Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

January 2011

Not long after we entered Wall Street as a naive youth in the early 1980s, we happened across a brokerage report written by an energy analyst a few years before. Energy stocks were the place to be during the late 1970s; oil embargoes and rising demand caused petroleum prices to rise sharply for several years, and the shares of companies in energy-producing and related industries were a major supporting factor in the stock market during an economic period beset by inflation and rising interest rates. Not surprisingly, Wall Street’s interest in the energy sector had grown in tandem with prices, both for the commodity and the stocks. Despite a recent significant decline in the price of crude, the report’s author showed unflagging optimism that oil prices would continue their upward march and, that consequently, companies in his specialty were suitable for purchase. As fate would have it, subsequent events confounded this expectation. Oil prices dropped from their embargo-induced highs, energy sector companies (the ones that survived) proved to be poor investments for several years, and a lot of drilling equipment (some financed at interest rates of 20%) ended up as rusting junk in the American oil patch. The experience of reading this report in the 1980s had a profound and lasting impact on our investment thinking. By striking a chord with our appreciation for history as a guide to understanding the present, it left us highly skeptical of any reliance on trends or forecasts in making investment decisions.

A year-end piece in the Wall Street Journal reminded us of this episode. At this time of year the financial press is full of retrospectives on the old year and forecasts for the new one. This year the outlooks were predictably optimistic given that stocks and other assets have been on a roll for two consecutive years. In contrast, a refreshingly skeptical journalist reproduced a Journal article from January 21, 1980, the day when gold reached a long-standing record price of $875 per ounce (the late 1970s and early 1980s were a tumultuous period for many commodities, not just oil). The article discussed the volatility of the day’s trading, mentioning the impact of movements in the dollar’s value, as well as, curiously, concerns about events in Iran and Afghanistan (proving once again that some things never change). The comments of market participants three decades ago make the article especially instructive for the present-day reader. According to one gold dealer, “Everyone seems to be hanging in there still and I’d say the price looks ready to go higher.” There was no inkling among traders that they had just witnessed a gold price that would not be seen again for almost three decades. Such is the uncertainty that we constantly face when dealing with potential investments that even developments expected to take place in the immediate future cannot be anticipated with the level of confidence necessary for decision-making.

Moving forward thirty years, gold now sells for around $1,400 per ounce (still below 1980’s inflation-adjusted price of approximately $2,300) after a tenth consecutive year of gains continued the metal’s rebound from sub-$300 levels at the turn of the millennium. For those who have a bent for speculating in hard assets, commodities were a very attractive place to be in 2010. Gold’s 30% rise was in fact quite tame when compared with silver, up 84%, and palladium, which almost doubled at plus 96%. Non-precious metals rose as well—copper, for example, gained 33% to a record. Cereal grains and other “soft” commodities rose sharply, and oil closed the year above $90, for a 15% gain. One commentator noted that petroleum prices tend to become a problem for the economy when they hit 6% of average consumer budgets—they are now at 5.5%. Commodity inflation at this rate could result in other problems as well: high grain prices “feed” food cost inflation across the board (a gauge of global food prices hit a record in December), and a couple of years ago, rapid cost increases for basic foodstuffs led to riots in a number of countries. A portent of things to come may be seen in places like Bolivia and Iran where the recent suspension of expensive fuel subsidies have led to tensions, even military alerts, within those countries.

Not to be left out, financial assets also had a good year in 2010 as the best December in two decades gave a final boost to the indexes. The broader averages such as the S&P 500 rose 15-18%; more specialized indexes were up 20% and more. The S&P 500 is now 87% above its March 2009 low, but still 20% below its late 2007 peak, lending encouragement to those who see more good years to come. Stocks caused some excitement in December when they regained their pre-Lehman Brothers levels, managing to overcome a host of worries, among them fears of inflation (in spite of the fact that it is quite low at present) and a nasty European debt crisis. That is what markets do: they will rise or fall regardless of what anyone expects.

Two bumper years of gains in equities still haven’t been enough to change investor sentiment, as 2010 marked the fifth consecutive year of outflows from U.S. equity mutual funds. Some of that money is going into funds that invest in foreign stock markets, and probably into exchange-traded funds (ETFs). Nevertheless, the shellacking fund investors received in 2008-09 has apparently left an enduring impression. The other haven for money fleeing stocks—bonds—may have reached a point of saturation (more on this later).

Hedge funds returned 4.5% on average last year, significantly less than the indexes. One of the appeals of these operations is that they are supposed to be “uncorrelated” with the market—when the market zigs, hedge funds zag; that certainly was true in 2010. Finally, a study conducted at the universities of Tennessee and South Florida concluded that when corporations spend on lobbying and political campaigns, “they enjoy about 20 percent higher performance.” Why invest in plant, equipment, and employees when you can buy a politician?

Slim Pickings

It can be dangerous to slavishly follow the example of others in this business, but we do make note of the activities of people with proven business or investment acumen, especially when it involves matters in which we ourselves hold strong views. For this reason it caught our attention when we saw that pension funds run by Mexico’s Carlos Slim (the world’s richest person) and his Grupo Financiero Inbursa had over 50% of their assets invested in short-term government bills in the midst of a big rise in the prices of longer-term bonds. That conservative stance hurt results vis a vis other funds in 2010, but puts Inbursa in a good position to weather an eventual rise in interest rates that would hurt longer-dated paper. “There are moments to be conservative and moments to be aggressive...this is a moment to be conservative,” according to Inbursa.

We have shunned bonds for quite some time in favor of money funds, which in reality represent investments in the shortest term fixed-income securities. Unattractive yields, and an unwillingness to creep down the quality scale have kept us in a highly liquid position, as has our general tendency to eschew the popular—in finance it’s a good idea to avoid following trends and fads. Recently bonds have become very popular: over $600 billion went into bond funds since the beginning of 2008. The huge demand for bonds has not been lost on issuers as corporate bond sales exceeded $3 trillion worldwide for a second year. Companies have been able to cut their capital costs by calling old debt issues, replacing them and maturing debt with lower-cost bonds. Benefitting from a desperate search for yield among investors and funds, “junk” has enjoyed particular favor, and financially-weak issuers previously unable to access the public markets have been able to raise funds. One bond fund manager was quoted as saying, “This was a once-in-a-career opportunity to refinance everything you possibly could.” Issuers from low-rated companies to European sovereigns should hope this environment continues for a while—there are literally trillions of dollars of debt of all kinds to be refinanced during the next few years.

We have long felt the risks in bonds were being mispriced, but the financial crisis-engendered “flight to safety,” as well as central bank policies, have kept bond prices aloft far longer than we would have expected. Nevertheless, there are signs the bloom is off the rose when it comes to the bond market. While still historically low, interest rates rose significantly after the Federal Reserve announced it would purchase more U.S. treasury issuance, with the 10-year note’s yield increasing fully one percentage point from October to early December. Perhaps in response to the bump in rates, mid-December saw the largest bond fund outflows since 2008. We believe a repricing of risk in the bond market is inevitable—just as it was in stocks and real estate. When this will happen is unclear; perhaps it has begun already. As we saw with gold in 1980, one never sees these things clearly except in hindsight. In the meantime, we agree with Mr. Slim: when it comes to fixed-income securities, current market conditions require conservatism.

 

Dennis Butler, MBA, CFA