The Pause That Refreshes

The Pause That Refreshes

Halfway through 2015 the S&P 500 is flat, a refreshing pause from the current stock market advance that began in March 2009. It is now the second longest bull market since 1962 and the third largest in terms of appreciation in over fifty years. The S&P 500 has appreciated 205% since its March low. Only the 301% appreciation from 1990 – 1998 and the 228% bull market of 1982-1987 are larger. This leads to the question, what is left? Of course no one can answer with certainty. A better way to frame the question is: given the difficulty of forecasting, what is your assessment of risk in the financial markets, and is it time to stress the avoidance of loss versus a more aggressive pursuit of positive returns? Before we attempt to answer, it is helpful to review our thesis over the past six years in order to place the current phases of both economic and stock market cycles into a longer term context.

This Time is Different

“This Time is Different” is the title of a quarterly letter we wrote in early 2010 and borrowed from the title of a book written by professors Carmen Reinhart and Kenneth Rogoff. They covered the quantitative history of all the major financial crises on a global basis and the resulting aftermath. Their principle thesis was that in almost every historical case studied spanning what they term the modern time period (1800-2008), subsequent economic growth was difficult and slow for several years. It is important to make two qualifications. First, significant recession years that did not involve a major banking and financial crisis did not qualify. For example in the large declining economy in the early 1920s, recovery was significant and led to the Roaring 20s. Second, this thesis did not cover the stock market, which in many cases had sharp recoveries. Without articulating all the reasons for slow economic recoveries, the significant cause was the very large amount of debt created by governments as a result of extreme pressures on the banking system and financial markets. The average increase in public government debt as a percentage of GDP was 78%, which placed large constraints on sovereign governments’ ability to stimulate fiscal policy. The historical record also documented that many years after the financial crisis, government defaults occurred on sovereign debt where the debt created was far in excess of the average (i.e., Greece). This thesis made sense to our firm and as a result we have consistently been positive on the economy for the past six years, but with the slow growth caveat. As we all now know, the current economic recovery has been the slowest for the United States since the end of World War II.

Our approach to the stock market was also positive beginning in late 2008 into early 2009. The 52% decline created not only an atmosphere of extreme pessimism but also very low valuations, especially among great growth companies. Once we saw the massive intervention by the Federal Reserve and the injection of liquidity, we thought the economy would stabilize. As the bull market progressed, we remained positive as pessimism and denial of the bull market remained until 2013 and 2014, keeping valuations reasonable. Bonds remained unattractive under a zero rate monetary policy and the excess money supply flowed into the stock market.


Our January 2015 commentary, titled “Maturing on Optimism,” assessed the more advanced state in the stock market. Valuations are no longer cheap but still appear reasonable on a forward twelve month basis. However, there are now pockets of speculation and overvaluation indicating that Mr. Market is beginning to exhibit early signs of euphoria. Examples would include healthcare companies, especially biotechnology, technology sub sectors such as cyber security companies, the large volume of mergers and acquisitions with the high valuations paid, and private equity financing extremes such as Uber. In addition, Federal Reserve Policy is now changing toward normalizing interest rates which means declining liquidity. There is a general consensus, based on initial tightening moves by the Federal Reserve historically, that the initial increases will not be disruptive to the financial markets. No one really knows for sure, but given that the Federal Reserve may already be late in changing policy, we believe a complacent outlook is unhealthy. The fact is risk has now increased given the above reasons. Though risk is not at extremes, we do feel it calls for a slight shift toward more defensive thinking. The risk to bond investors is now at an extreme level, especially if our economy begins to accelerate along with inflation. Therefore, it would be unrealistic to be outright bullish and expect the returns earned over the past six years to be the norm.

Economic Outlook

Although the stock market may be in later innings, this does not necessarily hold true for the economy. The slow growth recovery has resulted in little economic excesses. In short, we see no clear signs of a recession.

Except for near record new car sales, consumption has not been as strong in other sectors such as housing. There has not been any major capital spending cycle. As employment is now strong and wages improving, shortages may begin to appear forcing industrial capacity to expand. One major reservation we have is the weak global economy, especially China, the second largest economy in the world. China’s economy has been weak as they struggle with the end of their large infrastructure boom supported by a huge increase in public debt. In addition, the large speculative bubble in the China stock market and current turmoil will make their efforts to transition from a heavy reliance on industrial production to a more consumer based economy more difficult as personal wealth is destroyed.

In conclusion, risk has increased as the cycles mature. Therefore, portfolio strategy and timing of new purchases should take this assessment into consideration. Examples include, being less aggressive on new portfolio positions, confirming that long term business fundamentals remain positive in stocks that meaningfully decline, and continuing our disciplines of selling or reducing positions where valuation is questionable. Also, moderate cash positions are appropriate if no purchases are available at reasonable valuations. We remain committed to investing in high quality companies that are available at reasonable valuations and are poised to act on new ideas if valuations decline to an attractive level.

We close with a quotation from Howard Marks, Chairman of Oaktree Capital Management and who has an excellent long term record: “Several things go together for those who view the world as a uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly…and emphasis on avoiding pitfalls. To me, that is what thoughtful investing is about.”

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