Disciplined Investing: Truths for the Long Term
Tumultuous, unpredictable, volatile. Any of these words could describe global capital markets in the fourth quarter, and, yes unfortunately, at the start of 2016 as well. As I gathered my thoughts for this first letter of 2016, one disconcerting reality kept surfacing: whatever I write in the midst of this squall will be on record forever. And given the market’s capriciousness, anything I say about short-term market conditions today could easily be proven wrong tomorrow. How humbling. So what gives me the courage to comment on the current conditions? The firm belief that no matter what happens in the short term, the recommendations I make about disciplined investing, diversified portfolios, and the vital role of stocks in achieving financial goals will always hold true in the long term.
While my professional colleagues scrutinized investment trends these past few weeks, the hot topic outside financial circles was the historically large Powerball jackpot. In the midst of the lottery mania, I was asked how I would advise someone to invest a lottery windfall. Playing the lottery and sound investing are certainly polar opposites in terms of wealth building strategies. Still, my answer was easy (though the execution is clearly not). I would say exactly what I consistently tell Pitcairn clients about their investments. Keep your focus on the long run, be disciplined, combine diverse strategies to achieve your objectives, and embrace the belief that slow and steady offers the greatest probability for success.
Looking at asset returns for 2015, one might think it was a dull year, which we all know it was not. Many asset classes were close to flat in 2015, losing or gaining just a bit. The year was certainly disappointing for stocks, but we have been saying for about three years now that a flat year would be neither surprising, nor particularly detrimental, given how well stocks have performed since 2011. In fact, the lackluster 2015 return in conjunction with some earnings growth in the coming year would bring equity valuations back into line, which is a good thing for the long run.
As December’s difficult market conditions spilled over into 2016, we greeted the new year with no shortage of potential worries for the market – China’s economic slowdown, the US dollar, the Federal Reserve’s intentions for future interest rate increases, the US economy’s resilience. In our view, these concerns are worthy of attention, but are not a death knell for the bull market. We think the current pullback is more likely to follow in the footsteps of the August correction, with a rebound to follow at some point in the future.
We stick by our belief that a bull market ends when there’s irrational exuberance, excessive valuations, or a recession. We still do not see investors taking too much risk in their portfolios or companies taking inordinate risks in managing their businesses. Fear remains the predominant emotion of the current environment. As to valuations, no matter how you slice them, valuations are not excessive. And, if anything, recent declines have brought valuations to more reasonable levels. As we have said recently, of the three potential catalysts, recession is the one that calls for the most attentiveness. US economic data has been more mixed over the last few months. Add in mixed data from around the globe, particularly Asia and China, and there is cause for vigilance. However, we believe that, on balance, the US economy is sound and not rolling into recession.
There is greater economic malaise around the world, with a number of trends dampening global economic activity. China and oil prices remain the key factors driving investor sentiment regarding the global economy. Though China is undoubtedly slowing (see Chart A), our view is that ultimately China’s control over its economy and the power of its consumer spending engine will lead to a little more certainty than what we now see. We believe commodities are primed for a bounce back, with statistics showing them as more than two standard deviations oversold. Unfortunately, there’s no assurance the recovery will come any time soon. The global economy could take five to six months to sort itself. Global markets are facing significant headwinds, but we do not see a severe global recession on the horizon.
Five years ago, we stated that the Chinese economy offered significant promise, but undeniable risk. Few people wanted to hear about China’s risk in those days. Today, China remains in a learning phase with risks and opportunities. During the quarter, the International Monetary Fund signaled its willingness to put China’s currency into its SDR (special drawing rights) basket. Now, China’s government has the difficult task of moving its currency down to a level where it can be freely traded, while at the same time maintaining a high degree of stability.
China’s consumption engine is enormous to say the least. On “Singles’ Day” in November, the Chinese equivalent of Cyber Monday, internet sales exceeded $14 billion, a 60% increase from last year. However, the country’s central bank, the People’s Bank of China, has made some pretty large missteps since July and investors are questioning whether the country’s leaders can manage the transition from an export-driven economy to one fueled by domestic consumption. On the positive side, segments of China’s economy are improving. Car sales are quite robust, property prices are improving after being depressed, capital spending is picking up and there is ample liquidity, all indicators that China’s economy is not teetering on the edge of a cliff.
The Chinese government has substantial power to stimulate its economy if desired. China’s equity markets are just 15% of GDP versus 95% in the US. Yet, compared to the US Fed’s ability to influence our economy and equity markets, China’s influence is exponentially larger. That does not mean potential rewards are a sham, nor does it suggest that investors should go full on into Chinese equities. It is likely China will have more stumbles because its leaders are still learning. However, we are confident that over the next decade or two the tremendous power of consumers outside the US, especially in China, will be harnessed in a way that is positive for capitalism, the global economy, and global stocks.
Turning to other global regions, countries with economies keyed to oil – Australia and Brazil, for example – suffered severely in 2015. However, conditions in core Europe have become more promising. Though political developments in Europe have muddied the economic picture, employment growth and consumption are both improving and manufacturing, based on purchasing managers’ indexes (PMIs), is solid. By comparison, US PMI numbers are still reasonable, but softening, and PMIs in Asian and oil-related countries are generally quite weak.
The biggest news for the US economy in the fourth quarter was the long-awaited and incessantly debated Federal Reserve interest rate increase. The Fed finally raised the Fed funds rate by 0.25% in December, the first raise since 2006 (see Chart B). We had hoped the Fed would make its move in September, and you could make a case that purely on a data analysis basis, December was actually a slightly worse time to raise rates than September.
The Fed’s action has injected some volatility into the capital markets. Our hope was that markets might calm down after a rate increase, but weaker economic data, oil prices, and events in China have kept markets roiled up. Actually, market volatility in December and the first two weeks of January has been far more normal than the calm we enjoyed between 2009 and 2014. We have just grown so used to a reduced level of volatility that it will now take markets time to readjust to this more normal pattern.
The Fed has suggested it wants to do four interest rate increases this year. Their comments bring us back to the old debate between fire and ice, where the fire camp wants four increases and the ice camp thinks the Fed should never have even made the first increase. A normal rotation of Fed governors has tilted the Fed Open Market Committee a bit more in favor of higher rates. However, Fed Chair Janet Yellen still leans toward slow, careful action.
The US is seven years into the current business cycle. That’s a long time, but cycles don’t usually end from old age alone. We think there’s time left. Still, a downturn will eventually occur and when it does, the Fed needs room to lower interest rates in response. Right now – even after the first increase – they don’t have that room. We believe the Fed will raise rates again this year to give it the ability to respond to weaker economic activity down the road. As of mid-January, the market seemed to be pricing in about two increases, and we think that is probably the most the Fed can manage.
None of what is happening is abnormal or unexpected. The market has been drawn into a cycle of negativity prompted by the US industrial sector weakening along with the global economy. Yes, the industrial economy – energy, materials, mining – is modestly weaker than we want, but the market seems to be disregarding the tremendous strength of US consumers in a consumption-driven economy. On the consumer side, whether we’re measuring household net worth, light vehicle sales, accumulated credit card debt, or consumer sentiment, US consumers are in good shape. Better consumer spending combined with a potential pickup in US government spending – based on budgeting for 2016 and beyond – bodes well for better growth. With consumers as a driving force, the US economy will probably grow about 2%; that’s not bad.
If the economy goes to -2% GDP instead, then we are in a recession and US equity markets will have a tougher time. But given US demographics, an aging workforce and falling labor participation rate, an economy growing at 2% is realistic. According to Dr. David Kelly at JP Morgan, if I were 25 and running an 8-minute mile, it might be possible for me to pick up my pace and shave a few minutes off that. If I ran an 8-minute mile today, I’d be ecstatic with that performance. Demographically, the US is not where it was in the 1950s, so we need to manage our expectations.
Most developed non-US markets had a strong fourth quarter and, for the year, performed reasonably well or better in local currency terms. However, the impact of the strong dollar pushed returns flat to negative. Returns in local currencies tells us how actual companies performed before we put the currency translator on top. And those companies and their stocks did okay.
Individual countries faced particular challenges. For example, Canadian stocks were significantly affected by falling oil prices. Brazil’s stock market performed very poorly in local terms, stymied by commodity price declines and internal political problems, compounded by how weak the country’s currency was compared to the US dollar (see Chart C). In Europe, only Switzerland posted a positive return in USD terms, and it was a nominal gain at 0.4%.
There is still significant debate about Japan’s stock market, which was up 9.9% in local terms for the year and actually held that gain since the Japanese yen was one of few currencies that did not depreciate against the dollar. We have come down positively on Prime Minister Abe’s efforts to make serious cultural changes in order to solve its work force participation problem. Japan is a very closed economy with no tradition of immigration. To foster employment growth, Japan needs to change the attitude toward women in the workforce. We are still optimistic that Japan and the Abe administration can gradually bring about such a change.
This time last year China’s equity boom was in full swing. The rally continued until June when the market cratered, causing Chinese officials to take clumsily executed steps, including a currency devaluation that roiled global capital markets and provided resounding evidence of China’s influence. We got a reprise of that lesson at the start of 2016 when Chinese officials took steps to curb market volatility. Their new circuit breakers had the opposite effect and global markets again suffered the ripple effect. Eventually, China introduced more effective policies, but by that point, the correction snowball was already rolling down the hill, bringing us to where we are now with widespread negative sentiment.
Other emerging markets were also quite weak in 2015, down nearly 15% for the year, based on the MSCI Emerging Markets Index. US dollar strength contributed to these losses, but was not the sole driver. Emerging markets are more closely tied to commodities than developed commodities and falling commodity prices were a huge headwind. Active management approaches favoring emerging countries that don’t depend on commodity exports and have strong domestic consumption (which is less sensitive to currency exchange effects) fared significantly better.
The broad US market eked out a small gain of 0.5% for 2015, as represented by the Russell 3000® Index. The S&P 500, which measures large cap US equities, fared slightly better and generated a 1.4% return for the year, the seventh straight year of positive returns for large cap US equities. This streak is now tied for the third longest run of consecutive annual gains since the formation of the S&P 500. For the year, growth stocks outperformed value stocks and large cap stocks outperformed small cap stocks.
Two market trends from 2015 deserve further discussion. In a reversal from two or three years ago, non-dividend paying stocks outperformed dividend-paying stocks. Previously, the market had placed excessive value on the dividend component of equity returns, to a point where we questioned buying those dividend-paying stocks at such high values. That reversed in 2015 and non-dividend paying stocks took the lead, partly because oil and utility-related sectors, which are high dividend payers, got caught in the commodity price downturn.
The second trend was the narrowing group of good performers. The 10 largest stocks in the S&P 500 based on market capitalization generated a 17% return; the other stocks in the index were down about 5.1% (see Chart D). Most good performers came from the growth-oriented technology and consumer discretionary sectors. Even though US equities delivered a small gain for the year, the narrow market is one reason it didn’t feel “good” and why it was a much harder environment for active managers to add value over passive investors. Weaker performance from so many stocks contributed to negative investor sentiment. We will be closely monitoring this internal market dynamic. Prolonged outperformance from a small group of stocks is not a sign of a healthy market. We think better performance from a broader range of stocks will resume in 2016, but if gains continue to come from such a small number of stocks, we would consider that a red flag.
In our last quarterly letter, we said US equities would primarily take direction from Fed comments and actions, and, to a lesser extent, from events and data in China. These are inter-related influences, because a deteriorating China situation would affect the Fed’s ability to raise interest rates. As we said above, the market seems to be pricing in two Fed rate raises and we think that would be healthy for the economy and stocks. However, even though the increases are expected, we don’t think the market will respond with the same low level of volatility we saw from 2011 to 2013. We are resigned to a higher, more normal level volatility, but that does not weaken our thesis that US equities will be one of the better places for people to invest.
Last year, US equities faced a double headwind of low energy prices and a high US dollar, which reduced the value of earnings coming back to the US. The current low oil price scenario is 90% a supply story. There is concern about China’s falling demand, but on the supply side, Iran has been brought into the oil markets for diplomatic reasons, the Russians are boosting production to shore up their economy, and shale production continues in the US. Saudi Arabia figures it can harm Iran and Russia by pumping more and driving prices lower. As Saudi leaders come under internal political pressure, they may be willing to let prices drift back up, depending on the geopolitical situation with Iran. Over time, we believe these supply issues will normalize and that oil is closer to an inflection point.
The combination of the US dollar and falling oil prices turned the S&P 500 earnings growth rate negative last year. Stabilization or a reversal in these two areas would bode well. If the dollar doesn’t go any higher and oil doesn’t go lower, we could see 6%-8% year-over-year S&P 500 earnings growth. The dollar and oil reverting to their means, even a little, could result in low single-digit earnings growth. With that level of earnings growth, given current multiples, US equities could deliver a solid return in 2016.
Despite a lot of heated rhetoric to the contrary now, a low oil price is good for the US economy and for all consuming economies because it leads to wealthier consumers. Lower oil prices mean less money spent heating homes or fueling cars etc., which increases consumer spending power. The US dollar and oil prices typically trade in tandem, which means lower oil prices have been more of a benefit for the US economy than other countries where oil prices haven’t fallen as much in local currency terms because of US dollar strength. And, it’s important to note that even if oil prices fall further, recessions are rarely caused by low input costs.
For years now, the market has thoroughly dissected every Federal Reserve comment, seeking to pin down the timing of its inevitable shift to higher interest rates. After so much anticipation, it should not be too surprising that bond markets took the December interest rate increase largely in stride. The 10-year Treasury benchmark showed little price movement, ending the year yielding 2.27%. The Barclays US Aggregate Bond Index returned 0.5% for the year.
The US high-yield market experienced more stress during the year (see Chart E), but the majority of weak performance was in the energy sector where companies had done a great deal of borrowing to expand infrastructure and capabilities. Unfortunately, the borrowing and building hinged on expectations for a certain oil price and profitability. In the face of falling oil prices, bonds below investment grade suffered a significant sell-off.
I recently met with a distressed credit hedge fund manager to talk about the credit markets. What I took from that meeting was that fixed income managers are generally more concerned about the short-term pricing environment for high-yield bonds than about underlying bond fundamentals. They don’t seem as worried about issuer quality or repayment risks as the fear that a bond’s market price might fall and they will have to carry that price in their performance. Such fear has been emblematic of high-yield and is a key reason we don’t think the high-yield market is signaling doom for the US economy.
In December, the Fed highlighted labor market improvement as the primary reason for its policy shift, while acknowledging that inflation expectations have been below its 2% target. The US economy is still delivering decent employment results and we may finally be on the precipice of wage growth, which the Fed is looking for to justify additional rate increases.
Fixed income is definitely a Fed story. We believe that for the first time in a long time, a series of interest rate raises will pressure the core fixed income sector, something we have been expecting for the better part of a decade. This time, the chickens may finally come home to roost. Consequently, we do not anticipate meaningful gains in fixed income this coming year. There may be some opportunities within the high-yield sector, particularly in non-energy and non-oil or commodity-related segments, and our managers are certainly looking at whatever opportunities present themselves.
Global REITs were down slightly for the year, while US REITs were up about 3% on a total return basis. This is not bad considering that most other dividend-paying investments were pretty beat up over the course of the year. We are at a point of the investment cycle where REITs are going to be influenced by interest rate trends and if inflation resurfaces, REITs would be vulnerable. Though we think any dramatic REIT gains are behind us for this cycle, REITs should still be solid performers given expectations for modest, but not substantial inflationary pressures.
Global infrastructure, as measured by the S&P Global Infrastructure Index, delivered negative absolute performance due to downward pressure on commodity-linked sectors, but active managers found opportunities in select sub-sectors and regions like toll roads, airports, and Europe. Global infrastructure’s dividend yield remains relatively attractive compared to other yield-oriented investments.
The master limited partnership (MLP) sector was quite weak, primarily because the sector didn’t have enough insulation against falling oil prices. MLPs, like other energy-related securities, suffered from concerns about their ability to access funding through the capital markets and to grow distributions.
Commodity prices were also down significantly for the year, with some of the impact driven by weaker Chinese demand as that country finds its way to the proper growth rate. It is very hard for me to believe commodities could have another year as difficult as 2015. I see the group as interesting at these valuations, but still believe it’s too early to move into it.
On a total return basis, hedge fund results for 2015 were generally unimpressive. A small sub-sector of hedge funds had strong performance while a larger group performed poorly. In the continued wake of disappointing performance, a number of poor performing hedge funds are being shut down and investors are questioning the asset class’s future viability. It’s true that over the last five years, having a portfolio predominately composed of hedge and private equity funds for the most part failed, but that doesn’t mean hedge funds can’t contribute to a more diversified portfolio.
Academic studies show that over the last 20 years, including hedge funds in a diversified portfolio has resulted in better return potential and a lower risk profile (see Chart F). Our contention is that as the Fed raises interest rates, markets will move into a more normal equity environment with increased volatility and more return variation between asset classes and individual securities, the kind of environment where hedge funds should perform better.
The world’s capital markets are in a delicate place right now and it’s too soon to be sure how the markets will sort themselves out. In times of uncertainty, it’s always best to stick with the fundamental truths of investing. We can’t expect quick, easy gains from our investments any more than we can expect to win a Powerball drawing or get our bodies in shape with some “seen on TV” exercise gizmo.
We know how to be healthy physically and financially because the long-term strategies haven’t changed. In uncertain times, we may be more tempted by a quick fix, but that’s actually when we need to go right back to the basics of what we are trying to achieve. Make sure your strategy aligns with your goals. Make sure we know what, if anything, has changed in your life so we can craft your plan to reflect that and to be sure you are positioned for the maximum likelihood of success. Truths are often easy to ignore, but that doesn’t make them any less true.