This issue will be brief, sticking to what we feel are the main tenants for performance going forward. I have often pointed out the futility of future economic predictions and trying to pick tops and bottoms in the market – particularity in the short-term. In the longer term however, we can use probabilities and valuations to our advantage.
U.S. Stock Market
What’s up is down and down is up in today’s stock market. Weaker than expected economic data once again lifted stocks due to the FOMC not raising interest rates.
In a normal market, weaker than expected data would be considered negative news, leading to a price retraction. However, in the current environment of unprecedented quantitative easing, monetary experiments and protracted ultra-low interest rates, bad news is good news.
Currently stock prices aren’t about valuations and earnings outlook, but low interest rates and monetary policy. The sentiment of “there is no other place to put your money” and the associated increase in risk taking in the search for yield will eventually change. We just don’t know when or what the triggering event(s) will be.
By most if not all financial metrics, current stock valuations are near or higher than at any time in history other than 1998 and 2000. This includes trailing, current and forward GAAP PE ratios, the Tobin Q ratio, price to sales, price to cash flow and total market cap to GDP among others.
There are a couple additional factors to consider.
Although declining only 1.8% last quarter, pre-tax domestic corporate profits (without capital consumption adjustment) excluding the energy sector and Federal Reserve Banks were down 5.2% over the four quarters ending in Q1 2016.
The tough earnings environment has led to approximately 90% of companies resorting to non-GAAP versus GAAP earnings to financially engineer bottom line numbers to meet earnings per share expectations.
Additionally, in 2015 and so far in 2016, corporations have returned over 100% of their earnings. The last two times the percentage of earnings returned was over 100% occurred in 2007 and 2008.
This is not to say that the market can’t or won’t plug along higher. All you have to do is look at 1998-2000. Based on that time period we could still see a 10-20% increase in market prices.
The above does illustrate however, the current risks associated with aggressively buying the U.S. Stock Market.
There have only been two times in history that the 10-year Treasury Note has yielded less than the dividend on the Standard & Poor’s 500 index of stocks. Both times led to losses for bond investors within about a 12-month timeframe. That said, it’s important to maintain diversification and not try to outguess the markets.
We shifted and continue to favor bonds with lower durations. During times prior to rate increases and appreciation in inflation, bonds with lower duration are considered less risky than those with higher duration.
The possibility of the Treasury funding the current deficit through the purchase of T-bills that mature in less than a year, would help our position.
Valuations in Europe continue to be attractive as they sit near 2011-2012 levels. For this reason, I believe there is greater price appreciation potential and less downside risk in European assets compared to the U.S. over the long-term. That’s not to say there won’t be any short-term pain in the interim.
Traders around the world are starting to prepare for possible rate hikes after the European Central Bank announced that they could start winding down their quantitative easing program ahead of schedule. Brexit and the potential problems surrounding Deutsche Bank also continue to be a concern. Both situations could lead to reduced capital spending and economic growth throughout Europe. It’ll be important to watch for any materialization of a credit slowdown in the European banking system which could pose a systemic risk to the financial system. However we don’t see any Lehman moment (which makes for a great sensationalized headline) resulting from it.
There has been a massive global shift in assets to the Emerging Market Indexes in 2016. The 15% year to date return for Emerging Market securities has now eclipsed the 14% loss seen in 2015.
This shift in assets has been due to high U.S. stock valuations and low interest rates causing investors to continue to look for yield and “safe havens” to invest their money while earning an acceptable rate of return. Emerging Markets are seen as a good fit due to valuations being below historical averages, offering higher dividend yields, the stabilization of commodity prices and the Fed weakening the dollar.
While I would agree with the above, the concerns I continue to have about China (which have been written about in previous issues) trump the attractiveness of Emerging Markets Indexes in which China constitutes the greatest portion of such funds. This concern has recently been supported by Chinese Real Estate Mogul, Wang Jianlin. Wang believes China’s real estate market is the “biggest bubble in history” and China will struggle for another two years.
Additionally, any tapering of quantitative easing resulting in higher interest rates would lead to a surging dollar. This would hurt commodity prices and put further pressure on those countries with heavy debt levels. We are already seeing the dollar appreciate on speculation the FED may raise rates once prior to the end of the year.
Active Portfolio Strategy
As we’ve mentioned previously, one of the best ways to outperform the market is to become more cautious when markets become overheated (1998-2000, 2007, 2015-2016?) and more aggressive once markets become severely undervalued (2002-2003, 2009). So far this strategy has held up well and we expect the trend to continue. Details of asset allocation for your retirement accounts can be found in the Value Investors Association Membership area.