The Margin of Safety Quarterly Summer 2017
Second Quarter 2017 Key Takeaways
- The second quarter proved to be another very strong period for global stock markets.
- First half 2017 stock performance was even stronger than the quarter.
- Core bonds also delivered solid returns, rising 1.5% for the quarter.
- The calm global markets were briefly interrupted during the last few days of June.
- Economic and corporate fundamentals largely still look solid, and investors expect the second quarter earnings season to demonstrate a continuation of the strong growth trends exhibited so far in 2017.
- The past quarter and first half of the year were characterized by historically low stock market volatility, the strong performance of both stocks and bonds, and the reversal of market trends set in motion by last year’s U.S. presidential election.
Second Quarter 2017 Investment Commentary
Low volatility and positive global market returns continued during the second quarter of 2017. For the quarter, larger cap U.S. stocks gained 3.1%, developed international stocks rose 6.4%, European stocks jumped 8.4%, and emerging market stocks rose by 3.4%. At the half way point of 2017, large cap US stocks were up just over 9%, while international and emerging market indexes were each up in the mid-teens. International stocks continue to lead the way as we write this newsletter and our portfolios are strongly benefiting from their overweight to foreign stocks, specifically European and emerging market stocks.
Core bonds return 1.5% for the quarter. The yield curve “flattened” considerably (i.e. rates declined and bond prices move in the opposite direction), with the difference between the 10-year and 2-year Treasury yields ending the quarter at close to a post-2008 low. In aggregate, the flexible bond funds we hold in place of a large portion of our portfolios’ fixed income allocation again outperformed the core bond index for the quarter and year to date. Floating rate loans delivered modest gains, but because interest rates declined during the first half of 2017, they failed to match the bond benchmark. Our emerging bond (local currency) manager returned just over 3% for the quarter and about 11% year to date through June 30.
Based on our research, reading and discussions with other professionals we respect, we think the odds favor a continuation of the ongoing mild global economic recovery we’ve witnessed so far this year. That should be broadly supportive of riskier assets, such as stocks and corporate debt. Our crystal ball is no better than any one else’s (meaning no one can consistently predict the future) but we believe there is still more room to run for foreign stocks versus the U.S. market. Valuation matters and given their more attractive valuations and earnings growth potential, even after their strong performance in the first half of the year, we think generally that prices are more attractive outside the US. Our confidence in the strength of the economic recovery in Europe also led us to unwind our currency hedged European equity position in May.
As we look back over the past quarter and first half of the year, a few things stand out. Overall stock market volatility remained extremely low, despite significant domestic political uncertainty and unsettling global and geopolitical events. Both risky assets (stocks) and defensive assets (core bonds) performed very well. And the period was marked by some significant market trend reversals from the previous year.
The S&P 500’s actual realized volatility recently fell to near its lowest level in the past fifty years, according to a recent Goldman Sachs report, while the S&P 500 Index continued to hit all-time highs. The U.S. stock market’s calm ascendance seems to fly in the face of ongoing political uncertainty and geopolitical tumult. Each day seems to bring a new headline concerning something else to worry about.
That said, maintaining a degree of composure is a valuable attribute of successful long-term investors. One of our favorite Warren Buffett quotes on this topic says it all, “The most important quality for an investor is temperament, not intellect.” Global risks always exist and unexpected events inevitably happen, causing markets to fall no matter their valuation. The world and financial markets have faced numerous negative shocks over the decades, but the broad economic impacts have ultimately proved transitory. Over the long term, financial assets are priced and valued based on their underlying economic fundamentals—yields, earnings, growth—not on transitory macro events or who occupies the White House. Therefore, we believe it is beneficial for investors not to react to every domestic political development or geopolitical event with the urge to sell their stocks nor get overly excited and jump into the market on some piece of news they view positively. We don’t think refraining from such short-term trades is complacency—if the choice is supported by a sound decision-making framework. Having a disciplined investment process and a focus on the long term are essential to best achieve your financial objectives.
It may seem somewhat surprising or contradictory that both global stocks and defensive core bonds have performed well. Treasury bond prices typically rise when people are worried about the economy or other macro risks, but that doesn’t seem to be what is driving core bond prices this year given the low volatility and strong performance of riskier assets. Rather than fears of an impending macro shock, it seems the bond market is responding largely to the recent declines in inflation and inflation expectations (inflation is the enemy of bondholders).
The equity market, on the other hand, likes neither too little inflation nor too much. So stock investors have had plenty of reasons to propel prices higher: Inflation is lower but still in the ballpark of the Federal Reserve’s 2% target. The global economic recovery is ongoing. S&P 500 company earnings are rebounding. And global central banks, including the Fed, are not expected to aggressively tighten monetary policy any time soon.
In the short term, both markets may be “right.” But the current state is not sustainable for very long—something has to give. The Fed holds a big key as to how things might play out: will it tighten too much, too little, or manage it just right? Nobody knows, but based on history, we wouldn’t put all our chips on any single scenario. Potential changes to fiscal, tax, and regulatory policies are also big unknowns.
A final observation: several of the market trends and consensus market views we highlighted at the start of the year have reversed (again):
- European stocks are beating U.S. stocks by a wide margin.
- The U.S. dollar is down (about 6%).
- Treasury yields are down.
- Oil prices have plunged 20% from their recent highs.
- Growth stock indexes are crushing value indexes.
- Larger caps are beating smaller caps.
- Emerging market stocks are outperforming U.S. stocks.
The recent market shifts only reinforce the point we made then. We don’t think anyone can consistently and accurately time short-term swings in markets or inflection points in market cycles. It is when “the experts” are overwhelmingly aligned on one side of a trade and the consensus is strongest that a trend will continue, that it actually has the most potential to reverse.
Most of the market reversals we’ve seen this year are consistent with, if not driven by, an unwinding of the so called Trump trade. This is shorthand for the markets’ almost knee jerk reaction (which soon became consensus) that Trump’s election and the Republican sweep of Congress would herald a period of inflationary, pro-growth fiscal, tax, and regulatory policies, unleashing the U.S. economy’s animal spirits. Instead, as the Trump administration has gotten bogged down in a myriad of other issues, with little progress on the economic front, confidence in that scenario has diminished.
In general, we agree with Warren Buffett who recently said, “If you mix your politics with your investment decisions, you’re making a big mistake.” We made no changes to our portfolio positioning when Trump was elected, and we highlighted the significant uncertainty around potential Trump policies. That’s not to mention the highly uncertain timing, implementation, and magnitude of their ultimate economic and financial market impacts. Therefore, the unwinding of that narrative this year hasn’t led us to make any portfolio changes.
Asset Class Comments
We think it is prudent to construct portfolios that are prepared for, and are resilient to, a range of potential outcomes. As a result, in our balanced portfolios, we maintain some exposure to core bonds, despite very low current yields, because of their risk mitigating properties in the event of a recession or other shock. But given core bonds’ paltry yields and unattractive longer-term (five-year) return prospects, we maintain meaningful exposure to other more flexible and opportunistic fixed income funds as well as to floating rate loan funds (in our most conservative portfolios). These investments should also provide some protection against rising interest rates and inflation.
Based on our analysis of valuations and longer-term earnings fundamentals—even putting aside any near-term political or geopolitical risks—U.S. stocks present unattractive expected returns over our five-year tactical investment horizon, evaluated across the macroeconomic scenarios we think are most likely to play out. Valuation risk is high and offers no margin of safety in the event the optimistic scenario currently baked into valuations doesn’t play out. Therefore, we are underweight to U.S. stocks and to equity risk in general, but we don’t see any particular near-term trigger for a sharp market decline.
The “Holy Grail” for our stock managers is business value. If they can buy the stock of a growing business at a discount to the price that a smart business owner would pay for the whole company, the investment is very likely to be successful. The stocks that are “working” in this market are generally very good companies, but the stock price for many is high enough that the odds are stacked against investors. Buying the best companies, regardless of price, worked—until it didn’t—with the “Nifty Fifty” in the 1970s, the tech/internet stocks of the late 1990s and the housing and mortgage-related financials in the mid-2000s. Our stock managers want to buy good businesses at a discount to the current stock price. To paraphrase Ben Graham, “Buying a great business at too high a price is a speculation.”
Given the above observation on valuation, however, we note that our active stock managers build their portfolios one investment at a time. Our active managers are not “benchmark huggers” and their portfolios look very different from their respective benchmark. So, even though the general US market looks pricey, our active US stock managers can still find individual companies that meet their stringent investment criteria. In addition, our US stock managers have concentrated stock portfolios – generally 20-50 stocks. Therefore, they only need a few attractively priced stocks (i.e. high conviction ideas) for their portfolio. However they are not finding as many at current prices.
Warren Buffett likes to describe the stock market as analogous to a baseball game in which there is no umpire calling balls and strikes. The batter (investor) can stand at the plate and let pitches (stocks) go by indefinitely, “waiting for his pitch” (a bargain investment). Meanwhile, the fans in the stands are screaming, “Swing, you bum!” Our stock managers are not asleep at the plate—rather than invest in companies that do not meet their investment criteria, our managers will let cash build in their portfolio. The cash level serves a dual purpose – it provides some downside protection if stock prices decline while also providing a source of funds to buy stocks at lower prices.
Outside of the United States, we see strong potential for both improving earnings growth and higher valuations—leading to relatively attractive longer-term expected returns. We have a moderate overweight to both European and emerging market stocks.
We believe the outperformance of foreign stocks still has room to run given their superior valuations and earnings growth potential versus the U.S market. Even with their strong performance so far this year, our longer-term return expectations continue to favor Europe and emerging markets compared to the United States.
Foreign stock markets are also seeing increasingly positive investor sentiment and strong cash inflows. More than $12 billion has flooded into U.S.-domiciled European stock funds and ETFs this year, reversing 13 consecutive months of net outflows prior to that. Year to date inflows into emerging market stock funds are close to $30 billion.
Momentum seems to be shifting in favor of foreign stocks. We are seeing more and more Wall Street strategists recommend an overweight to European and emerging market stocks: a position we have held for a while. This can feed on itself in a virtuous cycle—as more money flows into these asset classes, it can boost prices and returns, attracting yet more inflows and driving prices higher.
Our lower risk liquid alternative strategies are performing well in absolute terms. For the trailing one year ending June 30, 2017, the manager returned 6.73%, in line with returns of a 40/60 stock, bond blend. The returns are good given the strong performance of US stocks for this time period and our expectation for future returns is to exceed that benchmark. Our position for alternatives is a multi manager strategy and a new manager will be added shortly to the strategy, a long/short credit manager.
Putting It All Together
We don’t expect a recession in the near term, but we remain alert to and positioned to meet the high level of uncertainty that characterizes both global financial markets and the current geopolitical environment. We maintain exposure to assets—core bonds in particular, as well as diversified alternative strategies—that should generate positive returns in the event of a recession and a bear market in stocks. Our value managers will continue to use their disciplined investment process to identifying stocks that are attractively priced and if there are not qualifying investments, cash will build and be available to deploy during periods of volatility.
We leave you with one of our favorite Ben Graham quotes:
The best way to measure your investing success is not by whether you are beating the market, but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.
River Capital Advisors News and Final Comments
We continue to monitor Washington for any meaningful tax reform or legislation. There is a lot of smoke in the sky but as we write this newsletter, we do not yet have any proposed legislation. As the year progresses, if proposed legislation is not developed, tax law changes will be differed to 2018.
We appreciate the steady referrals we have been receiving in 2017. We are humbled by the confidence that our clients and professionals we respect show by allowing us to talk to individuals who are tired of sales pitch’s, being sold financial products that benefit the seller and not the buyer and to help individuals put in place a financial and investment plan that will allow them to meet their financial goals. Clients are also using our financial website to take control of their financial life, to organize their important financial documents, to track their spending and to monitor the progress of their financial plan in real time. The development of a solid financial plan, that encompasses all aspects of a families financial life is most empowering.
Last but not least, by the time you read this Stephen and Allison Kyle will have welcomed their second child, Annabelle Yvette Kyle, to their family! Congratulations to Stephen and Allison!
Enjoy the summer and stay cool.
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