Letter - October 2014





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In the past month, a long expected correction has confronted the stock market. As we write, the Dow Jones Industrial Average is down year-to-date while the S&P 500 is up low single digits. Certain sectors have been hurt particularly hard: agriculture, energy, materials and small capitalization stocks.

Few people should be surprised. A month ago stocks were not particularly cheap. In fact our cash reserves, in many cases, are now above 20% of assets as we earlier took profits but found valuations of potential new investments unappetizing. How far might the correction go and could it turn into a bear market? How the events around the world develop and affect corporate profits will be decisive.

After a five year run, valuations are full so further upside for stocks will depend on continued growth in corporate earnings. The current correction reflects in part investors’ reappraisal of growth assumptions. A slow-down in China, Europe and Brazil has created jitters. Additional concerns include:

Strength of the Dollar

The dollar is attracting investors world-wide as a safe haven from troubles around the globe. The Russian/Ukraine conflict, the surge of ISIS, the destabilization of Iraq, and the spread of Ebola has created an air of uncertainly and menace that makes investors increasingly cautious. Markets hate uncertainty.

A strong dollar also raises concern about profit growth. Approximately 40% of the earnings of the S&P 500 are generated overseas so a strong dollar means that a given level of foreign earnings will convert into a lower level of reported dollar earnings. As the dollar strengthens against foreign currencies, notably the yen and the euro, corporations may feel pressure on their earnings, perhaps as early as the fourth quarter of this year.

A strong dollar also reflects sluggish (at best) growth in many parts of the world relative to US growth causing capital to flow into the dollar. For example, in recent weeks economic figures from the European Union, an important trading partner of ours, have been disturbingly weak. This is in part due to sanctions against Russia and in part due to an inability to find the right policies to generate growth in the eurozone.

The Fed

The Fed is now moving towards ending quantitative easing whereby it has been buying debt securities with printed money, a policy that has kept interest rates artificially low for a long time. This has been a painful period for investors seeking a relatively low risk return and has forced many into higher risk investments such as stocks and junk bonds, which may not be appropriate. With the prospect of the Fed changing policy towards pushing interest rates higher, investors may wonder whether they want to own stocks at current valuations.

A challenge to world order

In numerous parts of the world, there is an ongoing challenge to the post WWII world order. Russia’s invasion of Ukraine, the ISIS aggression in the Middle East, China’s uncertain intentions in South China Sea all have the effect of uprooting the status quo that has created prosperity over the post-war era. Expanding trade has been a big driver of growth. The new reality is anti-trade and prosperity may take a hit as a result. Borders no longer seem inviolate. Turmoil is anathema to growth and prosperity…and to corporate earnings.

The good news: Corporate earnings for the third quarter recently ended are widely expected to grow at a respectable +6% rate. While GDP is growing sluggishly at 2-2.5%, corporations have been able to maintain earnings growth through modest revenue gains, expense control and stock buybacks. Despite the issues discussed above, fourth quarter earnings are currently expected to continue to show strength. We will be watching as managements discuss guidance for Q4.

Though recovery from the great recession has been sub-par by historical standards, the US remains an attractive place to invest relative to many parts of the world. A strong currency, a vibrant corporate sector and America’s appeal as a safe haven in a troubled world underlies the attraction. So despite the volatility and pain the correction may continue to bring, we feel that the bull market remains intact, with the usual caveats.


Tom Herzig


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