Letter - October 2015





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The current correction in stock prices should not come as a surprise to readers of our quarterly commentaries. We have long argued that prices were high and that it was only a matter of time before excesses would be purged. We have maintained high cash balances, an unpopular stance, arguing that selling high, only to use proceeds to buy high, was not a sensible course of action.

The S&P 500 is, as we write, now down 12% from its summer high. The decline has been precipitated by a series of events: the devaluation of the Chinese Yuan, faltering growth in China and the rest of the emerging economies (Brazil, Russia, Thailand…), the fear that a rise in US interest rates would weaken economic growth in America and strengthen the dollar, further undermining growth. Geopolitical events aside, there is a general uneasiness that world GDP growth is slow and fragile, with economies prone to blow-up. By choosing not to raise short term interest rates at its recent September meeting, the Fed has re-enforced this uneasiness.

We have written in past letters that the zero interest rate policies of the Fed and the European Union has resulted in a misallocation of capital. Projects financed with zero percent money are not necessarily viable at more normal rates of 3% or so. As a result, excess capacity has been built for which there is little demand, which could eventually crush prices. Hence the crash in commodity markets, excess iron ore production, excess steel capacity and excess oil.

Fred Hickey makes an interesting observation in his recent monthly letter, The High Tech Strategist. The astronomical valuations of private start-up internet companies is creating a bubble in West Coast real estate values, particularly around San Francisco and Silicon Valley. Private companies, having raised huge sums from private investors at bubble like valuations, are snatching up office space at increasingly high rents. Should reality begin to set in that many of these companies are not viable and at some point may be unable to pay the rent, the extent of the real estate bubble will become apparent.

Another sector that is correcting sharply is biotech. We have singled out this sector for its overvaluation a number times. In a recent week one biotech index fell 14%, a crushing decline. We expect more damage to the sector as biotech exchange traded funds (ETFs) are liquidated, forcing indiscriminate selling across the board.

While investors focus on the market's fall from its highs of last summer, many large capitalization stocks have been hit even harder over that same period: Monsanto down 34%, General Motors down 27%, Amgen down 27%, IBM down 25%, to name a few. Herein we are starting to spot value. We are beginning to consider investing some of our cash balances in stocks that now have more realistic and attractive valuations. Noting that we are entering October, a month which has witnessed nasty declines in the past, we are wary of calling a bottom. We will be watching up-coming earnings reports closely for signs of encouragement.

We have experienced a number of bear markets over the last 30 years. They have all been unpleasant but in time stock prices return to growth. During market downturns it is important to temper short-term expectations and focus on the long-term resiliency of economic growth.


Tom Herzig


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