Posted by David Tillson in January 2016 - Fourth Quarter Commentary
This quarter’s letter was initially designed to take a slightly somber tone of “2015 was a little rocky, but not too much damage was done.” However, given the inauspicious start to 2016, a different focus is clearly in order. Just to put 2015 to bed, the market, depending on your definition, was essentially flat. The Russell 1000 and S&P 500 Indexes were up approximately 1% while their growth and value constituents showed plus 5% and negative 4% returns, respectively. Major bond indices were in these same ranges which had the practical effect of most major investment strategies having similar performance. For those investors who were looking for a home run, it was necessary to have owned the likes of Amazon or Netflix (up 120% and 135%, respectively). With investments in such areas as Emerging Markets, Energy and Commodities declining anywhere from 10% to more than 40%, simply avoiding losers turned out to be one of the best ways to protect your purchasing power in 2015.
At the start of 2016, it’s evident that investors are concerned that our relatively sluggish recovery from the Great Recession is faltering. The numerous worries and risks that seem to be foremost in peoples’ minds are: rising interest rates, the collapse in the price of oil, weakness in China and in corporate earnings at home. On top of this there is also concern around potential inflation and potential deflation, the length of the stock market’s bull market, and geopolitical risks. This list of concerns is longer than normal which may mean that either the world really is falling apart or that human behavior is once again skewing peoples’ focus away from a balanced view of the world. While our crystal ball is not any clearer than anyone else’s, we would like to add some balance to opposing views. To sum up the major questions: 1) Has the stock market risen too far without a correction? 2) Will the U.S. fall into recession? and, 3) Is inflation or deflation the greatest worry?
Stocks have risen, but has it been too far? They have compounded at 15% per year since the end of 2008 (well ahead of the past 90 years’ 10% average return) and have not had a negative year for the past seven years. Many investors feel that this alone means that the market is overdue for a correction, which the first few weeks of January graciously provided. Now the question is: “How much more is to come?” Our perspective is that the past seven years marked a recovery from a very deep trough and that we are finally more or less where we should be in terms of the valuation people are willing to pay for stocks. If we are, volatility and regular corrections should not be surprising. The decade of the 2000’s began with the tech bubble and progressed to a housing bubble, which created two major stock market collapses. Stock returns have averaged only 5.0% annually since 2000 (height of the tech bubble), and only 8% per year for the 20 years since 1995 (before the tech bubble), both of which are below the 10% ninety year average. Our answer to: “Has the market risen too far?” is “Possibly,” but the rise has not been so far that investors should fear another correction like those of the 2000’s. Long term investors recognize corrections for what they always have been – temporary deviations from a secular upward trend. Today however, we ask whether conditions are truly different from the past and whether any differences are material enough to have broken the secular long term trend of 6.5% earnings growth.
If there are no major fundamental changes with the economic climate in the U.S., then the probability of 8-10% long term equity market returns (based on 6.5% earnings growth and 2.5% dividend yields) is still reasonable and achievable. Some possible differences include the emergence of China as a world power, aging populations in developed economies, and the build-up of debt combined with the difficulty of creating inflation. Throughout history civilizations have risen and fallen and China’s emergence as a major world power does not appear to us as a threat to our economy. Aging populations do create long term challenges and are one of the differences that may impact economic growth in many countries. Younger people form new households and spend more than they earn (borrow money) thereby creating faster economic growth and potential inflation. Older people spend and borrow less and also depend on the younger wage earners to pay their pensions and health care which puts a drag on economic growth. As countries develop and populations become more highly educated and wealthier, birth rates typically fall. Western Europe has been coping with this phenomenon for many years and China, due to its past one-child policy, is facing the same challenge. The U.S. has not yet reached that tipping point of not replacing ourselves, but our population is aging – just more slowly than Europe, Japan and China which gives us more time to deal with the problem. While the inflation/deflation equation could ultimately morph into that “it is different this time,” it is certainly not likely anytime soon.
In December, the Federal Reserve finally raised interest rates. This was more symbolic than momentous since a one-quarter-of-one-percent rise in short term interest rates will do little to change anyone’s behavior. Investors focused less on the actual rise and more on the Fed’s forecast and expectations for future increases. The Committee did lower its forecasts but remained stronger than current market expectations. In the first weeks of January, short term rates have remained at the desired level but longer term rates actually declined by roughly the same quarter-point which is not what the Fed desired. The Fed has signaled its intent to raise short rates several more times in coming quarters, but given current conditions, we would not expect the next increase before late spring. The U.S. is tied to the world economy and while the Fed would like to be able to set policy based only on our domestic conditions, it cannot. The rest of the world is still in an easing mode as central bankers try to stimulate economic growth. Too high rates in the U.S. leads to capital inflows causing the dollar to strengthen even more than it has in the past year. U.S. based companies will benefit through lower costs, but will suffer as they try to export their then more expensive goods. Consumers will benefit from lower prices, but if manufacturing falters, then job and wage growth will suffer. In effect, a stronger dollar imports lower prices and deflation. One worry is that the world could enter a race to the bottom as everyone tries to weaken their currency more than their neighbors to gain an advantage for their own economies. So far, this has not become widespread, but the U.S. has borne the brunt of much of the rest of the world debasing their currencies against the dollar. Should the U.S. decide to enter into a currency war (very unlikely), the consequences could be dire.
Inflation is needed for any country which has amassed a large amount of debt since they must either grow or inflate their way out of their debt problem. Inflation can spur growth and it can also diminish the real value of the accumulated debt. The trick is to use inflation judiciously and to control spending at the same time, since inflation affects interest costs which then trickle into a country’s budget. The Fed’s target for inflation is 2% and they believe that the economy is currently operating close to that rate. The U.S. probably has the best chance of any developed country in the world of reaching their inflation target. Western Europe, Japan and even China are still using easing policies to stimulate their economies and hopefully, inflation. While historically these policies have been able to create inflation and growth, the current environment is more challenging. They have, at least, held off deep recessions. This is important because in a recession GDP growth contracts and interest rates decline – not something any central banker wants. We believe that the Fed will do nearly anything that it takes to prevent a recession in the U.S. and abide by the adage of “Don’t fight the Fed.” While we think that a recession is unlikely anytime soon, we also do not expect an escalation in GDP growth much beyond its past rate.
Despite massive amounts of quantitative easing since 2008, bankers have been unsuccessful in creating inflation and given the very low level of interest rates around the world, financial markets believe low inflation will persist. Thus, deflation may remain a potential problem for some time. As we have mentioned in several past commentaries, companies are dynamic. They can and do adjust to changing conditions whether it is inflation, deflation, technological change or competition. We are confident that companies will continue to not only survive, but innovate, evolve, remain competitive and grow. As they do, they will produce profits, and from these profits, they will pay dividends to their owners. Currently, the dividend yield on the S&P 500 Index is 2.4% - higher than the 2.0% that a buyer of a 10 year U.S. Treasury Note will receive. And, the dividend rate has been rising in excess of 10% per year since 2009. It is highly likely that dividends will continue to increase, although at a rate more in line with earnings, as contrasted with no growth in the bond’s interest payments for the next 10 years. Current cash flow and growth in that cash flow is the main reason that we believe that the better investment strategy for a deflationary environment is equities over bonds. Until central bankers cease trying to control financial markets with ultra low interest rates, the same logic also holds true for a rising interest rate environment.
In closing, 2016 has been a rocky start with an overdue correction, and no one is certain if it is over or if we have another leg down. We are of the belief that except for having fewer recessions, the next decade or so may look more like the 1950’s and 1960’s than any more recent period. The charts below show that if this is the case, we should expect market declines of 10-20% every 4 to 5 years and it may take 3 to 6 quarters before the market recovers and sets a new high. Volatility and corrections are normal and occur at unexpected times. Therefore, one should never invest money in stocks when that money is needed at a specific time in the near future. Trying to time the market is difficult, at best. Picking the peak is hard enough but getting back in when most news is still terrible is even harder. As a long term owner, sleep well at night knowing that you are invested in high quality companies, that you are diversified and that you continue to collect your dividends. Keep daily pricing in perspective; it is only a temporary marker. Cash flow, both from dividends and eventually from the ultimate sale proceeds, is what is important.
We end with a quote that may or may not apply to the commentary, but given what is going on in the world today, it could give solace to some of us as we try to understand human behavior.
“Only two things are infinite, the universe and human stupidity,
and I’m not sure about the former.”