Market ReviewSubmitted by Karstens Investments on November 17th, 2016
By Michael D. Karstens, CFP®, AIFA®
Given the seemingly endless stream of bad news, let’s start with some good news. Following the Brexit driven sell off in June, stocks rebounded nicely during the third quarter. Developing markets jumped 9.15% for the quarter resulting in strong YTD gains of 16.36%. Developed international markets were also positive rising 6.5%, pushing YTD results back into the plus column to 2.2%. In the US, some of the sectors that previously suffered the most posted the biggest rebounds. The NASDAQ (+9.69%) and Russell 2000 (+9.05%) were among the biggest winners for the quarter and are now up 7.09% and 11.46% for the year. It is hard to believe but interest rates fell further and bonds posted positive numbers as well.
Despite global unrest, economic uncertainty, political instability, and deficit issues, it’s been a decent time for investors. As you can see on page 4 most of the funds have posted very positive YTD numbers and most have posted acceptable 3 and 10 year numbers as well. With the exception of gold, the 5 year returns are very strong although these numbers reflect a fairly low starting point in the market. It would be fair to say the markets have indeed climbed a wall of worry over the past 5 years.
With that having been said, we find it important to discuss some of the challenges that we see ahead. As we have written, our biggest concern revolves around deficit spending, total debt and quantitative easing. For the fiscal year ending in September, the Congressional Budget Office now forecasts a deficit for the year of $590 billion up $152 billion from last year. These numbers don’t really show the entire story as the total government debt for the year skyrocketed by $1.42 trillion to just under $20 trillion. Say what you want about the current Presidential candidates but neither seems to have any desire to address budget deficits or the entitlement spending problems. In fact, one candidate stumps for more infrastructure spending, free college education and earlier Medicare. The other favors more defense spending, infrastructure spending and slashing taxes. Let’s hope that deficits don’t matter – because if they do, we can face some daunting challenges ahead with either candidate. These deficits seem to have the baby boomer generation concerned. A recent study, published in April 2016 found that only 24% of baby boomers are confident of having enough money to last through retirement. I would say that investors are more concerned today than they have been in the past 30 years. The Millennials seem to be less concerned. I happen to have three Millennials at home and they are excited about the new concept of “retirement before working.”
Most of the experts that we have followed over the years have been proven right many more times than not. They share the same concerns about the Fed’s negative interest rates and the potential unintended consequences. With interest rates driven to artificially low levels, entities such as pension plans, insurance companies and foundations can’t generate decent enough returns to meet their liabilities. Pensioners and retirees cannot live off of zero percent “risk free” returns, so many are forced to take more risk than they should or consume less. There is no question low interest rates have driven stocks and real estate to very high levels.
So what’s an investor to do? We believe the two greatest risks investors face are inflation or deflation. We hope both are unlikely and we can easily live somewhere in the middle – however neither can be ruled out. To protect against deflation risk, the answer would likely be preservation of capital, cash and high quality bonds. On the inflation side, one would expect stocks, gold, natural resources and real estate to hold up reasonably well.
Over the years we have often written about value investing and the value based principles of John Templeton and Warren Buffett. Recently we came across an interview that featured the value principles of well-known hedge fund manager, Seth Klarman. We list eight of these principles below and then share some current thoughts on today’s indexing craze and how far it strays from value based investing.
1. “The data shows (rather conclusively) an extraordinary positive correlation between the time horizon of investors and their performance.”
2. “The way to maximize outcome is to focus on the process.” If you are disciplined about attending class, attentive to completing assignments thoroughly, and steadfast in your resolve to put in the necessary time to prepare for an exam, you are more likely to see more A’s and B’s. If a team has strong coaching, a disciplined practice schedule, and rigorous game day preparation, there are likely to be more W’s than L’s. If an investor buys bargains with a margin of safety, is diligent in staying alert for changes in the thesis and disciplined in selling when price approaches fair value, there is likely to be more Alpha than Beta. In fact, “All an investor can do is follow a consistently disciplined and rigorous approach and over time the returns will come.”
3. “There is no investment good enough that you can’t mess up by paying too high a price.” The problem with paying too high a price for an asset is that you eliminate the chance that anyone following a sound investment process would buy that asset from you in the future. To this point Klarman warns, “If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation. Only if an asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what future buyers might pay, then it’s an investment.”
4. “Value investing (buying stocks at an appreciable
discount from the value of the underlying businesses) is one strategy that provides a road map to successfully navigate not only through good times but also through turmoil.”
5. “People should be highly skeptical of anyone’s (including their own) ability to predict the future, and instead pursue strategies that can survive whatever may occur.”
6. “Short-term performance envy causes many of the shortcomings that lock most investors into a perpetual cycle of underachievement.”
7. “Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.” Just because we didn’t live through the Great Depression doesn’t mean it could never happen again. Just because we didn’t live through the German Hyperinflation doesn’t mean it couldn’t happen again.
8. “In a rising market, everyone makes money and a value philosophy is unnecessary. But because there is no certain way to predict what the market will do, one must follow a value philosophy at all times.”
One concern we have today is the huge popularity of indexing, ETFs and concept ETFs. For example, take the iShares Emerging Markets High Yield Bond fund, symbol EMHY. As you would suspect, it invests in high yield bonds in emerging markets. What many people don’t realize is new money in the fund is invested based on float, i.e. how many bonds are outstanding. Hence, as a highly leveraged company such as Petrobas (Brazilian oil company) issues more debt (float) the fund is forced to purchase more Petrobas bonds. It strikes us as strange that the main rational for investing in more bonds is that the company is taking on more and more debt. This seems like a potential disaster to us. Similar issues occur on the equity side. Virtually no consideration is given to valuation or more importantly debt levels. It just doesn’t seem like the best approach.
Ben Graham, in a 1963 speech, listed the two conditions that make it “possible for a minority of investors to get significantly better results than the average. One is that they must follow some sound principles of selection which are related to the value of the securities and not to their market price action. The other is that their method of operation must be basically different than that of the majority of security buyers.”
Indexing and ETFs today are certainly not different from the majority of investors nor is the selection process related to the “value” of securities. We prefer to invest in a value-based and business-owner approach that stands apart from the crowd. We believe this approach can deliver long-term outperformance but more importantly, absolute returns that help meet client goals.