Investment Update

The unusually tight trading range that defined the stock market in the first half of the year gave way to the downside in the third quarter. Slowing global growth became a flashpoint of concern midway through the quarter, triggered by disappointing economic data out of China, the continued erosion in oil prices and an untimely Fed decision to defer on imminent rate hikes.
Most broad U.S. stock indices declined in a 6 – 9% range for the quarter. Non-U.S. stocks fared worse, while growth strategies and larger-cap stocks declined less than value strategies and smaller cap stocks. All sectors lost ground in the quarter, with economically sensitive stocks (Materials, Energy) su ering the worst. By quarter-end, even the standout Health Care sector corrected over 10% in the quarter.

The last correction of this scale was in the late-spring/summer of 2011, associated mostly with the debt ceiling debacle, government shutdown and the European debt crisis. Four years later, interest rates remain at historic lows and the economy continues to irt with “stall-speed,” but stocks have almost doubled from the bottom of this previous sell-o . Valuations have more recently pulled back from their peaks, but with the increasing levels of uncertainty, it is not surprising to see this translate to sharp swings in the market.

As has become customary, for our third quarter client letters, we are using our Q&A format to address some of the key investment issues of the day.

1. The last two years this third quarter note commented on the disparity between the relatively sluggish economic recovery and a very rewarding stock market. Your response suggested this disequilibrium could not be inde nitely sustained. Are we seeing this now being addressed?

That is most likely the case. Prior to this most recent quarter, stock returns over a three and ve year time frame have compounded at a 16% – 18% annualized return. Granted that was preceded by the nancial crisis, but it stands to reason that the trajectory of this recovery in nancial assets would eventually atten out. With the underlying economy’s more modest recovery, equity valuations have naturally expanded from undervalued levels to more fully valued multiples. As we’ve discussed before, valuation is a good measure to assess the future opportunity for stocks, but it is not particularly helpful in providing any near-term signals about the market’s direction.

Reconciling the di erent paths of the sluggish underlying economy and the stronger stock market does not necessitate a correction/bear market in stocks to restore equilibrium. Rather, a pick-up in growth leading to improved earnings expectations could have accomplished the same thing. In fact, it would be reasonable to view the rst six months of this year’s tight trading range as a market looking for con rmation that the economy is catching up to the embedded expectations built into current stock prices. Instead, the conviction around those expectations has been undermined by the Chinese slowdown, falling oil prices and an uncertain Fed policy.

As we move into the third quarter’s earnings season, analyst expectations on future earnings have now been reduced. In one way, this creates a lower bar for companies to surprise with better numbers, but it also reveals that this will likely result in consecutive quarters of negative earnings growth, year over year, which is unusual for an economy that is not in recession. Granted, the numbers look better when the Energ y sector is excluded.
We will talk more about recession risk below, but for now, the U.S. economy is expanding, albeit modestly, and stocks are likely to recover as they have in the past. Whether stocks take another meaningful decline in the interim in unknowable, but as we have been reminded, the risks of this are greater when stock prices get too far ahead of the fundamentals for which they are ultimately linked.

2. I’m tired of reading and hearing about the Fed’s plan to raise interest rates. How can a quarter-point rate increase be so important?

On the surface, it has taken on too much signi cance, especially since the expected quarter point hike is more symbolic than material. e Fed’s position has consistently been that they would err on the side of making sure the economy is on rmer ground before initiating this process. ey have muddied the picture, though, by changing the criteria of what constitutes rmer ground, now apparently extending to economic conditions around the world.

In some ways, the Fed is a victim of its own commitment to transparency – full disclosure of their thought process in the belief that this will make for fewer surprises and smoother transitions. More than their predecessors, Fed Chair Yellen and her colleagues have made frequent commentary about the path to higher rates, but it has lacked consistency. As our friend, Dr. Ed Yardeni, remarked recently, the downside to the Fed’s transparency is revealing that the Fed is clueless. e market’s negative reaction to foregoing the rate hike in September runs counter to how stocks have previously responded to this message and marks recognition that the bene ts of ZIRP (zero interest rate policy) have more than run their course.

Some have suggested that implementing the rst rate hike would also quell the heightened uncertainty, but we believe that is wishful thinking. It won’t be long before prospects of a second rate hike emerges, not to mention other issues fully capable of rattling investors. Uncertainty in times like these is normal and e orts by central planners to remove it can actually be counterproductive. As noted value investor Howard Marks has observed, more mistakes are made by investors when they are certain about things than when they are not.

3. Two things I don’t understand about the decline in crude oil prices – how come most of the impact on the economy I read about is negative and how could a decline in oil prices possibly raise the risk of recession?

All this seems counterintuitive. Lower oil prices will eventually produce windfall bene ts to consumers and businesses, but the magnitude of the decline has exposed a nearer-term disruptive impact to the economy, made more severe in that it had not been anticipated by the markets. e U.S. is one of the largest producers of oil in the world and for years the boom in production has created many good paying jobs, resulting in billions of dollars in new investment.

While it has taken a while for actual production to slow down, large and small projects have been curtailed and job cuts are occurring at both the smaller, entrepreneurial rms and the major multi-national oil companies. e elimination of this activity directly impacts companies involved in drilling, producing, oil service, fracking, heavy manufacturing , engineering , transportation, nancing , and real estate. Second order impacts are widespread, including the economies of speci c geographic regions that have bene ted from expanding energy production.

The part of this equation that gets to the recession risk is the investment side. Much of the aggressive growth in oil production has been nanced with debt, and the reserves that serve as collateral for a lot of that debt are now worth half of what they once were. About 16% of the face value of the high yield debt market is related to the Energy sector. Investment strategist Don Luskin calls this a “reverse oil shock,” where signi cantly lower oil prices will lead to junk bond defaults and losses at some banks, all of which could result in a tightening of overall credit conditions. Depending on how low oil prices sink, this stress in the high yield market could further dampen economic growth. The odds of this are still remote, but a year ago, such an idea would have been inconceivable.

4. I don’t pay much attention to bonds, especially when their expected return is so limited these days. Why do I see so many articles talking about bond risk and should I be concerned about the bonds you own for me or of this risk spilling over to my stocks?

To answer the second question rst, the bonds we invest in are conservative by most standards. We keep maturities relatively short and the exposure to rising interest rates is relatively moderate. We also stay within investment grade quality bonds versus lower quality, higher yielding bonds. is latter group has more recently come under pressure, as is o en the case when investors worry about the health of the economy or a tightening in credit conditions.

When yields on lower quality bonds rise relative to high quality bonds, this is called a widening of credit spreads. ese spreads are used as a measure to gage how investors feel about risk and widening spreads are o en a precursor to a more challenging environment for stocks. We have seen this widening at all bond credit levels, even the spread between good quality corporate bonds and Treasuries. Equity investors have taken note of this and it has contributed to the negative sentiment toward stocks.

A more serious concern around bonds has focused on the dwindling liquidity of the bond market. Increased regulation (post nancial crisis) was designed to make nancial institutions safer, but it has also made it more di cult for nancial institutions to make a market trading bonds. is means there are fewer potential buyers at the critical times when there are excess sellers.

The risk of this imbalance is exacerbated by the advent and success of bond ETFs (exchange traded funds). ese investments have attracted enormous amounts of money because of the convenience and perceived enhanced liquidity features. Instead, there is real concern that the liquidity attributes of bond ETFs will not hold up as advertised under broad selling pressures. Under this scenario, the price of the ETF security becomes disconnected from the value of the underlying ETF holdings.
Bond ETFs have yet to be tested by a mass selling event, but that is more a matter of when, not if. As an investor, the best way to avoid being hurt by liquidity risk is to avoid being in a position where you have to make a sale. ese price dislocations from an imbalance in buyers and sellers can be severe, but they are temporary in nature. A natural price equilibrium is eventually reestablished.

5. I know nobody wants to go through 2008-2009 again, watching the broad equity market get cut in half. I also know we are overdue for a normal bear market (down 20% plus) and that would be bad enough. Can you o er any words of assurance (not literally) that we are not setting up for another signi cant collapse?

We appreciate your gurative use of “assurance.” e odds are very much against another decline of that magnitude. Of course, the odds were against it in 2008. We’ve seen the highly improbable happen twice in the last 15 years.

The 2000 tech bubble collapse was valuation driven. While some warned of a bubble, others accepted a new paradigm for valuation. Today’s valuation won’t keep the market from a large decline, but it won’t likely be the catalyst. e breakdown in 2008-2009 was a panic that resulted from exposing nancial risks that had not previously been contemplated. e phrase “systemic risk” has become a part of the standard “what can go wrong” lexicon. is doesn’t mean we can’t repeat the mistakes of the past (don’t look now, but margin is at record levels and credit default swaps are back, as are sub-prime loans) but these are now known risks.

Fundamentally, there are no visible signs of a massive credit squeeze (beyond pressures in energy debt) or collapse of con dence in the nancial system, however awed our system or policies are. We know the Fed has fewer tools this time if something goes o the track since rates are already at the bottom and it would be hard to have much con dence in another round of quantitative easing. To the extent that the Fed has played a signi cant role as the markets’ backstop of last resort, investors will have to get used to the reality that a transition from this role will create more volatility, as evidenced by the recent correction.

Perhaps the best assurance we have against another collapse is the ongoing fear that it can happen. is may sound like it is largely a matter of psychology, but in the short-run, that has a lot to do with it. Too much optimism prevailed in 2000 and complacency would better characterize 2008. Today’s environment seems more circumspect for reasons that are not hard to understand.

For now, with a correction already in hand, a normal bear market should de ne the downside. Attempting to predict or time this possibility is always tempting, but the past six years have not been kind to those who have tried. Instead, our valuation ranking process is active in identifying opportunities that these kinds of markets provide. Heading into the fourth quarter, we are mindful that little good news with respect to China’s or our own growth rate, productivity measures or third quarter earnings can go a long way in improving sentiment. Either way, the recent correction strengthens our view that equities will provide the most attractive return opportunity of the major asset classes over the next five years.