Second Quarter, 2018 - Market ReviewSubmitted by Karstens Investments on May 3rd, 2018
By Michael D. Karstens, CFP
In January we wrote “There wasn’t as much as a single 3% pullback in all of 2017 and we are currently in the longest period ever without such a minor correction, over 420 days and counting.” Almost on cue, volatility reappeared and created a number of wild days. Stocks roared in January with the S&P 500 up over 5% and setting several record highs. Things changed dramatically in February with stocks plunging on concerns of rising interest rates and collapsing bets by hedge funds of volatility staying low. During the quarter there were 41 triple digit moves up or down in the Dow Jones Industrial Average compared to just 58 in all of 2017. Additionally, the Russell 2000 moved 1% or more in 33% of its trading days.
Although volatility returned, the overall results for the quarter were somewhat flat. The S&P 500 fell 1.2% for its first quarterly loss in nine quarters and the DJIA slipped 2.5% for the quarter. The NASDAQ composite had a roller coaster ride but finished up 2.3%. Foreign markets faired a bit worse with the Stoxx Europe 600 declining 4.7% and Japan’s Nikkei losing 5.8%. Interest rates continue to be an important topic. As you know, we have written for some time that ultra low interest rates have had a very positive effect on stock and real estate prices. We don’t think it is a coincidence that as interest rates have risen, there has been pressure on stock prices. Although the average investor probably hasn’t noticed, interest rates have moved quite a bit higher. As a matter of fact, the 10-year treasury note bottomed at a low of 1.37% on July 15th, 2016 and has more than doubled to 3% as I write. Short-term rates have moved even more with one-year T-bill rates currently at 2.26% up from 0.79% just over a year ago in January, 2017. Unfortunately, most banks, CDs and Money Market funds (MMFs) are not keeping pace with these higher rates.
Due to this, we are actively moving low paying CD and MMFs to short-term treasury bills. The yield pick up isn’t huge but it feels much better earning around 2% than close to zero! It reminds me a little bit of the story of having someone pounding your head against the wall and then being grateful when they stop! It’s not that great of news but it sure feels better.
As we look ahead, I would like to share some quotes from this year’s Berkshire Hathaway Annual Report as they seem to match up closely with many of our current views.
Regarding 2017 acquisition activity Buffett wrote, “In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and finally, a sensible purchase price. That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”
I found the last sentence to be extremely insightful. Most of the media appeared to portray that Mr. Buffett seemed to think that stock prices were not extremely high but I read this to imply that stocks are at very high levels today. This would parallel our research that stocks are trading at very high levels compared to historical levels.
Also, in line with our thoughts on interest rates, Buffett seems to feel somewhat the same as he touches not only on the impact interest rates have on stock prices, but also on the wisdom of keeping some dry powder in the form of T-bills.
“The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. Acquisitions on all-equity basis, knowing that our tastes for overall debt is very low and that to assign a large portion of our debt to an individual business would generally be fallacious. During the 2008-2009 crisis, we liked having Treasury Bills – loads of Treasury Bills – that protected us from having to rely on funding sources such as bank lines or commercial paper.
We have intentionally constructed Berkshire in a manner that will allow it to comfortably withstand economic discontinuities, including such extremes as extended market closures.”
One of my favorite all-time quotes from Buffett goes something like this “Charlie and I are always surprised by the number of people that spend their life accumulating enough tokens to live comfortably yet they continue to risk these tokens to gain more when more tokens would not increase their standard of living but losing the tokens could have a significant negative impact.”
We believe very strongly that in the long-term stocks and real estate will offer superior returns to cash, CDs, bonds, etc. However, we also realize that there will be short to intermediate periods of time (1-10 years) where this may not be the case and that stocks could fall 50% or more. This has already happened to US stocks three times during my lifetime, 1973-1974, 2000-2002 and 2007-2009.
For those that are younger and just starting out, these drops are not a huge concern and I might even argue an advantage. For those that are older and have accumulated significant tokens, taking some of these tokens out of the risk pool in the form of T-bills etc. probably makes sense. In this regard, Buffett once again had this to say in his 2017 report:
“Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:
This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary - and an unsettled mind will not make good decisions.
Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.”
Looking ahead we are without doubt in interesting times. There certainly is some good news regarding the economy. The U.S. economy remains strong and global growth is at higher levels than it has been in some time. Corporate profits are at record highs and inflation remains near the Federal Reserve’s target. There are also plenty of things to worry about. Global money printing seems to be slowing and the consequences are unknown. We continue to believe excessive debt and unfunded liabilities loom overhead like storm clouds and at sometime will have a negative impact. Global tensions, political chaos and uncertainty seem to be at extended levels. Stock and real estate both trade at very high historical levels and we are now in one of the longest expansions in history. While we certainly don’t see reason to hit the panic button it does seem prudent to exercise some degree of caution and be aware of the risks. With that, I will close with the final quote from this year’s Berkshire shareholder letter.
“In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.
“When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:
“If you keep your head when all about you are losing theirs…
If you can wait and not be tired by waiting….
If you can think – and not make thoughts your aim…
If you can trust yourself when all men doubt you…
Yours is the Earth and everything that’s in it”