May 2015

“You can observe a lot just by watching.”

- Yogi Berra, Catcher and amateur philosopher – New York Yankees

There has been a lot to observe in the first the two weeks of May:

  • The Las Vegas handle alone on the Mayweather-Pacquiao fight was $80 million.
  • The total betting on the Kentucky Derby was $130.5 million.
  • Via the draft, NFL teams will “bet” $120-$150 million on college players who have never taken an NFL snap.
  • Bond King, Bill Gross made a public “wager” that the 35-year old (and $76 trillion --with a T) bond bull market was over.

We all make bets.  Boxing insiders were confident of Mayweather.  Horse racing enthusiasts “knew” American Pharaoh was something special.  NFL general managers pored over film before making their picks.  And, in a rather melancholy piece, Bill Gross raised the white flag on his 35-year investment-of-choice. 

As an investor, you are not much different than the sports fan or the “bond king”….you, too, have to make your bets on the winners over the losers.  The “smart money” will advise that before you commit to anything, you have an overarching philosophy to help guide your decisions. 

And, it’s this “fundamental philosophy” that is the subject of this blog.

In the “bet” between stocks and bonds (equities vs. fixed income), we have long had a philosophy that this environment favors stocks---and they will remain the best bet in the long run.  (We’ll address real estate in a later blog, but most long-term readers know we are positive on owning income producing real estate).  Anyway, our stocks-over-bonds bias goes deeper than balance-sheets, historical returns, or risk-reward calculations.  Our philosophy reflects a foundational belief regarding the inherent nature of the two investments.  Here are two recent examples:

  • Recently, Audi announced they had successfully made diesel fuel from carbon dioxide and water.  The fuel is already being used to power the new Audi A8.  Audi is currently making only 160 liters per day and the question is whether the process can be economically scalable.  Still, if it can scale, it is an amazing game-changer.
  • Also, earlier this month, there was a report from the European Central Bank (ECB) saying that the fair value of Greek bonds would be 95% less were it not for the ECB backstops in place.

Talbot Financial clients do not currently own Audi stock nor Greek debt, yet the contrast stood out to us on a philosophical level. 

Whether Audi can make the new fuel work is subject to debate.  What is not subject to debate is that Audi is trying to make a product that will be better for the company, the consumer, and the world.  They are striving for excellence.  We believe that Apple, Microsoft, IBM, Travelers, Macy’s and a host of other companies are doing the same in their respective areas of expertise.

In contrast, bonds represent debt.  We know that debt (and the leverage it creates) can be a useful tool in creating wealth and earnings momentum….when used practically & prudently.  In fact, corporate sellers of debt have greatly enhanced their economic value in the last five years.

We do not believe, however, that prudence is the hallmark of today’s government bond sector.  The concept of sovereign debt “saturation” is now being openly discussed.  Those trillions in bond debt have already been deployed/spent, and unlike the money spent on Audi’s new fuel, governmental deficit spending offers little hope for stronger governmental balance sheets in the future.  We question whether sovereign debt will get “safer” going forward.

In the long run, the equity markets are positively influenced by a growing worldwide population and an expanding global wealth base.  Conversely, many governmental balance sheets are stressed by growing elderly populations, lower birth rates, lower revenue due to high unemployment and inefficient entitlement programs.  To us, the risk reward ratio between investing in great companies vs. investing in sovereign debt is weighted toward the future value we see in well-run companies.

Risk and reward must be weighed against every philosophical belief, otherwise it becomes too easy to drift to the esoteric without regard for reality.  Yet, even by this measure, in our mind, stocks still hold sway over bonds.  Allow us another few examples.

  • In April, the German 10-year bond yield was .05%.  That’s right, .05%--guaranteed for 10-years.  Last week, that yield had risen to .59%.  Granted, that was only a little over a ½% move, but moved the price of the bond by negative 6%.  That is the equivalent of a 1080 point drop.
  • Closer to home, on January 30, 2015, the US 10-year bond yielded 1.64%.  Last week, it registered at 2.21%---a 34.7% move up.  Clearly, if you bought that January 30 bond, you have had quite a drop in value. 
  • Almost simultaneously, during 2015 Q1 earnings season, over 70% of S & P 500 companies beat their Earnings per Share (EPS) estimates and dozens of firms raised their dividends or announced share buy-backs.  In fact, April was the largest buy-back month ever recorded.

Last week, Federal Reserve Chair Janet Yellen stated that US stocks could be overvalued vs. “safer” assets such as bonds.  We almost spit out our coffee.  Her long term risk-reward calculations in this environment are clearly different than ours.  If her view is that interest rates will go up, we all know that bond values will go down.  How is that a “safe” investment?

Of course stocks and bonds do not operate independently of each other.  When the Lehman crisis came to the fore in 2008, the failing bonds sent stocks reeling across the board—irrespective of revenue or earnings growth, balance sheet fundamentals, or remarkable innovations.  In “black swan” events, everything becomes correlated.

What happened in the aftermath was, however, instructive.  Since the Lehman crisis, bonds have boasted strong double digit returns.  For the same period, the S & P 500’s return was over 300%.  Innovation had far better returns over debt….the safer asset?

The irony of sovereign debt and central bank policy is that today’s actions will likely drive deep value in large cap equities for years to come.  As central banks drove rates to “zero” (or below!), the most solvent and credit-worthy “mega-corporations” have almost totally restructured their balance sheets with laddered debt at generationally low costs.  This will benefit them many years into the future.  When these savvy large cap corporate treasury operations “win” by raising low cost capital, the losers are investors in that low yield debt in the case that interest rates rise.  Corporations are “betting” on higher interest rates.

We too have “bet” on the balance sheets of many of these large companies.  We like the fact they are selling bonds to the market and raising dividends, or buying back shares, both shareholder friendly actions.

And finally, Yogi Berra turned 90 this week.  We wish the Yankee catcher happy birthday, and we’ll endeavor to watch and observe the markets as well as he did from behind the plate.

Happy Investing!


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