Bryn Mawr Trust Quarterly Market Insights, Fall 2019

Amid a particularly complex global economic and political backdrop, this quarter we tackle ten of the most pressing topics for investors.  There is likely something for everyone is this piece, as we cover everything from the practical considerations of how to invest new cash, to more esoteric topics like negative interest rates and the U.S. national debt.

Top 10 List – Table of Contents

Now or Later?

What should investors do with cash near all-time equity market highs?

Naturally, investors don’t want to invest a large sum of money just before the stock market peaks.  These concerns become amplified when markets are at or near all-time highs, as they are today.  So how should investors go about investing a large some of cash?

The conventional wisdom is that dollar cost averaging (DCA) is the best approach – slowly buy into the market over time, mitigating the likelihood of investing everything at exactly the wrong time.  The problem is the math tells us that DCA, although perhaps an effective behavioral tool allowing investors to create a plan to get invested, doesn’t usually produce a better result when compared to lump sum investing.

The reason for this counterintuitive conclusion is quite simple – the market tends to rise over time.  To quantify this, from January 1871 to July 2019 U.S. stocks returned an average of 0.025% per day, including non-market days and weekends.[1]  Due to this simple fact, dollar cost averaging usually means you are buying in at higher, not lower, average prices.  Perhaps frustratingly, the minority of cases in which DCA does outperform lump sum investing (when the market is falling) are precisely the times in which sticking with DCA can be most difficult.  Investors are emotional, and it is always uncomfortable to buy into a market that is going down…even if that was the plan.

The Data

In order to properly analyze both strategies, we chose to use a 12-month investment period for the DCA option.  In other words, buying in equal quarterly purchases over a year.  We then compared the DCA performance to that of a lump sum investment over the same 12-month investment period to determine which strategy has been more successful. At the end of 12-months, once both strategies are fully invested, the performance is the same from that point forward.

The result was that from March 1960 through March 2019, lump sum investing outperformed DCA 70% of the time.  The average annual price return difference was 2.2%.[2]  Including dividends, the disparity would be larger.  Interestingly, the return distribution is also very symmetric.  The worst year for lump sum investing trailed dollar cost averaging by 20%, while the best year for lump sum investing beat dollar cost averaging by 24%.  So, one’s fear of a market crash should be balanced with the fear of being left behind as the market rapidly rises.

Does Valuation Matter?

Surely periods of above average valuation lead to more success for DCA?  Not exactly.  The odds shifted a bit, but lump sum investing still consistently outperformed.  This is because valuation, although incredibly powerful when forecasting long-term returns, has very little correlation with returns over a 1-year period.  For example, the forward S&P 500 price-to-earnings ratio has a correlation of 0.10 with returns over the next year.  The correlation is much higher (0.89) with average annual returns over the next 10 years.  During shorter time horizons, things other than value (headlines, emotions, the business cycle) have more influence on market performance.


Trade and the U.S. Presidential Election

When President Trump announced his first round of U.S. tariffs on Chinese imports in January of 2018, they covered roughly $1 billion of imports related to solar panels and washing machines. From that point, the list of goods to which tariffs apply has been steadily broadened (now roughly $300 billion) as has the actual rate, with the most recent escalation coming on September 1, 2019. China has regularly imposed counter measures on U.S. goods and ceased (or at least greatly curtailed) the import of certain U.S. products.

This standoff between the U.S. and China has clearly been detrimental to U.S. economic growth. While difficult to accurately quantify, a good portion of the deceleration in quarterly GDP from the 3.2% rate posted in the second quarter of 2018, to the 2.0% figure registered for the same quarter in 2019, can clearly be put at the feet of the growing trade tensions between the countries. China too has been impacted by slowing growth, which by definition has curtailed global economic growth, since these are the world’s two largest economies.

While the Trump Administration’s approach (escalating tariffs) to confronting China on the trade front has certainly not had bipartisan support, the underlying issue of addressing China’s trade imbalance and forced technology transfer has been far more universally embraced. Simply put, regardless of the party in power, we will likely not be returning to the status quo pre the current standoff.

So where do we go from here? Through the eyes of President Trump, he knows that his approval rating (currently 43%) is roughly the percentage of the vote he is likely to get in next year’s election. He also knows, that what applied to Bill Clinton’s election (It’s the Economy, Stupid) is still applicable, and that this trade issue is what is creating the slow-down in the U.S. economy. Consequently, his desire to strike a deal well before next year’s election increases by the day. It would also give him a signature achievement on which to run for reelection.

From China’s perspective, some have argued that China may play a waiting game and try to run out the clock between now and the election, with the hope a change in the White House could possibly remove this issue. However, as noted above, regardless of the party in power, returning to the old standard will be a non-starter – – – change is coming. We would also stress that China fully recognizes the need to keep its economy growing, particularly as they face other issues on the home front, most notably the growing unrest in Hong Kong.

Our belief is that some type of a deal will be reached over the coming months. That said, it is highly improbable that it will be the grand bargain the United States is looking to achieve, since any deal involves a negotiated outcome. Far more likely is an interim or partial deal, either of which would still reduce uncertainty and increase global growth. The Federal Reserve has been forced off the sidelines to help counteract the headwinds created by the trade issue. The resolution of the trade issue, even if only in a partial manner, would be stimulative to global growth, corporate profits, and by definition, equity prices.

After the better part of two years of escalating friction between the U.S. and China, we believe that the trade narrative is finally poised to get better over the coming months. 

Mind the Performance Gap

Domestic vs. International, Growth vs. Value

Over the trailing five years, the S&P 500 Index has produced an average annual return of 10.8%, vs. 3.3% for the MSCI EAFE Index of developed international equities. Sadly, the news gets a bit worse when the period is extended, as international equities have severely lagged over the trailing 10 years, with the S&P 500 Index compounding at 13.2% per year, vs. 4.9% for the MSCI EAFE Index. This may have investors questioning the wisdom of international exposure within the equity allocation of their portfolios.

Does the United States have some inherent home field advantage? This question can be addressed in a variety of ways related to currencies, the formation of the European Union, and others. A simple starting point is to look at the historical returns.  This analysis paints somewhat of a mixed picture.

Since January of 1970 the best performer in any single year is little better than a coin flip, with the U.S. outperforming 26 times and international developed 24. Then too, for the first 27 years of this comparison (1970-1996), the cumulative returns between the two geographies were essentially the same. The first noticeable, sustained, divergence took place in the 1990s.

Annualized Returns by Decade Chart

Source: Morningstar, Inc.

The chart above segments the average annual returns by decade and displays a rather interesting picture. In three of the decades the MSCI EAFE Index outperformed, but by a relatively modest margin. Then, in the two time periods where U.S. stocks generated the better results, the disparity is far more pronounced.

Looking at those two time periods, the U.S. outperformance in the 1990s and the current decade have been greatly influenced by the same dynamic; broadly speaking, growth outperforming value, and more specifically, technology stocks (which are disproportionately represented in the U.S. Index) generating outsized returns.

The first of the two time periods (1990s) corresponds to a massive move in technology stocks, where the tech sector within the S&P 500 produced average annual returns exceeding 30%. Similarly, the current time period has also witnessed technology (growth) stocks dramatically outperforming. That has a much greater impact on the S&P 500 Index, where the technology sector has a current weight of 22.3%, vs. just 6.7% within the MSCI EAFE Index.

This is obviously not to say that the growth bias is the sole reason for the U.S. outperformance in these two decades. Still, the figures from the 1990s and the current time period provide empirical evidence of the huge impact of growth vs. value (over the past five years the Russell 3000 Growth Index is up 13.1% per year, vs. 7.7% for the Russell 3000 Value Index).

To that point, while every investor, growth or value, obviously wants to invest in companies that regularly increase earnings, the question becomes is the price (P) paid for the growth reasonable relative to said earnings (E)? In the chart below, that question is addressed from a statistical perspective within the United States, by looking at the Russell 3000 Value and Growth Indices.

Russell 3000 Value NTM P_E Chart

Source: Strategas Research Partners, LLC

This shows a current (almost) off the charts bias towards growth, when viewed through the lens of the price paid for the next twelve months (NTM) of earnings for each Index. Given the technological changes taking place today, some of this added premium may be warranted, but certainly nowhere near all of it. So, we would contend that the extreme bias displayed in the chart above is both an argument for meaningful domestic value exposure within portfolios, and given the composition of the MSCI EAFE Index (lower exposure to growth), also maintaining exposure to international equities.

Finally, while many may point to currency having a huge impact in the outperformance of U.S. equities over the recent past, at least since 1990 the return for the EAFE Index, whether in local currency or the U.S. Dollar, has been essentially the same.

While we don’t know when this extreme bias toward growth will reverse, we think value investing will likely outperform over the very long-term.  When it does, those that have exposure to value, both domestic and via international exposure, will be thankful they adhered to the tenants of a diversified portfolio and did not concentrate their equity holdings in the asset class that had generated the best returns over the recent past – – – U.S. growth stocks.

Concern or Scapegoat?

Stock Buybacks

 The level of share repurchases (“buybacks”) by corporations has been widely referenced as a major factor contributing to one of the longest bull markets in U.S. history.

Investor flows into equities have been subdued over this market cycle, which is somewhat perplexing given that the S&P 500 Index has more than quadrupled since the lows registered in March 2009.  The table below groups net buyers of stocks held in the Russell 3000 Index into various categories.  Over the past 5 years, corporations have been a significant source of demand for equities and have accounted for more purchases relative to any other group of investors.

Annual Equity Flows Based on Investor Category

Annual Equity Flows Based on Investor Category

Source: Strategas Research Partners, LLC

Some investors fear that a drastic reduction in corporate buyback activity will cause a precipitous fall in stock prices given the lack of demand from other investors.

Furthermore, some are convinced that management teams are artificially boosting share prices by lowering the share count at the expense of future profitable investments that could ultimately lead to more robust growth.   The belief is that management teams have disproportionately benefited shareholders, at the expense of workers, productive capacity, and overall economic growth, which has helped contribute to the growing level of income inequality.  The passage of Tax Cut and Jobs Act (TCJA), which enabled corporations to repatriate offshore cash at a reduced tax rate, has further stoked the populist fervor over corporate greed and income inequality.  Based on data compiled by the Federal Reserve, U.S. corporations repatriated approximately $777 billion in 2018, which is the same year that S&P 500 companies set a record for annual stock buybacks with a tally of over $800 billion, an increase of 50% from 2017.

We believe that it’s quite possible, though difficult to quantify, that certain individual companies have spent exorbitant sums on share buybacks, possibly to the detriment of the firm’s operations going forward.   This is especially true if purchases are financed with debt that could place undue stress on credit metrics or are being done to offset stock issuance to corporate management teams. However, we believe that most companies that have engaged in stock buybacks are financially stable and have ample free cash flow to finance share buybacks.  In general, free cash flow yield (free cash flow/sales) has been elevated for S&P 500 constituents post the 2008/2009 financial crisis.  While corporate financial leverage have risen, a variety of credit metrics we’ve reviewed don’t portend an imminent crisis in terms of corporations being unable to service their debt.

Furthermore, we don’t’ see enough evidence that buybacks have suppressed research & development spending and capital expenditures, which have risen quite significantly since the onset of the current economic expansion.  Other than 2007 and 2018, corporations have spent considerably more on capex relative to share buybacks over the past 20 years.  A portion of repatriation proceeds have clearly gone towards buybacks and debt payments, but corporations have also used their capital for business investments, a topic not as widely discussed by the financial media.

S&P 500: Annual Difference Between Dollars Spent on Capital Expenditures & Buybacks
($Billion) 1998-2018

S&P 500 - Annual Difference Between Dollars Spent on Cap. Expenditures and Buybacks

Source: Strategas Research Partners, LLC

From our perspective, buyback activity is just another method of returning capital to shareholders in a form other than dividends.  Corporations were not permitted to purchase shares through open market transactions until the adoption of SEC rule 10B-18 in 1981.  Since the early 1980’s there has been an increase in stocks buybacks commensurate with a decline in dividend payout ratios.  Today, the annual dividend yield for the S&P 500 is roughly 2%, which is materially lower than the 4.50%-5.00% level equity investors received for the 60-year period prior to when stock buybacks became more widely adopted by corporations.

According to research conducted by Strategas Securities, LLC, the dividend payout ratio has steadily declined from approximately 90% in the 1930’s to 35% in the current decade.  In fact, dividend yield accounted for more than half the returns received from equities prior to the 1980’s.  While the dividend yield for stocks has fallen, a shareholder’s cash yield, or the combination of dividends payments plus buyback yield (annual percentage of common equity retired), has not changed considerably over time.   We don’t think corporations are currently returning an exorbitant amount of cash to shareholders.  It is inconsequential whether funds are returned to shareholders via dividends or stock buybacks.  In fact, stock buybacks have some advantages for taxable investors given that they are not subject to any taxation compared to dividend distributions.

Regarding the premise that stock buybacks are causing a massive market bubble, we think that’s a bridge too far.  Just because two variables move in tandem does not necessarily signify causality.   It is possible that the stock market would be trading at lower levels today if buyback activity was more muted.  However, a case could also be made that a portion of the free cash flow previously applied towards buybacks could just have easily been distributed via dividend payments, which wouldn’t have drastically affected aggregate return realized by investors.

It’s a Mad, Mad, Mad, Mad World

Negative Interest Rates

Lending money to someone and paying them interest seems crazy.  However, that is exactly what is occurring with $15 trillion of negative yielding debt around the globe.  What is going on?

First, a little history.  The Swedish Riksbank bank was the first to institute negative interest rates during the depths of the financial crisis when it lowered its deposit rate to -0.25%.  This policy created a small penalty on financial institutions who kept excess reserves with the central bank. During this time, other central banks around the globe were also resorting to non-traditional measures to stimulate economic growth, but negative policy rates had not become mainstream. Today, central banks in Denmark, Japan, Switzerland and the euro zone have transitioned from spectator to experimenter.  Negative policy rates have become more common, as central banks attempt to promote economic growth and stable prices.  Simply put, central banks are attempting to spur bank lending to consumers and businesses as well as reduce incentives for consumers and businesses to save.  Both should influence spending which then contributes to economic growth.

Have negative rates been an effective policy tool?  Of course, it is hard to know because of the counter-factual (what would have happened without negative rates); however, in our view it is hard to argue that negative interest rates have had the desired effect.

In Europe, for example, economic success has been limited.  Inflation remains well below the European Central Bank’s (ECB) comfort level while fears of deflation and stubbornly low economic growth are major concerns.  The ECB has implemented a mix of remedies, including engineering low bank borrowing rates, quantitative easing, forward guidance as well as negative deposit rates.

Regarding the latter, financial institutions that elect to park excess cash with the ECB as opposed to lending are being charged to do so. Collectively, ECB policies are geared towards reducing the incentive to save, in turn promoting spending.  To date, given the current state of economic growth in Europe, it is hard to argue that negative rates have been a necessary or successful policy measure.

The U.S. Federal Reserve (Fed), in contrast, has primarily used the federal funds target rate to achieve its goal, while also relying on the purchase of U.S. Treasury and agency mortgage-backed securities (quantitative easing) as well as simple communication to the public regarding the path of future interest rates (forward guidance).  In many ways, the Fed’s policy measures appear more successful in achieving their objectives when compared to central banks that have resorted to negative rate policies.  In reality, this likely means that structural elements of an economy, such as labor mobility, demographics, and regulation are far more important to robust economic growth than the level of interest rates at the zero-lower bound[3].

Given the questionable effective of negative interest rate policy, it is also important to understand the potential risks.  We believe there are numerous unintended consequences worth considering, and frankly, these risks apply not only to negative interest rates, but to the general systematic suppression of interest rates we have seen by central banks over the last 10 years.  For example:

  • Limited ammo – Persistently low or negative interest rates provide little room for central banks to lower interest rates if and when monetary policy calls for such action. Current policy tools will need to be reassessed and a shift from monetary to fiscal policy will most likely become more important to stimulate economic growth.
  • Misallocation of capital and asset bubbles – An investment that is guaranteed to lose money if held to maturity isn’t too exciting compared to assets that have the potential for positive returns. Although the latter is more appealing, it also creates an environment where investors are chasing the same asset classes, potentially leading to asset price distortions as well as unintended portfolio risk from lack of asset diversification.
  • Stress on banking system – low and negative interest rates suppress bank profitability. As policy rates and yields shift lower, the yield curve becomes flatter.  Banks traditionally borrow funds short and lend long, earning the difference between the two rates.  When lending rates continue to fall as borrowing costs are more anchored, bank interest margins become squeezed.

Likely Direction of US Rates

Fed policy rates and bond yields have been trending lower since late 2018.  Incoming U.S. economic data have been mixed but overall continue to indicate that economic growth is decelerating.  Additional rate cuts this year and into 2020 are already reflected in bond yields.  For example, the 10-year U.S. Treasury yield has dropped from 3.24% on 11/8/18 to 1.67% on 9/30/19 – a difference of 157 basis points (1.57%).

10-year US Treasury yield
(10/31/2018 – 9/30/2019)

10-year U.S. Teasury yield

Source:  Bloomberg Inc.

Given the sharp drop in yields, we believe the current interest rate environment provides enough accommodation for the weakest U.S. economic sectors, such as manufacturing, to stabilize while other rate sensitive sectors, such as housing, are already reaping the benefits.  It’s important to keep in mind that rate/yield adjustments to monetary policy take time to work through the system.

As a base case, we expect interest rates to gradually increase as year-end approaches.  Fears of an immediate recession will subside, and bond yields will adjust higher.  Interestingly, regardless of what happens with economic growth in the near term, the current level of rates is probably “wrong”.  If we avoid a recession, which is the most likely scenario, rates are currently too low.  If the current economic soft-patch devolves into a recession (which would likely be the result of a shock such has deteriorating trade negotiations), rates are probably too high.

What should investors be considering/doing?

Low bond yields lead to increased price volatility when interest rates rise because coupon interest provides less of a cushion when bond prices decrease.  Managing duration risk in this environment is very important.

We are currently targeting short to intermediate maturities within bond portfolios and have a modest bias towards high grade corporate issuers for additional yield.  Given a mostly flat yield curve when looking at the difference between the two-year and ten-year part of the curve, we don’t believe the additional basis points earned from longer-dated maturities is worth the additional price risk.  Instead, given our views on economic growth in the short-term, we are more comfortable adding additional yield via short to intermediate term credit.  In tax sensitive accounts, our thinking is the same, control for duration risk and focus on high quality issuers.

A Ticking Time Bomb?

U.S. Corporate Debt

Corporations have taken advantage of ultra-low borrowing costs in recent years to raise cash for their operations, to fund mergers and acquisitions, and to support shareholder-friendly policies such as dividend payments and stock buybacks.  On an absolute basis, outstanding debt has increased to record levels.

Nonfinancial Corporate Dept as of perscent of DGP exceeds prior peek

Sources: Federal Reserve Board of Governors; NBER

Two questions naturally come to investors’ minds – is the current level of corporate debt cause for concern, and if so, how should investors prepare?

The dollar amount of outstanding debt is certainly larger today, an obvious statement when looking at the chart above.    On the surface this may be cause for alarm, but the financial health of corporate issuers and their ability to service this debt is less alarming.

  • Corporate debt outstanding relative to firm profits (leverage ratio) are at reasonable levels, while corporations are generating enough free cash flow to comfortably service their debt obligations (debt coverage ratio). In fact, companies in the S&P 500 can cover interest costs seven times with earnings – a more comfortable margin than companies enjoyed at any time in the 1990s or 2000s.
  • Corporate cash levels have risen substantially over the years leading to healthier and more liquid corporate balance sheets.
  • When comparing nonfinancial corporate business debt relative to net worth, the debt picture doesn’t look all that dire. The ratio has mostly fluctuated between 42% and 45% over the past five years.
FRED - nonfinancial corporate business; dept as of percentage of net worth

Source: Federal Reserve Bank of St. Louis

Although today’s corporate debt market is not overly concerning in our view, we are sensitive to changing economic conditions and the potential impact to corporate balance sheets.

The natural ebb and flow of the economic cycle underscores the inevitability of an eventual recession.  At that time, debt markets usually become incrementally stressed, and the amount of debt outstanding, along with the proliferation of lower credit quality issuers during the current expansion could leave credit markets more vulnerable.

During economic downturns, corporate revenues tend to fall as economic growth stalls.  Historically, investors have reacted by reducing credit exposure.  As demand for credit slows, credit spreads widen, increasing corporate funding costs.

Bloomberg Barclays US Agg Corporate OAS
(10/4/2007 – 10/3/2019)

Bloombery Barclays US Agg Corproate OAS chart

Source: Bloomberg Inc.

Overall, we believe the financial health of corporations is strong enough to withstand a modest economic contraction.  Of course, more severe economic contraction will always test the credit market’s resiliency.

When thinking about potential vulnerabilities to a deeper economic downturn, the current credit composition of the corporate debt market is worth considering.  Since the financial crisis, the BBB sector, the weakest subclass within investment grade, has far outpaced issuance in the A, AA, and AAA rating scale.  In fact, the BBB sector is now roughly the same size as the other three rating categories combined.

This trend is important due to the simple fact that higher rated credits are less likely to have significant problems during a recession.   The size and composition of credit markets will need to be monitored along with any indication that economic conditions are deteriorating.  We acknowledge certain weaknesses in the corporate debt market but would stop short of calling for a bubble or debt driven crisis.  To that end, we have taken targeted steps to reduce risk in our fixed income portfolios.

What to do and how to invest?

For certain investors, corporate bonds can be an essential component of an investment portfolio.  As the economic cycle ages, we have made targeted adjustments to manage credit risk while maintaining a healthy and diverse allocation to corporate debt.

  • Altering credit duration. We are comfortable buying issuers across different sectors such as financials and industrials.  We continue to favor corporate bonds given our positive near-term expectations for U.S. growth, but would prefer to purchase issuers with short to intermediate maturities.  Longer maturities are more exposed to price depreciation from credit spreads widening.  This position helps minimize the duration risk of the portfolio as well.
  • Moving up in credit quality. Although an allocation to high yield debt may be appropriate based on an individual’s risk tolerance, moving up in credit quality provides some protection if conditions turn more abruptly than expected.  The portfolio will be giving up some yield, but it is more balanced and better positioned to withstand unexpected shifts in credit sentiment.

In summary, corporate debt issuance has increased, but balance sheets remain healthy.  Recession talk is somewhat premature, and although we don’t foresee any immediate shift in corporate balance sheet health, we believe modest adjustments to bond portfolios is a prudent and appropriate course of action.

Put it on my Tab

The National Deficit and Modern Monetary Theory

 Whether amongst politicians, economists, or investors, few topics are more contentious than government spending.  The role that government serves in economic affairs has been widely debated since the founding of this country, and since the Financial Crisis, the national debt as a percentage of GDP in the United States has continued to climb higher.  Should we be worried?

FRED - federal dept_total public dept as percent of gross domestic product

Source: Federal Reserve Bank of St. Louis

The natural tendency is for people to prefer less debt, not more – hence the 1972 Time Magazine cover “Is the U.S. Going Broke?”.  Clearly this is not a new concern.  We would agree that lower debt levels are preferable, but it is hard to argue that current levels of national debt pose an immediate risk to the market and the economy.  The breaking point, although difficult to assign a specific dollar amount, would occur when the U.S. was a true default risk.  What seems to be clear today, according to an analysis from Moody’s Investor Service, is that the U.S. is not currently at any serious risk of default.  Additional things to consider:

  • Market volatility. Much to the chagrin of deficit hawks, the U.S economy has yet to unravel, and other than a few episodic bouts of market volatility, stock prices have continued to climb higher. In fact, “U.S. national debt has increased by 8.4% per year since 1966 and over that time the S&P 500 has advanced 9.7% per year. Clearly, rising debt levels by themselves are not an impediment to equity returns”.  Even rising debt to GDP levels show no discernible pattern with market returns.  “From 1982 to 2016 this ratio moved from 32% to 105%. Over this time period, the S&P 500 gained 11.7% per year”.[4]
  • Inflation and interest rates. Inflationary pressures have not mounted, and interest rates have not skyrocketed, even as the U.S. debt to GDP ratio breached the 100% level. Even as debt levels have risen, interest cost is very low at just 1.5% of GDP.  Interest cost as a percent of GDP is lower than any time in the past 40 years.
  • Are we becoming Japan? Many assume that the U.S. is destined for the same slow growth as Japan. Japan’s debt to GDP ratio crossed 100% in 1996, and during the subsequent decades, Japan’s real GDP grew a cumulative 11%.  However, this growth needs to be put in the context of Japan’s well-known demographic challenges.  In fact, Japan’s GDP relative to its working age population is very similar to that of the United States.  Japan doesn’t necessarily have a debt problem, they have an aging population problem.

Some would go as far as to suggest that the level of government debt doesn’t matter all.  We would not put ourselves in that camp, but the theory is worth exploring.

As government debt levels have risen, a more obscure economic doctrine, Modern Monetary Theory (MMT), has gained more prominence.  The basic premise of MMT is that the government can have a material influence in managing economic affairs.  While Keynesian Economics attests that fiscal policy can play a role in stimulating demand when growth slows, MMT advocates more expansive use of government spending.   “Instead of the Fed cutting rates in a recession, the government should spend more; rather than raise rates during a boom, the government should raise taxes (or spend less).”[5]  According to MMT, a sovereign state that issues its own currency is not subject to the same budgetary limitations as households and businesses, and large deficits are not necessarily problematic.  Since the U.S. dollar is no longer on the gold standard after the end of the Bretton Woods system in 1971, there are theoretically no constraints in terms how much money the government can create.

Supporters of MMT believe that there is no natural rate of unemployment and “money printing” in and of itself does not cause inflation.  Excessive spending causes inflation, and according to MMT, spending can be regulated and controlled based on the degree of taxation.  Central banks over the past several years have increased the money supply significantly, yet rates have fallen, and demand has been lackluster with no visible signs of inflation.

Although we don’t think that the U.S. national debt poses an immediate threat, we do have some concerns about the long-term ramifications regarding the prospects of unlimited budget deficits.  Some variations of MMT have been tried in the past.  Latin American countries over the past 50 years have engaged, at times, in an aggressive form of fiscal expansion financed by government “money printing”.   In each instance, hyperinflation, currency devaluations, and economic turmoil ensued. [6]

The U.S. dollar does have an advantage relative to emerging market countries because it is the world’s reserve currency.  However, we still believe there can be stark differences in the real and theoretical worlds. What we don’t know is how financial markets would react to wide adoption of MMT and whether elected officials would have the political will to broadly tax its citizens to curb spending if inflationary pressures mounted.  There is also the possibility that excessive government spending could cause deflationary forces that are difficult to overcome.  We think MMT is an interesting theory, but the practical application would likely create high degrees of uncertainty, and that is perhaps the market’s biggest weakness.

Not Partying like it’s 1999

Today’s Initial Public Offering (IPO) Market

 This year, numerous well-known private companies have decided to list their shares on public exchanges, and the recent response from investors has prompted certain key questions.  Companies like Uber, Lyft, and Slack have struggled post their IPOs, making some investors worry that this apparent lack of demand is a harbinger of more widespread difficulties for the stock market.

High-profile 2019 IPO BUSTS

Source: FactSet, Inc.

WeWork, the most recent example, ended up pulling their planned IPO after the company’s financials were more intensely scrutinized by would-be public investors.  Do recent IPO struggles meaningfully impact our market view?  In short, we believe that pockets of excess have arisen in private markets, but the performance of IPOs in 2019 underscores a lack of investor euphoria.  Companies have still been able to access public market capital, but investors are being more careful about valuation and profitability.  In our view, this appears to be healthy behavior.

Performance of Recent IPOs

It is worth noting that overall, IPO performance has been solid.  The Renaissance IPO index, a good proxy for the performance of newly public companies, has outpaced the S&P 500 index this year, with a total return of 22.5%. In our view, this reflects investors’ continued desire to commit capital to IPOs, without indiscriminately bidding them higher. The perception that investors have shunned IPOs in 2019 simply isn’t accurate; it just so happens that certain “brand name” offerings have been received with less fanfare than originally expected. We believe this underscores two critical points.

  1. Public market investors are not exhibiting exuberant, throw money at anything, behavior that typically precedes more significant market sell-offs. The average first-day return for an IPO in 1999 was 57% versus today’s average of 19%.
  2. Investors need to be discerning when thinking about investing in an IPO. Due diligence on the company is important, and a complete understanding of its fundamentals are necessary.  Simply participating in a big-name IPO does not guarantee a large return.  Over the past 20 years roughly 30% of IPOs have 5 -year buy and hold returns of -50% or worse, while about 25% produce returns greater than 100%.[7]

Ballooning Private Equity Capital has Created Pockets of Excess

Assets under management in the private equity space have grown exponentially in the past 20 years.  At the same time, the number of U.S. companies listed on public exchanges has fallen.

number of companies lists on U.S. exchanges vs. private capital AUM

Source: Strategas Research Partners, LLC

In many cases, companies are choosing to stay private longer, as abundant access to capital affords them the ability to delay the public market requirements of quarterly earnings reports and myriad company disclosers.  The cause of this trend is debatable, but we believe that institutions chasing the promise of high returns in private equity markets is likely a primary driver.

As private equity funds are forced to invest larger and larger amounts of capital, it is almost axiomatic that some misallocation of capital would occur.  If anything, this concerns us more about investments in private equity, and further highlights the importance of using discretion when deciding whether to purchase shares during an IPO.

This is Not 1999 – Valuation Matters

The most well-known example of IPO market excess, which in hindsight was a clear indication of trouble ahead, was during the Technology boom of 1999.  From 1999 through 2000, a staggering 892 companies went public.  Investors would buy anything, and that was a bad sign.  This compares to 363 IPOs from 2018 through September 2019.  The actual dollar amount being raised today is on pace to break the 1999 record, but as discussed in the next section, today’s companies are often larger, more established firms before going public.  In addition, IPO dollars as a percent of total market capitalization today are about half of what they were in 1999.

IPOs are not what they once were…and maybe that is good

Companies are going public later in their lifecycle, meaning much of the outsized returns may have already accrued to private investors.  For example, the median age of technology IPOs has gone from 4 years in 1999 to 12 years today.  This does not mean that investing in an IPO is never a good idea, it simply means that return expectations should be managed given the mature nature of many of these companies.

Back to Basics

Corporate Profits, Valuations, and other Fundamentals

Investors are compelled to digest and assimilate a plethora of data (some important and some not) in order to forecast the range of potential return outcomes for various asset classes.  We consistently try to block out the noise and focus only on factors we think will materially affect longer-term equity returns. In the end, the ultimate drivers of stock prices are earnings growth and interest rates.

The outlook for earnings is imperative because the stock market is ultimately driven by corporate profit levels.  The chart below juxtaposes the S&P 500 Index with corporate profit figures tabulated by the U.S. Bureau of Economic Analysis.  Persistent periods during which stock prices rise without the support of earnings lead to higher market valuations and lower future returns.  The late 1990s is a good illustration of this phenomenon.

U.S. Corporate Profits Vs. S&P 500 Index
(40 Years Ending 9/30/19)

U.S. Corporate Profits vs. S&P 500 Index - 40 years ending 9.30.19

Source: FactSet, Inc.

Assessment of Recent Earnings Growth and the Stock Market

As seen above, corporate profits look to have flatlined in recent years.  As it relates to the stock market, the corporate profit data referenced in the chart above pertains to all businesses, both public and private.  The sector composition of the S&P 500 Index, for example, does not necessarily reflect the actual industry composition of the entire U.S. economy.  The S&P 500 Index has a greater allocation to faster growing, larger cap tech stocks.  Based on data provided by S&P Dow Jones Indices, the trailing 12-month earnings per share (“EPS”) for the S&P 500 Index is more than 35% higher today relative to the 3rd quarter of 2014, the time corporate profits peaked based on the data provided by the Bureau of Economic Analysis.

There is also the perception that the divergence in corporate profit data compiled by U.S. Bureau of Economic Analysis and public equity markets is a function of stock buybacks (financial engineering) as well as the lower tax rate resulting from the Tax Cut and Jobs Act.  However, we think this view is a bit misleading. Revenues, an important component of the EPS calculation, have grown north of 20% for S&P 500 companies over the past 5 years.  In addition, operating profit margins, which are indicative of how cost-effective management teams are in running their franchises, have trended higher as well. As a result, the baseline corporate profits in the public sector have grown over the past five years.

 Short-Term – outlook for corporate profits and assessment of equity market valuations

S&P 500 earnings growth was quite robust for the 2-year period ending December 31, 2018.  Strong equity market performance in 2017 foreshadowed a recovery in corporate earnings in 2018.   Earnings growth has slowed in 2019 as enthusiasm surrounding the corporate tax cut wanes and the ongoing effect of global trade tensions ripple through the global economy.

S&P 500 Change in Forward 12-Month EPS vs. Change in Price_ 10 Yrs.

Source: FactSet, Inc.

Looking toward 2020, we believe S&P 500 EPS will continue to grow.  The Federal Reserve has been more accommodative with monetary policy, after raising interest rates nine times over the past few years.  Changes in interest rates tend to flow through the economy with a lag, and we are likely to see a positive impact on things like manufacturing in Q1 of 2020, assuming trades dispute do not escalate further.   Although we believe the 11% earnings growth forecast for 2020 may ultimately be reduced, we believe a growing economy will support corporate profitability.

While equity markets are not by any means cheap based on a variety of financial metrics, we don’t think valuations are poised to reset lower.  The term “TINA” (there is no alternative[8]) has become cliché, but we agree with the basic premise that equity valuations are likely to remain attractive relative to bonds as we move through 2020.   The chart at the top of the following page shows shareholder yield (dividend yield plus share buyback yield) relative to the 10-year Treasury yield.  Stocks are still attractive using this metric.

Shareholder Yield vs. 10-Year Treasury Yield
(12/13/98 – 6/30/19)

Shareholder Yield vs. 10-year treasury yield

Source: Strategas Research Partners, LLC

Longer-term – equity market valuation and returns

No single measure of stock market valuation is perfect.  Taking numerous measures into consideration, our assessment is that the stock market is generally expensive relative to its own history.  This should not be a controversial conclusion.  Over the long term, the average annual total return for the S&P 500 is about 11%.  Since the Financial Crisis, the average annual return as been 14%.  Periods of above average returns are typically followed by periods of below average returns and vice versa.  Measures of valuation do a very poor job of predicting stock market performance in the short-run, but they are almost all that matters when thinking about the likely return over the next 10 years.  Today, we expected average annual returns during the next decade to be lower than historical averages.

Finally, although we believe low interest rates will likely push investors towards stocks in the near term (therefore supporting elevated valuations), we would highlight that the lowest interest rate environments (like today) have historically produced the lowest equity market returns over the subsequent decade.  Simply put, although low rates might perpetuate higher than average valuation in the near-term, those higher valuations are still a very powerful force when thinking about longer term market performance.  Often, it is the lowest rate environments that push stock valuations the highest, and in the end, the price you pay is the biggest driver of your ultimate return potential.

All Good Things Must Come to an End

The Next Recession

We continue to believe the odds favor a continuation of the current economic and market cycle, but we must also acknowledge the heightened chance of periodic volatility given the uncertain political backdrop.  In such an environment, investors should fight the urge to panic, but also be diligent about ensuring portfolios are properly balanced and that asset allocations accurately reflect intended levels of risk.

We believe evidence of a persistent economic expansion includes:

  • U.S. initial unemployment claims remain extremely low
  • Consumer confidence measures have eased but remain elevated
  • Senior loan officer surveys have not exhibited the tightening in lending standards typically associated with recessions.
  • Inflation remains low which allows the Fed to keep interest rates low

Given this backdrop, it is difficult to assume an imminent economic contraction.  In our view, slower growth is probable in 2020, a recession is not.  As the deepest and most protracted bear markets have historically been associated with recessions, we are not inclined to recommend an overly defensive posture in portfolios at this stage.

A Bottom in the Manufacturing Cycle

Assuming some form of de-escalation in trade tensions, we believe the soft-patch in global manufacturing will bottom by the end of the first quarter of 2020.  The contraction in global manufacturing has been an acute source of market anxiety, and in our view, has been a primary catalyst for the overly pessimistic outlook for the economy.  Key observations include:

  • Changes in interest rates impact the economy with a lag. The economy is still in the later stages of digesting the move higher in rates we experienced in 2018.  Since then, rates have moved meaningfully lower.  Lower rates should be supportive of the economy in the first quarter of 2020.
IBM (NAPM) Manufacturing, purchasing manages index - U.S.

Source: FactSet, Inc.

  • ISM Manufacturing PMI moved below 50, but it has done so 6 other times over the prior 20 years without a forthcoming recession. While the sample period is limited to just two recessions, a decline of the services sector meaningfully below 50 has proved more telling.  This has not yet happened.
ISM manuf. PMI_real DGP Growth YOY_ISM non manuf. PMI_real GDP Growth YOY

Source: CornerStone Macro Research

  • There are two widely followed manufacturing PMI surveys – one by Markit and the other by ISM. Recently, the two series have diverged, with the Markit data series still in expansionary territory.  The difference is likely driven by the ISM’s bias toward larger companies which more readily reflect growth issues outside the United States.  Markit data has a higher correlation with actual U.S. output and probably better reflects the domestic U.S. economy.
  • Lastly, the trend in global Manufacturing PMI data appears to be improving. The percent of countries with rising PMIs is up to 35% in Q3 vs only 17% in Q2.

Taken in combination, the economic backdrop is likely to stabilize in early 2020.  Although we do not forecast a dramatic reacceleration in growth, stock prices move based on expectations.  Currently, economic expectations are low, so a “less bad” global economy might be good enough.

[1] Dollar Cost vs. Lump Sum Investing: What to Do with a Windfall. August 25, 2019.
[2] FactSet, Inc., Bryn Mawr Trust
[3] The Zero Lower Bound (ZLB) or Zero Nominal Lower Bound (ZNLB) is a macroeconomic problem that occurs when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth.
[4] Bilello, Charlie. “Should Investors Fear Rising National Debt?”. July 13, 2017.
[6] Modern Monetary Theory: Cautionary Tales from Latin America. Page 3. Hoover institution Economics Working Papers
[7] Epoch Investment Partners.  Blitzscale and Hope: Unicorns, IPOs and the Fear of Repeating the Late 1990s. June 19, 2019.
[8] As it relates to investments, the phrase refers to the lack of satisfactory alternatives to stocks when bond yields are so low.

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