Q1 2023 Commentary: Slowly moving in the right direction . . .
April 2023
Q1 2023 Commentary: Slowly moving in the right direction
What happens when they schedule a recession and it never arrives? Since last summer when it became very apparent that the Federal Reserve would continue to raise interest rates aggressively to curb inflation, the expectation of a pending recession has loomed over investor sentiment. Also contributing to recession fears was an inverted yield curve in which short-term rates are significantly higher than long-term rates. This inversion has been in place since the middle of last year and is often a prelude to recession. This pervasive recession expectation led to extremely pessimistic investor sentiment in the second half of last year. As we noted at the time, such extreme pessimism has historically signaled that a stock market bottom is near. Extreme bearish sentiment usually precedes a higher stock market in the ensuing year. So far, so good. The stock market has rallied, albeit choppily, since October.
Under more normal circumstances, investor pessimism might be warranted. However, we are not under normal circumstances. The economy is still under the lingering influence of the covid pandemic stimulus. M2 money supply growth provides a measure of the magnitude of the stimulus. In the middle of the pandemic M2 money supply increased by 25%, a gargantuan amount. Since they started measuring money supply in 1959, money supply had only rarely increased annually by more than 10%. Those that were convinced the spike in interest rates made a recession a foregone conclusion seemed to forget about all the cash sloshing around in the system. Economic growth has been sustained because of the post covid opening and lingering economic stimulus. The initial report of first quarter growth of 1.1% matched the Atlanta Fed GDPNow website’s consensus estimate. There is no recession in sight and as the economy acclimates to the new interest rate environment the threat of a severe recession recedes.
What will be critical going forward is getting inflation under control. We are getting there. Shortterm rates have now been raised to the level of inflation which gets us to a restrictive monetary policy and a level that will fight inflation. Commodity prices are already down, and housing prices and rental rates are starting to fall. Still of concern are wages, which are a significant component of inflation and still rising sharply. However, job listings are coming down and wage growth is leveling off. We are keeping our eyes on the bond market which is signaling that inflation will be tamed. If inflation was expected to become entrenched at higher levels, longterm yields would be higher. However, the ten-year US treasury yield has fallen from 4.2% in November to less than 3.5% today. While long-term rates stay in their current range, our concern is only about when, and not if, inflation will get back to the Fed’s 2.0% target rate.
With stable inflation comes a more stable economy and a stable economy is good for the stock market. Therefore, as we move forward, we expect the investment environment to improve. Furthermore, the federal reserve appears to be nearing a pause to its interest rate hikes which will improve investor sentiment as belief grows that interest rates have peaked. Meanwhile, as every month passes the impact of artificial monetary stimulus fades and a truly healthy economy emerges. All of these factors moving in the right direction gives us confidence in future stock market returns.
Q4 2022 Commentary: Setting the stage for a better 2023 . . .
January 2023
Q4 2022 Commentary: Setting the stage for a better 2023
The fourth quarter offered little relief from the difficult three quarters that preceded it. As such, both the stock and bond markets fell by double digits in 2022. The rapid rise in interest rates pushed the bond market to its worst return in many decades and effectively ended what has been a 40-year bull market in bonds. The S&P 500 was down 18%, ranking 2022 among the worst ten years in the last hundred. The technology stock heavy Nasdaq performed even worse, falling more than 30%. Still, there is reason for optimism.
It is no secret that rising interest rates, orchestrated by the Federal Reserve in order to tame inflation, are the overwhelming reason for the stock market’s struggle. Between covid related supply disruptions and the extraordinary covid relief stimulus, the inflation problem has proved to be more than transitory. However, Federal Reserve chairman Powell has vowed to bring inflation under control and to take whatever steps necessary to do so. Wall Street appears to believe him as indicated by the dramatic inversion of the yield curve in which short-term interest rates are considerably higher than long term rates. Interest rate inversions happen rarely, and in this case the bond market is telling us it believes inflation is a short-term problem and not a long-term concern. However, in the short term we will have to accept the Fed’s medicine to ensure that the long-term objective is achieved.
Fortunately, we are already through much of the adjustment necessary for the stock market to see better days. Much of 2021’s excesses have been unwound. Speculative fervor has evaporated. IPO volume has dried up and SPAC’s have been relegated to the dustbin of Wall Street fads. Corrections to valuation have been rolling through market sectors since the fourth quarter of 2021. These corrections started with the most egregiously overvalued stocks, and many are down by 70% or more. These companies were growing quickly but had no earnings. It turns out, earnings matter. It turns out, valuation matters too. Stock valuations have come down to realistic levels across all market sectors. Even the highest quality and most profitable companies, particularly in technology, have had to adjust to the new environment of higher rates and slower growth. Companies like Microsoft, Alphabet and Amazon have had to face the reality that the 2020-2021 boom times would not continue and are now going through layoffs.
This is all part of the typical stock market cycle, and we are approaching the stage when a disciplined investor should be preparing for the turn higher. After 14 months of correcting stock prices, we find ourselves once again in familiar territory. Broadly speaking, the stock market and individual stock valuations are reasonable and risk has been substantially reduced.
Given the immediate uncertainties, we must remember that we are not making decisions for results next week. Instead, we must consider where we will be a year, or even two, from now. The stock market is forward-looking and anticipates what is to come. Today we are a year into the rising interest rate cycle and it is beginning to have its desired effect. Inflation is turning lower, and the labor market is coming into balance. A year from now, the investment environment should be significantly better and the stock market will anticipate it. The next phase of the cycle is when investor pessimism turns to optimism, and we must be positioned for that now. We are confident that we are closer to the end of this bear market than to the beginning.
Q3 2022 Commentary: A time of maximum pessimism . . .
October 2022
The third quarter concluded with little to cheer. After a decent bounce to stock prices in July, the stock market gave it all back and then some from the middle of August onward. The catalysts for the retreat were a disappointing inflation report and Federal Reserve chairman Powell’s much anticipated address at Jackson Hole. Both extinguished any thought the Federal Reserve would put an end to its interest rate hikes any time soon. Powell’s speech was short and not so sweet. He indicated interest rates would be unequivocally going higher. Furthermore, subsequent remarks by Fed governors have been united in their hawkish stance on interest rates. While rate hikes loom the stock market is likely to struggle. By the end of the quarter the S&P 500 was down 4.9%.
As interest rates rise, bond prices fall. Longer-term bond prices fluctuate more as interest rates rise. In accounts that hold fixed income securities, we have held short-term bonds to minimize price fluctuations in the event of rising interest rates. Now that rates are higher, we are now buying US treasury notes to lock in attractive rates without risk to principal. Further portfolio management changes involve cash management. Because zero interest policy meant cash could held without sacrificing return, we held cash. With rates up, we are now managing cash balances more aggressively to earn interest with money market funds.
The investment environment is dominated by inflation. Where inflation heads will determine interest rates and fed policy. There are signs of inflation’s components moderating. However, headline inflation continues to be stubbornly high despite the federal reserve’s action. Remember, it takes quite a bit of time for the full impact of monetary policy changes to be felt. This lag means that interest rate moves higher from earlier in the year are only now impacting the economy and consequently inflation. The stock market has adjusted to this new environment and stock prices are as attractive as we have seen since 2018. With a longer investment time horizon and some patience, we can focus on fundamentals which are the ultimate driver of value.
Sir John Templeton, one of the most astute investors of all time, famously observed “bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.” This has held true through all modern market cycles and there is no reason to think anything has changed. Recent American Association of Individual Investors polling reveals bearish sentiment to be the highest since the market bottom of the 2009 Great Recession. Conversely, the percentage of those that are bullish is at a historically low 18%. We are sure Templeton would be smiling at these numbers. As he observed, bull markets are born from the type of pessimism we see today. At these extremes of pessimism, the record of stocks being higher six to twelve months from now is very good.
This is not to forecast that markets have bottomed, it is an observation that we are in an environment of pessimism from which bull markets arise. We would caution that the transition from the current bear market to the coming bull market will continue to be volatile. The volatility reflects the uncertainty and confusion that permeates the investor sentiment. However, as inflation is brought under control, and it will, the next bull market will begin.
Q2 2022 Commentary: Stick to our knitting . . .
July 2022
Very little worked for investors in the first half of the year. Both stocks and bonds tallied their second poor quarter in a row. The S&P 500 fell by 12.8%, driven lower by continued supply chain disruptions, covid shutdowns in China, unrelenting inflation, and concerns about a looming recession. The Nasdaq market was down substantially more. In all, the stock market posted its worst first half since 1970 and it has given back much of last year’s gains. The bond market offered no safe haven as rising interest rates caused bond prices to fall.
At the beginning of the year the global economy seemed well along the way in its transition to a post pandemic environment. The strong economy allowed the Fed to begin raising interest rates to fight inflation. The plan was to ease rates higher without threatening growth. Unfortunately, the severe lockdown response to covid cases in China exacerbated supply chain problems and hostilities in Ukraine triggered further inflation pressure. These actions prompted the Fed to raise interest rates more aggressively than expected. A less accommodative fed has raised alarms that tightening monetary conditions will throw the economy into recession. However, a recession is hardly inevitable. The most recent Federal Reserve Beige Book Survey of Current Economic Conditions indicated that the economy was expanding at a moderate pace. Unlike the run-up to past recessions, there are no severe imbalances in the economy and the financial system is strong. Furthermore, there are signs that the inflation may be moderating with gas, metal, and commodity prices down substantially in the past few months. We are encouraged that the inflation fight may be turning in our favor.
The pervasive pessimism about the economy and the stock market has led to serious corrections in many sectors of the stock market this year. The highest-flying growth stocks have crashed, some by eighty and even ninety percent. Technology stocks that benefited from surging sales to housebound families and remote workers saw their stocks peak in November. Many of these stocks have collapsed by more than 50% with many down more than 80%. In other words, stocks have gotten a lot cheaper. Meanwhile, the American Association of Individual Investor survey of investor sentiment has turned extremely bearish and has been this bearish only one other time since the early 1990’s. Institutional investors are similarly pessimistic. History shows that when sentiment moves to extreme pessimism, the stock market is almost always higher a year or so later. That is because the negative outlook is already reflected in lower stock prices. Coupling negative sentiment with many high-quality stocks trading at the lowest valuations in years and we are very optimistic about our prospects. John Templeton was one of the greatest investors of the last century. One of his less well-known sayings was to “focus on value because most investors focus on outlooks and trends.” We intend to do just that. If we can acquire stock in great companies at attractive prices, we will be rewarded over time no matter what current trends otherwise indicate.
Bear markets are the ultimate test of investor resolve. The tail end of a bear market can be painful and market volatility can be hard to stomach. However, we cannot emphasize enough that long-term investors must remain invested in order to benefit when markets turn higher. Among John Templeton’s more well-known quotes is “the time of maximum pessimism is the best time to buy.” When we look at where stocks are being valued and we see overwhelming negative sentiment, we have to conclude that the time of maximum pessimism is not far off.
Q1 2022 Commentary: The balancing act . . .
April 2022
Inflation, war, rising interest rates; The world has changed, and it has real implications for investing going forward. Reflecting these changes, it was a difficult quarter for most asset classes except commodities. Comments from federal reserve chairman Powell and other fed officials signaled an end to the zero interest rate policy that had been in effect for some time. The Fed’s turn toward a hawkish interest rate stance was immediately felt on bond prices. Interest rates rose sharply this quarter leading to a 5.9% drop in the bond market. This drop was the worst quarterly performance for bonds in more than forty years. Just this week the 10-year US treasury bond yield broke above three percent for the first time since April 2019. In the face of rising interest rates, the stock market also turned down after a seven-quarter run of positive performance going back to when the pandemic began in March 2020. For the quarter the S&P 500 lost 4.6%.
The economy continues to hum along and expectations for continued growth in 2022 are widespread. The consensus estimate of economic growth is 3.0 percent. The unemployment rate has dropped to 3.5% and job growth has been strong. Strong economic growth and low unemployment has allowed the federal reserve to turn its focus to reining in inflation. The fed’s dual mandate is for stable prices and maximum employment. We are arguably at full employment and there are 1.7 jobs currently available for every person unemployed. Inflation in March was 8.5% year over year, the highest since 1981. In response, the fed is now phasing out its asset purchases and has raised rates for the first time since 2018. The bond market has anticipated further fed rate hikes and pushed interest rates substantially higher across the yield curve doing much of the work for the fed immediately.
Often our commentary reiterates that the investment environment remains positive despite various concerns that pop up from time to time. Over a period of years, this positive environment has contributed to steadily rising market valuations. Well, the investment environment turned decidedly less favorable in the new year. The fed’s move from an accommodative to a tightening monetary policy is a headwind for stocks. Inflation puts pressure on corporate profit margins which are now contracting from all-time high levels. The unfortunate circumstances in Ukraine signal an end to geopolitical calm that has benefited the global economy since the Berlin wall came own in 1989. Taken together, these factors raise uncertainty and lower stock market valuations. The price to earnings ratio of the stock market is used as a proxy for stock market valuation and it has been declining and will continue to decline if uncertainty rises.
Taken in isolation a lower price to earnings ratio is problematic for the stock market. However, the strong economy can offset lower stock valuations as corporate earnings continue to rise. The S&P 500 aggregate earnings are expected to grow by 10% in 2022 and 2023. Furthermore, some of the concerns may not be as long lasting as expected. Although it is too early to draw a definitive conclusion, there are signs emerging that supply and demand imbalances may be resolving. Prices for used cars have been falling after surging last year. In addition, shipping and trucking rates have been coming down for more than a month. If there are further signs of price pressures easing, then interest rates may stabilize. On balance, many of the worries are already reflected in stock prices and serious corrections in many market sectors have already occurred. In our hunt for good companies at great prices, we are seeing many more opportunities now than we were earlier.
Q4 2021 Commentary: The Way We Were . . .
January 2022
Q4 2021 COMMENTARY: THE WAY WE WERE…
It was a very good fourth quarter and year for the stock market marked by a resurgent economy and surprising earnings growth. The S&P 500 rose by 28.7% in 2021, tacking on 11.0% in the fourth quarter. Our value-based, contrarian, strategy more than kept pace with the market’s return. Bond market returns were more difficult. The Barclay’s aggregate bond index was flat in the quarter, and for the year was down 1.5%. Rising interest rates, which negatively impact bond prices, were the cause of bond market losses. A strong economic recovery and higher inflation that has been more persistent than transient, has led the Federal Reserve to accelerate plans to raise interest rates. We expect the Fed policy change to increase financial market volatility as we transition to a higher interest rate environment.
Looking forward to what is to come in 2022, expect further normalization in the economy and financial markets. The process will continue to be slow and uneven, but life is returning to pre-pandemic norms. Unexpected events, like the appearance of the omicron variant, are likely to keep cropping up. Hiccups along the way that unsettle financial markets will be opportunities to position portfolios for the continuing recovery. The economy has been strong and wage gains put the consumer in a good position. Unemployment is a low 3.5%. We have massive fiscal and monetary stimulus to thank for that. However, easy money is going away. Government benefits are being scaled back, but this is also part of a reversion to the norm. The economy is indicating growth will continue and advance under its own power.
Of concern are ongoing supply chain problems that have disrupted the availability of components needed in many sectors of the economy. These shortages have led to higher prices. Some of the problem is due to covid related labor supply shortages. The other factor is the much higher than expected demand for goods as consumers shifted to buying more goods and fewer services. This situation is a symptom of the extraordinary circumstances of the pandemic. As the pandemic transitions to endemic, supply chain issues will be resolved, and inflation will ease. The Federal Reserve has indicated that it will raise interest rates partially in response to inflation pressure, but also because its zero-interest rate policy is no longer necessary to sustain the economy. Rising interest rates are a headwind for the stock market. However, rates will rise only when economic growth justifies it and the Fed will pause should growth flag. As long as rates rise in a measured fashion, the stock market will handle the change. If the economy does well, corporate earnings will also do well. Since earnings drive stock prices, the stock market should do well even if rates drift higher.
In its simplest form, the stock market moves higher and lower on changes in corporate expected earnings and how much investors are willing to pay for those earnings. Both components came together in 2021 to push stock prices substantially higher than anticipated. S&P 500 earnings vastly exceeded all expectations in 2021. Growth will slow in 2022 but should still exceed 10%. The stock market ended the year near its all-time high. However, under the surface many of the most speculative stocks have traded substantially lower. Stocks that seemed to trade untethered to any valuation measure are now trading as much as 70% off their pandemic highs. Valuation matters, and the day of reckoning for valuation has arrived. We own companies that are profitable and reasonably valued and therefore in fine shape. A stock market that pays heed to valuation is another return to normalcy that is good for us and our portfolio.
Q3 2021 Commentary: Good, just not as good . . .
October 2021
Q3 2021 COMMENTARY: GOOD, JUST NOT AS GOOD…
The stock market’s steady march higher continued through August much as it had for more than a year. By mid-September, the S&P 500 had gone more than 200 days without closing below its 50-day moving average, the second longest such streak since 1990. Slow and steady has been winning the race. However, the streak came to an end in September and stocks drifted lower until the end of the quarter leaving only a modest 0.58% quarterly advance for the S&P 500. The economy appeared to pause over the summer due to supply chain and delta variant Covid-19 concerns. Longer term interest rates drifted modestly higher during the quarter resulting in a small 0.11% gain for bonds in the period. As we move forward, economies and financial markets will normalize as we emerge from the pandemic shock. The summertime pause will be a small bump on the road to full recovery.
Stock market returns in 2021 have been driven by a surge in earnings expectations. At the start of the year, the S&P 500 companies’ earnings, in aggregate, were estimated to be $165. Today, the estimate is $201. Earnings expectations have risen enough to lower the market earnings valuation despite the index’s impressive move higher. Stimulus funds and return-to-normal activities have juiced the economy. We are now in the middle of the third quarter earnings
reporting season, but early results point toward more of the same strong results. By and large, companies are beating expectations and it looks like estimates for the fourth quarter and next year will ratchet higher. Earnings ultimately drive stock prices and further earnings growth is strong support for current stock levels.
There are many niggling issues that will cause concern among investors, but we do not expect any to derail the stock market. Supply chain issues will persist, but they are probably at their worst right now and will improve as all parties work (literally around the clock in west coast ports) to resolve bottlenecks. With so much attention being paid to this issue, these problems will become yesterday’s news in 2022. The Federal Reserve will begin to taper its purchases of bonds, but its actions have been so well communicated in advance that the stock market is already adjusting to that eventuality. It is broadly recognized that the economy has stabilized and there is less need for stimulus so scaling it back should not be a problem. Finally, inflation has proven to be less transitory than expected and if it persists it would be a significant negative for the stock market. However, the current inflation spike is predominately a function of supply chain scarcities which will pass. We agree with former Fed chairman Ben Bernanke that inflation will slow in 2022 as supply chain issues wane.
What is evident from the way the stock market traded this year is that none of these concerns have reflected negatively in the stock market. Only the late summer economic sputtering attributable to a rise in the covid delta variant had real impact. Purely from an investment
standpoint, the positives swamp the negatives. Leading economic indicators remain positive and signal continued economic growth. Consumers are flush with cash to spend, and fiscal and monetary stimulus continues. These factors will keep the economy and corporate earnings on the right track. The normalization process is moving forward, and our daily activities are returning to pre-pandemic routines. The process will be uneven and that will lead to more stock market volatility, but some volatility is perfectly acceptable given overall positive trends.
Q2 2021 Commentary: Carry on, but keep an eye on inflation
July 2021
Q2 2021 COMMENTARY: CARRY ON, BUT KEEP AN EYE ON INFLATION…
Carry on Mr. Market, carry on. What we got in the second quarter, was more of what we got in the first quarter. The S&P 500 advanced 8.5% in the three months ending June 30th, which built on the 6.2% gain in the first quarter. Put together, the 15% gain in the first half of the year was among the best in decades. Not only has the stock market performed well, but it has done so with little volatility. We have not yet had even a five percent correction this year. Fueling the rise, in part, was a benign interest rate environment. There was much wringing of hands earlier in the year when long term interest rates moved higher. However, the 10-year US treasury yield fell in the second quarter to 1.48% from 1.68%. Long-term rates have fallen further in July. Due to falling rates, the aggregate bond index gained 1.83%, helping it recover from first quarter losses.
The hot topic of the moment is inflation and whether its recent surge is transitory as Fed chairman Jay Powell maintains. There is a lot of debate, back and forth. We are inclined to believe current inflation will subside as the economy continues to normalize. The components of the price index whose prices have spiked higher are chiefly pandemic specific and caused by unexpected demand from the strong economy. As supply catches up with demand, prices should settle back to earlier levels. We are already seeing the type of adjustment we can expect in the price of lumber which is now down 65% from its high price on May 10 and back to last November’s level.
That stock prices are driven by what happens to earnings is a foundational belief. We need look no further than the earnings picture to understand what is going on in the stock market. In January, earnings for the S&P 500 companies in 2021 were expected to rebound to pre-pandemic levels in the $165 neighborhood. Six months later, those expectations have ballooned to $193 according to FactSet Research. Second quarter earnings reports are trickling in this month and in aggregate are blowing away the estimates despite higher expectations. All indications are the growth trend will continue in the third quarter which is broadly supportive of stock prices.
Of course, regarding stock market levels, the second part of the equation is how much are investors willing to pay for earnings. Currently, the market appears comfortable at a price to earnings ratio at the historically high level in the low twenties. This P/E level may well be as high as can be expected. It appears that investors are unwilling to pay much higher multiples for stocks. The evidence is in the response, to date, of second quarter earnings reports. Despite companies posting numbers at a rate well above estimates, the stock market response has been disappointing and reporting companies have struggled to move higher indicating valuations are reaching their limit.
The good news is that the low interest rate environment will not change any time soon. Fed chairman Powell has emphasized in congressional testimony that Fed rate policy will not change until the labor market recovers. The unemployment rate is currently 5.8% and there is plenty of room for that rate to improve. The Fed will hold steady until the unemployment rate falls significantly from here. That time is well into the future. An accommodative Fed and a strong economy means there is still room for the stock market to move higher.
Q1 2021 Commentary: As it rains money, it’s all good for now . . .
April 2021
Q1 2021 Commentary: As it rains money, it’s all good for now…
We are still riding the wave more than a year into the pandemic paradigm. A year ago, in this letter we wrote “the turnaround from where we are now is not in question…it is inevitable and the only question is how long it will take. The government is seeing to it that we will muddle through in the meantime.” In many respects those words are as relevant today as they were then. Financial markets have hopped from the initial CARES Act stimulus wave to the vaccination wave and now on to the latest wave of stimulus. During the quarter, the S&P 500 tacked on 6.2%. The Federal Reserve continued its zero-interest rate policy for short term rates. However, longer term rates rose significantly during the quarter responding to improved economic expectations. Rising rates on the long end of the yield curve drove bond prices down. The US aggregate bond index fell by 3.7% in the quarter. Bottom line, persistent good news has raised US economic expectations and been a boon for the stock market and our portfolios.
While we can thank rising expectations for the march higher by the stock market, it is a potential cause for concern. In the meantime, the adage “don’t fight the fed” is a dominating paradigm in the stock market. The Fed continues to forcefully reiterate that it has no intention of letting up on its easy money policies. In addition, the economic recovery has been strong. Anticipation of the economy opening has led to strong consumer demand. Job creation in the first quarter was strong and unemployment has fallen substantially. Frankly, we were skeptical of a strong economic surge and expected a more modest but steady recovery. More than a decade ago, former fed chairman Ben Bernanke earned the moniker “helicopter Ben” when he speculated about directly dropping money into the economy to combat deflation. In 2020, the government effectively implemented the strategy. JP Morgan Chase CEO, Jamie Dimon, summed it up in his company’s earnings release; “with all of the stimulus spending, potential infrastructure spending, continued Quantitative Easing, strong consumer and business balance sheets and euphoria around the potential end of the pandemic, we believe that the economy has the potential to have extremely robust, multi-year growth.
Given the state of the recovery, what can we expect from the stock market. Late last year, after the vaccination approvals we speculated on the earnings recovery in 2021 and 2022. If aggregate S&P 500 earnings could climb all the way back to pre-pandemic levels (as analysts were projecting) the S&P 500 would be trading around 22x estimated earnings. Low interest rates justify the current lofty earnings multiple. In anticipation of the economy emerging from covid-19 limitations and further government stimulus it was reasonable to expect better than 10% earnings growth for the S&P 500 for the following year. With these estimates AND steady interest rates, it was reasonable to project a 10% market return in 2021. So far, so good. In the ensuing four months, earnings projections have ratcheted higher. Consensus estimates for 2021 and 2022 have increased by almost 10%. These numbers provide for meaningfully higher price targets from today’s level of the S&P 500, again with the caveat that interest rates hold at current levels.
With higher expectations comes a higher bar that needs to be cleared to justify current prices. The market valuation reflects a rosy scenario in the year ahead. Should the rosy scenario be called into question there may be a few bumps in market advance. Any market weakness would be viewed as a buying opportunity. We do not necessarily expect the stock market to be a smooth ride in the months ahead, but it should be a pretty good one.
Q4 2020 Commentary: Time to walk the walk . . .
January 2021
Q4 2020 Commentary: Time to walk the walk…
Ignoring the noise and remaining focused on the narrow set of circumstances that we believe are driving stock market prices has served us well. If we need to be reminded that politics rarely have a meaningful impact on the stock market, we need look no further than January 6th and the storming of the capitol. That day’s events did not register on the stock market. Unless it meaningfully impacts the economy, politics are of little interest in crafting an investment portfolio. The stock market rally continues to be fueled by optimism for an economic recovery from the Covid-19 induced recession.
Vaccine approvals in the quarter spurred the S&P 500 rally further and 2020 was finished off with a 14% gain in the quarter. Bonds maturing within two years have seen little change in yield and are hovering just above zero percent. Longer term bond yields drifted higher, and the aggregate bond index returned 0.67% in the final three months of the year. At the market lows in March the S&P 500 was briefly down 33%, but the subsequent rally drove the index to a 17.9% for all of 2020. The bond market was also higher for the year as the economic upheaval early in the year drove interest rates down and drove returns 7.5% higher.
Where can we go from here? Last April, we proposed that closing the economy meant we could virtually ignore the numbers in 2020. As soon as Congress passed the Cares Act and the Federal Reserve pledged to peg short- term interest rates at zero, investors were willing to overlook 2020 and focus on 2021. The economic stimulus and government benefits instilled certainty that the US economy would make it through the year. Little else matters in 2021 but the prospects for recovery, which are ultimately tied to the prospects for a vaccine. Financial markets have been, and continue to be, supported by positive news flow. The stock market has moved on consistently positive news that further government stimulus is coming, that vaccine development was progressing toward approval and following approval that vaccinations can be rolled out on a massive scale. In this environment, valuation has not much mattered and stock market valuation has drifted to higher and higher levels.
Pockets of the stock market are now trading in irrational ways and it is disconcerting. Every day there are stocks that trade explosively higher and lower with no real news. These stocks are pinballing all over the place, untethered to any relation to valuation. The cause has been attributed to numerous reasons including FOMO (fear of missing out) in which investors pile into whatever stock is going up, or TINA (there is no alternative) in which stocks are viewed as the only asset class in which good returns can be had. There is speculation that new stock market traders are treating the stock market like a video game, or that quantitative traders and their computer algorithms are amplifying gyrations. Whatever the reasons, we will be giving these stocks a wide berth. We are comfortable holding a portfolio of attractively valued companies and know we can sidestep these situations that are confined to well defined areas of the market.
To reiterate, stock market excess is not yet pervasive. We find ourselves in peculiar circumstances. We proudly hang our hat on relying on company fundamentals to guide our investments and search relentlessly for investments that are at historically low valuations. We are very price sensitive, and it serves us well over time. Currently valuation does not seem to matter, but ultimately it will and high-quality companies with fair valuations will do well. There are plenty of stocks that this rally has left behind and they will do well in the coming economic environment. It is these kinds of companies that fill our portfolio.
Q3 2020 Commentary: Vaccine watch . . .
October 2020
Q3 2020 Commentary: Vaccine watch…
Let the good times roll? The incongruence of the march higher in the stock market versus an economy that is still rocked by the covid-19 pandemic is striking. Certainly, the sheer magnitude of the CARES Act funding has helped sustain the economy. When much of the stimulus funds came to an end in August, enough cash had already been pumped into the system that its effect continues to be felt. Furthermore, the gradual re-opening measures have also contributed to the partial recovery from the initial economic shock. So, despite the shutdown and limited reopening, the economy has bounced back better than was generally expected. Current conditions give investors hope we will survive 2020 and turns the focus toward 2021 and beyond. In that regard, optimism persists.
Enough positive news in the 3rd quarter drove the continuation of the stock market rally off the March 23rd low. The S&P 500 advanced 8.5%. In the bond market, the Federal Reserve continued to reiterate it is not even thinking about thinking about raising interest rates. With rates stable and at pegged at very low levels, the bond market returned 0.6% in the quarter.
Surprisingly, strong economic numbers in the summer propelled stocks higher. Stimulus continued to ricochet through the system. The news has sustained investor belief that the economic environment can survive until the pandemic can be controlled. However, when the augmented unemployment benefits ended in August and prospects for another round of stimulus bogged down in Congress, stocks struggled highlighting the importance of further stimulus to the stock market.
At this moment, further stimulus appears to be caught up in election politics, but another package, in some form, will ultimately be passed providing further support for the economy and the stock market. Federal Reserve Chairman Jerome Powell, in speeches and congressional testimony, has repeatedly reiterated the need for further aid to keep the consumer charged up buoy the economy. From here, the overwhelming factor supporting stocks is the stimulus package. Well, the stimulus package…and a vaccine.
Progress on a Covid-19 treatment and a vaccine continues. Head of the National Institute of Health, Dr. Anthony Fauci recently reiterated a vaccine is likely to be approved sometime just before, or early in the new year. Widespread availability and a return to normalcy will come sometime thereafter. All signs point toward this eventuality, in the Spring at the earliest. The stock market has incorporated this relatively positive scenario into its expectations.
While stimulus continues and vaccine prospects meet targets, the market will be fine. We also need to remember that the economy is not the stock market. There is no doubt there has been vast damage to small business which makes up a large percentage of US employment. We see businesses close permanently all around us. However, the stock market, and the S&P 500 in particular, is made up of the largest corporations in the country that have many resources to manage through these times. We should expect the S&P 500 to outperform the economy. For many, buying the best of the best is a safe trade. Owning the Amazons, Googles and Microsofts of the market is expected to ultimately pay off even if one overpays today. However, real opportunity exists among the smaller companies and it is among these where patience and price sensitivity will be amply rewarded.
Q2 2020 Commentary: Expectations are up, will they be met?
July 2020
Q2 2020 Commentary: Expectations are up, will they be met?…
Financial markets bounced back sharply in the 2nd quarter from the 1st quarter Covid-19 swoon. Although the magnitude of the recovery was startling given the uncertainties we face, it was not wholly unexpected. The advance was triggered by anticipated events such as the massive stimulus bill that literally showered money on the economy. Initial attempts to re-open the economy after the shutdown also emboldened investors, although that is now reversing. In the quarter, the S&P 500 rose 20.5%, driven by large moves among the largest growth companies.
Meanwhile, many small and value stocks languished. Bond markets also performed very well as interest rates fell and bond prices rose as panicked “sell everything” selling pressure on all financial assets abated. The 10-year US treasury yield fell to 0.65% from 0.70% and the Barclay’s US Aggregate bond index gained 2.9%.
Currently, tens of millions of Americans have lost their jobs and more than a million people are filing for unemployment benefits every week. The Covid-19 pandemic continues to be as bad as ever, except, thankfully, for the death rate of those infected due to improved treatment of the disease. Political animosity rages on and demonstrations are daily events. Despite massive political, social, and economic problems, the stock market is not far from the all-time high levels achieved in February, before the Covid-19 pandemic surged. It is fair to wonder why.
There is a logic to the stock market recovery. First and foremost, the prospects for a treatment of covid-19 are encouraging. Already Gilead Science’s Remdesivir is being used in hospitals with some success. In recent weeks National Institute of Health Director Dr. Anthony Fauci has repeated that his examination of the research data leads him to believe promising treatment and vaccine candidates are likely to be identified in the fall and that a treatment, or treatments, will become available around the new year. Over the most recent weekend there were further encouraging reports of progress made in the research effort.
If a Covid-19 treatment is coming, all that needs to be done is to support the economy between now and then. If we can bridge that period by minimizing the damage to the economy, a substantial recovery can begin that will support the stock market. The government, in a rare act of bipartisanship, has demonstrated its willingness to do whatever it takes with the passage of the three trillion-dollar Cares Act aid program. This week it looks like there is further consensus in Congress to continue with more aid. Given these circumstances, we will be staying the course with our equity portfolios as we have throughout the pandemic.
A characteristic of the current stock market is the chasm between the performance of growth stocks and value stocks. This is a trend that has been in place for years and it continued in the 2nd quarter. The S&P 500’s growth stocks were up 26% while its value stocks rose only 13%.
We know this performance divergence cannot last forever. At some point the growth stock valuations will rise to unsustainable heights. Conversely, value stocks are heading toward valuations that are too cheap to ignore. Our portfolios contain a fair number of high-quality growth companies. The most likely portfolio activity going forward would be a migration from growth stocks back to more traditional value stocks. Ultimately, those decisions will be based on valuation and where we see the greatest appreciation potential over the long term.
Q1 2020 Commentary: It doesn’t matter, until it matters . . .
Q4 2019 Commentary: Hunting for value in a rising market . . .
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January 2020
Q4 2019 Commentary: Hunting for value in a rising market…
On December 31st we turned the page on a startlingly successful year in the stock and bond markets. The US markets lead the way, but global markets also performed very well. Fourth quarter results put a nice cap on the year with the S&P 500 adding 9.1% to the gains of the first nine months pushing the total return for the year over thirty percent. Interest rates continued to drift lower which added modestly to the year’s 8.7% return for the aggregate bond market index. Over the course of 2019, the US 10-year Treasury bond yield fell from 2.68% to 1.92% on the reversal in Fed policy from planned interest rate increases to ultimately lowering rates twice. As we wrote early in the year, don’t fight the Fed when they are lowering rates.
Stock market analysis does not have to be complicated and we try to keep it as simple as possible. Stock prices are a function of earnings and how much investors are willing to pay for those earnings. The year’s success was due to investors being willing to pay more for the same earnings because S&P 500 earnings in 2019 will finish essentially unchanged from those in 2018. The stock market’s more than thirty percent surge higher resulted from paying more than 18x those earnings at year end, up from 14x twelve months earlier. Growth prospects improved and investors are paying more for earnings. The price to earnings (P/E) multiple at 18.6x, is toward the higher end of our comfort zone. As earnings expectations move higher, those expectations will need to be met to justify current prices. Fortunately, with interest rates moving lower and the Fed on hold with regard to interest rate policy, we do not feel we are at dangerous levels and are merely proceeding with a measure of caution.
Just what is expected? The consensus estimate of earnings growth in 2020 is 9.5% with much of the growth expected in the second half of the year. That kind of growth is reasonable, particularly given the favorable economic backdrop and if a rumored middle-class tax cut comes to pass. Beyond general market levels, we are reminded that it is not just a stock market, but also a market of stocks (apologies for use of that hackneyed phrase, but stay with us) and there are sectors of the market that we view much more favorably than others.
Large growth companies and many technology stocks have moved to significantly higher valuations, while value stocks have languished. Value stocks have underperformed growth stocks for years now and in the last three years, in particular, the spread in the P/E valuation between the highest and lowest quintiles of the S&P 500 has become as large as it was at the peak of the technology bubble in 2000. This disparity cannot continue forever. So, while valuation for the S&P 500 has moved significantly higher, a significant portion of those companies have not participated. As a value investor, this spread has our attention and has coincided with a period of good performance in our portfolios despite the broad market struggling.
Despite our tilt toward value stocks, our portfolios have performed well over this period of growth stock dominance. The reason is because we have bought high quality growth stocks when they have been temporarily out of favor and reasonably priced. Those opportunities among growth companies have become scarcer as valuations have risen. However, other parts of the stock market have been relegated to investment oblivion and it is from this group that we can continue to find good companies at good prices. It’s a recipe for success that is proven over time.
Q3 2019 Commentary: One step forward, a half step back . . .
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October 2019
Q3 2019 Commentary: One step forward, a half step back…
The drum beat of serious concerns for the stock market hammered on during the summer, yet we find the S&P 500 just a few ticks off its all-time high levels. We’ve heard of the impending recession from many different sources, yet the unemployment rate is the lowest in 50 years. Economic growth continues quarter after quarter (for more than ten years now) and the US economy is projected to grow comfortably in 2020. It is quite a conundrum to be inundated with such pessimism in the face of an economy that continues to chug along. In the third quarter, the S&P 500 advanced 1.7%. Helping the stock market was declining interest rates in the US and around the world. Lower rates also contributed to another strong quarter for the bond market resulting in a 2.3% return for the Barclay’s US Aggregate bond index.
Of course, context and perspective are everything when viewing financial markets. The S&P 500 return in the first nine months of the year are the best since 1997 when the tech bubble was just getting going. However, the market has just been regaining ground lost in last year’s 4th quarter retreat. In fact, the stock market has barely advanced since the beginning of 2018, 21 months ago. Stalled earnings growth and political and trade uncertainty have certainly increased investor caution and kept the market from breaking through to new highs.
To categorize the current environment, we are inclined to drag up from the past an idea popularized by Pimco, the bond investment company, of the “new normal” in which economic growth coming out of the financial crisis would be modest for an extended period. So it has been, and so it appears still to be. The pattern has been re-established after a spurt of higher growth following the passing of the “Tax Cuts and Jobs Act of 2017.” In 2019 we have settled into growth that is plodding along in the 1.5% to 2.0% vicinity. Clearly, both the US and the global economy are slowing. The Fed has responded by cutting interest rates. Still, the US continues to add jobs and the consumer is in good shape and remains optimistic. With consumer spending representing 2/3 of economic activity, we think the economy can continue to muddle along as it has for so long now.
At heart we are contrarians. We believe the best values are found by going against the consensus opinion and this perspective informs our current outlook. Yes, Europe, China and Asian economies have slowed and Europe’s economic engine, Germany, is probably already in a recession. All of this is well understood and already reflected in current stock prices. It is the primary reason the stock market has barely advanced since the beginning of 2018. However, as contrarians, we want to be fearful when others are greedy and greedy when others are fearful, to paraphrase Warren Buffett. In other words, invest when current conditions are poor, but subject to improvement.
The global economy will respond to low interest rates. Significant fiscal stimulus is likely and will lead to a turn in the global economy and improving conditions in 2020. The trade and tariff wars are likely to recede for political reasons. A recession could be catastrophic to the President’s re-election prospects. If it looks like tariff escalation could seriously impede the economy, we believe the President is likely to back away from further trade conflict. Under this scenario, the investment environment has plenty of room for improvement in 2020 and as pessimism abates, enthusiasm for stocks can rise. With the stock market valued at a reasonable 17x earnings, there is more than enough reason to stay the course we have maintained through the expansion.
Q2 2019 Commentary: The Fed’s got our back . . .
Q2 2019 Commentary: The Fed’s got our back…
Don’t fight the Fed. Is that all there is to it? The experience of the past nine months would argue yes, that is the case. That bromide is tossed around whenever the Federal Reserve seems intent on moving interest rates in a particular direction. If rates are going down, buy stocks. Be cautious if rates are rising. In the Fall, the Federal Reserve signaled its intention to raise interest rates over the course of the coming year and the stock market sold down sharply. By January, faced with concerns about economic growth, the Fed indicated it might reverse course on its interest rate intentions. Since that time, the stock market has recovered from its losses and moved to all-time highs. The stock and bond market extended very good first quarter performance in the second quarter. The S&P 500 gained 4.30% and posted its best first half of the year since 1997. The Bloomberg Barclays U.S. Aggregate Bond Index rose 3.08%, primarily due to the 30-year U.S. Treasury yield falling from 2.41% to 2.00% during the quarter.
The new high for the S&P 500 came after marking time since its last high almost 18 months ago. The catalyst then was the new tax law that lowered many tax rates passed in late 2017. Remember, the stock market anticipates what is to come and prices stocks in anticipation of strong earnings and earnings growth to come. Gains in 2017 came in anticipation of 2018 earnings and the expectations were met.
When we consider an appropriate level in the stock market, the focus must be on earnings which is the economic part of the equation. In general, as earnings go, so goes the stock market and a strong economy should translate into strong earnings growth. The second part of market valuation is sentiment and how much investors are willing to pay for earnings. That level is most often expressed as a multiple of earnings or the price to earnings ratio (P/E). When investors are confident about the future, they are willing to pay higher prices for stocks. Bull markets typically end when confidence becomes so great and prices paid for stocks are at such a high valuation that results do not meet expectations. This most famously occurred at the height of the dot.com bubble when a survey of investors revealed that they expected to realize annual returns well in excess of 20% even though the long-term average was in the neighborhood of 10%.
Currently, we are nowhere near market bubble levels, nor is investor sentiment overly confident. Even though the economic expansion became the longest on record in July, investors remain skeptical. Their skepticism stems from uncertainty. Economic uncertainty in the form of slowing global economies, trade and tariff uncertainty, and political uncertainty are all raising investor angst. Whether its domestic turmoil or increasingly contentious foreign policy, all these factors raise uncertainty and lower the amount investors are willing to pay for stocks. One of my colleagues describes current investor sentiment as a fear of heights. However, just because we are at new highs, it does not mean we need to fear a major sell-off. Modest volatility is to be expected and the stock market valuation has moved higher, but it is still within a reasonable historic range.
Coming full circle, however, let’s not fight the Fed…nor the Bank of Japan…nor the European Central Bank…nor the People’s Bank of China. Lower interest rates have driven nice stock market returns in the first half of the year. The global effort to jumpstart the world economy will lead to better growth later in the year and continued good results for our portfolio of stocks.
Q1 2019 Commentary: Eyes on the horizon
Q1 2019 Commentary: Eyes on the horizon
For an extended period of time the stock market exhibited an extraordinary period of calm. Volatility was very low, and the stock market went for historic periods without a major correction. In the last year that has changed, and the oscillations of the market have become more extreme. Last Summer we had the best quarterly return in five years. That was followed by the worst quarterly performance since 2011. In the first quarter, immersed in a government shutdown and a slowing global economy, the stock market advanced by the greatest amount since 1998. The S&P 500 advanced by 13.7% for the quarter and has continued to march higher in April. As of this writing, the stock market is within a single percentage point of the all-time high set in September of last year. Although prospects for stocks are generally positive, we should be prepared for market fluctuations similar to what we have experienced in the last year.
The stock and bond market recoveries from 4th quarter woes were triggered, almost entirely, by the Federal Reserve’s announcement that interest rate increases were on hold. The Fed was reacting to signs that both the US and global economies were slowing. The bond market response to the Fed abandoning planned interest rate increases was for the yield on the 10-year US Treasury to plummet and bond prices to push higher. Higher prices propelled the Bloomberg Barclays US Aggregate Bond index 2.9% higher in the quarter.
Tax cuts fueled a torrid rate of earnings growth for the S&P 500 in 2018. However, expectations for early 2019 turned much lower reflecting the anticipated slowdown in the economy. First quarter earnings estimates are 3% lower than a year ago, which will be the first year-over-year earnings decline since the second quarter of 2016. The prospect of flat earnings, a slowing global economy, political and trade turmoil and the Fed’s position to keep raising rates pushed investors to the sidelines. It must be remembered that financial markets are always reflecting what investors, in aggregate, are expecting in the future and projecting what is to come. Last Fall, they did not like what was on the horizon. In the first quarter, that changed.
With the Fed on hold, expectations for growth have taken a turn for the better. There is a concerted global effort to spur economic growth. Chinese monetary policy has been very accommodative and interest rates in Europe are falling and have even gone negative in Germany. These actions bode well for later in the year and the stock market is overlooking the current rough patch with expectations that earnings growth will resume in the 2nd half of the year.
Beyond the Fed standing down on further interest rate increases, additional developments have spurred investors to buy stocks. Foremost among them are the diminishing prospect of a continuing or expanded trade war with China. It seems that the best situation for the stock market with regards to the trade war would be for negotiation to linger on. Every time a white house official proclaims there has been progress in the trade talks, the stock market responds favorably. As soon as there is an agreement, expect its impact on the market to fade. In the meantime, the bond market has done the job for the Fed. Lower interest rates have raised optimism for the rest of 2019. The economy continues to be strong. Despite the move higher, the stock market is not near an extreme valuation and we continue to be positive about portfolios going forward.
Q4 2018 Commentary: The Fed Pivots
Q4 2018 Commentary: The Fed Pivots
What do you follow up the best quarter in five years with in the fourth quarter? The worst quarterly performance since 2011. Yes, volatility is back. The S&P 500 gave back all the gains of the first nine months and then some in the fourth quarter resulting in a 4.4% decline for the year. The large cap index fell 14.0% in the quarter. For all of 2018, there were very few financial markets that performed well. International stocks fell. Emerging market stocks fell. Bonds dropped. Commodities collapsed late in the year. With a rather dramatic six months in the rear-view mirror, most forecasters seem to expect more of the same in the next six months. While stock market volatility is likely to persist, we view the current situation quite favorably and an environment in which we expect your portfolio to do well.
There is some concern regarding economic growth in 2019, however the most probable outcome is for continued, but slower growth. The key for the stock market lies with inflation. As long as inflation remains near the Federal Reserve’s target of 2.0%, the Fed and can act to promote economic growth and full employment. At this point, there are no signs of inflationary pressure building despite the long expansion. Economies around the world are slowing. The German economy contracted in the 3rd quarter and does not look to have improved in the 4th quarter. The rest of Europe will follow Germany’s slowing path and the UK has serious Brexit issues. China’s growth in 2018 slowed to its slowest pace in three decades. In the face of the slowing global economy, demand for commodities has fallen and their prices along with them. Tumbling commodity prices is no better exemplified than the price of oil falling from $75 to below $50 in the 4th quarter.
Absent inflation concerns, the Fed and its international counterparts have no need to continue raising interest rates. Fed chairman Powell indicated in December that the Fed is likely to stand pat if current conditions persist. Chinese authorities are already taking steps to strengthen their economy and the European Central Bank have essentially ruled out any rate hikes until 2020. This situation means that investors no longer need to fight the Fed and that monetary tightening will not pose a threat to the economic expansion continuing.
A potential benefit of the slowdown is the impact on various US trade negotiations. As economies weaken, the pressure will build on both to strike a trade deal. In the meantime, it is reasonable to expect further volatility due to the rise in geopolitical uncertainty. Since the Berlin wall came down marking the end of the cold war in 1991, we have been conditioned to practically ignore politics in investment deliberations. However, events of the past year have had an impact on the stock market. Trade wars are impacting economies and shifting policies are raising uncertainty which leads to a lower price that investors are willing to pay for earnings. The price to earnings multiple on the S&P 500 contracted significantly in the past year and now stands at 15X. Last year was one of adjusting to a new paradigm that had a negative impact on stock prices. At this point the adjustment appears to be substantially complete and political risks seem to be already reflected in the market. Despite slowing growth, the economy is still doing well. Investment sentiment appears as half full or half empty depending on your perspective. In recent months, investors embraced a half empty view. We are comfortable with investment prospects and finding attractively priced stocks. We view the investment landscape as a glass half full and feel that in time most will join us in our view.
Q3 2018 Commentary: “healthy normalization”
Q3 2018 Commentary: “healthy normalization”
Best quarter for stocks in five years. Let that thought settle in for a moment. The bull market that is now in its tenth year continues to churn out positive returns. Despite the extended bull run, signs of market excesses are hard to find and market mavens continue to remain skeptical of the bull market’s endurance. Indicative of the skepticism, the Investment Company Institute reports that investors are still pulling money out of stock funds and stock ETFs. Last quarter, $51 billion was withdrawn from these funds. Still, the stock market continues to climb the wall of worry. One worry in particular has everyone’s attention, rising interest rates. The 10-year US treasury yield rose to 3.06% on 9/30 following the Federal Reserve’s rate hike in the last week of the quarter.
As good as the quarter was, October has been the reverse. Large growth stocks and technology stocks have come under sharp selling pressure. Still, it is hardly time to abandon stocks. The stock market is doing what it does; it fluctuates. The path to higher prices is not a straight line. In recent years we have become so accustomed to a tranquil market, that a few bad days sparks an overwrought reaction. However, many stocks in the S&P 500 have already been going through a correction. Currently, more than seventy percent of the S&P 500 stocks are down by more than 10% for the year and many are down by more than 20%. Corrections have been few and very far between over the last five years. The current retreat is the opportunity we have been waiting for to put cash into the stock market at attractive prices.
We are not beginning a bear market. The US economy is unequivocally in a strong position. GDP growth was 4.2% in the 2nd quarter and the Blue Chip Economic Indicators consensus estimate for the 3rd quarter calls for 3.4% growth. Unemployment is a very low 3.7%, while an average of 190,000 jobs are being added to the economy each month and wages are growing for workers. The Federal reserve is raising rates, however it is only moving from accommodative to neutral monetary policy. JP Morgan Chase CEO Jaime Dimon called it a “healthy normalization” after years of artificially low rates. Rate policy will continue to be measured and not something that will derail the economy. In a series of speeches, Fed officials have confirmed their belief that the US economy is strong and inflation remains well contained. Fed Chairman Powell projects that unemployment can remain under 4.0% and inflation at 2.0% for the next three years. If inflation remains in check, Fed policy will remain at neutral and we will continue to enjoy a good investment environment.
There are issues that are concerning, but they remain just that. It is too soon to say whether slowing global economic growth, higher tariffs and production costs, or rising interest rates will stifle the economy. However, agreements with Mexico and Canada on trade and the potential meeting with the Chinese in November bodes well for the trade situation. The economy appears strong enough to handle these headwinds. Meanwhile, the surge in corporate earnings continues. The strong economy, the boost from the corporate tax cut pushed year-over-year earnings growth to 24% in the 2nd quarter. Growth in the 3rd quarter is projected for 19%, and the 4th quarter is estimated at 17% before moderating to 7% in the 1st half of 2019. Because earnings have been so strong, the stock market valuation has actually gone down since the beginning of the year. The state of the economy and prospects for further earnings growth, raises our conviction for a good stock market going forward albeit with more volatility.
Q2 2018 Commentary: political headwinds are just that
Q2 2018 Commentary: political headwinds are just that
Generally, politics has little impact on our investment process and decision making. Most government policy just does not impact the outlook for our investment portfolio in a meaningful way. For the first time in a long time, however, politics is forcing its way into our thinking about the investment environment.
Foremost among concerns for the bull market’s prospects are the trade conflicts the US has started with countries around the world. Unfortunately, the threat of tariffs and trade wars is not going away any time soon. At this point, the conflicts are only skirmishes and we do not believe they will develop into something that dramatically alters the investment landscape. The economic impact is not yet significant, and the greatest impact has been on stock market valuation. If the threats continue or escalate, investor uncertainty will increase, and investors will become more cautious. The impact on the stock market of investors becoming more cautious is a lower valuation of stocks. Our outlook could change, but for now tariffs are only a headwind for the market and not something that will cause a serious stock market event.
The US economy keeps chugging along. Job growth has been steady, adding around 200,000 new jobs each month. The unemployment rate fell to 3.8% before ticking back to 4.0% last month. The reason for the uptick was due to people re-entering the job market which is actually a sign of strength. In his semiannual testimony before Congress, Fed chairman Jerome Powell was unequivocal that the economy was strong. He reiterated that tax cuts and government spending would sustain demand going forward and there is little threat of recession. Inflation is running close to the Fed’s 2.0% target which has allowed the Fed to take a measured approach to interest rate increases which investors have accepted without problem.
In response to economic strength, the Federal Reserve raised rates in June to a range of 1.75% to 2.00% and signaled that it was prepared to continue raising short term rates steadily into 2019. However, a byproduct of the Fed’s interest rate action is what’s called a flattening yield curve in which short-term and long-term interest rates converge. The 2-year US Treasury yield was recently just 0.24% lower than 10-year US Treasury yield. The spread was the lowest since 2007. Historically, a flat yield curve has not necessarily provided a reliable signal about the economy. However, an inverted yield curve, in which short term rates rise above long-term rates, has been a significant event that often precedes a recession. For this reason, the yield curve has attracted a lot of attention. The situation is a concern, but again not so much that we change our outlook. An inverted yield curve is a rare occurrence and until it happens we can stand pat.
Investor sentiment has become more cautious and that has been reflected in higher volatility this year. Investor concerns have led to the first half of 2018 being a mixed bag for the stock market. Still, the S&P 500 is up for the year. We must not forget the economy is sound, inflation is under control and earnings growth continues to be robust. Third quarter S&P 500 earnings are expected to grow by over 20%. Meanwhile the market price to earnings valuation is a comfortable 16 multiple. We have been in a long bull market and at some point, it will end, but we do not think it will happen any time soon.
Q1 2018 Commentary: . . . a pause that refreshes
April 20, 2018
Q1 2018 Commentary: …a pause that refreshes
Just like that, the extended record of calm in the stock market came to an end. While there were only 8 days last year in which the S&P 500 traded up or down by 1% or more, there were 23 such days in the new year’s first quarter alone. While a more volatile stock market may not feel very good following such a smooth ride last year, it will ultimately be to our benefit.
In the aftermath of tax cut legislation and strong fourth quarter earnings, the stock market surged higher by more than seven percent in January. However, unexpectedly high January employment costs reported in the first week of February triggered concerns about inflationary pressure and the threat of a more aggressive rate hike timeline by the Fed. These concerns, along with an increased fear of trade wars breaking out on multiple fronts, turned investors cautious and the stock market gave back its January gains in February and March. For the quarter, the S&P 500 finished with a modest 0.8% loss, the first negative quarterly return after nine consecutive quarterly gains.
Interest rates pushed higher, and like the stock market the primary driver was the fear of inflationary pressure. The Federal Reserve chairmanship was assumed by Jerome Powell who appears set to continue along the course set by his predecessor, Janet Yellen. As long as the economy continues on its current trajectory, interest rates will continue to inch toward a neutral policy. Long term rates have been drifting higher and the US 10-year treasury yield moved 0.40% higher in the first quarter to settle at 2.80%. The Federal Reserve seems committed to a controlled and well telegraphed interest rate policy that will not upset financial markets. However, rising rates will be a headwind for bond prices and was the cause for modest losses in the bond market. The aggregate US bond market index fell by 1.5% in the quarter.
Rising stock market volatility is a welcome change. Larger swings in the stock market is advantageous to our investment process. As a contrarian investor, we rely on systematically taking advantage of investors overreacting to market news or a company’s short-term problems. For the past few years there have been very few significant downward moves in stock prices. Historically, the stock market has experienced a 10% correction around once per year. We just experienced our first 10% correction in two full years. Sasser Investment Management anticipates and plans for making changes to portfolios during these times that allow us to increase the quality of our holdings and buy stocks at attractive prices. In the present environment, we are seeing considerably more potential opportunities than we have in some time and believe this will lead to favorable returns going forward.
Whatever may be happening in Syria, North Korea or Washington DC, it is not having a major impact on financial markets. Investors simply do not believe these situations will have any significant impact on corporate earnings and neither do we. Our focus will never stray very far from what is happening to corporate earnings because earnings drive stock prices. At this point, the earnings news is all good. All eleven economic sectors in the market will have revenue and earnings growth for the second quarter in a row. First quarter results are now estimated to grow by more than 17%. The S&P 500 is trading at sixteen times expected earnings, which is a comfortable market valuation. The current bull market is getting long in the tooth, but we see no reason for it to end any time soon.
Q4 2017 Commentary: . . . and the beat goes on . . . and the beat goes on . . .
January 15, 2018
Q4 2017 Commentary: …and the beat goes on…and the beat goes on…
It was a remarkable year for financial markets in 2017. The stock market traded persistently higher with practically no volatility. We could run through a litany of impressive market statistics but suffice it to say that stock market returns were very good, and the investment environment was as stable any other one-year period in the last hundred. We have now gone an unprecedented 300 plus days without the stock market retreating by even 3.0%. The S&P 500 gained 6.6% in the fourth quarter, rising in each of the three months in the quarter. In fact, the S&P 500 posted gains in every month of the year, the first time that has ever happened going back to the large-cap index’s inception in the 1920’s. Bond returns suffered in the quarter from rising interest rates, yet the Barclays Aggregate Bond Market index still managed a 0.4% return.
It was a simple formula that led to the 2017 returns. The resumption of earnings growth and a stable interest rate environment fueled the stock market. After more than a year of stagnant earnings, going back to 2015, growth resumed in 2017. The S&P 500 companies increased their cumulative earnings by more than 10% for the year and fourth quarter earnings, being reported now, are on track for another quarter of double-digit growth. The US economy has been growing at a rate above 3.0% for that last few quarters. In addition, the global economy is growing across the board. In 2017 every member country of the Organization of Economic Co-operation and Development (OECD) will have growing economies, the first time they all have grown in unison in ten years. More importantly, global economic growth estimates are ratcheting higher for 2018.
With economic growth increasing around the world and the US economy growing at a solid pace, we are confident US corporate earnings growth will be sustained through the year. The corporate tax cut and repatriation of corporate cash held outside the US will also provide a boost to economic activity. The tax cut is already having a major impact on stock prices in January and should continue to be beneficial through the year. Therefore, from an earnings perspective, we have every reason to be positive about the stock market in the year ahead.
How successful corporations are at growing earnings is only half of the equation for our stock market outlook. Of equal importance is how much investors are willing to pay for earnings. At this time, the S&P 500 is trading around 18x this year’s expected earnings which is historically on the high side. Trading at higher multiples of earnings is justified in the low-interest rate environment which has existed since 2008. However, higher interest rates may be coming, and they are probably the greatest threat to stock prices. We will be watching carefully for higher rates and factors that may lead to higher rates. One factor we will have our eye on is inflation.
Persistently low inflation has allowed the Federal Reserve to maintain a zero-rate policy that pulled the economy through the financial crisis. However, change may be coming. Commodity prices are creeping higher. Oil prices have moved above $60 per barrel. In addition, we are approaching full employment in the US and the potential for wage inflation is rising. One example of rising wages is WalMart raised wages to employees in the aftermath of the corporate tax cut. Finally, the weaker dollar will raise the cost of imported goods. Thus far, inflation has been well under the Fed’s 2.0% target rate. Until inflation increases and significantly impacts interest rates, the investment environment remains positive and a major correction unlikely.
Q3 2017 Commentary: No doubts, winning streak continues . . .
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October 15, 2017
Q3 2017 Commentary: No doubts, winning streak continues…
The eerie calm in the stock market has extended into the Fall. In the week ending September 22, the total trading range of the S&P 500 was just 12.3 points, or 0.49%, the lowest weekly trading range since 1972. This absence of volatility has persisted all year. The S&P 500 has traded up or down by more than 1% on only 8 days in 2017. The last year the number of 1% trading days was lower at this point in the year was 1972. Furthermore, in our last letter we highlighted the extended period since the last 5% correction in the market. That streak continues and as of last week is now the longest on record having exceeded the previous record of 333 days. For the quarter the S&P 500 advanced 4.5% and it has now had positive returns for eight straight quarters. It really does not get much better than this.
But wait there’s more. This business cycle has now moved into its 99th month of economic expansion, which is the 3rd longest expansion since 1902. Of course, the Federal Reserve has shepherded the economy along through massive monetary stimulus and artificially low interest rate policy. If one wants to quibble, one could argue the expansion has been marked by only moderate growth, but eight years on we would have to rate the Fed policy a success. Economies are growing in all corners of the world and global economic growth estimates are rising. Interest rates are still low and will remain low even after the Fed bumps the discount rate again in December.
At the beginning of the year we expressed that it would take a resumption of earnings growth to take stocks higher. At that time, we were on our fifth straight quarter in which aggregate quarterly earnings for the S&P 500 had been lower than the previous year’s. Stock market momentum appeared to be flagging. Thus far, we have certainly gotten the earnings growth we were looking for in the first half of the year. Earnings advanced by more than 10% each quarter and the stock market has responded accordingly. Third quarter earnings are estimated to grow by 2.8%. However, if we exclude insurance company losses due to hurricane damage, earnings would be significantly higher. Our outlook for the stock market will continue to be favorable as long as we project earnings growth to continue.
We do need to keep an eye out for signposts of irrational activity in the market. Recently, Bioptix, a company that licenses fertility hormones for livestock, announced it was changing its name to Riot Blockchain and getting into the cryptocurrency business. Cryptocurrencies, like Bitcoin, are unregulated digital currencies. Bitcoin has appreciated more than 400% this year. In response to the Bioptix announcement, its stock surged higher. This reminds me of the sleepy little chain of book stores that added .com to its name in 1998. When Books a Million changed its name to Books a Million.com the stock price leapt from $3 to $38.94 within two days. This brand of lunacy has been largely absent in this bull market. If we start to see more of this kind of thing, our concerns will mount.
One thing that has been consistent in this extended bull market has been the skepticism with which investors have viewed it. Investor skepticism is healthy for the stock market. Market bubbles occur when investors lose all caution. We may be in the early stages of that skepticism waning. For now, however, we will stay on the same track we have been following. The ingredients that have gotten us this far are still firmly in place.
Q2 2017 Commentary: Slow and steady is winning the race . . .
July 20, 2017
Q2 2017 Commentary: Slow and steady is winning the race…
In 2009, the large bond investment manager, Pimco, dubbed the post time of shedding and cold rocks environment as the “new normal.” The new normal was an environment in which the massive buildup of global debt over many years would restrain economic growth well into the future. It is now eight years later and the new normal has become the old normal. The US has experienced a long period of growth, but it has been slow growth, exactly as Pimco predicted. Only the hyper stimulative efforts of monetary authorities around the world have kept economies and financial assets growing. The cost of these policies is even more debt and the likelihood that long-term real growth exceeding 3.0% in the US will be very difficult to achieve.
Economic and financial conditions have been so steady that one almost has to feel pity for the financial media. It must be difficult to attract viewers when there are so few panic inducing headlines to blast us with. Since the Brexit vote more than a year ago, there has been precious little financial market volatility. In fact, the S&P 500 has not corrected by 5% since that vote last Summer. According to LPL Financial’s senior market strategist, Ryan Detrick, there have only been six other periods of this length without a 5% correction since 1950. The most recent was all the way back in 1995. Though we marvel at how calm the markets have been, it is not completely baffling when we take a step back and realize how stable the economic environment has been. Economic growth has been very steady around two percent. Some quarters have been a little faster and others a little slower. Inflation has been low. With the investment backdrop being so stable, it is little wonder financial markets have been as calm as they have been.
The only real events that have roiled the market at all, is talk of monetary tightening around the world. In Europe, Mario Draghi hinted that the European Union may begin to curtail its bond buying program like the US did when it ended its quantitative easing four years ago. In the US, speculation that the Federal Reserve would begin to reduce the leverage on its balance sheet also raised investor concern. Any action that might slow down economic growth would be unfavorable for earnings growth and put pressure on stock prices. However, slow and steady has been a winning combination for the stock market. The second quarter saw the S&P 500 rise 3.1%, adding to gains in the first quarter. Long term interest rates fell modestly, despite the Federal Reserve raising short-term rates. The 10-year US Treasury note’s yield fell from 2.40% to 2.30% sending the aggregate bond market index 1.4% higher for the quarter.
We are not particularly concerned that Federal Reserve policy will derail the stock market. It is abundantly clear that Janet Yellen and the Fed will move very, very slowly and deliberately toward normalizing Fed monetary policy. As long as inflation remains subdued, the Fed will be under no pressure to accelerate its timetable and disrupt the economy.
As we have expressed recently, further earnings growth will be required to take stocks higher. In 2017, so far so good. In the first quarter, the S&P 500 earnings greatly surpassed expectations growing by 15%. Second quarter earnings are expected to grow by 7%. Analysts are forecasting 8% to 12% growth in the second half of the year. The second half estimates may be aggressive unless tax cut legislation is passed. Still, growth is expected without a tax cut. We find ourselves locked into the winning combination of a steady economy, low inflation and earnings growth. Under these conditions, me maintain our favorable investment outlook.
Q1 2017 Commentary: Rising market expectations . . .
April 30, 2017
Q1 2017 Commentary: Rising market expectations…
Six months ago, we were talking about the resumption of earnings growth by the S&P 500 companies and in the fourth quarter we were not disappointed. For the first time since the third quarter of 2015, earnings for the S&P 500 were higher than the previous year’s level. Earnings growth has continued in the first quarter and this growth and the prospect of continued growth is propelling stocks higher. In the first quarter, the S&P 500 rose 6.1% led by large growth companies and the technology and real estate sectors.
As anticipated, the Federal Reserve raised the federal funds rate by one quarter percent continuing its move to normalize interest rate policy. The Fed was comfortable taking this action because economic trends have consistently indicated the economy is capable of self-sustaining growth. Despite short term rates rising, long term rates have held steady. The 10-year US Treasury yield fell slightly, moving from 2.44% to 2.40%. As we have seen over the course of the current bull market, rising earnings and low rates provide powerful fuel for the stock market. These conditions are expected to continue.
Rising long term interest rates would be a significant obstacle for the stock market to overcome. However, higher fourth-quarter have yet to materialize and we do not expect them any time soon. The stable 10-year Treasury yield reflects the expectation that inflation will remain low. In the first quarter inflation was moderate and there were no red flags among commodity prices and wages that might alarm the bond market. Furthermore, the announcement that first quarter GDP grew at a sputtering 0.7% annual rate is sure to postpone a rise in rates. First quarter GDP growth was the slowest in three years and reminds us that the economy is still stuck in the moderate growth mode that has persisted since 2009. At this point, there is little risk of an overheating economy spurring rates higher.
The Trump rally continues, but the rally can be attributed more to the growth in earnings in the fourth and first quarters than anything the Trump administration has accomplished. The news on first quarter earnings is good. Of companies reporting so far, 77% have exceeded their consensus estimate. The S&P 500 companies are on track for earnings to grow by more than 12%. Also significant is that the quality of the growth is sound. The past few years, revenue growth has been anemic and often earnings growth has been manufactured from cost containment and share buybacks. However, first quarter revenues are growing at better than 7% which is the highest rate since 2011.
Earnings growth is all well and good, but the S&P 500 is already trading at 17x this year’s earnings estimate. To justify current market levels, future growth prospects must be sustained. Investors are fully expecting a major source for this growth to come from the new president’s legislative policies. With that in mind, the train wreck effort to reverse Obamacare could be viewed as a blessing for investors. Instead of getting bogged down in a legislative quagmire over healthcare, the Trump administration has turned to , the tax reform and other pro-growth policies that investors initially expected. If the administration can push forward with these initiatives, the bull market can continue. New policies boost future earnings expectations which ultimately support stock prices.
Q4 2016 Commentary: Trumped . . .
January 23, 2017
Q4 2016 Commentary: Trumped…
Before the election and after the election. One needs to clarify that timeframe when discussing anything about financial markets in the fourth quarter. In the month prior to November 8th, the S&P 500 had drifted consistently lower. On November 9th, the market turned around and took off. One needs to go back to the 1980 election to find such a dramatic and abrupt change in investor sentiment after an election. The stock market rose 9% in the period between Ronald Reagan’s election and his inauguration. The Trump rally had a similar dimension. Both Ronald Reagan in 1980 and Donald Trump today promised to “make America great again.” We’ll see how it turns out this time around.
The post-election turnaround carried the S&P 500 to a 3.8% gain for the quarter. In the bond market, the strengthening economy and the well telegraphed and expected rate hike by the Federal Reserve in December moved interest rates higher and consequently bond prices lower. The 10 year US Treasury yield rose significantly from 1.61% at the beginning of the quarter to 2.45% at year-end. The impact of higher rates drove the Barclay’s Aggregate Bond index down 3.0% in the fourth quarter.
The Trump rally is based on faith. Faith that taxes will fall, regulatory red tape will be unwound and infrastructure spending will surge. For now, investors have enthusiastically anticipated what they expect to come. Any or all of these actions are likely to positively impact earnings growth which would support stock prices at current levels. However, it would not be a surprise to see some turbulence in financial markets after the inauguration once the realities of governing are faced. We are not in the business of making predictions, but it feels very much like there has been so much anticipation of the Trump presidency, that any hiccups along the way toward implementing the Trump agenda will be problematic for the market. Until Trump was sworn in anything and everything was possible and investors have embraced what is to come. However, what is possible and what transpires are often very different, particularly in the messy world of politics.
Still, the turn in sentiment in the US has been profound. The National Federation of Independent Business optimism index in December saw its biggest one month increase since July 1980 and the University of Michigan Consumer Confidence index is at its highest level since June of 2004. Confidence in the economy has been sorely lacking since the recovery began seven years ago, and its recovery bodes well for the economy. With expectations running high, if the Trump economic agenda is passed in the coming monthsquarter-point the stock market could move significantly higher just on enthusiasm alone.
Further support for equity markets comes in the form of earnings. Earnings growth returned to the S&P 500 in the third quarter for the first time in a year and estimates for the fourth quarter are rising. It is mid-way through this earnings announcement period and FactSet Research forecasts that fourth-quarter earnings will grow by 3.4%. data-driven confidence, political reform, and earnings growth are a recipe for further gains in the stock market. There will be periods of turbulence and market dips that we will view as buying opportunities. Higher stock prices have led to a number of the portfolio’s holdings approaching their price targets. Further gains may lead to higher than usual turnover as we reposition the portfolio in the first half of 2017.
Q3 2016 Commentary: Calm but no storm . . .
October 25, 2016
Q3 2016 Commentary: Calm but no storm…
The S&P 500 marched forward in the third quarter under relatively benign conditions. Most of the gains were achieved in the first weeks of July. Stocks then entered an extended calm period before ending the quarter 3.9% higher. The Summer is generally considered a slow time for financial markets. “Sell in May and go away” is a long-standing Wall Street axiom. However, in the past two years we experienced major market corrections during this time. Many expected similar upheaval this year considering the stridency of the presidential election and speculation over interest rate policy. It was not to be. Prior to September 9th, the S&P 500 went 44 days in which it did not move more than one percent. Meanwhile, the market volatility index, VIX, fell to its lowest level in two years during this extraordinary period of tranquility.
The bond market managed to rise 0.5% in the quarter and was buffeted by speculation that the Fed would raise interest rates at the September FOMC meeting. Having held interest rate policy steady in September, any Fed rate hike is off the table until its December meeting as it is customary not to change monetary policy around the time of national elections. However, a consensus is forming that rates will be raised by the end of the year. The Fed still maintains that any rate hike will be “data-driven” and there will be plenty of data released between now and December such that no rate decision is certain. A quarter point rate hike, if implemented, is manageable as it will only confirm that the economy is on solid footing
We have no doubt that volatility will increase, but not so much to create undue concern. The election is almost behind us and is having little impact on financial markets at this point. Between now and the end of the year, we believe expectations for corporate earnings will exert the greatest influence on stocks. As we have mentioned previously, earnings growth has stalled since 2015 and given the level of stock prices relative to earnings, we are inclined to believe it will take a resumption in earnings growth to take markets higher. It is the middle of quarterly earnings reporting season and results are encouraging. FactSet Research reports the S&P 500 companies are on track for quarterly year over year revenue growth for the first time since 2014. Earnings growth is expected to resume in the fourth quarter following a third quarter that looks to be essentially flat. For reasons we can’t identify specifically, there is currently a high degree of unease among investors. We do not feel this trepidation is warranted and believe no major market correction is imminent. Global fiscal and monetary stimulus, corporate earnings growth and rising employment instill confidence in our current position.
At the end of the day, our investment philosophy and decision making are not determined by the economy, or politics or market trading patterns. At its core, we are making a judgment on the quality of a business and the price at which the market allows us to purchase it. We believe in being patient and waiting for the time when a good business can be bought at a once in a generation price. We must not be unduly influenced by the ever-present factors that can distract us from this mission. It is a common refrain to hear that the market is too rich, or too volatile or too risky to act now. Interest rates, oil prices, terrorism, warfare etc. are cited as reasons to take to the sidelines. However, we don’t invest in markets, or countries, or industries. We invest in companies for the long term. At any particular time, there are many companies trading at low valuations or thirty percent or more off their recent high prices. The best of these companies are candidates for the portfolio. For these stocks, there is no reason to wait. The price is right.
Q2 2016 Commentary: Moving quickly beyond Brexit . . .
July 22, 2016
Q2 2016 Commentary: Moving quickly beyond Brexit…
For all the hullabaloo the Brexit vote caused in June, it ultimately made little difference to US equity prices. The initial shock that triggered a two-day market retreat was followed by a swift three-day recovery. In fact, by July 11th, the S&P 500 had gone on to make new all-time highs. That’s what’s known on Wall Street as climbing a wall of worry. For the second quarter the S&P 500 gained 2.46% as prospects for interest rate hikes dimmed. Following the trend around the world, interest rates in the US slid further. As a result, the bond prices rallied and the aggregate bond market advanced 2.2%.
If Brexit is going to be a train wreck, it is going to be a slow motion train wreck. It will take years for the process to play out. If I had to, I would bet that the peak of Brexit’s impact on the market has already passed. Because Brexit will change the economic and political landscape over an extended period, it will have little impact on our current investment outlook. Mario Draghi, President of the European Central Bank, estimates that Great Britain leaving the EU will slow European economic growth by just 0.5% over three years. The immediate fallout from Britain’s vote to leave the EU is the renewed strength in the dollar and lower long-term interest rates. The dollar has surged against the pound and strengthened against most currencies. A strong dollar could slow earnings growth just as it did in 2015 and perhaps delay the resumption of earnings growth necessary to move the stock market higher in the second half of the year.
The 10-year US Treasury yield fell to an all-time low of 1.36% earlier in July. At the beginning of the year, the Fed was expected to bump short-term rates higher by as many as four times. Now, there is ,doubt that there will be any rate hikes in 2016. The prospect of stable, or even lower interest rates removes a , concern for investors and has been immediately beneficial to stock prices as the shock from the Brexit vote fades. We expect further pressure for lower rates going forward. With rates in Japan and Germany in negative territory and many other sovereign rates around the world well below those of the US, investors will want to own US debt. Strong demand will keep long-term rates very low for the foreseeable future.
Last August and again in February we experienced , rapid 10% corrections in the stock market. Both times we used the opportunity to acquire strong companies at attractive prices. During broad market corrections, selling is indiscriminate and all stocks go “on sale”. Finding high quality stocks at discount prices becomes easier. However, the circumstances are different when the stock market is making new highs and valuations rise. In this environment, uncovering investment opportunities requires more focus. Company specific issues trigger selling in a stock that creates a discount to long-term value. Many companies stumble in their execution of short term operations and shortsighted investors dump their stock. However, temporary problems do not impair long-term prospects. More often than not, it is these situations that we rely upon for our investment ideas.
There is no doubt that unusually low interest rates have supported a higher market valuation. In addition, US stocks are considered by many to be the best investment alternative right now. Given low rates and positive sentiment, we can expect higher valuations to persist. The stock market may be hitting new highs and stocks are no longer cheap, but it does not mean we need to be defensive. We will always be wary, but good investment opportunities are still available.
Q1 2016 Commentary: Follow the earnings . . .
April 20, 2016
Q1 2016 Commentary: Follow the earnings…
Markets completed a round trip during the first three months of the year. The S&P 500 finished the quarter higher by 1.3% but not before getting off to the worst start to a year in stock market history. By February 11th the S&P 500 had fallen by 10.5%. More importantly, the mood of the market continues to swing rapidly between pessimism and optimism. Investor sentiment veered toward pessimism over concern for poor economic growth in the US and fears of global economic recession. However, the mood rapidly changed for the better following a rebound in job growth and the Federal Reserve’s signal that it would raise interest rates more slowly than previously planned in 2016. The number of rate hikes planned this year has been reduced from four to two. The response in the stock and bond markets has been uniformly positive and the catalyst for the recovery by the end of the quarter.
Much as we have maintained for the past six years and reiterated over the past six months, economic growth will continue to be moderate. There will be some months in which the economy pauses and others when growth appears to be accelerating. However, when reviewing the most recent numbers, it is apparent the economy is doing just fine. If financial markets get hung up on specific data points, all the better for our portfolios. It is incumbent upon us to have the discipline to take what the market gives us and use volatility to our advantage. We were buying in February near market lows and were able to initiate positions in companies at attractive prices.
With our focus on bottom-up stock selection, we are much more concerned with the outlook for corporate earnings than macroeconomic trends. Last year’s earnings for the S&P 500 companies did not exceed the previous year’s. An earnings recession is generally defined by lower year over year earnings for at least two consecutive quarters. The S&P 500 companies are now reporting what will be their fourth consecutive quarter in which aggregate S&P 500 operating earnings are lower than the previous year’s total. Granted much of the decline can be attributed to the disaster going on in the energy and commodity sectors. However, if we exclude the energy sector’s results, earnings in the first quarter are still expected to be down 4%. Stagnant earnings growth reflects the slowdown in international markets, particularly China and Europe, and the impact of the strong dollar on currency translation and the higher cost of US goods abroad.
As the market worked its way higher since February, the price/earnings ratio of the stock market has expanded to its approximate historic average. For the market to move higher, either earnings or the price/earnings ratio must grow. With somewhat elevated PE ratios, we expect it to take earnings growth to take stocks higher. It hardly seems a coincidence that the stock market has struggled to move higher for more than a year while earnings growth has stalled. However, as we look toward next year the prospects for earnings growth improves. Oil prices are stabilizing and the energy sector losses will subside. Global economic growth will pick up as the enduring stimulative government policies around the world gain traction. Finally, the headwinds over the strong dollar will abate as the dollar is already weakened versus world currencies over the past five months. In politics, they say to follow the money. We would suggest that stock market investors follow the earnings. In the next year, we will follow the earnings and the stock market higher.
Q4 2015 Commentary: Be not afraid to buy low . . .
January 25, 2016
Q4 2015 Commentary: Be not afraid to buy low…
After noting last quarter how we had finally experienced a ten percent market correction after four years, we have again seen the stock market fall by more than 10% as we began 2016. In fact, this is the worst start to the year ever for the stock market. A return to more “normal” market volatility after four exceptionally calm years may be disconcerting to some, but it does provide the disciplined investor a greater opportunity to buy stocks at attractive prices. In the August period, we were able to put cash into the market at some of the best prices of the year. We are using the current period to rebalance portfolios and again add to the stock portfolio. This is the time to position portfolios, not for the next month, but for the better environment, we expect in the next year.
The S&P 500 was actually lower at the end of the year than it was at the outset. Dividends pushed the year’s total return into positive territory to 1.4%. In the 4th quarter, the stock market recovered much of the losses experienced in the summer. Like the stock market, the bond market had an up and down year. The Barclay’s US Aggregate Bond index total return in 2015 was 0.5%. The low-interest rate environment is a large reason for the meager return. However, fears of the Federal Reserve raising rates had a negative impact and the high yield bond sector, which has a large representation of energy companies in it, was the weakest sector of the bond market due to the rising threat of borrowers defaulting on their bonds.
A significant number of stocks did not do well in 2015 and they were not just oil stocks. Much of the year can be characterized by rolling bear markets within rotating sectors of the market. Energy stocks collapsed during the year along with oil prices. The end of the year was marked by significant underperformance by retail stocks. Entertainment, drug, biotech and other industries had significant corrections at various times of the year. In the plainest terms, it was a difficult year for anyone to make money in the financial markets. In early January, Oscar Shafer pointed out in the Barron’s Roundtable, 70% of the Russell 2000 index of small US stocks, 49% of the S&P 500 stocks and 68% of Nasdaq stocks were trading more than 20% off their 52-week high price. Since that time the indices have continued lower.
Our private real estate backed loans continue to do well. All loans outstanding performed as expected and all loans yield at least 8.25%. We have been able to expand the number of these loans we can offer although the timing of availability is still irregular.
We would reiterate what we have expressed for the past year. The investment environment is not as bad as most recent bad news might indicate nor is it as good as any good news might suggest. We have been and will remain in a moderate growth economy. Slowing economic growth outside the US and the strengthening dollar have stalled earnings growth. After a very good three year period in the stock market, a pause is not unexpected. We will move past the negative impact from last year’s stronger dollar. Interest rates will remain low and with monetary authorities in Japan, China, Europe and elsewhere around the world providing stimulus to their economies, we can expect global growth prospects to improve in 2016. It all adds up to a resumption of earnings growth and a better stock market from current levels.
Q3 2015 Commentary: Ripples on the pond
November 2, 2015
Q3 2015 Commentary: Ripples on the pond
For the first time since the summer of 2011, the stock market experienced a 10% correction from its most recent high price. Four years is an exceptional period of time without a major market disruption. Despite rallying in September, the S&P 500 fell by 6.4% in the quarter. We view the quarter’s stock market activity as a return to a more normal pattern of volatility in which five or ten percent corrections are more frequent. In 2011 US debt was downgraded and Congress was threatening to close down the government. Well, Congress is still threatening a shut down over debt limits, but this time around it was fears of slow global economic growth and rising interest rate concerns that sent markets down. However, following the pattern we have seen for the past four years, market weakness has been followed by a swift recovery.
We are comfortable with current market levels. Stock market measures are moderate and not at any sort of extreme levels. Market valuation is in the vast gray area in which stocks are roughly fairly valued and trading within a comfortable valuation range. Price to earnings based on estimates for the next 12 months on the S&P 500 is not cheap, but neither is it particularly expensive at 16x. With interest rates still low and Asian and European financial authorities committed to six-yearvery loose monetary policy, we believe staying invested is the best strategy. As demonstrated in September and October, a market retreat is likely to be shallow and short-lived. Economic weakness will hand-wringing with further monetary stimulus and pro-growth government action. Diverging from long term portfolio asset allocations is not justified by today’s favorable investment environment.
The current investment environment reminds us of a Rorschach test. Like a Rorschach test, each observer of the stock market can see just about anything they want to ,. Stocks can look expensive by one measure, but cheap if you exclude certain sectors. Low oil prices are hurting the energy sector, but helping the transportation and travel industries. The labor market may look like it is improving since unemployment is threatening to go under 5%, however the labor participation rate, a measure of the labor force relative to the population is very low indicating plenty of slack in the workforce. It seems inevitable that no matter what the latest news brings, either positive or negative, we will continue to muddle along in the moderate growth environment which we have experienced for the many years now. The economy will not be as good as the most recent strong report may indicate, nor will it be as bad as the next poor economic release might suggest.
We are moving cautiously toward new investment opportunities. As contrarians we are intrigued by the energy sector. It has been more than a year since oil prices started falling yet it appears we are still a long way from a recovery in oil prices. Despite the number of working wells being cut by more than half, inventories are still high. Oil in storage in October was at the highest level in 85 years. Until supply begins to fall into balance with demand we will sit patiently. The largest of the S&P 500 growth companies have performed well thus far in 2015 and have supported the index level. However, many of the components of the S&P 500 have not fared so well. Smaller companies, in generalfirst-quarter are looking more attractive than they have in some time. Individual stock performance is really a mixed bag with no specific industries looking particularly cheap. Opportunities are on a stock by stock basis and we are encouraged by what we are finding.
Q2 2015 Commentary: Beneath the surface
July 25, 2015
Q2 2015 Commentary: Beneath the surface
There were a number of concerns for the financial markets in the second quarter that did not amount to much in terms of market price. Between the financial “crisis” in Greece, economic and stock market concerns in China, and interest rate uncertainty in the US, there was much to talk about. However, the hand-wringing did not translate into stock market volatility. Ultimately, the stock market nudged higher with the S&P 500 rising 0.3% in the quarter. Stocks have spent much of the first half of the year in positive territory, but have been regularly retreating to where we started on January 1st. Interest rates drifted higher in the spring with the expectation of the Fed raising interest rates. Rising interest rates results in lower bond prices and the Barclay’s US Aggregate Bond index fell by 1.7% accordingly.
We have enjoyed two years of steadily rising US stock prices with very little volatility. During this period, the rise in earnings has not kept pace with the rise in stock prices resulting in a higher price to earnings ratio for the stock market as a whole. In other words, the stock market has become more expensive. The S&P 500 now trades at eighteen times this year’s earnings estimate, which is above the historic average. The six-year rise in market valuation is concerning because it cannot go on forever and, in general, means that it becomes harder to find attractively priced stocks. To justify higher prices we will eventually need earnings to grow.
Earnings in the first half of the year have been a mixed bag and these results go a long way toward explaining this year’s stock market action. In the first quarter, the consensus earnings estimate for the S&P 500 fell significantly and by the time earnings were reported in April the S&P 500 companies were expected to report earnings that declined four percent versus the prior year’s first quarter. However, first-quarter earnings beat expectations by a considerable amount and actually ended up rising slightly. This unexpected performance has supported stock prices at current levels. Similarly, in the second quarter, the S&P 500 companies’ earnings were expected to decline by 4.5%. Of the companies that have reported thus far, earnings have declined by 2.2% according to Factset Research; better than expected but not great either.
There is cause for optimism, however, once we dig into the numbers. The energy sector is a gigantic drag on earnings with a whopping 54% estimated decline in the 2nd quarter. If the energy sector earnings are excluded, earnings grow 4.1%. As we pointed out in an earlier letter, the strong dollar negatively impacts earnings for companies with large international sales. Again according to Factset Research, S&P 500 companies (ex-energy) that do a majority of their business in the US are on track for 8.3% growth. Once we strip out energy companies, US companies are doing better than appears on the surface.
Given, the modest earnings growth we have experienced thus far in 2015, it is understandable that stocks have struggled to move higher. Flat earnings growth translates into a flat stock market. We must be patient while earnings catch up to stock prices. The economy remains well positioned to continue its six-year expansion. Employment is up and the Fed will continue its accommodative policies. On balance, we remain positive about the portfolio and see no compelling reason to assume a defensive posture.
Q1 2015 Commentary: Ripples on the pond
April 25, 2015
Q1 2015 Commentary: Ripples on the pond
The current US economic environment is eerily similar to this time last year. Severe winter weather (though apparently not quite a polar vortex) in many parts of the mid-west and eastern regions of the country seems to have caused a significant slowdown in economic activity. The March employment report showed only 126,000 jobs created, which was about half of what was expected. In addition, the number of jobs created in the previous two months was revised lower by 69,000. This lull in job creation set off alarms that the US economy might be in trouble. However, like last year we see little reason why the economy will not pick up as the weather improves. The recipe for economic growth that has driven the economy for years now, remains firmly in place. Inflation is low, monetary policy is loose and the risk of the Fed changing its policy anytime soon has dropped significantly.
During the quarter, concerns about economic growth and low inflation pushed the ten year US Treasury yield down to 1.93% from 2.17% at the beginning of the year. Estimates of first-quarter economic growth have been revised significantly lower. In January, the consensus estimate of first-quarter growth was 3.0%. By the end of the quarter, the expectation was for 1.0% growth. The Federal Reserve has been given little impetus to raise interest rates and most Fed watchers have pushed the timeframe for rates to rise from June to much later in the year. Furthermore, monetary policy remains very accommodative, almost without exception, in countries around the globe. Belief that interest rates will remain in place through government policies around the world, provides powerful support for stock prices. We do not see a reason to fight the Fed and remain positive about the stock market.
We do have some concerns. There is little doubt that the Federal Reserve’s interest rate policy has supported stock prices since 2009. With interest rates at such low levels, investors are seeking someplace to earn decent returns. That place has been the stock market. Following the time of shedding and cold rocks and subsequent bear market, many shell-shocked investors swore off the stock market. Since then, investors have been slowly coming back to stocks. At some point, however, one can have too much of a good thing. As more money is directed toward stocks, the market valuation has expanded. The Value Line Investment Survey of 1700 stocks was trading at just 10x earnings in 2009. Since then, the market multiple has expanded to 19x earnings. As the price to earnings ratio expands, we become increasingly uncomfortable. Investors have become emboldened by returns over the past two years and are slowly turning from fearful to greedy. The potential for prices to rise to dangerous levels has increased. We are not there yet, but we are on guard against it.
For a contrarian investor, extremes create opportunity. Any time major events have a large impact on the stock market, opportunity is created for the contrarian investor. The collapse in oil prices will create opportunity in energy stocks. Extreme interest rate policies are likely to create distortions in market prices that can turn advantageous for the opportunistic investor. Market volatility has been very low for an extended period, but that seems to be changing. The change would be welcome and very positive toward our outlook for future returns.
Q4 2014 Commentary: Moving on.
January 20, 2015
Q4 2014 Commentary: Moving on.
Another year removed from the time of shedding and cold rocks of 2008-09 and another good year for US financial markets is in the books. The memory and pain of the 38% decline in the S&P 500 in 2008 still lingers in investors’ minds, but the markets have moved on. The 13.7% gain in 2014 marked the sixth consecutive year in which the stock market advanced. Volatility, as a proxy for investor angst, has been at historically very low levels over the past two years. Distressed property transactions have returned to pre-crisis levels. It is time to turn the page on that chapter in the markets.
The equity market finished the year strongly with the S&P 500 rising 4.9% in the quarter. Interest rates continued to fall, which pushed bond prices higher. The US aggregate bond index rose 1.8% in the fourth quarter and 6.0% for the full year. Frankly, there is not much mystery why results were very good for stocks and bonds this year:
Economic growth rebounded to 5.0% in the 3rd quarter after weather-related problems slowed growth early in the year.
Unemployment fell from 6.6% in January to 5.6% in December.
Jobs created averaged 246,000 per month vs 194,000 in 2013.
The ten year US Treasury yield fell from 3.03% to 2.17%.
Inflation was less than 1.0%
Operating earnings for the S&P 500 are on track to rise 8%.
Let’s see…good economic growth, check…low unemployment, check…falling interest rates, check…gas prices below two dollars per gallon, check. It really doesn’t get much better and, fortunately, it appears that these conditions will persist. Mario Draghi’s recent announcement that the European Central Bank would commence its own massive, US style, quantitative easing program will support a strong dollar and attract foreign investment. Relative to the rest of the world’s economic problems, the US represents the proverbial best house in the neighborhood. International demand for US stocks and bonds will support prices going forward. It remains to be seen whether the US economic engine can keep chugging along when much of the rest of the world is teetering toward recession. However, with quantitative easing in full swing in Japan and Europe, we are inclined to believe that the US economy will be fine. The decline in the price of oil, while detrimental to oil industry employment and earnings, will benefit all US consumers as they pay less for gas and energy.
Despite the economic travails in Europe and Japan and the slowing growth in China, the 800 lb. gorilla in the investment room is still the price of oil. Since last summer, the price of a barrel of oil has collapsed by more than 50%. As a contrarian investor, we are naturally interested in the investment opportunity this kind of price decline can create. At $46 per barrel, many oil wells are not profitable. Drilling rigs are being shut down and exploration budgets are being slashed. As we have often heard recently, the cure for lower oil prices is lower oil prices. Lower prices bring reduced exploration and well closures that will bring supply into balance with demand. However, reducing supply is a slow process and it makes sense to bide our time for now. At some point in 2015 we expect investment in energy companies will make sense and produce exceptional returns for years to come. We are not at that point…yet.
Q3 2014 Commentary: Interest rates going nowhere
October 20, 2014
Q3 2014 Commentary: Interest rates going nowhere
Rarely do macroeconomic or political events exert significant influence on our investment decisions. We construct portfolios with a bottom-up approach, finding good companies at a discount price. Over the long term, economic conditions have far less impact on results than disciplined selection of individual securities. Specific company performance will ultimately determine its stock price. It is a good idea, however, to be aware of changes in the global arena because they can guide us to opportunities. A strengthening US dollar and collapsing inflationary pressures are two current changes that must be acknowledged in the global investment environment.
Since 2008, governments the world over have provided massive amounts of stimulus to the global economy. All the while, investors have been terrified this monetary stimulus would ignite inflation. However, no inflation has appeared and recent signs point to disinflation. In Europe, governments are more concerned with deflation and there is little to suggest short-term will turn higher anywhere. Growth is meager outside the U.S. and commodity prices are plummeting. The price of oil has collapsed and the part-time of gas in the US is at a four year low. Wages, another significant component of inflation, are stagnant. Average hourly wages are up 2% over the past year despite the improving labor market. There is little to fear from inflation.
The US dollar appreciated 7.7% against world currencies in the third quarter. The Euro stood at
1.37 versus the dollar at the beginning of the year and now stands at 1.26 to the dollar. The strong dollar impacts the price of international goods and services. Imported goods will be cheaper, while US exported goods become more expensive for purchasers outside the US.
In a low inflation and a strong dollar world, interest rates will remain very low. Cheap imports and lower gas and heating bills will benefit the consumer. Companies that sell directly to the US consumer should have the wind at their backs. On the other hand, companies with a high percentage of international earnings may find themselves less price competitive in , markets because of the strong dollar. As investors, we try to put as many factors in our favor as possible when we construct a portfolio. By stacking the odds in our favor, we create an advantage. Given what’s going on in the world, we would prefer to add a domestic company whose business benefits from low inflation and a strong dollar. The retail sector, mentioned as an attractive sector for investment in our last letter, fits this profile and we expect good things from the positions we have added in this group.
Reported earnings for the S&P 500 companies in the third quarter have been good. Employment reports indicate the economy is on firm footing. The recent downturn in the market is the first meaningful sell-off in the stock market in a year. With stocks off 7% from the September high, we have been able to put cash to work at attractive prices or reposition portfolios for the turnaround to come. We have been waiting patiently for lower prices and are taking advantage of them now that they are here. Bear markets result from excess, yet market dynamics are hardly excessive,and prices are fair. Our expectations for the stock market remain positive for the year ahead.
Q2 2014 Commentary: Market keeps rolling along
July 25, 2014
Q2 2014 Commentary: Market keeps rolling along
The good times keep rolling along for US financial markets. Market volatility is very low and a rising market continues to defy expectations for some sort of correction. It has now been more than 1000 days since the last time the S&P 500 fell more than 10% from their high. This is the fourth longest period since 1984. It would appear that the US economy has survived the winter polar vortex and continues to grow moderately. In the 2nd quarter the S&P 500 rose 5.2%. Sasser Investment Management’s stock portfolios have generally exceeded the market’s return for the first half of the year. The bond market continued to defy expectations that interest rates will rise. In the second quarter, the ten year US Treasury bond yield fell from 2.72% to 2.51%. Consequently, the bond market had another solid quarter returning 2.0%.
The most direct evidence of the nasty impact winter’s weather had on the economy was the downward spiral in the first quarter’s reported economic growth. The initial GDP report in late April was for a measly 0.1% expansion. However, the final number published in late June showed that GDP fell by a whopping 2.9%. Much of the poor result can be explained away by the weather, one-time events, and inventory numbers. These apparently dismal numbers were generally ignored because . Currently, we prefer to keep our eye on the employment numbers as a critical signpost for the economy. Indeed, the employment situation is decidedly more upbeat. In June, the Department of Labor announced the US added 288,000 jobs and revised the total for the previous two months higher as well. The average monthly increase in jobs over the previous three months is 272,000, which is the highest since May of 2006. The lone caveat to the employment picture is that many of the new jobs are only part-time, but the employment situation is still improving and keeps us positive about the economy and financial markets.
Our investment process relies heavily on a contrarian strategy in which we find companies that are cheap because they are out of favor. Investors with short-term investment horizons sell stocks en masse when short-term problems arise. Stock prices then tumble and opportunity is created. A very good and recent example of this kind of situation comes straight off the cover of the July 14th Barron’s which exclaims – “Retail on Sale.”
It has been a difficult period for retailers in general. According to Barron’s the six worst performing stocks in the S&P 500 in 2014 are retailers. In addition, comments from Wal- Mart’s CEO explicitly stated that job growth is not translating to retail sales. Many retail stocks have badly lagged the market. At some point, however, job growth must spur consumer spending. Now is the time to position for the rebound. One candidate for the turnaround is Target. Over the past year, persistent problems with its expansion into Canada, a large credit card data breach and a generally weak retail sales environment pushed the stock price from $73 to the mid-50’s; that is retail on sale. At its current price the stock yields 3.6%. Eventually, Target will get it right in Canada and operations will improve. At 20% off, Target is the epitome of a name brand on sale. There are still enough stocks like Target out there to be found and that makes us confident about our portfolios going forward.
Q1 2014 Commentary: Opportunity still knocking
April 25, 2014
Q1 2014 Commentary: Opportunity still knocking
After a prolonged period in the stock market without a 5% correction, we finally got one in late January. As has been consistently the case over the past eighteen months, the selling was short livedlonger-termand stocks reversed course swiftly and within a month we’re back to making new all-time highs. Ultimately, the S&P 500 finished the quarter positively, gaining 1.8% after including dividends paid. Signs of a stumbling economy, weather-related or not, helped to drive interest rates lower and give a nice boost to bond prices. Municipal and emerging market bonds performed very well, recovering from weakness in 2013. Like the S&P 500, the US aggregate bond market index advanced 1.8% in the quarter.
A resumption of historically average market volatility would be to our benefit. The stock market is currently valued within a broad range of what we would consider fair value. The global economy is something of a mixed bag but is generally showing moderate growth. The US continues its below average recovery. Fears of a serious slowdown in the US were pretty much put to rest with the most recent employment report. Job growth of 192,000 in March and a revision higher for the previous two months indicate the economy is stable. Weather problems over much of the country are expected to delay, but not cancel spending. With little that can derail the economy and a stock market that is within the range of fair value, maintaining our current allocation of stock market exposure is appropriate.
The Federal Reserve, under the new leadership of Janet Yellen, has maintained the policies of her predecessor and continued the process of weaning the economy from its stimulus efforts. Scaling back the monthly mortgage and Treasury bond purchases continues and the Fed will have headlong from the market by the end of this year. These actions are just another step along the way toward more normal markets. In recent years, stocks have in their movements. That is, stocks seemed to move in lockstep as macroeconomic events took precedence in driving stock prices in what came to be known as the “risk on, risk off” trade. Stock market correlation is now much lower and we are seeing stock prices fluctuate more due to industry and company-specific fundamentals. In this environment, our contrarian based investment process will be rewarded. As industries and companies fall from favor, prices will fall to attractive levels and we will be a for acquiring at these prices over the long term.
This quarter marked the five year anniversary of the bear market low in March 2009. It has justifiably taken investors a long time to get over that period’s stock market and financial system crisis. It was a traumatic time and far worse than the 1987 crash or the bursting of the tech bubble because of the very real fundamental threat to our entire financial system. However, by most measures, the excesses of that period have been exorcised and systemic shocks are unlikely in the immediate future. At present, markets make sense; for the moment at least.
Q4 2013 Commentary: A remarkable year.
January 25, 2014
Q4 2013 Commentary: A remarkable year.
Financial markets were both remarkable and unremarkable in equal measure in 2013. Remarkable certainly is that the S&P 500 finished the year at its all-time high and rose 32.4%. This return was the index’s largest annual gain since 1997 and came despite an economy that is still growing modestly and experiencing annual corporate earnings growth that is a pedestrian five percent. In this environment, our stock holdings performed well. The bond market continues to suffer from interest rates creeping higher and the US aggregate bond market index fell 2.0% in 2013. Unless there is a crisis that causes investors to pile into US bonds as a safe haven, we expect the upward pressure on rates to continue and for the US bond market to continue to struggle as the economy improves slowly, but steadily.
Unremarkable in 2013 was stock market volatility which was the lowest since 2007 as measured by the S&P 500 volatility index. More importantly to investors, the stock market traded in a very limited and stable range over the entire year. Historically, the stock market experiences around three market corrections of five percent or greater per year. In 2013, however, the S&P 500 did not correct by more than five percent even once. When the market did retreat, it did so for just a handful of days before turning around and heading back to new highs. Our outlook was and is positive, but we have waited for more significant pullbacks in the market to invest cash.
The tranquility in financial markets is remarkable when one considers that the events of last year included Congress’s fiscal cliff standoff and sequestration in the first quarter, significant tax increases and a spike in longer-term interest rates mid-year, and the government shutdown and the commencement of the taper from Fed bond purchases in the fourth quarter. All of these events are reason enough to give investors pause, yet they continue to go headlong into US stocks because they are viewed as the only viable investment alternative. Bond investments pay little interest and are subject to interest rate risk. The real estate debacle is still on peoples’ minds and economies around the world appear worse off than our own.
From a strategic standpoint, we have been conservative and sold stocks as their valuations rose and hit price targets. A market correction is overdue and likely to be of greater magnitude at the current higher market valuations. Over the course of 2013, the median price to earnings ratio (PE) of the Value Line stock index increased from 15 to almost 19. With valuations creeping higher there is a narrower margin for error in the performance of the economy and the stock market. It is now even more important to buy with a discipline to both protect the gains we have achieved and to position portfolios for gains in the future.
Peter Lynch, the long retired, but legendary portfolio manager of the Fidelity Magellan fund is known for saying that if one spends “more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” Lynch’s quip is relevant to the current environment. We find little reason to fixate on the economy. There will be ups and downs, but it will continue along its slow growth path much as it has for the past four years. Our time is better spent and our returns will be maximized if we can find great investments. At present, we have our eyes set on a number of opportunities that meet our investment criteria and look promising for inclusion in the portfolio. Their time will come.