Change. It’s the genesis of all growth. Yet at the same time, it can also serve as the mother of all discontent. Today we are in the midst of extraordinary change in the world, in our economies and in our cultures brought about by changing global demographics and by rapid, transformative changes in technology including hardware, software, social media, artificial intelligence, automation, and genetics to name just a few.
Since what results from all this change is not always perceived as positive, governments around the world have been experimenting with new policy tools versus those that seemed to work for them over the past quarter century. With these new approaches has come much critique. In a world with today’s amazingly powerful communication tools at our disposal to promulgate, distribute, and debate opinion and critique, consensus appears nowhere in sight.
And while we may be devoid of a single, unifying voice to provide us either a sense of direction or a global narrative which we can all relate to, what we are not missing is hard data.
We are not missing the facts and events to observe and analyze; the facts that normally matter most to markets. Things like sales, earnings and cash flow growth, rising employment, rising capital spending (in the U.S., not just in emerging markets), and increasing dividends. Usually, these are all one needs to hold up a buoyant stock market. But “usually” is not where we are today. Today, a big driver of both the markets and the economic outlook is sentiment. And sentiment is decidedly negative. In fact, even at the time of this writing, during the historically volatile month of October, the market seems to be overtaken by a preoccupation with just about every negative news story one can imagine. Everything, that is, except the aforementioned factors which usually matter most.
In a recent interview, Bill Nygren, the renowned value investor from Oakmark, stated in seeming frustration that, “Those who are arguing about this being a longer-than-average economic recovery are failing to understand the magnitude of the recovery thus far…we have barely gotten above normal growth rates since the [previous] bottom.” Could it be that the tone and volume of the discourse has caused our attention to be placed in the wrong places?
It seems reasonable to assume that the volume of discourse is decidedly above historical levels, given the modern media triumvirate of social, news, and entertainment platforms. But is the tone really that different?
Eric Sevareid, the famous CBS news journalist who, with Edward R. Murrow, brought national news coverage in the US from an era of newspapers and radio to television, was quoted in 1964 as saying that, “The biggest big business in America is not steel, automobiles, or television, it is the manufacture, refinement, and the distribution of anxiety.” Today, we presume that Sevareid would probably allow the addition of the word outrage alongside anxiety. Both seem quite effective at attracting and holding our attention and interest. But is anxiety and outrage where the astute investor should be placing their attention?
With the shifting that is underway among the economic and political tectonic plates around the world, perhaps we would also be wise to remember the words of Stefan Zweig from his autobiography, The World of Yesterday (1942). In discussing his formative years, Zweig describes life in Vienna, Austria, at the turn of the century as a society that seemed to represent the global high-water mark of civilization. In what sounded like a fantasy world, Zweig reminisces of how he and most of his contemporaries in the Austrian bourgeoisie indulged themselves day after day in intellectual advancement, appreciation of the visual and performing arts, poetry readings, and philosophical debates. Looking back, he recalls how they were disinterested in and detached from political and social developments taking place just 300 miles to their north in neighboring Germany. At that time, a growing voice was being given to anti-Semitism, socialism, and inequality of the races while events such as hyperinflation justified an increasing series of violations to the post-WW1 Treaty of Versailles. Soon, the daily obsessions of the typical Viennese became irrelevant.
Like Zweig and his fellow Austrians, we would all be well-advised by history to keep an ear to the ground and our eyes focused on the horizon rather than on cable news. But unlike Zweig who, because his focus was on things trivial and irrelevant, missed seeing the beginnings of what was to become perilous, today the focus of investors on so much that could eventually turn out to be irrelevant could be causing many to miss out on the positives: namely a multi-year expansion in earnings and equity valuations that many seem to disbelieve.
To that end, an important part of our ongoing approach to investing in equity markets has been to always strive to keep our attention focused upon facts and events both here and abroad while discounting the noise of opinions and commentary. Our aim in doing so is to gain a better understanding and insight so that we can invest successfully over the long term. While this may come as a surprise to some, our recent findings from sticking to this discipline have been quite encouraging. There is a lot of good news to factor in to one’s outlook on the equity markets if the focus is limited to measurable facts and verifiable events.
For starters, consider asset flows into equities. Listening to much of the news coverage about the equity markets, we hear that equities are overvalued and over-owned and that the success of the FAANG stocks have driven widespread speculation. But the facts tell quite a different story. Year-to-date through August, according to Investment Company Institute (ICI), outflows from U.S. equity funds have totaled ($77 billion). This is on par to exceed 2017 and 2016, which saw outflows of ($50 billion) and ($68 billion), respectively. Contrast that with the much more suspect bond market, which has seen steady inflows for much of the past three years and beyond. Despite rising interest rates, taxable and municipal bond funds have seen inflows of $175 billion since the start of the year. Since a big part of the argument for equities being over-valued is over-ownership, it’s worth considering that owners of U.S. equity funds have been net sellers despite the run-up since the election.
Whether they are indicative of anxiety about the duration of the current expansion or not, such outflows have had a significant impact on equity valuations. In mid-2016, amid concerns about a financial crisis in the EU on the heels of the UK’s Brexit vote and after several years of tepid earnings growth, the S&P 500 (market) forward P/E ratio hovered around 16.5x. Following the election as many economic indicators surged, the market P/E followed along, rising as high as 18.5x by December 2017. All that changed as we entered 2018. Despite two quarters of earnings growth reported of 14.5% and 25.4%, respectively, and the current quarter looking to be a continuation of this trend, the market’s forward P/E has compressed recently to 15.9x. Apparently, the strong trend of earnings and GDP growth have not been sufficient to offset a news cycle that is constantly providing us with updates on worst-case scenario analysis of solid growth in jobs and wages (inflation!!), trade negotiations (inflation!!), a flattening yield curve, and a tech sector doing unspeakable things with our personal information, emails, and photos.
And what about earnings growth? Keeping in mind that if the market’s P/E was (in theory) to stay constant, we would expect the market to rise by an amount equal to earnings growth less distributed dividends. In fact, over the past four quarters, the S&P 500 earnings have grown 22.8%, while the return through midOctober has been 15%. Simply stated, that would imply a market that became 8% cheaper than it was a year ago. If consensus earnings growth for the next four quarters of 17.8% comes to fruition and the market fails to move up by the same amount, then stocks will just become cheaper.
This is not to say that there are not pockets of overvaluation. One place to look for such excess might be in the private markets, which seems to be where much of the return envy has resided over the past decade. Most notably are some of the “unicorn” companies that have achieved super-sized market capitalizations without ever having to produce a profit. Since regulations and a market bias against volatile (or negative) earnings have made it increasingly unappealing for smaller companies to come public, the private markets have blossomed into a critically important asset class despite its limited access to a wide segment of the investing public. At present, there is over $1 trillion of unfunded capital looking for worthy investments in the private space. But the appeal of remaining forever private may be changing. Noteworthy is the recent confusion surrounding a large company’s CEO vowing to his public shareholders last month that he was going to take the company private (bringing them along in the investment), contrasted with another company’s new CEO pledging to take that company public (the largest of the private unicorns) after recognizing the shortcomings of not having public shareholder scrutiny and accountability.
But perhaps one of the most misunderstood and debated topics of this current market cycle is in trying to discern what is driving the dichotomy of growth and performance of U.S. equites relative to the rest of the market. Even earnings signal that something is clearly up. Morgan Stanley’s All Country World Index (ACWI) which includes U.S. companies grew 47% over the past 5 years (7.55% annualized). But if you exclude the U.S. from this group, the non-US ACWI grew only 13% over the same time period…a paltry 2.55% annualized. Growth rates that stray this far apart make a case for the U.S. market being one of the key drivers of global growth. But the bears see it differently.
Some argue that the U.S. in the midst of a “sugar high,” with our present 4.2% level of annualized GDP growth resulting primarily from a short-sighted tax stimulus that temporarily put money into consumer wallets. Under this scenario, once consumers finish burning through this bolus of extra spending power, GDP growth will revert back to a lower equilibrium level. While consumer spending is certainly important to GDP growth, we find that growth in the labor force, growth in productivity, and growth in U.S.-focused capital expenditures are more important determinants of overall growth in GDP. All three of these are presently on the rise and seem unlikely to decelerate as soon as consumers have spent their 2018 tax savings.
To be fair, the improvement in U.S. capital expenditures began long before the 2016 election and the implementation of new fiscal policy policies. Beginning when China joined the World Trade Organization in 2001 until 2014, U.S. companies were spending a decreasing amount of their cash flow on this side of the Pacific, opting instead to invest in the offshore boom in Asia-based manufacturing facilities. This trend continued as long as the cost of wages, transportation, and logistics to ship goods back to the U.S. remained at a significant discount to manufacturing back at home. Based on available data, it appears that the turning point was sometime in 2013-2014 when Chinese total investment as a percent of GDP began to fall and U.S. capex began to rise. So, while the current administration takes a lot of credit for bringing jobs back to the U.S., it appears that the real heroes were the market forces that made offshoring in China increasingly unattractive. The positive side of all this from the U.S. perspective is that more capex being done at home has resulted in more jobs being created, wages that are growing, and more productivity gains from updated plants and modernized equipment.
Recognizing that these positive trends were already firmly in place in early 2016, it is possible that the structural changes introduced by the new administration: lowering our tax rates to a level more competitive with other Organization for Economic Co-operation and Development (OECD) countries, reducing regulation and creating incentives for U.S. companies to repatriate overseas helped the tailwind that was already underway become more sustainable. This tailwind becomes even more powerful and sustaining when one considers how important the U.S. recovery is to global growth. To date, much of Europe has yet to make the structural changes to boost growth and improve the balance sheet of their banks while China’s economy is undergoing stress from efforts to deleverage their financial system and to reduce their GDP growth rate to a more sustainable level.
So, where does all this leave us? We see the present situation as being in the midst of a powerful economic expansion in the U.S. that seemingly gets no respect. The bears argue that it’s late in the cycle and whatever benefits we have achieved in the past year will soon be snuffed out by runaway inflation, higher rates, a flattening yield curve, a stronger dollar, or misguided dealings with our allies and trade partners.
October often brings out the worst of the market’s fears, and this year has been no exception. We already have rumors of a brewing cold war with China, a spike in interest rates, a super-charged electorate looking for vindication by November 6, and most recently what appears to be a state-sponsored act of murder by one of our key allies in the Middle-East. We at The Knall/Cohen/Pence Group are not immune to such fears. While mid-term elections rarely have any meaningful long-term impacts on markets compared to underlying fundamentals, the other risks listed above warrant proper attention and response to ensure that they do not become real impediments to the pace of this recovery in the U.S. and elsewhere.
But until facts and events tell us otherwise, we will continue to believe that the current expansion has further to run. And the evidence to support that view is still compelling. Our banks have extremely healthy balance sheets, they continue to grow earnings, raise dividends, and buy back stock. The U.S. consumer is also in great shape with the lowest ratio of debt payments to disposable income in 25 years and U.S. household debt to GDP, the lowest since 2000. Companies continue to grow earnings, spend on new capital equipment, and create jobs pushing our unemployment rate down to 3.7% and driving wages and consumer confidence higher. With earnings projected to grow 8-10% next year and dividend yields that are almost as high as interest payments on bonds, stocks do not appear expensive.
The facts are there for all of us to observe. The picture that they reveal currently appears quite constructive. Conversely, much of the opinion and commentary paints a different picture. The picture upon which the majority of market participants choose to focus their attention will likely determine the direction of the markets over the next 2-3 months. However, it is the substantive facts that will determine what the market does over the long term. As always, our focus will remain on the horizon.