Commentary:   January  2016 Dennis C. Butler, President Centre Street Cambridge Corporation Private Investment Counsel

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JANUARY 2016

O

n December 14, 2015, a curious thing happened in the U.S. stock market. Looking at the popular barometers one would think that prices were up nicely: the Dow Jones Industrial Average added 0.6%; the S&P 500 index gained 0.5%; and the Nasdaq Composite rose 0.4%. But on the NYSE, so-called �market internals�”  painted a very different picture: 2300 issues (or 72% of the total) saw price declines; 572 stocks recorded new low prices for the trailing twelve-month period (versus 7 new highs); and trading volume in decliners exceeded that of gainers, 2.8 to 1.6 billion shares. Far from being an isolated occurrence, this pattern had been repeated on numerous occasions during 2015 as the market's advance, meager as it was, became increasingly �narrow. ” By late November a small group of five issues accounted for the entire rise in the S&P of about 1% at that time; most stocks in the U.S. had declined in price.

This phenomenon (an odd effect of the way in which the indexes are constructed) happens occasionally and has been far more pronounced at times in the past. In 1929 and 1999, for example, just before markets suffered sharp plunges, small numbers of stocks lifted the averages to extraordinary heights. We don't mean to imply that such statistics will consistently foreshadow bear markets; rather, their usefulness lies in clarifying investment results that appear to be out of kilter with market averages. During a period of generally declining stock prices — �whether reflected in the indexes or not — investors will find it difficult to make much headway. When the market gauges act in the peculiar fashion noted above, weak relative returns often cause dismay among the less sophisticated and lead to bad decision-making (such as chasing high-flying stocks). This is one reason why it is wise to largely ignore short-term results and to always view them in the context of general market conditions.

Among the S&P 500 stocks, 284 finished lower for the year, continuing the �bad breadth” pattern noted above, and in keeping with the stock market's listlessness during the past two years. Trading finished 2015 on a low note, a sign of nervousness about the usual suspects — economic conditions, corporate earnings, and falling oil prices. The averages were slightly positive for the year, with gains in the Dow Jones and S&P 500 indexes limited to 0.2% and 1.4% respectively (including dividends). The NASDAQ Composite reflected enthusiasm for the popular technology issues of the day and rose 5.7%. 

                             

 

Potential U.S. Federal Reserve actions and havoc in the oil markets dominated financial news during 2015. After nearly a decade of extraordinarily easy monetary policy, market participants expected the Fed to begin reigning in the largesse in the face of improved economic conditions. Waiting too long, it was feared, could risk inflation. Many Fed officials, on the other hand, were wary of squelching a recovery that was not very robust. Despite the Fed claiming that its decision-making process was �data dependent,” observers obsessed over every monetary policy committee meeting, and were upset when decisions did not match their expectations.

We believe that far too much attention is paid to the Fed's periodic deliberations. Like the �Kremlin Watchers” of the Cold War era, observers attempt to divine meaning and intention from every change of personnel and every nuance of the central bank's communications. Indeed, we would prefer that the bank return to its past secretive ways for this very reason. In the greater scheme of things, these minor moves make very little difference, and from our perspective they have almost no impact on investment policy. The Fed acted vigorously to prevent a financial crisis from turning into a catastrophic depression. This was an important event, particularly as it gave the public and investors confidence that the Fed would act aggressively to prevent broad swaths of business earning power from being wiped out in a prolonged, severe downturn such as occurred in the 1930s. That the Fed no longer acts as if it believes corporatized, limited-liability capitalism to be, in any important sense, self-regulating is also significant in that it instills hope that the probability of a future crisis has been at least somewhat reduced.

Regarding the oil markets, the fall in prices to eleven-year lows was a source of both wonder and worry. While a boon for consumers, low prices caused pain in exporting regions from Texas to Russia. Petroleum-based economies will likely slow further, meaning fewer imports and less business for trading partners, and there will be fewer petrodollars circulating for investment. Indeed, sovereign wealth funds have already begun liquidating securities portfolios to cover budget deficits. Given the fact that some petroleum exporters have oil-financed social welfare schemes as well, the potential for social tension is also greater, an unwelcome development in areas such as the Middle East.

While we would not dream of attempting to forecast the market for a commodity such as oil, we believe there is a growing probability of significantly higher prices over the next several years. Trends contain the seeds of their own destruction, a process that is already evident in the oil markets. As the price slide lengthened to 18 months (crude prices fell over 30% in 2015 alone), major oil companies cut their exploration and development budgets by over $250 billion due to poor project economics at current prices. This means that less energy will be available to tap in the future. Meanwhile, spurred by lower prices, demand continues to rise (SUVs are back in vogue in the U.S., for example). It has been estimated that over the next several years the draw on the world's oil resources due to growing use and, importantly, reservoir depletion, will more than offset potential new supply from producers such as Iran (the country plans to resume exporting immediately upon the ending of sanctions), Libya or Venezuela. If this comes to pass, along with insufficient investment, there will be interesting times in the energy sector going forward. Meanwhile, hedge funds have increased their short positions (selling a borrowed asset in the expectation of buying it back later at a lower price) in the oil markets to the highest level on record — �a contrary indicator if ever there was.

                             

 

�Financial markets are always on an earthquake fault and that fault can move at any time,” opined a Georgetown University professor using an analogy that, if not entirely accurate, is descriptive of markets during speculative frenzies. At such times, the slightest slippage in what was thought to be solid bedrock can cause extreme ructions, and it is precisely at those times when it is critical to remember that the primary goal (and responsibility) of the investor is not to aim for the highest return possible, but rather, to preserve capital. To be sure, an adequate return is important, but always secondary to the goal of capital conservation. This is why the investor must be able to identify the fault lines of risk before pressures rise to the breaking point. Risk aversion is, therefore, a key part of the investor's toolkit.

Recently Gillian Tett of the Financial Times penned an insightful piece on the risks that have developed as a result of the prolonged easy monetary policies in place since the financial crisis. While all eyes focused on the Fed last month, an obscure government office issued its inaugural Financial Stability Report. The Office of Financial Research (OFR), set up after the crisis, studies risks in the U.S. financial system, of which Tett discussed three, all of which are basically related to the investment world's desperate �reaching for yield�” in an environment of ultra-low rates.

First discussed was credit risk, the possibility a debt issuer will have trouble meeting its obligations. Credit risk has risen as corporations have taken advantage of low rates and tremendous demand for income-producing assets to increase their debt loads. More debt in itself might not be a big problem were it not for the fact that the funds so raised have generally not gone to business investment or R&D, but instead to things like financial engineering and �balance sheet efficiency.”  In other words, corporations have been busy buying back their shares (useful if you want to cash in stock options), paying out dividends, and pursuing merger deals. Such practices are not necessarily pernicious, but buying back shares at high prices (almost always the case) or paying out more in dividends than you earn (making up the difference with debt) is not sustainable. Mergers motivated by low capital costs are also suspect as cheap capital encourages higher bid prices for targets and transfers value to sellers.

Much of that demand for debt issuance came from managers of fixed-income funds engorged with cash from investors seeking the safety of fixed-income investments. These managers, to satisfy their craving for yield, have purchased everything from investment grade paper to junk debt issues structured to provide few protections for buyers. As a result, �portfolio risk” has increased, leaving fund investors vulnerable to potentially steep declines in value in the event of rate increases or economic difficulties. The OFR estimated that fund losses of over $200 billion could occur with a one-percentage point rise in long-term U.S. interest rates. Holders of supposedly �safe” bond funds could be in for a surprise. Many are not waiting; since the beginning of June 2015 U.S. fund investors have pulled roughly $36 billion out of both investment-grade and junk bond funds, leading the market for junk to post its first annual loss in several years.

The third risk results from a shift of cash equivalent investments that has resulted in hundreds of billions of dollars moving out of money market funds and into banks and the Federal Reserve. This massive transferral of funds may eventually disrupt the functioning of normal Fed monetary policy, which involves the buying and selling of money market instruments such as treasury bills. There is also the possibility that any return of this cash to money funds as conditions normalize could impact the financial system in ways that no one yet understands or can predict.

As investors, we do not need to know what will happen in the future — an unattainable goal in any case. We do need to be aware of underlying risks, especially when they are not generally acknowledged or understood. Today's risks from monetary largesse may have an analogue in the overheated property markets of the last decade; now, we must prepare for the aftermath of an overheated bond market. Ten years ago, we were very wary of the real estate bubble, and advised staying away from property. The OFR's assessment may describe risks that have a less direct bearing on individuals' lives and choices, but anticipating their potential aftermath and protecting against it is critical in meeting the investor's primary goal of capital preservation. 

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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28).   "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:

Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695

Email: [email protected]
URL: http://www.businessforum.com/cscc.html

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