Worry Returns

After a long absence, market worry returned with a vengeance over the last 10 days or so. The S&P 500 Index currently sits 7% off its all-time high, a figure that understates the recent volatility. The S&P 500 had a three-day period in which it closed more than four standard deviations (i.e., likelihood of 1 in 15,787 events) below its 50-day moving average each day (Table 1). Such a move has now happened twice in the history of the index, with the other time being May 15, 1940, right as Germany was invading France, Holland, Belgium, and Luxembourg.

 Table 1

Table 1

There are certainly big reasons for concern, which we have discussed regularly in recent years: low worldwide interest rates and inflation; high U.S. corporate profit margins; European currency, debt, and demographic issues; Japanese currency, debt, and demographic issues; and, highlighted in this recent round of volatility, Chinese investment, debt, and banking issues.

Yet, while we have a market that is valued at the high-end of its historical range (Table 2) on top of all-time-high corporate profit margins (Table 3), we do not think current issues approach those experienced at the outset of World War II.

 Table 2

Table 2

 Table 3

Table 3

We thought a few points might offer some useful perspective:

1)     We think about expected stock- and bond-market returns in 10-year chunks. A 7% market decline increases a decade-long expected return by roughly 0.7% per year, all else being equal.

As a result, a 5.0% expected return over 10 years would turn $1,000,000 into $1,628,895, while a 5.7% return results in $1,740,804. The difference is not inconsequential, but it isn’t the kind of move that should encourage major portfolio shifts, unless there is more concern ahead.

2)     The S&P 500 was at today’s level as recently as 10/28/14. Of course, we didn’t believe the stock market was very attractive then, and corporate fundamentals have not improved significantly since. As a result, with a slightly wider frame, today’s level is attractive relative only to where it has ranged in the last six to nine months.  

3)     We wish our favorite stocks had more dramatic drops than the market in these more volatile periods. Unfortunately, that isn’t usually the case. When markets move down rapidly, the correlation of the downward movements is high across all stocks, due to across-the-board indiscriminate selling. Additionally, since we have a preference for high-quality stocks, our favorites may not fall as much as the market in highly volatile periods.

 

We remain worried. As discussed above, there are big reasons for concern. And we still think the stock market is high, with an expected future return well below that of historical levels. Of course, that’s offset by alternatives we find to be lousier – a bond market that yields about 2% and cash that yields about 0%.

But we believe your portfolio has been and remains reasonably positioned for these risks, attempting to balance the likelihood of each risk with the magnitude of its impact. Your stock portfolio remains focused on high-quality companies, and your bond portfolio remains oriented toward short duration bonds (i.e., those that mature in the next few years) and inflation-protected bonds. We are attempting to be conservatively positioned until more attractive values present themselves; at such times, we hope to be opportunistic by investing in more high-quality stocks and/or by increasing overall stock exposure.

 I have included an excerpt below from a CNBC interview with Warren Buffett in 2011. It clearly articulates our thinking and our current preference for stocks over bonds, despite our concerns.

The world's always uncertain. The world was uncertain on December 6th, 1941; we just didn't know it. The world was uncertain on October 18th, 1987; we just didn't know it. The world was uncertain on September 10th, 2001; we just didn't know it. The world—there's always uncertainty. Now the question is this—what do you do with your money? If you leave it in your pocket, it'll become worth less over time. That's almost certain. You can put it in bonds and get a certain 2 percent for 10 years, but that's almost certain to be less than the decline in your purchasing power. You can put it in farms, and the farms will probably keep growing corn and soybeans, and they'll grow it whether Italy has trouble tomorrow or not. It's very interesting to me…if you own a farm and somebody says Italy's got problems…do you sell your farm tomorrow?
If you own a good business locally in Omaha and somebody says Italy's got problems tomorrow, do you sell your business? Do you sell your apartment house? No. But for some reason, people think if they own wonderful businesses indirectly through stocks, they've got to make a decision every five minutes. So if Ben Bernanke comes up and whispers to me that he's going to do X, Y, or Z tomorrow, I'm not going to change my view about what businesses I want to own. I'm going to own those businesses for years, just like I would own a farm or an apartment house. And there will be all kinds of events and there'll be all kinds of uncertainties and in the end, what will really count is how that business or farm or apartment house does over the years.
I can't perfectly time the buying and selling of it. I'm going to own these businesses 5 or 10 or 20 years from now, and there will be all kinds of good news and all kinds of bad news. But the good businesses, they do wonders for you over time.

Meet Mr. Market

Since the lows of the financial crisis in March 2009, the S&P 500 has more than tripled. Tripled. There have been small hiccups along the way, but stocks have gone up rapidly — and quite steadily.

The last month or so has been much less steady. After reaching an all-time high on September 18th, the market dropped eight percent through mid-October. It was reportedly due to all sorts of maladies: European economic weakness, Federal Reserve gear shifting, home-price deceleration, Ebola, etc. Since then, prices have nearly fully recovered, and now sit at 99% of their all-time high. Everyone seems to feel better again. But why is that?

Many of us have a funny way of thinking about stock prices. We tend to believe that yesterday’s price was the right one, if it was higher than today’s. Then, it must be time to get worried. The market must know something. Maybe we should sell? 

However, when today’s price is higher than yesterday’s, we have no such fondness for yesterday’s. Then, it must be time to get excited. The market must know something. Maybe we should buy?

Our portfolios are direct measures of our financial well-being, so they can cause anxiety when they shrink. But to grow them, we must accept that there will be periods of discomfort. 

Of course, it’s easier to remind ourselves to accept this volatility during the ups than the downs. Since the market closed today within 1% of its 222-year-high, we take the current moment as an opportunity for such a reminder. Corporate earnings grow over time, but not smoothly. Investors, collectively, are usually quite rational, but become fearful rather readily. With a wider perspective, we can avoid believing that every disappointing or worrisome news item carries directly to the next financial crisis.

Investment strategies stretch a long, long time — 30 years or more in the large majority of cases. Just think about all the things that have caused both rational and irrational ups and downs in the market since 1984. We provided a few highlights from each of those 30 years in a table just below. Wars, recessions, terrorist attacks, natural disasters all came and went, and the market has continued its long-term trend upward. 

In the next 30 years, we’ll see more crazy market action, but the net all of the volatility should be a nicely appreciated stock market. In fact, we have far more confidence predicting market returns over the long term, because there is zero predictability over short horizons but good predictability over long horizons.

Ben Graham, Warren Buffet’s mentor and the father of value investing, wrote long ago of a character called Mr. Market:

"Imagine you had a partner in a private business named Mr. Market. Mr. Market, the obliging fellow that he is, shows up daily to tell you what he thinks your interest in the business is worth.

On most days, the price he quotes is reasonable and justified by the business's prospects. However, Mr. Market suffers from some rather incurable emotional problems; you see, he is very temperamental. When Mr. Market is overcome by boundless optimism or bottomless pessimism, he will quote you a price that seems to you a little short of silly. As an intelligent investor, you should not fall under Mr. Market's influence, but rather you should learn to take advantage of him.

The value of your interest should be determined by rationally appraising the business's prospects, and you can happily sell when Mr. Market quotes you a ridiculously high price and buy when he quotes you an absurdly low price. The best part of your association with Mr. Market is that he does not care how many times you take advantage of him. No matter how many times you saddle him with losses or rob him of gains, he will arrive the next day ready to do business with you again."

As hard as it can be, it’s important to remember that Mr. Market is not there to instruct us, but instead to serve us, if we choose. We need to watch for the big risks, but it is the rare issue that significantly impacts the long-term, fundamentally driven value of a great business. The rest is a symphony of noise for us to filter out. The best approach, we believe, is to check stock portfolios infrequently and think about stock-market volatility as an opportunity, provided by Mr. Market, for the purchase of stocks at more attractive prices.

 

1984

  • AT&T breakup.
  • Prime rate raised four times, ultimately to 13%.
  • UAW-GM strike.

1985

  • Federal price controls removed on half of natural gas produced in the U.S.
  • Seventy Ohio thrifts closed to prevent run on deposits.
  • United Airlines-Auto Pilots' strike.
  • Conventional mortgage rates fell to 12%, the lowest since October 1979.
  • Steelworkers in Pittsburgh conducted first major walkout in 26 years.
  • The Farm Credit System sought a Federal bailout of a $74 billion portfolio (i.e., monstrous at the time). President Reagan later signed farm subsidy bill to bailout the System.

1986

  • Space shuttle Challenger exploded.
  • U.S. airstrike against Libya after missiles fired at U.S. planes. 
  • Federal Reserve Chairman Paul Volcker warned of public and private debt buildup as threat to economy.
  • Soviet nuclear plant at Chernobyl destroyed by fire.
  • U.S. Supreme Court ruled that Gramm Rudman Hollings mechanism for across-the-board, automatic spending cuts unconstitutional. Dow down a record 62 points.
  • United Steelworkers struck for first time since 1959. 

1987

  • Brazil suspended interest payments on commercial debt.
  • Ecuador rocked by severe earthquake.
  • U.S. dollar fell to post WWII low against the Yen.
  • USS Stark struck by Iraqi missile in Persian Gulf.
  • Kuwaiti tankers placed under U.S. flag for transit through Persian Gulf. 
  • On October 19, the Dow Jones Industrial Average experienced its largest one-day percentage drop in history, 508 points or 22.61 percent. This drop caused volume to surge to an unprecedented 604 million shares. 
  • Severe earthquake hit with epicenter near Whittier, California.
  • Dollar hit postwar lows against Yen and Mark.

1988

  • Television writers' strike.
  • Prime rate of interest cut once and then raised four times.
  • USS Vincennes shot down Iran Air Flight 655.
  • Severe earthquake killed more than 100,000 in Soviet Armenia.
  • Bomb caused crash of PanAm 103 in Lockerbie, Scotland.

1989

  • Exxon Valdez ran aground in Alaska, spilling 11 million gallons of oil.
  • Hurricane Hugo hit the Carolinas.
  • International Association of Machinists strike at Boeing.
  • Earthquake measuring 7.1 hit San Francisco Bay Area.

1990

  • Drexel Burnham Lambert filed for Chapter 11 bankruptcy-law protection.
  • Iraq invaded Kuwait.
  • U.S. launched Operation Desert Storm against Iraq.

1991

  • Prime rate cut five times.
  • Sierra Madre earthquake in LA county.
  • GM announced closure of 21 plans and elimination of 74,000 jobs.

1992

  • RH Macy filed for Chapter 11 bankruptcy protection.
  • TWA filed for bankruptcy protection.
  • Los Angeles riots.
  • Earthquake in Palm Springs.
  • Hurricane Andrew hit Florida and Louisiana.
  • Hurricane Iniki hit Kauai.

1993

  • President Clinton announced economic plan, cutting defense spending by $188 billion from 1994-1998. 31 major bases closed.
  • World Trade Center bombing.
  • Great Flood of '93 from Minnesota to Missouri, causing $12 billion in damage or 10 million acres.
  • NAFTA is passed.

1994

  • Northridge, CA earthquake.
  • Fed Funds rate raised six times.
  • Congress approves GATT, cutting tariffs globally.
  • Orange County, CA filed for bankruptcy protection.

1995

  • U.S. trade deficit soared 68%.
  • Kobe, Japan earthquake.
  • Clinton Administration announced program to prop up the Mexican peso. Peso devalued by 40% against the U.S. dollar between 12/31/94 and 1/31/95.
  • Bomb blast at Oklahoma City federal building.
  • NASA announced job cuts totaling 29,000 over five years.
  • Boeing cut 5,000 jobs
  • President Clinton authorized movement of U.S. troops into Bosnia.

1996

  • U.S. federal government shut down as budget talks stalled.
  • President Clinton signed landmark telecom bill.
  • UAW strike at GM.

1997

  • U.S. trade deficit hit eight-year high.
  • Unemployment fell to 25-year low.
  • China regained sovereignty over Hong Kong
  • Teamsters strike at UPS.
  • Dow Jones Industrials posted worst one-day point loss ever -- 554 points, or 7.2%.
  • Yamaichi Securities was Japan's largest corporate failure since WWII.
  • South Korea agreed to broad dismantling of its interlocked financial and industrial system as the price for a record $55 billion IMF bailout.
  • Asia's crashing currencies had very negative effects on financial health of the region. The Indonesian rupiah and Korean won lost more than half their value against the U.S. dollar.

1998

  • Bond yields reached lowest levels since 1960s.
  • Boeing eliminated 6,000 jobs.
  • Xerox cut 10,000 jobs, or 11% of its workforce.
  • OPEC cut crude-oil production by 1.25 million barrels per day.
  • Intel eliminated 3,000 jobs.
  • National Semiconductor cut its workforce by 10%.
  • Motorola laid off 10% of its workforce, or 15,000.
  • UAW strike at GM.
  • Texas Instruments eliminated 8% of its jobs.
  • Rockwell International cut 9% of its workforce.
  • IMF provides Russia with $14 billion assistance package.
  • Dow fell 513 points on 8/31/14. NASDAQ had its worst point drop ever.
  • Northwest Airlines laid off 27,500 employees, or 55% of its workforce.
  • Citigroup eliminated 8,000 jobs.
  • Russia devalued its currency and restrictions international transactions, including debt repayments.
  • Raytheon cut its workforce by 14,000.
  • Packard Bell NEC cuts its workforce by 20%.
  • Merrill Lynch cut its workforce by 5%.
  • NEC Electronics cut 13% of its workforce.
  • MCI Worldcom cut 5% of its workforce.

1999

  • The euro was introduced, creating a single market in Europe.
  • Brazil devalued its currency.
  • U.S. trade deficit hit all-time high, up 58% from previous year.
  • Hurricane Floyd battered East Coast.
  • 7.6 magnitude earthquake hit Taiwan.

2000

  • NASDAQ hit record high of 5,048 on 3/10/00. (NOTE THAT THE NASDAQ IS STILL ONLY BACK TO 4419 14 YEARS LATER.)
  • Jobless rate of 4% was lowest in three decades.
  • Oil prices were rising. U.S. inventories at lowest levels since 1976.
  • Dow and NASDAQ recorded losing years for first time in a decade.

2001

  • Federal Reserve surprisingly cut the Fed Funds rate by 0.5%. NASDAQ jumps 14.2% in a single day.
  • The Fed Funds rate was cut an additional 10 times.
  • PG&E utility unit filed for bankruptcy.
  • Tosco refinery explosion pushed gas prices to near-record highs.
  • California hit by rolling blackouts.
  • September 11th, 2001. Terrorist attacks. U.S. stock trading halted for four days.
  • Recession began in March 2001.
  • Enron filed for bankruptcy.
  • Markets fell for second straight year since 1974.

2002

  • Euro became legal tender in 12 countries.
  • SEC launched formal investigation of Wall Street analysts' conflicts of interest.
  • WorldCom files for bankruptcy protection.
  • IMF signed an emergency loan to Brazil.
  • U.S. Airways filed for bankruptcy.
  • Cargo operations at 29 West Coast ports ground to a halt when terminal operators locked out unionized workers.
  • United Airlines filed for bankruptcy protection.

2003

  • Doctors in Hong Kong report first case of Severe Acute Respiratory Syndrome (SARS).
  • Operation Iraqi Freedom begins.
  • Baghdad falls and Iraqis and American troops topple statue of Saddam Hussein.

2004

  • Hurricane Charley hits Florida.
  • Three more powerful hurricanes hit Florida and neighboring states.
  • A magnitude 9.0 earthquake — the strongest in 40 years — struck Indonesia, triggering a tsunami that killed tens of thousands of people in more than 11 countries.

2005

  • Blizzards blanket the Northeast.
  • The Federal funds rate is raised six times.
  • CPI posts biggest drop since 1949.

2006

  • Alan Greenspan stepped down after 18 years as Federal Reserve Chairman. Ben Bernanke stepped in.
  • Hezbollah attacks Israel.
  • Heat wave set records across U.S. and caused power outages.
  • BP announced plan to shut down Prudhoe Bay oil field in Alaska.
  • Intel announced layoff of 10% of its workforce.

2007

  • Both existing and new home sales dropped most since 1990.
  • Winter storms blanketed much of Midwest and Northeast.
  • Rising default rates hit subprime mortgage industry hard.
  • Declining markets in Europe and China, plus a steep drop in durable goods orders, caused biggest one-day drop in the Dow in six years.
  • Mortgage defaults hit 10-year high.
  • U.S. payroll job growth slowest in four years.
  • S&P and Dow hit record highs.
  • Mattel issued massive toy recalls for Chinese-made products.
  • Fed injected nearly $40 billion into the banking system to keep markets operating normally.
  • Bank of America invested $2 billion in Countrywide, helping the nation’s largest mortgage lender with a severe liquidity crunch.
  • Fed injected over $40 billion in temporary reserves into U.S. money markets.
  • Citigroup, Bank of America, and JPMorgan Chase agree to $75 billion superfund to restore confidence in credit markets.
  • President Bush announced plan to voluntarily and temporarily freeze mortgage rates of of some mortgage debtors holding adjustable-rate mortgages.
  • Sales of new and existing homes down 40% in California.

2008

  • Bank of America agreed to purchase Countrywide.
  • Crude oil topped $100 per barrel.
  • Gold futures hit $1,000 per ounce for the first time.
  • Gas prices rose to another record.
  • JPMorgan Chase agreed to buy Bear Stearns for a fraction of its value of just weeks earlier.
  • Fed expanded range of programs to boost financial market liquidity.
  • Retail chains experienced wave of bankruptcies.
  • Crude oil hit new high of $140 per barrel.
  • Extended unemployment benefits began.
  • IndyMac Bank seized by financial regulators.
  • President Bush signed housing rescue law.
  • Georgia-Russia conflict escalated.
  • U.S. government took over Fannie Mae and Freddie Mac.
  • Washington Mutual seized by the FDIC, banking assets sold to JPMorgan Chase.
  • Citigroup purchased banking operations of Wachovia.
  • Financial crisis spread to Europe.
  • Emergency Economic Stabilization law — commonly referred to as a bailout of the U.S. financial system — became law.
  • Wells Fargo merged with Wachovia.
  • Worst week for the stock market in 75 years in October 6-10.
  • Fed provided $900 billion in short-term cash loans to banks.
  • Fed made emergency move to lend around $1.3 trillion directly to companies.
  • On 10/11, Dow capped its worst week ever with its highest volatility day ever recorded in its 112-year history.
  • European leaders announced recapitalization plans for Europe’s banks.
  • OPEC cut oil production by 1.5 million barrels per day.
  • Federal government approved plan to help Citigroup.
  • U.S. auto industry bailout approved.

2009

  • Barack Obama was inaugurated as President of the U.S.
  • President Obama signed $787 billion economic stimulus package into law.
  • President Obama unveiled the Homeowner Affordability and Stability Plan.
  • Dow dropped below 7,000 for first time in 12 years.
  • U.S. Treasury Secretary unveiled the Public-Private Investment Program.
  • Chrysler filed for bankruptcy.
  • GM filed for bankruptcy.
  • Case-Shiller housing index shows first rise in three years.
  • Cash-for-clunkers program ended.
  • Jobless benefits extended.
  • Homebuyer tax credit extended and expanded.
  • S&P finished the year 65% above its 3/9 low and was up 23% for the year. NASDAQ finished the year up 79% from its low and was up 44% for the year.

2010

  • President Obama signed landmark healthcare bill.
  • BP had massive oil spill in the Gulf of Mexico.
  • Ash clouds from Icelandic volcano shut down airports across Europe.
  • Wall Street Reform and Consumer Protection Act signed into law.
  • U.S. poverty rate jumped to 14%, its highest level in 16 years.
  • Californians’ income fell for first time since World War II.
  • Federal Reserve announced second round of quantitative easing through purchase of $600 billion of long-term Treasury bonds.
  • For second straight year, no inflation-based increase in Social Security benefits.

2011

  • Commodity prices soared.
  • Uprisings in the Middle East — the Arab Spring — begin.
  • Powerful earthquake and tsunami devastate Northern Japan.
  • U.S. joins airstrikes in Libya.
  • Osama bin Laden killed.
  • President Obama signed debt ceiling bill.
  • S&P downgraded U.S. credit rating.
  • Federal Reserve announced plan to extend average maturity of security holdings by buying $400 billion of longer-dated securities and selling $400 billion of shorter-dated securities.
  • Six central banks took joint action to enhance global liquidity.

2012

  • Facebook IPO.
  • S&P upgraded California’s financial outlook.
  • Moody’s cut ratings of 15 major banks.
  • Supreme Court upheld healthcare law.
  • City of San Bernadino, CA filed for bankruptcy.
  • European Central Bank launched “outright monetary transactions” program.
  • Spain’s credit rating downgraded by S&P.
  • U.S. home foreclosures fell to five-year low.
  • Superstorm Sandy slammed Northeast and mid-Atlantic states.

2013

  • Congress avoided “fiscal cliff”.
  • 2012 hottest year for contiguous U.S. since records began in 1895.
  • President Obama inaugurated for second term.
  • Dow hit 14,000 for first time since 2007.
  • Eurozone experienced first year with no growth in any of the four calendar quarters since record keeping began in 1995.
  • Japan recorded its first trade deficit since 1979.
  • Automatic federal government budget cuts known as “sequestration” took effect.
  • Dow surpassed pre-financial-crisis levels.
  • Fitch downgraded Italy’s credit rating.
  • Cyprus experienced severe financial crisis.
  • Boston Marathon bombing.
  • U.S. stock market “flash crash”.
  • Tsunami hit east coast of U.S.
  • City of Detroit filed for Chapter 9 bankruptcy protection, marking the largest municipal bankruptcy in U.S. history.
  • Federal Reserve announced it would continue its bond-buying program due to concerns about weakening growth.
  • Federal government shut down for two weeks.
  • Fitch placed U.S. federal government credit rating on “watch negative”.

2014

  • Crisis in Ukraine.
  • Janet Yellen took over as chairwoman of the Federal Reserve.
  • Russia formally annexed Crimea.
  • European Central bank set its deposit rate at -.10%.
  • Crisis in Iraq began.
  • U.S. and allies launched first air strikes against ISIS in Syria.
  • Hong Kong protests.
  • First case of Ebola in the U.S. confirmed.

Will the United States Default?

 

Our political madness is the lead media story every day, and the default-related technicalities and prospects have been thoroughly discussed. Despite the emphasis, the financial markets do not seem worried. The S&P 500 is within 1% of its all-time high. The 10-year U.S. Treasury bond yields just 2.69% -- hardly a punitive rate.

We see the odds of a timely increase in the debt ceiling, and therefore an avoidance of default, at greater than 95%. The U.S. dollar is the primary currency held in central-bank vaults around the world and is the primary currency of global trade -- collectively referred to by some economists as America's "exorbitant privilege". A default would surely shrink this privilege, and it could cost our economy far more than all items at the center of the congressional debate. We also saw Congress briefly hesitate to take action during the 2008 financial crisis, but the severity of the market's reaction induced a rapid response. It's hard to see default as anything but highly improbable and, in the worst case, a very temporary condition. 

An imminently approaching default, and certainly an actual, even momentary default, could cause significant volatility in the markets. With a quick resolution, however, we believe most markets would promptly return to previous levels. Compared with other recent moments of extreme market movement, this one is based solely on political unwillingness, rather than on a huge fundamental fault (e.g., lousy tech companies with outrageous valuations in 1999; wild lending standards, crazy-low yields, and heavy bank leverage in 2008). Again, if the markets were really concerned about our ability or willingness to pay our debts, our 10-year Treasury bond would NOT yield just 2.69%!

Since we expect little net effect from the debt-ceiling issue, and since we believe no one is skilled in the prediction of day-to-day market gyrations, we plan to maintain your portfolio's typically calm stance. As always, we watch the options market for affordable opportunities to hedge unusual risks and protect your portfolio at reasonable cost, but we do not plan to use options at the moment.

It may be that bondholders around the world begin to charge the U.S. Treasury a (marginally) higher interest rate in the future, but we believe that will be the case regardless of the path our Congress takes to raising the debt ceiling. The world is already watching, and our process must be creating greater lending reservations every day. Even if this issue causes bondholders to demand higher rates from the U.S. Treasury, this does not affect our outlook for your portfolio. We believe your portfolio is well positioned for increasing rates, whether resulting from political theater or the more fundamental factors we monitor (i.e., inflation and real interest rates).

In the investment classic The Intelligent Investor, Ben Graham said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." In managing your portfolio, we always look past the market's daily yeas and nays, and instead focus on the number on the scale, which weighs the fundamentally driven, long-term values of your securities.