1st Quarter 2015

Troubles are just the shadows in a beautiful picture.

– Professor Pangloss


The title quote from the perpetually optimistic protagonist in Voltaire’s satirical novel Candide seems to fit well with the current mood in the financial markets. Despite the shadows of European deflation, an over-leveraged Chinese economy that is running out of steam and a host of other economic and geopolitical risks, investors continue to bid up the valuations of risky assets. This behavior, of course, is largely driven by the expensive price of ‘safe’ assets. Europe currently faces negative interest rates, even for high quality corporate borrowers. Today, one could purchase Nestle bonds maturing in February 2018, and through that date lock in an annualized return of -0.7%. Denmark appears on the verge of offering negative interest residential mortgages. While the current environment does not war- rant panic, it would be nice if valuations reflected some probability of bad outcomes. Instead, the yield and return chasing behavior that tends to occur late in market cycles continues to become more prominent.

The momentum of large cap US stocks faded during the first quarter, with the S&P 500 returning 1.0%. Small cap fared somewhat better, with the Russell 2000 Index returning 4.3%. The Utilities sector, which returned 29% last year, suffered modest declines. Energy continued to drag, driven by low oil prices and uncertainty over the financial health of smaller producers. Growth stocks continued to outperform, driven by a recovery in Technology and continued strong performance from Healthcare. In a reversal from 2014, non-US stocks outperformed with the MSCI EAFE Index of developed non-US markets returning 5.0%, despite continued strengthening of the dollar. Japan’s economic recovery led it to be this year’s best performing major non-US market. Commodity-producing emerging markets continued to lag while commodity importers such as India and China performed well. Nevertheless, China remains at risk due to its slowing economy and overhang of corporate debt.

Current S&P 500 Valuations Forecast Mediocre Future Returns

Since 2010, S&P 500 earnings growth has slowed to below 8%. P/E expansion accounted for nearly half of the index return in 2014. Most of the equity market performance since the recovery from the Financial Crisis began in 2009 can be viewed as a reduction in the equity discount rate – the return which investors demand before they will buy stocks. Falling discount rates equate to a rising P/E ratio. The equity discount rate consists of two components – a normal interest rate which is tied to Treasury yields and a risk premium which is the additional return investors require to invest in stocks. Both of these components have fallen since 2009, providing a substantial boost to equity returns. The risk today is that these discount rates are finding a lower bound and may increase in the future.

Due to these low discount rates, we currently view large cap US stocks today as priced to return in the neighborhood of 4.5% plus inflation. It would take a decline of 25% to get back to a more historical return of 6% plus inflation. It would then take approximately 20 years at the new 6% real return rate for the equity investor to recoup this 25% draw-down and get back to a 4.5% annualized real return. Using the same methodology on non-US stocks reveals valuations that offer returns more in line with historical averages. The current valuation of European stocks reflect a future 6% real return while emerging markets are discounting real returns of 8%.

Emerging Markets have Become the Growth Engine of the World Economy

In 2013, the latest year for which the World Bank published a complete set of global GDP data, the countries within the MSCI Emerging Market Index accounted for 53% of global GDP growth. The countries termed Frontier Markets, consisting of ‘emerging’ emerging markets such as Nigeria, Sri Lanka and Vietnam, contributed 8% of global GDP growth for the year. The developed world contributed 38% of the growth in Global GDP, almost all of which was the US and Japan. The emerging markets were the primary engine that pushed the global economy out of the post-financial crisis recession. Due to slowing Chinese growth and the accompanying collapse in commodity prices, they have struggled for the past several years. Given the poor prospects for strong demand growth in the developed world, consumption growth in the emerging markets remains the most important factor in continued economic expansion.

Oil Prices will continue to be Volatile

The near 50% decline in oil prices came about due to a combination of factors: the increased productivity of US shale assets, declining demand due to stagnant economic growth outside the US, and the resumption of Middle East production after the disruptions stemming from the Arab Spring. The opinions of industry insiders we respect have tended to view that this downturn will last longer than the consensus expects and will create substantial distress among producers who over-leveraged them- selves in the shale bonanza of the past few years. We are cautiously optimistic that this will create some attractive investment opportunities. Our caution comes from the real possibility that the large amounts of capital available to larger producers and private equity funds will exceed the number of distressed opportunities and the cyclical risks that accompany any investment in natural resources.

ETF Flows Impacting Equity Returns

Utility Exchange Traded Funds (ETFs), which at one point last year owned over 5% of the outstanding market value of the sector, experienced redemptions equal to nearly 20% of their year-end 2014 market value, while the sector returned -5.2% for the quarter. Ownership of Real Estate Investment Trusts (REITs) by ETFs continued to climb, with the funds now owning nearly 7.5% of the sector’s market value. Dividend yields above 3% in these sectors appear to be the main driver of ETF investor interest, despite the fact that the yields are at historical lows. Perhaps surprisingly, given last year’s performance, ETF investors added to energy funds during the quarter with total inflows of $6 billion, representing a 13.7% increase from the beginning of the year.

While volatility in the equity markets cannot be avoided, investors should work to minimize risks of permanent capital loss. This most commonly occurs in one of two ways: either a stock goes into financial distress, or it was purchased at such a high valuation that a return to more modest levels would result in a catastrophic loss from which it takes years to recover . The former was how most money was lost during the 2008 Financial Crisis, whereas the latter typified the late 1990s Technology Bubble. Current equity valuations, unlike the situation in the late 1990s, do not contain a significant risk of permanent capital loss. Aside from poorly capitalized smaller oil & gas producers, few indications of the risks of widespread financial distress exist within the US. Nevertheless, it makes sense to focus on investing in high quality businesses with strong balance sheets that are trading at reasonable valuations.

– By Stephen C. Browne
CFA Chief Investment Officer

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