The Standard & Poor’s 500 Index had its worst ever start to a year falling 10% as of February 11. Subsequently climbing 13%, the Index managed to close the first quarter up 1%. Not since 1934 had the S&P 500 or its predecessor index begun the first quarter down 10% or more and managed to finish the quarter in positive territory. The drop and ensuing bounce were “insane” so said one market commentator.
Contributing to the January and February market “insanity” were a soaring U.S. Dollar making our goods more expensive abroad, concern that the Federal Reserve would start raising rates at an inopportune time, and heightened investor anxiety that this seven year bull market is slowing down. Also, oil fell 28% the first few weeks of January and was down 75% from its June 2014 highs. This fueled fears of a credit bust given energy’s approximate 15% representation of the high yield market and many banks’ cooperative lending spirit during the fracking boom.
Several developments ignited the rally. Commodities, such as oil, stabilized and Federal Reserve Chair Yellen indicated monetary policy would remain accommodative. A high profile vote of confidence came from the CEO of JP Morgan, Jamie Dimon, who personally purchased $25 million of JPM stock. International and small-cap stocks followed V-shaped declines and recoveries similar to the S&P. The MSCI All-World Index fell 12% only to finish flat for the quarter. The small-cap Russell 2000 fell 16%, but ended down just 2% after a ferocious March rally.
Needless to say, those like Jamie Dimon who “bought the fear” of January and February were rewarded. Those who sold into the fear missed an historic rebound. As for what to do now, almost no one expects much from 2016. Normally, the contrarian in us would see this as an opportunity. Yet, we are slightly more measured than usual because of the Fed-aided run of the past few years, U.S. market valuations, margin pressures largely from higher wages, and geopolitical uncertainty. Below we discuss many of these topics. We also hope to leave you with a better understanding of our investment philosophy and how we are approaching what many traders regularly point out is the seasonally weak summer season for equities.
“My sense is that economic anxiety means electoral volatility.” –Senator Tim Kaine, Virginia
Investors have plenty to consider heading into the second quarter. Fed policy is at the top of the list, although a distant second to the Presidential election for some of us. Specifically, Fed Chair Yellen remains resolute in her defense of a dovish Fed policy stance. Her comments increasingly cite the economic and deflationary risk of global uncertainty, particularly with regard to China. Consistent with this commentary we saw 10-year Treasury yields decline from 2.3% to 1.6% intra-quarter. After last Friday’s “goldilocks” jobs report, the 10-year yield currently stands at 1.8%.
While some have speculated about a path to negative rates, which have permeated Europe and Japan, the chorus of Fed Governors objecting to nearly a decade of easy money Fed policy is strengthening. Our view for the rate outlook remains the same. We don’t expect rates to move dramatically higher anytime soon. It is time, however, for the Fed to move further from zero. As a result, we remain sensitive to owning long duration securities. We also are concerned about the mal-investment that often results when a company or individual’s current cost of debt is near zero.
Another significant unknown is the threat of the U.K. exiting the European Union. Visitors to London have long been told to “mind the gap.” Now investors must mind the “Brexit” given its potential commerce and currency implications. Recent polls of British voters favor staying put, but further division around immigration and limited economic reforms throughout Europe could shift public opinion. The British pound is already feeling the weight of the threat down 4% versus the U.S. dollar during the March quarter.
Is the Market Expensive?
It Depends on the Dollar, Energy, and if You Prefer GAAP or Non-GAAP
The S&P 500 is currently valued at 17X 2016E earnings, which are estimated to be up 3% versus 2015. This compares to the often referenced 16X long term average. Taking the favorable view and removing the drag of Energy, S&P earnings are growing 8% and the index trades at 16X P/E. If the dollar weakens, the E in the P/E gets even bigger considering almost half of S&P earnings come from outside the U.S. Remove the high-multiple F.A.N.G. stocks (Facebook, Amazon, Netflix, and Google) and the market trades at 15X 2016 estimates.
Of course, before we get carried away we should note earnings are increasingly undergoing adjustment. In the fourth quarter, the difference between GAAP and Non-GAAP reported earnings was 24% versus a typical 13%. Though trending in the wrong direction, this is still much less than the alarming 46% difference back in 2008 according to RBC Capital Markets data. For the purists among us, the S&P trades at 24X GAAP 2015 earnings versus a historical 16X. Much of the current discrepancy is due to energy-related asset value write downs. Yet more aggressive adjustments are being taken for items such as stock compensation expense and acquisition integration costs. For instance, many high-profile tech companies exclude stock compensation expense from reported earnings, even though this “expense” can represent as much as 15% to 30% of revenues.
With All this Uncertainty, Why Even Ride the Market Roller Coaster?
Except for the youngest amongst us, we rarely recommend a ride on the stock market roller coaster without a seat belt. In this vernacular, the seat belt generally includes cash, fixed-income, and other less correlated investments. For those of you watching closely in the first quarter, you were reminded of the benefits of a seat belt since our accounts generally proved much less volatile than the market. Also, most appreciate the way to get hurt on a roller coaster is to jump off.
Even still, asking if equity investing is worth the stress is understandable. Put simply, yes because of the beauty of compounding. Whether via growing dividends or appreciation, enhancing a $1 million portfolio’s return by just 1% as a result of an equity allocation represents $105,000 and $282,000 of value in 10 and 25 years, respectively. A 2% enhancement increases the value by $219,000 and $641,000. The magnitude of just small differences over long periods of time is also why we seek to minimize total investment expenses, particularly for the most efficient segments of the market where active management struggles to keep up with the major indices.
Warren Buffett discussed the beauty of compounding in the context of per capita GDP in his recently released annual letter to shareholders. He highlighted that even in a paltry 2% GDP growth environment we should expect 1.2% of per capita growth. In 25 years, that annual increase equates to nearly 35% of real GDP per capita growth or an incremental $76,000 of annual household income for a family of four. While we can debate whether future GDP growth reaches the masses in today’s fast-changing economy, the wonder of compounding is compelling.
Seat Belts Are Important, But There Is No Substitute for Earnings
Economic cycles and evolving business models can augment or depress corporate earnings in the short term. It is this stream of cash available for investors, however, that provides the “margin of safety” made famous by Benjamin Graham. In 2014 and 2015, we wrote about the risks of biotechnology stocks as an asset class and Silicon Valley “unicorns” (i.e., early-stage private companies with $1 billion plus valuations without earnings). At the time, we certainly recognized the excitement surrounding innovation in biologics and the scalable nature of a new mobile application. We also appreciate the potential of identifying the next great growth stock. But without earnings and thus cash available for reinvestment or to distribute to investors, there is little way to predict a company’s downside risk. Accordingly, amidst the volatility of the past six to nine months, the values of most biotechs, tech start-ups, or companies in need of external capital suffered mightily compared to high-quality companies with sustainable and growing earnings and, most especially, dividends.
“If everyone is thinking alike, then somebody isn’t thinking.” –General George S. Patton, Jr.
One of the more amazing market stories of the past year has been the rise and fall of Valeant Pharmaceuticals (VRX). We have never owned the stock and were largely unfamiliar with the company until the headlines started surfacing last summer. For years, the acquisitive company was a favorite among high-profile fund managers with the stock more than doubling from late 2014 until August 2015, reaching a $90 billion market capitalization. The shareholder list was a who’s who among New York-based hedge funds and many value-focused mutual fund investors, some of whom had 20% to 40% of their portfolios invested in this single company. Yet it took an obscure short-focused research firm to highlight the earnings risks and allegedly fraudulent practices of the company. The stock has since collapsed 90% from its August 2015 highs.
How do so many smart people make the same mistake? Fear. In particular, the fear of missing out and falling behind in a competitive industry. We are certainly not without our share of mistakes. But we are content to miss out and try hard to recognize the risks associated with “group think” that often characterizes Wall Street.
Welcome to the “Fiduciary Standard” Club
Many of you have read about the Department of Labor’s efforts to apply a “fiduciary standard” to the investment management of retirement accounts. Currently, most investment brokers and “financial advisers” are held to just a “suitability” standard. The higher “fiduciary standard” requires advisers to place clients’ interests ahead of their firms’ and disclose all costs and any potential conflicts of interests. Adoption is expected this year. Importantly, nothing changes for Woodmont or our clients. We’ve been held to the “fiduciary standard” (for retirement accounts and others) since our founding in 2000 given our status as an SEC-registered investment advisor (RIA).
Change Can Be Good
One thing that has changed for Woodmont is our portfolio reporting system. By now, we hope you have successfully logged in to access your portfolio appraisals online. The new system includes all the historical information you had come to appreciate, as well as many new features such as daily updates and a mobile app soon to follow.
We appreciate your patience during this conversion. Some firms take the opportunity during these types of conversions to ditch the historical performance record. Our team and particularly Tina Cherry and Lola Johnson have taken major steps to preserve not only performance data but each clients’ transaction history. For some of our clients this was more than 20 years of data. Thus, if something seems to be missing or you have questions on how to access your information, please don’t hesitate to contact us. We want to get it right and are excited for you to begin accessing this new system.
In the meantime, we extend our best wishes for a wonderful spring season. We look forward to visiting soon and appreciate your continued trust and confidence.
Tags: Quarterly Commentary