They Don't Call it Fall for Nothing
"Believe only half of what you see and none of what you hear."
– Edgar Allen Poe
"They Don’t Call It Fall For Nothing." – Investor David Hay
Will the market melt down? In late August, as well as in late September, one would have thought so. A key volatility indicator spiked up more quickly in late August than it did even during the depth of the financial crisis in the fall of 2008. In this secular bear market that we believe started in early 2000, which has seen tremendous rallies and tremendous collapses – twice – this type of event does not surprise, and we expect more of it before its end.
It’s a tough time to be a value-oriented investor. Similar to past phases in which the stock market reached long-term tops, fewer and fewer stocks have led to the broad market making those tops. On September 29 of this year, 253 of the 500 stocks in the S&P 500 index were down by twenty percent or more, and the best performing stocks are not the quality value securities we favor. As one of our fund managers put it, ‘value has no momentum, and momentum has no value.’ This type of market will be one where we will underperform shorter-term, and in fact the dispersion between the most expensive and the cheapest stocks is at historic levels as well.
Why and what’s happening? The first story leading to this correction is changes in the Chinese economy. China is still growing – but at a slower and slower rate; that and the recent sharp drop in their stock markets have given investors pause in a number of sectors, and leave a void for what economy can lead global economic growth.
Deflation has been an adjunct worry here. While productivity increases are good and can create stable or even falling prices, continued availability of cheap money and low interest rates leads to a less healthy drop in prices, and leads both individuals and entities to borrow more than they could afford in a more normalized environment. The artificially low interest rates we’ve had for nearly a decade have thus led to a lot more debt piled into our economy: consumer debt, government debt, corporate debt, margin debt. Margin debt, for instance, stood at all-time highs before the August and September stock market volatility this year - higher even than before the financial crisis in 2007.
Debt is one form of capital, and in today’s environment it has led to financial engineering rather than investment in organic growth. Companies borrow money to buy back stock, and can thus slightly increase their earnings even if their revenue notches slightly downward. So cheap money = more debt = an environment in which difficulty growing the top line discourages healthy companies investing in innovation and growth. Financial capital thus dominates industrial capital, and investors find themselves taking more and more risk to attain a reasonable rate of return. This environment punishes savers and folks looking for moderate returns on moderate risk, and because we still favor discipline in the allocation of your capital, we remain cautiously positioned.
Meanwhile, the US economy is okay – though earnings are being revised downward in many cases for the remainder of the year, so the likelihood of the Federal Reserve feeling confident enough to raise rates recedes somewhat. If the Fed can’t raise rates a full eight years after the onset of the financial crisis and with a decent US economy on the move, and not much unemployment, when will it be able to raise rates? It has become apparent that the Fed is looking at a set of global responsibilities – debt, currency and trade issues globally are influencing its choices as never before.
Since the Fed declined to raise rates in September, there’s been talk of negative interest rates (you buy a US bond, which is deemed safe, but at a negative interest rate – investor Jim Grant calls this “return-free risk”). The last two three-month Treasury bill auctions were made at zero interest. There’s also been talk of, ultimately, another program of quantitative easing beyond the one that finished late last year. While this is all in the realm of speculation, we see the big issue as being that financial repression – keeping rates ultra-low to stimulate the economy, but at the same time punishing savers and thrifty stock and bond investors – is here to stay for some time.
Our approach to your portfolios remains value-driven. International stocks have gotten cheaper and while they took a hit this quarter, we and your managers are interested in opportunities that are coming into range in this sector. Your modest emerging markets exposures are outperforming, and a rally and some stabilization in the price of oil has helped carbon-based and renewable energy investments in the past few weeks. Portfolios have sprung back some from the lows of the end of the quarter. Your managers are continuing to scour for value-based opportunities in the US market as well, however, many continue to hold cash awaiting lower prices and better opportunities. While frustrating to see your returns down this quarter and year, we think the selections are healthy because they are uniformly based on good companies with healthy balance sheets, not too much debt, and decent cash flow. While the market may not value that during any given quarter, and the complacency of this momentum-driven market could continue, the market does value value over time. And with a tip of the hat to the late Yogi Berra, we recall that “it ain’t over till it’s over.”
This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.