Dear Investor,
I hope this letter finds you well and enjoying the summer months.
The key word describing the political, economic and financial environment today is impatience. Lately the U.S. stock indices have seen their daily volatility increase and in some instances these indices have moved in opposite directions. That occurrence is unusual and signals to me that the market is being utilized more on the basis of trading instead of investing. It’s a complex topic, but major averages like the S&P 500 and the NASDAQ tend to move together. Some investors are simply chasing returns, which is risky.
During the second quarter of 2017, the S&P 500 Index gained 2.6%, the NASDAQ Index gained 3.9%, while the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 1.0%. The Average Crude Oil Spot Price was down 11.4% in the quarter.
Investors are impatient and the market is moving unpredictably because the new administration has been unable to accomplish its plans in a material fashion. It seems that every day there is a new headline that conflicts with what was just reported. This confusion jeopardizes the probability of positive outcomes from which higher stock valuations have largely been built.
Market valuations are based on the balance of purchases and sales of market participants who are most interested in just gains and place a lesser interest on economic, political, or social implications. The Market does not have a conscience and moves with the changes in the collective perspective of all market participants. This absolutely doesn’t make the collective investor correct in their investments, nor their political, or social views since human nature tends to place greed ahead of fundamentals and conscience.
Today, I believe the major stock averages are being pushed up by too many investors crowding into a concentrated area of investments, (like the FANG stocks of Facebook, Amazon, Netflix, and Alphabet’s Google), in order to participate in the stock market. A compounding effect comes into play as even savvy institutional, ETF, and mutual fund managers are forced into purchasing favored names from fear of being left behind or underperforming the averages. This fear of underperforming in the short term is a career risk for a fund manager that directly conflicts with evaluating an investment on its fundamental future prospects and risk.
The sort of imbalances I am feeling about some areas of the market today is reminiscent of the Internet or dot-com boom in the late 90’s to early 2000. At that time, there were many companies losing great amounts of money but enjoying market valuations of over a billion dollars. In order for many professional investors to go along and invest in these money losing companies, they espoused stories about an epiphany and paradigm shift in how investments could be evaluated. One angle of a dot-com losing venture was to be valued on the number of people or “eye-balls” interested in their offering rather than the hard economics supporting their business model.
When trades become crowded, their unwinding can cause sharp sell-offs as investors rush to exit out of the same door. This time around it may be the popular FANG names that many own which will be the crowded trade.
Despite my feeling of skewed valuations in some areas of the market, the economy continues to grow, the Fed continues on a market friendly monetary policy, and there appears to be ample liquidity in the markets to provide for economic activity. Investors should prepare for a “reset” in expectations as I continue to believe that prospects surrounding the timing and magnitude of tax and regulation relief, healthcare savings, infrastructure spending, and even the building of our southern border wall are too ambitious. “Reset” is a nice code word for market correction.
As a market corrects, many times the focus gravitates to different areas which have become undervalued. If a correction develops over missed expectations about the administration’s policies, the companies that benefited will most likely fall out of favor.
The areas where I continue to find attractive opportunities are in mid to small companies with growing sales and earnings. Particular areas of interest have been in technology due to the persistent demand for faster and more robust acquisition, process and transfer of information and healthcare/medical due to our aging demographics. One out of favor area which may hold future promise is the energy sector. Oil prices have fallen this year to the mid $40’s after recovering from an early 2016 drop to the high $20’s. The precipitous drop to the 2016 low was strangely accompanied by a growing demand for oil since 2011. In addition, Saudi Aramco stated that the outlook for oil supplies is “increasingly worrying,” with about $1 trillion in investments lost during the current industry downturn and fewer new deposits being discovered.
My belief about the rise in interest rates is that it will not be excessive and it will be less than the consensus expectation of future rate increases. Central Bank discussion about lessening their accommodative position is fine, but they will be very cautious in anything that could increase rates significantly. According to figures from the Institute of International Finance, global debt topped 325% of GDP as government debt jumped. Servicing that debt becomes increasingly difficult as rates rise and would certainly be a drag on the economy.
We are early in the earnings reporting season, but I am eager to identify the next round of growth companies that have a differentiated product or service, that are priced attractively, and that are in a position to continue to grow in the current economic environment. As in previous quarters, if there is a liquidity shock to the economy, or if there is an indication of a faltering economy, defensive actions will become a primary objective.
To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.
As always, Torii Asset Management strives to provide the best service possible to you, our client.
Very truly yours,
Martin L. Yokosawa