Key Takeaways —
Global stock markets generally fell in the third quarter. While larger-company U.S. stocks actually finished the quarter with a modest gain of 1.1%, smaller-company stocks were down 7.4% and developed international and emerging markets also posted significant declines. However, we think the real news is what has happened in the last 4 weeks ending October 15th. In that time, all equity markets are down somewhere between 6-9%, which brings us the closest we have been to a 10% correction in almost 3 years.
Developed international and emerging-market stocks fell during the quarter, particularly in dollar terms as the U.S. dollar rose against other currencies. (A stronger dollar reduces returns on investments that are denominated in foreign currencies.) In the bond market, yields rose slightly at the prospect of the Federal Reserve’s exit from its bond buying program (QE3) and eventual increase in interest rates (most likely in 2015). The core bond benchmark was flat for the quarter.
The quarter’s financial market results were set against a now familiar set of macroeconomic and geo-political considerations and worries. These same issues have shaped markets over the course of the year as well. They include divergent economic outlooks around the globe, with the United States seemingly on a path of modest recovery, Europe facing stalled growth and potential deflation, and China continuing to seek a balance between maintaining sufficient economic growth on the one hand and economic reform on the other. Geo-political issues, including the escalation of U.S. military action in the Middle East, the military conflict in the Ukraine, and a potential ebola epidemic in Africa, also continue to concern investors.
This Investment Commentary will break from our usual format and instead address some questions we have gotten from our clients regarding the market in a Q&A format that we think will better communicate our position on your investments.
Current Views and Portfolio Positioning
Given that the markets were down 5-6% in the first two weeks of October, we think it is prudent to back up and take a bigger picture viewpoint on the markets rather than focusing solely on the third quarter. In doing so, we want to address the flurry of news and market activity from the last two weeks and hopefully provide a little backdrop and perspective. As we have done in a few of our past newsletters, we believe that a Q&A format is the best way we can address some of the questions that have recently come our way:
Q. Is this the beginning of a Bear Market?
A. At this point in the U.S., large company stocks are not down 10% from their highs, so technically we haven’t even reached a market correction yet, much less the classical definition of a bear market. Since we are still creating over 200,000 new jobs each month and corporate earnings this quarter (as in the last few quarters) are very good, it is highly unlikely that we are in the beginning of a bear market.
Q. If it is not a Bear Market, what is causing the markets to go down so much?
A. At the very core, the market is concerned about the rate of growth of economies around the world, especially since the data out of Europe recently is showing the potential for very low or negative growth and even possibly deflation. As we have discussed with our clients this year, the good returns we had in 2013 were in anticipation of higher growth around the world and in the U.S. in 2014. The U.S. has been stuck in a low growth rate (about 2%) for the last 5 years and there was an expectation that we would move solidly to the 3% range. We think it is safe to say at this point that those hopes have been dashed. As the market has come to the realization of a lower growth rate, it has therefore has been sold off. This is a very normal and typical part of a market cycle.
Q. Why have oil prices declined by almost 20% this year and isn’t that supposed to be good for the market?
A. One of the reasons oil prices have declined is the anticipation of slowing worldwide growth, although it seems that another viewpoint has arisen in the last month or so as well. This viewpoint believes that Saudi Arabia in particular is trying to break the back of U.S. shale oil production. Since shale oil from North America is more expensive to produce , the Saudi’s are trying to drive down the price low enough to make it unprofitable to produce here. However, from a longer term perspective, lower oil prices are tremendously beneficial to any economy that imports oil, including Europe and even the U.S. to a lesser extent.
Q. The dollar has risen more than 8% over other developed countries in the third quarter. I thought a strong dollar was good, why are the markets reacting negatively to that?
A. We think the issue is how quickly the movement has occurred, not just the movement itself. Any time you have a fast movement in currencies, either up or down, it is potentially negative, because multinational businesses need a stable currency and when it is not, it creates numerous problems for them as they plan and also convert their profits back into dollars. It certainly makes sense that the U.S. is attracting capital flows, particularly from Europe and Japan given the weakness of their economies, but it doesn’t make nearly as much sense to us that emerging market currencies have done so poorly in this environment. If the U.S. attracts capital and does well, emerging markets and their currencies should do well also.
Q. I thought that when the Federal Reserve wound down the quantitative easing (QE program) and stopped buying bonds, interest rates would rise. What happened?
A. That was the prevailing thought, especially at the beginning of the year, but it is important to remember that we are in a global market. You might look at the U.S. and think that we have low interest rates, but if you look around the world you’ll notice that many countries’ rates are even lower. We do not have the lowest interest rates; in actuality, we are closer to the middle or even higher end of the spectrum. As a general rule, investors are drawn to strong economies with high interest rates, which is what has happened this year.
Q. Of all the things going on in the world from a geo-political and global macro perspective, what concerns you the most?
A. Today, we think the largest risk we face is an ebola breakout in the U.S. We believe that if we get even 100 confirmed cases in the U.S., possibly even less, business and economic activity would slow to a crawl. The environment could potentially be similar to right after 9-11, as business travel ground to a halt and people stayed in their homes. That would create a change in the fundamentals of the U.S. economy and therefore with the investments in our portfolios. While we think there is a low probability of this happening, it is the one issue we see currently that could change the fundamentals. The vast majority of the other issues that we have outlined here and that you see on a day to day basis in the news have little chance of changing the fundamental drivers of the U.S. economy.
Q.When you speak of fundamentals, what exactly do you mean, and do they really still matter when there are so many big macro issues driving the news and the markets?
A. Yes, we still believe that fundamentals (i.e. company earnings and valuations) do matter. Fundamentals are, generally speaking, things that affect the growth of a company and/or the economic conditions in which it operates. The vast majority of our money managers have a “bottom up” investment philosophy, which means they look at the profit of a company first and then work their way up the balance sheet to determine whether that company’s earnings are sustainable and growing relative to the cost of the investment in that company.
Markets do go through periods of time in which they ignore fundamentals because of other global macro issues like the ones we see today. In our view, we have been going through that exact environment over the last 9-12 months, and there has been a disconnect between the market’s activity and the underlying fundamentals. Specifically, stock prices have been getting ahead of the fundamentals with the assumption that growth would soon catch up. One of the advantages of corrections is that they temper that enthusiasm, and stocks usually begin moving on fundamentals again after a correction. So, if there is any silver lining, it is that if this does become an “official” correction (decline of 10% or more), our portfolios should begin to move based on fundamentals again rather than being whipsawed by the news of the day.
Q. As I look at our portfolios, it looks like the funds that are invested in the U.S. have lagged their benchmark, the S&P 500 this year.
A. Yes, the vast majority of our U.S. equity managers have lagged their benchmark and as we have looked intently at this over the last few months, we have identified a couple of reasons for this. The first reason is that although we do not have a dedicated position to small companies (which have done much worse than large companies this year), the vast majority of our portfolios do have some allocation to mid-sized companies which have been a drag on returns. More importantly, we believe a large part of the reason has to do again with the market’s fixation on other fears other than the factors that ultimately affect companies’ earnings. The environment we are in is so driven by global central banks and geo-political fears that “bottom up” security analysis has been largely overlooked. As mentioned above, it is not unusual to go through periods of time like this, but in the long run we believe that fundamentals and valuations drive returns.
Q. You have been discussing emerging market stocks and their value for the last 12 to 18 months, but it doesn’t seem that we have gotten excess returns.
A. It is correct that emerging market stocks have not added to returns in the portfolio. They have actually underperformed U.S. markets over the last 12 months, but we believe the investment thesis is still in place. Many people have been discussing emerging markets slowing down in growth, but in reality, they have steadily grown at about 4%-5% for the last 2 years. The thesis is to invest in markets that will grow twice what developed markets (U.S., Japan, and Europe) will, and also do not have the debt issues that the developed market countries carry. Emerging markets are not without risk, particularly currency risk as we have seen this summer, but we still believe that long term they will provide superior returns to U.S. and developed markets given their current valuations.
Hopefully the above format was helpful and informative. Our viewpoint has not changed, we still believe we are muddling along economically as we have for the last few years. Going forward that is the most likely outcome – continuing to muddle along. The world will grow at a slower rate and the U.S. economy will unfortunately grow at a slower pace than we have seen historically. Given this backdrop, the returns we have had in the last five years will probably not be repeated, but we believe we will be able to generate acceptable absolute returns.
Ultimately, in our investment analysis and decision-making, we try to focus on what is knowable with a reasonable degree of certainty or within a reasonable range of outcomes and probability. There are times when what we determine is right for our client’s long-term benefit is at odds with what the markets are doing in the short term. However, we believe that our discipline and adhering to our circle of competency: our expertise in asset class analysis, fund manager selection and portfolio “risk” management will continue to enable us to meet our clients investment objectives over time.
Jon Houk, CFP®