Trademark Market Perspective for May 3rd, 2017

I just returned from the Morningstar conference in Chicago.  I always find it interesting to compare each conference I attend to past conferences in order to determine what issues become more and less important over time.   The active-passive debate generated a lot of discussion.  Morningstar derives an important part of its income from rating mutual funds and would therefore likely be hurt by the demise of active funds, yet it threw out only modest support to the active fund industry (specifically Dodge & Cox and PRIMECAP Odyssey).  Ironically, greater support for active funds came from Blackrock, the owner of iShares, CEO Larry Fink.  Also, while it is no secret that growth as a strategy has run laps around value since the last recession, growth managers seemed to take index performance criticism more personally.  Value managers across the board acknowledged their struggles in this market but felt certain that their time would come.[i]

There were two other areas that were prominent at the conference this time that were hardly even issues in the past, behavioral finance and sustainable investing.  When I began my investment career, Modern Portfolio Theory ruled the land.  Nobody dared say out loud that investors weren’t rational.  If two investors ever came to opposite conclusions, it had to be that their time horizons or investment mandates were different.  Or one had information that the other didn’t.   Today the industry seems to fully embrace the notion that investors (even professionals) have biases, and emphasis is now on how to recognize and use them.

Sustainable (or ESG[ii]) investing has flourished recently as it has emerged as a more palatable way of avoiding “bad” companies.  The goal of ESG investing is to invest in companies whose practices rank high in environmental, social and governance performance standards.  The environmental screen helps avoid companies (such as those in the coal industry) whose assets might become stranded as more climate-friendly power generation grows in usage.  Social seeks to avoid companies whose policies might generate unfavorable publicity and/or lawsuits, such as discriminatory hiring or anti-consumer practices (among other things).  Governance issues sought to expose the fact that in companies where employee relations were poor, minority shareholders were ignored, or executive compensation was excessive the stock tended to underperform.   Morningstar paid only the mildest attention to what it called “socially conscious” investing in the past, but is fully on board with sustainable investing today.

Nobody at the conference disagreed with the notion that stocks and bonds are both fully valued (if not expensive), but very few thought that the current environment (2% growth give-or-take and an inflation rate of under 2%) posed any threat to the bull market’s continuance.  The biggest risk factors cited were rising U.S. rates and a strong dollar.  Mildly disappointing GDP or retail sales are not going to kill the bull market.

Investing ideas:

• Last winter in the wake of the market reacting to what it though President Trump would do, interest rates rose sharply. The 10-year Treasury bond briefly exceeded 2.6%.   Speculative trading positions were very short the 10-year as many projected 3% yields by June.  Fast forward to today and traders have closed those positions at a loss.  Trading sentiment among speculators is now that interest rates will go lower.   I think that sets us up for a test of 2.50% at the very least.  Now may be a good time to trim duration.

• Another area I believe investors will prioritize is dividend growth. For a long time, investors preferred companies with excess free cash flow to buy back stock as opposed to paying big dividends because dividends are taxable.  Today there is a growing sense that stocks are so expensive that share buybacks in most cases don’t make sense.  For this reason, companies are increasingly opting to declare one-time special dividends (most recently Costco), and investors are rewarding that choice.

• This is the part of the market cycle where it is the most difficult to hold value stocks. One value manager said that he understands that he is “asking people to own names that they will probably hate”.  Some people are better off acknowledging that they don’t have the stomach to be value investors and not investing that way in the first place, he said.  That avoids “bad exit under-performance”.

• Dollar-based emerging market investors have been the biggest beneficiary of the fact that the dollar has been unexpectedly weak this year. A strong dollar forces countries that borrow in dollars to use up more local currency to pay bondholders, negatively impacting liquidity.  This is something EM investors have to watch carefully.  For the moment, however, the dollar decline is a positive for EM, and off-the-cuff tweets only make this situation better.  The risk factor here is a comprehensive tax reform package that would incentivize companies to repatriate overseas capital.

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[i] I personally believe value managers need an economic growth expectation of less than 0.5% or greater than 3% to regain favor versus growth.  A slowdown to less than 0.5% signals recession and would likely compress growth P/E multiples.  An acceleration to 3% or more signals the kind of strong expansion that encourages capital spending and makes cyclical stocks the biggest winners.  I believe neither is in the cards in 2017.

[ii] Environment, Social, and Governance