Warmest regards to our clients, colleagues, and friends on this Memorial Day weekend 2014. Often considered the start of summer, Memorial Day originated after the Civil War to commemorate fallen Union and Confederate soldiers, when families would gather to picnic at the grave sites of lost loved ones. Over the years, it has evolved into a day of remembrance for all US soldiers who have died in combat. On this glorious spring Saturday, when Boulder is full of runners and creek festival-goers, it seems surreal that the US is currently at war. Yet that is indeed the case – although it may unfortunately surprise many of us.
The Afghan War, or Operation Enduring Freedom, began on October 7, 2001 and is now 12 years and 6 months long. 3,441 coalition soldiers have been killed so far (with American soldiers accounting for 2,322 of those deaths) – along with an undetermined number of Afghans. So as we celebrate this weekend with friends and family let us also take a moment to remember the origin of the holiday and the men and women who have given their lives so that we can enjoy the immense privilege of living in this blessed nation – as well as for an end to the Afghan War and the speedy return of the 33,500 US soldiers still deployed throughout the conflict zone.
Although global equity markets have struggled to find a consistent direction in 2014, both the S&P 500 and the All-Cap World Index (ACWI) are still up a modest yet respectable 3% year-to-date, with the S&P 500 closing near an all-time high on Friday, but my sense is that markets are due for a more substantial correction and continued choppy, rough sledding for the remainder of the year. The post-Lehman recovery has been rather anemic, especially on the job creation front. Meanwhile, the Yellen-led Federal Reserve has begun to taper its quantitative easing program and could be within 12 months of raising rates. A few other data points that suggest volatility may lie ahead:
1. The S&P 500’s average intra-year drawdown is 14.2% — while 2014’s max drawdown so far has been a meager 5.8%.
2. The US bull market that began on March 9, 2009 has now lasted for 62 months as of May 9, 2014. The average US bull market since 1950 has lasted 58 months.
3. The S&P 500 has now gone 596 days without experiencing a loss or gain of 3% or greater – something it did 85 times between 2008 and 2011.
On their face, these observations might suggest that a good strategy would be going to cash now, waiting for a correction, and then re-establishing one’s equity exposure at lower levels. Too bad that doesn’t work. Mr. Market seems to particularly relish both puzzling and punishing market timers. Consider that the market looked a bit rich toward the end of 2012, only to go on an absolute tear in 2013. Further, not all markets are created equally. While US valuations seem stretched, Europe appears poised for a sustained rally and emerging markets, especially Asia, are trading at bargain multiples – especially for high-quality, dividend paying companies. Consequently, we have been consistently taking profits on, and reducing our weightings to, high flyers (such as US small cap) and building positions in under-appreciated areas (such as European large cap and US energy — up 6.37% YTD).
Despite potential volatility on the horizon, we remain rationally optimistic. The economy appears to (finally) be picking up steam and shaking off the need for extraordinary measures from the Federal Reserve. Europe is growing again and animal spirits are returning to the Continent. Developing markets are making a steady transition toward domestic consumption and away from export-driven expansion. While markets may be choppy, global growth should improve and against that backdrop patient and discerning investors can continue to capture gains in underappreciated assets.
Additional thoughts and errata . . .
At the start of the year, the media was buzzing about the coming bear market in bonds. 2014 so far has been quite the opposite. Indeed, the 30-year US Treasury has gained ~11% year-to-date. Technically, a bear market is a decline of greater than 20 percent. Using that standard measure, there has never been a 12-month period where bonds have lost 20 percent or more. In other words, don’t believe the hype. Bonds may post nominal declines if and when interest rates rise, but investors holding to maturity (like BSW clients) should tune out that noise – they’ll benefit from higher rates upon reinvesting.
US Large Cap Growth:
We believe the recent sell-off of large-cap growth is irrational and unwarranted. One of the primary drivers of the US market’s gains in recent years has been multiple expansion – essentially the price investors are willing to pay for a stream of earnings. Considering that multiples are already at lofty levels, future gains will need to come from earnings growth – which comes from revenue growth and/or improving margins. Margins are at or near all-time highs of 10% — having only exceeded 8% twice in the past 65 years. This leaves just revenue growth to carry the load. As such, companies that have demonstrated the ability to consistently grow top-line revenue will (eventually) be rewarded – even if margins contract and multiples stagnate.
Dividend-Paying Emerging Markets Companies:
Emerging markets have been out-of-favor and unloved. But valuations on EM companies that pay dividends to their shareholders are reaching levels not seen since the Asian financial crisis and their yields are now nearly double that of the S&P 500 — along with better growth and demographic drivers. It is a remarkably deep bargain on high-quality EM companies.
We hope this Update & Commentary provides you with better insight into your BSW Growth Portfolio — and many thanks for reading. If you would like to discuss these positions or your portfolio in greater detail, please don’t hesitate to contact BSW. As always, we are happy to help.
David Wolf, Chief Investment Officer