I’m not emotional…I just have a FEELING!
May 4, 2017
Market Summary – 1st Quarter, 2017
“I have been through some terrible things in my life, some of which actually happened.”
Investors recently celebrated the 8th anniversary of what has frequently been referred to as the most unloved bull market of all time. Perhaps never in history have so many experienced such high levels of anxiety in times of such prosperity.
One likely cause of such behavior is the lingering hangover from two 50% market declines in the span of just ten years (2000 to 2002, and again from 2007 to 2009). Then more recently, anxiety ticked up another notch based on the surprising political developments of 2016. In times like these, emotions tend to overshadow fundamental factors that should guide investment decisions.
Investors have been presented a picture of a world in chaos. Tweets and pop-up notifications were added to the arsenal of a fear-pushing industry that already enjoyed 24 hour a day/7 day a week cable news, social media, internet news, as well as local broadcast and print news outlets. All of this contributes to an elevated level of anxiety that translates into a view that stocks are too risky. Sadly, elevated anxiety levels have caused some investors to miss out on what has been, and we believe will continue to be, a great opportunity to build wealth. Investors may be surprised to learn that while upheaval in the geo-political climate has captured the headlines, and depicts a world teetering on the edge, the economic reality beneath the surface is much calmer.
Much ado about nothing
While the headlines have fueled investor anxiety, the smart money is focused instead on the economic scorecard. Savvy investors appreciate that future economic growth has much more to do with wealth building than interestingly unimportant headlines.
A prime indication of today’s economic calm was the lack of reaction to the Federal Reserve’s March 15th interest rate hike of 0.25%. Until now, speculation about rate hikes has led to significant volatility in the markets. Yet this latest move was greeted with a collective yawn. The probability of a Fed rate hike at the March meeting soared from around 20% in late February to more than 80% a week later1. This sudden about face might have sent markets reeling in previous times. Instead, the market took this rate hike in stride. Equity markets remained steady in the days leading up to the Fed meeting, and actually closed higher on the day the rate hike was confirmed. Investors appeared equally calm about the Fed’s forthright comment that more rate increases are likely later this year. In light of other factors, like the potential re-emergence of a fiscal policy in Washington and solid economic growth, investors feel less compelled to put the Fed’s actions under a microscope.
Other “benchmark” measures of risk have also been subdued. The Chicago Board Options Exchange Volatility Index (the “VIX”), often referred to as the “fear index,” has been, and remains, low. In addition, the equity risk premium, which measures investor angst towards investing in equities, has come down noticeably from its heightened 2011 levels.
If you’re still not convinced that the equity market’s reality is not on the same page as your favorite media outlet, consider that the three months ended this March were the least volatile for the Dow Jones Industrial Average in the last 50 years2.
In this period of high anxiety, the facts point to a different reality – one in which economic growth remains steady, corporate earnings are improving, and inflation is under control. History tells us that this usually adds up to a constructive environment for value-based investors.
By contrast, we believe that the bond market offers much more significant risk. Consider that in the summer of 2016, the yield on the benchmark 10-year U.S. Treasury note dropped to 1.37%. Since then, it peaked at 2.62% (on March 13th). When interest rates rise, the value of bonds in the market declines. An investor who purchased a 10-year bond last July would have seen it drop in value by more than 10%, hardly a safe haven. We believe that the era of rising interest rates, increasing inflation, and eroding bond values is still in its infancy. Nobody knows how fast or how high rates will rise, but we remain confident that the pain felt by bondholders will be significant.
A discerning eye for good value
Long-term investors don’t let anxiety about market volatility or current events distract them from more important considerations. The value of picking the “perfect day” to invest or identifying a market bottom pales in comparison to what really matters – the ability to identify and invest in the select group of companies that offer outstanding investment opportunity over the long run. Our own track record demonstrates that external events and market timing become insignificant concerns. It is a fine line that separates stocks of individual businesses with wealth-enhancing investment potential from the rest of the pack. That’s why it’s so important to focus time and resources on determining where those unique individual opportunities can be found in order to generate long-term wealth, rather than discussing “the market”.
Back in 2003, MPMG Senior Portfolio Manager Phil Grodnick was quoted in a magazine interview saying, “We’ve been fighting a market that didn’t give a lot of credit in the past three to five years to the uniqueness of a company. It was basically painting by numbers. The index funds were forcing the issue about where people were making their selections. So if we get back to the old days, where you actually make an investment in a company because of its merits, that would be interesting.”3
At that time, Phil was prescient, and stock picking with a value focus came back into favor. Tenured clients of MPMG may remember that his statement was made in the early stages of what proved to be an impressive run for our portfolios.
Phil’s comments seem just as relevant today. As it becomes evident to investors that a “painting by numbers” approach offers limited potential going forward, it opens the door to opportunity for those who focus on paying the right price for a quality company. Even at a time when the stock market is near all-time highs, overlooked and undervalued stocks can be found.
Is there a “right time” to invest?
Anxiety-stricken individuals who have chosen to sit out the bull market are, in many cases, waiting for a better time to invest. They are convinced that a market downturn is just around the corner, and that their procrastination will be rewarded. These investors have also convinced themselves that even when a steep market decline occurs, they’ll have the courage and skill to jump back into stocks at just the right moment.
History shows that most investors don’t demonstrate such foresight. Individual investors’ flow of funds into stocks are the greatest at the least opportune times: near market peaks. Equally unfortunate, individual investors are typically absent from the market during the early and middle stages of a bull market. They are, sadly, often buying high and selling low – a surefire way to lose money. The most recent example of this comes from a study that shows how investors were net sellers of equity mutual funds from 2008 through 2012 even though the bear market in stocks ended in early 2009, and markets recovered rapidly afterward.4
Fundamentals still look favorable
We can assume that, sooner or later, expectations of a temporary market downturn will be realized. Successful investors appreciate the fact that corrections (a decline of at least 10% in the market) happen all of the time. These corrections are natural events. What is not natural is the absence of a correction for a long period of time. They also understand that most of these corrections are unpredictable, or arrive with little or no warning. Trying to time the market is a futile task. Rather than worry about trends in the broader market that they can’t control, investors with a proper perspective focus their energies instead on individual stock selection.
By contrast, anxiety-ridden investors become obsessed with preparing for the next 30% to 50% drop in the market, like what we saw in 2001-2002, and again in 2008. When such setbacks occur, one of three catalysts tend to be the cause – extreme stock price overvaluation; threats to the banking system; or a contraction in global profits. We contend that there is little evidence pointing to any of these three factors coming into play in the near term:
- Stocks are overvalued…or are they?
A misperception is that after an eight-year bull market and the major indices at or near peak levels, stocks must be too expensive from a valuation perspective. While there are some popular stocks reaching what may be unsustainable prices, the overall S&P 500 Index’s price/earnings ratio of 17.6 based on forward (or anticipated) earnings suggests that average valuations are well in line with historical levels.
- The reinforced financial sector
By virtually every relevant statistic and ratio, the banking system is now in better shape than it has been in decades.5 In fact, the Tier 1 capital ratios (the most closely followed ratio for evaluating a bank’s financial health) for systematically important banks have more than doubled since 2009.6 No longer are the world’s banks glorified hedge funds that can take excessive risk without consequences. These in-house trading operations have largely been disbanded, and what is left are well-capitalized banks with a greater focus on traditional lending activities and risk management.
- Continued economic expansion
Growth in the U.S. and around the world appears to be stable and potentially strengthening. This is evident on the domestic front by looking at a projected upturn in corporate sales and earnings. It’s hard to find a period in history where major market declines occurred when valuations were not excessive, the banking system was sound, and revenue and earnings were expanding.
As we discussed in detail in our previous newsletter (4th quarter 2016, “A New Year, a New Economic Course…Now What?”), Congress and the White House are working on a number of proposals designed to create a more favorable business environment. These include (but are not limited to): tax reform, a plan to repatriate corporate profits currently stashed overseas (presumably much of it to be reinvested), and significant de-regulation of select industries. These business-friendly proposals could help generate even greater economic growth and enhance profit potential for well-run companies. Stocks of quality firms that are attractively priced are best positioned to benefit in this type of environment.
In short, the combination of favorable existing fundamentals and potential policy changes belie the anxiety being felt by some investors.
The right stuff
Investment success is not simply a matter of luck and timing. Measurable wealth is achieved as the result of a well crafted, researched and executed investment strategy. Now, more than ever, investors who are serious about maintaining and building wealth must set aside the distractions that are driving their anxiety and return their focus to the fundamentals.
1 Barbara Kollmeyer and Anora Mahmudova. “Stock market books weekly gains as Yellen says March rate hike ‘likely appropriate,’” Marketwatch.com. March 3, 2017.
2 Crystal Kim, “The Least Volatile Quarter on Record Since the 1960s.” Barron’s. March 31, 2017.
3 Tony Carideo, “Hunting Dogs,” Twin Cities Business Monthly, March 2003.
4 Rick Ferri, “The Problem with Market Timing,” Forbes, June 12, 2014.
5Leslie Shaffer, “US Banks are at their healthiest in decades: Richard Bove.” CNBC. April 6, 2016.
6Natasha Sarin and Lawrence Summers, “Understanding Bank Risk through Market Measures.” Brooking Papers on Economic Activity. Fall 2016.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.