To Our Clients and Friends of Parthenon LLC
The market continued to march higher in 2014 with a third consecutive double-digit return for the S&P 500 – the first such streak since the 1990s. The index (with dividends) was up 13.65%. The stock market recovery from the depths of the financial crisis of 2008 has been robust. The broad market, as measured by the S&P 500, is up 159% from year-end 2008 through 2014.
Bond yields ended the year near historic lows once again. The ten year Treasury bond yield ended the year at 2.17%, down from 3.03% at the end of 2013. The yield is below that at year end 2008, the abyss of the financial crisis, and for those of us who ply our trade in the financial markets that is an astonishing fact. The incongruity of the remarkably low bond yields against the backdrop of current economic statistics is quite interesting. The persistence of low rates has confounded more than a few prognosticators. We suspect we would have had no shortage of takers had we been willing to place a bet five years ago that rates would remain flat even if the stock market more than doubled, unemployment fell below 6%, and the quarterly GDP growth rate hit 5%. We likely could have made that bet with most of the imminent economists of the world, and received good odds to boot. While we have, as always, avoided predictions on the timing of interest rate moves (as we also do not “predict” the stock market) we have noted the low yields every year since 2008, along with our caution that rates are likely to rise as (if) the economy accelerates and moves further beyond the depths of the financial crisis.
How can bond yields be so low, while the stock market is strong and the domestic economy is stable, growing, and appears to be modestly accelerating? A strong stock market, with above-average valuations, is not necessarily at odds with extremely low yields. Low bond yields, if used to discount future company cash flows, justify and support higher stock valuations. In addition, there is clearly an element of “default investing” occurring, as there are few other promising places for investors to go for robust returns when bonds, and cash, provide so little promise. In addition, and just as importantly, corporate earnings have been strong over the past three years. The juxtaposition of low yields with a growing economy is the greater conundrum. Many economists and market pundits have said for years that bond yields must rise or the economy must decline, the two cannot co-exist indefinitely. Perhaps, but the reasons they currently co-exist are myriad. The Federal Reserve has kept short-term rates near zero, so longer rates cannot detach significantly from short rates. U.S. bond yields remain higher than those in most developed countries, and the dollar is strong, and getting stronger, so money is flowing to the best of the mediocre options. The US economy appears to be growing while Europe and much of Asia are slowing. Do low rates signal an impending global downturn? Maybe, though that signal has been there for several years, and so far the “signal” has been wrong.
Bonds play an important and necessary role in many investment portfolios. While we are cautious on longer bonds, we continue to focus on maturity balance and bond quality, while searching for mispriced bonds that offer yields that are above the average market rates adjusted for risk.
Beware of Rising Expectations
“Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” Demosthenes, Greek Statesman/Orator.
Higher stock valuations mean lower long-term investment returns, so a logical, sensible response to a prolonged period of valuation expansion would be to moderate future expectations. That is not the usual response for many, if not most, investors. A long period of above-average stock returns can begin to seem normal, with double-digit returns viewed as an entitlement. For many investors, the recent past becomes the prologue and they begin to forget that stocks must ultimately track the value of their underlying businesses. Investors begin to look not at the businesses to determine the actual increase in value but rather view the rising stocks as the true “value adjudicator.” Such “creeping expectations” can be an insidious affliction, with the potential to negatively impact asset allocation decisions and planning.
Near and intermediate investment results will be dependent on numerous variables, most of which are unpredictable. However, the paramount variable is current valuation and it is neither unpredictable nor unknown. While the market, we believe, is not in the extreme danger zone reached at times in the past, valuations are stretched. Consider that three years ago the stocks of many high-quality, financially strong companies could be purchased for 12 to 13 times earnings. Today, those same businesses are 17 to 18 times earnings. Although the economy is stronger, and most of our companies are reporting good earnings growth and generally positive outlooks, overall equity market results are likely to be lower than the recent past given current valuations.
We have previously discussed the North American oil production boom brought about by improved oil extraction technologies, specifically several years ago under the heading of “things that could go right.” Boy, did it ever go right. The boom produced jobs and it produced oil, a lot of oil. And that gusher of oil has precipitated an oil price collapse (aided by Saudi Arabia’s desire to reduce competition).
(As an aside, in another in a long history of apocalyptic “expert” predictions gone awry, you may have heard the term “Peak Oil.” Those were the oil “experts” favorite buzzwords of the mid 2000s. Peak Oil is (was) the theory that oil production world-wide had peaked, and as demand continued to rise, and supply could not grow, the growing imbalance would force oil prices ever higher. Those experts looked prescient when oil prices hit $150/barrel in 2007. As we now see, “peak price” would have been the more appropriate “buzzwords”).
Lower oil prices are obviously an economic positive for America. Who has not enjoyed pulling up to the gas pump recently and seeing those prices? Consumer spending is a huge part of our economic picture, and lower prices at the gas pump are a generous “rebate” for consumers. That rebate can, and will, be spent on other consumer goods and services, boosting the economy. Lower energy prices are also a substantial cost reduction for many industries – from their basic energy usage to freight costs.
Not all is positive. There will be direct and collateral damage from such a swift and dramatic decline in oil prices. Energy company capital spending plans are dropping and jobs will be lost – some very good, high-paying jobs. Some states, particularly Texas and North Dakota, may be net losers even as the U.S., and most of the developed world, will be net winners.
Some nations, such as Russia, Venezuela, and others hugely dependent on oil revenues, particularly those with higher cost oil production, are in trouble. That “trouble” is unlikely to stay strictly within the borders of those nations as sovereign debt is held world-wide. Oil production and service companies that borrowed based on cash flow expectations calculated on higher oil price estimates may find their debt loads now unsustainable. Banks that loaned to those companies will see higher charge-offs and more bad debt expense.
There may be opportunities in the carnage for value investors with a contrarian bent. We are searching the wreckage, with an emphasis on balance sheet strength. We are keenly aware that it is early in the process and, as the tide recedes, recognize that the damage can be substantial and easily underestimated.
Still Rational Optimists
Over a decade ago, we headlined a section of a client letter “Rational Optimists”. The following is an excerpt from that letter: “…we try to maintain a constant investment demeanor and mindset that might aptly be called the rational optimist. We are optimistic by nature. We believe that our companies will succeed when we purchase their stocks, we believe the economic system in the U.S. is incredibly resilient and, as it has many times in the past, will overcome the seemingly daunting problems we encounter. We believe the U.S. will ultimately prevail in our geopolitical struggles. We think optimism is a necessary ingredient when staking your financial future on a collection of businesses, when that future is inherently uncertain. But our optimism is always tempered by a rational expectation of the probable returns from our current and prospective investments. That rationalism informs our analysis and our estimation of the price to pay to appropriately balance risk and reward.” That was written in 2003, just after the deep market decline that coincided with the technology/dot com implosion, and with memories of 9/11 still fresh. Optimism was needed then and it was needed again in 2009 to not abandon all hope, and stocks, and instead seize and hold onto compelling long-term opportunities.
While stock prices today do not reflect extreme optimism and exuberance, we recommend emphasizing the “rational.” Not because we have suddenly become pessimists – far from it. The economy has again demonstrated the resilience we wrote about in 2003, and believed in during 2009. Stay optimistic, but do not forget that rationalism should temper optimism. We would not be surprised should volatility increase and investment returns prove temporarily less robust. Our long-term focus, and our long-term optimism, are and will remain intact.