See
also:
General Index
of all guest columns written by Dennis C. Butler,
CFA
JULY 2016
he British
vote on whether to retain its European Union membership of over forty-years
standing dominated the business news during the year's first half, and fears
that the "Leave" camp could win the contest unsettled financial markets in
the run-up to the referendum in late June. They were not unsettled enough,
apparently, to "price in" the eventual outcome, and two days of selling
promptly followed the "Brexit" vote, leading to losses of about 5%, or $3
trillion of equity market value. The British currency lost a record 10% in
one day, dropping to levels not seen in over 30 years. Regaining some of its
"haven" status, gold rose to two-year highs, and even silver perked up after
a long period of lethargy.
Beyond
stock market upheavals and renewed speculation in precious metals,
repercussions of the British decision were felt word-wide. In Britain
itself, certain real estate investment funds were forced to freeze investor
redemptions due to the depletion of cash reserves, moves reminiscent of ones
that took place during the financial crisis of 2008-2009. But the primary
transmission mechanism for economic and political worries was the bond
markets. As neatly illustrated in the graph on this page, which shows the
historical yield pattern of the 30-year U.S. treasury bond, the rush to safe
havens has reinforced a 35-year trend of ever-lower bond yields. The yield
on the 30-year reached a record low after the Brexit vote, as did that for
the 10-year treasury note. The latter security is important as a benchmark
for determining the rates on other financial instruments — U.S. mortgages, for
example.
Developments in the bond market during the last year have been truly
extraordinary. Even before Brexit about $10 trillion of sovereign debt,
issued mostly by European countries, but also Japan, yielded buyers a
negative return. Instead of
stuffing cash in mattresses, buyers paid governments to look after it. That
figure has expanded to roughly $12 trillion. The entire debt stock of
Switzerland now offers negative returns, including that for a
50-year bond. Issuers from the
U.S. to Australia are paying record low rates on their debt. Ireland and
Belgium have sold 100-year maturity debt yielding just 2.3%. Slowing growth
in the world economy, excess liquidity, central bank stimulus policies, and
safe-haven buying have produced, by some measures, the lowest rates in
hundreds of years even thousands, according to one Bank of England report.
As one observer quipped, instead of "risk-free return" (referring to the
credit-risk status of the highest grade sovereign bonds), we now have
"return-free risk."
We believe that when the financial history of
this period is written, the dominant theme will be this relentless decline
in interest rates. Its impact has been felt everywhere in the financial
realm, from the housing market to hedge funds. Even the roots of the
financial crisis can be laid at its doorstep; the "reaching for yield" behavior of market participants in an era of low
rates created a demand for the types of exotic products that almost wrecked
the banking sector. Even now a new reach for yield —
any
yield in this case — is, in our view, storing up trouble for the future. Any
security that offers a decent-looking yield in the current environment of
negative returns for low risk will almost certainly require a far higher
rate to entice buyers when conditions return to normalcy. Higher yields
imply lower market prices — perhaps, much lower — than those prevailing
currently.
How all of
this plays out in the future will be a matter for the historians, but in the
here and now, those of us with responsibility for investing other people's
money are forced to "speculate" on possible outcomes and weigh risks. In
this situation we are reminded of another period, the late 1890s, which was
also characterized by a long trend involving an important facet of finance.
In that case the U.S. had known about 25 years of deflation (falling
prices). A survey of economists at the time revealed that virtually all of
them expected the deflationary trend to continue. As it so happened, shortly
thereafter, a period of
rising
prices began that continued for about thirty years.
During the last thirty-plus years, the world has experienced disinflation,
with the prices for goods continuing to rise, but at a decreasing rate.
Since bonds are sensitive to inflation, their prices have responded as shown
in the graph, with falling yields (and rising prices) as inflation
"expectations"
fell over time. The result has been that an entire generation of investment
professionals, and a large part of the investing public, has known only a
world of declining interest rates. Those who entered careers on Wall Street
during the last decade have experienced very low rates, and now negative
ones. Millions more have taken out mortgages at 4% or less (6% used to be
the norm). Furthermore, you don't have to go back a century to find a
long-term trend reversal in the financial markets; interest rates have been
falling for 35years, but before that were 30 years of rising interest costs
and falling bond prices. We wonder how the current Wall Street establishment
and the public will react to an unexpected change in the current,
well-established trend. We are skeptical about the eventual outcome. Buying
a 50-year bond with a negative return requires either a great deal of faith
in one's ability to predict the future, or a belief in the greater fool
theory
— probably both. We confess to possessing neither.
When Will They Ever Learn?
So far in
2016 we have experienced two episodes of stock market swoons. In the year's
opening months, fears surrounding the implications of the oil price collapse
induced a sell-off and declines in the 10-12% range. Recovering energy
prices led the equity markets higher as well, and stocks were roughly flat
by the end of the first quarter. The Brexit-induced fall in late June
reached 5-6%, but waning fears over the consequences of having a European
Union without the UK ended the stock market rout, and indexes had returned
to about pre-Brexit levels by June 30.
As we
contemplate these episodes of market turmoil, and the many others that have
occurred since the early 1980s when our personal experience with the markets
began, we are struck by how little is learned from these events. The same
patterns repeat themselves time and again — panic, selling, and depressed
prices, followed by a return to calmer conditions, but with higher prices
for securities that are now owned by someone else (an interesting aside: in
the aftermath of the panic selling during the collapse of the early 1930s,
stock ownership in the U.S. actually
broadened; someone was buying what the investment trusts were selling).
Many on Wall Street and in the business media speak of the markets in
anthropomorphic terms, as if markets can weigh, judge, and act in an
understandable fashion. They really can't. Markets represent a seething mass
of ever-changing participants. Individual operators may learn from
experience and act accordingly. In the aggregate, however, markets learn"
nothing.
Market participants as a whole are incapable of
looking beyond the short-term fears that possess them in a moment of panic.
In a way this is understandable. When one looks at a long-term chart of a
stock market index, it is positively sloped prices have risen over the
long run; in a long enough time range, even the 1929 crash is a small "blip" on the graph. However, each
little downward move indicated on the chart represents falling prices, and
to someone living through the event, that can be a frightening experience.
One
never knows
for certain
whether the historical pattern will resume its nice upward slope going
forward, or whether price weakness is the beginning of something more
serious and long lasting. So far, at least, markets have always recovered
from downdraughts and marched higher over time.
Markets' inability to learn means their behavior
at times of stress is not likely to change much. Panics of varying magnitude
will always occur from time to time, as will extremes of enthusiasm. As
investors, we seek to look far ahead, understanding that the upwardly
sloping chart means short-term concerns are usually overblown, and that
conditions will recover in time. We welcome markets'
arational
behavior as it creates opportunities for us. At all times we keep in mind,
however, that prices may not recover quickly, and that long drawn-out
periods of frustration are possible. The traditional definition of
investment has always emphasized the need for long-term thinking.
Year-to-date returns at June 30 came in at 3-4% for the Dow and
S&P 500 indexes
— not too bad, all things considered. Gold regained its
"haven" status according to the commentary, presumably in response to
political events and economic uncertainty. Oil retained most of the price
gains since bottoming at $27 earlier this year. Believing as we do that most
market behavior is meaningless, we do not read anything into these
short-term results, and do not see them as foreshadowing future moves. As a
market observer once said, "through all things we make our way."
______________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over
33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at
www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the
Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of
NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of
Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or
"What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at
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