Last month marked the 30th anniversary of Black Monday, October 19, 1987, prompting us to take a look back at how the Dow Jones Industrial Average has evolved since that infamous day. Of the 30 stocks in the index at the time, Bethlehem Steel, Eastman Kodak, GM, Union Carbide, U.S. Steel, and Woolworths have all gone through bankruptcy. Some reorganized and reemerged, but most didn’t. Sears, which also was part of the index in 1987 is quite likely to be gone in the next six months. Digital Equipment Corporation (DEC) was not in the index, but as the leader in mainframe computer production, it was the premier technological company at the time. Unfortunately for DEC investors, the utilization of mainframes dwindled as minicomputers sales soared, and a significantly diminished DEC was bought by Compaq computer in 1998. At the time of the time of the DEC purchase, Compaq was a pillar of the tech industry, and together with Dell, Microsoft, Intel and a host of other tech companies were represented in virtually every growth portfolio. Four years later, Carly Fiorina, the one-time Presidential hopeful and then Chairwoman of Hewlett Packard engineered an $87 Billion “friendly” merger between HP and Compaq. The integration of the two companies did not go well and it wasn’t long before investors were punishing the stock which, in turn, led to the ousting of Ms. Fiorina.
One would think that such woeful performance would weigh heavily on investors as they evaluate the riskiness of the current stock market as it rallies to new highs on a nearly daily basis. Last month we wrote about Warren Buffet’s proclamation that the Dow index would probably hit 1,000,000 in the next 100 years. The “Oracle of Omaha” in his promotion of buy and hold investing, didn’t mentioned that the Dow Jones Index is not a buy and hold index and regularly drops underperforming companies. The theory of a buy and hold portfolio completely ignores what to do when a company starts to show financial strain or loss of competitive advantage. To hear Buffet tell it, investors would be best served by buying and never selling. However using the 1987 Dow Jones index as a proxy for a buy and hold portfolio, an investor in that index would have had 20% of their 1987 portfolio fall to zero. Of course that’s taking portfolio construction to an extreme and the investor would have been well served by simply rebalancing their portfolio to mirror the new index components. The point is, setting it and forgetting it, as Mr. Buffet suggested, is a perilous plan; and that goes for the bond market as well. With interest rates pegged at artificially low rates and credit spreads at the low end of their long term range, it’s easy to be lulled into a false sense of security. We see it in abundance across the various sectors, both domestically and internationally, high yield and investment grade, emerging market and sovereign debt. Driven by the incessant search for yield, appetite for return is forcing investors to take risks that aren’t commensurate with the measly returns offered. While it’s plausible that the low rate environment could last for the foreseeable future, we believe that investors will ultimately be punished for imprudent investing.
Turning to the economy, data reported during October painted a picture of unmitigated strength. The litmus test for economic health is the labor market and despite hurricanes Irma and Harvey-related hiccoughs, the economy continues to create jobs at a rapid pace. The unemployment rate fell to 4.1% as 261,000 new jobs were gained in October, and the prior month’s job figure was revised higher by 51,000. Equally encouraging was the 3.0% GDP growth rate registered in the third quarter. Economists had warned that the aforementioned hurricanes were likely to trim as much as one percent from that growth rate and were shocked to see the three “handle”. To summarize the state of the U. S. economy, the labor market is at full employment, manufacturing is booming as is the tech sector, inventories are lean, and home builders can’t build houses as fast as they’d like because of a shortage of workers. Historically, at this stage of the economic cycle, the Fed would have overnight interest rates at a level 75 to 125 basis points above inflation. That would translate to a short term rate somewhere between 3.00% to 3.50%, instead of the 1.25% level at which it currently stands. Our concern is that the economy is at risk of a spike in wage growth that spooks the Fed and it’s bevy of new governors and they respond by speeding up the pace of rate hikes or more sharply curtailing the quantitative easing still in place. That would undoubtedly destabilize stock and bond prices. As we said earlier, investors will ultimately be punished for imprudent investing.