As bottom-up stock pickers, we are nearly exclusively focused on identifying stocks of well-run companies that offer attractive, risk-adjusted return prospects. Our criteria include reasonably valued companies that exhibit durable competitive advantages, strong balance sheets, and competent management.
We hope that the strategy summary sent to you over the holidays that provided an overview of our analysis and outlook on your holdings was well received. If you have not already, we encourage you to page through this summary and call or meet with us to discuss them. Some clients who have read the reports have commented that their confidence has strengthened, especially amid a “Year of Turmoil” that has continued into 2016- welcome confirmation to our motto, “Know what you own. Know why you own it.”
Note to 8: The Fed increased its key rate.
We rarely, if ever, try to predict the performance of a major index like the S&P 500. However, we periodically reflect on the past and consider future long-term outcomes for the stock market for perspective. While slow global growth is considered the “new normal,” looking back at history shows that the “new normal” rarely lasts. See Figure 1.
The driving factors for the overall stock market are interest rates, economic growth, corporate profits, and investor emotions. Any single factor can negatively affect stock prices despite the other factors contributing in a positive way. This is why stock market returns and the economy are much less correlated than conventional wisdom would lead one to expect. The complexity of these four factors makes forecasting the stock market nearly impossible within time periods of less than 10 years or so. Ultimately, valuation prevails over long time periods.
1964 - 1981
For example, from 1964 to 1981 the economy grew at a very healthy clip. Annualized GDP growth was 3.3% during this period at least 30% faster than current forecasts, yet stocks returned just 2.2%. The major culprit for this low return was interest rates and high levels of inflation. The 10-yr. government bond rate increased nearly 2.5 times to a whopping 15% in late 1981. Large interest rate movements have wide reaching and powerful effects on investments, including stocks.
1982 - 1999
Enter Paul Volker. As chairman of the Federal Reserve, Volker raised interest rates even higher which increased unemployment to 10% but also broke the back of inflation. Interest rates declined, government spending increased, GDP growth accelerated, and the stock market took off like a rocket. The S&P 500 returned almost 15% per year during this period, a phenomenally high rate.
In the late 1990s, after so many years of wonderful stock returns, investors started to become very complacent. Many looked less at company fundamentals and valuation and more toward figuring out who they knew in order to buy pre-IPO shares in anything related to the Internet. Risk seeking was in vogue, as shown by the Sep 6, 1999 Time Magazine cover: “Why we take Risks: From extreme sports to day trading, thrill seeking is becoming more popular. Here’s what makes us go for it.” Investors had wildly optimistic expectations. A Paine Webber and Gallup Organization survey released in July 1999 showed that new investors to stocks (investing less than 5 years) expected 22.6% annualized returns for the next 10 years. More experienced investors (more than 20 years’ experience) expected 12.9% annualized returns – still very high considering the long run history of stock returns and the then elevated valuation levels.1 Then SEC Commissioner Laura Unger cited the survey in a speech Sept 10, 1999 entitled, Does the Internet Empower or Just Excite Investors?
2000 - 2015
The dot-com bubble burst in 2000. From early 2000 to early 2016 the S&P 500 returned just 2.0%! The technology heavy NASDAQ finally eclipsed its prior 2000 peak the first time last year in April! How can this be? Most forecasters in 2000 would not have expected 10-Yr. U.S. government bond rates to continue declining from 6% to close to 2%. Had they projected this to happen, stocks would have looked even more attractive back then. Rates declined because central banks’ attempted to boost slowing GDP growth, which actually started to occur before the Great Recession.
There is no consensus on why economic growth has slowed but this slowing growth has hampered stock returns and lowered expectations. Theories include a sustained lack of demand, slowing innovation, adverse demographics, lingering uncertainty, post-crisis political polarization, debt overhang, insufficient fiscal stimulus, and excessive financial regulation.2 The poor returns experienced from peak to peak over this period were based on unrealistic assumptions made by exuberant investors caught up in a tech bubble, coupled with lower than expected economic growth and a financial crisis that lowered investor psychology to levels not recorded since the Great Depression. Extremely low interest rates and above average corporate profit margins have been positive factors for stocks that have cushioned the negative effects of slowing economic growth and subdued investor psychology.
2016 and beyond
Return expectations within the investment community and beyond for the next 10 years or so continue to be much lower when compared to the late 1990s. Nowhere have we read or spoken to anyone with 10-year return expectations today close to the Paine Webber Gallup survey in 1999. State retirement systems have actually trimmed assumptions since 2008, due to the low interest rates earned on bonds and the slow growth outlook for the global economy. The current average target is the lowest since at least 1989.3 These subdued expectations indicate a lower risk environment for the U.S. stock market compared to the tech bubble period, which is a positive factor as we consider future stock market return potential.
Looking toward 2030, interest rate policy should correlate with economic growth. The U.S. Federal Reserve increased rates for the first time since June 2006 in December 2015, a sign that the economy is strengthening. However, all other central banks that have raised rates following the Great Recession have since lowered them back. If U.S. economic activity remains sluggish (or dips into recession) and inflation stays low or non-existent, policy makers will keep rates very low, which should be a positive factor for the stock market that will help dampen the negative effect of slowing growth. Corporate profit levels are above normal, and this could remain so for a while, or not. Accelerating economic growth would likely put upward pressure on wages, reducing profit levels. The pace and timing of any changes in these three factors will have profound impacts on broad stock market returns over the next decade.
Barring major unforeseen changes to interest rates, economic growth, and corporate profit levels, investor psychology will remain the primary driver of returns over the near-term. For the next few years, we anticipate continued low interest rates, modest revenue and earnings growth, and moderate market valuations with returns for the stock market to be higher than returns for bonds, but lower than historic stock market returns. Regardless of the environment, as bottom up investors willing to stray from the benchmarks, we will continue to identify and invest long-term in well-run, reasonably valued companies.
1 Paine Webber and the Gallup Organization. (July 1999) Index of Investor Optimism.
2 Lo, Stephanie and Kenneth Rogoff. (2015) Secular stagnation, debt overhang and other rationales for sluggish growth, six years on. Bank for International Settlements, BIS Workings Papers, No 482.
3 Martin, Timothy W. "Public Pension Funds Roll Back Return Targets." The Wall Street Journal 4 Sep 2015. Web. 1 Jan 2016. http://www.wsj.com/articles/taxpayers-more-pension-burdens-headed-your-way-1441388090