Resilient Markets — July 2014

July 28, 2014

Dow Jones Average: 16,961
S&P 500 Index: 1,978


Resilient Markets


The investment markets have remained calm, even buoyant, in the face of rising
geopolitical tensions and conflict. The emergence of ISIS (Islamic State in Iraq and Syria)
has widened the Syrian civil war to Iraq. Hamas and Israel are back to shelling each other
once again. And a civilian plane with nearly 300 people on board was tragically shot down
over the Ukraine. The stock market reacted to the downing of flight MH17 with a brief, oneday
sell-off, before proceeding to new highs.

The resilience of the markets has once again driven home the fact that investors
worldwide hold a mountain of capital, and are desperately searching for places to put their
money. The Federal Reserve and other central banks have added trillions to the surfeit of
capital over the past five years, while giving investors fewer, palatable investment choices.
The result of more capital chasing fewer, decent investments has been asset price inflation. In
theory, asset price inflation can create a wealth effect that spurs economic activity. While this
has occurred to some extent, it is not a solid foundation for economic growth. It is more like a
short-term sugar or caffeine high where fatigue often follows an initial burst of energy.

The Federal Reserve took command of the markets five years ago, using unprecedented
tools that have certainly aided stock prices. We tend to agree with those who say the Fed has
manipulated and controlled asset prices. While happy about higher prices, many investors
remained concerned that artificially controlled price levels are inherently unstable and more
likely to experience a reversal. With the Fed having so thoroughly orchestrated the stock
market rise, a feeling of panic would sweep through the markets, if investors felt that the Fed
was losing its grip on the economy or interest rates.

For the markets to remain high and resilient the global economy needs to grow at a
modest pace and interest rates have to stay abnormally low. Because the Fed has considerable
power over interest rates, the greatest risk to the markets would seem to be an unexpected,
economic contraction. Central banks primarily use low interest rates to promote economic
activity. But with rates near zero percent there appears to be little more the Fed or other
central banks could do if the global economy started to weaken. There are still issues with
some of the European economies and with the underpinnings of China’s growth. The Fed
must be hoping that consumption patterns and the cost of raw materials remain steady
throughout the world.

The economic progress and market rally of the past five years has been built on a massive
expansion of government debt. The total debt burden held by governments, individuals, and
companies is now far greater than the debt levels that destabilized the financial system in
2008. There is a mountain of debt every bit as big as the mountain of capital that exists in the
world. The key difference from five years ago is that governments, which have the authority
to print money to make debt payments, now hold a greater percentage of the debt. An outright
default by a government is less likely than individual or corporate bankruptcies. Nonetheless
it is still a tenuous situation that has almost no margin of safety. An economic downturn of
any proportion could be quite damaging given the inherent fragility of a heavily indebted
system. Even though the markets have been resilient in recent months, investors should be
vigilant to any signs of economic weakness.

Current Strategy

While the rate of gain in U.S. stocks slowed considerably from last year, the market indices
still managed to grind out a gain in the second quarter of 2014. It was a mixed picture,
with many stocks having stalled out, a few making good gains, and quite a few dropping in
price. The bull market seems tired, but stocks continued to benefit from a lack of investment
alternatives. As long as the global economy grows at a modest pace, and interest rates remain
historically low, it is hard to foresee a catalyst that could trigger a serious market correction.

Our clients’ exposure to stocks has moved gradually higher in recent months as we added
a few new holdings and sold very little. Even though the market indices remain stuck at a
rather static high point, there has been considerable movement in individual equities. We have
taken advantage of those swings, buying some high quality companies at prices thirty percent
off recent highs. Our preference is companies with commanding, competitive products and
good balance sheets. The recent buys fit that description, which should make them good,
long-term holdings, in our opinion.

Fixed income holdings appreciated in value in the latest quarter as interest rates fell by
about half a percentage point. While the drop in rates temporarily pushed up bond values, it
also pushed back the day when rates return to a more normal level. The current bond market,
with rates of 2.45% on ten-year treasuries, gives investors a minimal after-tax return. If an
investor is willing to make a 15-20 year commitment to bonds, higher after-tax returns are
available in the municipal market.



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