Jul 09, 2014
More of the Same, This Time
Quiet is not an adjective often used to describe financial markets, but it fits, along with steady, resilient, calm and positive for the second calendar quarter. News flow over the quarter was relatively uneventful, notwithstanding renewed geopolitical concerns. As such, the fundamental backdrop this past quarter has been a continuation of existing trends – supportive central banks, excess liquidity and increased investor confidence. More recent support has come from a pick-up in merger and acquisition activity and corporations stepping up their share of buy-back programs. The outcome of all this has been stock prices moving higher.
Returns in the quarter were broad based across multiple asset classes. The current bull market now exceeds five years (well longer than average) and has set 22 all-time highs since the beginning of 2014. We have experienced 32 months without a 10% correction, 50 days without a 1% move in either direction, six consecutive quarters of positive returns (longest since 1998) and measures of volatility that have collapsed to levels that are near record lows. Paradoxically, there has been a growing anxiety over investor complacency.
For the quarter, domestic stock returns bested their non-U.S. brethren, both developed and emerging country. Small-cap stocks again lagged the performance of larger companies, a trend begun last quarter. Value and Growth equity styles performed similarly in the quarter and yield-oriented stocks benefited from increased interest in stocks that pay above-average dividends. Bond prices, likewise, gained ground with the 10-year Treasury yield ending the quarter at 2.52%, down from 2.7% last quarter and 3% at year-end.
It’s Different This Time
Sir John Templeton once said these were the four most expensive words in investing. The phrase is usually associated with trends that are powerful enough to convince investors of new paradigms. History has not been kind to new paradigms, though, and investors are justified in being highly skeptical of anything that is introduced by these four words.
That said, it is easy to misapply this phrase to anything that looks different. Market environments, investor expectations and relationships among global markets, among other things, can change, or better said, evolve. The part that doesn’t change is human behavior, especially when driven by fear and greed. Sometimes it can be more insightful to understand the role this plays in assessing whether a new trend or development is truly different.
In a slight departure from our normal quarterly commentary, we thought it would be interesting to look at a few of the issues in today’s investment environment where this phrase could apply and see whether a claim for being different might have merit. We’ll first look at a few historical examples of where the claim of being different has gone both ways.
(1) A belief in the late 90’s that new technology, inventory management systems and growth in the service economy would repeal the traditional business cycle of booms and busts, i.e. no more recessions. The great recession five years ago showed that the business cycle had less to do with the manufacturing cycle and more to do with basic human behavior expressed by other means (speculation, leverage and derivatives).
(2) The Tech bubble convinced many investors that traditional valuation metrics (actual earnings) were too “old economy” when applied to exciting new technologies, no different than the valuations that were justified for the “nifty fifty” blue-chip stocks in the early 70’s. We know how both those new paradigms ended.
(3) In the mid-2000’s, Alan Greenspan rejected the possibility of a nationwide housing slump because housing cycles had always been local and there were limited opportunities to speculate on a broad scale. What he didn’t fully appreciate was that the tools to allow investors to speculate in housing had changed. While the outcome here was clearly different, the underlying greed that drove the housing crisis wasn’t.
(4) In the aftermath of the financial crisis, some strategists predicted that the recovery would be different and called for a “new normal” to describe years of subpar economic growth. While the recovery of stocks five years later has been more normal, the underlying economy remains the weakest post-recession recovery ever. It may be too soon for the new normal crowd to take a victory lap, but their logic of seeing the unique nature of the collapse and subsequent government intervention led them to extrapolate a different outcome.
In today’s investment environment, there are several key issues that are candidates for the “It’s different this time” moniker that we think deserve careful consideration.
(1) Traditional economic theory would project that the unprecedented monetary stimulus provided by the Fed (the great experiment) would result in accelerating inflation. Five years later, not only has this not happened, but deflation remains a lingering risk. Looking back, economists can now offer cogent explanations why inflation has not gained traction. It is too soon (if not dangerous) to fully discredit conventional thinking about inflation, but this missed prediction underscores the fallacy of overlaying the examples of the past without an appreciation for the broad set of circumstances that are different (zero interest rates, quantitative easing, severe loan restrictions, etc.) which in this case have so far resulted in a different outcome.
(2) There is a relatively new thought making the rounds that has to do with a new equilibrium level of interest rates. The belief is that once the Fed begins to raise interest rates, the pattern of rate hikes will plateau at a lower level. Some suggest the cycle will peak with Fed Funds at 2%, rather than the average level of 4%. This would have significant implications on how investors would value both stocks and bonds, not to mention the impact on fixed income oriented retirees. This viewpoint has been espoused by current Fed Chair Janet Yellen and fellow Fed Board members and may explain, in part, the reason why interest rates have pulled back this year.
This new paradigm on interest rates assumes inflation stays relatively dormant and economic growth rates remain sluggish. While there may be good reason to be skeptical regarding inflation, chronic slow-growth seems more likely the longer our existing economy muddles along. This also raises the issue about whether normal economic growth expectations should be different. That could be the sole topic of a future investment piece, but we believe there are structural issues like tax policy, regulatory burden, Federal debt levels, and demographics that could challenge the economic growth assumptions that markets have typically assumed to be normal.
Probably the hardest sell-point regarding a new paradigm on interest rates is the credibility of the Fed. Not only is this view self-serving (keeps debt service costs lower and helps calm concerns around the inevitable end of zero interest rate policy), but the Fed’s track record on forecasting interest rate boundaries is mixed at best, not to mention they also whiffed on foreseeing the greatest economic and financial debacle in 80 years.
(3) The past five years have seen corporate profitability recover back to pre-crisis levels with current profit margins at all-time highs. Profit margins have historically been one of the more dependable financial measures to mean-revert (go back to long-term averages) because it is the essence of competition to be attracted to businesses where profits are high. Thus, it is a real leap of faith to buy into a new paradigm of higher profit margins.
This belief is built around corporate management’s newfound discipline to protect current high margins that have resulted from restrained hiring practices, improved productivity and more discerning capital expenditures, following the financial crisis. This behavior was born out of necessity due to high uncertainty about economic growth and governmental policies.
This discipline would typically unravel when economic activity finally picks up and businesses see more robust top-line revenue growth, prompting the cycle of new hiring and investing in new capacity to gain market share. For now, higher profit margins should prevail, but unless we are destined to a new paradigm of sluggish growth (see above), human behavior and animal spirits should eventually trump today’s discipline and profit margins will likely regress to their longer-term mean.
We think the value of this discussion is not to refute the intended message that it’s usually not different this time, but rather highlight that many real life issues are often more complex. Most important, IS to not let this valuable piece of wisdom obscure real change that is taking place for reasons that will be important to all of us as investors.