Berkeley 2nd Quarter Market Commentary
As we write, US equity market returns are up slightly for the year. If pressed to predict a year end return, we would expect returns to be flat to down from this point- though we’re not willing to make any investment decisions based on our guess. Our objective is to find companies that we can purchase when the market price inadequately reflects value and to sell them when the opposite occurs. Some will argue this is impossible to do because the market is rational and prices reflect the collective knowledge of all the market members. This argument might include a plug for long term investing- to which some of you might recite Keynes famous line: “in the long run we are dead!” At the polar extreme of long term investing, one might ask “does closely studying the minute to minute short term gyrations help one make money?” Not likely, unless one has a super-computer stationed next door to the stock exchanges and armed with complex algorithmic formulas. A caveat: computer programs, though quick to decipher and trade on bits of timely data, can on occasion get the trade all wrong.
For the past six months we have conjectured that attractive pricing was occurring in commodities, especially oil, and emerging markets. And in fairness, these areas account for most of the slim gains markets have attained in early 2016. While way too early to declare a new bull market for commodities, oil, and emerging markets, we are happy to own a few investments in this area and giddy that we have accumulated some cash in our portfolios to increase ownership if and when we are tempted to pull the trigger. This approach is neither short nor long term. We refer to it as tactical.
We continue to hold a much larger portion of our investor portfolios in cash. For the record, if you hold cash you lose value over time to inflation. And this could not be any more painfully true than when cash equivalent investments yield – well nothing! If you have enough cash, banks are asking you to pay them a little interest to domicile your money. Such is the world of ZIRP (zero interest rate policy). We can provide you with three reasons investors might appreciate cash at a zero rate of return as an attractive asset class: Cash is an effective hedge against market loss. Cash provides an opportunity to take advantage of market declines. Cash provides stability during times of market uncertainty and helps reduce emotional mistakes. The rationale behind our cash position lies in our calculation that financial and real estate assets are priced to perfection. Using GAAP, the US stock market trades for about 22 times earnings. Thirty year treasury bonds trade for about 37 times the yearly interest one earns. Sporting lofty prices doesn’t mean prices have to correct. However, the margin of safety has been reduced to the point that we will risk being patient with some of your assets and search for more attractive opportunities. Again, we refer to this as tactical.
In 1989 the Japanese market (Nikkei) peaked at 39,000. The average price earnings multiple reached 100. Without rehashing too much history, the Japanese Federal government, Central Bank, commercial banks, and corporate leaders colluded to drive stock and real estate prices to bubble territory- and the collapse to follow left Japan economically crippled.
The figure below illustrates the 2 ½ lost decades for Japanese stock investors. Interestingly the central bank playbook for economic revival looks eerily similar to our Federal Reserve policies of zero percent interest rates, quantitative easing, currency creation, and confusing rhetoric.
Many watched the replay of Ernie Els walking off Augusta National’s first green after taking six putts to hole his ball from three feet. Els, affectionately referred to as the “Big Easy”, has two US Open and two British Open championships to his credit and has twice finished second in the Masters. How could a player of his ability temporarily lose his ability to complete a simple athletic exercise he has indubitably practiced a hundred thousand times? Els’ struggled to craft an explanation other than to characterize his meltdown as a case of the dreaded “yips”. The term yips was coined in 1927 by the reigning US open champion Tommy Armour after exploding on the seventeenth in the Shawnee (Pennsylvania) Open and carding a rumored “23”! Armour stated: “I simply don’t know what happened. I just had a severe case of the yips or something.”
In December, Fed chairwoman Janet Yellen announced the central bank’s decision to raise interest rates by one quarter of a point. She additionally suggested the Fed had penciled in four quarter point rate increases for 2016. Not surprisingly, the S&P suffered a rough patch dropping about 10% in the first two months of the year. One shouldn’t simply assign all the weakness to the Feds change in tenor. Oil prices collapsed again! China depreciated their currency again! But perhaps more importantly the expected growth in US economic expansion again failed to materialize. So Yellen back pedaled on rates in March and noted that the Fed’s employment and inflation objectives “will require a somewhat lower path for the federal funds rate increase than was anticipated in December.” The Fed met again this month and for the moment suggests that they “remain cautiously optimistic”. Don’t you enjoy oxymorons?
We were promised another rate hike- maybe a quarter percent, but yet to be determined. Will the interest rate change lead to another nasty correction in equities and commodities? The proper response is of course, who knows. But note, when it comes time to pulling the interest rate trigger, Yellen and company appear to have a temporary case of the “yips”.
We understand that the presidential election has led to an elevated level of angst. Perhaps past campaigns have been conducted with greater malice – we can’t remember one. You will undoubtedly learn that the markets will react positively and negatively to the election of each candidate. We’re not sure this election will have any meaningful short term impact on stock valuations or interest rates. From a larger perspective we hope that our future will also offer a solution to our grandchildren’s future, instead of the one where they are saddled with our addiction to national debt. Sadly the leading candidates spend considerable campaign efforts in demeaning the opponent and little on vision and less on strategy. We’ll each enter the booth in November and when pulling the lever many of us might develop a case of the dreaded “yips”.