Investment Update

A Tentative Start

On the heels of the strong finish to last year, stock market averages posted flattish to moderately positive results for the quarter. Beneath the surface of this relatively lackluster outcome are several observable shifts from recent trends.

  • A pick-up in volatility during the quarter follows last year’s relatively smooth ascent. Stocks dropped 6% in January and followed that up with an 8% recovery.
  • Investors are seeing stocks trade more on their own fundamentals and less around big-picture global risks, translating to a wider divergence in performance among different segments of the market.
  • The recent incursion of Russian forces in the Ukraine has increased geo-political tensions, but it has not become a driving force behind stock prices like in recent years.
  • The prospect of accelerating economic growth was dampened by weaker holiday sales and weather-related softness in recent business and employment data. As such, interest rates did the unexpected and rolled over after year-end, with the 10-year Treasury declining to 2.7% from 3%.

Momentum Stalls

The first quarter was a dichotomy of sorts, with more defensive investments like utilities, health care and dividend paying stocks performing well, while at the same time, there were signs of increased speculation. Reminiscent of previous market peaks, new public stock offerings (IPOs) – at what would seem unsustainable valuation levels – were well received, margin debt on stock purchases exceed previous highs, and investor demand for lower quality corporate debt was strong. This increased appetite for risk among investors is a sign of both a healthier market (in terms of returning to normalcy) and a bull market that is moving into a more mature stage.

In an interesting twist, the momentum story-stocks popularized by the media – Tesla, Netflix, Twitter, 3D printing, Facebook, Celgene, to name a few, took a tumble near quarter-end as investors took cover in big-cap Value holdings. It is hard to read too much into this shift, for no other reason than it may completely reverse by the time this note is distributed, but this reversal of fortune coincided with Fed talk of higher interest rates occurring sooner than expected. Those concerns have again been put on hold, but they will inevitably return and perhaps we got a glimpse of how higher risk investments will fare when that happens.

For the quarter, the S&P 500 advanced 1.8%, the DOW declined 0.7%, the NASDAQ gained 0.5%, larger-cap was generally better than small, Value bested Growth, European returns were barely positive and Asian and less developed countries lost ground. Bonds returns were modestly positive, benefiting from the pullback in interest rates and continued tightening of credit spreads.

Outlook

Analysts have been actively taking down their 2014 earnings estimates but weather-related excuses may reduce the impact that Q1 earnings disappointments could have on the market. It does, however, set the stage for a pick-up in economic activity, come spring. How the market reacts to better or worse than expected earnings and top-line growth is complicated by the transition in the Fed’s monetary policy.

Having grown accustomed to the “bad news is good” scenario with the Fed providing the safety net of excess liquidity, the market has yet to get comfortable with the “good news is good” outcome as this safety net is being withdrawn. In spite of Fed assurances, skeptics are not convinced that the tapering (gradual stimulus wind-down) is not tightening. In fact, a little good news on the economic side could go a long way in moving interest rates back to year-end levels and triggering more stock volatility.

Surprises would include an escalation of risks in the Ukraine, China allowing their economy to slow, a spike in energy prices, Europe adopting U.S. style monetary stimulus to boost economic growth and the Fed changing the pace of the unwinding process. In the long-run, a stronger
U. S. economy is good and getting back to interest rates in equilibrium with economic fundamentals rather than artificial support is also good, but the transition process to get there changes the “Fed’s got your back” mindset that investors have grown accustomed to. For firms like us, where the research focus is on evaluating individual companies, this volatility means we may have more opportunities to pick up the companies we want to own at better prices.

Five Years from Now

March 9th of this past quarter marked the five year anniversary of the low point in the financial crisis. Much analysis has followed to understand how a collapse like this could have happened and how it could be avoided in the future. Wall Street Journal columnist, Jason Zweig, recently offered his insightful views on lessons learned from the crisis. With stock prices (and earnings) now fully recovered and more, we thought we’d elaborate on some of these lessons in the context of what investors were expecting five years ago and how the market experience since then can help us think about the next five years.

  • The events of five years ago left a lasting impression on the psyche of investors. The “black-swan” nature of the collapse (referencing a sequence of events never contemplated) left investors feeling vulnerable that something like this could happen for reasons they could not imagine in advance. The experience of the past five years shows the lingering fear of another financial collapse kept many investors under-invested in the market’s subsequent recovery. There is a well understood tendency in decision making to relate both the magnitude and/or freshness of an event with the frequency. In other words, the greater the consequence or ability to recall, the more likely people will overestimate the probability of an occurrence (i.e., lottery tickets, plane crash). While the possibility of another financial collapse occurring in the next five years cannot be ruled out, the likelihood is very small. In fact, the occurrence of a black swan event actually reduces the odds of a reoccurrence, because by definition, it becomes a known risk.
  •  Investors have reason to be skeptical of so-called expert advice. Few can legitimately claim they foresaw the debacle and most were expecting further downside when markets finally hit bottom. The recovery of the past five years has humbled most strategists and prognosticators, especially those who have constructed bear case scenarios all the way through to new market highs. Continued skepticism toward those providing a precise picture of the future, especially with the intent to scare, should serve investors well. Howard Marks, a well-known Value investor reminds us to be careful of the investment Guru who got it right “once in a row.”
  • The memory of what it felt like to be in the midst of a market collapse can’t be replicated by a risk tolerance questionnaire or from reading history books. Those who felt compelled to become more defensive after the last decline should ask themselves why they would expect to feel any different the next time. Financial writer Jerry Goodman (pen name Adam Smith) was quoted as saying “If you don’t know who you are, the stock market is an expensive place to find out.” In the same spirit, a market at near all-time highs is an ideal time to reassess your risk profile and evaluate the options without being compromised by emotion. No doubt the next five years will include challenging times for long-term investors, but going in with a balance between safety and growth appropriate to one’s own circumstances will provide the best chance of capturing the long-term rewards.
  • This last point is related to the previous two, but still worth a separate mention. One of the incorrect lessons learned after the crisis was the idea that market timing was the only way to avoid taking the full hit of the stock decline. Investors who took this to heart five years ago, because they were determined to never let something like this happen to them again, found themselves getting head-faked by temporary dips in a strong bull market. This does not mean investors should be oblivious of markets at extreme valuations, but there is nothing in the experience of the past five years that should embolden anyone’s confidence that market timing will help them over the next five years.

The value of looking out five years (or longer) is putting the emphasis on results at a destination or endpoint, rather than the distraction of the path taken to get there. We hope five years from now we will be able to say again that it’s hard to expect the next five years to be as good as the last.