Letter - July 2015





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A Short Letter

A short letter…no, we are not suggesting that investors go short the market (betting on a decline) though that may be a profitable trade. We refer rather to the fact that since the latter part of 2014 little has changed, whether it be stock prices, geopolitical events or macroeconomic conditions. There is little to say that we have not discussed already over the last six months.

Since the end of 2014, stock prices have basically gone sideways. The media has hyperventilated over occasional new highs but the fact is that those new highs have so far been marginal to the extent that they are inconsequential. The market remains bifurcated. The strong sectors like healthcare, particularly biotech, have out-performed the wider market by a substantial margin while old tech (Microsoft, Intel) and energy have struggled.

Mergers continue to be in vogue. In a slow growth GDP environment of 2.5%, managements apparently feel the need to merge to create economies of scale in order to cut costs. Unfortunately, cutting costs usually means worker layoffs. Regrettably, such actions do not enhance economic growth in the aggregate.

And there seems to be a new spin on corporate mergers. Since the US has the highest corporate income tax rates of any major country, there is an incentive for US companies to lower taxes by merging with foreign companies and moving the corporate domicile outside the U.S. Such tax considerations have become a key part of the cost-saving justifications for M&A deals.

Geopolitically, there has been little cooling in the hotspots around the world. Russia continues to challenge Ukraine and NATO member states. ISIS seems to be running away with the fight against a 32-member coalition rounded up by the US. The negotiations with Iran over its imminent nuclear capabilities continue to be deadlocked as deadline after deadline comes and goes. President Obama can claim one world-shaking success: diplomatic ties with Cuba.

From a macroeconomic view point, it is the same old, same old. While growth is persistent in the US, it is only 2-2.5%, lower than the typical rate during recoveries. Europe appears to have stabilized though meaningful growth has yet to materialize. Three cheers for the euro-zone for not getting worse.

Stock market bulls point out that while annual GDP growth has been anemic since the bottom of the last recession in 2009, the duration of the upturn has been long by historical standards. Cumulative growth has been more potent than is generally acknowledged and has contributed to growth in corporate earnings and stock prices. There is little reason to expect the slow grinding growth will not continue into the year ahead. This could, bulls argue, prolong the bull market for some time to come.

As of this writing, it remains uncertain as to whether Greece will remain as part of the euro-zone. Because of its small size, 11 million people, the economic repercussion of Greece leaving is not material. It is said that China creates the economic equivalent of Greece every six weeks. The issue is psychological. Had Abraham Lincoln not fought and won the Civil War to preserve the Union, there would not be a United States of America today. Similarly, should the Greeks successfully secede from the euro-zone, it could encourage weaker members, Italy, Spain and Portugal, to also resist the structural, economic and social reforms needed to assure long term prosperity. Such contagion in the future could threaten to render apart the European Union.

We remain cautious on the stock market. Portfolio cash positions remain high awaiting more reasonable valuations that may come with a correction. Earnings period is soon upon us, which could give the market some short term direction. Meanwhile, excesses (bubbles?) build. Artificially low interest rates continue to stimulate a misallocation of capital. To our mind, the question is not if problems are coming, but when. It could be some time.


Tom Herzig


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