Investment Update

Going Nowhere, Fast

Broad stock returns were relatively unchanged for the quarter, a fitting outcome for a market that moved frequently with conviction in both directions. It is also not surprising to see a consolidation of the very strong returns in the prior quarter.

Much of the fundamental narrative has centered around three key issues – the further decline in crude oil prices, the continued appreciation of the U.S. dollar relative to other currencies, and the projected decline in 2015 corporate earnings growth. Markets were also preoccupied with the usual concerns – handicapping the timing of the Fed’s first rate hike, weaker economic data and geopolitical instability. Short-term rallies were often related to any Fed commentary that hinted at pushing back the timetable for rate hikes – a theme that never seems to grow old.

For the quarter, the S&P 500 managed a positive return of 1.0%. Non-U.S. stocks, for a change, scored some of the best returns and Growth stocks had a decided edge over Value stocks. The NASDAQ finished ahead by 3.8%, the DOW was up fractionally and the stocks of smaller companies bested larger firms. Bonds posted respectable returns in the quarter (relative to a limited opportunity) as the 10-year Treasury yield declined to 1.93% from the year-end mark of 2.17%.

On Everyone’s Radar, Now

The recent unexpected developments noted below have clearly added to investor uncertainty, but the broad market has also been resilient so far in absorbing the ramifications of plunging oil, a soaring dollar and weaker earnings growth.

  • Oil Prices – The 50% plus decline is remarkable on several levels, not the least of which is that virtually no one saw this coming. Even though most agree this will be a net positive to the economy, the suddenness and magnitude of this move has been unnerving. So far, the benefits to the manufacturing cycle and consumer spending are not visible. That should come later. Prospects for a quick rebound have also faded. Even when oil prices firm on disruptive news out of the Mideast, like we saw recently from the turmoil in Yemen, the rise has not been sustainable. Oil supply remains robust as U.S. crude production rose to a new high during the quarter, even as new projects are being curtailed. Stocks are discounting oil staying in this new lower range.
  • Dollar – The U.S. dollar has appreciated 13% in the quarter against the Euro and stands 28% higher over the past year. Currency changes do not often rank among the list of investor concerns and on the surface, most investors believe that a strong dollar is a good thing. It is for some (U.S. consumers of foreign goods), but not so for others (U.S. producers who sell their goods outside the U.S.) What’s notable about this currency move is the magnitude of the change and again, few saw this coming. With the European Central Bank following the Fed’s script to stimulate their economy with massive amounts of liquidity, they are successfully driving interest rates lower, supporting stock prices higher, and depreciating their own currency to make their exports more attractive. We’ve seen this movie before.
  • Earnings –A strong dollar is also causing U.S. multinational companies to reduce their 2015 earnings projections because foreign revenues now translate into fewer dollars. This currency squeeze, along with reduced projected earnings from the Energy sector, has reduced analyst first quarter estimates to negative year-over-year comparisons, the first time this has happened since 2009. This earnings picture may improve over the course of the year, but in the meantime, it does focus attention on the market’s relatively high valuation. While negative earnings growth is not always predictive of an economic downturn, the last two recessions were both preceded by a decline in year-over-year earnings. It certainly becomes more challenging to envision meaningfully higher stock prices (P) when P/E multiples are full and earnings (E) are not growing.

Valuation, Again

We’ve written many times about the role of valuation as the driver of our investment philosophy and stock selection process. It is the primary focal point from which we construct equity portfolios from the bottom up, one stock at a time. Valuation metrics are also used in top-down strategies to characterize the broad market, measured against itself based on history, or one market relative to another or one sector compared with another.

Issues about whether the markets are in general “overvalued” are a common refrain, especially as we are in the midst of a 6-year recovery from the financial crisis. The relevance of this analysis depends on how that information is used. History has shown that valuation is a very blunt instrument for those who would use it to make timing calls in their exposure to stocks. Stocks can stay at under or overvalued levels for long periods of time. And as we saw six years ago, markets do not have to be in overvalued territory for an unforgiving bear market to take hold. Those waiting for a valuation signal then saw values drop to inconceivable levels before finding a bottom.

So how then are general, market-based valuation measures helpful? In our view, they provide a broad perspective on framing risk and return opportunities. While they may offer little help in the way of timing, they can present potential upside or downside to an investment based on the likelihood of a positive or negative scenario. At current market levels, it is reasonable to say that stocks are more vulnerable today to an economic downturn than they were several years ago. As one of our favorite strategists, Don Luskin, liked to say back then, “you can’t fall out of a basement window.” Today, he admits, it would hurt.

As a bottom-up manager, we are less put off by the top-down generalizations of high valuation attributed to markets or sectors, as it is our objective to find those individual securities that are the exception. Sometimes after long sustained market gains, this search does become more difficult, and this gives us our best insight to the market’s overall valuation. That said, we are currently able to find and own attractively priced investments. This doesn’t mean that they won’t go down in a broad market downturn, but our valuation process gives us confidence that these are the kind of assets we will want to own when markets eventually recover.

There are numerous financial measures, conventional and arcane, to gauge if a market or stock is cheap or dear. The most common is the simple P/E ratio, a multiple that divides a company’s share price by its earnings per share. It can use the most recent 12 months earnings figure or one based on a projection of earnings for the next 12 months. Either way, the multiple can be compared to its historical multiple to determine a relative sense of value. Today’s forward P/E multiple on the S&P 500 is approximately 17 times versus a 30-year average multiple of approximately 14.5.

Even a simple measure like P/E does not have a uniform method of calculation. Another version, espoused by Nobel Prize winner, Robert Shiller, adjusts the earnings figure for inflation and uses a 10-year rolling average. This measure, currently reflecting a 27 times multiple, has often taken a more pessimistic view of the market’s valuation. The primary takeaway from this perspective is that future returns from stocks will be less than average when starting at these higher valuation levels.

We are not strong advocates of this alternative valuation measure and strict adherence to Shiller’s P/E would have caused investors to miss a good part of the market’s recovery. Still, given where we’ve come from the past six years, we think it is logical to take a more cautious stance with respect to future return expectations. We believe that P/E multiples, like any other single measure of value or risk, are best used in combination with other indicators in discerning an investment’s true value. This is how our models are constructed when we evaluate individual companies. To the extent there is merit in assessing the valuation of the broad market, we think the same principles should hold.