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Quarterly Letter to Clients

October, 2013

Indices at quarter-end (September 30, 2013):

Dow Jones Industrials: 15,129.67 3Q'13 +1.48% YTD +15.46%

Standard & Poor's 500: 1,681.85 3Q'13 +4.70% YTD +17.93%

In the past I have noted that as prices rise, so does risk, and conversely, as prices decline, risk evaporates.

Here is the question: are the risks right now greater in stocks or in bonds? We have had thirty-plus years of falling rates (meaning rising bond prices), and we have had more than four years of exuberant, soaring stock prices, leaving us at very high risk levels in both sectors.

In bonds today there is a general feeling that rates will rise and bond prices will fall as a result. That seems to be a premise with a sound foundation. After all, rates hovered at about as close to zero as one could expect for quite a long time, and recently they have begun to move, and sharply, the only way they could--up.

So for the moment, let’s assume the case, that rates continue to rise.

I often play a game that I call “If-Then.” It is a simple q and a: if this happens, then what can we expect? Thus I ask: if rates rise, then what happens to stocks? Most people focus only on the effect rising rates will have on bonds, but I can tell you that all asset classes are affected.

Now anyone with a smidgen of debate in them will recognize that if the “if” premise is incorrect, then the “then” assumption will necessarily be wrong. But we have no choice; we must always make assumptions about the future based upon our best knowledge at the moment, and we must plan according to those assumptions, even if God does laugh.

Bond pricing may be somewhat formulaic: we input parameters, e.g., the coupon, maturity, and quality, and then, using the general level of interest rates, we can arrive at an approximate price level. We can adjust pricing for expectations of moves in rates. And we know with certainty that if rates rise then bond prices fall.

Stock pricing, far from being formulaic, is notoriously perverse, with a multitude of inputs.

Among that multitude of factors a major component is the P/E (price-earnings) ratio. Stated as simply as possible, a business is worth some multiple of it’s earnings. What should that multiple be? It is different for different industries, and it also varies according to expectations, macro and micro. Further, it will typically be higher for companies with no debt versus debt-heavy companies; higher for younger companies versus established firms; higher for growth; and so on. We have had long periods of excess in overall valuations, both high and low, and long periods of non-correlation. Psychology plays a larger part than we like to admit.

Still, the multiple that one might logically be willing to pay for a business is dependent upon the general level of interest rates: the higher the rate the less you will be willing (or able) to pay. Thus if rates go up, all else equal, then stocks can be expected to come down. In fact, the starting point for calculating the P/E ratio is the inverse of interest rates: higher rates mean a lower P/E.

Stocks are often said to follow the trend of their earnings over the longer term. You can argue this, and you can argue that there is no science to stock pricing. The stock of Microsoft has basically flatlined for the last decade-and-a-half, a period that saw their earnings soar. (So much for prices following earnings over the longer term.) During that period rates came down, but so did the P/E of MSFT. As I said, stock pricing is perverse, it is anything but formulaic. MSFT is just one example proving that there are no hard-and-fast rules.

But now let’s come back to the basic “if-then” premise. Remember that if the “if” premise is incorrect, the “then” assumption will not be accurate.

In this case, the “if” is that rates rise, something that I have thought imminent for six years. And they have finally done so. But what if they do not continue to rise? If you find it impossible to imagine that rates stay depressed for much longer, ask yourself how palatable it might be to any political party to allow rates to rise dramatically; ask yourself to remember Japan, where rates were miniscule for two decades. Remember that anything is possible, however improbable it may seem.

I realize that I have not answered the question of which asset class is riskier. I have no answer, and I offer only the discussion. But I will say that I do expect rates to rise, and that it is pretty much a given that this year will be great for stocks but not great for bonds.

But that is now history. We must input all of our knowledge and look forward. We are apparently at a vulnerable point in all markets, and I am charged not only with making your money grow, but also with protecting it from decline. It is a task that I take very seriously.

Jim Pappas