A Period of Consolidation

Amid increasing volatility and a period of consolidation, the S&P 500 Index returned 3.8% through the 2nd quarter and is only slightly above levels reached in December 2014. Within this 18 month consolidation period, under the surface many stocks have had significant corrections and some sectors such as energy, materials, and selective industrials have declined over 40%. These declines are pertinent because many investors fear that the current length of the bull market, which is the second longest on record, means we are approaching the last innings. However, as many stocks have corrected, a good case can be made that this 18 month consolidation could result in a continuation of the bull market that began in 2009. Let us examine the current investment environment keeping in mind that we will manage risk through our bottom-up stock picking disciplines, maintain normal cash reserves, and refrain from participating in the loser’s game of trying to time the market.

The S&P 500 Index opened the year with the worst two-week start to a calendar year on record after the Fed raised rates for the first time since the financial crisis, while concerns mounted regarding slowing economic growth and low productivity gains. A sharp rebound of over 12% in February and March was led by energy and material stocks, as oil prices stabilized and fears of China’s economy slowing and of increasing risks of recession faded. Most recently, global markets were roiled as United Kingdom citizens surprisingly voted to exit the European Union. Global stock markets quickly recovered from the broad selling related to Brexit and even Britain’s key stock index, the FTSE 100, is now trading at highs for the year.

According to Bloomberg reporting, in the weeks leading up to the vote odds makers had a 90% chance of a “remain” outcome, but quickly adjusted expectations to a 90% chance of “exit” after the first results were revealed. Simultaneously, the British Pound declined the most in a single session since 1983 and stock markets in most every country declined significantly as investors bought traditional safe haven assets such as U.S. Treasuries, the Japanese Yen, and gold. Interest rates reached record lows with the yield on the U.S. 10-year Treasury note recently falling below 1.4% for the first time on record. (1) Defensive stocks such as utilities, real estate, and domestic consumer staples outperformed while financials, materials and industrials lagged. In the days since the vote, stocks have rebounded, Prime Minister David Cameron and other politicians resigned, credit ratings agencies lowered the U.K. credit rating, and the process continues to play out with limited visibility. Many were clearly caught by surprise by this binary event that has triggered a series of possible new events with a wide range of long term outcomes.

On one end of the spectrum, the U.K. could reverse its decision since the vote was a non-binding recommendation by the people to U.K. leadership. The official process to leave has not yet been submitted to the E.U. A reversal seems unlikely, but some are hopeful. On the other end, Brexit could give new energy to voices in other countries seeking to leave the E.U. and eventually cause a complete dissolution. This also seems unlikely in the near term, but possible over many years. While recognizing the situation is fluid, a likely scenario is one in which the U.K. leaves and remains loosely tied to the EU.

Regardless of the eventual outcome, Brexit has been a moderate shock to political officials, central bankers and business leaders around the world as they make key decisions. Plans for interest rate increases in the U.S. have been postponed and could possibly be lowered back down. Walgreens Boots’ CEO summed it up well on a recent earnings call: “The situation – it’s very volatile at this time. For sure, the period of uncertainty will be quite long whatever happens, because even if the U.K. leaves Europe, it cannot happen overnight. It will take at least two years and the consequences of it will be much longer than two years.” As a net importer, the U.K. is expected to experience a recession of some degree as consumers feel the impact of a sharply lower currency and businesses take a more defensive posture, postponing new investment decisions.

Our focus on selecting U.S. listed companies has helped insulate your portfolio from this short term volatility related to Brexit. We do not own any European banks for example. However, we do own many domestic companies that conduct business in the U.K. and that have operations in Europe. Lowered growth expectations and increased uncertainty as a result of Brexit has put pressure on these stock prices in particular. At this time, given the uncertain outcome, we feel it is too early to draw longer term conclusions regarding these companies with European exposure.

Stepping back, monetary policies have taken a very prominent role as central bankers around the world have been aggressively loose since the financial crisis. Unprecedented Fed lending during the financial crisis peaked at $1.2 trillion in order to provide liquidity during the crisis. Many years later, interest rates are at record low levels and appear to remain so into the near future. As shown below the U.S. is experiencing negative real interest rates, which is calculated by subtracting the inflation rate from the nominal interest rate, on maturities less than 3-years.

These unprecedented conditions have incentivized corporations to behave differently. With cheap money, slow growth, and general uncertainty limiting confidence to pursue capital projects, many have increased debt, repurchased stock, and pursued mergers and acquisitions. Furthermore, years of cheap money has lowered the returns investors require, resulting in many new ventures and unproven technology concepts, such as apps, receiving more capital on very favorable terms compared to the past. This low interest rate environment has naturally resulted in higher valuations and therefore diminished prospective return potential therefore limiting the number of attractive investment opportunities, in our estimation. We have responded by increasing scrutiny of our existing holdings, re-positioning into stocks with more favorable risk/reward based on our analysis, and building a watch list of high quality companies that we would like to own should their stock prices decline or medium term business outlook improve.

As political discourse heats up this election year with voter engagement at historically high levels (2), the debate continues to center around the economy and terrorism, while trade policy and immigration have assumed increasing importance.

Over the past several decades, presidential elections had little impact on the broad economy and stock market outside of healthcare, financial and defense sectors, but this year’s election may impact other sectors such as industrial and consumer more than usual. A shift towards populism and focus on immigration and trade policies could possibly have a more direct impact. The populist groundswell has affected proposed policies of both candidates and raised questions about the benefits of some well-established policies, adding to the uncertainty. For example, the North American Free Trade Agreement is now surprisingly being debated, when just a year ago it was hardly ever mentioned. Regardless of the election outcome, increased skepticism of established policies such as NAFTA will likely be debated over the next several years. Positions will be moderated in an effort to negotiate our political process centered on the concept of checks and balances, and compromises will surely be made in any negotiations with other countries. Unexpected change can create great investment opportunities.

While economic conditions are especially confusing at the current time, it is important to remember that employment is rising, wages are increasing, housing prices and sales are increasing, energy prices have bottomed and are recovering, and interest rates are very low. These are very positive factors favoring investments in high quality stocks. For long-term oriented investors, we estimate that stocks remain relatively more attractive than bonds by a wide margin. We estimate that the major stock indexes offer prospective 10-year annualized total return potential of mid-single digits compared to corporate 10-year bond yields of less than 2.5%. Note that the S&P 500 dividend yield is 2.1%. Our estimate for stocks would increase if growth prospects accelerated and inflation expectations increased commensurately. Stagflation, a situation in which inflation increases without growth, is a potential risk that could develop in this slow growth, easy money environment. This situation would likely impact bond investors more than those invested in stocks, but would generally be a negative development for investors. After reflecting on historical experiences, evaluating the current unusual investing climate, and considering possible outcomes, we have concluded that the best path forward is to avoid the loser’s game of trying to time the market, maintain our disciplines, and review our holdings with increasing scrutiny with a steady focus on identifying better risk/reward opportunities. As the election approaches, we are closely tuned in to any potential policy shifts related to trade and immigration which may impact your holdings and/or present new opportunities and remain watchful for any clarity related to Brexit.

July 2016

(1) Zeng, Win and Christopher Whittall. “U.S. 10-Year Treasury Closes at Record Low.” The Wall Street Journal. 5 Jul 2016. Web. 7 July 2016.

(2) “2016 Campaign: Strong Interest, Widespread Dissatisfaction.” Pew Research Center. 7 Jul 2016. Web. 8 Jul 2016.