While a little skepticism is good, some investors take it too far. The last few quarters have certainly given the skeptical investor plenty of concerns: Negative interest rates, chaotic European Union and U.S. election politics, volatile energy and stock prices and abrupt drops in U.S. government bond yields, just to name a few. The recent turmoil in the U.K. should remind investors of two things. First, collectively the world’s economy is more connected than ever, and second, there are always risks present in the markets. Since we almost always have capital to invest as we help new and existing clients achieve their long-term goals, the question is, where are the best places to invest that will protect capital and still give our clients the opportunity to achieve their long-term financial goals? We have a picture in our conference room that depicts a man huddled underneath a chair. The caption reads “Hide from Risk and you hide from Reward”. The man uncomfortably crouched under the chair is the skeptic who’s fear is causing him to miss out on the comfort and benefits of sitting on the chair.
If you have been a long-term reader of this newsletter, you know we have been mostly positive on stocks, specifically U.S. stocks, over the last 6-7 years. The bull market recently had its 7th birthday and the skeptics continue to rationalize their decision to remain on the sidelines or to get out completely. In the earlier stages of this market cycle, skeptics cited debt ceiling fiascos in the US, Chinese real estate implosions and the infamous meltdowns in the US municipal bond market. Yet the current bull market that started back in March of 2009 has been built on the back of skepticism, fear and pessimism and has rarely even looked back. The real estate and banking meltdown of 2008/2009 revealed a number of scams, fraudulent lending and reckless uses of other people’s money by large institutions. When financial markets turn from extremely negative to positive, the way they did back in March of 2009, the skeptics rightfully question the authenticity of the recovery. However, that skepticism led investors to stay on the sidelines, which was extremely detrimental and costly, as the stock market proceeded to nearly triple over the next 7+ years. Let us be clear, we continue to see opportunities, which we will discuss below, but the distance the stock markets have climbed since 2009 and the current anemic yields on US government bonds has shifted our view of where the opportunities lie.
A temporary pause in appreciation provides a valuable opportunity. Over the past 18 months, the S&P 500 has failed to make any meaningful price advances— on the first day of January 2015 it sat at 2054, we closed the books on the second quarter of 2016 at 2099, just 45 points higher. The paltry returns coupled with a pickup in volatility have allowed the skeptics to dominate the conversation again, this time it is fears of slowing global growth, high stock valuations, election jitters, unrest in the European Union and lower bond yields.
Corporate earnings have been improving and have had time to catch up to stock prices which have remained largely flat. With improving earnings and flat stock prices, valuations are starting to get more reasonable, a point not often highlighted by the media. They would rather you focus on the phrase, “stock market hits another record high” which while true, in reality is not all that much higher than the record highs set 18 months ago.
While the current economic recovery has been grindingly slow, we are slowly creating more jobs, wages are slowly increasing, and the housing market is strengthening. Investors should embrace the pause in the markets and the economy as an opportunity to reflect on their investment goals, time horizon and risk tolerance. Higher stock prices provide an opportunity for us to take profits from stocks or sectors that may have run up and rotate into stocks or sectors that are cheaper based on current fundamental value measures. Also, firms that pay dividends and routinely grow those dividends typically perform well when markets are trending flat. We remain convinced the dividend paying stock universe, and especially stocks that habitually increase dividends over time, will provide good returns.
We continue to see opportunities in both the stock and bond markets, but do acknowledge that the skeptic’s make some valid points now that we are 7+ years into the expansion. Investors are facing a more perilous investment journey going forward. The argument goes, “much of the low hanging fruit has been picked.” Investors are currently facing tougher conditions than we had the past 7 years they warn.
The Price to Earnings ratio (P/E) of the S&P 500 5 years ago was 15, near its 80-year average. Today S&P 500 sports a P/E of over 18. While this may be above average, some argue that the depressed earnings of the energy and financial companies are the main culprit, since these sectors are suffering from historically low oil prices and interest rates. Certainly there have been times in the past when the market’s P/E has been both higher and lower. When the market’s P/E has been below 10, it has often been a wonderful opportunity, and when it has been above 20 it hasn’t been as fruitful, however neither number is magic in terms of predicting the market. We don’t see today’s valuation as a big deterrent, but it does emphasize the need to be selective about which stocks to own rather than simply buying the entire market.
Bond investors should be slightly apprehensive considering yields have dropped 50% or more over the last 5 years. For example, investors’ would’ve received a 3.15% yield annually 5 years ago to lend their capital to the US government for 10 years. Today, the rate for a 10 year IOU to the US government is 1.46%. The Consumer Price Index(CPI) over the last 5 years shows prices for goods and services have risen 1.29% annually. The current CPI is well below its 3% long-term average. We agree with the skeptics regarding low yield and high interest rate risks offered today by long-term government bonds. However, the skeptics fail to acknowledge that all bonds are not created equal and not all bonds behave the same way. Municipal bonds for high income investors remain attractive, especially in states which aggressively tax income. Muni bonds historically have not been as interest rate sensitive as long term government bonds. Investment grade corporate and high yield asset classes provide much better yield opportunities than low yielding long-term government bonds. We look at some parts of the stock market, like utilities and see valuations that were once reserved only for the growth darlings of Wall Street. Many are sporting valuations higher than perennial growers like Google (P/E of 27.2x) or Visa (P/E of 27x). The real difference is future growth potential, Google has posted an amazing 33% annualized earnings growth over the last decade and Visa an impressive 24% over the last 5 years. The law of large
numbers dictates growth cannot persist at exceptionally high rates in perpetuity, but we would argue Google and Visa have
much higher growth prospects than most highly regulated utilities. This is a sector where we see more risk than reward.
Like skeptics, when we see today’s valuations and slower growth potential we too get concerned, but the fact remains we see reasonable valuations in pockets such as select individual stocks, and sectors such as technology, financial services, energy and industrials. Dividend paying stocks remain attractive and enhance returns when markets grind sideways. The problems so well outlined by the skeptics or covered so well by the media in the local paper does not mean investment opportunities are eliminated, but potentially hidden in different parts of the stock or bond markets. For the investors like us, that roll up the sleeves and rummage around in the bargain bin there are values. Our job is to find them. We thank you for investing alongside us as we continue to focus on building wealth wisely.