Market Commentary

Illusions Become Real

January 2014

"Illusion is the first of all pleasures."
–Voltaire, The Maid of Orleans, 1756

"If men define situations as real, they are real in their consequences." –William and Dorothy Thomas, The Child in America, 1929

"You will eat and not be satisfied." –Leviticus 26:26

The income generated by the companies in the S&P 500 did not increase last year. Net profits of all the companies put together, dollar for dollar, were slightly down. In fact, the net income of these companies hasn't grown for 18 months – the total profit of the S&P 500 last increased in the middle of 2012. [i]

How can that be when those same companies' stocks went up 32 percent last year? In part, companies are not so much investing in the potential for new growth in sales, as they have been using record amounts of cash to buy back shares of their own companies. The biggest, strongest companies on American soil are, in an odd kind of way, eating themselves to grow.

In the stock market, though, investors looked at those same companies and judged that the same dollar of their future income was worth a whole lot more by the end of the year than the beginning. We see this expansion of U.S. stock market value, by about 20 percent on an earnings basis for the S&P 500 in 2013, as the result of a few critical phenomena. First, ultra-liberal monetary policy, the likes of which we haven't seen since, well, Napoleon. The availability of super-cheap money forces any investor that wants a measurable level of return to invest in risky things that get even riskier as they become more expensive. Certainly the near-term decline in the value of gold and gold-related investments is also evidence of this: who needs insurance against the failure of money when money is so easy and so cheap? This becomes a cycle that feeds on itself (and usually overshoots on the up and down side, both – for stocks, and, ultimately, we think, for gold).

A notably fragile economic recovery coming in part from this very policy is taking shape and is becoming real. This is new news, particularly after government-induced headwinds last year. We think it's possible economic growth surprises to the upside in 2014.

What of the bond market? The Federal Reserve has been very busy supporting the bond markets, actually going into the market for which it sets short-term rates and buying long-term bonds with the pressing of a computer key – printing money by taking these long-term bonds onto its balance sheet. Research estimates that the Fed is currently responsible for between about a third of the new long-term Treasury market and up to two thirds of the mortgage securities market. [ii] This is the ultimate backstop – in effect, the Fed has created a kind of analog to what is happening with company buybacks. The bond market has, for the last several years, been kind of eating itself as well.

In effect, during the past two years, value has been at war with liquidity, and liquidity has been winning. Your cautiously positioned portfolios have underperformed as a result. We don't want to chase asset inflation that is the result of an easy money experiment. Your savings have been hard-won and it's not prudent to buy the uptrend. We are not big fans of paying high prices in stock and bond markets that are eating themselves. And that's not to say we don't see vibrant, innovative areas of the economy that can, should and will grow. A client asked us recently, 'do you not like stocks?' We like them plenty. We just want to buy them cheap so there's less risk, and we're in an environment with plenty of risk, and high values, so we haven't chosen heavier stock ownership in this environment.

All eyes are on the Federal Reserve and its decision to pull back on these bond purchases. Longer-term interest rates have begun to move up, and have brought longer-term bond prices down. We successfully guarded you against bond market declines in 2013. The market is at an important inflection point and we want to sidestep likely further declines in long-term bonds as interest rates rise. Rising rates could also give the stock market a bit of a scare sometime in 2014.

On the earnings side for stocks, it's possible this same share buyback and valuation alchemy continues to work for awhile. We and your managers think that valuations are high and have pulled your portfolios back to more defensive positioning. But, we think there may be economic fireworks this year that could lead to opportunities. The wealthy have grabbed the lion's share of the gains of these recovery years, and we expect 2014 to be a breakout year for the middle class exerting wage pressure on companies – directly and through government. We do think interest rates will continue to go up, and the Fed's actions will continue to make headlines, leading to opportunities that could open up in emerging markets stocks, certain types of bonds, and, ultimately, a wider selection of well-priced stocks around the world. As Voltaire points out ,'illusions are pleasant.' And, to a certain extent, we are watching an illusion become real – but we await more investment at lower values with less risk.

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

[1] Source: Bianco Research

[ii] Sources: Forbes, 11/25/13, Wall St. Journal, 9/18/13, Marketwatch 3/27/13. Please contact us for specific details