Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

April 2018

One of our favorite writers on matters pertaining to finance and investing, John Authers of The Financial Times, recently remarked that “capitalist markets are meant to be cruel and unforgiving places.” This description pretty much sums up the entire investment challenge, and brackets the risks involved therein. Markets are chaotic. They reflect hopes, fears, and outright rolls of the dice, as well as the occasional reasonable business idea. Markets owe us nothing, and it is wise not to place too much faith in them, or rely on them for our well-being, as they can act in ways that are contrary to our interests. Approaching them in a formulaic fashion—especially that based on recent behavior and without heeding the ever-present uncertainly—is asking for trouble; it may work, until it doesn’t.

Events over the past year provide ample evidence of our need for care when dealing with markets, subject as they are to human emotion and illogic. 2017 was one of the calmest periods in market history—the least volatile in over fifty years. Stock indexes moved in a narrow range—seldom more than one percent in a day’s trading. Interest rates remained low, and security prices rose steadily to new records. Year-end tax legislation raised expectations for higher corporate profitability, helping to boost prices to greater heights early in the new year.

The bottom began to fall out following the peak on January 26, 2018. Observers pointed to several possible causes for the sudden reversal: concerns over rising interest rates and debt as a result of the tax cuts, the reduction of central bank stimulus measures, inflationary pressures, and potential trade wars. Challenges to the business models of the so-called “FAANG” stocks (Facebook, Amazon, Apple, Netflix, and Google), whose strength was responsible for a disproportionate part of 2017’s gains, also appeared to play a role. Whatever the constellation of causes, the change was swift. By February 8, the S&P 500 equity index had suffered the quickest ten percent fall from a high point on record. Many market participants, accustomed to an extended period of subdued volatility, were caught off-guard. Some had even bet on a continuation of subnormal price fluctuations, employing “derivative” products that were quickly wiped out in the market’s new-found fury. Such is the cruel and unforgiving punishment for speculation.

For us, the high drama of this period was just that: good entertainment. Over time, markets are always volatile. 2017’s calm was an aberration, and what we have experienced during the last two months is simply a return to more normal conditions in which it is not unusual for a stock index to rise or fall one or two percent per day. Yes, to hear that “the market fell 700 points today” may sound alarming, but in reality, it is less than three percent of a Dow Jones Industrial Average standing at 24,000—a move of note, but nothing that should be upsetting from an historical perspective.

At quarter’s end, the carnage was not too bad. Popular indexes including the Dow and S&P fell modestly; the Nasdaq, home to many of the big tech stocks, actually rose over two percent, reflecting the strength in those issues prior to February’s rout. In the bond markets, prices initially fell, and interest rates rose (in a few instances to levels not seen since the financial crisis) as the probable stimulative effect of tax cuts and government spending increases on an already strong economy increased inflation expectations (a hefty increase in government debt issuance as a result of those tax and spending policies was also expected and weighed on bond prices). Rates subsequently subsided as fears of trade wars and the “flight-to-safety” phenomenon drove investors to bonds. One corner of the bond market drew keen interest from observers: the “spread” between the yields on long-term and short-term U.S. treasury securities. This figure has declined in recent months to less than 0.5%, the narrowest in over a decade. The narrowing of this spread, or a decline into negative territory (a “yield curve inversion”) is viewed by many as an omen of economic recession. While there are forces at work that may have reduced the value of the spread as an economic indicator (flight-to-safety and quantitative easing are possible factors), it is certainly a figure that bears watching.

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The outgoing president of the Federal Reserve Bank of New York recently advocated changing banks’ “cultures” and executive compensation schemes, including requiring those rich pay packages to bear the initial brunt of the costs of bank misdeeds, instead of having shareholders suffer most of the pain of these all-too-frequent burdens, as is now the case. The unfairness of the current arrangements became patently clear during and after the financial crisis. Yet little has changed. In recent times the chief executive of one of the large banks walked away with a personal fortune of approximately $140 million, even after shareholders of his bank paid hundreds of millions of dollars in fines. Clearly, reform of such practices is sorely needed and would do much to improve the risk control cultures at banks. It is unfortunate that this particular Federal Reserve official’s advocacy came at the end of his term, blemishing, in our view, an otherwise good record of promoting sensible regulation of these important institutions. Perhaps his would have been a lone voice in the wilderness had he acted earlier, but one has to believe that a person in authority advocating genuine and tough reforms could have had some impact.

Along these lines it is disheartening to see that efforts are afoot to weaken some of the regulatory measures adopted after the 2008 crisis. Perhaps some tweaking is needed in the case of smaller banks, but to relax certain trading restrictions (for example, the “Volcker Rule”) or ease capital requirements are not steps in the right direction. Not only would these measures increase the likelihood of future financial calamities, but, given the political sentiment against “bailing out” failing banks again, a future crisis could be worse than what we experienced ten years ago.

The bottom line is that little, fundamentally, has changed at banks. Remuneration policies and management incentive schemes remain as before (Wall Street bonuses returned to pre-crisis levels last year). As markets and politicians forget the past, the probability of future troubles increases. In short, from an investment standpoint, banks may be purchased on a bargain basis (usually following some turmoil), but “banks as long-term investments” should probably be considered an oxymoron.

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“Only the foolish learn from experience—the wise learn from the experience of others.” A sentiment attributed to an eastern European proverb (and also to Benjamin Franklin), it often comes to mind as, half-way through our fourth decade in the investment business, we ponder our path through a period that has witnessed great market cycles, as well as vast changes in how Wall Street conducts its business. As an algorithm for life it is broadly applicable. We certainly feel that it explains how we matured as an investor, and developed a philosophy and approach that, hopefully, is of significant benefit to our co-investors.

In investing, learning from experience can be costly. That is why it is important to take heed of the experiences of others who went before you, learning from their procedures and, importantly, their mistakes. To err is human, and such is the nature of investing that wrong decisions will sometimes be taken, but following the knowledge and methods of those who have successfully dealt with similar situations in the past fosters one’s understanding and builds confidence in one’s own judgment.

Books are an essential part of this process, being a source of knowledge for the wise. We were fortunate early on to have been steered to important tomes, well-known within certain circles within the industry (but unfortunately seldom used in business schools). We also pursued our own reading, usually of obscure authors from years past. In addition to providing historical perspective, such broad reading helped to create the intellectual framework and sensitivity to risk that is so important in seeking investment opportunities and dealing with changeable markets.

Not everything, however, can be learned from books; some things are best learned directly from others, filtered through their own experiences and study. Early on in our career we gravitated towards individuals who, through contact or repute, struck us as being especially astute or insightful. Their contribution to our thinking and decision-making was critical. Through a combination of inspiration, or their referencing particular points in analysis or history, they helped us shape and hone our own methods, as well as develop an intuitive understanding of what constitutes good potential investments.

The mentors of our early days in the investment field are all gone now, yet we still heed their advice and carry on what we learned, using their wisdom and experience to meet the challenges of an increasingly homogenized and institutionalized investment world.

 

Dennis Butler, MBA, CFA