3rd Quarter Market Update
Stock prices declined in the third quarter. They did so in the US and most everywhere else in the world, particularly emerging markets in which currency declines compounded losses. Commodity prices were candidly taken to the “wood shed” as declines were most shocking in the oil patch! High yield bond prices dropped 7% as economic data hinted at slowing growth for China and the US. Cash equivalents (yielding about zero) proved to be a wonderful hiding place and we are looking for a time to put it back to work. Regretfully, as we surmised last month, we believe the short term market trend could lead us to still lower stock prices. To pretend we know when and at what level the markets will bottom is nonsense. However, we would not be surprised to see stocks retest the lows of late August.
We can find no shortage of macro issues that should cause concern. And we must admit these concerns may be already discounted by the recent correction. However, three issues are of particular concern to Berkeley: Number one on the list is what’s left in the Fed’s bag of tricks if we experience another 2008 type credit crisis? Secondly, could that crisis be triggered by fallout from the rapid erosion in commodity prices? At current levels, many commodity producers could falter. Thirdly, if the Federal Reserve believes our economy is healthy enough to handle higher tightening will price earnings multiples contract? And yes, China, Syria, Greece, ISIS keep us anxious.
Since 2008 the Federal Reserve (via highly accommodative monetary policy) has fostered an environment they believed would be conducive for economic growth and job creation. The short term benchmark rate was lowered from 4.5% in 2008 to (about) zero where it remains today. Beginning in 2009 the Federal Reserve initiated open market purchases of Treasury and Mortgaged back bonds correctly thinking that such activity would lower the yields on longer term rates. After about $Three trillion in purchases, the ten year Treasury bond hovers at 2%. Although successful in keeping interest rates low for an extended period, the efficacy of the strategy on growth and employment is questionable. Economic growth as measured by reported GDP estimates has been rather ordinary. Reported improvements in the employment rate need to be viewed in light of the depressing decline in US labor participation rates. However nations, states, municipalities, corporations and individuals have binged on new debt enticed by Fed induced low rates. According to the Federal Reserve, total US nonfinancial debt has grown to $44 Trillion through the second quarter. In case you wondered, US annual Gross Domestic Production is about $17 Trillion. Will we continue to borrow our way to prosperity? We will till we can’t!
If you believe that a company’s share price is related to the company’s growth in earnings per share, we agree. The fastest growing companies are apt to have significantly higher price earnings multiples than mature companies whose growth has slowed –normally due to market saturation. Occasionally, as in Tesla for example, the company remains currently unprofitable, and yet sells at a very high multiple to earnings expected many years into the future. Interestingly Tesla reported sales over the past twelve months of $3.7 Billion while GM over the same period sold $152.7 Billion. Tesla’s market cap is $32 Billion (8.6 times sales). GM’s market cap is $46 Billion (.3 times sales). The gap in valuation highlights the differing perceptions of investors on two companies selling the same product. Which of these companies do you believe will be selling cars in thirty years? When evaluating a company we certainly examine factors other than growth expectations. We evaluate management, capital structure, dividend policy, executive pay and the quality of earnings.
Drawing from the work of noted economist, Ed Yardeni, US companies have indeed taken advantage of low rates to borrow extraordinary amounts of money as the Fed would have expected. However much of the debt was used to buy back shares, fund acquisitions and pay dividends. I have included charts showing the growth in buybacks and dividends for the S&P 500.
We will argue that the share repurchases have been great for share prices. The demand for shares has grown and the repurchases have diminished supply! Importantly, earnings per share could grow without any organic increase in earnings. It’s just math. We refer to this as financial engineering and its implementation has rendered balance sheets with more debt and less cash. Higher dividend payouts have also been wonderful for share owners and oftentimes the share price rises in step with dividends. Companies can choose to increase dividends by paying the same percentage of higher earnings, increasing the payout ratio or borrowing to do so. Importantly we should ask, are companies depleting cash which they might need for growing the business or for a safety net in leaner times?
The unintended consequences of the current Fed policy make it better to be a borrower than a lender. Savers have been tasked with deciding between no return and no risk or some return and greater risk. Legions of baby boomers are stretching their retirement dates having to wait for more asset accumulation or higher interest rates or both! Savers have been penalized. If you are a borrower, perhaps this is the time to renegotiate your rates and terms. We have little knowledge of the Fed’s next policy move. Chairwoman Yellen left policy unchanged in September. For the moment, we believe concerns about potential rate hikes will have a more punitive influence on equity prices than actual implementation if and when a rate hike occurs.
We are beginning a quarter which has been pretty good for share prices! According to an Ibbotson study, the fourth quarter has been kind to stocks and December is often the kindest month. September has often been the worst. Third years of second term presidents have also fared well. According to Mark Hulbert, the third year produces double digit returns about 80% of the time. And we read this morning that the fourth quarter is pretty good if the second and third were negative. However, we’re not willing to make investment decisions based on these types of observations. For us it’s about the math and some expectation for asset prices to be mean reverting. If you tasked us without worrying about the next ten minutes or the next ten years of potential volatility to put money to work today, we would advise you buy commodities, emerging markets, and gold. They are well on their way to being fat pitches!
Securities offered through Triad Advisors Member FINRA/SIPC; Advisory Services offered through Berkeley Capital Partners, LLC. Berkeley Capital Partners, LLC is not affiliated with Triad Advisors.Tags: commodities, federal reserve