Musings on Munger

January 2, 2024

By Mark Oelschlager, CFA

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Charlie Munger, one of the great investors and Warren Buffett’s right-hand man for decades, passed away recently, 34 days shy of his 100th birthday.  Over the years, Munger shared his wisdom with attendees at Berkshire Hathaway’s annual meeting and in many media interviews.  When explaining his secret to investing he often emphasized his rationality, noting that it was a rare trait among humans.  He understood that emotion, the yin to rationality’s yang, is counterproductive to successful investing.  Munger never bought a stock because someone else was doing so or because it had been going up; he bought it because he had determined it was a prudent investment based on the fundamentals, quality of the business and the prevailing price.  There is a lot of wisdom to be gleaned from legends like Munger; we just have to be willing to listen.

 

Stocks roared back in the fourth quarter, first on the belief, then the tacit confirmation by the Federal Reserve (Fed), that lower short-term interest rates are on the horizon.  Fed Chairman Powell stated that the Fed is likely done raising rates and expects to lower them modestly by the end of 2024.  This dovish pivot was surprising, as core inflation, while having declined, remains well above the Fed’s 2% target.  Stocks and bonds both rallied on this news, and continued doing so, despite attempts by Fed officials to walk back the Chairman’s comments the day after he made them.

 

Small-cap stocks, left behind for much of this year, participated in the rally.  In fact, Bespoke Investment noted that the Russell 2,000 made a new 52-week high just 48 days after hitting a 52-week low, which is the shortest such turnaround time in the index's history dating back to the 1970s.

 

After suffering for the better part of three years, bonds staged a comeback.  Ten-year Treasury yields peaked at 5% in October and then began a steady decline to 3.8%, in the neighborhood where it spent the first half of 2023.  This 120 basis-point decline in yield translates roughly to a 10% gain in price for that particular bond, a massive move for a fixed-income instrument.  This also illustrates the importance of managing duration risk in a bond portfolio.  Investors who held only short-term bonds in mid-October failed to lock in those higher returns that are now no longer available.

 

The decline in shorter-term yields is tied directly to expectations about the Fed, but the fall in longer yields, like the 10-year, is more complicated, since it is formed by a combination of expected near-term and long-run inflation expectations, expectations about the economy, and more.  It is possible that the recent rally in bonds is at least partly explained by increased concern about the economy, which remains strong by many measures but has shown some signs of deterioration.

 

The consensus is that we are going to have a soft economic landing and the Fed will begin easing rates in 2024.  It is important to remember that one year ago most (including us) believed that we would enter recession in 2023.  The lesson is that things can (and often do) turn out much differently than the market expects, which is why we never want to put all our eggs in one basket and why our level of skepticism should correlate positively with the degree of unanimity or certitude in the market.

 

Sentiment surveys as well as trading data indicate that optimism has rebounded to a high level.  In addition, stock valuations are high – both in an absolute sense and relative to prevailing risk-free rates of interest.  And as we discussed, a soft landing is expected.  The market can vacillate between overpricing and underpricing risks, and our judgment is that currently it is underpricing it, meaning it isn’t demanding enough of a margin of safety given the risks.

 

As students of history, it is hard for us to believe that the economy and world of finance will skate through the historically rapid interest rate increases of the last two years without things eventually breaking.  The US is only three months clear of the last central bank rate hike, so the lagged effects of these hikes still need time to work their way through the system.  We would also point out that, despite the perception that the market should be off to the races when the Fed begins cutting, history is replete with examples to the contrary – the cuts often occur early in a bear market.  There are certainly instances of Fed easing being followed by rising stocks.  The point is that it isn’t the slam dunk many believe.

 

This has probably come across as an overly bearish commentary, so it’s important to point out the positives such as our economy’s resilience and the tremendous profitability of corporate America.  Profit margins, especially those of the large companies, have been incredibly impressive.  America remains the world’s economic superpower.  But we are trying to stay rational, and the mix of high valuations (especially in light of higher interest rates), the lagged effects of interest rate increases, still-elevated inflation, and ebullient sentiment we believe warrants caution.

 

Our goal is to outperform the market and our peers over a long period of time.  Some managers keep the pedal to the medal regardless of the backdrop, adjusting only after it has become obvious that things have changed and then racing everyone else to the door (thus having to sell into rapidly falling prices).  We try to be proactive, adjusting the risk profile of our portfolios based on prevailing conditions.  When we are being paid to take risk, such as in 2008 and 2020, we do so.  When the reward is less enticing, we pull in our horns.  This doesn’t mean we aren’t always on the lookout for new ideas – every year we find new ones – but we believe it’s important to respect the investment landscape.

 

Northern Ohio is home to perhaps the best amusement park for roller coasters in the world, Cedar Point.  (The analogy I’m working toward is probably not the one you’re expecting).  A typical roller coaster starts out by making a slow and steady ascent (click click click), with a fair amount of time passing before reaching the peak.  At that point, you can feel a release, no more clicking, and, with the support gone, your momentum is now carrying you over the peak and downward, picking up speed quickly.  The plunge to the bottom is much faster than the climb.  It has struck me that market action is often similar to this crank and release.  Stocks, especially today, driven by price-following strategies, tend to enjoy a seemingly inexorable steady rise before periodically plunging when conditions change.  The reason they plunge is that so many market participants are following the same strategy, thus causing them to all sell at the same time.  We prefer to stay above the fray, not trying to time the peak in a chart but rather judging stocks as businesses and incorporating our read of the world into our portfolio management.  We consider it an advantage that our strategy has become more rare.

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We hope everyone had a great holiday season.

 

Best regards,

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Mark Oelschlager, CFA  
President & Chief Investments Officer

Oelschlager Investments 

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