The following commentary represents the views of the Multi-Cap Value Strategy Team.
The first three months of 2015 gave investors their first taste of volatility in quite a while. Stocks generally acted as if they had no short-term memory at all. Performance in January was weak, while February’s returns were the strongest since October 2011. (Source: Standard & Poor’s) As March ended, the S&P 500 finally broke a string of 28 consecutive trading days without back-to-back gains, a rare streak that had happened only twice since World War II (May 1970, April 1994). (Source: Bespoke Investment Group) Not that the market’s ups and downs mattered all that much in the end, as share prices finished the quarter not far from where they started. We wouldn’t be surprised if the market’s churning action persists for a while, or if it eventually ends in a correction. Yet so long as monetary policy remains relatively friendly and a recession is nowhere in sight, this long, post-crisis bull market still appears to have some life left in it. Low risk-free rates suggest that equities will continue to offer higher expected returns than most other asset classes, though gains should be far more modest than in recent years. So far, that looks to be playing out in 2015. Still, despite our more cautious outlook, we are confident that our value-based strategy remains well-positioned to deliver superior returns over the long-term, with less downside risk than the major U.S. equity averages.
If all goes according to plan, the last of the two major pillars of the Federal Reserve’s post-crisis monetary policy, which has produced six years of a powerful bull market in stocks (and bonds) but also a lackluster economic recovery, will finally pass into history. First to go, in 2014, was quantitative easing, but not before the Fed had pumped trillions of dollars of liquidity into the economy to encourage spending and investment (i.e., risk-taking) and discourage saving. Expected to fall, sometime later this year, is the second pillar, zero-percent interest rates, also designed with the same goals in mind. In our view, much of the blame for the historically weak expansion lies with the federal government, whose onerous tax and regulatory schemes and dysfunctional politics have been a continuing drag on growth. It’s no wonder that the stimulus has always received a warmer reception on Wall Street, where it boosts asset prices and enriches corporate coffers, than on Main Street, where growth in the real economy remains subdued. Easy money gives U.S. companies free rein to make large share repurchases, pay higher dividends, refinance high-cost debt, and the like. All of this has created an idyllic, once-in-a-lifetime world for investors, one of steadily-rising share prices in the face of a growing list of geopolitical and economic concerns that would have derailed more normal markets. And as an added bonus, the stock market’s rise has, until recently, been accompanied by unusually low volatility.
Since the financial crisis, ultra-low rates on so-called risk-free assets such as short-dated Treasuries have jacked up the present value of future cash flows from riskier assets such as stocks. This in turn justified, to a certain degree, paying higher prices for those income streams. But the extremely accommodative monetary regime in place since 2009 has not otherwise repealed what is an immutable law of finance that governs the limits of investment returns: The higher the price that an investor pays for a given stream of future earnings and dividends from stocks (and interest payments from bonds), the lower the return they will earn on that investment over time. There is always a point, in other words, when security prices have risen too high to offer investors an attractive rate of return for the risk assumed, no matter how low the prevailing risk-free rate may be. Today’s extraordinary environment of negative real interest rates has made finding that point an increasingly difficult challenge.
So far, investors appear to have taken comfort from the fact that the path toward higher rates will be slow and gradual, and that the Fed is determined to take every precaution so as not to undermine the sluggish recovery. At the same time the Fed looks to be hemmed in by easy-money policies across the rest of the world, which has caused the dollar’s value to skyrocket against most other major currencies. This makes prices of American goods sold abroad more expensive, hammering the profits of U.S. multinationals. Both conclusions are undoubtedly true. But the ultra-low rate era has also given rise to a comforting corollary, which has morphed over time into an unshakable mantra for investors: It is that stock prices today deserve to go higher simply because “there are no other alternatives.” Put another way, stocks may be expensive in absolute terms, but they are still attractive compared to most everything else, especially low-yielding bonds. Better to reach for a low expected return than receive none at all — even if that return may be outweighed by the potential downside risk.
This is where we part company with the market consensus. While the “no alternative” argument clearly had merit at one time (especially during the early post-crisis years, when share prices were truly inexpensive), it has, in our view, become increasingly unsustainable the higher this bull market climbs. After all, if a zero-percent interest policy is always a good thing for stocks and the economy, then why did the Fed wait until more than a century after its founding to start one? Moreover, from now on, why shouldn’t rates remain locked at zero forever? The answers to both questions are so obvious they don’t deserve a response.
Nor is there much historical support for the proposition that stocks perform well during times of monetary tightening. Any rate hike, even from a starting point near zero, is still a move higher, while raising the risk-free rate, no matter how small the rise, still lowers the present value of future cash flows from stocks (and bonds). During past Fed-tightening cycles going back to 1966, the stock market barely kept pace with inflation, generating an average yearly real return of just 0.8%. (Source: “Fed Up: How Will Rising Rates Affect Stocks? The Wall Street Journal, January 30, 2015). The last three times that the Fed embarked on a new tightening cycle (1983, 1994, and 2004) equity prices were flat to down 10% over the next 12 months. (Source: “Forecast: Head Winds,” Barron’s, April 13, 2015)
Our immediate concern is that the market reaction to even slightly-higher rates could be more severe this time. Much like in 2014, the economy has gotten off to a very slow start this year. A steady stream of downbeat data over the past few months suggests that the expansion has hit another rough patch. How long it lasts remains to be seen, but we can say there are presently no signs of a rebound in sight. Just this month, the Federal Reserve Bank of Atlanta slashed its first-quarter growth forecast to zero, down from a 1.9% rise in February. This is obviously not welcome news for a stock market that wasn’t cheap to begin with, and that has now been hit by a torrent of downward revisions of earnings estimates and the most negative company guidance since 2008. (Source: Bespoke Investment Group) Consensus forecasts for the first quarter presently call for a 4.8% drop in profits at S&P 500 companies, due largely to the continuing fall in energy prices and the soaring value of the dollar. If accurate, it would mark the first year-over-year loss since the third quarter of 2012 and the biggest decline since 2009. (Source; FactSet) And right now the second-quarter outlook is only slightly less dreary. Heading into 2015, the S&P 500 was trading at 17 times forecasted profits for the next 12 months, which was its highest forward P/E ratio since 2004 and well above the average long-term multiple of 15. (Sources: Standard & Poor’s; Yardeni Research) This number is undoubtedly even higher now.
All of this has led us to conclude that a more cautious near-term posture in the Multi-Cap Value Strategy is in order. Recently, we raised more cash by trimming the size of a few highly-appreciated positions to reduce risk. We may raise additional cash in the future, if circumstances warrant. This cash reserve should help protect the Multi-Cap Value Strategy from suffering a direct hit in any future market downturn, as well as allow us to initiate new positions and/or add to existing ones when prices are more attractive. The market’s essentially uninterrupted rise in recent years has inflated both valuations and bullish sentiment to the point where stocks appear far more vulnerable to follow-through selling during pullbacks than before. After all, more than 40 months have now passed since the last 10% correction, an unusually long time. Yet at the same time we do not see the risk of anything like an equity bear market on the horizon, as it would take a recession or some external shock to the financial system for that to happen. In short, while we would rather be putting portfolio cash to work, there are few truly attractive opportunities available. We have found instead that for most stocks their expected long-term returns cannot be justified at current valuations absent a heroic assumption that interest rates will stay very low for at least several more years. For us that is simply a step too far. So, for now, we have chosen to wait patiently for better days ahead.
by Gilpin W. Bartels
Mr. Bartels is Senior Vice President and Multi-Cap Value Portfolio Manager at Pennsylvania Trust.
The information herein has been obtained from sources we believe to be reliable but is not guaranteed and does not purport to be a complete statement of all material facts. This report is for informational purposes only. The views expressed represent the opinions of the Multi-Cap Value Strategy Team and are not intended as a forecast or guarantee of future results. All securities trading, whether in stocks, options or other investment vehicles, is speculative in nature and involves substantial risk of loss.