The Oak Financial Times - Oak Financial Group, Inc.

SPRING 2015
O A K F I N ANC I A L G RO U P , I N C .
The Oak Financial Times
A Quarterly Publication
Written and Published By
Oak’s Investment Team
O A K F INA NC IA L G R O U P
“Planting a seed for the future.”
1177 High Ridge Road
Stamford, Connecticut
06905
Phone: 203-329-9043
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Fax: 203-966-9152
www.oakfingroup.com
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or call our office at 203-3299043
The Great Unwind
In the second half of the 1990’s
most of the world was struggling
with slow growth or outright
recession. The United States, on the
other hand, boomed causing the
value of the U.S. Dollar to climb. The
U.S. economy is far from booming
today, China is slowing, Japan is
trying to crawl out of a 25 year
disinflation cycle, and expectations
for growth in Europe are being
ratcheted down dramatically.
As the economy in the U.S. picked
up steam in the late 90’s, the
Federal Reserve raised interest
rates. Given the unique position of
strength in the U.S. relative to the
rest of the developed world, the Fed
was the only major central bank to
tighten. The hike in Fed Funds rates
caused the dollar to soar, which led
to a decline in long term interest
rates. In addition, the strong dollar
caused commodity prices to fall,
including oil, and served as a
catalyst for emerging market
equities to crater.
Although the consensus on the
street is that the Fed will hike rates
mid-year, we believe Chair Yellen
has ample grounds to delay such a
move. With the collapse in
commodity prices, the inflation rate
remains far below the Fed’s two
percent target, and a stronger
dollar cheapens foreign imports at
the same time that it constrains
U.S. exports. Multiple countries in
Europe now sport negative interest
rates and aggressive policy
loosening across the developed
world has had the effect of
tightening U.S. policy on a relative
basis.
In spite of the extraordinary
monetary ease in the U.S. and
around the world, there has been
no upward pressure on wages and
the costs of most goods and
services have been declining on a
global basis.
We think the market current
consensus on the timing of the
Fed’s next move is wrong. We do
not expect the first rate hike by
Yellen until later this year, at the
Will history repeat itself? We believe earliest. We have more to say
we have entered a period of greater about this in the section to follow.
volatility, and we expect more of the
same throughout 2015. Today, the An environment with wage
debate rages on as to when, not if, containment combined with the
the Federal Reserve will start to hike printing of money is a recipe for
rates.
risk assets (stocks, real estate, art
etc.) to continue to soar. For many
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companies, however, the boost
provided by the combination of
cost cutting and reduced interest
expense has probably about run
its course. Liquidity has been the
fuel keeping this market afloat.
No one knows for sure whether
the market will soon decline or
whether valuations will expand
even further leading the overshoot
in risk assets to continue. Another
possibility, of course, is that U.S.
stocks tread water for the
foreseeable future, perhaps with
periodic bouts of stomach
churning volatility. In this scenario,
we would expect other equity
markets around the world to
attract investment flows as
investors seek lower valuations.
Off the 2009 bottom, after all,
European stocks have lagged the
U.S. by about fifty percent.
Japanese and Chinese equities
hav e
ha d
s im ilar
underperformances.
Even though many equity market
valuations are cheaper than the
U.S., we continue to come back to
the thought that today’s
valuations, in the broadest sense,
only make sense based on
expectations that global interest
rates will stay low essentially
forever. Should expectations
change, the market will re-price all
asset classes around the world
leading to a possible scenario
where everyone heads for the
exits all at once.
Although we have significantly
reduced our exposure to the high
yield sector of fixed income, we
have seen signs of market
dislocation in this space as
investors reassess risk, come to
grips with the reality that the Fed’s
extraordinary
policy
accommodation may be coming to
an end, and rotate assets
accordingly. Last year’s darlings
(REITS, Utilities, and Long Dated
Treasuries) have suffered and
there has been widespread
withdrawal of investment funds
from the riskiest portions of the
high yield bond market as
investors assess the potential
impact of the Fed’s next move.
Until recently, even the lowest
rated companies have been able
to take advantage of the
extraordinary demand for yield
from investors and issue bonds at
historically low yields.
The proliferation of exchange
traded funds (ETFs) in the fixed
income area has led the public to
invest (unwittingly in most cases)
significant allocations of their
overall bond exposure in the
riskiest high yield securities with
little regard for the underlying
financial weakness of the
borrowers.
as we continue to look at our
options.
1. Stay fully invested in the U.S.
stock market and hope for
the best.
2. Sit with heavy doses of cash,
and hope that market turmoil
soon leads to better priced
opportunities and well timed
entry point.
3. Diversify into countries,
regions, and asset classes
that are more reasonably
valued than the U.S. market
alone. Tactically own sectors
of the economy that our
macro analysis leads us to
believe are well positioned to
outperform. Rely on the active
managers in whom we have
tremendous confidence.
Our vote continues to be with the
latter.
One if by Land, Two if by Sea
The same holds true for sovereign
bonds, as many of the most widely
held bond funds has substantial
exposure to high risk, illiquid
government bonds from issuers
such as Venezuela, Ukraine, and
Puerto Rico, to name just a few.
We classify some of these
securities as “roach motels”. Once
you enter, you may not be able to
get out.
We have contended for quite
some time now that the bond
market and its proxies (such as
REITS and Utilities) were stretched
as the public piled into them for
income, with little thought of
losing principal. The sharp drop in
the Utilities Index, which we have
watched closely, seems to have
gotten people’s attention. This
trend is likely to continue should
interest rates remain on the rise.
The growing list of economic
warning signs continues to build
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This famous phrased penned by
Henry W. Longfellow in the poem
Paul Revere’s Ride is a reference
to the secret signal orchestrated
by Revere during his ride from
Boston to Concord. On the verge
of the American Revolutionary
War, Revere took on the task of
alerting patriots of the route the
British troops chose to advance
to Concord in an effort to attack.
Although no physical battle is
imminent today, the language
that the Federal Reserve
Chairwoman Janet Yellen uses or
purposely does not use in her
official statements bears similar
comparison to Reveres warning.
In this modern day scenario,
Janet Yellen is warning of the
Feds path of action in terms of
interest rate movements. In lieu
of hanging one or two lanterns,
Yellen’s signal is the use or
calculated omission of the word
“patient” in her testimony.
The phrase patient is used to
gauge the speed/willingness that
the Federal Reserve can/will
increase the Fed funds rate. Pre
Ben Bernanke, the Federal
Reserve was not forthcoming in
explaining when and how actions
would take place.
The highly
searched for word continues to be
echoed in the Fed’s post February
notes, as it weighs a hike in
interest rates. Chairwoman Yellen
reiterated that rates will not rise
for at least the next two meetings,
or until June, at the earliest. Wall
Street believes that once the key
word is removed from the
statement, a rise in the fed funds
rate will quickly follow.
While it was clear enough to
understand Mr. Revere’s
message, we should take a step
back and explain the meaning
behind Ms. Yellen’s message. The
Federal Reserve controls the fed
funds rate. The rate at which
depository institutions (savings
banks, commercial banks, etc.)
lend funds maintained at the
Reserve to other depository
institutions overnight. When this
is extremely low as it is today and
has been since December 2008, it
helps stabilize an economy and
financial system. According to
Yellen & Co. we have experienced
and continue to experience strong
job gains and lower
unemployment.
In Addition;
household spending has picked
up as well, most recently due to
energy prices falling.
If incoming economic data
indicated faster than expected
progress, the Federal Reserve
Committee’s dual employment
and inflation mandate would
cause a rate increase to occur.
We are currently teetering on that
line. The nerve-wracking decision
the Fed needs to make is when to
raise rates, with every decision
however comes consequences. If
rates rise too early they might
dampen the apparent solid
recovery in real activity and labor
market conditions, stifling
economic growth. Too late and it
could lead to undesirable inflation,
therefore it is important to get the
timing for action accurate.
It is possible that interest rates
may rise this year, however, if they
do it will be at a gradual level as
the Fed cannot afford to be wrong
and lose their credibility. We have
positioned our clients’ accounts in
a manner where our active fixed
income managers can find ideas
and opportunities that should not
hinge on what Yellen & Co. do or
do not do.
Ken Leech, the
manager of Western Asset Macro
fund, has uncovered ideas that
revolve around a global macro
strategy focused on long-term
value investing and active
management of duration, yield
curve, volatility and currency. His
largest holding as of December
31, 2014 is in a Mexican bond
yielding 6.5%, which is a much
higher coupon than what you
would find crossing over the
border into the U.S., and takes
advantage of a country with a
quality balance sheet.
Gary
Herbert and team, at
Brandywine’s Alternative Credit
Fund, are heavily invested in non
U.S. mortgages. The idea unfolds
as such: If you want to buy a home
in the U.S. you typically would put
down a 20% deposit (or less). If in
time you can no longer make your
mortgage payments, you turn the
ownership of the home over to the
bank and walk away from your
debt. In countries like Spain they
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operate under stricter rules. A
down payment is closer to 50% of
the home and if you hit a rough
patch in life you cannot walk
away from your debt, as it is your
responsibility throughout your life
to pay that mortgage off. In
hindsight Paul Revere’s famous
informative ride should be
considered a “trot” in the park
compared to Janet Yellen’s
means of informing patriots
today.
On March 18, 2015, several
weeks after the above piece was
drafted, the Federal Reserve
released minutes from their most
recent meeting. To quote the
Fed, “the Committee currently
anticipates that, even after
employment and inflation are
near mandate-consistent levels,
economic conditions may, for
some time, warrant keeping the
target federal funds rate below
levels the Committee views as
normal in the longer run.” If one
was to read through the entire
transcript they would notice that
The Fed
removed the word
“patient”. However, digesting a
combination of the entire Fed’s
statement, the U.S. economy
being below pre-crisis levels,
headline inflation under the Feds
2% target and a strengthening
U.S. Dollar causing our goods to
be too expensive for the rest of
the world; Oak financial Group
still believes that we will not see
a rate hike in 2015.
Stroke of Midnight
“Nothing sedates rationality like
large doses of effortless money.
After a heady experience of that
kind, normally sensible people
drift into behavior akin to that of
Cinderella at the ball. They know
that overstaying the festivities —
that is, continuing to speculate in
companies that have gigantic
valuations relative to the cash
they are likely to generate in the
future —— will eventually bring on
pumpkins and mice. But they
nevertheless hate to miss a single
minute of what is one helluva
party. Therefore, the giddy
participants all plan to leave just
seconds before midnight. There is
a problem, though: They are
dancing in a room in which the
clocks have no hands." Warren
Buffett
Perhaps you have heard the
phrase “Risk-on, Risk off” to
describe the market over the past
several years. It is the new brand
of volatility that we see in the
market. Simply stated, it is the
repeated pattern of behavior
whereby many investors move
their money, in herd-like fashion,
from high risk areas to what they
believe are lower risk investments
(and back again) depending on
the general and immediate
perception of risk and opportunity.
Although bouts of market volatility
are nothing new, swings have
occurred with greater intensity,
and in greater volumes, than prior
to the financial crisis of 2007-09,
as markets today are fueled by
cheap money, reduced liquidity,
and central bank easing. One
needs only to recall the recent
plunge in oil from over 100 to
near 40, or the dramatic rise in
the value of the U.S. Dollar, to
understand how volatility can
quickly emerge and roil markets.
Aggressive monetary policy, zero
interest rates on cash, financial
engineering, among other factors
have tempted many investors to
abandon discipline and
diversification in favor of following
the trend (and the crowd) in
pursuit of higher returns or the
perception of greater safety.
These moves may provide short
term gratification, but often lead
to long term regret.
One recent beneficiary of “risk on”
money flows and significant media
attention, has been the NASDAQ
Composite Index as it tested the
5,000 level at the beginning of
March of this year; a level this
index has not seen since early
2000. Looking deeper at the
NASDAQ 100 Index, we see that
only five stocks have accounted
for the entire performance of the
index this year. In other words, 95
percent of the stocks in the index,
regardless of their fundamentals,
have combined for a zero return
as of the end of February. Hardly
the kind of characteristics a
modest risk investor or retiree
should look for if their goal is to
construct a truly diverse portfolio
that is designed to reduce price
volatility.
As we all know, timing is
everything in investing. Knowing
when to get in seems easy when
you are following the crowd in a
rising market or you are behaving
like Cinderella at the ball,
according to Warren Buffett. But
knowing just when to get out is the
challenge. As Buffett and our past
newsletters have warned, nobody
knows when to leave the party.
In 2000, Julian Robertson hedge
fund manager of Tiger
Management Corp., closed his
fund and returned capital to
investors. Looking back now,
Julian’s timing was superb. The
U.S. stock market has registered
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highly volatile but otherwise
mediocre returns over the many
years since the closure of the
fund.
Recently, another legendary
hedge fund manager, Stan
Druckenmiller, returned funds to
investor and retired. In comments
to the Wall Street Journal, he
cited the heavy emotional toll of
not performing up to his
expectations. Rumors circulated
that he had bet heavily against
bonds on the presumption that
yields had nowhere to go but up.
As regular readers of this
newsletter know, we believe we
are entering a new market cycle
in which the traditional
correlations between stocks and
bonds has begun to change. No
longer will investors be able to
rely upon bonds as providing a
different and distinct pattern of
returns when compared to their
equity portfolio. We expect to be
able to look back in a few years
and wonder why so many of
today’s investors continued to
invest primarily in a mix of stocks
and bonds, rather than take a
broader approach to portfolio
diversification.
We select from a wide variety of
products and strategies that are
geographically diverse and
include alternative investments
that have exhibited low
correlations to traditional equity
and fixed income asset classes.
Rather than own a static index,
which may trade up or down on
the on the basis of just a few of
its largest capitalized holdings
and which must own “everything
all the time”, we believe in the
long term benefits of owning a
flexible, actively managed
portfolio that embraces multiple
asset classes in addition to the
traditional combination of stocks
and bonds. This approach is
designed to mitigate overall
portfolio volatility and can help
guard against unpredictable “risk
off” drawdowns.
Changes are afoot in global
markets, particularly over the past
six months. Chinese and Indian
stocks are higher, and the Nikkei
Index in Japan has crossed levels
not seen since the year 2000.
Ireland and Spain, which were left
for dead only a few years ago, are
starting to show signs of economic
expansion in spite of the generally
bad news being reported from
Europe.
Utility stocks, which had a great
run in 2014 as many yield starved
investors piled in to the sector as
a bond substitute, dropped 14% in
early 2015. Oil prices, as we
m en t i on ed, hav e dr opp ed
precipitously.
Gold, which has declined from
about 1,950 to below 1,200 over
the past five years, has been
largely abandoned by investors
who seek momentum and positive
trends. Talk of using gold as a
possible hedge or portfolio
diversifier has grown all but silent.
continued discipline of these
managers will once again be
rewarded.
Rather than fear market volatility,
we embrace it as an opportunity to
deploy capital. We believe we are
well positioned to weather
continued “Risk on, Risk off”
market swings as the year
progresses, and we will seek to
take advantage of favorable
investment opportunities that may
result.
Conclusions
1. We continue to expect
International Equities to out
perform U.S. Equities in 2015
and have increased our
international exposure in
2015.
2. Alternative managers that
were detractors from
performance in 2014 should
start to shine in 2015.
3. The U.S. dollar continues to be
in a Cyclical Bull Market, which
should continue to way on
commodity performance.
Value stock managers such as
Wally Weitz, Donald Yacktman,
and others who have
demonstrated track records of
strong long term performance,
have trailed their passive
benchmarks recently. The zero
interest climate that the Federal
Reserve has engineered has hurt
managers that rely on individual
security analysis and business
fundamentals and rewarded
popular social media and other
stocks with lofty valuations. As
conditions evolve, we believe the
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