Rising Bearish Sentiment Brings Some “Good News”

In wake of stock market sell-off of the past few days, there is increasing evidence that small investors are getting scared. The Associated Press this morning reports that “the number of small investors who say they feel bearish soared this past week” and “some stock funds have been hit with their biggest withdrawals since 2012”. Here is the link to the AP article:

http://money.msn.com/business-news/article.aspx?feed=AP&date=20140201&id=17312155

 

 It may sound illogical but it is actually a good sign. As we’ve noted previously, the stock market has not had more than a 10% correction since mid-2011. This is longer than the statistical norm for time intervals between “corrections” which, since 1945, have occurred on average about every 20 months and average about 13% decline. The fact that small investors are getting nervous and pulling out is positive in that it relieves some of the extreme positive sentiment that is associated with rising markets, particularly a rise like we saw in 2013 (which was up 30%, about 3x the long-term average annual return).

 

We think the underlying fundamentals for U.S. companies remain sound based on improving economic growth and higher earnings in 2014. At about 15x 2014 earnings, valuation is “neutral”, no longer “cheap” but not excessive either. In addition, as we’ve mentioned previously, the financial arbitrage that currently exists between the cost of debt and equity capital is also providing support for equity valuations.

 

This morning’s auto sales and factory order data were lower than expected, partly contributing to today’s sell off, but we note this data bounces around significantly and does not move in a linear fashion. We don’t read much into the softer data. There may also be some investor concern with Janet Yellen taking over as chief honcho at the Federal Reserve, however our expectation is she will maintain a gradualistic approach towards unwinding of the quantitative easing program of the last five years. Concerns over slowing growth in China are legitimate, however, with over $3.5 trillion in monetary reserves, we think China has the financial wherewithal to engineer a “soft landing” for its economy. We continue to believe the best opportunities remain in U.S. stocks, in which we remain overweighted.

 

Our strategy of diversification among multiple asset classes is an important way in which we aim to provide not only asset growth but also reduce portfolio volatility, an important aspect of achieving improved risk-adjusted returns. Corrections and market pullbacks are normal, and in many cases, necessary, as they relieve extended positive sentiment and allow the market to “recuperate” technically. We expect this correction will prove to be another normal mid-cycle correction in an ongoing secular bull market.

 

China Ripple Effect

We mentioned in our recent Q1 investment commentary that we believed, moving into early 2014, the risk of a market pull-back or correction had increased for a number of reasons: 1) the market’s extraordinary gain in 2013, 2) concerns over initiation of Federal Reserve taper, 3) concerns over slower growth in China, 4) divergences in certain technical market indicators, 5) having gone over two years without a correction of 10% or more, which is about twice the statistical norm.

Over the past seven trading sessions, the market measured by the S&P500 has declined about 3.5%. The reason? China. Investors have become more concerned that growth in China may be slower than previously expected. This has a potential “ripple effect” particularly to emerging market economies which are more heavily dependent economically on China. We believe these issues will prove transitory, or an “adjustment”, in the overall global growth outlook, and should not have too great an impact on U.S. companies. If the Chinese economy does slow to a degree much greater than expected, it could have some impact on U.S. corporate earnings to a greater degree than we now expect.

With respect to our investment strategy, we continue to remain more heavily weighted in U.S. stocks. In international stocks, we do have exposure to EAFE, a broad international index, but we are underweighted in emerging markets equities. We believe fundamentals for U.S. stocks remain generally positive: earnings growth is expected to accelerate in 2014; U.S. corporations continue to hold record levels of cash; M&A activity should remain strong in 2014; inflation remains subdued. Positive investor sentiment has become somewhat more of a concern but at 14.8x 2014 earnings, valuation is not excessive.

As we always do, we are keeping a close eye on developments in China and emerging markets.  We  have not changed our view that the risk of a 10% or greater pullback in the U.S. stock market has increased. However, we would view such a correction as a normal “adjustment” within a longer term bull market, and as of now, we are taking no specific actions to change investment allocations or strategy. As a reminder, an important way in which we aim to buffer client portfolios from market volatility is through our strategy of asset class diversification. This diversification helps to reduce sensitivity to changes in equity prices and, thereby, reduce portfolio volatility with the ultimate long-term goal of improved risk adjusted return.

Notes From Our First Quarter Investment Strategy Meeting

We held our first quarter investment strategy meeting on December 30, 2013. 2013 was an extraordinary year for the stock market reflected in a total return for the S&P500 of about 30%. There are only a handful of years in the past 60 which have seen gains of this magnitude. The stock market overcame an amazingly high “wall of worry” in 2013. These worries included things such as the debt ceiling, the Syrian conflict, Federal Reserve policy, slowing corporate earnings, slowing growth in China, and continued government policy uncertainty, to name but a few.  

What drove the market up this “wall of worry”? Several factors: capital seeking higher return alternatives to bonds; improving outlook for the economy and corporate earnings; and “financial engineering”. With regard to this last point, the current low cost of debt is providing an opportunity for corporations and investors to improve their investment returns by using low cost debt to make acquisitions and buy backs shares. This is similar to what occurred in the 1980s and we believe will provide a positive backdrop for stocks in 2014.  

We remain positive on the outlook for stocks. Fundamentals for equities, particularly the economy and corporate earnings, remain generally positive. Of increasing concern, however, is valuation. With the S&P500 now trading at about 15 times 2014 earnings, stocks are no longer “cheap”. This raises a bit of a cautionary flag that a) valuation may not be the driver of stocks prices it has been heretofore and b) market risk has increased. Another concern is the fact that the market has not had more than a 10% correction since mid-2011, which implies the odds of a correction in 2014 have increased.

The investor “conundrum” continues for the bond market. We believe returns on bonds, which have averaged 5-6% over the past several decades, will be considerably lower going forward.  We believe the secular trend in interest rates is now up, as opposed to the last thirty years, in which the secular trend had been down. We expect this new secular trend will keep pressure on bond returns. We expect interest rates will rise in 2014 in a gradual but steady fashion.

With respect to portfolio changes following the meeting, we further increased exposure to large and mid-cap stocks. We believe quality, dividend-paying stocks continue to offer value and attractive risk/reward. We further increased exposure to technology stocks as we view the sector as undervalued. We reduced exposure to REITs but increased our exposure to energy. Within bonds, the most notable change was the elimination of our position in preferred stocks and the addition of a position in high-yield corporate bonds as a way of reducing duration while maintaining a high income stream. We also raised our exposure to short-term bonds to reduce duration and interest rate risk.

A New Paradigm

Our last post dealt with the mechanics, or “financial engineering”, available to capitalists currently in which low cost debt can be used to improve return on invested capital (ROIC) by using debt to buy back or reduce outstanding shares (or equity capital). As we explained, the reason for this is the current arbitrage that exists between the cost of debt and equity capital.

In addition to repurchasing or reducing equity capital, availability of low cost debt capital can be used to acquire undervalued businesses. This is what happened in the 1980s in the great “leveraged buy out” (LBO) wave, which lasted from 1982-1989. During that period there was a significant number of corporate takeovers fueled largely by debt. Some of the larger examples of takeovers during that period included Beatrice Companies, Revco Corp, Jim Walter Industries, Federated Department Stores, Uniroyal Goodrich, and Hospital Corporation of America. Capitalists realized that these businesses were under-earning their cost of capital and through restructuring and re-capitalization of the businesses, ROIC could be significantly improved, hence greater return potential for equity holders.

We have something similar to the 1980s occurring in today’s environment. There are many large companies trading at historically low valuations relative to their cash flow potential. The technology sector, for example, is one in which there are a number of large companies trading at very low valuations relative to sustainable cash flow. This can cause a couple of things to happen both of which can be fueled using low cost debt: 1) acquisition of the undervalued companies through an LBO; and/or 2) restructuring and reduction of equity capital base to boost return to equity shareholders.

We believe we are in a “new paradigm” similar to the 1980s. M&A activity has increased in 2013 and is expected to increase further in 2014. Leveraged loans are rising significantly, providing significant capital to fuel this activity. There are a number of very recent examples of M&A activity among large companies including: Sysco merging with U.S. Foods; American Airlines merging with U.S. Airways; and Avago Technology merging with LSI. The combination of slow global and corporate top-line growth combined with continued access to low cost debt capital should enable this new paradigm to continue for several years. This new paradigm should also help to support valuations for public equities and provide fuel for further increases in stock prices.

 

Might Financial Engineering Extend The Bull Market?

For both investing and the economy, cost of capital and return on invested capital (ROIC) are vital concepts. Generally speaking, investment capital will seek its highest return. This is partly what drives stock prices but it also is an important element in private investments and capital spending decisions by businesses.

The past several years have witnessed financial market anomalies not seen in many decades. One of those anomalies currently is the unusually wide disparity between the cost of debt capital and the cost of equity capital. Because of the long decline in interest rates, the cost of debt capital is now very low relative to the cost of equity capital.

Anomalies like this present capital opportunities. Specifically in this case, an arbitrage opportunity exists in which low cost debt can be used to boost shareholder returns (ROIC). How does this work? Say, for example, a large company has a current cost of debt capital of 2% and a cost of equity capital of 8-9%. It might make financial sense for this company to take on debt and use that capital to reduce equity capital through share buybacks. The result of this is higher ROIC.

The potential for exploiting the current debt/equity arbitrage has positive implications for the stock market and the economy. Why? First, it means that capital heretofore not invested in equities can come into the market via acquisitions and share buybacks; and second, capital is allocated more efficiently in the economy, an important benefit.

History repeats itself. We saw something like this in the early and mid-1980s. As interest rates (cost of debt capital) came down during the 1980/81 recession, it allowed strong companies to take on debt and acquire undervalued companies through leveraged buyouts (LBOs). This “financial engineering” process is occurring again and could be further fueled by this debt/equity arbitrage.

From a financial planning perspective, to the extent this arbitrage opportunity can continue over the next year or two, it reflects positively on stocks as an important vehicle for enabling clients to grow their financial assets, meet long-term financial goals, and keep up with inflation.

 

Twitter and Animal Spirits

It seems like our little “correction” appears to be over. The stock market indexes are all at or near all-time highs. Investors continue to remain comfortable with the “goldilocks” environment (not too hot, not too cold) for stocks: rising earnings, low inflation, and reduced fears over Federal Reserve policies. The situation in Syria? De-fused for now. Debt ceiling debate? It may get ugly for a while, but ultimately there will be a resolution to the debt ceiling.

Of greater concern of late is the “Twitter” and rising animal spirits. “New age” internet stocks, like Zillow, Netflix, and Facebook, have been on a tear lately, some of them up by over 200% in the last year. On top of this, Twitter, a social media company, recently announced it will go public. Why now? Twitter and its bankers sense the market is ready for it….the “animal spirits” of the market are ready and salivating for the next quick flip IPO.

Traditionally, when we talk about “animal spirits”, it refers to the human propensity for taking on more risk when things “look good”, when the market’s been up, and, oh yes, when it now seems OK to take on more risk. That smacks of “overconfidence” and overconfidence is a problem for the stock market.

While we suspect there is more upside for the stock market in the near term, the rising animal spirits may be an early warning sign that the market is no longer be “cheap” and that market “risk”, or volatility, may be increasing. From a financial planning perspective, the best way to protect retirement and investment portfolios from volatility is through appropriate asset allocation and diversification. Holding multiple asset classes in a portfolio reduces risk because different asset classes typically behave differently in different parts of a cycle (for example, bond prices usually go up when stocks go down). Sticking to a long-term financial and investment plan also lowers risk by reducing the temptation to “time” the market and buy or sell at the worst possible time in the cycle.

 

Three Terrible Days

Did you see this on the news? We were amused earlier this week when a commentator on a daily stock market program declared in horror that the stock market had been down three days in a row……Three days in a row!! Wow…...like it was the beginning of the apocalypse….or was it the beginning of a new, dreaded market correction? You know as well as I do that three days of a trend in the markets really doesn’t mean much. But it sounded so “daunting”. It perpetuates the “fear factor” and creates confusion. But, financial media know this is what keeps people watching and, of course, sells commercials.

Let’s look at what’s really happening. As bull stock markets go, the current one, which began in March 2009, has been pretty average or “normal”. There have been five corrections (market pullback) since March 2009 that have averaged about 13% and have lasted about 3.5 months. This is very much in line with the long-term averages. Corrections are normal and are healthy for the markets because they curb excesses and help maintain balance.

Granted, there have been some legitimate concerns lately about the potential for a correction based on a change in Federal Reserve policy and renewed debate over Federal debt ceiling. One thing we do know absolutely is that the market will correct again at some point. But we also know that the market has rebounded from every correction and bear market and that general stock market fundamentals remain sound.

So should you fear the coming correction or lay awake worrying about it? One of the best ways to protect an investment portfolio from inevitable pullbacks is through appropriate asset allocation and reasoned sector exposure. Holding multiple asset classes can help lower portfolio volatility and moderate losses in a correction. Reducing exposures to stocks and sectors that have performed extremely well is another way in which investors can mitigate the impact of a potential correction. The advice we give to clients is to develop a sound investment strategy or financial plan and stick to that strategy throughout the market vicissitudes. This helps to reduce the temptation to time the market and buy or sell at exactly the worst time.