March 2015 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

Last fall I wrote about how economic expansions can often take place in three phases.

The first phase is the recovery phase. In that phase, investors have just been burned by a bear market and therefore still don’t really believe that the markets and economy are recovering. Sentiment in that phase is characterized by cynicism and fear and valuations are usually low. In the current bull market, this phase lasted from 2009-2011.

The second phase is the growth phase. As memories of the bear market fade away, investors begin to feel more comfortable committing capital to markets. By the end of the second phase, valuations usually rise to high but still somewhat rational levels and sentiment improves to become more optimistic. In the current bull market, this phase lasted from 2012-2014.

The third phase is the bubble phase; it is one that doesn’t always occur. The third phase is characterized by euphoria, greed and prices that disconnect from fundamentals. The marketplace takes on a casino mentality in which prices go up just for the sake of going up.

Today we sit at an investment crossroads. Since late September we have been in a transition between phases, but it’s not clear which direction we will go next. Down one path there is the possibility of the end of this cycle, which would bring a bear market. Down the other path is the prospect of a third phase, which would bring a level of excitement that we have not seen since the late 90s.

Up until now, I never thought that we would see a third phase in this cycle. The only three phase cycles that I’ve ever studied were the late 90s and late 20s. I did not think that we could have a repeat of the dot com era within two decades of the last bubble. But as I look around the marketplace, I’m no longer so convinced that we wont see a boom.

To be clear, on a fundamental level, I don’t see any reason that stock prices should continue to rise. Multiples have already expanded to extreme levels matching 1929, 1962 and 1987 (all three of which preceded 25%+ declines). Meanwhile, earnings growth has slowed meaningfully. In 2015 revenue for the S&P 500 is now projected to decline from 2014. Many people argue that stocks should rise to match low interest rates, but to accept that argument one would have to believe that interest rates are rationally priced. Thanks to central bank actions, fixed income markets may represent the greatest financial bubble in history.

Still, equity markets do seem to want to go higher, so without any fundamental underpinnings, a bubble is the only way for prices to continue the advance.

Let me say that I sincerely hope that we do not see a third phase of expansion. While a roaring bull market would certainly be exciting while it lasted, the aftermath of a three phase cycle has typically left the economy in tatters. If prices keep rising from here without a commensurate rise in earnings, there is nothing to be cheering about.

If we do enter a third phase, I am conflicted as to how we should react as investors. On the one hand the third phase of a cycle could pose an opportunity to make money. However, on the other hand, the third phase is the least predictable of any phase. There’s no telling where, when or how it could end, and once it does there is no fundamental safeguard to support purchases made at ethereal levels. It took 25 years for prices to recover after peaking in 1929. While that example may be extreme, it is still a possibility that capital committed today could be impaired for years into the future.

It’s also foolish to think that we are going to be able to get out before everyone else. There is nothing to say that a 1987-like crash couldn’t erase all paper gains within the course of a few days or a week. When there is no long term justification to hold our investments, we’re better off not holding them than trying to play a short term game.

As I’ve always written, valuation is our North Star. I will never purchase an asset that I believe to be uneconomically priced just because I think it’s “going higher.” I believe that this is the only responsible way to invest. We’ll keep navigating towards that North Star even if others drift off in another current, because we know that this is the only way for us to navigate our ship soundly so that we reach our long term objectives.

There may be some clients who feel differently though. If you are interested in taking on the risks associated with participating in a third phase of an advance, please contact me and we can work on a solution that’s right for you. My recommendation is unequivocal though. I think our greatest opportunity for profit is to continue sitting tight.

Scott Krisiloff, CFA