Market Commentary

Reality Distortion Field

November 2014

"He wishes he had never entered the funhouse. But he has." – John Barth - Lost in the Funhouse

We write with an update on your portfolios and recent market volatility picking up, as well as on headlines today out of Japan.

We encourage you to call us about your portfolios and any questions you have. We are ready to act should appropriate opportunity arise, or should sales need to be made. We are working daily on your portfolios' characteristics, their exposures here in the U.S. and overseas, both on the stock and fixed income side and how you are hedged in this market.

We realize you are having the experience of underperformance to a market that’s gone up, a lot, and news that things are good. And yet your portfolio here has lagged. Unemployment is down, the economy is up, real estate prices are back up, credit is back. Stocks are the best way to make long-term money, and the S&P 500 index has beaten everything in sight.

So, we want to acknowledge that your experience with your assets here is now really divergent from many others’ experience, and from the headline news. We are working hard for you and it’s clear we’ve been wrong for the last while.

The major force driving the market from the summer of 2011, when quantitative easing made its biggest push during the European debt crisis, and we became more conservative, is clearly these easy money policies around the world. That’s starting to shift, though the direction is that this could go on for some time. This week, our central bank wrapped up some of the more aggressive parts of its easy money policies, although it indicated it would like to hold rates low for an extended period of time. Today the Bank of Japan announced what the Wall Street Journal called ‘shock and awe’ easing of its monetary policy, continuing a radical policy of money printing that surprised investors in its magnitude. At the same time, the Government of Japan announced a fresh public commitment in its own pension fund of $1.2 trillion to a dramatic shift towards domestic stocks and foreign stocks and bonds – away from its own government’s bonds. Over in Europe, inflation is up a bit, though the Central Bank in Europe would like to ease some more it won’t, and the Germans aren’t of a mind to let it do so. Greek bond yields, like a canary in a coal mine, have dramatically spiked up again, bringing questions about Europe’s stability back to the forefront. So, while the global easing of the last five years floated everything up, and it may continue to float for awhile, there are cracks in the coordination around the globe. We expect this to be a source of dollar strength, US bond strength and overall asset volatility down the road, because the dominant narrative - that central bankers have successfully engineered us out of the financial crisis - is the one that matters most of all, and it has driven record corporate profitability and market returns.

In all, we are struck by how globally connected this rally and this monetary easing campaign has been, and interruptions in it, which look likely from here out, are similarly going to have global consequences.

There was a very compelling phrase reported in Walter Moss’ biography of Steve Jobs that came out a few years ago. Jobs, a brilliant innovator, at times enforced with his colleagues a ‘reality distortion field,’ where the reality he wanted to create for his customers became the one that existed – if everyone around him was willing to walk with him through the field to get to the other side. Apple is one of the most admired companies in the world partly due to Jobs’ ability to make this happen. When it comes to your money, however, right now the whole world seems to have moved into a reality distortion field with central bankers – who appear to have successfully financially engineered an end to the financial crisis with nearly inconceivable amounts of money printing - $4 trillion was put on the U.S. Federal Reserve balance sheet – but supposedly with zero adverse affects. We don’t know if this was a brilliant innovation, or if it will all end in a big mess. It is unprecedented in the modern world, and we don’t feel it’s responsible to treat your money as part of an experiment in product or financial design.

And, so, we continue to be cautious given the unprecendented amount of liquidity chasing expensive assets around the globe. And, we continue to think that fundamentals like price and acquiring cash flow cheaply still matter very deeply. And stocks by long-term measures are as expensive as they’ve been since 2007 and 1999.

We are looking carefully at emerging markets – whether it is good for you to have small allocations, as many of you do, or whether it is too early to be in stocks that may become much cheaper, given the likelihood of dollar strength and liquidity and economic reversals in some of those markets. We are also looking at adding to core managers from your stable liquidity, who have done well in this market from a stock picking perspective even as they are holding substantive amounts of cash for a cushion and a resource when prices fall. And, what of gold? In this environment gold and gold-related stocks don’t have much of a bid. We are considering these hedges and will keep them in place for the time being – we realize they are deeply oversold and it’s not our intention to bail out at bottoms; however if we feel there is a better opportunity we will certainly take that step.

We want to be frank, open, and transparent at all times in our communication with you, and hope this note is helpful for understanding our portfolio positioning for you. We are all hands on deck, and welcome your questions, concerns, and calls.

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

[i] 'Welcome to the Revolution,' Grant's Interest Rate Observer, May 31, 2013