Investment Outlook
Fourth Quarter 2014
October 1, 2014
By
John E. Montgomery
Managing Director & Chief Investment Officer
Capital Fiduciary Advisors, LLC
4720 Montgomery Lane, Suite 650
Bethesda, MD 20814
301-652-6951 (phone)
301-652-6954 (fax)
[email protected]
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“Forgive the length of this letter;
I didn’t have time to make it short.”
− John Montgomery
with nods to Cicero, Blaise Pascal, John Locke,
Benjamin Franklin, Mark Twain,
and any others who may have said it first.
O
ctober 1st marked the 40th anniversary of my start in the investment business.
After completing 18 years of formal education and receiving an MBA from
NYU, I decided it was time to learn something. And what I learn every day is
how little I and virtually everyone else knows about politics, the economy and
financial markets. I had intended to title this Investment Outlook “Everything
I’ve learned in 40 years in the Investment Business. The Shortest Investment
Outlook I’ve Ever Written” but, alas, I didn’t have the time to make it short.
By October 1, 1974, Richard Nixon had resigned and had been replaced by Gerald
Ford, the first unelected President of the U.S., who had pardoned Nixon. The Watergate trials
had just begun. Alan Greenspan (yes! that Alan Greenspan) had been handing out W(hip)
I(nflation) N(ow) buttons even while the economy hurtled towards recession. OPEC had
quadrupled oil prices helping to exacerbate the worst recession (1973-1975) since the end of
WWII. U.S. GDP was under $1.5 trillion. As of mid-year 2014, after 5 more recessions, U.S.
GDP is over $16 trillion. In 1974, the average salary was $13,900, the average cost of a home
was $34,900. The Cold War was going strong. China was still a “stinking commie hell hole.”
Franklin National Bank failed in October of 1974, for my first financial crisis. People read
newspapers and watched network TV for their news. Cable was in its infancy. There was no
internet. (Ah! The internet – it has greatly increased our access to information without
increasing our knowledge let alone to our wisdom.)
The day I started in the business, the Dow Jones Industrial Average declined 3 points
to 604 on 17 million shares traded. That October, the Dow rose 9½% or 58 points in spite of
October historically being considered one of the worst months of the year even back then.
(Thirteen years later the Dow dropped 508 points on October 19, 1987 and 34 years later it
declined 733 points on October 15, 2008). The Dow put in a double bottom in December of
1974 which completed a top-to-bottom bear market decline of 46% from its all-time high in
January of 1973. The Dow rose more than 60% in 1975-1976 and closed on Tuesday,
September 30, 2014 at 17,042 for a 28-fold increase since October 1, 1974.
Lesson: “No one ever got rich betting against America.” – Warren Buffett. At least,
not yet.
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POLITICAL OUTLOOK
“Politics is the art of the possible.” − Otto von Bismarck. The conservative Prussian went on
to say that politics was also “the art of the next best.” Maybe, …if people would cooperate.
Everyone keeps telling us that Washington, D.C. has a poisonous political atmosphere
that is possibly the worst ever. Forty years ago a president facing impeachment for petty
crimes resigned and was replaced by his nonelected V.P. who had replaced his predecessor as
V.P. who had left after he was caught taking bribes. The Watergate trials were underway. In
the 1974 mid-term elections, Republicans lost 48 seats in the House and 5 in the Senate as
well as many state houses. This ushered in a period of heightened liberalism ultimately
leading to Jimmy Carter’s election in 1976. The more things change…
In one Investment Outlook penned log ago, I opined that “If the road to hell is paved
with good intentions, then our elected officials are certainly the general contractors.” In
another, I answered the question “What do you get when you cross the little ‘Dutch boy’ with
the sorcerer’s apprentice?” The answer: “government.” But my favorite quote on politics,
which I used in a 2003 speech, is credited to Lord MaCaulay in a May 1857 letter to an
American friend. He wrote,
“A democracy cannot survive as a permanent form of government. It
can last only until its citizens discover that they can vote themselves
largesse from the public Treasury. From that moment on, the majority
(who vote) will vote for those candidates promising the greatest benefits
from the public purse, with the results that a democracy will always
collapse from loose fiscal policies?”
Once anyone is given anything, it is virtually impossible, politically, to take it away. In 1974
the federal government’s debt was $484 billion. Today it is more than $17,600 billion – a 36fold increase!
In spite of all of the successes of free market capitalism, many politicians and most
citizens neither get it nor believe it. Regardless of whether you believe that free markets, low
taxes and small government are the way to go, OR if you feel that big government has a moral
obligation to make life fairer and to redistribute the wealth our economy produces, it is a bad
idea to hobble the horse that pulls the economic wagon. Piling on more taxes and more
regulation certainly hobbles that horse.
In my opinion, it is a testament to the strength of the U.S.’s free market system that it
is able to move ahead as well as it does in spite of the amount of sand the politicians continue
to throw into the gears. Free market capitalism works and I would like to see the U.S., and
other countries, give it a try. There are a lot of things that are going right in the U.S. economy
– the energy revolution, biotech, 3D printing, the manufacturing renaissance, nanotechnology,
Silicon Valley – more often in spite of, not because of, government.
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I’ve lived in Washington, D.C. for over 50 years and been in the investment business
for 40. It’s hard to be more cynical and jaded than I am.
Lesson: As far as politics go “I try to stay cynical but it’s hard to keep up.” – Lily
Tomlin
Our current take on the political outlook is that “don’t wish too hard, you may get
what you want.” We expect that the Republicans will hold the House and win the Senate.
Gridlock will continue and Republicans will get blamed for it thereby setting up for a role
reversal in 2016.
ECONOMIC OUTLOOK
“It’s tough to make predictions, especially about the future.” − Yogi Berra
Early on in my career when I worked at Julia Walsh and Sons, we managed a college
foundation’s assets. On the faculty of that school was an economics professor who had built a
computer model of the U.S. economy which had 4,000 inputs – the largest such econometric
model at that time. At each six-month review, we were challenged to forecast the economic
outlook for the next half year vs. the computer model. We merely looked at the stock market.
If it was up, we’d forecast growth. If it was up a lot, we’d forecast strong growth. If the stock
market went down, we’d forecast an economic slow down. If we had experienced a bear
market, we’d predict a recession.” We usually beat the computer.
The stock market is one of the Leading Economic Indicators and reputed to be one of
the best. Paul Samuelson once quipped that the stock market has forecasted nine of the last
five recessions which is a much better track record than the Federal Reserve which predicted
none of the last five recessions. When Alan Greenspan was in the private sector as an
economic forecaster he had one of the worst records for predicting the economy of any of his
contemporaries. Regardless, he became the head of President Ford’s Council of Economic
Advisors and, later, the Chairman of the Federal Reserve.
Lesson: As Peter Lynch once said, “If you spend more than 13 minutes analyzing
economic and market forecasts, you’ve wasted 10 minutes.” I’ve wasted far more than 10
minutes over the last 40 years.
Current economic outlook: With the stock market near all-time highs, the yield curve
positively sloped, and the Fed likely to continue to err on the side of ease the U.S. economy
is likely to continue to expand but more slowly than the consensus is currently forecasting.
INVESTMENT IMPLICATIONS
In general, doing what feels really uncomfortable works pretty well. For instance, buying long
U.S. Treasuries in the early 1980s, selling stocks in late 1999 and early 2000, buying stocks in
February 2009 all worked great even though most people were comfortably doing just the
opposite. Generally, the best time to BUY is when prices are low (but not as low as spirits)
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and risk (and fear) are high and the best time to SELL is when everything is “puddle
wonderful” (as my brother, Mark, calls it) and everything looks like it’s “blue skies and green
lights.”
When Julia Walsh & Sons was acquired by Tucker Anthony in 1983, I traveled to
Rhode Island to meet with early quant pioneer, Stanley Berge, who worked for Tucker. After
spending an entire day teaching me some of the earliest and best “tricks of the trade”, Stanley
Berge said to me (almost as an afterthought). “There is one thing you should always
remember, John, that when studying the markets, it’s always best done while standing on your
head.”
Buy low. Sell high. Such an easy concept. Much more difficult to execute.
The other “easier-said-than-done” investment concept is to know your risk tolerance.
Risk is defined by Wikipedia as “the potential of losing something of value.” Easy enough, I
guess. But, how much can you lose? Over what time frame? How lost is it? How do you know
in advance? I was planning to say that risk is like pornography – “hard to define but you know
it when you see it” – but it’s not even that easy.
But, if you want to make money in the markets, you have to take risk – whatever risk
is. You’ll probably know risk when you “see” it but it sure won’t be easy to take it.
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Here are some of the other Rules of Investing in no particular order:
Buy value;
Be patient;
Don’t try to time the market;
Sell your losers;
Let your winners run;
And last but not least, use common sense.
One of the greatest compliments I ever got was from a student of one of the Principles of
Investment classes I taught at Georgetown. At the end of the semester he said to me, “It seems
that common sense plays a large role in your investment philosophy.” To which I responded,
“I sure hope so.”
Lesson: The most dangerous words in investing are that “this time it’s different.” –
Sir John Templeton
Current Investment Implications: There are currently more opportunities to sell high
than to buy low.
INTEREST RATE OUTLOOK
“Don’t fight the Fed” – Marty Zweig
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I first met Marty Zweig on Wall Street Week when he was the guest and my mother was a
panelist. While Marty was speaking about stock market investors fighting the Fed, but his
advice is equally pertinent to bond investors. Besides, Marty’s dyspeptic personality was
much more aligned with the usually dour bond market than the more optimistic stock market.
Marty pointed out that market participants should never argue with the only weatherman who
can make it rain. Good advice especially if you are planning a picnic.
As the Fed, which celebrated its 100th anniversary last year, morphed from the “lender
of last resort” (which it does quite well) to “central planner” (which is something no one does
very well and certainly not central bankers) financial markets have become even less
forecastable. “MO”mentum has become more of a factor and volatility less so, at least until
very recently. The Fed has increased its propensity to manipulate markets and financial
“players”, as investors are now called, have become increasingly dependent on the
Greenspan/Bernanke/Yellen “put.”
Very few centrally planned economies have produced sustained economic growth or
improved standards of living for their citizens anywhere close to that of free market
economies. Nevertheless, politicians and, now increasingly, central bankers try to deliver
economic growth, full employment, low inflation, income equality fairness…I’m sure I forgot
something. How are they doing so far? With the political system gridlocked the economy and
financial markets are ever more dependent on monetary policy. This is NOT a good thing.
With the possible exception of Paul Volcker, no central banker that I’m aware of has
ever forecasted a recession, prevented an economic crisis, properly addressed a “bubble” or
cured cancer. The Fed generally follows markets rather than lead them especially a turning
points and central bankers tend to be more reactive than proactive. The Fed did a spectacular
job in late 1970/early 1980 under Volcker and a great job under Bernanke during the
subprime meltdown. The rest of the time, not so great.
When people used to ask me what I thought about Alan Greenspan’s monetary policy
back in the 1990s and 2000s, I would respond that it “reminded me of my golf game.” Say
what? My friends would always tell me how good I was at getting myself out of trouble to
which I would respond that that was because I was so good at getting myself into trouble.
My observations are that the Fed was more of a dot.com bubble and subprime crisis
facilitator than preventer. IF the current near record low interest rate and new near record high
stock market environment end badly, the Fed will not only be likely to have caused yet
another crisis but will be expected to deliver us from its evil.
Lesson: I used to really like and trust the Fed. Now, not so much.
Current outlook for interest rate and bonds: Sooner or later, but probably later, the bond bears
will be right. The Fed is likely to stay easy for much longer than it should and it probably
already has. Watch the “belly of the yield curve” (2 - 5 year maturities) for clues. These rates
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are rising faster than shorter and longer maturities and often act like the “canary in the mine
shaft.”
STOCK MARKET OUTLOOK
“Just when you think you’ve found the key to the stock market, somebody changes the lock.”
– Unknown
The stock market is easy; it’s just not simple. I believe that over the long term equities will
outperform every other asset class but I also agree with John Maynard Keynes that “in the
long run we are all dead” and that “the markets can stay irrational longer than you can stay
solvent.”
Over the past 40 years, at least five truly horrendous bear markets have occurred with
the last three progressively worse (1987 down 33%+, 2000-2002 down almost 50%, and
2007-2009 down more than 50%). Every single bear market in the history of the U.S. has
been followed by a bull market that took stocks, in general and as measured by the major
indices, to new highs. Most of those bull markets were met with great skepticism but bull
markets generally don’t end until most become bullish, if not euphoric.
The current bull market is no exception and may be the most acute example of the
phenomenon. So far we have hit 34 new highs in 2014. The S&P is up almost 200% over the
past 66 months which is both greater than the average gain over a longer period of time than
all except for a handful of the 12 previous bull markets, all of which ended badly…as will this
one.
What have I (maybe) learned?
 Bear markets are more painful than bull markets are fun.
 Owning a portion of a company (not just a stock quote) is a good way to build worth.
 A company’s share value is based on earnings so you’re better off…usually…buying
shares of companies that are growing earnings.
 Dividends play an important role in the return you earn from the stocks that you own.
 It’s better to buy stocks when they are cheap but buying stocks just because they are
cheap doesn’t always work.
 Not all of the best investments are home grown. Like that incredible annoying ride at
Disney World: “It’s a small world, after all.”
 Be a contrarian (within reason) and be an independent thinker.
 Try to leave your emotions out of it. As Warren Buffett has often said “Be fearful
when others are greedy and be greedy when others are fearful.”
 Don’t try to time the market. In 40 years I’ve never met anyone who did so correctly
with consistency.
 Free advice is worth every penny that you pay for it.
Lesson: “The stock market is filled with people who know the price of everything but
the value of nothing.” – Philip Fisher
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Current Outlook: If everyone didn’t turn so pessimistic every time the market corrects,
even just a little, I’d be downright bearish. As Jason Trennert at Strategas points out, There Is
No Alternative right now to equities. This will remain true until there is an alternative. Slow
growth, low inflation and low interest rates are good for stock prices…up to a point. We
continue to like to have lots of dry powder (a.k.a. cash). We prefer large cap, blue chips with
dividends since they appear to be better values. We feel emerging and frontier markets
provide superior valuations to most developed markets, albeit with greater risk. (There we go
again with that “risk” thing.)
In conclusion, I would like to close with how I ended every one of the “Principles of
Investment” courses I taught at Georgetown: “The investment business is the greatest
business in the world. In what other business can everybody be an expert?” After 40 years,
I’m still trying to learn to be an expert. Another 40 years might do the trick!
This information is not meant as a guide to investing, or as a source of specific investment
recommendations, and Capital Fiduciary Advisors, LLC makes no implied or express
recommendations concerning the manner in which any client’s accounts should or would be
handled, as appropriate investment decisions depend upon the client’s investment objectives. The
information is general in nature and is not intended to be, and should not be construed as, legal
or tax advice. In addition, the information is subject to change and, although based upon
information that Capital Fiduciary Advisors, LLC considers reliable, is not guaranteed as to
accuracy or completeness. Capital Fiduciary Advisors, LLC makes no warranties with regard to
the information or results obtained by its use and disclaims any liability arising out of your use of,
or reliance on, the information.
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