July 2017 Market View
The Market Advances as Washington Thrashes
In our April letter, we discussed the fact that the U.S. economy was continuing to advance while Washington toiled at reform. After watching the circus unfold in Washington over the last three months we can no longer call it “toiling”. They are “thrashing” and it is truly disappointing. Career politicians in both parties have created gridlock and none can predict how it will be resolved. Healthcare reform, corporate tax reform, and repatriation of corporate capital to the U.S. are in peril. Only time will reveal what, if anything, our elected representatives can produce.
The good news is that Congressional dysfunction is having little negative effect on the U.S. equity market or economy. We are often asked: “How much of the market’s price advance is due to investors thinking that reforms will be passed?” From what we see at this point, our answer is: very little. If reforms are not already “priced in”, it means that if Congress can pass reform, then further upside seems likely. If Congress cannot get anything done, then we remain at the status quo, dependent on corporate earnings growth and/or multiple expansion to move stock prices higher.
We are also asked: “Isn’t the market high and expensive?” Obviously, the U.S. stock market is higher than it was a year ago, 14% higher on the S&P 500. However, the S&P 500 is trading at approximately 18x forward earnings estimates now, almost precisely the same valuation as it was trading at last July. In fact, when you look at the valuation of the S&P 500 using the forward earnings estimate multiple, the market is neither “cheap” nor “expensive”. The position of this metric is almost exactly mid-range, when looking back over 30 years of data.
The “Next Problem”: Jobs or Debt?
Less than six weeks ago the Department of Labor reported that the economy produced only 138,000 jobs in May. Many financial reporters characterized the report as a precursor to a massive slowdown in the U.S. economy. However, economic reports should be viewed on a three-month moving average to avoid drawing incorrect conclusions from noisy short-term data. Sure enough, the reporters were proven incorrect again when the economy produced 222,000 jobs in June.
Searching for a new economic metric on which to build their negative case, the Pouting Pundits of Pessimism now point at the level of U.S. corporate debt. At $18.9 trillion it is the highest ever, relative to Gross Domestic Product. However, corporations hold debt against assets and income, not GDP, and both assets and income are also at all-time highs. In fact, corporate debt is 44.5% of assets today, lower than the 40-year average.
Further, according to the Federal Reserve Bank of St. Louis, corporate assets exceed total debt by $1.4 trillion – a record spread. Debt, relative to nearly every meaningful comparison is lower than the 20 and 40-year averages. Most importantly, interest payments on the debt are 11.2% of profits, lower than the 13.2% average since 1980. Rising interest rates, even if they rise significantly, will have little effect. This is because only 28% of corporate debt is short-term, much lower than historical averages.
None of this is to imply that the economy will grow forever, without another recession. Another recession is inevitable, but we don’t see anything on the horizon at the moment to suggest that it is imminent. The question is: When the next recession comes, do you want to try to sit passively through it with your investments, or do you want to take defensive action to mitigate its effects? This brings us to our next point.
The Passive Investing Craze
Passively investing in Exchange Traded Funds (ETFs) and Index funds, rather than in individual stocks, has become extremely popular over the last several years. One friend calls it “buy-and-don’t-look-investing”. Just buy, hold on, and don’t open your monthly statements. See how it all turns out when you retire. This idea has been sold to individual investors primarily by touting the lower fees of ETFs and Index funds, and showing the uptrend of the U.S. stock market over a very long period of time. When one looks closely at the numbers however, one sees that the fee savings versus a mutual fund are typically quite small – less than 0.5% – unless compared to an extremely large Index fund. Importantly, there have been several lengthy periods of price declines within the decades-long market uptrend.
In trying to save money on fees and covering their eyes, we wonder if these investors truly appreciate the elevated risk they are assuming. Do they know that since 1900 there have been more than 10 periods when the market declined by more than 35%? Do they understand the pressure that they will feel in the next large market downturn when their advisor tells them to “just hang in there as we agreed-to at the beginning”? Investors close to retirement, or in retirement, who are passively invested in Index funds and ETFs could get hurt very badly in such a scenario. If retired, they will be withdrawing capital to support their retirement. Withdrawing capital on top of a portfolio that is sustaining losses causes rapid depletion. For those who haven’t yet retired in this scenario, there simply won’t be enough time left to recover.
Simply because passive investing has worked well since the Great Recession, does not make its case for the future. As value investor extraordinare Warren Buffet said, “What the wise man does in the beginning, the fool does in the end.”
Passive investing within 10 years of retirement, or during retirement, is a very risky strategy indeed.
We discuss this with each new client and come back to it often in our writing because we want all of our clients to clearly understand the logic behind our philosophy of active management. Within our macro-economic framework and our “30,000 foot-view” of industry trends and capital flows, we drill down and perform research and due diligence on each of our positions. We look to invest in strong businesses with growing revenues & earnings, high return on invested capital and attractive dividends (when we can find them). We hope to hold positions for more than 12 months to enjoy long-term capital gains tax treatment.
With a U.S. stock market that is neither “cheap” nor “expensive”, selectivity remains the key to achieving our clients’ investment objectives. In that pursuit, we constantly work to identify themes and trends upon which we can build portfolios:
- We foresee U.S. interest rates rising slowly into the future. The Federal Reserve has told investors that they have embarked on a slow path to higher rates; this includes beginning to run-off a portion of the approximately $4.5 trillion in U.S Treasury and mortgage backed securities from their balance sheet. Additionally, the European Central Bank’s Quantitative Easing program is coming to an end, which will likely put upward pressure on our interest rates and the U.S. Dollar. This will likely be a negative for bonds, but could be positive for financials.
- We may have an opportunity in biotechnology / pharma and other healthcare companies as the dust is settling from the Congress’ healthcare reform efforts. Following the ASCO Conference in early June, several exciting drug developments were announced and the Senate Republicans shared their initial healthcare reform bill. Both these events changed the tone for the biotechnology / pharma group. We are looking for a bit more visibility before committing more capital to the space.
- In technology, we remain enthusiastic about the future for Artificial Intelligence, Machine Learning, Artificial Reality, Cloud Computing and Autonomous Vehicles. We will continue our effort to invest in the leaders in these groups.
- Increased spending on defense by governments worldwide and in the U.S. seems likely to us, as does infrastructure spending, if the Congress can act.
- Last is our “catch all” bucket of companies we find in different sectors which have growing earnings and attractive dividends that are selling at a reasonable price. Our “dividend payers” have provided us handsome income and solid price appreciation. Further, they are often ballast during periods of market volatility – ballast that we once received from bonds.
We have enjoyed a positive market during the first half of 2017 and the S&P 500 has now exceeded the low end of our price target envelope for the year. So far, the vast bulk of our companies have reported positive revenue and earnings results for the Second Quarter, and their outlooks for the remainder of the year are positive. What could upset the apple cart? Outside of a major geo-political event, normally bull markets end with excesses built up in the economy. With this expansion growing slowly at ~2% per year, few excesses are evident. Disruption in retail is real, as is an oversupplied energy market. We are avoiding those areas.
Thank you for your continued support and as always, feel free to call if you have any questions or concerns.
Stay cool and enjoy your summer,
Please feel free to forward this to friends who you believe might be interested. To make sure you don’t miss our urgent updates, add Bryan@BeckCapitalManagement.com to your address book. If you have received this from a friend and would like to receive the next six issues at no cost or obligation, please send an email to Bryan@BeckCapitalManagement.com
All rights reserved by Beck Capital Management LLC.