Second Quarter 2016 Investment Commentary
Stocks moved in a trading range during the first part of the quarter. The big story in financial markets was bonds--specifically negative yields on government bonds. But that changed in June, when the relative calm in global stock markets came to a sudden halt. Trading became increasingly swayed by swings in emotions along with polls predicting the outcome of the United Kingdom’s so-called Brexit referendum on whether to withdraw from European Union membership. Contrary to forecasts, the United Kingdom voted on June 23 to leave the European Union. The British prime minister apparently had a hissy fit and quit.
As a result, the British pound sterling fell 11% against the U.S. dollar, its lowest level since 1985, and the euro fell 2.4%. Global stocks fell smartly. The S&P 500 fell by 3.6%, and the FTSE 100 fell by 8.7%. Financial stocks were sold, and defensive dividend-paying utility and telecommunications stocks were bought. Investors quickly shifted to “safe haven” investments: gold, Treasury bonds, and certain currencies, such as the Swiss franc, Japanese yen, and U.S. dollar. UK property funds with about $23 billion in assets suspended redemptions. Shortly thereafter, ratings agencies stripped the UK of its triple-A credit rating and also downgraded the EU’s rating.
There is, of course, a lot of uncertainty regarding the economic, political, and financial market implications of Brexit. But investors apparently held on to hope that central bankers will do something. That includes expectations of rate cuts from the Bank of England, potential additional bond buying by the European Central Bank, and a growing hope that the Federal Reserve will further delay raising U.S. rates and pull another rabbit out of the hat. In other words, more manipulation in order to extend a reckoning. So, in the week following Britain’s history-making vote, global stock markets rallied as the quarter ended, leaving developed markets at about a breakeven for the quarter. By month’s end, the amount of government debt (mainly eurozone and Japan) with negative yields had risen by nearly $1 trillion. The yields on U.K. 10-year gilts dropped below the 1% level. The U.S. 10-year bond ended the quarter with a yield of 1.48%.
There is now $13 trillion of global negative-yielding debt, according to Bank of America Merrill Lynch, and the figure is rising fast. Yields on corporate bonds are also still falling. For example Walt Disney locked in the lowest long-term borrowing costs of any U.S. company in history when it issued a 10-year bond with a 1.85% coupon (like magic).
Falling yields are a result of slow economic growth; central banks’ ongoing low/negative interest rate policies, including government intervention in bond markets; and heightened demand for perceived risk-free assets as a reaction to the uncertainty. As rates fall, investors reach for higher income from riskier investments.
I believe that U.S. equities are overvalued and that their expected returns over the next five years will be historically low relative to their risks. Global debt continues to rise and productivity growth to decline. For example, Japan’s debt to GDP is now about 240%. Debt causes future consumption to be brought forward. So, once debt is incurred, consumption that might have happened in the future won’t happen. Extremely low rates delay bankruptcies by weak companies. At a certain level of debt, growth and income begin to diminish. So today’s solutions are setting up tomorrow’s problems.
Money is so cheap that businesses borrow to buy back their own stock, causing the deception of increased valuations. There were $161.4 billion in stock buy-backs in the first quarter. It appears that a lot of capital is not being put to productive use, but being used instead to prop up equity values. That should tell us what we need to know about stock valuations. Earnings have declined for four straight quarters and a meaningful drop is projected for this quarter.
Even though we are at an all-time high for U.S. stocks, the SPDR S&P 500 ETF is less than 4% higher than this time last year. And the Global Dow is at the same place it was three years ago.
Our flexible fixed-income strategy funds performed reasonably well during the quarter. Floating-rate loan funds slightly trailed core bonds. Floating-rate funds should perform relatively well when rates are moving up. We have been able to get some nice profits from mortgage REITs but they are quite risky due to high leverage. But at such low starting yields, expected returns on core bonds are extremely low. Investors are earning very little (or actually paying via negative yields) for the safety of holding government bonds. Core bonds have historically been an important risk reducer because, when fear trumps greed, investors move from riskier investments into Treasuries and high-quality corporates. In light of the current interest rate environment, it’s difficult to judge whether the trade-off—reduced risk of losses versus longer-term upside—is worth it for the conservative part of our portfolios.
Even as yields fall in emerging markets, investors are pouring money into emerging-market debt funds in their search for higher yields. Fitch has downgraded the credit ratings of 15 nations in first half of the year. The previous high was 20 downgrades for the whole year of 2011, during the Eurozone credit crisis. Lower quality = higher risk for lower returns…makes me go hmmmmm.
Low Yields, Low Returns
The S&P Global Developed Sovereign Bond Index hit a new record-low yield of 0.4% as of June 30. As noted above, the amount of global sovereign debt with negative yields had reached $13 trillion. Extremely low to negative bond yields suggest very low five-year expected returns for core bonds. However, they don’t preclude strong returns over shorter-term periods if bond prices are driven higher by investor fears, ongoing central bank bond purchases, and/or speculative short-term international bets. Eventually though, the “bond math” catches up to you. In other words, you can’t escape the pull of the starting bond yield in determining your total return as a bond investor. I am cautiously taking advantage of any apparent opportunity, even if it is on a very short term basis.
Stock market valuations (e.g., price-to-earnings multiples) have a historically strong inverse relationship to future market returns. That is, the higher the current valuation, the lower the future realized return. So high valuation multiples are the flipside of low yields. Higher valuations mean lower yields, which lead to lower expected returns.
Unlike bonds, which have a defined stream of cash flows (interest payments) and a set maturity date, stock market returns are subject to a much wider range of potential outcomes due to uncertainty and variation in earnings growth and valuation multiples. Valuation multiples are impacted by earnings fundamentals but are also driven by investor sentiment (greed and fear) and herd behavior, at least in the shorter term, making them unpredictable.
A Traditional 60/40 Portfolio Has Unattractive Expected Returns
For a very long time, investment returns have been materially aided by declines in interest rates, globalization, and an enormous expansion of debt. The question is, how much longer the trend can continue. Back when QE first started, many were worried about what would happen when the Fed sold bonds back into the market. I’m still worried. Brexit and a growing populist movement point out the possibility of de-globalization. Without new credit, economic growth moves in reverse. The Fed has printed $4 trillion of new money and similar amounts with the BOJ and ECB. Central banks have lots and lots of money available but it depends on the private system – the economy’s real bankers – to decide to use and expand “credit”. If banks don’t lend, either because of risk to them or an unwillingness of corporations and individuals to borrow, then no credit growth results. If real GDP doesn’t continue at the same pace, companies and households go bankrupt.
Things will go bad when the general public realizes that the global central bankers have lost control. That may result in another crisis. Crises bring once-in-a-lifetime investment opportunities that you can seize…but only if you have enough cash or other liquid assets at your disposal.
No matter how you slice it—in nominal or real terms, in absolute terms or relative to historical performance—looking out over the next five years, the return prospects are poor. Achieving a reasonable total return without exposing ourselves to high risk will require lots of time and effort.
Historical charts show the 60/40 portfolio (60% stocks and 40% bonds) has generated above-average returns since the Great Recession ending in 2009. A key driver of this strong performance has been the impact of quantitative easing and other aggressive central bank policies, which have helped push down interest rates. This has meant higher bond prices and capital appreciation for the core bond index in addition to its income yield. Central bank policies also contributed to at least a meaningful part (perhaps most) of the increase in stock market valuations. This was one of former Fed Chair Ben Bernanke’s explicit objectives when the Fed undertook multiple bond purchase programs in the years following the financial crisis. Although there was a sharp V-shaped rebound in S&P 500 earnings off the extreme lows of the 2008–2009 financial crisis, the hoped-for stimulative “wealth effect” for the actual economy barely materialized as GDP has grown at only about a 2% rate.
In more recent years, a significant majority of the S&P 500’s return has come from P/E multiple expansion rather than actual earnings growth. For example, for the five years ending March 31, 2016, the S&P 500 gained 73%, but 46 percentage points of that total return came from P/E expansion. Meanwhile, total earnings per share growth was just 6% over the entire period (i.e., 1.2% annualized). Dividends accounted for roughly 11%.
The 12-month trailing P/E of the S&P 500 is currently around 23X, compared to its median since 1950 of roughly 17X. As long as interest rates remain at extremely low levels, P/E multiples may remain higher than normal. But if current interest rate levels are not sustainable—and I don’t think they are—then it is likely the valuation multiple will drop toward more normal historical levels. If rates do stay at such depressed levels for the next five years, it likely means economic and earnings growth have remained quite depressed as well, which is unlikely to be bullish for stock market valuations.
Stocks Should Return More Than Core Bonds
I expect low returns for stocks over the next 5 years compared to long-term historical returns. If we have a period of deflation or depression, high quality bonds would surely outperform stocks. Otherwise, stocks are likely to generate higher returns than core bonds. I think we should expect roughly a 3% annualized return premium. But stocks have significantly higher volatility, higher downside risk, and higher risk of permanent capital loss than core bonds. This being the case, we should always be compensated for this risk with a higher expected return from stocks compared to core investment-grade bonds. This is referred to as the equity risk premium.
The actual average annualized five-year excess return for stocks over core bonds was 4.6%, going back to 1950. However, the average equity return premium has fallen to 3.4% over the past 30 years. There have been several periods where the actual equity risk premium was negative—clearly not the market’s expectation at the beginning of those periods!
Analysis suggests U.S. stocks are trading above their fair value range with expected returns in the low single digits (or worse), except in optimistic scenarios. With the prospect for returns on bonds being so low and the interest rate risk high, I’m underweight. In what I would consider to be a normal investment environment, I would have only a very small allocation to cash (say 1%). At this point we have a relatively significant allocation to cash. We also have a higher than normal allocation to alternative strategies that have a risk level similar to core bonds, but with a higher potential return.
Again, bond interest rates are at historical lows. They may go lower, even negative as indicated by the Fed Chair. But the probability is much in favor of higher rates. As you know as rates rise, bond values fall. Therefore, the risk/reward ratio is not favorable.
I have heard several comments by the experts on CNBC as to why stocks are not overvalued, primarily low rates and low inflation along with, “there is no alternative”. However, every historical metric that I have seen in the past few years clearly indicate that stocks are overvalued—and some indicate extreme over valuation. For example the total market cap to GDP is about 123%. The previous high was 148% during the tech bubble in 2000. The lowest point was about 35% in the previous deep recession of 1982.
But…here we are at an all-time high. Global central bankers may be able to extend high valuations for years. But I continue to believe that there is a high probability of a significant downturn in stock valuations as well as in high-risk (low grade) bonds. I am managing my clients’ accounts accordingly. Therefore, I continue to attempt to earn a decent return, taking advantage of opportunities even on a short-term basis, without subjecting my clients to significant risk. This is a chore and, in my opinion and experience, it takes lots of hard work and active management.
When I can help in any way, please let me know.
Thank you for the opportunity to serve,