4Q 2013
Jim Goff, CFA
Janus Director of Research
This is not a story about getting back on the horse that throws you. It is about just staying on the horse. It is also a market story.
I had the privilege of being invited to join a large group horseback ride for a week in western Colorado this summer. It was a great experience, with the opportunity to see parts of America you can only see on the back of a horse. I spent a lot of time preparing so my horse and I could survive the long ride. As I sat down to write this letter, it struck me how my experience with horses was similar to my experience in the stock market.
Although I have owned horses for years, I don’t have a lot of time to ride. I was at best an intermediate rider. The uncertainty of what might happen on a long ride worried me. Fear keeps a lot of people from ever getting on horses. I get thrown or have to bail off my horse every year or two, sometimes resulting in moderate injuries that require time to recover. Sounds like the stock market, doesn’t it?
When I work with one of my horses that has not been ridden much, it sometimes misbehaves, acting like a kid seeing what he can get away with. The horse’s bad behavior sometimes irritates or scares me. If I am agitated, the horse senses it and misbehaves more. It can end up really badly. If I stay calm and steady with the horse, we generally are able to work through the issues, and the ride goes well. When we panic during a volatile market, the results are often poor. It is our reaction to difficulty, more than the difficulty itself, that drives the outcome.
I was thrilled to get the invite to go on The Big Ride this past summer. I had dreamed of joining this group for years and now the opportunity had just fallen in my lap. It was a chance to meet some great guys, get more involved with horses and see beautiful country.
A lovely view
We do have a beautiful country, in terms of views in the Rocky Mountains and in our economic outlook. In economic and investment terms, I believe that the fundamentals of the U.S. economy are among the best in the world. As always, there are plenty of things to be concerned about, but the list is narrowing. The American system is strong enough to recover despite the dysfunction in Washington and the uncertainty it generates. The U.S. economy will continue to grow, most likely at an accelerating pace.
Some positives include:
· Consumer net worth has rebounded because of higher home and stock prices, bolstering consumer confidence
· Corporate profits, which drive stocks, are high and rising
· Corporate profit margins are high, but sustainable
· Corporate cash is extremely high and capital spending is set to rebound
· Employment is improving
· Inflation is low
As we have often discussed in these letters, the turn up in housing in the United States is generating positive ripples through the economy. The energy renaissance means that our long-held goal of greater self-reliance in energy is coming. The energy industry is driving direct increases in employment, a lower trade deficit, higher federal and state tax revenues and investment and job growth in adjacent industries, especially chemicals and manufacturing. Energy is driving widespread benefits in the U.S. economy that will only increase over time. OPEC is starting to worry and manufacturing jobs are being in-sourced from China.
From a government level, health care inflation is hitting a multi-decade low, and the federal government deficit is declining rapidly. Federal tax revenues are rising significantly and spending has been flat for years. The U.S. financial system and government is in the best shape it has been in years – and the government piece is hard for me to acknowledge. A lot of slack remains in the system. Employment needs to improve, but the good news is that we do not have bubbles in the system that are going to burst and derail this recovery. The economy can grow with low inflation.
Goldie
We have a few horses. I have traded some out, mainly the ones that bucked me off one time too many, and brought in steadier ones over time. For this ride, I chose Goldie. She had been a sheepherder’s horse and had been through it all – from chasing mountain lion tracks to a leisurely trot to an all-day adventure pushing sheep. She was young, athletic and could most likely handle the grueling ride. She was fast and smooth, but more importantly, she was steady. I did not want to get bucked off on The Big Ride in front of a hundred other riders. As with stock selection, we want to go fast (growth and reward), but we don’t want to get bucked off (volatility and risk).
I increased my riding from a few times a month to a few times per week. Goldie got in great shape, we got used to each other, we both got better and it all started to click. We rode smooth and fast across numerous trails through the woods on these beautiful summer evenings. I had no fear and it brought me great joy. I had underestimated the joy of riding. It reminds me of how we underestimate, particularly after bad times, just how good the stock market can be over a multi-year period like the last few years.
The Big Ride, like the market, had a lot of horses and riders. There were 162 of us, a line of riders snaking more than a mile, meaning there was the potential for trouble because some horses react badly in a crowd. The rider usually suffers for it. The organizers give away ignominious awards for unscheduled dismounts and I was determined not to get one. I was vigilant about spacing to stay away from problematic horses. My horse and I were healthy and unembarrassed. Goldie and I were in tune and everything was going well.
Further to go
I dreaded writing this letter. U.S. market indices are generally up over 20% year to date and risk-reward in the equity markets has become more balanced. Who wants to write a letter saying he is neutral? Not me. My contrarian instincts make me want to not like the market. But as I review the state of the economy and markets, I still believe the market has further to go.
One of the key things I see is that, for the first time in many years, we are largely seeing a synchronized global economic upturn. The U.S. has been growing moderately for a couple of years now, but the question marks are going away. Prime Minister Shinzo Abe was not on the radar screen a year ago and he has clearly brought change to Japan, and that economy is decisively turning up. Europe, one of the biggest question marks a year ago, may have bottomed and is showing some growth. China, another uncertain area and facing what most thought was a hard landing, is clearly improving. Brazil and India continue to do poorly, but will most likely follow China up over time. This synchronized global upturn is good for earnings and stock markets generally as investors start to worry less about the system, less about risk, and more about reward.
Cowboy up
At night, the horses are tied, somewhat spread out, to a long rope called a picket line. We were deep in the forest, not at some dude ranch with a barn. On the third night, another horse kicked Goldie and broke a bone in her leg. When I saw her favoring the leg, I was distraught. This little mare that had been so good and had taken such good care of me was suffering. My heart broke, but cowboys don’t cry.
In market terms, Goldie’s injury was my Lehman Crisis. In 2007 and 2008, we knew that housing could be a bubble. We bought good companies with good management and avoided high-priced stocks. We avoided exposure to housing names. But when the housing bubble popped, it damaged the financial system and the stock prices of our good companies. Despite our diligence, we were surprised and badly hurt. This was just like the Big Ride where Goldie was badly injured despite a lot of preparation and care. I finished the ride on a borrowed horse and managed to stay on top. Similarly, after Lehman, we stuck to our discipline of investing in good companies that create long term value. Our discipline paid off.
A year or two ago, pundits were discussing how low-risk bonds had beaten the stock market over a 10-year period, which is unusual. Was our horse, the stock market, dead? Commentators also suggested that buy and hold investing was dead. Investors should take a contrarian view to absolute statements such as these. Fast forward a year, a year in which bonds declined and stocks continued to appreciate, and you can see that staying disciplined and staying with stocks has paid off over different investment horizons.
After a bumpy ride, some investors are saddling back up but are moving slowly. Flows into equities have turned positive, but a multi-year look at the data suggests the rotation back from fixed income into equities has far to go. The “Great Rotation” is not great yet, but it will be. Despite the market upturn, I see the underlying tone of investors as still bearish. Countless articles have been written about the rise in price/earnings ratios for the market from 14 to 16. For the first time in years, the market actually has been driven in part by an expansion of valuations. It is like people forgot that was possible. Corporate earnings will continue to move higher and price/earnings ratios will continue to move higher, resulting in solid market gains.
Take a lesson from my ride. Stay calm and stick with a horse you trust. It cannot always be smooth or predictable, but it can be beautiful.
Happy Trails,
Jim Goff, CFA
Director of Research
P.S. We used a horse trailer to take Goldie home, where she is recovering. She will be evaluated this fall. If we cannot ride her again, she can expect a long life of leisure eating grass in a pasture with her friends. Also, if her riding career is over, we intend to breed her. Goldie will be a mom.
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Investing involves market risk. Investment return and fund share value will fluctuate and it is possible to lose money by investing.
Past performance is no guarantee of future results.
There is no assurance that the investment process will consistently lead to successful investing.
The opinions are those of Jim Goff as of October 2013 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes. In preparing this document, Janus has relied upon and assumed, without independent verification, the accuracy and completeness of all information included in this letter which is from a variety of sources. Janus cannot be held responsible for any direct or incidental loss incurred by applying any of the information in this publication.
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