Positively Uncertain

"October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February." -- Mark Twain

This past summer, several issues raised investor concerns, ranging from the fear of the Federal Reserve "tapering," to possible military action in Syria. Despite the concerns, the broader U.S. stock market, as well as most foreign markets, turned higher. In fact, this past quarter's performance ranked as an outlier to the high side, rising roughly 5% over the past ninety days.

The small insight that can be taken from this past quarter's performance is that investment discipline should trump the ebb and flow of short-term concerns. This couldn't be more true than now given the ongoing U.S. government shutdown and rampant political posturing over the debt ceiling. In fact, we only have to go back one year to recall the headwind posed by the "fiscal cliff" standoff, which would result in the simultaneous increase payroll taxes and automatic government spending cuts, and purportedly send the U.S. back into recession.

Admittedly, the current prospect of the U.S. government defaulting on its obligations is potentially a more serious prospect, though one that we don't believe is probable. This said, given that the fiscal cliff wasn't averted until three hours before it was set to occur, and Congress has a fairly dismal record recently of behaving well, we're not holding our breath that this round of posturing ends well.

While the market hasn't reflected these concerns by moving lower, it has shown up in popular sentiment polls, with Congress getting only an 8% approval rating recently. What sentiment polls like this speak to is American's growing current distaste for politicking. After all, while concerns persist over the health of the economy; the stubbornly high level of unemployment, and the sluggish pace of the current economic recovery, a not insignificant number of the past years' bouts with market volatility have actually been induced by politicking.

As investors, we love predictability and loathe uncertainty. We undertake a lot of research to identify long-term investment opportunities, as well as to categorize the associated risks. Opportunities and risks we welcome, as they fall somewhere in between almost completely, and almost incompletely calculable, and represent the counterpoint to prospective return. Uncertainties however, are by definition unpredictable and therefore, the investor's biggest challenge. Despite everything, we continue to do what we do on the research and investing front, albeit with a heightened level of scrutiny of the "what ifs" irrespective of our view that a U.S. default is improbable.

One topic we want to touch on before commenting on the regular look-ahead, is the supposed safe-haven solution to a prospective debt-default by the U.S. government. In the media today, there are countless stories quoting the wisdom of professional investors advocating raising cash and/or moving to the "safety" of bonds. To most, this likely seems prudent, as cash and bonds have historically been the safe alternative to risks and uncertainties. This said, this is one bit of conventional wisdom that needs to be examined.

Hypothetically, let's just say that Congress does botch this one, allowing the U.S. government to default. Shortly thereafter it's well known that the first major event will be a default on its upcoming interest payments - on U.S. Treasury bonds. Let's collectively ask ourselves, what is a bond worth if it's issuer suddenly stops making the interest payments? If you answered anything between "zero" and "less," you're more right than wrong.

But there's still cash as a safe haven, right? Let's have a look. In the "golden" days, as we all know, the dollar was backed by and fixed in price to gold, meaning that if we didn't like the Dollar, we could exchange dollars at face-value for it's equivalent in gold. Today, in addition to toxic mortgages and "faith," it's the assets held by the dollar's sponsor, the Federal Reserve, as what a dollar is now, is a Federal Reserve "note," otherwise known as an IOU. While the Fed does hold quite a bit of gold, U.S. Treasuries make up one of its largest assets. What this means is that people and businesses would be less accepting of it in exchange for a real good, requiring us to offer more, less valuable dollars, for something real - this is otherwise known as inflation. So while the dollar isn't a write-off, it's safe haven status certainly appears questionable.

Hopefully it has come across clearly that that we don't think this outcome is probable, but nonetheless, we think it's instructive to put into context why we're not advocating a marked shift in strategy to cash and government bonds. We much prefer to either own real things, or securities that represent real things, such as high quality companies, with globally diversified businesses.

So, what lies ahead? After yet another sluggish summer of economic activity, there have been recent hopeful signs of a global pickup in economic activity, spanning the U.S., Europe and broader Asia. Interestingly however, third quarter corporate earnings estimates have come down during the past quarter, though this may in fact set up many companies to surprise to the upside in the current earnings season, as most of the revisions were likely based upon cautious company management teams at the end of last quarter, when energy prices were rising, and interest rates were expected to rise (from Fed Tapering) and impact consumers.

Perhaps most important to how the market performs in the final quarter of the year, will be the degree to which current uncertainty subside. While much emphasis is being placed on those uncertainties today, the reality is the timing of the debt-ceiling issue has has well-known for some time, and therefore has long been holding back the market's potential.

The most forthright assessment of the market today is that it should be viewed as high-risk, high-reward, demanding that an investment discipline be extremely focused on understanding how today's perceived risks, could impair the expected return of an investment. This said, the current investing environment has been in place for some time, as evidenced by today's continuing attractive company valuations.

All told, recent and prospective market volatility shouldn't overshadow the fact that despite the less than ideal backdrop, the market has had a very good year thus far. While we're certain to see continued volatility over the coming months, over the long-term global economic conditions are still merely in the mending phase and recovering from years past. Any incremental improvement should lead to a better environment for equity markets to reflect the latent value (earnings) that has been building up during the past several years.