John Rogers' Ariel Investments June Commentary
The $85 billion question these days is: was the market sell-off in response to Ben Bernanke's recent public statements reasonable? We think there is no simple, straightforward answer to such a question but are happy to provide our views on the situation.
First, it should be clear what Mr. Bernanke said and what happened afterwards. On June 19, 2013, the Fed Chairman said if the economy continues on its projected course it would be "appropriate to moderate the monthly pace of purchases later this year" and take "measured steps through the first half of next year, ending purchases around midyear."1 Everyone has always known quantitative easing would have three more stages: a slowdown in buying, the end of buying and the selling off of purchases. In June Bernanke spoke about the timing on the first two in a future where economic growth continues. Note: he did not talk about the third stage, selling bonds. What happened in the wake of the comments (through June 30th) was a market sell-off in virtually every asset class. In the U.S., the S&P 500 Index fell -2.70%, the Russell 2000 Index slid -2.16%, and the Barclays U.S. Aggregate Bond Index returned -1.34%. Stocks around the world fell also: the developed markets MSCI EAFE Index dropped -3.90%, the all-world MSCI ACWI Index fell -3.04%, and the MSCI Emerging Markets Index fell -1.25% (which was actually a deceleration of its early-month declines). Meanwhile, Gold plummeted -12.80%.
While the reaction was swift, decisive and harsh, it was hardly unpredictable or irrational. For proof, we go to the transcript of the 2013 Berkshire Hathaway Annual Meeting. At the event, legendary investor Warren Buffett mused: "When the market gets any kind of signal that buying [of Treasuries by the Fed] ends or selling starts, is that shot heard around the world? Anyone who owns securities will start reevaluating their hand and people evaluate very quickly in the markets."2 From Buffett's perspective then, two things are clear: the end of buying and the beginning of selling are potentially synonymous, and these things happen fast. Buffett also addressed the way in which people will think when he answered a question about 0% interest rates: "Interest rates are to asset prices sort of like gravity to the apple. When interest rates are low there is little gravitational pull on asset prices…Interest rates power everything in the economic universe."3 So, in Buffett's view, if interest rates are going up from zero, all asset prices are likely to drop by some amount. In summary, the drop in prices and their speed were predictable.
Some might argue, however, that the sell-off was too large—an overreaction—or that U.S. stocks should have fallen most. We disagree. Our view for some time has been that some asset classes have been in or near bubble territory for years—gold, bonds and emerging markets stocks, for instance. So we have not been surprised at all to see those prices fall more than others. Moreover, we are starting to see signs of what happens when a bubble pops. Morningstar is reporting that fund flows in June 2013 may be "a bloodbath on the level of October 2008."4 That is, it appears that many investors sold heavily and broadly this past month. As for the discrepancy between foreign stocks and U.S. stocks, although Fed policy should hit closer to home for the latter, the former have been far more popular lately. And, in our view, they have been (broadly, of course) more expensive—so that sell-off looks reasonable.
Most importantly for our investors, at Ariel we only take interest rates and their changes into account at the margins. We have made no investment decisions based on a zero-interest-rate world, nor have we attempted to prognosticate when rates will rise and how far they will go. This stance does not stem from a lack of curiosity nor from an inability to perform the calculations. Rather, it goes to a fundamental philosophical position that is cautious and conservative: we want to own shares in companies that will thrive whether interest rates stay low, go up rapidly or anywhere in between. So while we are watching with interest as this drama continues, we would maintain that it should have a limited impact on the fundamentals of our portfolios.
The opinions expressed are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
Investing in equity stocks is more risky and subject to the volatility of the markets. Investing in micro-, small and mid-sized companies is more risky and more volatile than investing in large companies. Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, foreign currencies and taxes. The use of currency derivatives and exchange-traded funds (ETFs) may increase investment losses and expenses and create more volatility. Investments in emerging and developing markets present additional risks, such as difficulties in selling on a timely basis and at an acceptable price.
Bonds are fixed income securities in that at the time of the purchase of a bond, the amount of income and the timing of the payments are known. Risks of bonds include credit risk and interest rate risk, both of which may affect a bond's investment value by resulting in lower bond prices or an eventual decrease in income. Treasury bonds are issued by the government of the United States. Payment of principal and interest is guaranteed by the full faith and credit of the U.S. government, and interest earned is exempt from state and local taxes.
1 Essex, Martin. "US Yields and Dollar Strong, Equities Weak on Stimulus Fears." Wall Street Journal. 20 June 2013. Web.
2 Buffett, Warren. "2013 Berkshire Hathaway Meeting." Interview.
3 Buffett, Warren. "2013 Berkshire Hathaway Meeting." Interview.
4 Rekenthaler, John. "Smoke Signals." Morningstar. 2 July 2013. Web.