Market Commentary

Icarus’ Wings

July 2015

"In markets, humility is more than becoming. It’s essential to survival." – James Grant

Greek Crisis

Professor Richard Thaler had a problem. Early in his career, he figured out that his academic discipline, Economics, was founded on the postulation that people were more mechanical than human. His recent memoir, Misbehaving, is his sometimes hilarious retelling of a career in which he built an overwhelming case that, as his reviewer Michael Lewis put it, ‘the weird self-defeating stuff that people do isn’t random and inexplicable but fundamental to human nature. More to the point, human beings were not just occasionally irrational, but systematically irrational.’

Lewis attributes Thaler’s success to his ‘sense of wonder, a tendency to ask embarrassing questions, and a mistrust of grown-ups’ ideas about what’s worth spending time thinking about and what is not.’ So, we ask ourselves, what are some grown up ideas about what’s worth spending time thinking about?

Don’t be surprised if … QE returns, because when you are already down the rabbit hole you might as well look for Alice.

Number one in the grown up department is when the Federal Reserve will raise interest rates, how long and sustained the rate rise will be, and how it will consequently affect a recovered economy (and thus the stock market). We expect gradual action, but knowing that the future is unpredictable and people act irrationally – we leave open the possibility they may continue to delay rates in another next stage of QE stimulus. Steve Romick, manager of the FPA Crescent fund that our clients own, recently said “Don’t be surprised if … QE returns, because when you are already down the rabbit hole you might as well look for Alice.” Basically, things could get more irrational before normalized rates return.

Number two in the grown up department is inflation, which is subdued somewhat since the price of oil has collapsed. We also have a tight labor market, though; wage demands are gaining traction after many years. In anticipation, your managers are buying companies with pricing power to offset the impact of inflation. Given current low interest rates globally, they are also emphasizing the ability to maintain demand for products during a downturn.

Number three in the grown up department is the renewed credit crisis in Greece. If there were ever a situation of ‘systematic irrationality’ it would be the unfolding Greek situation. It has taken several years for Greece to get into this situation and we don’t foresee a clear resolution in the near future. Your managers are continuously seeking investment bargains, and will be attentive to investment opportunities that are created by the situation and its consequences.

  Read an informative primer on Greece

These grown up ideas are worth thinking about and we and your managers consider them quite seriously. And, yet, we continue to see high valuations in the stock market, and a hallmark of our discipline for you is to be cautious at high valuations, while constantly scanning for opportunities in quality companies at good prices. Simple, right? Perhaps, but hard to execute after years of sustained price rises in the markets floated by cheap money which then creates the effect of even more money moving into the market chasing success. One of Thaler’s key insights is that people can be systematically irrational; there is plenty of that operating in the markets now, and it makes value judgements complicated.

Longer term, we are enthusiastic about opportunities in renewable energy, and in the Bay Area tech economy in general.

We saw many valuation metrics and valuation creativity in 2007 and 1999 at the very tops of the last two bull runs - and yet arguably they were all in place in 2005 and 1997 too – meaning, we don’t know anything about the timing of what’s next. For that reason, we are adding to stock exposure very carefully, and retaining significant exposure to managers who hold cash when prices are too high, and during a downturn have the ability to benefit from buying low.

Longer term, we are enthusiastic about opportunities in renewable energy, and in the Bay Area tech economy in general. A.T. Kearney’s recent Global Cities Index postulates that in ten years the most vibrant local economy in the world will be here in the Bay Area; we look forward to working to take advantage of this growth for you in constructive ways and to watching this dynamism take shape. We are starting to phase in a small position in your portfolios related to specialized technology oriented towards economic and environmental sustainability. We also are adding selectively to global managers who have done a good job with up- and downside markets. Lastly, we have left behind a holding that became too dependent on commodities pricing and a couple of binary political resolutions, as we feel the runway for recovery of commodities pricing is too long.

In all, we continue to be constructive with caution, optimistic about the future, and looking for more opportunity at better prices.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

1 Michael Lewis, Bloomberg View, The Economist Who Realized How Crazy We Are,’ May 29, 2015.

2 Steve Romick, Speech to CFA Society of Chicago, ‘Performance Disclosure,’ June 25, 2015.

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