Weitz 1Q18 Letter: What’s Causing the Volatility? Value Matters

Smart Money
  • In the first quarter of 2018, we saw the first serious market volatility in two years
  • There were days on which the Dow dropped over 1,000 points, and there were more triple-digit moves than in any quarter since the depths of the financial crisis in 2008
  • One day in early February, an ETN built specifically to profit from an absence of volatility, imploded. It fell over 80% and was liquidated by its sponsor

What’s Causing the Volatility?

  • Tech Stocks
    • Some of the largest tech companies have come under particularly strong pressure
    • Cambridge Analytics misuse of Facebook data brought Facebook’s basic business model under scrutiny
    • Presidential tweets accusing Amazon of hurting small retailers, not paying enough taxes and taking advantage of US Postal Service caused some wild fluctuations in its stock
    • Google also dropped almost 15% in the first week in February as questions arose about threats to its advertising business
  • Index Funds and ETFs
    • Flows of capital into and out of the fund maintain proportions (capitalization weighted)
    • Thus, stock price movements of the very largest companies have a disproportionate impact on the volatility of the ETF
    • Large inflows mean large, non-price-sensitive buy orders which can exacerbate volatility of the underlying stocks. The reverse is true when investors sell the funds and the component stocks must be sold on short notice
  • Interest Rates and Inflation
    • Interest rates have been unusually low both because of Fed policy and because inflation has been low by historical standards for several years
    • Now the Fed is raising short-term rates and letting its bond portfolio self-liquidate as bonds mature
    • Withdrawal of the Fed’s capital from the bond market puts upward pressure on interest rates. Inflation is beginning to tick up because of economic growth and very low employment, and this also pushes interest rates higher
    • Rising interest rates act as a headwind for stock and bond prices. The impact is direct for bonds. A 10-year, 2% bond issued at a price of $100 falls to $83.65 if comparable bonds soon become available with 4% coupons
    • Higher interest rates generally lead to lower P/E ratios
  • Political Climate
    • Polarization of Congress and the determination of the president to bring change to Washington have injected a large dose of uncertainty into the stock and bond markets
    • Concerns around the current political climate and ‘what might be’ is not helpful for business planning
    • War with North Korea and other apocalyptic events are not impossible, but they seem so unlikely that we do not dwell on them in picking stocks and planning investment strategy
    • Promised regulatory relief has been welcomed by the business community. Budget hawks have also cheered the “streamlining” of various government departments and agencies. We suspect that actual rule changes and compliance cost savings will be less than anticipated, but from many individual companies’ point of view, these are positives
  • Trade Issues
    • Tariffs and other impediments to free trade have not worked well in the past and seem particularly unwise given today’s complex global supply chains
    • Outcomes of “Art of the Deal”-style bluster and backtrack negotiating tactics are hard to predict but seem certain to complicate life for many businesses, farmers, workers, consumers, and investors
  • Tax Code
    • Changes to the tax code are significant. While it arguably benefitted a different segment of the tax paying population than advertised, it has had a major positive impact on much of corporate America
    • Ironically, Berkshire Hathaway, whose chairman disagreed with the structure of the cut, was probably the biggest single beneficiary, with roughly $29 billion in one-time tax savings in 2017 plus ongoing savings due to the lowered corporate tax rate
    • Potential downside of the cut is that, in combination with a less-than-conservative spending bill, the impact on the growing budget deficit may well turn out to be inflationary

Our Game Plan

  • Near-term outlook for the “market” is not the same as the outlook for our next 3-5 years of returns
  • Historically, after a long bull market, we generally see a period of sideways market “consolidation”
  • Over the past 9 years, company earnings have grown, and the valuation placed on those earnings (P/E) has also grown
  • It would be perfectly normal to see a period of years in which earnings continued to grow but P/E ratios shrink. The result would be a market that generally moves sideways but with plenty of short-term volatility
  • Our approach is to take aggressive positions when investors are fearful, and stocks are very cheap; to hold them as markets recover; and to harvest the gains when an overvalued market makes stocks relatively unattractive
  • This is not an environment in which we expect oversized absolute gains, but we are hopeful that it is one in which we can protect capital in the near term and set up the portfolios for very good returns over the next 3-5 years

Weitz Investment Management 1Q18 Letter, April 9, 2018

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