Perspectives
Volume 7, Issue 2 | Summer 2014
“The qualities most useful to ourselves are, first of all, superior reasons and understanding, by which we are
capable of discerning the remote consequences of all our actions; and, secondly, self-command, by which we
are“The
enabled
to abstain
from present
pleasure
or toofendure
present
pain inand
order
to obtain a greater
pleasure
qualities
most useful
to ourselves
are, first
all, superior
reasons
understanding,
by which
we are
capable of discerning the remote consequences
of
all
our
actions;
and,
secondly,
self-command,
by
which
we are
in some future time.”
enabled to abstain from present pleasure or to endure present pain in order to obtain a greater pleasure in some
Adam Smith, Theoryfuture
of Moral
Sentiments (1759)
time.”
Adam Smith, Theory of Moral Sentiments (1759)

The good news…
Total Return
Total Return
SinceReturn Total
3/31/2014
Since
1/1/2014
•
The good news… Total
Return Since
3/31/2014 Since
1/1/2014
Standard & Poor’s 500 Index
+ 5.22%
+7.08%
Standard & Poor’s 500 Index
+ 5.22%
+7.08%
Barclay’s
Aggregate
Bond
Index
+1.53%
+3.40%
Barclay’s Aggregate Bond Index
+1.53%
+3.40%
Thebad
badnews…
news…
• The
- Stock prices continue to rise faster than the profits of the underlying companies, making them more expensive.
- The
Stock
prices continue to rise faster than the profits of the underlying companies, making them
result: more risk and lower future returns.
more expensive.
The result:
morehigher).
risk andThe
lower
future
- Interest
rates are lower
(bond prices
result:
morereturns.
risk and lower future returns.
- Interest rates are lower (bond prices higher). The result: more risk and lower future returns.
•
Oh my! Strangely, a vision of Dorothy comes to mind…. No, it’s not lions and tigers and bears, but we do find ourselves
 Oh my! Strangely, a vision of Dorothy comes to mind…. No, it’s not lions and tigers and bears, but we do
looking over our shoulders a bit for approaching danger.
find ourselves looking over our shoulders a bit for approaching danger.
Anelement
elementof
ofthis
thisconcern…is
concern…isthe
the fact
fact that
market
hashas
now
gone
overover
thirty-three
monthsmonths
without so much
• An
thatthe
thestock
stock
market
now
gone
thirty-three
as a 10% “correction”….the fifth longest such period on record.
without so much as a 10% “correction”….the fifth longest such period on record.
James J. Izard, II, CFP®
Michael P. Disharoon
Katherine C. Willis, CFA®, CIC
Caroline S. Oliver, CFA®, CFP®
Dickinson B. Phillips, CFP® Henry U. Harris III, CFA®, CIC
Jonathan E. Morris
Jonathan L. Taylor, CFA®
John C. Benedict, CFA®
Justin A. Topping


•
 •
•

•

•

•
Investing is a social science…much more art than real science (despite sales-oriented suggestions to the
contrary).
Recognizing this…we pay a great deal of attention to behavior, knowing that investors frequently do the
Investing is a social science…much more art than real science (despite sales-oriented suggestions to the contrary).
wrong thing at the wrong time.
Recognizing
this…we been
pay a the
great
deal of drivers
attentionoftobehavior
behavior, since
knowing
that investors
frequently
do the
Fear
and caution…have
primary
2008-09,
but today
we sense
a wrong thing
at the wrong time.
shift….not so much complacency as acquiescence. The sense that for those who took shelter in cash during
theFear
Great
Recession
– only been
to bethe
leftprimary
behinddrivers
by theofstock
market’s
there
is now
a compulsion
to so
and
caution…have
behavior
sincerecovery
2008-09, –but
today
we sense
a shift….not
much
complacency
as
acquiescence.
The
sense
that
for
those
who
took
shelter
in
cash
during
the
Great
Recession
–
do something…anything to earn more than the near-zero return currently found in those instruments in
only to be left behind by the stock market’s recovery – there is now a compulsion to do something…anything to earn
which
safety.return currently found in those instruments in which they sought safety.
morethey
thansought
the near-zero
If we’re correct…then it would also imply, by extension, the prudent course of action might now be to
If we’re correct…then it would also imply, by extension, the prudent course of action might now be to gravitate toward
gravitate
toward that very place they are leaving….
that very place they are leaving….
That’s right…money market is looking more appealing, both for its absence of volatility and the prospect
That’s
right…money
looking
more
appealing,
both for its absence
of volatility and the prospect that shortthat
short-term
interestmarket
rates is
may
begin
to rise
in the not-too-distant
future.
term interest rates may begin to rise in the not-too-distant future.
To be sure…while stock valuations have grown elevated, they remain near fair value, so long as inflation
To be subdued:
sure…while
stock
valuations
have grown
elevated, they
remainPartners,
near fair illustrates
value, so long
as inflation
remains
remains
(the
chart
below, courtesy
of Strategas
Research
the average
Pricesubdued: (the chart below, courtesy of Strategas Research Partners, illustrates the average Price-to-Earnings ratio of
to-Earnings
ratio of the S&P 500 Index within ranges of inflation from less than 0% to over 7% from 1950
the S&P 500 Index within ranges of inflation from less than 0% to over 7% from 1950 forward)
forward)
Average S&P 500 NTM P/E by CPI Y/Y Tranche
(1950 - Current)
17x
16x
15x
14x
13x
12x
11x
10x
9x
8x


14.3
15.2
14.6
13.1
11.9
10.8
8.8
<0%
0-1%
1-2%
2-3%
3-4%
4-5%
5-7%
> 7%
Lofty… Presently, the Consumer Price Index is running at just under 2% and stocks are commanding an
• average
Lofty…
Presently,
the15.7
Consumer
Price$1
Index
running
at just under
2% andThus,
stocks
are commanding
share
price of
times each
per isshare
of projected
earnings.
while
share prices an
areaverage
not
share price of 15.7 times each $1 per share of projected earnings. Thus, while share prices are not excessive, neither
excessive,
are they neither
cheap. are they cheap.
•
 •

16.1
•
 •
 •
Social science, continued… Along the behavioral discussion noted earlier, we wonder what it is that
Social science, continued… Along the behavioral discussion noted earlier, we wonder what it is that investors least
investors
least expect. Something which would catch everyone so flat-footed that it would sponsor the
expect. Something which would catch everyone so flat-footed that it would sponsor the long-overdue correction.
long-overdue correction.
Could
it be…
inflation?
Having
been
range-boundbetween
between 1%
1% and
and 2%
2% for
for over
and,
perhaps
Could
it be…
inflation?
Having
been
range-bound
over two
twoyears,
years,inflation
inflation
and,
more importantly, inflation expectations, appear very docile. Thus, its appearance could be the kind of surprise that
perhaps
importantly,
expectations, appear very docile. Thus, its appearance could be the
sends more
the financial
marketsinflation
into a tailspin.
kind of surprise that sends the financial markets into a tailspin.
Moreover…where we have recently witnessed rising prices of both bonds and stocks, an inflation scare would be just
Moreover…where
we have recently witnessed rising prices of both bonds and stocks, an inflation scare
the thing to send them both into reverse.
would be just the thing to send them both into reverse.
Inflation?
From
what
source?
We’reglad
gladyou
youasked.
asked.Certainly,
Certainly, the
candidate,
but we
Inflation?
From
what
source?
We’re
the price
priceofofoiloilisisalways
alwaysa agood
good
candidate,
think the least suspected source might just be wages.
but we think the least suspected source might just be wages.
real,
inflation-adjustedwages
wageshave
havebeen
beenflat
flat for,
for, like,
ButBut
real,
inflation-adjusted
like, forever…
forever… Like,
Like, precisely.
precisely.
•
•

Supply and demand… While the discussion rages about joblessness, the issue isn’t just about jobs, it’s also
 Supply
and
demand…While
Whilethe
thediscussion
discussionrages
rages about joblessness,
Supply
and
demand…
joblessness,the
theissue
issueisn’t
isn’tjust
justabout
aboutjobs,
jobs,it’sit’salso
also about
aboutWhat
job skills.
What
you
will see
belowtois believe
reason to
believe
thatsoon
therebewill
soon be
upwardonpressure
oncompanies
job skills.
you
will
see
below
is
reason
that
there
will
upward
pressure
wages
as
about job skills. What you will see below is reason to believe that there will soon be upward pressure on
wages
asup
companies
have
to paypersonnel.
up for suitably trained personnel.
have
to pay
for suitably
trained
wages as companies have to pay up for suitably trained personnel.
 First, a look at the trend in job openings… (Strategas)
 First,
a look
trend
jobopenings…
openings… (Strategas)
(Strategas)
First,
a look
at at
thethe
trend
in in
job
JOLTS: Job Openings: Total
JOLTS: Job Openings: Total
(SA, Thous)
(SA, Thous)
5500
5500
5000
5000
4500
4500
4000
4000
3500
3500
3000
3000
2500
2500
2000
2000
•
'01
'01
'02
'02
'03
'03
'04
'04
'05
'05
'06
'06
'07
'07
'08
'08
'09
'09
'10
'10
'11
'11
'12
'12
'13
'13
'14
'14
 Then
look
at the
difficulty
companiesare
are having filling
filling many
Then
look
at the
difficulty
companies
manyof
ofthose
thosejobs…(Strategas)
jobs…(Strategas)
 Then
look
at the
difficulty
companies arehaving
having filling many
of
those
jobs…(Strategas)
50
50
45
45
40
40
35
35
30
30
25
25
20
20
•
'00
'00

NFIB: Businesses with Few or No Qualified
NFIB: Businesses with Few or No Qualified
Applicants for Job Openings
Applicants for Job Openings
(SA, %)
(SA, %)
'04
'04
'05
'05
'06
'06
'07
'07
'08
'08
'09
'09
'10
'10
'11
'11
'12
'12
'13
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'14
'14
Saved for another day… will be a discussion of the apparent failure of both education and business to
 Saved
another
day…will
will beaa discussion
discussion of
business
to provide a
Saved
forfor
another
day…
ofthe
theapparent
apparentfailure
failureofofboth
botheducation
educationand
and
business
provide
a sustainable
sourcebe
of aptly trained individuals.
We would
observe
that
the prohibitively
high to
cost
provide asource
sustainable
source
of individuals.
aptly trainedWe
individuals.
We would
observe
that thehigh
prohibitively
high education
cost
sustainable
of aptly
trained
would observe
that the
prohibitively
cost of higher
is
of
higher
education
is
entering
–
what
we
believe
–
is
the
early
stages
of
a
sea-change
in
its
delivery
entering
–
what
we
believe
–
is
the
early
stages
of
a
sea-change
in
its
delivery
system.
Electronic
delivery
of
education,
of higher education is entering – what we believe – is the early stages of a sea-change in its delivery
system.
Electronic
delivery providers,
of education,
while
traditional
providers,
offers
the
prospect
while
threatening
to traditional
offers
thethreatening
prospect of to
reaching
thousands
more
of our
high
schoolof
graduates,
system. Electronic delivery of education, while threatening to traditional providers, offers the prospect of
at a reaching
vastly reduced
cost
and
without
the
need
for
the
enormous
infrastructure
seen
at
our
universities
today.
thousands more of our high school graduates, at a vastly reduced cost and without the need forPartnering
reaching
thousands
of ourbusiness
high school
graduates,
at a vastly
reduced
and without
the need
forone-half of
in this
change
should bemore
American
to whom
we would
suggest
a lookcost
at Germany.
There,
nearly
the enormous infrastructure seen at our universities today. Partnering in this change should be American
the the
working
population
has beenseen
educated
apprenticeship
programs
(Statistiches
Bundesamt,
Strategas).
enormous
infrastructure
at ourthrough
universities
today. Partnering
in this
change should
be American
business to whom we would suggest a look at Germany. There, nearly one-half of the working population
business to whom we would suggest a look at Germany. There, nearly one-half of the working population
has been educated through apprenticeship programs (Statistiches Bundesamt, Strategas).
has been educated through apprenticeship programs (Statistiches Bundesamt, Strategas).
•
Excess… Our last issue discussed the mountain of money accumulated in banks now available for lending. These
so-called “excess” reserves, represent monies above those which banks are required to keep on hand. We concluded
with a reference to a WSJ article written by Alan Blinder, a former vice-chairman of the Federal Reserve. For those
who may have Googled and read the article, an A+!
•
How to stimulate lending? As referenced in Mr. Blinder’s article, the Federal Reserve is presently paying 0.25% to
its member banks on the excess reserves in its possession. How then to encourage banks to lend rather than sit on
the money? Why charge them of course! That is, instead of paying 0.25% in interest, charge them interest for leaving
it there.
•
Et voila… That is exactly what Mario Draghi and the European Central Bank elected to do just days ago. This
prompted us to go to the ECB website, where we discovered a Q&A outlining precisely why they took this action. So
simple and succinct and so far from what we have come to know as “Fed speak”, we felt compelled to post it here (with
some modest editing):
-“Why has the ECB introduced a negative interest rate?”
The European Central Bank's mandate is to ensure price stability by aiming for an inflation rate of
below but close to 2% over the medium term. Like most central banks, the ECB influences inflation by
setting interest rates. If the central bank wants to act against too high inflation, it generally increases
interest rates, making it more expensive to borrow and more attractive to save. By contrast, if it wants
to counter too low inflation, it reduces interest rates.
Since euro area inflation is expected to remain considerably below 2% for a prolonged period, the ECB's
Governing Council has judged that it needs to lower interest rates. The cut is part of a combination of
measures designed to ensure price stability over the medium term, which is a necessary condition for
sustainable growth in the euro area.
-“Do I now have to pay my bank to keep my savings for me? What is the effect of this negative
deposit rate on my savings?”
There will be no direct impact on your savings. Only banks that deposit money in certain accounts at
the ECB have to pay. Commercial banks may of course choose to lower interest rates for savers. At
the same time, though, consumers and businesses can borrow more cheaply and this helps stimulate
economic recovery.
In a market economy, the return on savings is determined by supply and demand. For example, low
long-term interest rates are the result of low growth and an insufficient return on capital. The ECB's
interest rate decisions will in fact benefit savers in the end because they support growth and thus
create a climate in which interest rates can gradually return to higher levels.
-“But why punish savers and reward borrowers?”
A central bank's core business is making it more or less attractive for households and businesses to
save or borrow, but this is not done in the spirit of punishment or reward. By reducing interest rates
and thus making it less attractive for people to save and more attractive to borrow, the central bank
encourages people to spend money or invest. If, on the other hand, a central bank increases interest
rates, the incentive shifts towards more saving and less spending in the aggregate, which can help
cool an economy suffering from high inflation. This behavior is not specific to the ECB; it applies to all
central banks.
•
Only time will tell… The actions taken by the world’s central banks over the past five years have no historical
precedent. Whether they are successful and whether there are unknown consequences, no one can be certain. Summer 2014 999 Waterside Drive, Suite 1000
Norfolk, VA 23510
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