Will February’s Market Volatility “Dog” The Rest Of 2018?

Steve Pomeranz: Michael Farr is an American author, president of the DC advisory firm, Farr, Miller and Washington and he’s a frequent CNBC contributor. He’s also a contributor to this show as well. We always appreciate when he comes on. He has unique insights into the market, and we’re happy to have him with us today. Welcome back to the show, Michael.

Michael Farr: Thank you, Steve. Very nice to be with you. It’s been a while. I’ve missed you.

Steve Pomeranz: I know. I’ve missed you too. I really have. We should get together more often, but today is the day. So, let’s get to work here. We’ve been through such a heck of a storm in the month of February in this US stock market. What do you think was the primary cause?

Michael Farr: It’s interesting, Steve, we’ve heard so many different reasons as to why the market was coming down. And the consensus seemed to focus on interest rates and a 10-year treasury falling and therefore, the rising in yield and getting up to 2.9%. We’ve actually gotten, of course, above 2.9%. That seemed to have a lot of people concerned. I heard other people say, “Well, the stocks were just expensive and stocks were overvalued.” Then there was nervousness about the government shut down, which actually did shut down briefly and then passed into the quiet of the night. And we kind of keep moving on with major issue after major issue. What it really seems to me, though, is a recognition that we are in the middle of a really major shift. For the past eight or nine years, markets, I think, have fed on really low interest rates and quantitative easing and interest rates have been, you know, below 1% on Fed funds for years. And lots of easy money.

Steve Pomeranz: Yeah.

Michael Farr: The Fed has reversed course, right? I mean they’re raising rates now. They have stopped their buy-back program so they’re not as actively buying treasuries in the market as they were up until a year or so ago. They’re letting their portfolio run off now. And this is a big reversal, right? So, they’re removing accommodation and at the same time you’ve got the economy looking pretty good. But the federal government, with this tax cut and with this new budget spending plan, are throwing a whole lot of money at the market which could be really inflationary. So, it seems to me to be a dangerous time. I think it’s a really big deal what’s going on. And this kind of correction that we saw in the first few days of February seems to have come and gone quietly. I don’t believe it’s over.

Steve Pomeranz: All right. Well, let’s get to that. You’ve opened up a lot of boxes here. Let’s take a few of them, anyway. I will tell you that you were talking about chief borrowing. So for a client of ours who needed money for his business, and it was quite a considerable amount of money, we were able to negotiate LIBOR plus 25 basis points. So at one point I think he was borrowing a ton of money at maybe, let’s call it a half of 1%. I mean it was unbelievable.

Michael Farr: Right, free money.

Steve Pomeranz: It was basically free, exactly. So, there was no reason to use his own money for this, this was a private business. Why not borrow at .5% and that lasted for years and years and years. But I guess that’s changing now, so you see this as a confluence of also this disparity between the fact that we have this rising economy right at the time when we are starting to have rising interest rates. And the increased earnings that we’re getting, maybe from the tax cut plus the fact that business is really good, companies are in very healthy financial shape. So earnings are rising but interest rates, or the cost of money, is rising. Inflation is starting to rise, I’m not sure exactly whether this is a sustainable trend, but we have seen some numbers there. All of that has come together and, as you said, it’s a major shift. What degree, technically speaking, because these movements in February were very vicious. The downside was insane. That could not have been from just a pure, healthy market or a major shift. Something else is going on. What do you think it is?

Michael Farr: Well, it feels like something else is going on. You know, markets have gotten so accustomed to only going up. I mean people …

Steve Pomeranz: Oh, I thought there were only dipping.

Michael Farr: Right? I mean, just buy the stock, it goes up and you don’t even have to think about anything else. And people say that they don’t like market volatility. That’s just a bold-faced lie. They love market volatility as long as it’s up. What they don’t like is downside market volatility. And over the past few years too, when we’ve started these algorithms and these computer trading, once we got into some fractions of a penny in fractions of a second and volumes are flying all over the place, and we’re seeing this huge volatility return. So, I think for 2018 volatility is the new normal for markets.

I don’t know, a normal correction, yes. You know, you get these regular corrections. There’s always a new reason for them. Everyone, as you and I, can go back over our careers, there’s always a special reason for that individual correction. But they can tend to snowball. I mean, emotionally, people start to get scared and everybody heads for the exit at the same time.

Steve Pomeranz: Yeah. But these algorithmic trading vehicles, you wrote about it. You said algorithms soullessly, icily trade. They don’t really care about anything; profit is their goal at any cost.

Michael Farr: Right.

Steve Pomeranz: Also, there’s some talk, I think some serious talk, about these volatility indexes, which have many products based on them and cause large amounts of money to go … When large amounts of money go into these index-based products, they hedge on the other side by buying or selling stock. And when this stuff goes against them, they tend to lose an awful lot of money, so then they really are hammering the stock market to sell, sell, sell triggering other algorithms. And before you know it, you’re down 1,000 points.

Michael Farr: Right. So, over the years, lots of folks have written different computer programs for investing. And they’ll put in, on the old-fashioned programs would put in things like price to earnings, multiples, and return on equity and everything else. The new computers programs don’t do that. They’ve decided they don’t care really about the fundamentals. They want to just see the order flow that’s coming across from the other computers, the buys or the sells, and they want to get in front of them by a quarter of a cent. And that’s what they’re doing and they’re doing it in volume and they can do it faster than you can blink, literally. They can do it several times before you can blink, literally. I mean that’s kind of mind-boggling. So, that’s the way that the computers make money now. And they don’t care which direction it goes.

Steve Pomeranz: Okay, so, you know, this idea about fast food and slow food, so let’s use that. These computers are fast food. A human mind, typical investor, smart investor who understands the companies that he owns, or she owns, understands the valuation, understands how they’re going to make money and so on. That’s slow food. We can’t operate in a fast-food environment. What is a slow food investor supposed to do?

Michael Farr: Well, I think the slow food investor does the only thing the slow-food investor knows how to do and can reasonably do that affords them some level of predictable safety and return over time. Which is pay attention to the fundamentals, really do your research, and then stick with your investments for a long time.

Steve Pomeranz: Ignore the volatility.

Michael Farr: Ignore the volatility. And it’s like what they say in the fish market, you’ve got to ignore the screaming and yelling and pay attention to the price of fish. You know, you really have to do that in the stock market. But you know, another point you made, Steve, that I think’s really important, every real market blow up, there have been these products, these derivative products that have shown up over the years. In 1987 it was the portfolio insurance that sold that blew up. And then we had these ETN things that people were trying to protect themselves from volatility. I mean, almost, you know, to your listeners, if somebody comes up with some special product, structured product idea from any investment bank or brokerage firm, run. Don’t walk for the nearest door, just run. Because that will, every time, that’s been the source of almost every blow-up we’ve had. Yes or no? What do you think, Steve?

Steve Pomeranz: Well, I totally agree. I mean it’s the promise of a free lunch. We can give you the return of the market or something a little bit south of the return of the market and we can do it with no risk. Not possible. Sorry, just not possible. That is actually the Madoff mantra, that no matter what the market does, I’m going to give you 10% and I’ve been able to do that for so many years for so long. And it turned out it was all fake and it was just total nonsense. These products may work for a while and while they’re working, you may make a lot of money. But when they go bad, they go bad quick. You can’t get out and it’s all gone.

Michael Farr: And this is what makes old guys boring. And I don’t want to throw you under the bus with me.

Steve Pomeranz: Yes, please.

Michael Farr: Well, yes, I will.

Steve Pomeranz: Well, okay.

Michael Farr: I mean, you know, we come up and say things like this to the young entrepreneur who just sold her company for $300 million and somebody is telling her that they’ve got a very complex solution where they can cover the downside. And they have this structured product that’s going to protect her and she can have the best of everything here. And then you and I show up. And we go, you know what? 30 years plus later you can’t. It doesn’t work. What you need to do is stick with the simple old rules and take a middle of the road approach. And they look at us and say, “Yeah, but that’s … No, you’re just too old to understand the new nifty stuff.” And by avoiding the new nifty stuff for over 30 years, Pomeranz and Farr have been in the business for 30 years successfully. The other guys are gone.

Steve Pomeranz: Yeah, but I’m tired of being under the bus, you know?

Michael Farr: I know it.

Steve Pomeranz: I want to come out. My guest is Michael Farr. He’s an American author, president of the DC Investment Advisory firm, Farr, Miller and Washington and a frequent CNBC contributor. You know, there is at least a chart that I use that’s from JP Morgan where it actually lists out the volatility of the market. I don’t want to spend a lot more time on this. But the average market volatility of the S&P 500 from the high point in the year to its lowest point in the year, the intra-year move is 13.8%. So, I think it’s something for us to remember. In 2017, that number was actually 3%. From the highest point in the year to the lowest point in the year in 2017, it was 3%. I think we’re moving more back towards the average which is, let’s say, about 14%. So, it’s really not a new normal, it’s the old normal, it’s just coming back. But it’s coming back with a little bit more viciousness because of these algorithms. But let’s move on for a second.

Michael Farr: And it’s going to feel shocking, too, when that happens. You know the other thing that happened in 2017,  Steve, was every month was positive. Every month had a positive return. The last time that happened was 1927. Now, memory serves, 28 was not a bad year. 29 was rather tough.

Steve Pomeranz: Right.

Michael Farr: You’ve got to pay attention when those apparitions happen. They may be telling you something. They may not, but you really do need to be aware.

Steve Pomeranz: Well, also as an investor, make sure that you follow the basic rules. You know, don’t margin your accounts. Make sure you’re buying quality, make sure you’re diversified so nothing that goes out of business is going to destroy you. And don’t speculate. Try to know what you own or hire an advisor who understands what you own and already have.

I want to tell you a little bit of an anecdote from a conversation I had this morning. A client of mine is a CEO of a small company and we were talking about the valuations of the market and he says, “Look, we’re looking to buy businesses but we can’t find any businesses to buy because prices are so high where the numbers make sense for us.” And it seems to me that if that’s happening in the private market, you know the public markets tend to be a little bit more funny money. The private market is like, hey, this is the money that’s in my pocket, you know? I’ve got to make a good decision here. What do you think about that?

Michael Farr: You know, it’s an indicator, but I think it’s also an indicator of how much money has gone into that private market, has gone into private equity looking for those venture-type investments at some level. There’s a lot of money chasing, not that many deals, and it’s driving the prices up. And God bless your client for saying, “Look, these things don’t meet our discipline and therefore, we can’t invest in them.” You get in trouble because we do the same thing when we invest in the public side. I’ve got a discipline. If it doesn’t meet my discipline, I can’t buy it. And if it meets my sell discipline, I have to sell it.

But if you go along in a really strong boom market where prices go up and up and up and you’re sitting on a bunch of cash and you say, gosh, I really need to maybe just push that rule a little bit, ease off of the discipline a little bit because I’ve got to get this money invested, boom. It will bite you in the neck every time.

I mean, you stick with your discipline over the years, it is really the only thing that’ll save you. And professionals know that and so if you’re going to take one thing away from the Steve Pomeranz Show, and there’s so many things you could take away, please take away that one tidbit. If you have a discipline, by all means, you have to have a discipline that you need to establish in unemotional times and stick with it during the emotional times and you’ll be okay.

Steve Pomeranz: Yeah, I agree with you. Let’s change gears one more time. I want to talk about, it looks like what’s going to be a soaring deficit and its effect on the economy. Now these are big issues, we only have a couple of minutes left. But here’s how I want to narrow this down. If, in fact, as it looks like, we’re going to have another trillion dollars in debt for 2018 because of the tax cut and other things, the Treasury has got to issue bonds to pay for that debt. I mean, we’re borrowing the money and we’re borrowing it from the public and we’re borrowing it from companies around the world. And in order to do that, one has to create a new issue of a bond and go out and sell it. Well, a trillion dollars is a lot of money, even when you’re dealing with world dollars and country money.

Michael Farr: Well, right now it’s about a fifth of our overall outstanding debt, right? It’s 5%, I’m sorry it’s not a fifth, it’s 5% of our overall debt and we’re going to be adding that amount almost every year for the next several years.

Steve Pomeranz: Yeah, so the Treasury has got to cope with that. What do you think is going to happen? Is that, in itself, going to cause higher interest rates?

Michael Farr: It easily could. You know? I mean we haven’t seen the Fed move at all and we’ve seen the 10-year treasury really move up. We’ve seen the two-year treasury really move up coming into this year. Some people will say it’s an expectation of the upcoming Fed meeting where it’s expected that they’ll raise rates. But you know, one way or another, if the Fed raises three times this year, so the forecast is that the Fed is going to raise three or four times this year. That’s three quarters, to a point or one full percentage point on short rates. That puts mortgages over 5%, that increases the cost of all of that outstanding debt that the government has.

So, you know, it can really slow growth, and I’m not sure that the economy is strong enough to endure significantly higher rates.

Steve Pomeranz: Yeah, we just don’t really know that. But I think savers will start to see some benefit and maybe some of that money will move out of the stock market and also have another tertiary effect of all that’s going on.

Michael Farr: It should help the banks and financials too.

Steve Pomeranz: Yeah, exactly. Unfortunately, we are out of time. My guest, as always, love to have him on the show here, Michael Farr, President of the DC investment advisory firm, Farr, Miller and Washington. And don’t forget to hear this again or listen to the full show. Get the summary of all the vital info that we’ve discussed here. Go to Steve Pomeranz.com and while you’re there, sign up for our weekly update where we’ll send you every weekly commentary that we have. All the interviews written, as well as audio, and you can listen to just one or you can listen to the whole show, whatever you’d like to do. We also have searchable archives if you think you’ve missed something, straight into your inbox. Michael Farr, thank you so much for joining us today.

Michael Farr: Steve, it’s a pleasure always. Thank you for having me.