Are Stocks Ahead of Themselves? In his latest quarterly commentary, Wally Weitz writes that his fund shop holds “substantial cash reserves” because stocks aren’t cheap

MONDAY, OCTOBER 21, 2013

Are Stocks Ahead of Themselves?

By WALLY WEITZ AND BRAD HINTON | MORE ARTICLES BY AUTHOR

In his latest quarterly commentary, Wally Weitz writes that his fund shop holds “substantial cash reserves” because stocks aren’t cheap.

(Editor’s Note: Weitz is president and founder of Weitz Funds and Hinton is the firm’s director of research. A longer version of this commentary, which includes the latest quarterly performance figures for Weitz Funds, is available on the company Website.)

Bonds, as we have discussed in recent letters, have probably come to the end of their 30-year bull market. Their yields are artificially depressed (and prices artificially inflated) by Federal Reserve actions. This leaves bond investors in an awkward position. We do not know when interest rates will rise, but absent a serious recession, they will. When this happens, holders of long-term bonds will be “locked into” current low interest rates and will experience poor returns.For example, a 20-year bond with a 4% interest “coupon” that sells for $1,000 today will become a 19-year bond in one year. If the going rate of interest on 19-year bonds is 6% at that time, that bond will sell at $775. The investor will have collected $40 interest but have a $225 unrealized loss. By contrast, today’s two-year bond with a 2% coupon will become a one-year bond a year from now and sell at about $980 if rates on one-year bonds have risen to 4%. In this case, the investor roughly breaks even—$20 interest collected and $20 price depreciation.

Given our expectation that interest rates will rise over the coming years, Tom Carney (a Weitz Funds portfolio manager) has focused our Short-Intermediate Income Fund (and the Nebraska Tax-Free Income Fund) on short, high-quality bonds. The strategy is to earn our coupon interest and reinvest the proceeds from maturing bonds into higher-yielding new bonds. At some time in the future, bond market conditions will change and we will be adequately compensated for taking both interest rate and (moderate) credit risk, but for now, we are maintaining defensive and conservative bond portfolio positioning.

Each of the past several quarters, we have written that stock prices seem to be rising faster than the companies’ underlying business values. In our last report, we described our Funds’ top ten stock positions and said that their long-term prospects were good, but that they were fairly priced. So, of course, those ten stocks rose by an average of 9% during the third quarter. We are not unhappy or ungrateful about earning these good returns—that is what we are here for. However, it seems likely that stock prices may be a little ahead of themselves.

The good news is that we believe that this period of stock price inflation is very different from the housing and mortgage market bubble that burst in 2007. Six years ago, home prices were rising rapidly, real estate speculation was rampant, and credit standards were abandoned. Risky mortgages were packaged into mortgage-backed securities of dubious quality, were sold to banks and speculators, and eventually caused hundreds of billions of dollars in losses for the banking system. Liquidity crises arose, bankruptcies were filed, bailouts were arranged, and “extraordinary measures” were taken by the Federal Reserve and the U.S. Treasury. We lived through it, but the country is still in recovery mode.

Because the recovery is weak and unemployment stubbornly high, the Fed is trying to stimulate economic activity by buying $85 billion per month of Treasury and mortgage-backed securities. We believe that quite a bit of this money pumped into bond markets has seeped into other parts of the securities markets—including the U.S. stock market. It also seems likely that the Fed’s promise to keep interest rates low for “an extended period” has attracted speculators who borrow short-term money at very low rates and invest in longer-term bonds which pay higher interest rates (“carry trades”). Hence, stock and bond price inflation.

Nothing is ever as simple as it seems in the world of global economics and stock markets. “Tapering” by the Fed (slowing the rate of bond purchases), and the Fed’s eventual selling of bonds, will inevitably reverse some of the security price inflation that has occurred over the past two years. Europe and China seem likely to cause anxious moments in financial markets, and our own budget and debt-ceiling negotiations are likely to be unattractive. But both the U.S. and global economies are growing and good companies around the world are finding ways to grow and increase the value of their businesses. This is why we believe that while the market may well get a correction—perhaps a sharp one—we are not headed back into a financial crisis where investors contemplate the end of the world and sell stocks accordingly.

We own shares in strong companies that have historically coped well with changing economic conditions and we trust them to navigate in turbulent times. We also hold substantial cash reserves in our funds and look forward to redeploying them, but we will be patient. Markets move on their own schedules and our goal is to be opportunistic on your behalf.