The U.S. economy improved modestly in the first quarter of 2015. The bigger story, however, was how well the rest of the world’s developed markets responded to financial stimulus. In the U.S. quantitative easing has been a fact of life since 2009 and the stock market is up over 200% from the March 2009 lows. In fact, “QE” has been so successful in stimulating financial activity that the Federal Reserve has signaled it is prepared to raise rates later this year. By contrast, Japan and the European Union started their stimulus programs much later and have not seen anywhere near the market recovery the U.S. has. That said, U.S. economic growth has been so gradual over the past several years that bond yields have continued to decline, providing another surprisingly good quarter for bond investors.
After two years in which large company U.S. stocks handily outperformed every other asset class, the benefits of diversification were quite evident in the first quarter. The S&P 500 index gained less than half a percent (0.47%) on the quarter, as the strong dollar hurt many multinational companies. Small and mid-size firms, which tend to do more of their business domestically, were up 4.35% and 5.01%, respectively. See Figure 1. Health care was the best performing industry group as investors continued to be attracted to their strong earnings growth. The worst sectors were utilities and transportation stocks – each gave back more than -4%. Both sectors gained more than 25%[i] in 2014.
Japanese stocks posted a 10.2%[ii] quarterly gain. The sharp decline in the yen in 2014 paved the way for the export sector to do exceptionally well. The rest of Asia was up 4.9% led by India which was up 9.9%. Europe has also been trying to push its currency lower, and that effort is finally starting to bear fruit. Europe rose 3.5% in dollar terms, but more than 10% in local currencies. The worst region was once again Latin America (off -9.5%) as Brazil is reeling from rising inflation and a corruption scandal.
Bond yields continue to confound the experts by staying low. Every time we think the interest rate cycle has decisively bottomed we get a surprisingly weak economic report and the next interest rate increase gets pushed a few more months into the future. The Barclays Aggregate Bond Index rose 1.6% last quarter. Inflation protected bonds rose 1.4%[iii], and municipal bonds tacked on 1.0%. As one might expect in a strong dollar environment, foreign bonds posted a loss on the quarter. The best bond sector was high yield corporate debt, which shook off a fairly awful second half of 2014 to end the quarter 2.5% higher.
Seeing that the depreciation of the euro and the yen were stealing growth from the dollar, the move to make this past quarter was to increase one’s foreign stock weighting, especially on a currency-hedged basis. There are ETFs and mutual funds that enable us to do this, and where available and risk-appropriate we took advantage. The second performance enhancing step this quarter was favoring growth-oriented funds at the expense of value-oriented funds. See Figure 2 In the later stages of a cyclical market rally, investors tend to get more aggressive and are willing to pay up for companies they feel would not be hurt if the Federal Reserve raised rates. Slower growing large companies with strong balance sheets tend to do well during most phases of the market cycle, but not this one.
We wrote last quarter that we really need to see economic growth pick up elsewhere in the world, because the U.S. couldn’t remain the one and only economic engine indefinitely. Happily, we have seen growth pick up overseas (admittedly from pretty low levels) and that gives us hope that the cycle can continue even longer. There are some headwinds, however, that suggest the going will get tougher:
- The Federal Reserve is almost certainly going to raise rates in the next few months. Given the massive amount of borrowing over the past several years, this is a concern that nobody seems to be able to accurately quantify. Higher rates don’t guarantee a decline in the stock market, but equities do perform much better historically when interest rates are falling.
- The U.S. manufacturing sector had an advantage when the dollar traded at $1.45 to the Euro and at 85 yen two years ago, but now we are at $1.08 and 121 yen. This is going to cost U.S. exporters. Iron ore mines in northern Minnesota have recently been idled because they are no longer competitive.
- According to Goldman Sachs’ David Kostin the S&P 500 Index trades at a forward P/E of 17.2x, the highest level in the past 40 years outside of the Tech Bubble. The median stock trades above 18x, ranking in the 99th historical percentile since 1976. Sure, we could go higher on a 1999 style blow-off top, but do you really want to bet on that?[iv]
Headwinds notwithstanding, as long as we remain in economic “Goldilocks” territory – weak enough to keep interest rates well behaved but strong enough to permit gently rising employment – stocks are probably going to remain the asset of choice.
Commentary – Extra Innings
Every quarter I attempt to come up with an analogy to describe the type of market environment we are in. This quarter I’m going to present two analogies. The big takeaway should be that we are in a favorable but fragile environment where any type of change will be viewed skeptically by market participants.
The Wheel of Fortune Analogy: Imagine you are watching the well-known television game show Wheel of Fortune. One of the contestants has been successful this round and has piled up $6,000 and a trip. There are only three consonants left and you are sure she must know the answer to the puzzle. You yell at the TV “Solve the puzzle now!” but she has noticed that each spin lands her in the same section of the wheel with only money spaces. So, despite the fact that each new spin offers only incrementally more money while risking all her winnings, she spins again.
The Baseball Analogy: It has always been fashionable for market pundits to describe the market cycle in baseball terms. For example, “Stocks have done very well over the past several years, but the Federal Reserve hasn’t even begun raising rates, so we think we are only in the seventh inning of the rally”. Maybe so. On the other hand, a better baseball analogy may be that the rally that began in the Spring of 2009 wasn’t the first inning of a new game but instead the top of the tenth in the old game. Let me explain.
The Federal Reserve, through its bailouts and liquidity programs, succeeded in making sure the fallout from the previous game, the real estate and financial crisis, did not result in a general deflation (which had historically always been the result of a debt crisis). The effects of this are mixed – the economy is unable to hit a home run, but it doesn’t strike out either. Though it is theoretically possible that one good hit could end the game, the Federal Reserve (umpire) is acting like the referee in those Buffalo Wild Wings commercials by pulling out all the stops to make sure that doesn’t happen.
The Federal Reserve and other world central bankers are working to create an environment that rewards risk taking on the belief that taking risks leads to economic growth and more jobs. But for some of the key players in the global financial system, the central banks won’t let them fail – even when they make bad decisions. China for example is struggling under the weight of overinvestment in infrastructure to the extent that many of their projects will never earn a return that justifies the cost of the capital provided. Similar if smaller inefficiencies are promoted by central banks all over the world (including our own). The concern here is that if you keep bailing out small missteps then bad behavior continues until it reaches a critical mass that becomes uncontainable (ala 2008). In market terms, we are in an investment environment where we no longer have frequent modest declines of 10-15%, which serve to remind us that market risk is always with us but can be overcome with patience and prudence. Instead, we have long rallies without significant pullbacks such that risk is forgotten. Ultimately these end in devastating routs that wipe out a significant chunk of the market’s value and leave individuals with a profound sense of distrust.
The upshot is that investors are playing a game where the odds of success in the short term are very favorable but the negative consequences of a sudden end to this “not too hot, not too cold” environment are so much greater than the upside should it continue. Put another way, the risk reward tradeoff is skewed. All things being equal, we would prefer not to be market timers since it is extremely difficult to call a market top. That said, the market is approaching a point where raising some cash might be prudent, despite the odds. We are not afraid to be early. After all, if you don’t have an eye on the exit, you risk getting trampled when the game ends.
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[i] Per JP Morgan Guide to the Markets, 4Q14
[ii] All of the international market indices cited in this paragraph are from MSCI via Morningstar
[iii] All of the bond market indices cited are from Barclays via Morningstar
[iv] Source: GSAM Short Stories in 3 Chapters, April 13th, 2005