ne 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 financialcrisis) 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.
The outgoing president of the Federal Reserve Bank of New York recently
advocated changing banks' "cultures" and executive compensation schemes,
including requiring those rich paypackages 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.
"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.
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