this cannot go on forever” filled the air. Between September 1986 and August 1987, stocks went from 16 times earnings (a PE of 16) to a PE of 21 times earnings, a 33% increase. That put the stock market valuation at its highest in 20 years. Today the stock market is trading at a PE of 25. It is up 180% from its low in March in 2009. On September 18th I glanced at this front page headline in Barron’s Magazine, “The Dow hits record highs four days in a row.” Several weeks later on October 9, the same publication ran this front page headline: “Dow climbs for fourth week in a row.” All this despite three hurricanes, a horrible massacre in Las Vegas, and nuclear saber rattling with North Korea. The market seems invincible, which again brings those words to mind: “This cannot go on forever.”

In October 1987, the financial media did not want to say that the market was over-valued and headed for a big correction; neither did they want to say stock prices were going higher because corporate earnings were accelerating. I suppose the media did not want to say one way or another because they didn’t want to be wrong. So they hedged their bets and said both. One day the story was how some sophisticated investors were making money, a lot of money, through high tech trading techniques; the next day the story was the grossly overvalued stock market. Today, the media are hedging their bets with the same two, alternating stories. One suggests stocks are headed higher, the alternative that they can go no higher, they are maxed out. It is a frustrating mix of foreboding and optimism, and altogether not much guidance.

Another parallel between now and October 1987 is the role of financial innovation. We have been conditioned to think that innovation is a good thing, and generally it is. But there are exceptions, and one may apply to the investment business. Here the repackaging of risk, even the disguising of risk, is often represented as innovation. In 1987 the particular innovation was called “portfolio insurance.” It promised to reduce market risk and make money in down markets as well as in up markets through the “programmed trading” of stocks, futures, and options. It was the black box of the day, that is to say, so long as it worked, investors didn’t care how. It worked as promised until October 19, 1987, when it stopped working. Then of course portfolio insurance did more than stop working: it made matters worse, a lot worse, transforming a garden-variety correction into a great stock market crash.

The comparable investment innovation at the present time is called “passive investing.” It involves the owning of entire markets (e.g., all the stocks in the S&P 500) through derivative securities called exchange traded funds (ETFs) and index mutual funds. It is a process that forsakes a real assessment of the quality, or lack thereof, of each and every business. Due to the general ease of its implementation, passive investing has exploded in popularity. But because it does not discriminate between good businesses and bad ones, market valuations have been driven up across the board. On top of this, the Federal Reserve Bank has similarly used “quantitative easing” to drive up the price of bonds and, at the same time, lower the borrowing costs of marginal companies. Again, this has pushed everything higher in price without regard to quality, prospects, and valuation.

There are other similarities between now and 1987 that I don’t have time or space to go into, like rising interest rates. But let me stop here. I do not want to overstate the point; I do not want to suggest that there is an identity between the market in 1987 and the market in 2017, and that we’re on a timetable to an inevitable stock market crash. For surely the economy is different today. At the very least it is much more complicated. Even so I would say that a few commonsensical practices that worked in 1987 will do so today. Similarly, bad practices then still are bad practices. Let me give one or two examples.

Trying to avoid market peaks, with the intention of jumping all to cash, sounds like a good idea, but upon closer inspection, the effort turns out to be a species of market timing that won’t work. And it can lead to costly consequences, like selling after a downdraft, after all the damage has been done, just in time to miss the inevitable rebound. This was the common error in 1987 and 2009, which cost years’ worth of appreciation to personal and retirement savings.

Ben Graham, the great teacher of Warren Buffet, said an investment philosophy should allow for human error, bad luck, and many things going wrong at once. It is the last of these that bothers me about innovations like passive investing. It has not yet been really tested. Supporters of passive investing, of whom there are many, ask what could go wrong. A lot, as we saw with portfolio insurance in 1987. Thus we keep the bulk of our portfolios in individual stocks and bonds. The formula has been tested, and proven.

An acquaintance recently called me to ask if he should be fully invested, given the height of the market. The answer, I said, was not so much a matter of whether one should be fully invested as how. As long as one owns a mix of individual stocks at reasonable valuations, quality bonds with fixed and certain maturity dates, a healthy reserve of cash and – – most important of all – – a long term perspective of three years, then yes, by all means, one should be fully invested. That’s what I said in 1987 and it worked, and that’s what I would say today.

It is for this reason that we work to provide all of our clients a portfolio that includes high quality companies at reasonable valuation, companies that we know and understand well. We endeavor to own businesses that possess durable competitive advantages, those that ought to appreciate more in good markets and depreciate less in bad markets. In addition to quality bonds and healthy cash reserves, we think that this situates our clients well, regardless of what the future holds.

Mark O’Brien