Shakespeare once wrote that, if there were no ugliness there could be no beauty. In an analogy, if markets could not go down, they could not go up.
The naïve and unrealistic expect markets to always go up. This idea is embraced in spite of the fact that there is no recorded instance in history of markets advancing in a straight line. Peter Lynch, one of the first market wizards of the early 1980s, used to quip that markets went down 20 percent or more on average one year in three and two years in five. As a fundamental investor, this did not trouble him. He saw such declines as ways to add to the holdings of the Fidelity Magellan Fund, which he managed. He was rewarded with an outstanding track record as a mutual fund manager that few have approached.
Consider this: the Standard & Poors universe of 500 companies generates, on average, $19 billion of profit per week. In spite of all of the comments to the contrary, there is no credible evidence that this rate of profit is going to decline. In fact, in the aggregate, it is expected to rise.
This is not to say that all companies will experience profit growth at the same rate. A changing economic landscape always produces new winners and losers in the short run. It is the nature of capitalism to reallocate assets to sectors where they have the greatest returns. When those returns are no longer there, capital is reallocated again. What is important is to determine the winners and losers over time. This is the providence of the long-term investor.
However, when markets decline as is now the case, the long-term perspective is often sacrificed to short-term swings. People get nervous and decide to abandon previously successful strategies because their stockholdings are down in value. Investors engage in what professionals call “rainbow chasing”, which consists of getting involved in whatever strategy or sectors showed the most promise over the past month. Some investors heed the blandishments of various doomsday scenarios and decide to buy gold or silver, or some other investment that produces no cash flow and never will.
And yet, any number of academic studies have shown the success of value investing versus chasing public offerings, fads, fashions or the like.
The reasoning is pretty basic. To have appeal as a value investment, the cost of the investment relative to its future potential has to be less than that of the overall market. A growth or fashionable investment often has higher projected potential, but much if not all of the potential is already reflected in the price of the stock.
In the past decade, a fashion of investing in ways that has prevented objective valuation has come back into being. Previously done in the form of limited partnerships, the new trends favor acquisition of entire companies, taking them off the market and often borrowing against their unencumbered assets. Later, the company is taken public again, but is so burdened with debt that it is but a shadow of its former self.
A current example of this trend is the upcoming initial public offering (IPO) of Albertson’s. The grocery chain was merged into Safeway last year by its controlling investors, Cerebus Capital.
The offering, for a minority interest in the firm (the private equity partners will continue to hold controlling interest), reports several interesting factors which are standard in this type of investment. First off, the private owners are paid generously by the company for “managing” it, although day-to-day operations are carried out by the staff. Part of the objective of the stock offering is to pay the majority owners their fees for management for the next five years.
The reissued stock in Albertson’s is for a company that loses money after servicing its debts Finally, the issuing statement says that the company will not pay a dividend for the foreseeable future, given the disposition of the private equity owners to siphon cash flow into their own coffers.
Two questions immediately come to mind. Why are the partners selling the stock, and who will buy it? Right now, grocery chains sport high valuations, so the owners of Albertson’s see a chance to cash out without giving up control. As for who will buy the stock: those who falsely assume the Albertson’s of five years ago is the same as the Albertson’s of today. Are people that unsuspecting? You betcha.
In spite of all the hand-wringing about the economy, employment and economic activity continue to push ahead. There are predictions of yet another month of strong employment gains in September. The economic impact of the rest of the world has been minimal, as the US gets less than 14 percent of its economy from exports, with 40 percent of that amount going to Canada and Mexico. Outside of the energy sector, the US economy has benefitted from the collapse of commodity prices as we are a net importer of most raw materials.
Contrast the state of the US economy to that of Germany. There, 45 percent of GDP is derived from exports, with its largest private sector employer, Volkswagen, under attack for various pollution violations.
Interest rates got another reprieve from the Federal Reserve, as no increase was made earlier this month. However, there does seem to be a determination by the Fed to raise rates later this year. The original date was assumed to be December, but the prospect of a Republican-led effort to shut down the government at that time may move the increase up to October or November.
The stock market declined on the news of the Fed not increasing rates earlier this month. On this basis, a small increase will probably cause the market to rally.
The collapse in commodity prices has continued to mask price pressures elsewhere. Services, are showing signs of inflation, especially medical services.
There is an excellent chance that, once the commodity price collapse sees its anniversary, the amount of inflation elsewhere will become more stark. For this reason, once rates do start to rise, expect several increases after the initial increase. A Federal Funds rate, currently close to zero, could be as high as one percent by the end of 2016.
The Stock Market
While market performance this past quarter and year-to-date has been negative, this should come as no surprise to those who study stock market history. The issue is what will the market do going forward.
By the fourth quarter of this year, the market should have found its footing and begun its ascent based on 2016 estimated earnings. Higher estimated earnings should be justification for a broad market rally into the New Year.
Warren M. Barnett, CFA September 30, 2015