The potential subject matter for this week’s update is so deep (voluminous) that doing justice to each relevant topic would require more of your attention than I dare ask you to devote less than two weeks before Christmas.
Therefore, I’m thinking I’ll simply list a few—and offer up a (I promise) brief summation for each. There’ll be much more in our forthcoming year-end letter.
Was last week’s stock market selloff really about:
2: risk in the high yield bond market, or
3: the looming Fed rate increase?
And when are we going to make some money?!?
So, was it oil? That seems to be what some really smart people think. And this chart of last week virtually proves them right:
The white line represents the S&P 500, the yellow is the price of a gallon of West Texas Intermediate Crude… click to enlarge…
Although, this more concentrated chart of the past 3 days tells a little different story:
And, as you can see in this year-to-date chart, sometimes oil and stocks tandem up, sometimes they don’t.
So why do I continue to buck the consensus when, per chart 1, there’s probably sufficient evidence to make the case that, at the moment, oil and stocks are pretty darn correlated? Well, I’m about to backtrack on that a bit, but first I’ll reiterate what’s behind my resistance: While, yes, the U.S. energy complex has been a real source of capital investment the past few years and, therefore, the lack thereof indeed inflicts economic pain (particularly on the manufacturing sector, and certain regions), the net effect of energy cost savings to consumers (not to mention energy-guzzling industries) in a consumption-driven economy is an unambiguous net positive.
Now for my backtracking: You may be aware that high yield bonds are presently getting hammered. As it is, the biggest issuers of high yield debt (loans made to borrowers whose credit worthiness demands that they pay up for their debt) the past few years have been energy producers. As oil prices fall, so, literally, do the marginal producers. And as the marginal producers fall, so does their wherewithal to pay back their debt. And there’s a lot of that debt sloshing around these days. And if it all goes belly up at once, a market that still suffers some PTSD from 2008 might have a flashback (remember that mortgage debt mess?). And forward-thinking institutional investors might want to short stocks now just in case. Hence, the maybe stronger correlation than usual between stocks and oil these days. (More on high yield in a minute).
Ah, but wait a sec! If you buy into the correlation story, and you want stocks to go up, all this shuttering of capacity (as those producers pack it in) is music to your ears! For, as the chart below illustrates, less production (amid steady demand) ultimately means a higher price per barrel.
The white line is the Baker Hughes U.S. oil rig count, the yellow is the spot price of a barrel of West Texas Intermediate Crude: click to enlarge
So are stocks suffering due to the rout in high yield bonds? Too soon to tell. But I will tell you that it’s not an across-the-board rout. As I suggested above, the principal drivers of the selloff in high yield bonds are energy/commodities companies and those with close ties; while the lower-quality debt issued by sectors that reflect the health of the consumer and the domestic economy—think financials, tech and media—are trading at perfectly normal levels. That said, the argument I presented above is certainly plausible.
So is the market tanking over the looming Fed increase? In my view, yep! Not that the other possibilities should be excluded. It’s just that they wouldn’t be nearly the issues were it not for the looming Fed rate increase. I.e., higher rates are supposed to mean a higher dollar (although I can debate that) and lower bond prices. And a higher dollar is supposed to mean lower oil prices, and lower oil prices spell disaster for the energy companies that issued high yield debt, and, alas, monster problems for the buyers of that debt. Here’s from :
Back to why all the hullabaloo (around a tighter monetary policy): Less available money means less money chasing stocks, higher interest rates on fixed income assets (competition for stocks), higher cost of borrowing for companies (lower profits) and the higher cost of home and auto loans for consumers (less economic activity, and lower profits), which makes for nervous equity markets. Hence my lack of sympathy with the consensus view that the market is going to take the beginning of the next Fed tightening cycle in perfect stride—despite the still historically low range we’d be looking at.
Now, I’m not predicting that the market is about to come crashing down in some epic fashion (although anything can happen). I happen to be in the camp that believes the economy is indeed healthy enough to withstand a slow and steady increase in borrowing costs going forward. And if my camp has it right, stocks—with their attendant volatility—are probably okay for the time being. Although the market leadership (in terms of sectors) is surely to change as the Fed slowly exits the lowest interest rate policy since the beginning of mankind. And, again, I’m guessing the transition to the next phase might be somewhat rocky in the beginning.
And, at last, the question of the day: When the *&#! are we going to make some money?
Albert Einstein was a really smart guy. But I wonder if he was much of an investor… Although he did understand at least one of the key basics:
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
But had he been a successful long-term investor, I believe he’d have committed to a different definition of insanity. His, as you know, was:
“The definition of insanity is doing the same thing over and over again and expecting different results.”
I’ve been looking for a follow-up quote that might suggest that he understood the ultimate secret to long-term investment success. Something like:
“Successful long-term investors are all insane, in that the secret to investment success is to have a discipline and to stick with it. I.e., to keep doing it over and over again.”
But, alas, nothing! Oh well, back to the issue: After a 2014 of flat to low single-digit results and, barring a monster Santa Claus rally, what looks to be a similar 2015 for global equity portfolios, when are we going see some real gains?
Well, you know that’s a question I can’t answer. Of course I can talk about valuations, interest rates, the economy, earnings prospects, currencies, sentiment, trends, technicals, liquidity, and on and on, and on—much of which I’ll be covering in the year-end letter—but all I can ultimately do is put the pieces together and opine on how they line up going forward. Which, if I did here, I’d be breaking the promise I made in paragraph two. Plus, I’m saving it for the year-end letter.
So, instead, I’ll leverage my experiences from 31 years of working with money and refer you back a few lines to what Einstein might’ve said had he understood equity investing.
As for our discipline: It’s to maintain global diversification, to never try and time the broader market, to rebalance periodically back to each client’s target mix (based on time horizon and temperament), and to periodically rotate, at the margin, among sectors/regions to create slight biases based on our view of the macroeconomic environment.
The past two years of marginal results (assuming nothing major for the balance of 2015) were anything but unusual. And, without knowing what the near-term has in store, I can say with confidence that to abandon a strategy that requires one remain exposed to the world’s best companies for the long-term would be sheer insanity for the otherwise long-term investor. I.e., employing the same strategy over and over again indeed leads to different results as market conditions change.
(As you might imagine, I could offer up charts ad nauseam showing previous two-year (or more) market pauses, or losses, followed by substantial gains [shoot me a message if you’d like me to]).
Einstein, savvy investor or not, indeed had insight into why your typical individual—when left to his/her own devices—tends (per the studies) not to fare so well when it comes to investing:
“Human beings must have action; and they will make it if they cannot find it.”
In other words, impatience is a portfolio killer!