“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” – Samuel Clemens aka Mark Twain
In light of recent geopolitical and market volatility, the quote above is both timely and insightful. Importantly, Clemens did not say that the majority is wrong, just that one should “pause and reflect.” By this I think he meant to review, re-examine and re-underwrite your premises, inputs and conclusions — and few things seem to prompt introspection more than big down moves in the markets.
Although much of the aforementioned volatility has occurred during this first full week of October, let’s review the landscape as of the close of the third quarter. The S&P 500 reached a new all-time high of 2019 on September 19th, also the date of Chinese internet-retailer Alibaba’s much-heralded IPO. For the quarter, US large-cap companies gained 1.13%, while US mid-cap and small-cap companies sustained losses of -3.98% and -7.36%, respectively. Driven by a sharp rise in the US Dollar, foreign developed and emerging markets declined for the quarter (-5.88% and -3.50%), eroding their year-to-date gains. Interestingly, the best performing region year-to-date remains “Frontier Markets” (+22.05%) while the best performing country is India (+24.71%).
The current global economic and investment narrative is complex and contradictory, with many exogenous geopolitical variables (ISIS in the Middle East, Ebola outbreaks in Africa, Russian aggression in Ukraine, etc.) further complicating outlooks. Consistent with Clemens’ quote, we are re-underwriting our positioning, especially where it is consistent with the “majority” of investors and analysts.
Majority says: “Interest rates are going to rise.”
One contributing factor to the market’s recent weakness is the anticipation that the US Federal Reserve will be raising interest rates soon, possibly as early as the first quarter of 2015. The Fed has a dual mandate of fighting inflation and “full” employment, which they have pegged at a 5.4% unemployment rate. Although the Fed is ending its Quantitative Easing (QE) program, several forces are aligning to make life hard for the Fed. First, unemployment has already reached 5.9%, with consistent gains of around 200,000 jobs per month. However, wage growth has been anemic and much of the nominal percentage gains in unemployment have been driven more by declining workforce participation than job creation. Labor force participation has been falling because of structural demographics, as well as expanding entitlement (disability) programs.
Second, countries around the world are taking a cue from the Fed’s playbook and engaging in “competitive devaluations.” Consider, for instance, that the yield on 10-year German Bunds is just 0.92%, while 10-year Japanese bonds yield only 0.52%. That makes US Treasuries look like a deal at 2.31%. As money flowed to the US, it pushed the US Dollar Index to a nine-year high. Because commodities are priced in dollars, the price of oil has fallen precipitously from $100 a barrel to $85 a barrel. Putting further pressure on oil prices: a) Domestic US oil production has surged, creating a glut of supply; and, b) Emerging market demand has waned with slowing growth. Likewise, following surging crop yields and dollar strength, agricultural commodity prices have been collapsing. Food and energy are the largest components of real consumer inflation, so these trends are very disinflationary – and run strongly counter to the Fed’s current objective of a 2% inflation rate.
All of these dynamics may conspire to paint the data-driven Fed into a very uncomfortable corner wherein they feel compelled to raise rates per nominal employment levels, but before the “slack” is really out of the labor market and in a benign inflationary (or even disinflationary) environment – which runs the risk of wrecking the US recovery.
So with regard to interest rates, we believe that the majority is wrong and that low rates are likely to last much longer than largely anticipated.
Majority says: “Foreign stocks are dead. US large cap stocks are a sure thing.”
Here’s a question: Over the last 10 years, what has been a better investment, US Stocks or Foreign Developed Stocks? Answer: Neither, it’s a push. The 10-year cumulative return of BOTH the S&P 500 and the MSCI EAFE is 104%. That surprised me, as the S&P 500’s blistering 32% gain in 2013 is still very fresh in my mind.
US economic growth has been much stronger than its foreign developed peers and stock prices have followed suit. Further, US economic growth appears poised to continue and US corporate profits remain at all-time highs. But there are a number of metrics that raise concerns regarding the ebullient outlook for US stocks. First, US small cap stocks have been getting hammered. US small cap underperformance is usually a “risk off” signal and is particularly concerning because US small caps are far more geared toward domestic US consumption and growth. Second, the S&P 500 is composed of the US’ largest 500 companies by market capitalization. These large companies are global enterprises and generate roughly 50% of their operating earnings abroad. A stronger US dollar (as discussed above) translates into weaker corporate earnings — and makes US products more expensive to foreign buyers. Third, much of the earnings growth of S&P 500 companies over the past 10 years has largely been geared to the emerging markets. Think about Ford, GE, Caterpillar, etc. Where are they selling the majority of their products? If EM is slowing, large cap US companies will feel the sting. Finally, the price-to-earnings ratio of the S&P 500 was trading at a 10-year high – 17 times 2014 earnings and roughly 16 times 2015 estimates. Not nearly the clear bubble territory of 25-30, but certainly not a screaming deal either. Many of these factors suggest that this recovery and the surge in US stocks has been more about financial engineering than true growth.
That said, the S&P 500 does appear healthier on other measures compared to past market tops:
Looking abroad, Europe was on-track to grow at 1% before Russia invaded Ukraine but may now sink to no growth. As a result, the European Central Bank (ECB) announced several monetary measures to stimulate growth, including a rate cut, credit-easing program, and the targeted long-term refinancing operation (TLTRO). All of these factors led to a steep (-9%) decline in the Euro versus the Dollar.
Before we write Europe off, however, it’s important to note that European exports as a percentage of GDP are DOUBLE that of the US. A weak Euro makes European products less expensive to US consumers, and makes dollar-denominated earnings more valuable to European companies (likewise for their Japanese and EM counterparts). Consequently, barring more Russian aggression, Europe once again appears poised for recovery. The ECB (and political will) has become more and more accommodative and pessimism regarding Europe is so in vogue that quarter-over-quarter and year-over-year comparisons should be easy to beat.
So with regard to the US vs Europe, we believe that the majority may be somewhat “right” but probably not as right as they think (as usual). Do US stocks look a bit richly valued? Yes. Are they still worth it? For now, probably. Does Europe have problems? Of course. Is it going to sink into the abyss? No. Are European stocks a good deal? Perhaps. Should you own both US and Foreign stocks? Certainly.
It’s easy and tempting to look back, in hindsight, and think how logically and predictably things have played out. Likewise, it’s easy and tempting to look ahead to the future and simply project current trends out ad infinitum. But as we’ve all learned over the years, easy and tempting things rarely yield good outcomes. Instead, good decisions require effort, discipline, and a healthy dose of skepticism, whether in portfolios or pinochle.
We wish you and your families a happy and healthy fall, and hope this commentary provides additional insight into our outlook and your portfolio. Please contact us if you have any additional questions, we are happy to help.
-David Wolf, Chief Investment Officer