My daughter, 21 years old at the time, first asked me about investing in crypto-currencies about 3 years ago. At the time, I think it was trading under $1000 for 1 Bitcoin.  I was trained as a securities and investment services lawyer and I’m a 30 years plus veteran of the global asset servicing industry, so I dove-in with my conservative, risk-averse bias answering, “it seems very risky; I do not think it is legitimate; it is subject to illicit activity such as fraud, cyber-crime and money laundering; you need to be prepared to lose all your money if you invest in it.”  As a virtually penniless undergraduate student from UCLA, she (and dad) passed on investing in the crypto-currency.

It is 3 plus years later and she missed out on a big score, right?  Well, again, as a lawyer, I think the answer is “it depends”. Making a decision to invest or trade in Bitcoin is just like every other investment, focus on understanding the investment thesis and the risks associated therewith and make a decision to invest or trade based on your specific personal situation.  What is an appropriate risk-based decision for Party A might be an inappropriate risk-based decision for Party B.

In this instance, none of us knows the future but there is a strong argument to be made that a digital currency makes more sense than paper money in an increasingly virtual world.  The question in my mind is whether the US Government and other developed countries are going to allow a private consortium to control the future of transaction exchange and money supply.  I do not think that is very likely; however, that does not mean it is not possible for Bitcoin or other crypto-currencies to develop as a private mode of exchange and be a legitimate store of value. For example, some professional athletes have asked to be paid in crypto-currencies and Elon Musk has commented that Tesla will at some point in the future accept Bitcoin as a currency of exchange. Ray Dalio, founder of Bridgewater Associates, one of the premiere asset management firms, recently commented on Bitcoin saying, “Bitcoin looks like a long-duration option on a highly unknown future that I could put an amount of money in that I wouldn’t mind losing about 80% of.”

Whether you or a friend or family member should invest in Bitcoin or other crypto-currency is a matter of what your predictions are for the future (i.e., that everything will be digital), how you feel about money and your overall risk profile. Some questions a person may want to start with are:

• Can I afford to lose all the money invested?
• Do I have a very long time horizon?
• Do I have the temperament to ignore very large price swings?
• Do I think Bitcoin will be accepted as a legitimate form of exchange around the globe?
• Will I worry that Bitcoin will be de-valued by some other digital asset invention?
• Do I believe that US currency will be displaced eventually by a private digital currency?
• Do you believe Bitcoin will eventually replace physical gold as a hedge against government money printing that de-values paper currency?

For me personally, I am not interested in crypto-currencies after understanding the investment thesis and risks. I do not like the prospects of losing money on a speculative investment thesis.  That said, for others the bottom-line is there is no right or wrong answer except make certain that if you take the step you can afford to lose your entire investment.

James R. Foggo

Disclaimer

This article is intended for general guidance and information purposes only. Under no circumstances is it intended to be used or considered as financial or investment advice, a recommendation or an offer to sell, or a solicitation of any offer to buy any securities or other form of financial asset. Always investigate and research before you invest.

I recently found an answer in an article in the Wall Street Journal (May 29, 2020, Sect A, p.15) by Phil Gramm and Michael Solon entitled “Why the Fed may not duck inflation this time.”  Messieurs Gramm and Solon offer this explanation.  Following a new piece of legislation (Dodd-Frank Act of 2010) the fed required banks to park their excess reserves with the fed, paying them handsomely to do so (the latter was the new twist: to pay banks for parking their excess reserves with the fed; up to then bank reserves were not compensated ).  The fed then borrowed $3.7 trillion from this pot of excess bank reserves and bought as much in private and public debt, driving down interest rates, driving up bond prices and generally sustaining these markets.  The important point which I and everyone else missed was where the $3.7 trillion came from.  The fed had not printed it, as was generally assumed, but rather had borrowed it from the banks.  In doing so the fed created liquidity but did not create money, as I and everyone else had thought.

So that’s what happened, or at least I think it is what happened.  This would explain why inflation did not take off: the government was not printing money.  And, therefore, the thesis still holds: print money and there will be inflation.  A lot more can be said.  And a lot will be in subsequent submissions.  But let me close with this modest observation.  It is a problem when no one understands what “the experts” at the fed are doing with our money.  Missing is transparency.  The term is perhaps overused in this time, but no where else is it more important than it is with money and credit.

Mark O’Brien

June 8, 2020

Summary: the stock market’s rise since its extreme sell-off in March isn’t surprising, given the degree of government support that has been provided by the Federal Reserve and Treasury.  But this support may have unintended consequences, and it could induce inflation, which most investors are unprepared for.

About two months ago the United States enjoyed its lowest rate of unemployment in the past fifty years.  Since that time nearly 40 million people have lost their jobs and the US has reached its highest rate of unemployment in eight decades.  Air travel, hotel stays, and most brick-and-mortar retail shopping virtually ceased, threatening sector-wide bankruptcies that have begun with some familiar household names, including Nieman Marcus, J.C. Penney, J.Crew, Hertz, Gold’s Gym, and Pier 1.  Even as the coronavirus has swept across the US, multiple hospitals have closed and countless medical practices are threatened with insolvency for a lack of patients.  Global supply chains have been thrown into disarray, farmers have been destroying unharvested crops and culling herds, and a glut of oil supply briefly drove the price to buy a barrel in the US below zero, meaning that traders would pay you to take this essential commodity that it took some $50 per barrel of input costs to produce.

The commercial mortgage market has been teetering on collapse, as many business tenants have ceased making rental payments to their landlords.  Prices for residential real estate, meanwhile, have risen due to a dearth of supply, with the median price of an existing home in the US rising to a record high in April.  In mid-May the Mortgage Bankers Association reported that 4.1 million homeowners were in mortgage forbearance plans and overall 8.16% of all mortgages in the US were past due.

In the midst of all this, financial markets are witnessing a strong bull rally in bonds and stocks, with the S&P 500 Index (SPX) up +43% and the Russell 2000 Index (IWM) up +52% from their lows in late March.  The S&P sits at about -5% below its all-time highs reached before the coronavirus pandemic, and above where we were at this time last year.

In our email of March 15, written in the midst of the sell-off, we wrote: “There is some reason therefore to think that after the virus is contained the economy and financial markets could come roaring back with a quickness that rivals its recent decline.  This possibility means that investors cannot reasonably ‘go to cash’ with the bulk of their portfolio.”  This assessment seems to have been borne out thus far, although it’s premature to say that the virus is “contained.”

What’s going on?  Our answer, which may be surprising, is that everything is more or less proceeding according to plan.  This suggestion may sound absurd at first hearing, but consider: as the gravity of COVID-19 became widely appreciated in March, state and Federal governments set about a coordinated plan to fight the virus.  This fight (the war analogies were explicit) involved intentionally separating the real economy from financial markets, not just in the United States, but across the world.  Everything may be proceeding more or less according to governments’ plan, but the plan is still fraught with enormous execution risk and the possibility of longer-term unintended consequences.

It’s dangerous to try to float financial markets on government stimulus while shutting down economic production, and it can only go on for so long—how long, nobody knows.  But the advent of rioting and looting across American cities in the aftermath of the George Floyd tragedy suggests not much longer.  Would legitimate protests have morphed into violence if the lockdown hadn’t been in place?  This is a question worth pondering.  Given what we knew about the virus in February and March, the economic shut down was defensible, and perhaps the most reasonable course of action available.

Travel and industry were forcibly closed and over 90% of the US population put under “stay at home” orders to slow the spread of the virus, even as financial markets remained open.  More importantly, financial markets weren’t left to themselves, but immediately received trillions of dollars of subsidy from the Federal Reserve, which already dwarfs the entire monetary response to the 2008-2009 financial crisis.  The European Central Bank, Bank of England, and other central banks deployed subsidies that are even larger than the US’s, relative to the frequency of their currencies’ use.  Japan, which has the third-largest economy in the world, recently doubled its COVID stimulus package to $2.2 trillion or 40% of the country’s entire annual economic output.  The total amount of US government stimulus deployed in 2019 is estimated to be equivalent to a full five years’ worth of Federal tax receipts.

This Response is Different

Unlike the government response to the 2008-2009 financial crisis, the present bout of government stimulus packages from central banks and treasuries has three important features: first, it has come very quickly, in a few weeks instead of many months.  Second, financial authorities across the world have responded uniformly, with more or less coordination.  Also unlike ’08-’09 is a widespread determination by governments to push money into the entire economy and into the hands of ordinary businesses, individuals and families, and not just to provide financial liquidity that remains trapped inside the banking system.

The US Treasury began mailing $1,200 checks to home-bound workers and paying supercharged unemployment benefits to those already furloughed or laid-off.  According to a University of Chicago study, over 60% of unemployed workers are currently receiving considerably more in unemployment benefits than they did in income when they were working full-time.  In the United Kingdom, the central government directly assumed responsibility for most companies’ employee payrolls and the Bank of England began printing money directly into the government’s checking account in order to fund its pandemic response measures.  Thus far the Bank of England has created half a trillion pounds using this “temporary” policy of direct monetary financing, which is historically associated with failed banana republics, and not the founding country of modern capitalism.

In the United States the Federal Reserve has hired BlackRock, the largest investment manager in the world, to oversee a portfolio of corporate paper, bonds, junk bonds, and municipal bonds on its behalf, funded by new money that the Fed creates.  The Fed even has a Main Street Business Lending Program (MSBLP) that will make loans directly to small businesses.  The only asset class that the Federal Reserve has yet to buy directly is equity, and this will surely come when the next crisis hits.  (The Swiss National Bank and the Bank of Japan have been buying stock exchange-traded funds for years in order to manipulate their currencies and stimulate their economies.)  Thus the pandemic has prompted the gradual nationalization of financial markets by the central banks and government treasuries across the developed world.

Nothing in the Federal Reserve’s legal charter empowers it to take these extraordinary measures.  The Fed’s gotten around this inconvenience by having the Treasury make the actual purchases, while it provides the financing.  This workaround has the effect of fusing the Treasury with the Fed, in spite of the fact that the former is meant to be a creature of the sitting presidential administration, and the latter is meant to be politically “independent.”  The Fed is now committed—in a presidential election year, no less—to provide unlimited financing to the Treasury to boost the stock and bond markets.  President Trump hasn’t been shy about trying to influence Fed policy via Twitter.

But now he needn’t take such an indirect route, since the Treasury secretary serves at his pleasure.  If the stock market falters before the November election, Trump’s appointee will have a new and powerful tool to do something about it.

Taking full view of the size and scope of the government response to the pandemic, it shouldn’t be surprising that financial markets have rallied since the sharp sell-off in March.  Large public companies and the wealthy have generally avoided the harshest effects of the lockdown measures, which have fallen disproportionately on the poor and on independent, small businesses.  According to the Federal Reserve, 63% of workers with a college degree can fully work from home, while only 20% of workers with a high school degree can do so.  The Fed also estimates that a full 40% of households that earn less than $40,000 per year and had a job in February lost that job in March.  The recent rioting and looting across the United States only serves to aggravate the collateral damage from the pandemic response: outside perhaps of corporate commercial real estate, the unrest will disproportionately harm small business owners and the urban poor.

Assessing the Virus

Markets price in known risks.  As the COVID-19 pandemic has unfolded, it has increasingly become a “known unknown,” and to that extent the market can adjust to the risks it presents.  We don’t know whether a vaccine will be developed or if so, how long it will take, and we don’t know how many or how severe follow-on waves of infection will be in the future.  But we do know a lot more now that we did in late February and early March, when the market began to crash.  We now know that the US hospital system had enough capacity to meet the initial surge in acute infections and that for most people under 65 and without certain underlying conditions, COVID-19 appears to be less life-threatening than the ordinary flu.  In our home state of Pennsylvania, the median reported age of death from COVID-19 is 84, while general life-expectancy in the state is just 78.  The majority of reported deaths have occurred in nursing homes.

Compare the economic significance of a virus that does not seriously threaten the working-age population, like COVID-19, with the Spanish Flu epidemic of 1918, in which half of all deaths occurred among otherwise young, healthy people aged 20-40.  Now that government lockdowns are easing, and evidence is emerging that some lockdowns may have been too broad or long-lasting, we may witness an additional relief rally in financial assets, as investors get further clarity about how extensive the longer-term impact of COVID-19 will be.  The great challenge in the coming months will be the re-coupling of financial markets with the real economy, which will be made harder by the civil unrest.  Everything may be proceeding more or less according to plan so far, but “the plan” is still fraught with enormous execution risk and longer-term unintended consequences.

Recommendations

We draw several investing lessons from the experience of the past two months:

1. Introduce a portfolio allocation to gold, sized at about 10% of bonds, which is an alternative to excessively low or negative-yields and provides protection against debasement of fiat currency due to extreme monetary policy;
2. Maintain a diversified portfolio and avoid piling into what’s performed best through the pandemic;
3. Maintain a cash balance in portfolios that allows for any foreseeable income needs over the next twelve months to be met, and which provides a store of “dry powder” that can be used for new investments that appear favorable as bouts of volatility emerge.

The recommendation of gold deserves some comment.  In the context of financial history, we believe that gold may now serve as a better store of value than many segments of the bond market.  In previous periods when bond yields fluctuated within their historic range, the argument against gold was simple: it wasn’t a productive or earning asset like an ownership interest in a business, and it didn’t generate a stream of income like a bond, even as it had a cost of ownership due to storage and security.  Furthermore, some forms of gold ownership had unfavorable tax treatment.

Persistently low interest rates have dissolved  most of this argument’s force.  The attraction of gold lies in its resilience as a store of value: unlike bonds or fiat currency, gold isn’t a promise to pay that is contingent upon the faithfulness of counterparties, but gold is payment in and of itself.  The extraordinary monetary policies of central banks around the world have destroyed large swaths of the bond market by making it suitable only for short-term speculators.  The US dollar may be the reserve currency of the world, but this status creates perverse incentives for US policy makers, who in the short term are insulated from the bad effects of policies ultimately undermine the dollar’s value.  There are now some twelve trillion dollars’ worth of negative yielding bonds across global markets.  Even many bonds that aren’t negative in nominal terms produce a nearly guaranteed loss after inflation is taken into account.  In the aggregate, the bond market has become extraordinarily exposed to real losses if interest rates rise to levels that are modest by historical standards, and new catalysts for inflation’s return are appearing by the day.

At present there is still comparative value in segments of the US municipal bond and corporate bond market, but low rates and negative yields have made gold a uniquely attractive asset for risk management within a diversified portfolio.  Before the adoption of extreme quantitative easing programs by central banks, bond yields would function as indicators of market expectations about future inflation.  Quantitative easing has destroyed the information value of bond yields; they no longer reflect investors’ expectations and indicate risk, but they express improvisational policy targets of central bankers.

One consequence of this situation is that investors will have little warning about a pick-up in inflation before it is upon us.  It’s possible that inflation never returns and the US and the rest of the world gradually slide into Japan-style price deflation for decades.  But it’s also possible that inflation does return, as COVID-related supply chain disruptions, a politically induced reversal of globalization, and government stimulus programs combine to drive up costs across the economy.  In either scenario, pronounced deflation or inflation, a modest allocation to gold will likely be a more resilient store of value than near-zero yielding bonds or even cash, because deflation will increase the burden of debt and insolvency risk for companies and states alike.

At the end of June we will send our regular portfolio accounting and appraisal letter.  In the meantime we will post some economic and investment commentary on our website www.obriengreene.com.  These shorter posts will try to share some of our thinking about these extraordinary times in which we find ourselves.

Sincerely,

Matthew B. O’Brien
matthew.obrien@obriengreene.com
610-891-7880

DISCLAIMER: Please note that this letter does not constitution the recommendation to buy or sell any security, and is for informational purposes only.  Past performance does not ensure future returns and all investing involves risk.  Individuals should consult with a professional advisor before making investment decisions.    

I have weathered many market crashes, including the Great Crash of 1987, the year I started O’Brien Greene & Co.  What I can say about the experience is how fast things come back from a crash.  I would go even further and say that one is never prepared for the snap back.  I say this now at what is in all likelihood the darkest moment surrounding the Coronavirus crash (off over 20% in the last several weeks).  If there is a serious mistake people tend to make in market crashes, it is forgetting about the inevitable snap back.

We at O’Brien Greene have been careful in recent years to make sure client portfolios had enough cash for a year’s worth of monthly remittances plus a little something extra for emergencies.  We did this even as the stock market soared several months ago; we thought it was prudent because stock valuations were high.  Now that the market is tumbling, there is another form of prudence that is called for.  Selling volatile stocks for cash at times like this might feel good, but it is costly. I think this may be especially so right now.  That’s because at the beginning of the year, market commentators were united in optimism about high and even rising employment and wage levels, strong corporate earnings and balance sheets, among other things.  The point is that the economy was strong when the virus struck; it was not sick, as was the case before other crashes, like that of 2008.  Today, unlike then, banks are well-capitalized and more judicious in their lending.  There are pockets of excess and uncompensated risk, such as the private credit market, but we have been careful to avoid those.  Thus the snap back is likely to be particularly fast and strong.

What else? Structural long-term benefits are likely to follow.  I expect a wave of new investment in infrastructure and manufacturing, as some of the risks hidden in extended global supply chains have now become evident. We as a nation and economy have tried globalization and found it wanting in key regards; it is unlikely the nation will ever give over all drug and medical supply manufacturing to an unstable regime half a world away.  This is true for most sectors of the economy. So remember the positives.

There are of course many other things that can be said.  I will leave that to colleagues Sally Sulcove and Matthew.

Mark O’Brien

It’s essential to keep facts such as this in center view when misleading commentary from journalists or politicians tempt investors to panic.  One thing to count on is that our polarized political climate and the degraded state of the news media will continue to produce plenty of such commentary.

Consider this widely-shared headline from yesterday, here from CNN:

This extraordinarily misleading assertion is technically true, but it obscures the fact that the Dow Jones Industrial Average point system doesn’t reflect the actual magnitude of changes in stock prices.  Stocks dropped about -4.5% yesterday; in the stock market crash of 1987, stocks dropped -22% in a single day.

If stocks end up declining a full 30% from their recent highs, consider that this would put prices back to where they were in the late spring of 2017.  A 40% decline would put us back to around the time Donald Trump was elected in 2016.  Such declines would be painful to suffer and nobody wants them to happen, but meditating on these numbers should give investors confidence to stay in the market.  It’s not possible to time the market reliably and to jump in and out; investors who get lucky once when they “go to cash,” almost always lose in the long run, because they fail to get back in to the market to benefit from recoveries.  History has shown that the bulk of recoveries come in a few very strong upmarket days.  Missing out on these days permanently impairs long-term growth of capital.

Negative bond yields are the result of a worldwide shortage of safe assets.  What caused the shortage? Well-intentioned governments in the developed world; they caused the shortage through the agency of their central banks.  In the so-called Great Recession of 2008-9, central banks like the Federal Reserve (the Fed) expanded their money supply (a.k.a. printed money) in order to buy government bonds. Here in the US, the Fed bought hundreds of billions of dollars of Treasury bonds and government-backed mortgage bonds.  The Fed did all this buying to drive bond prices up and help the banks and insurance companies that owned these securities.  The theory was that rising bond prices would help (1) banks and insurance companies and the financial system in general and (2) support consumer and business confidence, and (3) avoid any more bankruptcies like Lehman Brothers.

In Europe and Asia, central banks did a lot more during the Great Recession.  They bought government bonds and corporate bonds (the Fed did not buy corporate bonds in the US).  In any event, all this new money from the US, Europe and Asia poured into bonds that in normal times are the safest of assets.  Only problem was, too much money went into these securities.  The surfeit of money pushed their prices through the roof to levels that now are remarkable if not bizarre.  Over recent months I have written in my appraisal letters about anomalies in the bond market, including junk bonds in Europe that are now more expensive (meaning they have lower yields) than US Treasury bonds notes and bills. But perhaps the biggest anomaly of all is negative bond yields.  In Europe alone there’s over $16 trillion in bonds with negative yields.  In the US bonds don’t have negative yields, but they are close.  The 30-year U.S. Treasury bond has a yield of about 2%.

So that’s where investors are: historically “safe” assets have prices that are so high that they render the underlying asset risky.  That seems to be a contradiction, doesn’t it?  But that’s where we are.  Think of it this way: the underlying asset may not be risky (i.e., the issuer of the bond is not going to go out of business) but the price of the asset is unrealistically high and therefore subject to downward correction.  The asset isn’t risky but the price is. To put it yet another way, the safest bonds in the world had too much money chasing them and this (too much money chasing them) has pushed their prices to unsupportable levels.

Let me circle back.  When I say the safest assets in the world, I should include prime real estate in London and New York too.  Prices here have gone so high as to render these investments very risky for the same reason that US Treasury bonds, bills and notes are risky.  Too much money has poured into prime real estate.  Like buying a bottle of the world’s best wine for a $1million; that’s risky, even though no matter what the price, it’s still a good wine.

How does one protect wealth in such a climate? The problem with gold:  when the US government abolished the owning of gold in 1933, overnight the price of gold collapsed 50%.  In more recent times the US government has permitted the ownership of gold, but the larger principle is that what the government did once it can do again.  Also, if you buy gold, it has to be stored somewhere and insured.  These expenses make it like a bond with a negative yield:  If the price of gold doesn’t change, you are guaranteed to lose money just by owning it.  Bitcoin and other cryptocurrencies hold promise but they are susceptible to similar problems: Governments can outlaw them.  Facebook is having some trouble with the government over its proposed artificial currency.  In addition to political risk, these artificial currencies have attracted a lot of unsavory types.  They may not all be criminal but some are.  I remember recent news stories about millions in bitcoins simply disappearing.  Since the currency is unregulated, legal recourse is difficult.

Rather than gold or cryptocurrencies, I think one is better off in so-called earning assets.  What is an earning asset?  A farm or a store or selected common stocks.  I don’t think you want to run a store or operate a farm.  But you do own stocks.   They have worked out.  This year alone they’ve risen over 15%.  Stocks, preferably ones with dividends, are a reasonable value.  The underlying companies provide a necessary product or service; they earn money.  Some stocks are too expensive to buy now; Apple, Facebook, Alphabet, Netflix come to mind.  But most stocks are not too expensive.  The latter are what you own in your portfolio.  So I say keep owning them.

Let me express some thoughts on market timing and locking in wealth. Stocks do not have a termination value.  In this regard they are unlike bonds, which have a fixed and certain maturity date, when one is guaranteed to get principal back.  But the termination value feature is very expensive, especially if you don’t need it. A 30-year Treasury has a fixed and certain maturity date, but one receives a yield to maturity of 2% over that period.  An investor is giving up a lot to get the precision of that 30-year termination value.   Most investors don’t need all their money on a fixed and certain date.  The bill for one’s retirement does not come due on a single date.  Rather one is going to spend out his retirement portfolio over a period of years and even decades.  In sum I would not worry about locking in the value of a portfolio today; one has to give too much up.

One last thought before I close this overly long reflection.  There’s a good chance that economic growth may slow in coming years.  I won’t go into detail on the reasons why, but they have to do with worldwide demographic change.  Populations in the developed world are just not growing.  In many places they are stagnating.  One thinks of Japan.  In a slower-growth economy such as we might have, I think investors have to have more of their wealth working for them in earning assets.  Money market funds, bonds and commodities like gold aren’t going to do it.

Sincerely,

Mark O’Brien

The quarterly performance numbers look surprisingly tame. Stocks (S&P 500 Index) up 1.19 % Bonds (US Treasury 1.125% due 6/30/21) up 0.22%.  They do not hint at all of the drama and anguish that was the 3rd quarter, nor the fatigue most investors feel at the conclusion of the period.

Curious to report, though, investors may feel exhausted at the end of the quarter but not the economy.   When you look at the traditional measures, you see an economy that still looks remarkably strong.   Unemployment is at a 50-year low, wages are rising at the fastest pace in 10 years, inflation is subdued and the prices of stocks, bonds and houses are as high as they have ever been.

If you look beyond the traditional measures, however, you can find problems, some of them unsettling. I will discuss one in the words below.  But first I want to make what ought to be an obvious point.  Given the alternatives to record high employment, rising wages, low inflation and high housing and stock prices, America is in a good place.  Stronger than that, there is no better place to be an investor, not in Europe, not in Asia, not in emerging markets. To paraphrase Abraham Lincoln, America is still the last best hope, whatever vexing problems it faces.

One more clarification: when I speak of problems, I do not mean the handful of worst-case scenarios that keep cycling through the media.  These combine fear, imagination and some new little fact;  if everything goes wrong, runs the story line, earnings slowdown, falling employment, rising trade deficit and recession are next. Most recently the “if everything goes wrong” story centered on trade war with China.  August in particular was given over to the subject, and stock prices responded with near- record level volatility.

Are these “if everything goes wrong” stories fake news? In regard to trade war with China, the entire U.S. trade deficit amounts to 3% of the economy (GDP), and China is only a portion of that. To be sure, trade with China is important, especially for certain sectors, but is it absolutely vital to the nation like the price of oil and the level of interest rates?  Hypotheticals piled on hypotheticals is not news and less is it analysis.  I think the real problem may be the much-diminished state of the financial press; no sector has suffered more from the disruption of the Internet, except maybe the retail sector.  In this vein, just as I am having trouble finding a good shoe store, I am having more trouble finding in-depth analysis of real economic and investment problems, like zero, negative and near-negative interest rates.

Low, zero and negative interest rates are working enormous change on every aspect of economic life in America and the rest of the world.  The brainchild of central bankers like the Federal Reserve, they were meant as a temporary measure to fight the recession of 2009, but like many government policies, they have taken on a life of their own. Curiously, though, we know little about the phenomenon. To the extent that zero and negative interest rates are discussed at all in the press, it is in anodyne passages like that below, which appeared this September in The Wall Street Journal as interest rates notched their lowest levels in recorded history.

Falling Treasury yields are a concern for investors because they typically are associated with declining expectations for economic growth. But they also could provide benefit to the economy by reducing borrowing costs for businesses and consumers. (WSJ, Sept 4, P, B12):

That’s all the Journal has to say about the lowest interest rates in history?  What about the insurance industry?  What about funding pensions? When I was in school, indeed, just a few years ago, the possibility that bonds could pay negative rates of interest would have been regarded as oxymoronic.  Who would buy a bond guaranteed to lose money?  Why would anyone want to?

Yet here we are: over $15 trillion dollars in bonds with negative interest rates.  Most of these are government bonds in Europe and Asia; here in the United States, interest rates are not quite negative but they are close: the 10-year and 30-year Treasury bonds yield1.4% and 1.9% respectively. Accompanying the historically-low interest rates are other distortions of equal significance.  Last week Disney and the University of Virginia sold 100 year bonds at single-digit yields.  The next stop is, I fear, 100-year bonds with negative interest rates.

The reason no one is talking about the current state of the bond market is because no one, including central bankers, academics and the media, knows what to say.  Our entire economic system is organized on the basis of positive interest rates.   That the foundation of our economic system has morphed into its opposite suggests a new order is about to emerge.  What shape it takes is anyone’s guess.  So is this a real problem?  I think so.

The practical consequences for investors are far reaching.  With the exception of certain sectors, like intermediate corporate and municipal bonds, the bond market is no longer an alternative.  It is not an exaggeration to say that central banks in the developed world (U.S., Europe and Asia) have narrowed the field of prudent investing to stocks, materially complicating our work at O’Brien Greene & Co.  Will these central banks be able to untangle the mess?  They are not saying, but my hunch is that low, zero and negative interest rates will be the most difficult problem in the modern era.

Sincerely,

Mark O’Brien

But a three percentage point drop is scary enough.  That’s because it follows on the heels of a 500 point-drop, or 2 percentage points, exactly one week ago. Three percentage points here and two percentage points there,  these sell-offs add up.  This is not the trend we want to see.

What’s behind the 700 and 500 point drops? The President threatens a trade war with China.  To be sure, his threats (in the form of social media “tweets”) lack the dignity of great statesmanship, but the underlying problem has been going on for a long time, and more dignified methods have not worked.  The United States and other developed nations of the West want China to play by the same trade rules everyone else plays by.  For the last 40 plus years China has resisted.  Now we have a president who knows how to play chicken, as we called it as boys, and who seems to enjoy it. Is playing chicken over trade policy a bad thing?  I am not prepared to say it is, especially since China has a lot more to lose than the United States. It may even be in everyone’s interest, including China’s, to let this contest run its course.  China and not the United States has the most to lose if the gambit runs awry.

What are the other measures that pundits and forecasters point to as indicators of recession and bear market?  There are really only two: a so-called inverted yield curve and the number of initial public offerings (IPO’s).  A word on these.

A yield curve is easily made on a piece of paper.  On a two-axis graph one plots the yields of bonds against their maturities.  This sounds a lot more complicated than it really is.  As I write the 3-month Treasury bill has a yield of 2.42%.  The yield of a 10-year Treasury note is 2.44%.  Now connect the dotes between the three month and 10-year securities.  The line goes from 2.42% to 2.44%.  The line barely slopes upward.  If, however, something in the economy changes and the yield of the shorter maturity security moves higher and the yield of the longer maturity moves lower, one has an inverted yield curve.  That is to say, the line slopes downward.  An “inverted” yield curve has accompanied the last seven recessions and bear markets, and someone noticed the connection.  Is accompaniment causation?  That’s the question.  But in recent weeks the yield curve has become inverted a few times, igniting a debate, and warnings, in the financial press about a pending recession and bear market.

Is this a big deal?  Probably not.  That’s because the United States government, along with the governments of almost all developed nations, have in the last 10 years been manipulating interest rates to the point where interest rates no longer mean what they used to.  Whereas professional investors used to worry about the shape of the yield curve, they don’t anymore.

More important, in my opinion, is the rush to market of new ventures, like Beyond Meat or Uber.  When founders and other insiders decide it is time to sell out, it is often a sign of a market top.  In recent weeks the I.P.O. market was on fire and one clearly saw signs of a market peak. More recently the market has cooled down.  In the last two trading days, Uber, one of the largest IPOs ever, lost 12% of its value.  Had Uber soared 150%, as Beyond Meat soared just a short time ago,  I would take it as a market top.  But the fact that Uber is cratering suggest that this market is still able to correct its own excesses, and the bull lives on.

That’s how it looks to me on May 13, 2019, which happens to be my birthday.  We’ll see if anyone is still reading.

Mark O’Brien

But first the good news part.  On Saturday, May 4, 2019 I open my copy of the weekend edition of the Wall Street Journal and beheld banner headlines: “The jobless rate hits a 50-year low.”  Now this is good news, I thought, the market should really do well next week.  The market had of course done well all year, up well over 15% year to date,  but this bit about low unemployment looked like break-out material.

We know what happened next.  The President tweeted threats to the Chinese government that it had better play by the rules of international trade or else, where the “else” would mean tariffs as high as 25% on Chinese goods.  This threat precipitated yesterday’s 450 point drop.  Fear of an all-out trade war, long-simmering just below the surface, broke out again, as investors took counsel of their worst fears.

I don’t think the President’s tweet will lead to a trade war, but the incident reminds me that the President is first and foremost an operator, always angling for an advantage.  Rather than just enjoy the headline (something most politicians would do), he put it to work.

The take-home lesson?  Next time we have a good economic statistic, brace yourself, it won’t last.

Mark O’Brien

Other important stock indices are down even more than the S&P: the tech-heavy Nasdaq Composite is down 23.86% from its 52-week high of 8133.30 from 08/30/18 and the Russell 2000 of small-cap stocks is down 27.28% from its 52-week high of 1742.09 from 08/31/18.

The party line at O’Brien Greene has been that we’re overdue for a correction.  Well, now we’ve got one.  However, it’s hard not to feel like this one has come on too fast and too strong, and that stocks will recover at least in part in the near-term.  Many economic fundamentals in the US appear to be quite strong, and stock valuations, especially after last year’s corporate tax cut, look quite reasonable.  European economies appear to have sputtered, but not so the US.  Some stocks on our watchlist have begun to look like downright bargains, and where portfolios have cash on hand we may put more money to work in stocks after the holiday recess.

The important point to keep in mind now is how modest the aggregate impact of this correction is thus far for long-term investors, in spite of the fact that it’s nothing but painful to endure, and it is particularly bracing because it’s been so long since we’ve experienced volatility of this kind.  Including the negative effect of the present 20%+ decline, stocks have still done quite well recently.

It is a good time to invest and to remain invested.  Even as attractively priced individual stocks emerge, there are larger trends that favor stocks generically: corporate profits are expected to grow in 2019, as is the underlying US economy, albeit more slowly than before.  When the numbers are in for 2018, the cumulative impact of increased corporate profitability, the fruits of lower taxes and repatriated foreign cash, will likely be astounding. The Financial Times estimates (12/23/18) that US companies will pour over $1 trillion in dividends and stock buybacks into investors’ pockets in 2018: these are not the circumstances of a crash, and most likely what’s happening now is that “…fear is overpowering the still-healthy technical picture.  Markets move on inflection points and, after starting to price in a decelerating economy and slower earnings growth this autumn, investors have started to fret that the post-crisis economic expansion could in fact end next year.”

Fretting investors is a good thing for the market, as is the normalization of interest rates and the cessation of the Federal Reserve’s extraordinary bond-buying (i.e., “quantitative easing”).  What’s truly worrying is when investors stop fretting at all.