Market Highs Absent the Euphoria
Equity investors entered 2016 with low expectations. Nine months later, markets are just shy of all-time highs. Year-to-date gains of 8% for the S&P 500, 4% for the MSCI All-World index, and 6% for the Barclays Aggregate Bond index have pushed us to these near record levels. After a greater than 10% correction to start the year, and the quick drop and pop from the Brexit vote, markets have steadily trended higher, including a historically calm two-month stretch in the summer without a 1% or greater daily swing. Income-focused investors, in particular, have experienced solid capital appreciation as fears over rate hikes gave way and the rush to buy stocks with relatively attractive yields went into another gear. Our dividend-focused clients have enjoyed this 2016 tailwind.
Yet, despite these gains, Wall Street and most investors are far from euphoric. Participation remains rather narrow with many companies still far from their highs. The market has been more interest-rate sensitive than earnings driven, and negative sentiment has kept investors defensively positioned. Love or hate this bull market, the question is “What to do from here?” On the following pages, we share our views, including highlighting some developments about which we worry and get excited. The worry side of the equation seems disproportionately weighted toward policy and leadership risks. The excitement side is rooted in frequent proof that individuals continue to innovate creating improvements to existing and exciting new companies in which to invest. Or, as President George Washington more eloquently put it “a people… who are possessed of the spirit of commerce, who see and who will pursue their advantages may achieve almost anything.” Thus, we continue to believe a diversified portfolio with exposure to equities that will participate in the upside from these pursuits makes sense for long-term investors.
Banks in the News Again, but Not Like 2008
Down 46% year-to-date, global banking giant Deutsche Bank’s market capitalization stands at a paltry $18 billion, despite having $2 trillion in assets. Last week, the U.S. Department of Justice (DOJ) requested the bank pay $14 billion for its mortgage lending practices. Some Deutsche Bank depositors and trading customers withdrew funds, which elevated fears of a run on the bank. Whether the DOJ thinks it will actually collect the fine, or maybe just liked the idea of aiming high after the European Union jumped over Ireland to levy its own $14 billion tax on Apple, we’ll never know.
To provide some context for the erosion of confidence in Deutsche Bank, Wells Fargo’s balance sheet is smaller but its market capitalization is twelve times greater. As for comparisons to 2008, Deutsche Bank’s issues have limited direct ramifications in the U.S. Yes, its global derivatives and commodity-heavy loan book raises lots of questions, particularly about unknown counterparty risks. Yet, despite protestations to the contrary it seems unlikely the German government would allow a Lehman-like failure. Regardless, it is important to note that unlike many of the major European banks, U.S. banks significantly deleveraged in the years following the financial crisis and have substantially increased liquidity.
As for Wells Fargo and its unauthorized account scandal, the extent of the fallout, including any moves to break up big banks, likely depends on the election outcomes. In the meantime, investors comfortable with the regulatory risks and that the scandal eventually passes, can collect a 3.4% dividend, which represents just 38% of Well Fargo’s now reduced expected earnings in 2016.
Federal Reserve: Did We Say Data Driven?
Looking back to January, many expected four Federal Reserve rate hikes in 2016. In June, the expectation had dwindled to two. After last week’s Federal Open Markets Committee (FOMC) meeting, it looks like we may get one come December.
According to Chair Yellen, “we judged that the case for an increase has strengthened but decided for the time being to wait for further evidence of continued progress toward our objectives.” Perhaps the Chair and FOMC could benefit from the sagacity of the late, “King of Golf” Arnold Palmer, when he said “the most rewarding things you do in life are often the ones that look like they cannot be done.”
We have been skeptical of the Fed’s willingness to follow through on rate hikes. Thus, we have sought to add fixed-income exposure upon any jump in yields throughout the year. Going forward, it is important to remember the Federal Reserve’s control of the interest rate landscape has its limits. With a yield of 1.6%, the Ten-Year Treasury stands roughly where it began the third quarter. Yet three-month LIBOR (the rate at which banks are willing to lend to each other) is at 0.8%, which is its highest level in seven years.
The LIBOR spike is largely attributed to money-market ”reforms” regarding asset pricing. Specifically, the removal of the customary $1 price floor has contributed to nearly $1 trillion of outflows from primarily commercial issue money markets to government-issue money markets. So, while the Federal Reserve can keep moving the goal posts associated with a decision to increase rates, fast-changing investor sentiment, and the resulting fund flows, can override policy objectives. In recent years, foreign investor flows into the U.S.’s fixed-income and real-estate markets have helped push prices to record highs. With nearly 30% of government bonds around the world yielding 0% or less, the U.S.’s relative attractiveness even after the costs of currency hedges is understandable. However, we are watching this international arbitrage situation closely. Because any credit or currency events that reduce foreign investors’ appetite for U.S. fixed-income and real estate could negatively impact asset prices independent of any Fed policy position.
Year-to-Date Equity Leaders Versus Laggards: It Pays to Pay a Dividend?
Other than some high-profile winners such as Amazon, which has returned nearly 75% from its February low and is up 24% year-to-date, dividend-centric stocks have led the charge in 2016. Even the NASDAQ’s impressive 10% gain in the third quarter was buoyed by rallies in Apple, Microsoft, and Intel — all technology companies with at-or-above-market dividend yields. Utilities and Telecom have increased 16% and 18%, respectively, thus far in 2016. Energy is the only sector that has performed better, up 19%. On the flip side, financials continue to lag up 1% year-to-date. The margin-compressing low-rate environment, Wells Fargo’s mess, and faulty European bank balance sheets have weighed on U.S. bank stock performance. Healthcare is another laggard, up only 1% thanks in part to political scrutiny of drug pricing and uncertainty regarding the future of the Affordable Care Act (Obamacare).
Utilities and Telecom did pullback in the third quarter when a September rate hike looked possible, which was consistent with our July comments regarding equity duration risks for these sectors. Despite this sell-off, most of our clients have benefited from 2016’s broader investor shift to dividend-focused equities. Whereas, many actively-managed funds entered the year overweight financials and underweight the equity yield plays. This has made for a difficult year for most funds. In fact, at last count, fewer than 20% of actively managed large-cap funds are outperforming the S&P 500 in 2016. The contrarian in us has led to the review of dozens of active funds, which have performed well in periods of heightened volatility. While always sensitive to the costs and tax-efficiency of any outside manager, we have selectively added exposure to some of these funds.
Bubble Trouble?
The S&P 500 currently trades at 18X 2016 estimated adjusted earnings and 21X actual earnings. As usual, the beginning-of-the-year earnings’ outlook has proved optimistic, in part because expectations for improvements in energy earnings have diminished. Of course, last week’s OPEC production cut and the resulting commodity bounce could stem the slide. Either way, our view is that equities in the aggregate are not in “bubble” territory. The S&P 500’s valuation remains above historical averages so U.S. equites in general are not necessarily cheap. And no doubt the investment incentives from leaving interest rates so low for so long has inflated some bubbles. We are still finding pockets of value, however, and are below nose-bleed market valuation metrics that have characterized most historical bubbles.
Having said that, we remain attuned to the valuation differences among different equity sectors. For instance, Utilities and Staples trade at 18X and 21X 2016 estimated earnings, respectively. REITs, which received their own categorization in the third quarter, trade at 31X “funds from operations” or effectively the cash available for distributions. At the other end of the spectrum, Financials are at 13X earnings. Generally faster growing Technology stocks are at 17X, which represents a discount to the broader market.
The premiums afforded relatively higher yielding, and perceived lower volatility dividend payers, are consistent with the investor thirst for yield we have discussed. While earnings predictability and less sensitivity to economic cycles arguably warrant a premium, the amount of premium is at historical highs, and the bond-like duration risks for many of these stocks are significant. Whether investors’ thirst for yield and “lower-volatility” have peaked, is subject to debate. What is less debatable, however, is the sectors’ correlation to interest rates. That means, the markets’ and our preoccupation with interest rates will continue.
New Investment Solutions Galore
For the late “King of Golf” and other uber wealthy retirees, interest rates and expected returns won’t impact where they vacation, live, or their healthcare options. For most retirees, pension plans, and endowments, lower expected returns and the current race to the rate bottom have serious implications. Wall Street is doing its best to try to solve the required versus expected low-return dilemma for these investors. In fact, it has been years since we’ve seen a greater stream of new investment solutions available to institutional and retail investors alike. Whether private equity for the masses, income producing or development real estate, structured notes, highly leveraged business rollups, or lawsuit and loan participations, these formerly niche offerings have gone mainstream.
As the number of public companies has fallen in recent years, some of these illiquid strategies have appeal. To evaluate, we run the numbers and weigh the risks of capital loss versus realistic return expectations. If it makes financial sense, is in the interest of our clients, and is consistent with their objectives we move forward. Unfortunately, the assumptions supporting attractive returns for many of these alternative investments look increasingly ambitious. Thus, as we think about investing cash we are holding for most accounts, we are convicted that doing nothing and patiently waiting for an asset class (traditional or alternative) to go on sale has historically proven an effective long-term strategy.
“Let our advance worrying become advance thinking and planning.” Winston Churchill
This summer, Woodmont distributed a client survey to help identify opportunities to improve the client experience. As part of this effort, we recently invested in tools that enhance our ability to establish and track clients’ long-term financial plans. We recognize many of our clients have their own resources to determine spending patterns, college savings, charitable gifts, and estate plans, relying on us solely for investment management. But, for those who look to us for a financial plan in addition to investment management, we would welcome an opportunity to update and test your plan using some of our new tools. Please let us know if you are interested. These planning tools can help determine the best financial recipe for meeting your long-term goals. We are as convinced as ever, however, that the real value lies in executing the plan, especially in an increasingly volatile and complex financial world. With seemingly endless options available to investors, we remain keenly focused on evaluating and selecting those investments that we believe will achieve our clients’ long-term investment objectives.
“Enlightened statesmen will not always be at the helm.” James Madison, Federalist №10, November 23, 1787
Regardless of your political preferences, it would be tough not to appreciate Madison’s wisdom given today’s political environment. Fortunately, Madison’s fellow founders shared his concerns. Their Constitutional solution? Establish three branches of government with significant checks and balances on the power of each. This separation of powers has and will be tested. Yet as significant, and deserved, as the general dissatisfaction and angst are this election season (on both sides), we believe the founders’ collective wisdom will supersede any limited enlightenment of today’s statesmen and stateswomen.
This political solace does not mean markets are not interested in the November 8 election, or any policy shifts it may represent. For months now, movements of certain sectors, and even currencies, have been correlated with changes in the polls. Healthcare (services and not pharma), energy majors and clean energy, small banks and insurance companies are viewed as beneficiaries under a Clinton presidency. The stocks of pharma, medical device, defense stocks, big banks and energy exploration companies generally do better on any uptick in Trump’s polling numbers. Most agree infrastructure participants win in either case, in part because of the long history of first term President’s promoting large stimulus plans. As for taxes, whether Trump or Clinton, we believe corporate rates and the repatriation of overseas cash are two potential areas for a stock market upside surprise. There is significant shared political interests in keeping corporate headquarters in the U.S. and bringing home some of the over $2 trillion sitting abroad. For individuals, it is tough to envision a scenario where tax rates for our clients go lower, increasing the importance of tax-efficient portfolios and planning.
Don’t Be Shy, and We Won’t Either
Thank you for your continued confidence. As always, please don’t hesitate to contact us if we can ever be of assistance. We value your trust and are here to answer your investment questions, and utilize our resources to update and test your financial plan. Best wishes for an outstanding fall season, and like you we’ll welcome the sun coming up on November 9th, regardless of the election outcome.
