Editor’s note: The Investment Panel feature in the Banking & Wealth Management special reports of The Central New York Business Journal, spotlights area investment professionals and their views on the financial markets and investments. In this issue, CNYBJ interviewed Jim Burns, Ted Sarenski, and Doug Walters separately via email, asking them the same questions.
PANELISTS
James (Jim) Burns, president of J.W. Burns & Company in DeWitt
Theodore (Ted) Sarenski, president and CEO of Blue Ocean Strategic Capital, LLC in Syracuse
Doug Walters, portfolio manager at Strategic Financial Services, Inc. in Utica.
CNYBJ: Is increased volatility likely to be the new norm this year, and, if so, what are you doing about it in your client portfolios?
Burns: As of this interview, we have now gone more than 1,200 days without a 10 percent or greater correction in the S&P 500 index, which is the fourth longest stretch over the last 50 years. Furthermore, the Federal Reserve’s Quantitative Easing (or QE) program, which has provided key support for the low volatility, high equity returns that we have been experiencing, ended in October. So, the odds favor a return of increased volatility, and I would say it is likely we will see a drop of 10 percent or more sometime in 2015.
However, keep in mind that many investment professionals — myself included — have been forecasting a correction for a few years now. But for me, it doesn’t really matter because I do not change my approach to investing. I essentially stay fully invested all the time, because I know I cannot time the stock market, and no one else can, either. The fact is, volatility is simply part of the investment process in stocks and should be expected, even welcomed. I’ve always said that investing for growth or long-term wealth creation is similar to staying physically fit. You have to be disciplined, patient, and stick with it — like no pain, no gain. This means there will be times when you feel like quitting, or selling out of the market, because of a frightening drop in stock prices. So, handling periods of intense stock-market volatility will always be part of successful investing in stocks. I believe this will be true 30, 50, and 100 years from now, so just expect it.
Bottom line, I’m not doing anything different in my client portfolios. I am buying great companies, with great managements, and selling at attractive prices. And I let these great franchises compound their earnings and dividend streams beautifully over the long term, and let the market volatility work itself out.
Sarenski: Computerization since the year 2000 has caused greater day-to-day volatility than at any time period prior to that. We will see greater volatility in 2015 for a few reasons. The Federal Reserve is likely to raise interest rates this year because the economy is recovering, political uncertainty exists both domestically and abroad, and there is uncertainty on how the drop in energy prices will affect economies worldwide.
We are reminding our clients that it is a long-term view that we look at continually. Asset allocation, having a diversified portfolio, is the way to mitigate volatility as many times various investment classes do not move in unison. We have seen the large-cap U.S. market be the leader the last two years while most other investment areas have been flat or negative. The last couple of years have seen the diversified portfolio lag behind the large-cap U.S. equity market. Each year is an independent event and no one can predict with certainty which area will be the best performing in any given year.
Walters: As we look forward to the rest of this year, investors are in many ways standing at a crossroads. The Federal Reserve has pursued an accommodative policy, which has set the U.S. apart from its developed-market peers. Globally, growth remains sluggish and geopolitical unrest persists. Yet domestically, we are eyeing a U.S. economic recovery and asking whether it has the fortitude to stand on its own two feet as the crutch of monetary policy is carefully and deliberately removed. All the while, the market’s margin of safety has been expended by five years of robust returns.
All of this equates to heightened uncertainty, which makes for uneasy equity markets. One manifestation of this is the rising volatility we have seen over the past quarter. Yet, despite the recent rise, volatility is not “high” by historical standards. In fact, volatility is currently below the 25-year average (even if we exclude the financial crisis of 2008). That is an amazing fact considering the turmoil that defined 2014 — a deteriorating global economic climate, ISIS, the Ukrainian/Russian conflict, a downed airliner, the Israeli/Palestinian conflict, and plunging oil prices.
With so much weathered by the U.S. equity markets in 2014, why should increased volatility be the new norm in 2015? The difference may be the Fed. This year may see the first federal-funds rate increase in nearly nine years. The Fed’s ability to walk the normalization tightrope will be under a microscope, magnifying the markets response, and keeping volatility elevated.
At Strategic, we employ a disciplined and repeatable investment process to identify quality investments with reasonable value. Our aim is to protect and advance client capital over the long-term, and therefore we do not get unduly distracted by near-term moves in volatility. With that said, volatility often does have a silver lining for investors. For the patient long-term investor, bouts of volatility in 2015 have the potential to open up valuation opportunities that did not exist in 2014. As active managers, we are always on the lookout for quality stocks whose assets are underappreciated by the market.
CNYBJ: What are some other key themes driving your view on where the financial markets are headed in the coming months?
Burns: We always try to employ second-level thinking. Legendary investor Howard Marks has stated that first-level thinking is simplistic and superficial, and everyone can do it. Second-level thinking, on the other hand, is deep, complex, and evaluates events from multiple perspectives.
Here is a recent example. On the Friday after Thanksgiving, OPEC, led by Saudi Arabia, announced it would not cut oil production. Oil prices immediately dropped sharply below the $70-a-barrel range, and it seemed to me like every investment professional and CNBC commentator was certain that this price decline would be good for the economy and stocks. I immediately questioned this idea. Fact is a collapse in oil prices can disrupt various economies, dislocate currency markets, and lead to big swings in the financial markets. It can also trigger deflation, which is very negative for stock prices. So far, this has borne out.
These dramatically lower oil prices will continue to be front and center in market discussions. So, while it is true that lower oil prices can be good for the consumer, what many do not realize is that the S&P 500 index and oil prices have been tightly correlated in recent history. This may seem counter-intuitive, but higher oil prices signal higher demand, and thus, more economic activity. I do believe oil prices will rebound somewhat in 2015, as hedge funds and speculators close out short positions. Thus, for long-term investment positions, we are looking to be opportunistic in the energy sector. We also continue to like health care, technology, and industrial stocks.
Sarenski: The coming months are likely to see the volatility discussed in the first question. U.S. large-cap companies are going to be affected negatively since many get significant revenues from their non-U.S. holdings. The U.S. economy is doing well, but much of the rest of the world is not recovering as well. This will eventually affect us here in the U.S. as it is certainly a global economy today and we cannot stand alone as a thriving economy as we did right after World War II.
We expect 2015 to end on a positive note. The Federal Reserve will likely raise interest rates this year, but it will be a gradual raise which will not cause the bond markets to lose value quickly. Asset allocation is still our dominant theme but flexibility is also important. Underweighting or overweighting certain investment areas may need to be done more frequently to adjust for market changes.
Walters: Predicting the short term is a fool’s game, which we have preferred to avoid, and we would question the integrity (or even sanity) of anyone who claims success at this pastime. Getting a short-term call right tends to have more to do with luck than investing prowess. Real wealth creation is achieved by applying a disciplined long-term approach applied consistently over time.
With that said, there are some notable themes that we are factoring into our long-term view. First, Fed Chairwoman Janet Yellen is faced with the monumental challenge of easing back from an accommodative policy that is without precedent. The path to normalization will be data dependent and deliberate so it won’t stall the recovery. The Fed’s ability to stay ahead of the curve so that a rising interest-rate environment is driven by economic growth, and not by escalating inflation expectations, is critical.
We will also be focusing on the international markets’ ability to take the stimulus baton from the U.S. The recent, and unprecedented, move by the European Central Bank (ECB) to follow the U.S., U.K., and Japan down the quantitative easing (bond buying) path is a good start. For the first time, the ECB did not disappoint, but actually exceeded expectations. However, the program is still in its early days.
Closer to home, equity valuations remain a concern. After rising for almost six years, segments of the market appear to be valued fully, if not outright expensive. The rally has been driven more by engineered improvements in profitability than revenue growth [Editor’s example: companies buying back their own stock reduce the number of shares outstanding, which lifts earnings per share]. We will be watching for a pickup in the pace of top-line growth to justify further upside from here.
CNYBJ: Provide specific recommendations for investments that clients should be making right now.
Burns: On the theme of opportunistic energy purchases, one company we like is Kinder Morgan, Inc. (ticker: KMI). It recently acquired all of its sister companies to focus on its main business — oil transportation via pipelines. Kinder Morgan is less of a pure play on energy prices and more as a mover of energy-related products, so declining oil prices shouldn’t really negatively impact the company’s earnings. Generally, as the price of oil goes down, consumers buy more of it. And this would increase the amount of oil transported. The company’s dividend currently yields about 4.3 percent, and management has declared that it intends to increase that dividend by 10 percent per year until 2020. For investors seeking a solid total return and a rising income stream, Kinder Morgan makes a lot of sense.