Second Quarter 2015 Market Commentary
By Mark Oelschlager, CFA
Co-Chief Investment Officer and Portfolio Manager
Stocks were relatively flat for the second quarter, with our funds doing slightly better than that, but that belies the eventfulness of the past three months. Late in the quarter when it became clear that Greece was going to miss a payment to the IMF (International Monetary Fund), global markets sold off. As we write this, the citizens of Greece are preparing to vote on whether to accept an offer from its creditors on the terms of a bailout. Greece’s failure to get its finances in order has been an ongoing saga for years, and we finally may be reaching the stage in which the country exits the Euro. Call 1-888-462-5386 or visit http://www.oakfunds.com/Funds/Performance
for standardized performance.
The recent disruption to global markets is likely due to fears that if Greece exits, other countries like Spain, Italy, or Portugal may follow. This would remove the perceived backing of their debt by the European Union, which could cause a selloff in those markets and possibly others, though the European Central Bank may provide support. In our opinion, while it may roil markets in the short-term, a “Grexit” sooner rather than later would be perhaps the best outcome, as it would send a message to the other members that they need to be fiscally responsible, would result in a stronger Union, and would end for good these periodic episodes (at least with Greece) that create drama in the financial markets.
Back in the US, strong employment gains and accelerating wage growth combined to cause somewhat of a shift in the market, with higher-yielding investments - long a darling due to the dearth of yield in the bond market – falling. Examples are real estate investment trusts and utilities. When economic activity was subpar, the Federal Reserve (the “Fed”) could be counted on to delay interest rate increases. Now, with employment and wages strengthening, the Fed is talking about starting to raise interest rates sometime this year in order to head off inflation. The Fed has always been particularly sensitive to avoiding a wage/price spiral – a situation in which strong wages force companies to raise prices in order to maintain profit margins, which cause workers to demand higher wages, and so on. With the prospects for higher interest rates finally in sight, higher-yielding stocks, many of which have traded like bond proxies, are less coveted.
As long-term investors we have positioned our funds for this shift, though admittedly we were early. We did this by avoiding the high-yield plays and building a healthy position in the financial sector, which for the past few years has been unusually anti-correlated with bond prices (and positively correlated with yields). Low interest rates have compressed the spread that banks normally earn between the yield on their loans and the cost of their deposits. You’ve probably noticed that deposit rates are essentially zero. The problem for banks is, as yields on their loans have continued to decline, they haven’t been able to reduce their funding costs (deposit rates) to maintain that same spread because they are already at zero! Hence the strong inverse correlation (a statistical measure of how two securities move in relation to each other) between the performance of bonds (remember: bond price moves opposite of yield) and bank stocks.
With the market focused on the financial sector’s short-term problems, we have looked at the long-term opportunity, knowing that eventually conditions will change. It is interesting to compare the environment for banks today versus ten years ago. Back then, when Oak’s investment in the sector was much smaller, spreads were wider, profitability was higher, capital ratios were lower, and the sector was a popular investment. Of course, over the ensuing years, which included the financial crisis, bank stocks performed very poorly. Today, even though sector P/Es (price-to-earnings ratios) are about the same as they were back then, we believe the stocks are much more attractive, as their earnings power has much more upside than it did back then and the companies are healthier. If wages and employment continue to improve, the financial stocks should do well.
Of course we don’t know for certain that the Fed will begin raising rates this year, and the developments in Greece may delay the launch, but we are confident rates won’t stay at zero forever. Speaking of rates, the movement in German bond rates is noteworthy. As we detailed in a commentary last year, European sovereign debt yields were at incredibly low levels, indicating that there might be a bubble in that market. If it was a bubble, it inflated even more in the first quarter, as yields continued to fall (prices rose). Shockingly, 10-year German bonds rose so much in price that their yields dropped all the way to 0.07%. This meant that if you purchased a German 10-year bond at that time and held it until maturity, assuming Germany makes good on its payments, your average annual return would be less than 1/10 of 1%! That’s the definition of an investment with downside but no upside. And as it turned out, after bottoming at 0.07% the yield rose to 1% less than two months later, due to a 10% drop in price. So the institution or individual who purchased that bond at 0.07% quickly lost 10% of their investment.
The popularity of bond funds in recent years has been astonishing, and it seems destined to end badly. Low yields have done nothing to scare off investors, who have continued to plow their savings into these perceived safe securities. Year-to-date, in the US, investors have put $77 billion into bond funds/ETFs (exchange traded funds) and withdrawn $70 billion from equity funds/ETFs, according to Evercore ISI. Much of the money that is sitting in bond funds has come in just the last few years, at yields that were low. It won’t take much of a rise in yields for these accounts to be in the red, which could lead to many heading for the exits, which would only exacerbate the decline in bond prices.
Merger activity is also worth mentioning, as the second quarter was the biggest for deals in US history, and by a significant margin. The fact that merger and acquisition activity is robust isn’t surprising given the combination of cheap money, sluggish economic growth, and the fact that corporate cost cutting has been largely exhausted. Healthcare has seen the most activity, as market power takes on greater importance under Obamacare.
As we approach Independence Day, and as we see what is happening around the world, we are reminded how fortunate we are to live in this nation that was founded on liberty and self-government.
Mark Oelschlager, CFA
Co-Chief Investment Officer & Portfolio Manager
Oak Associates Funds
To determine if this fund is an appropriate investment for you, carefully consider the fund’s investment objectives, risk factors, charges and expenses before investing. This and other information can be found in the fund’s prospectus, which may be obtained by calling 1-888-462-5386 or visiting our website at www.oakfunds.com. Please read it carefully before investing.
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Past performance is no guarantee of future results.
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.
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