Third Quarter 2013 Investment Commentary
Third Quarter 2013 Investment Commentary
The U.S. economy is improving at only a moderate pace and corporate earnings growth has slowed. The government faces significant monetary and fiscal challenges. But stocks showed substantial gains for the quarter and year to date anyway. Large cap stocks rose 5% for the quarter and were up 20% year to date as of September 30. Small caps were up 10.7% for the quarter and up 27.7% YTD.
Ten months ago, the government was facing another crisis called the “fiscal cliff” which was to begin on January 1. At that time tax rates would rise substantially and automatic 10% across-the-board spending cuts known as “sequestration” would begin. But the President and congress managed to work out a deal at the eleventh hour to avoid the worst of the matter. Part of the work-out was to temporarily postpone the budget due to their inability to negotiate. No subsequent progress was made on the budget and as of September 30—the government’s fiscal year end—the government had to be shut down…well, sort of.
The Federal Reserve (Fed) gave experts another surprise during the quarter. Prior to the Fed’s September meeting, experts were arguing about the amount by which the Fed would reduce the bond-purchasing program (“taper” QE). But to almost everyone’s surprise, they didn’t taper at all.
The economic outlook for Europe and Japan reportedly improved during the quarter. Developed market international stocks improved, earning about 7%. Emerging market stocks were mixed but, as a group, also rose about 7%.
At the end of the quarter, the benchmark 10-year Treasury bond yield stood at 2.6%. That was a bit higher than it was at the beginning of the quarter but down from the intra-quarter high. As measured by the Vanguard Total Bond Mkt Index fund, bonds earned 1% for the quarter but were still down by 2% YTD.
Free Markets (mostly)
Investments are very basically valued based on the discounted value of future streams of income. Valuations should be determined by the free market price mechanism. But sometimes prices are manipulated, which has seemingly become more prevalent. Today’s money market rates are imposed by the Fed’s Federal Open Market Committee. Bond interest rates may not be directly imposed but they are at least twisted, tweaked and nudged by the government.
Mr. Bernanke made it clear that a major purpose of QE and easy monetary policy was to cause investors to push up prices of investments and create the “wealth effect”. He has been successful in this, but the intended effects on the real economy are not so apparent. By pushing down the interest rate and the market expectation of future interest rates, the Fed has increased the relative attractiveness of pretty much all asset classes except cash, causing them to be bid up by investors. But it is important to realize that current valuations are reasonable only based on expectations of low interest rates. Remove that expectation and every asset class is subject to being re-valued.
You might call it a valuation risk when the discount rate on an investment is manipulated to extreme levels. Stocks compete with bonds. If I expect stocks to earn 5% for the next five years and five-year treasury bonds have a current yield of 5%, I’ll take the bond. An investment in stocks requires a “risk premium”. So, if competing interest rates are at naught, stocks become way more attractive and the valuations are pushed up. Then momentum kicks in and continues until…it stops.
Adding to the momentum problem—it’s estimated that about 70% of stock transactions are made by computers, based on very complicated mathematical equations and implemented on a split-second basis. In other words, computers are buying and selling stocks from and to each other in huge volumes based on formulas—no humans involved.
For all the Fed’s good intentions about being transparent, it is ironic that it has managed to surprise market participants yet again. A mere mention of the possibility of tapering its bond purchases in the spring led to a spike in bond yields not seen for nearly 20 years. More recently, when the Fed decided to delay tapering, bond yields fell. The Fed tries to manage market expectations but it obviously does not control them. Perhaps the bond market may have overreacted to the Fed’s implication that it would taper (the bond market pushed the rate on 10-year bonds up about 1%). Then Chairman Bernanke later cited the sharp increase in long-term bond rates as one of the reasons behind the Fed’s decision to delay tapering. In other words, bond yields went up more than the Fed expected or wanted. So, the question becomes, how can we be confident the Fed will be in control when it unwinds its massive bond purchases? How can we be sure that this experimental monetary policy will not lead to high inflation or other serious unintended consequences?
In light of the fact that we are still well below average historical interest-rate levels, what does it imply about the health of our economy if the Fed appears concerned that it cannot absorb interest rates that are higher than it expected? It might suggest that our economy still faces significant deflationary pressures. If the Fed’s credibility comes into question, how will it smoothly exit the ultra-loose monetary policy we have today?
One beneficiary of the Fed’s monetary policy has been housing. The rise in housing prices over the past year or so should help improve household balance sheets, lowering their need to deleverage. According to CoreLogic, about 15% of U.S. households have mortgages that are “under water” (i.e., their house is worth less than the balance on their mortgage). But this is a significant improvement from the 26% reported back in late 2009 and 22% about a year ago. As you probably know, a significant number of homes have been foreclosed but have not been put back on the market for sale. In fact, RealtyTrac reported that about 47% of those homes are still occupied by the previous tenant who defaulted and is now paying no rent. The reason for this could be to prevent an over supply of homes for sale, thereby causing pressure on prices. But the homes must eventually be put on the market.
With all the talk about deleveraging, It is important to remember that the absolute level of debt within the economy has not declined in a material way. Some of it has merely shifted from the private sector to the public sector. Ultimately, this debt has to be paid back. Public-sector deleveraging will have to take place at some point because the current path is mathematically unsustainable.
During the past couple of years or so, earnings for the S&P 500 companies have grown slowly but the stock market valuations have continued to rise substantially. The valuation of a stock is not measured by its dollar price, but by how that price relates to the stock’s earnings—the price/earnings or P/E ratio. For the past century through the late 1990’s, the S&P 500 typically peaked at 22-23 times reported earnings and bottomed at 7-9 times earnings. The S&P 500 now trades at over 19 times trailing 12-month earnings. This simply means that investors are willing to pay about $19 for $1 of earnings. This is above the historical normal ratio while (in my opinion) the investment market outlook is below normal. Depending on the time period used, the historical normal ratio is about 15. If the S&P 500 were to “revert to the mean” and trade at 15 times current trailing 12-month earnings, it would imply a price of around 1,350 on the S&P 500 index, which would imply a decline of roughly 20% from present levels. I think this would bring U.S. stocks within a fair-value range and I’d consider raising our exposure to U.S. stocks.
Although profit margins are high, “top line” revenue growth has been improving very little. So, how do companies increase “bottom line” profits without a proportionate increase in revenue? Some experts have estimated that about 40% of the recent earnings per share growth has been a result of a reduction in the number of shares outstanding. (Simply, earnings allocated to fewer shares in the hands of investors results in higher earnings per share numbers.) The reduction in shares outstanding is resulting from companies buying back their own shares from investors. Next year’s projected profit margins are based on all time highs. Profit margins may increase but at some point earnings growth and revenue growth have to match. Companies have obviously done a great job of decreasing expenses in order to improve earnings but, as a recovering CPA, I don’t think much can be left to cut in expenses.
I would argue that investment markets are reacting to stimulus other than long term proven investment fundamentals. Who would have predicted that the Fed could print trillions of dollars without consequence? Who would have predicted that the U.S. stock market would soar to new all-time highs while the economy languished with a near zero growth rate? During the second quarter large cap stocks earned 5.2% as measured by the Vanguard 500 Index fund. Small cap stocks earned 10.7% as measured by the iShares Russell 2000. So, stocks of large, high quality companies with healthy balance sheets and a long history of increasing dividends have substantially underperformed the stocks of small, lower quality companies with no dividends, high debt levels and high interest rates. Some of the high-quality stocks that I have purchased on behalf of my clients (Abbott, AT&T, Cisco, Coke, Conagra Foods, General Mills, Google, IBM, Kimberly Clark, Pepsi, Procter & Gamble, and Wal-Mart) lost money during the quarter. I found some small cap stocks that have never had any revenue but soared during the quarter. (How long has it been since the “dot-com” bubble?)
The point I want to make is, in order to get any return from U.S. stocks we have to use aggressive, optimistic sales growth and profit margin assumptions relative to both history, and to what I would consider practical based on the economic outlook. This kind of analysis supports the case to remain underweighted to stocks. I can’t justify margins staying at these elevated levels over our investment horizon, so it seems that we need to remain patient. .
In light of the fact that U.S. stocks have substantially out-performed international stocks this year, some may question the need to hold an international allocation. In fact, a review of the performance of all other asset classes for the past year or so would lead one to believe that they should all be sold and the proceeds invested in U.S. small cap, low quality stocks. But superior allocations among various asset classes are the starting point for our investment process. This improves the risk and reward ratio over a reasonable time period. When combined with other proven fundamental investment management principles that I have adopted on behalf of my clients, it reduces risk and improves potential return. My job is to build a weighted mix of asset classes I believe offer the best long-term-return potential for the given risk threshold of each client. It is easy to see which asset classes have performed best in the past but it is almost impossible to know which asset classes will be the next best performers. The most important reason for having a globally diversified strategic mix is that it should provide a much smoother ride than just being invested in U.S. stocks. The second reason to invest outside the United States is to tap into a broader investment opportunity set—much of which is not well-covered by Wall Street—allowing active managers to add significant value. This is especially true for emerging markets. Since I don’t know what is going to happen, I don’t structure my clients’ portfolios as if I do.
The case for having a dedicated long-term allocation to emerging markets is particularly persuasive. I read that emerging-markets’ share of world GDP has grown from 37% in the late 1990s to nearly 50% as of 2012, and currently has a share of about 11% of world market-cap. Emerging markets are home to a large proportion of the globe’s young working-age population, and are benefiting from the transfer of knowledge from developed nations that is happening at a rate faster than any other time in human history. This process ultimately leads to higher productivity, per-capita incomes, and GDP. The risks are higher in emerging markets over the shorter term, but even that does not wipe out the strategic case for owning emerging markets stocks and bonds in client portfolios.
Emerging Markets Risk
During the past two years, emerging markets stocks have underperformed U.S. stocks. When the Fed talked about tapering bond purchases earlier this year, emerging-markets stocks fell significantly. This may be a buying opportunity but the primary reason I have not increased our allocation is my concern related to China’s credit and infrastructure bubble. The Chinese government’s actions to rein in credit growth suggest they are concerned about past overinvestment and potential bad debts. China’s actions, in turn, are slowing growth there as well as in the rest of the emerging markets. The Chinese PMI is sitting just above the dividing line between growth and contraction. So, factoring in the China risk may make them approximately fairly valued, so I am sticking with our current position in emerging-markets stocks.
Emerging-markets local-currency bonds also took a big hit this spring and summer as emerging-markets currencies declined versus the U.S. dollar. I think this asset class is a good way to hedge a potential decline in the U.S. dollar and potential U.S. inflation in light of the Fed’s unprecedented monetary policies in recent years that have bloated its balance sheet. It appears that longer term growth prospects for emerging markets are stronger than the United States. In a subpar U.S. recovery they will probably perform better than U.S. stocks over the next five years. So I’m comfortable keeping our small allocation to emerging-markets bonds primarily through PIMCO Emerging Local Bond fund.
I accept the fiduciary standard. The word “fiduciary” is defined as “relating to, or involving one that holds something in trust for another”. An important part of my investment discipline is to protect client portfolios against downside risk scenarios I believe are plausible and not already adequately factored into asset prices. Taking this precaution means we will likely lag the broader stock market if a more optimistic scenario plays out. However, the fear of leaving some money on the table over short periods is not sufficient cause to deviate from the investment discipline that has served our clients well over the long term.
Thank you for the opportunity to serve.
Do not let kindness and truth leave you; bind them around your neck, write them on the tablet of your heart. Proverbs 3:3