To Our Clients and Friends of Parthenon LLC
After the most volatile year in the stock market since 2011, the S&P 500 managed to finish with a total return, with dividends, of 1.38%. Even with the paltry results of 2015, since the beginning of 2009 the S&P 500 has returned 162.8% or 14.8% annualized. That is well above the historic market norms of 8-10%. The strong move up was in large measure a rational and justifiable recovery from the depths of the 2008 market plunge. Nevertheless, a respite after such a strong move should not surprise nor unduly worry investors. The market pause has allowed, in a modest way, the economy and business values to catch up to stock prices. We think equity valuations overall are at the upper-end of reasonable, and our long-term outlook for stocks, while positive, is for returns at the low-end of historic average results.
Bond yields remained low, ending the year with the ten-year Treasury bond at 2.27% after starting the year at 2.17%. In December, the Federal Reserve raised the Fed funds target to a range of 0.25-0.50% from 0.00-0.25%. Market participants were well warned that the move was coming, as the Fed spent most of the year advertising a probable rate hike. This was the first Fed rate change since 2008, when rates were lowered effectively to zero in the midst of the financial panic. The seven year interim was the longest period between Federal Reserve rate changes in at least 40 years. The economy has been in uncharted territory since rates were lowered to near zero and the Fed has never raised rates from such an extreme low level. Because this is an unprecedented event, no one can be certain of the impact or risk of possible unintended consequences. However, as we have written on several occasions, if rates are pushed up by stronger economic growth, we will not be unduly concerned. Measured increases in rates due to economic growth are unlikely to bring on significant economic problems if the economy continues to grow (“measured” may be the key word).
As the year drew to a close, it was a different bond story that stole the spotlight. High-yield bonds (“junk bonds” in the vernacular) began to show increased signs of distress. Several prominent investors warned of greater damage to come. At least two bond funds that invest in high-yield bonds were forced to close the doors to investors and begin to wind down. We have no “dog in the hunt” directly, since we are buyers of higher quality bonds (though significant distress in junk bonds could spill over to the general economy). We bring this up primarily to highlight the risk investors take when reaching for high fixed income returns in a low yield world. There are more avenues than ever for individual investors to partake of Wall Street’s financial creativity, including mutual funds and exchange traded funds (ETFs). There is nothing inherently unethical in providing a means for individuals to own junk bonds, and the bonds can play an important role in the economy, including funding start-ups and acquisitions. Be aware though that the purveyors of high-yield bond products may not always highlight the risk or explain the appropriateness as aggressively as they highlight the high yields. So it’s “buyer beware” when offered a bond fund promising much higher than average returns. Finally, when contemplating Wall Street’s marketing and product creativity, we were reminded of a headline we saw in a satirical newspaper recently – “Wall Street firm develops new high-speed algorithm capable of performing over 10,000 ethical violations per second.” We are pretty sure it was just satirical.
The domestic economic story of the year, though, was neither the Fed nor junk bonds, rather it was the plunge in oil prices. Oil prices continued to plummet throughout the year and by year-end crude oil had fallen 30% in 2015, and a stunning 67% over the past 18 months. The world is awash in oil, with large increases in supply overwhelming very modest increases in demand. Interestingly, the stock market has often reacted as if the drop is universally bad, with the overall market falling in tandem with oil on many days. We are neither economic forecasters nor oil price prognosticators, so we will leave it to others to forecast both. Certainly, if oil prices decline further as a result of much weaker economies and lower demand, the stock market would be expected to react negatively. However, we find it difficult to see the argument that lower oil prices, created by an overabundance of supply from new technologies and improved drilling efficiencies, are an overall economic negative. Many energy jobs have been lost, and more are likely to be should prices remain low. In addition, many jobs that feed off the industry have been lost as well. Nevertheless, consumers and companies that are net users of energy have benefited. On balance, the positives of lower oil prices are likely to exceed the negatives.
We continue to examine the stocks that have been hard hit by the oil decline for potential opportunities to take advantage of the carnage. We are wary and cautious and, should we buy any, will only purchase with a large margin of safety obtained via a very compelling price.
“Noise” and the Long-Term Investor
The Presidential election, China, terrorism, and overall economic uncertainty ensure that 2016 promises to be a very noisy year. Investment “noise” is all the headlines, predictions, forecasts, etc. that we are bombarded with via television, the Internet, newspapers, magazines, and every other media venue (not to mention concerned friends and others). Before we discuss “noise,” let’s segue a moment and discuss the concept of “long-term investor.” What do we mean when we use the phrase? How does it impact our actions? The phrase is used so often by so many (including us) that it may seem to be simply a meaningless platitude. Some might argue that it is just a term used to obscure immediate investment problems and minimize short-term market pain. You know the drill – when the market is weak, then “think long-term.” For us, though, it is less a chronological construct, and much more an attitudinal and structural concept that informs and shapes everything we do in investing, from basic company research to portfolio construction. It means we acknowledge the inherent uncertainty and unpredictability of short-term market moves. Being long-term gives us optimism tempered by goals and expectations that are realistic and rational. We understand that if a century of market returns average 8% to 9% annually, then a meaningful period of well-above returns is likely to be followed by a period with below average results. We also recognize and understand that the market prices of our stocks will fluctuate unpredictably above and below the underlying business intrinsic values. Being “long-term” to us is less a measurement of the calendar and more a measurement of valuation.
We are not rigidly ideological or dogmatic about our “faith.” Make no mistake, if we could forecast short-term market gyrations with sufficient consistency, we would gladly use that clairvoyance to our advantage. We have not, in decades of investing practice and observation, seen any compelling evidence that it can be done consistently and profitably by investors. We are also not averse to making short-term investment moves, if they are driven by changes in valuation parameters or changes in business fundamentals. We have moved in and then out of some stocks quickly when valuations expanded so much that our estimate of the long-term returns were too small.
Armed with that attitude and outlook, how should an investor react to the cacophony of “noise?” We are tempted to say just ignore it all and move on. That simple recommendation, though not without merit, deserves a little more explanation. The reason we ignore nearly all noise is not that the event or prediction would be inconsequential if it occurred, but rather that nearly all such forecasted events are highly unpredictable. If we could predict the price of oil, the rate of inflation, the growth of China, and most importantly, the near-term direction of the S&P 500, we would position our portfolios accordingly. Instead, we accept that neither we, nor others, can make such predictions with a useful degree of accuracy and consistency. So it is best to prepare for the short-term uncertainty with an asset blend that is appropriate for both near-term exigencies and long-term goals.
Finally, our nominees for the most useless “noise” are those that combine bold, scare-mongering, inflammatory headlines, with the word “could.” You have seen them, and will again – “The market could fall 25%,” “the economy could enter a severe recession,” etc. Yes, and they could be right, or they could be wrong.
Actions not Taken
The achievement of financial goals is as much a product of what an investor does not do as it is of actions taken. We believe not doing things that place our clients’ financial well-being at undue risk is our paramount objective. It has been, and remains, one of our primary strengths. Not doing that is harder than you might think. It can be very difficult to withstand the temptation to participate in investments that have delivered significant returns for some investors, but also carry great risk. The most extreme example of that in our investment careers was the technology stock bubble of 1999-2000. We sat that one out, and felt for a time like the only kid not invited to the party. It is extremely difficult to not join the party, or to leave early. It can be even more emotionally challenging to not panic and alter a rational long-term strategy in response to short-term, immediate market weakness. If, as seems likely, the market remains volatile, it will be even more important to understand and focus on the ultimate objectives. We will continue to work hard to not take actions that put at risk the attainment of those long-term goals.