Never let logic, reason or pesky things like facts get in the way of a compelling headline. That must be the mantra of the financial press these days.
It reminds me of a scene from “Pirates of the Caribbean; The Curse of the Black Pearl.” (As our long-term readers know, there is very little one cannot learn about investing by simply watching this movie.) The scene is when Captain Jack Sparrow is in jail and the Black Pearl attacks. One of the other prisoners says he has heard stories about the Black Pearl and how they never leave any survivors, to which Captain Jack responds, “No survivors? I wonder where all the stories come from then.” The humor comes in the scene’s reality. We hear something that is just too good to not pass along and the next thing you know we are repeating something that makes no sense whatsoever.
Without survivors there would be no stories. Likewise, a bubble cannot pop if it did not exist. The story for the last few days of this downturn has been that markets – both bond and stock markets – in the emerging countries have been pumped up by the Federal Reserve’s (Fed) policy of quantitative easing (QE). The story goes that investors, who would have preferred to purchase Treasuries but couldn’t do so because the Fed has been buying them all, needed some place to go and they piled into emerging markets. Now that the Fed will be buying fewer bonds – that is what tapering is all about – these investors are going to drop emerging-market securities like a hot potato and run into Treasuries.
This story is almost as good as the crew of the Black Pearl never leaving any survivors. Like that story it has a flaw. Emerging markets were actually the worst place to be last year; in fact they have been the worst place to be for about three years – which is why they now appear cheap. How could emerging markets underperform if all these investors are being forced to invest there? That question is about the same as asking how those dead people spread all the stories about the Black Pearl. If QE did not prop up emerging markets, which is pretty clear, then the mild tapering of QE is not likely to cause any real issues.
I had the pleasure about a week ago of meeting with Dennis Lockhart, the president of the Federal Reserve Bank of Atlanta. He is always very professional and does not reveal anything unofficial, but reading between the lines of that meeting together with the official releases from Fed itself, it seems to me that the Fed is anxious to taper because they have finally realized that QE isn’t working. Some asset prices may have been pumped up, especially bank stocks and domestic small-company stocks, but the real economy has shown little benefit, if any, from QE. If it is not working then it is better to end it as soon as possible before any long-term unintended consequences occur.
So what is really happening in the markets? Markets do not go up in straight lines. After going up 32.39 percent last year and up 10.51 percent just in the last quarter, the S&P 500 is now down 3.06 percent year-to-date. The headlines are talking about markets “tumbling” and that is scary, but that is also the point; they are selling newspapers (or at least the electronic equivalent). Describing the current activity as “stocks in mild correction after a huge run-up” doesn’t compel attention like the word “tumbling.” However, no broad market indexes that we follow, including emerging markets, are even close to the ten percent drop that would constitute a normal correction during a bull market.
Of course, one cannot be complacent. We must always be prudent, and episodes like this are a good reminder of why prudent investing is done from the bottom-up. What is happening at the companies whose stock one owns is far more important than some sensationalistic headline. Prudent investing is absolute return-oriented, avoiding hot assets whose valuations cannot be justified. Prudent investing is also risk-averse, avoiding loss, or more specifically the permanent loss of capital. This does not mean avoiding three percent short-term price volatility; it means that when one is prudently invested, one is less likely to see any significant loss over time.
So what are we going to do in the face of outrageous headlines? We will stay prudent. What we own is sound and should do well in 2014. We have avoided or minimized areas like retail stocks, banks, and small company stocks in general that do appear overvalued and would likely lead the way downward if this proves to be more than a short-term blip. We will take action if this short-term volatility turns into anything more serious, but for now, rest assured: no bubbles have popped, nothing is tumbling, and dead people can’t spread stories.
Chuck Osborne, CFA
Managing Director
