2021 Q4

I hope everyone has had a good start to the year. Mine started with a bout of Omicron. I was patient zero in our household and then we went 6 for 6. Nothing serious but it did put me on my back foot to start the year…thus you are receiving this a few weeks later than we’d like. We appreciate your patience.

2021 was an interesting year for the stock market. The major stock indexes logged yet another double-digit year of growth. There were reasons for the markets to be optimistic. Corporate earnings were good, consumer demand was up, unemployment was low, money was loose, and the economy posted strong enough GDP numbers to bring us back to the long-term trendline of economic growth. These factors are all tailwinds for stocks and 2021 proved to be a good year for many companies.

A good year for many but not a good year for all

For some time now though, we have noticed disparity in different parts of the market. In some places, like traditional growth, valuations are high but not obscenely so. In other places, valuations appear to be reasonable. There are also areas of the market that have been downright speculative. In our 2021 Q2 commentary, we pointed to the speculative behavior occurring in certain areas of the market: SPAC’s, meme stocks, crypto-currency, FinTech, innovative tech, and non-profitable tech. These areas of the markets had received huge inflows of capital since the pandemic which had driven the price of many companies to lofty levels. About halfway through 2021 though, the gains started to reverse. By the end of the year, roughly 40% of the companies in the Nasdaq index had a share price that was 50% lower than their 52-week high.

The chart below has some notable names that experienced heavy losses in 2021. If I had continued this chart into 2022, it looks worse, but need something to talk about next quarter.

At the surface level of the market, this was barely noticeable. In fact, the Nasdaq 100 continued a steady upward climb through the end of the year. That begs the question, how is it possible that almost half the companies in an index can drop by 50% and yet that index still goes up in price?

The answer: Big Tech. With their earnings perceived to be destined to grow forever, capitalism and passive fund flows have rewarded the Big Tech companies handsomely. Google, Facebook, Microsoft, Amazon, Apple and Tesla have now grown to the point where they make up 45% of the total value of the Nasdaq 100. 6 companies = almost 50% of the market. They are so big that their combined market capitalization is twice the Gross Domestic Product of every country in the world, excluding the US and China. They’re big. Really, really big. Historically big. Andre the Giant big. The performance of these 6 stocks heavily influences the direction of the index, nearly to the point of domination. If they are performing well, a lot of other securities in the index can be performing poorly and you won’t notice it on the surface.  That is exactly what happened in the latter half of 2021. Big Tech was stable, other areas…not so much.

The chart below shows % drop-off from the highest price of several Ark Invest Funds. Ark managers focus on investing in what they believe to be life transforming innovations. Their funds are a good proxy for the types of companies who had their share price drop in 2021. They performed excellently the last few years and, arguably, for good reason. Many of these companies have extraordinary ideas and extraordinary products. They may very well may change the way we interact with the world. Areas such as FinTech, robotics, genome science, biotechnology, and the metaverse to name a few, all have the potential to deeply affect the way we live and interact with one another.

The world has seen several life altering innovations in the past couple of centuries: the automobile, trains, oil, electricity, and the internet, to name a few. In his book, Engines that Move Markets, Alasdair Nairn examines market behavior during these cycles of innovation. In each cycle, speculative market bubbles developed when innovation was coupled with what he calls a rare combination of coincident conditions. Let’s look through this list of coincident conditions and make some very brief notes (in parenthesis) on whether each of these conditions exist today:

  • The emergence of a new and potentially transforming technology about which extravagant claims can be made with apparent justification (Yep…quite a bit of it out there)
  • A climate of relatively easy money and credit conditions (let’s see here…lowest interest rates ever, multiple stimulus checks directly deposited into consumers accounts, and the largest increase of M2 money supply on record. I think this one is covered too)
  • General investor and consumer optimism (I’m feeling pretty good)
  • A wave of new publications promoting the merits of the new technology (um…yes. Also, Reddit)
  • An efficient and productive supply machine, capable of creating a host of new companies to meet investor demand (SPAC’s; ETF’s, Coinbase, Robinhood. There is nothing bad about any of them but it does illustrate that the finance supply chain is alive and well)
  • Suspension of normal valuation and other assessment criteria (I could go on about this one for a long time)

It looks like all the conditions that marked prior market bubbles are present today. While I would stop short of calling what has developed a bubble, the price of many securities did get expensive, very expensive. Fueled by government stimulus, time on their hands, new ways to speculate, and encouraged by the promise of a changing world, the market drove the price of these securities higher and higher. Eventually people woke up to the fact that, for instance, there are a limited number of people who will spend $1,500 on a stationary bike from Peloton. As always happens, the market then reversed many of the gains that had been realized over the last three years. As it is often said, trees do not grow to the sky.

While these speculative movements only happened in relatively small corners of the investing world, they are important to note for a couple of reasons:

First, it may mean that investors are turning a more discerning eye to where they invest their capital. The investing world has been seemingly oblivious to fundamentals for some time, focused on investments of promise rather than investments of profits.  If people are growing concerned about the truly speculative corners of the market, they also may start turning a more discerning eye to the price of the rest of the market. In the last few weeks of the year, it looked like even Big Tech was susceptible to some price reconsideration.

Second, it is a reminder that “the market” is a diverse place. We think this is a really important point as we look to the years ahead. The stock market certainly faces mounting challenges: inflation, rising interest rates, geopolitical tensions, a slowing economy, etc. There is also a lot of talk of the US market being over-valued. I could quote any number of investors, many of whom we have great respect for, that say the market is over-priced and due for a correction.  There is certainly an argument to be made there. But 2021 was a good reminder that “the market” is more diverse than we often give it credit. It may look expensive, there may be speculative areas, but there are also reasonably priced opportunities with the potential for good long-term growth. From our vantage point, there is more diversity in the price of securities today than we’ve seen for a decade. As such, we will continue to look for opportunities to invest capital at an acceptable level of risk.


2021 Q3

Happy fall to everyone. It’s my favorite time year. It always has been, even before pumpkin spiced lattes and all things flannel came in vogue. As the cool weather sets in, we hope that you have a great fall and holiday season.

The third quarter gave us no shortage of things to consider: market volatility, rising interest rates, a good ol’ fashioned government debt ceiling showdown, a floundering infrastructure package, defaulting developers, haywire supply chains…lots of stuff to ponder, far too much to get to here. We will give a market update and some thoughts on a couple of these issues. As always, if you have questions feel free to reach out.

The S&P 500 eked out a small gain for the quarter of 0.2%. During July and August, the market continued its upward climb with the S&P hitting a new high at the beginning of September. It was not to last though. Rising treasury rates and the specter of inflation spooked investors and the market quickly dropped 5%. Elsewhere in the world, rising energy costs and aggressive regulatory measures implemented by China pressured global markets. The foreign traded Chinese stock market, and other major markets suffered corrections, with many of their indices falling more than 10%.

It was good to see the market take at least another breather. It’s basically been on a non-stop upward climb since the Federal Reserve announced in March 2020 their intention to purchase $120 billion in US debt every month. The economic recovery from the initial COVID lockdowns has been robust, but many argue the main driver behind the continued market gains is the Federal Reserve’s asset purchases. The liquidity those purchases provide appear to have been necessary to avoid an economic collapse during the height of the lockdowns but at this point we might be getting too much of a good thing. The famed economist/professor, Mohamed El-Erian, recently remarked in a Financial Times article:

For their part, investors should recognize that the enormous beneficial impact on asset prices of prolonged central bank yield repression comes with a consequential possibility of collateral damage and unintended consequences. Indeed, they need only look at how hard it has become to find the type of reliable diversifiers that help underpin the old portfolio mix of return potential and risk mitigation[i]. 

One impact of additional liquidity and low interest rates has been consistently rising asset prices, such as we have witnessed in the stock market, bond market, real estate market, and just about almost every financial instrument. Many of these markets have hit all-time highs recently and, as we remarked in our last commentary, stock valuations are high on a historical basis by almost every metric. When the Federal Reserve tapers their asset purchases, which they will likely do in the near future, a part of the support for high asset prices will be removed and the market will be forced to stand on its own.

The unintended consequences of the Federal Reserve’s actions may play out over a long period of time. For instance, pushing asset prices to historical highs may mean we have to endure a subsequent long period of low returns. If you want to know what this might look like, Bank of America’s (BofA) research arm releases a chart forecasting 10-year returns (see right). One nice feature of this graph is they include their track-record since 1990 and, importantly, they’ve been in the ballpark of actual returns most of the time. As of now, they have the market, as defined by the S&P 500, pegged at an annualized negative rate of return over the next 10 years. GMO, an institutional investor, publishes a similar analysis, estimating forward returns for the next 7 years[ii]. Theirs, shown below, presents an even less rosy picture (an important side note…they present it in “real return” meaning, return minus inflation).


These estimates are not prophetic, but they are informative. The process BofA and GMO use for these estimates examines forward economic growth potential and assumes a reversion to the mean of investment returns, earnings per share growth, profit margins, and valuations. In simpler terms, if the US market is to repeat the performance of the last decade, it will have to buck historical trends or tap into some new channel of economic growth. Possible? Yes. Probable? No.

Looking back at the last 10 years, it is hard to fathom an extended period where the S&P 500 doesn’t perform exceptionally well, but history has shown there can be long periods of low to no growth in developed stock markets. For example, the United Kingdom’s FTSE 100 index is today just slightly above the value it was in 1999, i.e., last century. I was wearing Reebok Pumps and Starter brand hats when Japan’s Nikkei 225 Index hit its high-water mark in 1989.  We could site several well-reasoned explanations for those paltry returns but they both start with the same over-arching factor…valuations. 1999 was the height of the dotcom boom when tech companies were selling at ridiculous multiples.  1989 was the height of the Japan craze where markets had assumed that Japanese companies had discovered the secret sauce to perpetual growth (sound familiar?)[iii].  Even the S&P 500 has had these periods. If you refer to the graph from B of A, the 10 year forward returns for the S&P 500 from 1998, 1999, and 2000 were negative. With current market valuations, me might be staring down a similar period.

This doesn’t mean we need to run for the hills, go all to cash, or bury our head in the sand. There are many of different paths the market can take, even if performance isn’t what it has been. We are not suggesting “crash and burn” is inevitable. In fact, the current market could continue to be supported for some time. If S&P 500 earnings grow robustly like many predict, valuations will be more reasonable, though still a long way from historical norms. Also, “the market” is more diverse than most people think. The S&P 500 performed poorly in the first decade of the 21st century but there were pockets of domestic equities that did well and many foreign markets, like emerging markets, had strong performance. We believe similar pockets of more reasonably priced assets exist today.

Chinese Regulatory Crackdown

Much of the market turmoil experienced in the third quarter was stimulated by developments in China. The Chinese Communist Party (CCP) has taken several regulatory actions over the last year aimed at reducing big tech influence, shifting capital investment to different industries, eliminating the inflating costs of private tutoring, reducing carbon emissions (or more accurately stated, reducing reliance on fossil fuel imports), and reigning in overextended debt in the construction development sector. These actions have reverberated across markets as corporate profitability in some sectors has been directly impacted or, as in the case with the private tutoring industry, eliminated (private tutoring companies now must be not-for-profits). In addition, Evergrande, the country’s largest and most indebted real estate developer, is on the verge of collapse. They have missed several note payments to their bondholders and further note defaults look likely.

Unraveling the decisions of the CCP – their motivations and the long-term impacts – is difficult, to say the least. Some of the world’s most successful investors have contrasting points of view regarding China. For instance, Ray Dalio says that investments in China can’t be avoided and should be embraced. In contrast, George Soros has labeled China as un-investible. Some have labeled Evergrande as China’s “Lehman moment.” Others see it as a small hiccup on the road to fix structural problems and promote Xi’s “Common Prosperity” doctrine.

Diverse opinions concerning China is nothing new. For the last two decades, we’ve been reading about the impending collapse of the Chinese economy while at the same time reading about China’s eventual assumption as the world’s greatest super-power.  The reality is probably somewhere between those extremes. It is the second largest economy in the world and the largest by population. The country has experienced unprecedented economic growth during the last 30 years. The development of a large – and growing – middle class has created opportunities for growing corporate revenue. We also tend to view China not just the through the lens of the CCP. The corporations we own equity in support the life and livelihood of thousands, likely millions, of Chinese families.

In our view, recent events don’t change that over-arching outlook. We certainly don’t like the regulatory actions taken by the CCP (we believe in the superiority of a free market society. Also, we see some of these actions as discouraging entrepreneurship, productivity improvements, and innovation) but we see the intended utility of them. We also recognize that whatever the CCP does, it will be in the best long-term interest of the CCP. The timing of these regulatory changes is with purpose. It comes at a time when the country is benefiting from the re-emergence of the global economy. GDP growth was 18% in Q1 and just under 8% in Q2. This is a time where some short-term economic pain can be taken in favor of longer-term goals. But the recent regulatory actions do impact the risk profile of the country. The actions of the CCP have caused a lot of market volatility and have in some specific cases (private tutoring companies) destroyed wealth. In recognition of these increased risks, we are diversifying more broadly across Asia.

Inflation – Energy Prices Soar

Inflation continues to be at the center of debate and concern across markets. In July and August, inflation remained at over 5%. September results had not yet been released at the time of this writing, but inflation is expected to be lower (we’ve heard that before) as there are signs that many of the largest inflation contributors, such as airline fares, hotel fees, and used car prices, had decreased. However, the supply bottlenecks contributing to inflation don’t appear to be loosening up. In fact, they might be getting worse. We continue to have faith in supply side economics: as prices increase, purchasing will slow and this will help bring equilibrium back to the supply chain. That process may be a bit of a grind, and take some time, as the global economy muddles through an unprecedented whiplash of demand.

More concerning as of late is the recent surge in energy prices.  Power shortages are acute in China and India right now. Warm weather and the strong economic recovery have pushed energy demand to an all-time high. In addition, the central Chinese government is pressuring its provinces to reduce their carbon dioxide emissions, a difficult task for a country reliant on coal for 70% of its energy generation. The nation has started rationing power and forcing day-long factory closures.  With winter around the corner, China and India are both looking to liquified natural gas (LNG) imports to help fill the gap. Unfortunately, Europe also relies on LNG imports for much of its energy production and, in this global economy, increased demand in Asia – along with other factors – is pushing the price of natural gas to all-time highs across the globe.

The price of crude oil has also been increasing, recently rising to a 7 year high.  Oil may be seen as the red headed step-child of energy generation but that child is still the main breadwinner for the family.  Oil, along with its other carbon emitting siblings, can also be stored or produced at varying rates to adapt to variability in energy demands. In contrast, wind production and solar conversion can’t be ramped up during, for instance, hotter or colder days when energy consumption peaks. Renewables also present a problem when mother nature decides not to behave herself. For example, the share of electricity provided by renewables in the United Kingdom dropped in the spring of 2021 from the year prior because there was less wind and fewer sunny days.  Texas, of all places, also had to deal with this reality last winter when an ice storm froze wind turbines across the state. The cold snap had pushed up energy consumption and decreased energy output at the same time. With colder weather just around the corner in the northern hemisphere, energy demands will increase and already stretched power grids will have to increasingly rely on carbon emitting sources of energy.

Oil producers seem loath to meet this increased demand with increased production.  The Organization of the Petroleum Exporting Countries (OPEC) is unwilling to increase their production beyond the already outlined planned increases.  US energy producers have largely shifted towards a capital model that focuses on paying out cash to shareholders in the form dividends and share buybacks instead of reinvesting for growth. That is unlikely to change as the political climate makes the regulatory risk of investing in expanded production too high to entice companies and shareholders. Bottom line: be ready to pay higher prices at the pump and write bigger checks for your heating bills this winter.

Looking out to the longer-term, this same story of energy shortages is likely to play out time and again over the coming years as the world attempts to shift away from carbon emitting sources of energy.  Governments will be toeing the line between reducing their carbon emissions and keeping people warm, fed, and traveling at a reasonable cost. One has to look no further than the US, whose administration is pressing OPEC to increase production while at the same time taking regulatory steps to reduce domestic production and transportation. Traditional energy producers are looking less willing to play the game. Rolling power outages and spikes in energy costs are probably here for some time. Some will call it growing pains. Others will call it self-inflicted foolishness. Either way, oil and natural gas aren’t going away, and the price is likely to go up in the near term. We will all be paying more at the pump but the energy positions in our portfolios should fare well.  We will continue to look for opportunities to invest capital at an acceptable level of risk.Blake

[i] https://www.ft.com/content/225cb41f-2cfc-42de-9066-d0ce86a2fed7

[ii] https://www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-august-2021/

[iii] https://www.ft.com/content/99a8158d-d08c-4de9-9712-2301b9497779

2021 Q2

During the 2nd quarter, the economy continued its recovery from the economic shutdowns of 2020. Consumer spending, which makes up roughly 70% of US economic activity, has been strong. The job market has been in good shape, with the main challenge being employers filling open positions. It seems every business has “now hiring” signs posted. Banks are flush with capital. Many corporations are in an improved position compared to the beginning of 2020. While the pandemic was a challenge for most businesses, the support provided by the Federal Government and Federal Reserve gave opportunity for companies to borrow additional money, extend credit maturities, and lower overall interest costs.  With the economy seeing huge gains from government stimulus, companies are looking to report high earnings from the Second Quarter.

Within the last few weeks of the quarter, economic data started to deteriorate. It’s not a collapse, but things are not looking as promising as they once were. Several financial institutions have downgraded their economic growth expectations for later this year and into next year. There has also been a surge in COVID cases domestically and internationally as the Delta variant of COVID aggressively spreads. If global governments react with the same lockdown measures as they did in 2020, this will also put pressure on the economy. In addition, several of the protective measures implemented by the government are set to expire soon. The increased unemployment benefits are scheduled to cease in September, and the continuation of the eviction ban is in question. These could also have a damaging effect on the economy as lower income families deal with higher costs and less cash flow.

Questions still abound about the long-term health of the US Economy. The accommodative actions of the Federal Government and the Federal Reserve gave corporations the opportunity to retrench and restructure their debt, an opportunity they welcomed with open arms. US corporations issued more debt in 2020 than any previous year. While this was a boon in the recovery, as the economy cycles, many businesses will likely find themselves over-leveraged. All these gains have been achieved by unprecedented government support. Granted, this support was necessary in the wake of lockdowns. Without government support, economic recovery would have taken years, if it ever recovered at all. But this is now the second consecutive recession where massive government stimulus was necessary for recovery, and each step has required greater measures to be taken in support of the economy. In the process, the government has taken on more debt and may have created an economy reliant on low interest rates and easy monetary policy.

Inflation, Inflation Everywhere

Anyone notice prices going up lately? That’s a bit of a rhetorical question. I think at this point, everyone has noticed the increased cost of stuff (that’s technical jargon): used cars, houses, lumber, clothes, food, gas…it seems like everything has become more expensive the last few months. That’s not just perception. Inflation has arrived. The 12-month inflation rate in April, May, and June was 4.2%, 5.0%, and 5.4%, respectively.  That’s more than twice the average over the last 10 or so years.  Prices are going up, and we are all seeing it.

The question being openly debated in the financial news is, how long will this higher level of inflation last?  If you listen to the talking heads out there, there are a few contrasting viewpoints.  Leading one side of the argument is the Federal Reserve, who sees this period of high inflation as “transitory.” They state that this is the result of coming out of a period of lower inflation and congested supply chains, temporary issues they believe will eventually work themselves out as the economy transitions from closed to fully open. The counter argument is that we are witnessing sustained high inflation due to unprecedented direct government stimulus into the economy and the ongoing support of the Federal Reserve. 

Each side of the argument has its merits. Inflation was barely existent in 2020 and was historically low in the period between the Financial Crisis of 2008 and the 2020 pandemic.  If you look at inflation in that broader context, the high inflation figures experienced during the 2nd quarter could be partially attributed to a “base-rate effect.” Several industries, like the travel industry, dropped prices significantly in 2020 and are now increasing prices aggressively as demand has returned. The bottlenecks in the supply chain are largely the result of businesses decreasing inventory and production during the pandemic and then having to manage a sudden spike in consumer spending and government earmarking as the economy re-opened. Plus, the shipping and transportation industry can’t seem to get enough employees. Goods and materials are sitting in ports with no one to unload them or transport them to their destination. In short, there’s a mismatch between supply and demand right now. Arguably, the numbers also support this argument that inflation is more of a result of these short-term factors as opposed to a long-term trend: if you remove the certain components of CPI related to re-opening (i.e. hotel & air travel, computer chip shortages, used car prices, etc), the inflation surge is not much of a surge.

The counter-argument is somewhat compelling as well. Money supply (the amount of dollars in the financial system) increased by 25% in 2020 because of the massive stimulus efforts by the Federal Government and the Federal Reserve. Banks are flooded with deposits from corporations and individuals who have basically stashed their stimulus dollars. In fact, some banks are having to re-work their capital structure because they have so much cash in deposits. If that money starts getting into the economy, the mismatch between supply and demand could persist.

The difference between those two positions comes down to whether or not the high inflation rate will be sustained.  Price increases in some areas where inflation is really hot, such as used cars and housing, will likely temper as consumers begin to balk at the rising prices. Supply chain issues will eventually work out, as it is within businesses’ financial interest to quickly move base goods and products and as pent-up demand from the pandemic fades. If forward looking economic indicators are correctly showing a decrease in growth, that should also have a taming effect on inflation as well. As these economic forces work out, what we see as the most likely outcome is inflation settling in a slightly higher range than in the last decade as the deflationary impacts of globalization and decreasing working-age populations begins to counter-act inflationary pressures.

The path to that end may be volatile, and we also could be flat wrong. We’ve often remarked on economists’ inability to accurately predict inflation, and while it’s a nice ornament in the office, our crystal ball does not help us see any clearer than theirs. There are a number of unknowns that could continue to push inflation higher. Another stimulus package from the Federal Government may threaten to overheat the economy and add fuel to inflation. In addition, the savings amassed through stimulus could make its way into the system if consumers at large begin to expect higher sustained inflation.  If people believe they will have to pay a higher price for a good or service if they wait, they are more likely to spend now to avoid paying more later.  This can create a feedback loop…the consumer spends because pricing is going up, companies respond to the demand by increasing prices, and consumers again spend because pricing continues to go up.

So, we must move forward with a watchful eye towards inflation. Regardless of what happens with inflation, there are still some immutable facts. Good companies will continue to make money, and hard assets will retain value. We will continue to look for those kinds of positions and manage our bond exposures to react well in a rising interest rate environment.


During the 2nd quarter, the US stock market rose to some new high-water marks. Honestly, we continue to scratch our heads in wonder about the performance of the market as it continues its steady upward climb. Prices are optimistic and seem to be ignoring any future risks. It appears that a large volume of stimulus money has landed in financial market pushing arguably overstretched valuations higher and driving an increase in speculative behavior. In the last few months, shares of several companies whose business models have been seemingly left behind by market trends, like GameStop and Blackberry, have been revived by day-trading retail investors crusading against hedge funds who had shorted the shares. The price chart of lumber from April to the end of June looks like an outline of the Matterhorn. It went from $840 per thousand board feet in mid-April, peaked at around $1,700 in mid-May, and ended June at $716.  Bitcoin started the year at around $20,000, ran up to just over $60,000, and is now sitting at around $32,000 and is trending upwards.

This isn’t normal market behavior (although Bitcoin can go Wild-West at any moment), and prices don’t move this much purely based on fundamentals. It’s hard to explain a 100% increase and then a 70% drop in the price of lumber over the course of 2 months solely based on supply and demand.  Logjams of that magnitude don’t pile and then break free that quickly.  This was textbook speculative market behavior.

Times like this require an increased degree of caution and an eye on long-term valuations. Benjamin Graham, the often-coined father of value investing, believed one of the biggest challenges to investors was recognizing when the market had turned from investing money to speculating in money. There is a difference between the two. Investing is buying an asset for its value and long-term cash generating qualities whereas speculating is betting on future market movement (there is room for nuance here that we won’t get into). Speculation isn’t all bad. There is room for speculation in a portfolio. How much is dependent on the investor. But it is important to acknowledge when you are making a speculative bet and often in markets like we are experiencing the crossover from investing to speculation can be subtle. As the market continues to climb, it’s easy to ignore the fundamentals, ignore the mounting risks, create justifications for higher and higher valuations, and put your faith in the everlasting bull market, may it never die.

While that approach may work for a time, it can be detriment to long-term returns. It is a well-supported argument that the biggest indicator of future returns is current valuation. That’s why most of our focus will continue to be on the fundamentals: buying good companies at good prices or owning funds that focus on the same. There are some remaining corners of the market where those can still be found. They’re not going to space or talking about creating things like the metaverse, but they will generate cash, a lot of it. And we get to own that cash generation for a reasonable price.

Looking farther out, we do see a lot of innovation on the horizon. The medical industry, in particular, is witnessing technological change that has been previously unseen. Technological advances in energy, transportation, and the way we work are also taking place. While we see a lot of opportunities to invest in these markets, they seem priced for perfection at this moment. We will continue to look for opportunities to invest capital at an acceptable level of risk.


2021 Q1

Good news…this commentary is a wee bit shorter than the last. That was a marathon. Kudos to you if you made it through the entire thing. This one will be a bit more manageable.

What a difference a year can make.  Last spring, my wife and I celebrated Easter with just our children in our home. I still remember my disappointment, that I wisely kept to myself, when I learned Easter family pictures would still be required.  Getting a 3, 5, 7, and 9 year old to cooperate for photos is never easy and the process usually ends with someone in tears. Somehow, we managed through. Pictures were taken but soon erased as my daughter went on a crusade to remove any evidence that daddy had shaved his beard off during quarantine. Apparently, the site of my clean-shaven face while cycling through the photos on the iPad was just too traumatic for her.  She even brought it up this year as she told my wife a couple weeks before Easter, “Last Easter wasn’t very good because Daddy shaved his beard off. I hope that doesn’t happen again.” Her wish was granted…things were more normal for us this year. Pictures were expected, we spent the day with our extended family, and my facial hair was in full bloom.

Similar stories are being told across the country as much of the nation continues to revert to normal life. More people are returning to offices, sporting events have spectators, restaurants are filling up, and summer vacation plans are being made. This activity translates is showing up in the economic numbers.  Official GDP numbers for 2021 were not released at the time of this writing but the number is expected to be big. Massive government stimulus has effectively pushed the economy forward. If current estimates do continue to play out, the US economy will be “recovered,” (meaning, total GDP will be equal to pre-pandemic numbers) by sometime in the second quarter. 

The stock market outpaced the economy, reaching the milestone of “recovered” late in 2020. It continued to grind higher during the first quarter of 2021, closing on March 31st near it’s all time high. Much of the reporting around corporate earnings seasons has been positive. Companies are optimistic about the recovery and believe revenues will continue to increase over the next year as the consumer becomes more active and the government continues to support the economy through stimulus. From some perspectives, things look bright for the immediate future.

The market is not without risks. Valuations across the US financial markets have returned to their pre-pandemic high water marks by almost every traditional valuation metric. By a price to earning measurement, the Nasdaq hasn’t been this expensive since just prior to the 1999 tech bubble. On a price to sales measurement, the S&P 500 is more expensive than at any other point ever. Professor Robert Schiller’s Cyclically Adjusted Price to Earnings ratio is at 37. That is a historical high surpassed only, again, by the Tech Bubble in 1999.

Beyond valuations, signs of excess continue to surface in various places as stimulus cash is looking for places to go. Special Purpose Acquisition Companies (SPAC’s) have attracted large amounts of capital the last 6 months. SPAC’s are shell companies that raise cash and then look for a company to purchase. Investors are gladly handing their money over to SPAC’s (there’s even a rap song about them…I kid not), despite having no clue what exactly they will be investing in. In another sign of excess, the price of cryptocurrencies has risen precipitously over the last 6 months. The long-term viability of crypto has somewhat solidified the last few years but the price appreciation may have gotten ahead of itself as some currencies have recently experienced price increases of 100% or more in just a matter of days. There are many other examples out there of money looking for places to go that we could site. Bottom line, there is a lot of money out there sloshing around and it sloshes indiscriminately. This will likely continue until something knocks the market off its tracks.  When that happens, people will be a little choosier where their money goes.

Inflation may do the trick, as it appears to be mounting on the horizon. Material costs are in fact going up. The increase is extreme in some markets, such as lumber. These prices are starting to put pressure on profit margins as the increase in material cost eats into the profit companies realize on the sale of their product. This kind of pressure at the corporate level can only last so long before companies begin passing the increased cost on to the consumer.

An uptick in inflation could spell trouble for the market. Initially, company earnings will be impaired before they shift the price increases to the consumer. But more importantly, inflation might cause the most damage for equities, because of the response it engenders from the Federal Reserve. Consider that one of the justifications for today’s high valuations on corporations is the lack of decent alternatives. As Buttonwood pointed out in the January 30th Economist, when valuations were at similar levels in the late 1990’s, the yield on inflation protected bonds (TIPS) was almost 4%. In contrast, on March 31st, 2021 the yield on 10 year TIPS was -.67%. Yes, that’s a negative symbol in front of the number. You are effectively paying the government to borrow your money. Not a proposition many are interested in (A side note here – money has been flowing into TIPS as of late because of inflation concerns. We are not convinced that’s the best hedge in this scenario. For one, the interest rate is negative so to make money, inflation must happen. Secondly, utilizing ETF’s and/or Mutual Funds to purchase TIPS mutes the inflation protection because of portfolio turnover. Lastly, it can be a highly illiquid market. We went window shopping for some TIPS the other day and there weren’t a lot to buy).

Interest rates impact value all the way up the chain. With Treasury Issues yielding nothing or next to nothing, investors are willing to pay more for equities. If inflation causes the Federal Reserve to raise interest rates, then fixed income instruments become more attractive. That would likely have a negative impact the price of equities. While rate increases may still be some time off, we should remember that the market tends to be forward thinking when it functions appropriately. If the market sees inflation ticking up, it may put pressure on prices, regardless of the current action of the Federal Reserve.

So, it appears we are stuck balancing on this fragile wave of stimulus induced growth, riding it higher and higher while trying not to fall off the increasingly steep back of the wave. While domestic markets are richly valued, factors such as positive momentum, increased stimulus measures and positive economic growth could continue to drive it higher still. In many ways, short term economics look good. Global economies will likely have a banner year and consumers have $2.5 trillion more in savings than they did prior to the pandemic. Maybe it could work. That said, a lot of what is being conducted right now is a grand experiment. While continued government stimulus and intervention make things look good in short-term, how it plays out in the long-term is unknown.  Are we setting the nation up for greater long-term growth or are we creating an increasingly fragile system reliant on debt and government funding? Time will tell.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


2020 Q1

First of all, our prayers are that you and your families are staying safe. We are living through a strange and unprecedented time. Just a few of months ago, we were looking at calm markets with a slowing but growing economy. That quickly changed as COVID-19 hit the US, and the economy basically shut-down. The impact on financial markets was severe. Never have US financial markets displayed the kind of volatility in such a short period of time. In a matter of weeks, the market dropped almost 40% and then quickly recovered much of the ground it had lost. Along the way, we witnessed asset price fluctuations like we have never seen before, including during the 2008 Financial Crisis. 

With financial markets struggling, the Federal Reserve stepped in with a massive volume of purchases, expanding its balance sheet by $2 trillion in less than a month.  It took years for that to happen after the Financial Crisis in 2008. To provide the economy and individuals some support, the Federal Government also stepped in to provide stimulus checks for individuals and payroll support loans for businesses.  Never has there been a greater effort from the Federal Reserve and the Federal Government to prop up an economy.  

All of this makes the future more uncertain than usual.  The modern world has never experienced a period where the global economy shut down for months, and no one alive today has faced a pandemic of this magnitude.  This leaves a lot of questions about how events will play out:  How long will it take for the economy to “re-open?”  Will there be a resurgence or a second wave of COVID-19?  How soon will a vaccine or treatment be available?  How much damage has been done to the economy?  How willing will people be to return to normal social activities?  And longer-term, what effect will all this new debt have on economic growth going forward?  These questions are being weighed and considered in the press and by governments around the world but knowing the answers just isn’t possible.  The innumerable predictions, the media commentary, and government talking points are all just speculation.  Valuable speculation (that’s a rare thing) but still speculation.  Even in uncertainty, there are a few things we can have a high degree of confidence in, which have informed and will continue to inform our decisions about how to handle portfolio allocations going forward.   

First, the US economy and the global economy will recover but it will take some time.  Financial markets seem to be pricing in a “V-shaped” economic recovery: the economy crashed quickly, and it will jump right back up.  We see that as optimistic.  It may be a V-shaped recovery, but it’s going to look like a V my five-year-old wrote, meaning that the right side of the V is going to look very different than left side.  Parts of the economy are at an absolute standstill and re-starting does not happen with the flip of a switch. A strong initial jump is possible, even likely, but it will take time for people to fully return to their normal activities. The 30+ million recently unemployed will not all find their jobs waiting for them. It took 3 years for GDP to recover after the 2008 Financial Crisis.  We would not be surprised if this recovery were to take that long, or longer.  

Second, and related to the first point, a lot of bad economic data and corporate earnings reports will come out over the next few months.  Again, estimates on how bad are all over the board.  We have seen estimates ranging from a 10% total reduction in GDP to a 40% total reduction in GDP. Corporate earnings will not look any better. Over the next few months, we will begin to understand the toll levied against the economy. As we have said many times before, we cannot predict what the market is going to do over the next few months, but as of right now, financial markets appear to be overly optimistic.  We believe there is more pain to come in the markets as the damage assessment becomes clearer.  

Third, this situation will result in winners and losers among countries and companies.  Countries with the capacity to spend financial reserves, take on more debt and expand their monetary base without immediate adverse consequences will probably come out of this ok.  In contrast, over-indebted countries with insufficient financial reserves will have a much more difficult time.  Similarly, companies with strong balance sheets and a capacity to spend during this crisis to increase market share will ultimately come out of this stronger.  In contrast, smaller companies or over-leveraged companies will struggle to access cash or, in the event Federal Reserve keeps bond markets liquid, will come out of this with more debt and less cash flow.  

Fourth, corporate debt markets will be volatile.  Market reactions in March shined a big spotlight on the corporate debt market asset bubble that we noted back in our 2018 Q4 commentary. Certain areas of the bond market dropped precipitously in price. Actions taken by the Federal Reserve brought some calm to those markets, but the problems are not going away.  Coming into 2020, corporate defaults were on the rise and Rating Agencies were warning of a coming wave of rating downgrades.  Now that the global economy has shut down for two months, we should expect even more corporate defaults and ratings downgrades.  

Lastly, the Federal Reserve and the Federal Government will continue to pull out all stops to support the economy.  As we noted above, the concerted efforts by these two institutions to provide liquidity in the markets and stimulus to the economy has been unprecedented.  This will continue, although the pace of help from the Federal Government will likely slow as the process to pass stimulus packages becomes increasingly politicized.  

With those factors in mind, we will continue to hold our high-quality positions and look to be opportunistic about buying high quality growth assets at reasonable prices.  We have already executed on a few opportunities and if market volatility persists, more of those opportunities should come around.  It’s important to note here that we are looking for good long-term opportunities.  New positions may experience immediate priced declines, but if done correctly, these opportunities will pay handsomely in the long run.  We have also made some adjustments in the portfolios to take advantage of the dislocations that are likely to occur in the corporate bond market. 

Hovering over these decisions are the actions taken by the Federal Reserve which will continue to have implications across financial markets.  For comparison, in the wake of 2008 Financial Crisis, as the Federal Reserve pumped liquidity into the financial system, markets shrugged off poor economic data and began to climb.  We are mindful this could happen again.  Given the uncertainty, we need to carefully manage risk while maintaining exposure to potential market growth.   The weeks ahead are likely to be challenging, regardless of what the market does.  Each one of us is having to live through this situation in our own way.  For some of us, this virus presents very little risk to life or livelihood.  For others, the risk is high.  Many of us probably haven’t left the house for 5 or more weeks, except to get groceries. That’s hard for some of us but enjoyable for others.  Some of us work in healthcare or have an essential job that requires going to work and risking exposure.  We want to thank you for risking yourself and your loves one on others’ behalf.  Whatever your situation, our prayers are with you. We will continue to look for opportunities to investment capital at acceptable levels of risk.  

2019 Q2

The resilience of the US Stock Market continued in the 2nd quarter.  The economy is still growing, although more signs of a slowdown are appearing.  Due to some good posturing, Q1 corporate earnings did “surprise to the upside,”, but corporate earnings growth did slow, as we speculated in our Q1 commentary.  The slowdown in earnings is expected to continue as corporation report Q2 earnings. There was also some progress, or at least lack of regress, in the trade war between US and China.  At the G20 conference on June 30th, Presidents Trump and Xi agreed to continue disagreeing on friendly terms (without additional tariffs).  There’s no trade deal yet but the two fighters have returned to their corners…for now. 

The stock market and bond market continue to flash conflicting views on the economy.  The stock market points to continued growth; the flattening/inverting yield curve, to a recession. These conflicting views are not necessarily surprising.  An inverted yield curve typically occurs months before a recession (it’s happened with no recession as well), while the stock market tends to make huge gains in the lead-up.  In other words, the inverted yield curve is usually the guy who shows up early to the party, while the stock market tends to be the one who shows up late and surprised to learn there is a party. 

Market sentiment does feel strange right now.  Typically, an over-optimistic, sanguine sentiment presides late in the market cycle as the gains make their final push into an economic slowdown.  If we are in the stage of the cycle we think we are, this is usually when the money that’s been sitting on the sideline for years is dumped in but there has not been a lot flow into domestic mutual funds and ETFs so far this year.  The flow is positive but not by much.  Where is the money coming from that’s pushing the market so much higher?  A large contributor appears to be Corporate Share repurchase programs.

Corporate Share Repurchases

A share repurchase program is when a company utilizes capital (cash) to purchase their own shares, thus removing shares from circulation.  In 2018, corporations – in the S&P 500 – purchased over $800 billion of their own shares.  That set a record.  In fact, it blew past the old record.  According to Goldman Sachs, corporations will set yet another record in 2019[1].  This represents a huge transfer of capital into the markets.  If the Goldman Sachs estimate is correct, by the end of 2019, $1.7 trillion dollars will have been pumped into the stock market in two years.  Seems like a lot of money, right?  It represents almost 7% of the total value of the S&P 500.  It’s a lot of money.

Share buy-backs can be an effective tool to return money to shareholders, because they are more tax efficient than dividends.  Presuming the seller of the stock had a gain and held the stock in a taxable account, they would owe capital gains tax as opposed to the ordinary income tax they would owe on a dividend.  There are also benefits to the remaining shareholders.  Reducing the number of outstanding shares increases the percentage ownership of the remaining shareholders.  For example, if I own 10 shares of a company that has 100 total shares outstanding, I own 10% of the company (whew…that was hard math).  If the company purchases 50 of the outstanding 100 shares but I hold on to my 10, I am now the proud owner of 20% of the company.  That should make my shares a whole lot more valuable.  What a deal.  This is functionally what we see happening in the markets right now.  Companies are buying back their shares in record numbers, increasing their shareholders’ relative ownership.   

The potential benefits of share buy-backs cannot be argued against, but there are some troubling aspects of the current bonanza (to steal the technical term from the graph above).  For starters, what happens to markets when companies reduce their buy-back programs? If the folks over at Goldman Sachs are correct (and why would we ever think otherwise), these repurchases will go on for some time, but they won’t last forever. Data suggests that the capital for these repurchases has come from two main sources.  The first is additional debt.  In our 2018 Q4 commentary we commented on the US Corporate Debt Binge that has occurred over the last 10 years.  A lot of this additional debt appears to have funded share buy-backs.  This is somewhat speculation.  It is difficult to directly connect that these borrowed dollars went to purchase shares.  But when you examine the data of newly issued debt along with data on how capital was deployed, the connection is hard to deny.  Jeffrey Gundlach, the currently anointed “Bond King”, claims the two are related[2].  If anyone would have a “feel” for where the capital has come from and where it is going, I think it would be him.

The second source of capital for buy-backs is repatriation of corporate dollars held overseas.  Over the last several years, companies have accumulated large accounts overseas as a tax shelter against higher American corporate tax rates.  In many cases, companies were borrowing money to finance operations as opposed to bringing it into the US.  To encourage the repatriation of this money, the recent tax code revision featured a special rate for repatriated dollars.  The idea was for companies to use this money to invest in their business and grow the economy.  A lot of it appears to have gone to share buy-backs instead (this does not necessarily mean the money does not go to grow the economy…see Jamie Dimon’s comments below).  

What these two sources have in common is they are kind of one-shot deals.  Corporations can only access so much debt.  While repatriated dollars are a result of earnings, the volume is high because it was built up over years.  These one-shot deals have likely been huge contributors to positive market performance the last two years.  Markets go up when there are more dollars looking to buy than there are owners looking to sell.  In the last two years, corporations appear to have been the overwhelming net buyers.  What happens when that money slows down?  Will that bring about the turn of this extraordinarily long bull market?  Maybe.  It will certainly have an effect. How much is hard to tell.   

Impaired Corporate Performance?

Another concern to consider is how these share buy-backs will impact corporations’ revenue and earnings going forward.  There is always an opportunity cost when deploying capital. In the case of share buy-backs, companies may be missing an opportunity to improve their balance sheet or invest in future growth. CEOs are responsible for making these “capital allocation decisions”…how best to use cash to increase shareholder value.  In his most recent annual report, JP Morgan’s Jamie Dimon spent a couple of paragraphs on buy-backs, specifically on what circumstances need to exist for him to consider buying back JP Morgan stock.  Here’s what he had to say:

We much prefer to use our capital to grow than to buy back stock. We believe buying back stock should be considered only when either we cannot invest (sometimes as a result of regulatory policies) or we are generating excess capital that we do not expect to use in the next few years. Buybacks should not be done at the expense of investing appropriately in our company. Investing for the future should come first, and at JPMorgan Chase, it does.

However, when you cannot see a clear use for your excess capital over the short term, buying back stock is an important capital tool – as long as you are buying it back at a reasonable price. And when companies buy back stock (which we only do when it is at a price that we think adds value to our remaining shareholders), the capital is redistributed to investors who can put it to good use elsewhere. It does not disappear. We currently have excess capital, but we hope in the future to be able to invest more of it to grow our businesses.

In his view, stock repurchases are almost a measure of last resort.  It’s a good tool when there are not enough opportunities to invest excess capital into the growth of the business.  But as pointed out above, a lot of companies are not using excess capital.  They are financing the purchases with debt.  While it provides the immediate satisfaction of increasing the coveted and overly reported Earnings Per Share metric, it does not help the company in the long term.  The borrowed money comes at a cost (interest) and will have to eventually be paid back.  Debt should be used to finance growth, not engineer accounting.  The former can be responsible management; the latter is short-term thinking at its finest. 

Also, as Mr. Dimon points out, if a company is going to repurchase shares, they need to do it when they can get a good price, which makes us question the timing of current purchases.  To create shareholder value with buy-backs, CEOs should execute the programs when their stock is cheap. In his book, Creating Shareholder Value, Alfred Rappaport gave the opinion that repurchasing fairly priced stock added no value to shareholders, and buying overpriced stock would destroy shareholder value over a long period of time.  Opinions may differ as to whether stocks are currently expensive, but I don’t think you will find many people arguing that they are cheap.  If they are expensive, then corporations may be participating in the greatest destruction of shareholder value in history. 

You might think, hey, these are CEOs, really smart people who would not make such a bad decision.  It may be true that they are smart but that does not mean they are good at capital allocation.  William N. Thorndike wrote a book, The Outsiders, where he chronicled the decisions of successful CEOs.  In the first couple of chapters, he draws from some of Warren Buffet’s writings to make the points that one, in rising through the ranks of business, CEOs may have never had to make capital allocation decisions, and two, CEOs are as subject to “groupthink” as anyone else.  With little to no experience with deciding how to invest money and under peer pressure to look like other CEOs, the fact they are overpaying for their stock is not necessarily surprising.  In fact, it may be typical.  The last time buy-backs were north of $600 billion was in 2007, when the market was reaching its peak.  To be fair, this does make some sense.  Corporations will have the most amount of cash towards the end of an economic cycle, but they are not forced to use the cash for share repurchases.  I would rather have my corporations hang on to their cash, or even pay down debt, until they find good investment opportunities. 

Having used up cash and increased leverage, these share buy-backs have likely put corporations in a position where they won’t be able to weather storms or be as prepared to invest when the economy troughs.  It puts another strike against the current corporate health and, to us, further emphasizes the need to be mindful of company balance sheets.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


[1] https://www.ft.com/content/19435b4e-6c2f-11e9-80c7-60ee53e6681d

[2] https://finance.yahoo.com/news/corporate-stock-buybacks-rise-schumer-sanders-172223775.html

2017 Q4

2017 was a banner year for markets.  Rarely in history have the markets displayed such consistent increases.  We first noted the calm in the market in our 2017 Q1 commentary, and that theme continued through the year.   Looking specifically at the S&P 500 through 2017, we can see: 

At no point did the market close at less than 3% of its previously achieved high.   

December 31st marked the 13th consecutive month the S&P posted a gain (the last time this happened was in 1959).  

The highest daily increase in 2017 was 1.38%, one of the lowest on record.  

In prior commentaries, we have explored at length the various factors creating the calm in the market, and honestly, not a lot has changed.  Congress did pass a tax reform bill, but that was already being figured into market expectations.  So, we enter 2018 at the same pace and with the same calm that dominated markets in 2017. 

What will 2018 bring us?  In the past we’ve written about our trepidations with market forecasts and predictions (something about expert forecasting being as accurate as dart throwing chimpanzees).  It is uncertain what will transpire over the coming year and the useful benefits of prediction are limited.  What we do find useful, especially in times where the market calm tempts us to complacency, is to consider where we are.  Markets and economies go through cycles.  Markets move from a state of absolute fear (everyone is selling) to a state of absolute greed (everyone is buying) and then back to fear.   Economies go through cycles of expansion and recession and, while separate, these two cycles are closely related.  When the economy is growing, or shows the prospect of growth, markets tend to perform well.  When economic data points to a recession and a decrease in corporate profits, markets tend to perform poorly. 

Framing our thinking within the paradigm of these cycles is a reminder that things change.  It is especially critical to remember this right now as the length of the current economic expansion and the calm, steady upward climb of the market pushes us into complacency.  It helps us resist resting on our laurels because we remember that things will change.  Thinking in terms of cycles also helps us frame some of our portfolio decision making.  There are certain opportunities and risks commonly associated with the various parts of these cycles.  Having a general idea of where we are helps inform us of how our portfolios should be positioned and what we should be prepared for in the future.  So, let’s get out our road maps and see where we are at. 

Where are we? 

We are going to start with the easier of the two cycles: the economic cycle (oftentimes also called the business cycle).  The chart to the right outlining the business cycle is one that you can find in any Macroeconomics textbook (page 11 of mine).  It is important to remember that economics is not a hard science…economists are basically philosophers with calculators and spreadsheets.  That’s not an insult (or at least isn’t meant as one).  There are far too many variables, and so much of what happens in an economy is up to human behavior.  However, some general trends, like the business cycle, are consistent.  A well-functioning economy will expand, reach a peak, then enter a recession, before it eventually troughs and then goes into expansion.     

We’ve taken the liberty, in the style of a mall map, to indicate roughly where we are in the cycle.  Please don’t read too much into the sizes of peaks and troughs and don’t focus too closely on where the little star is, because I don’t know exactly where we are in the cycle and neither does anyone else.  However, certain characteristics tend to exist in certain parts of the business cycle.  Looking at the data across the board suggests our current business cycle is nearing a peak: unemployment, credit expansion, default rates, businesses growth, and other economic activities are at or nearing places typical of a business cycle that is getting close to a peak. 

This isn’t a call for a recession in 2018.  The recently passed tax reform bill will provide stimulus to the economy.  Companies are already announcing wage increases, special bonuses, increased capital expenditures, and job creation measures that will likely lengthen the cycle.  Even with that being the case, we may see some signs of a slowdown or even deterioration in economic data sometime in the next 12-18 months. 

Determining where we are in the market cycle is less data driven and more inference driven.  Market cycles do not tend to follow the same gradual changes of economic cycles.  Much of that has to do with what is driving market cycles: it is less about reality and more about peoples’ perception of reality.  Knowing exactly where we are is difficult but there are indicators you can look to: measurements of business and investor sentiment that can provide a loose picture of where we are at in the scale of Fear to Greed. 

To the right is a chart I keep and update on a continual basis (it didn’t upload very well into wordpress).  This is not something we came up with.  This is a guide investor Howard Marks uses and outlines in his book, The Most Important Thing. He calls it the “Poor Man’s Guide to Market Assessment” because it does not require a $25,000/year Bloomberg Terminal (has 2-6 computer screens and you can get about any economic/market data set imaginable) to complete.  We like it because of its simplicity and, because it’s generally true. 

Here’s how it works: the two right columns are opposing market characteristics.  You simply work your way down the list and bold which best describes today’s environment (I highlight but the spreadsheet didn’t transfer over well to wordpress). Is today’s economy vibrant or sluggish?  Is the outlook positive or negative?  Are lenders eager or reticent?   The more bold characteristics on the left, the farther in the market cycle we likely are.    

As you can see, most of the descriptors we chose when applying it to the US Stock Market are in the left column: lenders are eager, capital markets are loose, debt terms are easy, interest rates are low, spreads are narrow, markets are crowded, there are few sellers, recent performance has been strong, and asset prices are arguably high, to name a few.  These characteristics are indicative of late market cycles.  Admittedly, there is a lot of subjectivity involved in this chart.  It is not perfect, and neither are we in its application.  Another person may take the opposing viewpoint on some of our selections.  But when looking at market characteristics it appears we may be nearing the end of a market cycle. 

Knowing where we are doesn’t tell us exactly where we are going and when we will get there.  We don’t know what the year will bring.  Our guess is that there will be more volatility in the markets this year.  It is hard to imagine such a calm, steady year being followed up by yet another calm, steady year.  However, just because it is more volatile does not mean it will be worse or better.  But, predictions aside, the most important thing to take from all of this is not to buy into the calm.  It will not last.  The economy appears to be nearing a peak and domestic equity markets are exemplifying the characteristics of an over-priced, over-extended market.  We need to vigilantly work to hold assets that are reasonably priced, limit credit exposure, and be ready for mispricing opportunities that can arise if the market does turn.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2016 Q3 Quarterly Commentary

Interest Rates are Low?  Who Knew?  

The chart below shows the change in the interest rate of the 10 year Treasury bond over the last 34 years.  The early 1980’s were the tail end of a period of high inflation and interest rates.  Many of you probably remember having CD’s paying interest in the double digits.  In 1981 policies were enacted by the Federal Reserve that started a drop in interest rates that, as the chart below shows, has not really ended since.  Earlier this year the interest rate on the 10 year treasury hit a record low…the US has never seen interest rates this low.   In fact, if you put it in a broader historical context the current interest rate environment is the lowest the world has ever seen.  We won’t bore you with the details of Grecian, Roman, Byzantine and British Empire interest rates but it is true – interest rates have never been this low.  

The real effects of this on people’s lives are clearly visible.  On the positive side home, vehicle and unsecured financing is inexpensive.  This has allowed people to free up cash flow by reducing their interest costs and households have been slowly reducing their debt the last few years.  Total household debt relative to US Gross Domestic Product is the lowest it has been in over a decade. 

However, the negative consequences of low interest rates are starting to weigh heavily on investors and the economy.  Our economy is built upon a system of credit and interest and it is becoming apparent this system is impaired in a low rate environment.  Banks rely on the ability to lend money out for more interest than it costs them to hold it (net interest margin).  As interest rates entered into unprecedented lows their margins shrank and now depositors receive little to no interest while paying fees on their accounts.  Similarly, insurance carriers rely on interest payments from a bond portfolio to reduce premium costs and increase profits.  As income received from their investment portfolios have decreased insurance premiums have increased.  Pension funds who had generally counted on – foolishly in our opinion – an 8% annual rate of return to pay future liabilities are now facing a reality where 40% of their portfolio is only earning 2% – or less – interest.  That makes it kind of hard to earn the 8% they – and their pensioners – are counting on.  While low interest rates may have assisted in the avoidance of a total economic collapse if they continue too long our economic system may slowly break down.

What we think is more likely to happen is an attempt to return to normal via central bank raising interest rates. We have been waiting for this for a long time.  Admittedly, this low interest rate environment has lasted far longer and been more extensive, than we expected.  It could continue to go on longer than we expect.  But the commentary among the “economic and political elite” has begun to change.  The US Federal Reserve is receiving a lot of pressure to normalize rates and it appears they may resume that process soon.  

A World with Rising Interest Rates

This creates a very real risk to investors.  There is an inverse relationship between interest rates and the value of a bond.  If interest rates go down – like they steadily have for 30 years – then the value of a current bond goes up.  If interest rates go up then the value of a current bond goes down. Once this process of raising rates begins bond holders will be dealing with something they have not had to deal with in 30+ years – the value of their bonds going down.    

As Jack would remind us, the way people invested when he started as an investment manager 40 years ago this would not matter.   People would purchase a bond by directly lending the US Government or a company $10,000, for example, collect interest for 10 years and then at the end 10 years the entity would give them back their $10,000.  Whatever happened to the price of the bond along the way did not matter.  The investor got their $10,000 back at maturity no matter what the value of the bond did.  

But it does not really work like that anymore.  30 years of decreasing interest rates, an industry “scaling” their business models to maximize profits, and the creation and adoption of Modern Portfolio Theory (the en-vogue investment management theory of the day) have essentially changed how individual investors access the bond market.  Investment products have been designed and built around a bond market that steadily increases in value. The principal protection element of bonds (you get your $10,000 back the end of 10 years) has been at best limited and at worst eliminated through the management style of bond funds.  Bond fund managers rarely (very rarely) hold a bond till maturity.  In fact, the execution of a portfolio following Modern Portfolio Theory results in the creation of divided bond classes grouped by the maturity date of the bond.  This grouping forces the manager to sell their bond holdings prior to maturity, even it has to be sold at a loss. 

With the winds of change upon us we are being forward thinking in how to manage a bond portfolio in a rising interest rate environment.  There are methods to mitigate this risk.  Some strategies have already been implemented in portfolios and others will be implemented as conditions warrant. 


In the 2016 Quarter 1 commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year.  The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing.  We have never quite understood the general consensus of the financial world towards China.  They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar).  But to every one of these arguments there exists fundamental misunderstandings about China.  In the interest of brevity, let’s examine just one…overpriced stock markets.

In the Quarter 1 commentary we addressed the overpriced stock market.  In the Quarter 2 commentary we addressed lower economic growth prospects.  And this quarter we will wrap this up by addressing the misconceptions of China being overextended in debt.  

Wait a minute…there’s actually two sides to a balance sheet?  

During the last decade total debt in China – consisting of corporate, household, government and bank debt – has increased from roughly 150% of China’s Gross Domestic Product (GDP) to over 250% of China’s GDP.  That’s a lot of debt. In fact, when you take into consideration that the denominator in the equation has also increased significantly during that time period the increase in debt gets really big: total debt has gone up 465% in the last decade.  

Our recent experiences in western culture make these numbers very worrisome.  In the US, we have witnessed the danger of an over-leveraged economy: the 2006 housing crisis and the subsequent Great Recession beginning in December 2007.  But to every balance sheet there are two sides: assets (what you own) and liabilities (what you owe).  What is being largely ignored in the case of China is the asset side of the balance sheet.  

Let’s take a look at the household debt burden in China within the context of the real estate market.  In the last few years many pundits have expressed concern of a growing bubble in Chinese home prices.  Home prices have increased roughly 9% – on average – every year for the last 10 years.   In our economy those high increases would be troubling.  But Asian cultures tend to look at savings and debt differently than western culture.  In short, they save more and they go into less debt. A few statistics to consider:

  • Wage increases have averaged roughly 13% per annum for the last 10 years, which outpaces the home price increases.
  • In order to buy a home in China a 20% down payment is required.  That is not a banking standard.  It is a law.  That is if it is your first home.  If you are buying an investment property (second home) 30% is required. 
  • A 2014 study showed that 15% of all real estate purchases were paid with 100% cash.
  • According to a China Household Finance Survey in 2012, average household debt amounted to only 11% of home value; the median household debt was 0%.   
  • The same 2012 survey indicated that if home values fell 50% only 14% of mortgages would be underwater.  

Those stats paint a very different picture than an over-extended, over-leveraged consumer.  And a similar picture could be painted for corporate and government debt: there are assets to support their level of debt.  Even the structure of the debt (state financed in a closed system) makes the debt level more palatable.  While Chinese debt has grown excessively during the last several years it appears to be at manageable levels. 

That is not to say there is no risk here.  In our opinion this increase in debt is going to continue for some time.  China has aspirations for their currency (Yuan) to be used more heavily in international transactions and as a reserve currency.  In order for that to happen there needs to be more volume of Yuan in the market.  In a fiat currency system, money is created and put into circulation through debt.  If China wants more Yuan in circulation then more debt will be required.  Continuing to fuel this debt may put more strain on the Chinese economy.  While we do see long term value in investing in China we will be closely monitoring the situation watching for meaningful economic deterioration. 

As we examine the global landscape, China – and other select Emerging Markets – continue to have the greatest potential for long term growth.  We believe patient investors who endure the volatility often experienced in these markets will see long term gains.  We also see developed markets – such as the US and Europe – struggling to obtain meaningful economic growth.  As central banks and governments make more decisions and businesses and individuals continue to adjust to an economic environment very different than it was a decade ago we believe markets will continue to be volatile.  Throughout these developments we will continue to invest in areas where we see value and the greatest potential for long-term growth.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

All Quiet on the Western Front

After nearly two years of relative uncertainty, marked with brief moments of extreme pain, U.S. equity markets are enjoying a long run of relative calm. The S&P 500 has now posted 5 months in a row of positive returns and is up 7.66% through the end of July. Over the same time period the venerable Dow Jones Industrial Average has produced a 7.38% total return, with dividends reinvested.

Despite these figures, satisfaction lies far away, lounging without a care in the world for us. Anxiety runs higher than average as the collective heart of our collection of hearts seems to skip a bit with each new blurb, soundbite, earnings release, and blogpost (not this one, of course). One could very reasonably assume that up markets should produce up feelings. Very often they do. Yet our feelings are not so peppy, but rather taut like a violin string played very high for just long enough to snap. Consider:

If we look to our left, we see a broken European system forging ahead as if nothing is amiss. Unemployment rates in Spain remain at 20%, above 12% in Italy, and still in double digits in France. On our right we see a burgeoning domestic debt load, growing like a Greek tragedy with a terrific 2nd act (“Hello Entitlement Benefits! We thought you’d gone away while our heads were in the sand!”) And, if we get down on our bellies and squint just a bit, we can see the teeny-tiny interest building in our savings accounts. 800 pennies for 1,000 dollars should be the name of a Gaelic soul band, not the annual interest on our savings accounts.

What should we conclude from these competing weathervanes? Are the positive returns enough to keep the system going or will economic realities begin to cave in? Can financial optimism overcome economic realism?

A bellicose reader might observe that markets are always fraught with uncertainty, making today’s circumstance unexceptional. He might continue that the nearly unlimited universality of information brought about by the internet has made it fashionable to always be pessimistic. After all, the world is a big place, there must always be something wrong somewhere.

And, perhaps, he is right. But, perhaps, that’s only because we are asking the wrong question. Instead of asking whether or not we should be purchasing new investments, we should be reminding ourselves of timeless principles. Those truths that remain relevant in all circumstances.

We should remind ourselves of one such truth today, during a brief respite from volatility. In periods both of rosy returns and unending losses, it remains true that there are things you can control and things you cannot. Maintaining a steady eye on both makes all the difference. Markets have gone up. Good! I must realize that I did not make it so. Markets have gone down. Oh no! I must accept that I did not make it so.

If we do not accept that we cannot control markets, we are destined to be controlled by them. Conversely, if we accept that we hold no sway over the market’s whims, we can decide what it is that we would actually like to own. When we know what we own and why we own it, we can confidently move forward as prudent investors.

As is oft repeated, but not digested nearly enough: We will continue to look for opportunities to invest capital consistent with an acceptable level of risk.


A $65,000,000 Deceased Eagle? The Subjective Nature of Value

In 2007, an art dealer/collector by the name of Ileana Sonnabend passed away. Within her rather large and valuable art collection – her net worth was estimated at $1 billion – was a piece titled, Canyon. The artist, Robert Rauschenberg, used a combination of paint, sculpture and a stuffed juvenile bald eagle in constructing the piece. When I say a stuffed bald eagle I’m not talking a stuffed animal you’d buy your kid to snuggle with. This was an actual taxidermied eagle.

In the audit of Sonnabend’s estate tax return the IRS noticed this prized piece of art had been valued at $0.00. While that may seem strange it was with good reason. In 1940 congress passed the Bald and Golden Eagle Protection Act making it illegal to possess, sell, purchase, transport, import or export a bald or golden eagle in any condition…dead or alive. Ms. Sonnabend had been granted permission to retain her ownership of the piece as long as it was on display at a public museum but it was illegal for her estate to sell it.

What’s the worth of something you can’t sell? The valuators of the estate argued it was $0.00. The IRS on the other hand came to a valuation of $65,000,000, which came with a $40,000,000 tax and penalties bill (see here for NY Times article).

Two different groups looked at the same set of facts, the same circumstances and came up with valuations that were $65,000,000 apart. How can that happen? Each side had reasons for their figures but let’s not get lost in details. From a big picture standpoint it happened because valuations are subjective. They require assumptions. They require individual opinions.

Take a dental practice valuation for example. There are a number of subjective elements to a dental practice valuation. If the valuator utilizes a cash flow method they have to make decisions on what to include as add-backs to net cash flow. There’s no standard to that (at least not one I can agree with) and what and how much of what gets added back in is up to debate. And that’s only the beginning. How do you figure replacement value? What about the capitalization rate, which is partly a product of intangibles like location.

You may or may not be familiar enough with valuation lingo to know exactly what I’m talking about but I’m sure you see my point…when you look at a practice valuation you see an opinion derived through a lot subjective decision making. Give two different valuators the same info and you are likely to get two different answers. Add a third and I’m sure we could all guess the result…a different number.

That’s not to say valuations are meaningless. They do have value. But the figures shown should not be viewed as sacrosanct and in a merger or acquisition the value figure should not be solely relied on to drive price. What does matter? The answer is dependent on whether you are the seller or the buyer. Let’s start with the seller.

Have you ever watched the Antique Roadshow or at least seen a clip of the show? Ever noticed what the experts say when they are giving a dollar figure to the person who brought in the 18th century Chinese rhinoceros horn cups (really). In this specific instance they state auction value. At other times they state retail value or insurance value. There’s differences in those definitions but all of them revolve around the same concept – how much money someone will pay the owner to part with the item. For the seller of a dental practice, that’s what matters. How much you can get for the practice.

What a buyer should be looking for is the return on investment. The value of dental practices is almost entirely made up in their cash flows. The assets of the business have little value (secondary market equipment value is much much much much much lower than new purchase cost). The “asset” with the greatest value is goodwill but the value of goodwill is usually derived from the cash flow of the business which brings it back around to cash flow being the predominant driver of value. What a buyer needs to be concerned about is what kind of cash flow they will receive from the practice and what risks exist to the sustainability of that cash flow.

Do not get too attached to valuations. If you are selling a practice, use it to assist you in establishing an asking price. If you are a buyer, use it as a starting point to determine what return on your investment you could expect to receive.