We’ve felt a reticence to begin writing market commentary for the third quarter with the partial government shut-down now in its fourth day. The sentiment revolves around a general premonition that “everything could change” on a dime with a political resolution (or a deepening) of already entrenched positions in Washington, thus rendering our commentary moot. But we think that would make us guilty of a fallacy we often caution our client’s against—that of paralysis or impulsion in the face of soap-opera dramas presented by the news media, who by the way are the only winners in this showdown. Besides, we’ve been here before (and quite recently). The stakes are too high to flirt with failure and ultimately default; party affiliation will not insulate anyone, all parties to the impasse know it (despite the rhetoric), and we must operate under these premises. More on this later.
Let us turn our attention to the more germane pursuit of analyzing current economic conditions, market trends, and look ahead to what might be expected in the quarters before us. 2013 has been an interesting year in the markets to-date as we have seen significant decompression of correlations among both asset classes and sectors. If nothing else, major index performance over the last nine months has been a vindication for the principals of diversification. Early in the year the S&P 500 quickly achieved double-digit returns while bond prices accelerated their negative trend. Non-US markets measured by the EAFE index trailed US returns, but showed a positive trend due largely to the Japanese rally in response to their economic stimulus initiatives. Over this period, emerging markets fared the worst as investors worried about the effect of rising interest rates in the US impacting economies highly leveraged to capital inflows. But since the end of June, we have seen a significant outperformance of both emerging markets and the EAFE over US markets. Bonds have trimmed their year-to-date losses somewhat.
Throughout this year we have made certain judgments of equity market valuations, particularly in the context of addressing questions about “all time highs” for two of the three major US equity market indexes. We pointed out that the Dow Jones Industrial Average, for example, was trading at about 12.54 times 2013 earnings estimates in January, whereas the 2007 forward earnings multiple (marking the previous “all time high” for this index) was up around 16 times. Today this multiple has expanded to 13.99 times the forward 12 month earnings estimate*. In short, the index as a representation of US large Cap stocks, is not as “cheap” as it was at the beginning of this year (the Dow having climbed over 2,000 points thus far)—but neither is it trading at unheard-of valuations, considering that a purchaser of the Dow was paying just 10% less a year ago for a dollar of this year’s earnings than a purchaser today pays for a dollar of next year’s earnings. On a total return basis, January’s buyer of the Dow is up near 15% on their investment (this is a hypothetical illustration; investors can not actually “buy the Dow Jones Industrial” index). One of the primary reasons the P/FE ratio does not increase linearly with the advance of the index is that the forecasted earnings component of the P/FE relationship has increased as well. Scaling these index levels to something comparable across market segments, or over time should be a priority exercise when making generalized value judgments about the market. This is especially true when we’re bombarded with shouts and warnings of “all time highs” coming through the media.
Stepping back from the US and looking around the globe reveals even more compelling valuation metrics for stocks in virtually all geographic and economic categories; from Europe to Japan, and yes, emerging markets. Roughly two years ago CCR WM slowed our investment into Europe-centric equity investments given the roiling uncertainty of the EU’s role (burden) in supporting the unworkable balance sheets of Greece, Spain and Italy. While “austerity” leaves much to be desired as an economic policy, the growth challenges in Europe have been somewhat lubricated by the monetary policies of the EU as a whole. While we do not intend a macro-economic discussion of Europe here; it is at least important for investors to grasp the contrast in confidence that exists today as opposed to that which existed two years ago. To some, Angela Merkel’s triumph in last month’s German elections signals the end of the euro zone’s debt crisis, though longer term uncertainty over the union and the currency remain. This relative stability has allowed astute investors to recognize true fundamental value in many global corporations domiciled across Europe. Economically, Europe has outperformed the consensus negative growth forecasts we cited in January—but still only remains a GDP “flat line” year to date. Our view is in agreement that given comparative equity valuations, the glass is half full. We continue to recommend a managed approach though, rather than a broad-based index strategy as secular recovery is likely some way off.
We argued good news would be bad news with regard to US economics early in the year—at least in terms of the Free Money punchbowl tended by the Fed. First quarter non-farm payroll averages (233K per month) significantly exceeded their to-date average last August (130K per month) when Bernanke pledged open monetary spigots in perpetuity. Manufacturing, consumer sentiment, and housing metrics all ticked higher early in the year which could have been the catalyst for a public musing by the Fed Chairman that QE tapering by year-end was all but imminent. Retribution was swift in the bond market, with the ten year Treasury showing a sharply negative reaction in Q2 with yields spiking 64 basis points (from 1.84% to 2.47%), and the Barclay’s Aggregate Bond Index losing roughly 4% by Labor Day. As we cautioned earlier in the year, “balanced” portfolios, or portfolios otherwise heavily allocated to bonds have shown evidence of significant headwinds in their performance metrics this year.
Evidence suggests that higher interest rates over the spring and summer has slowed economic activity—particularly in housing. Permits for multifamily homes dropped 15.7% in August, suggesting higher mortgage rates could be making developers cautious about taking on new projects. This in-turn would likely feed directly into the job-market data in the months ahead, and this may be the primary reason the Fed surprised markets last month in not beginning a taper of the bond-buying program. While bonds in general (and Treasuries in particular) may have been given a “stay” by the Fed’s lack of action—we continue to believe that this year’s bond market returns are only a harbinger of things to come. Expectations should be calibrated to higher interest rates ahead, and portfolio durations should be kept as short as possible.
Back to the Washington Fiasco; there’s an old adage attributed to John Maynard Keynes that it’s “better to be roughly right, than precisely wrong”. We’re certain this calculus plays out inside the Federal Open Market Committee meetings every 6-7 weeks. As advisors, we understand that politics, policy and political philosophy are related tangentially to long-term investment climate. What we must continually remind ourselves as both advisors and investors though is that human nature is essentially consumed with self-preservation. To this end, we can at least be relieved that Congress is made up of humans! We do not know what the next week brings in terms of debt-ceiling developments—but we are unaware of any party to the conflict who is willing to throw themselves (and their party) out of office due to an unwillingness to negotiate—if even in the 11th hour. A prominent politician recently quipped, “This is not a game”, referring to the current political impasse. But that is precisely what it is. A game of “chicken” being played out through the media, and unfortunately this is part of the process these days. We witnessed this process play out two years ago and we urge investors to get past the posturing, and above all, to avoid doing anything which carries the risk of being “precisely wrong”.
*as reported by Birinyi Associates