Q4 Message from the Chairman: Conundrum(January 06, 2014)
Without question, 2013 was a great year for stocks. The broad market, measured by the S&P 500 Index, was up 32.39%. This was the biggest annual percentage gain since 1997. Small-cap stocks did even better, as the Russell 2000 Index rose 38.82%. The extent of the rise in stock prices, however, poses a conundrum.
To start, the reason for the stock market’s performance isn’t to be found in a particularly strong economy. As I said in my October message, the economy now appears to be growing at a sustainable, but slow, pace. Annual economic growth of less than 5% does not explain the year’s stellar gains in stocks. Nor is the reason to be found in low stock prices at the start of the year. When the market experienced a similarly strong surge in 2009, it was rebounding off the low valuations that resulted from the global financial crisis. But more normal valuations prevailed at the beginning of 2013, and valuations have only increased since then. So if it wasn’t a strong economy and stocks weren’t undervalued, just what accounts for the sizable bull market? That’s the conundrum.
I have acknowledged in previous messages that the Fed’s implementation of quantitative easing (QE) immediately following the global financial crisis was appropriate to help jump-start the economy. However, I have been arguing for several quarters that the Fed has long since overstayed its welcome. In April of 2013, I compared QE to pouring massive amounts of lighter fluid on a barbecue in an effort to get the charcoal briquettes going. I was concerned that the Fed, despite producing an impressive initial blaze, had failed to start a fire that would sustain the economy.
Beginning in May of 2013, Chairman Ben Bernanke hinted that the Fed would soon start to taper quantitative easing. But it wasn’t until December that the taper was actually announced, and I sense that our barbecued steaks may taste of lighter fluid. While I don’t believe that quantitative easing has provided lasting benefits for the economy, QE has lifted bond prices — driving down bond yields across the maturity and quality spectrums. In fact, the yield spreads between high- and low-quality bonds are now remarkably tight. Moreover, at current levels, interest rates do not encourage a fair and healthy lending environment for borrowers and creditors.
This brings us back to our conundrum. As interest rates have fallen, I believe investors seeking higher returns have piled into stocks, dramatically pushing up prices. In the past, investors looking to earn more on their cash often had a broad range of options that offered greater potential returns in exchange for assuming additional risks. For example, during more normal economic environments, an investor unhappy with money-market yields might have chosen a bank certificate of deposit (CD), or an intermediate- or longer-term Treasury bond. Today, however, yields on money-market funds and rates on bank deposits are absurdly low. Even 10-year Treasury bonds are only yielding about 3%.
Contrast today’s 3% yield with November of 1994, when the 10-year Treasury yield was almost 8%. This was at a time when interest rates were in the midst of their decades-long decline to today’s low levels. Back then, at close to an 8% yield, a potential fall in bond prices might be partially or fully offset by the substantial yield. Furthermore, bond prices had significant room to appreciate if yields were to decline (which is, in fact, what occurred). Today, however, interest rates are already so low that I believe the prospects are slim for a significant decline in yields and a corresponding increase in bond prices going forward. But if yields rise substantially, the principal loss on a 10-year Treasury bond could shock many investors. This is why I believe that, compared to the last few decades, intermediate- and long-term bonds offer higher risks and lower potential returns — a situation similar to the conundrum in stocks.
Despite my caution regarding stock and bond prices, I remain optimistic about the economy in general. During the three months since my last message, we’ve traveled further down the road without the wheels coming off, and I’m more inclined to think this economic recovery is genuine. Employment is up. Following payroll increases in October and November, the unemployment rate dropped to 7%, a five-year low. That’s good, but even at 10% unemployment (the worst rate in the last several years), 90% of the workforce still had jobs, with most people continuing to do the same things they were doing before the global financial crisis. They were working throughout the recession, and they’re still working today. That means cars have always been built and retailers have always been selling. Yes, conditions got dicey at times and people were scared. But the economy did not grind to a halt.
Overall, economic growth remains slow based on historical comparisons. However, we saw some good news in December when the U.S. Commerce Department revised upward the annual growth rate for third-quarter seasonally adjusted gross domestic product (GDP) from 2.8% to 4.1%. That marks the strongest pace since the fourth quarter of 2011. We also saw good news in the housing market, with prices rising and U.S. housing starts climbing to a near six-year high in November. The 22.7% monthly increase in housing starts was the single-biggest jump since January of 1990.
Even Congress got into the act in December, passing a budget agreement for the first time in almost four years. It seems Congress has gotten the message that most voters don’t want another government shutdown. Voters want Democrats and Republicans to get together, reach a compromise and implement it without all the fireworks. That appears to be finally happening.
As for the Federal Reserve, I don’t believe the proposed ascension of Janet Yellen to the top spot at the Fed signals a change in philosophy regarding monetary policy. I think the taper issue comes down to more and more people starting to doubt the effectiveness of quantitative easing. The critics are saying to the Fed, “Look, you’ve been doing this continually and the economy has only managed to grow slowly. In addition, we’re not getting the uptick in inflation that would normally accompany an economic recovery. In fact, we’re seeing some signs of potential deflation, which can be a very dangerous economic trend. So you don’t really understand all the effects of quantitative easing.” I think the taper is good because it reduces the Fed’s role in the economy and in the markets. Yes, the taper could temporarily be disruptive to some degree. But I don’t foresee significant problems.
On the positive side, our growing population of seniors should benefit when they can once again receive attractive, safe yields from fixed-income investments. Hopefully, as interest rates rise moderately and we see a more robust lending environment, economic growth will gain increased traction. A healthier economy — along with a reasonable level of inflation that normally coincides with stronger economic growth — should also provide a good environment for company fundamentals to catch up with stock valuations, which I think have gotten ahead of themselves. The Fed helped get us through the initial panic of the global financial crisis. But I believe the taper of quantitative easing is long overdue.
Outside the U.S., many investors have become concerned about the declining growth rate in China. But I think there’s more to worry about in Europe and Japan. As China transitions from an export-driven economy to one that is more consumer-driven, it is not unexpected that the economic growth rate is taking a hit. And China is coming off of double-digit growth. While growth may have declined to about 7.5%, that’s still incredibly fast. Europe, however, continues to have significant problems, one of which is youth unemployment. And the countries have yet to tackle the other half of the major economic challenge confronting the European Union (EU). While the EU has achieved monetary integration, fiscal integration remains elusive. Ultimately, the two need to work together. European countries have a long way to go before they have a uniform economic framework that truly benefits all. Japan is another potential trouble spot because the country has a substantial government-debt burden. Increased entrepreneurship and productivity would help address that situation. But Japan’s population is aging rapidly, and entrepreneurship and productivity are declining. So a solution is unclear.
I am more optimistic about economic growth in emerging markets. Generally speaking, emerging markets have improving demographics and impressive fiscal conditions. Overall, government debt as a percentage of GDP is lower than for developed markets. Emerging markets also benefit from following in the footsteps of more advanced countries. For example, new steel mills and communications networks in emerging markets use state-of-the-art technology. Because they can take advantage of the cumulative progress that’s been made in the world and because they have relatively young populations, emerging markets can grow amazingly fast.
As already discussed, I’ve become increasingly optimistic about the slow, steady U.S. economic growth, which should eventually lead to moderately higher interest rates. Since bond prices move inversely with interest rates, I don’t believe that bonds — particularly longer-term bonds — offer attractive risk/return trade-offs. And while an improving economy should provide a tailwind for company fundamentals, valuations are generally high. So the question becomes: What prices should we be willing to pay for stocks?
Given the exceptionally strong stock-market advances we’ve seen over the past five years, my outlook is incrementally more cautious. Although the improving economy may provide a boost for companies in the years ahead, much of the stock-market performance that has already occurred has been driven by expansion in price-to-earnings multiples. In other words, investors have been willing to pay more for a stream of earnings that has not accelerated much. I believe this sets the stage for increased volatility in stock prices. Like the frustrating scenario discussed in my Treasury-bond example, a stock purchased at 20 times a company’s earnings certainly has less upside potential and more downside potential than that same stock purchased at 15 times earnings. But despite the greater risk in the stock purchased at 20 times earnings, it is still possible that the company will grow enough to make the price paid today seem reasonable. I believe this is the expectation many investors currently have, if they are even pausing to consider the risk.
To put the current bull market in perspective, it is interesting to note that the S&P 500 Index has advanced every year for the past five years. The S&P 500’s 32.39% gain for 2013 was capped by a 10.51% increase in the fourth quarter. This marked the first time since 1997 that the Index posted positive returns in all four quarters of a calendar year. Regarding the bond market, the intermediate-term Barclays Capital U.S. Aggregate Bond Index declined 2.02% for the year and fell 0.14% for the quarter. Long-term government bonds, as represented by the Barclays U.S. 20+ Year Treasury Bond Index, declined 13.88% for the year and fell 3.23% for the quarter.
With stock prices generally at expensive valuations, it seems to me that we could experience a sharp market decline followed by a quick recovery similar to the “air pockets” we have occasionally experienced throughout history. These air pockets have been precipitated by events such as the nationwide steel strike in 1959, the acceleration of program trading in 1987, and the failure of Long-Term Capital Management’s hedge fund in 1998. I encourage all investors to fasten their seat belts because I believe air pockets are most likely to occur when valuations are elevated, such as we are seeing today.
In response to heightened risks, some investors may be tempted to pull out of the market entirely. But the problem with that approach is the need to be right twice: When to sell? And when to buy back into the market? I wouldn’t want to be forced into trying to make two good timing decisions. Timing the market is not what we do at Wasatch Advisors. We focus mainly on investing in solid companies that we think have significant long-term growth potential. But I am approaching this market with some caution and some dry powder — a portion of a portfolio in cash. And I’m paying particular attention to valuations because the most expensive companies typically take the steepest dips during an air pocket. By holding some cash, I’ll also be positioned to take advantage of more attractive valuations that will result if, and when, the market temporarily drops to lower levels.
At Wasatch Advisors, because we invest in companies that we believe are high-quality, it is not unusual for some of our portfolios to lag during market environments when more speculative stocks are experiencing outsized gains. Conversely, Wasatch’s portfolios often do better than more aggressive portfolios during negative market environments. Although our U.S. stock portfolios posted strong absolute returns in 2013, some of them trailed their benchmarks. When we look under the hood, we find in many cases that the stocks in which we had the strongest conviction — and hence the largest weightings — performed well, but lagged the market as a whole. In contrast, some of the best-performing stocks in our portfolios during 2013 were those with lower weightings. We typically take smaller positions in stocks that we find interesting but that we feel carry greater risk. When investors are moving up the risk spectrum in search of higher returns, these lower-weighted positions often do especially well.
In 2013, some of our emerging-markets holdings also experienced modest underperformance relative to the broad indices. These companies largely focus on burgeoning local economies and serve the growing demand from home-country consumers. Although these companies generally continued to manage their operations well, the returns of some of our holdings were adversely affected by local-currency declines versus the U.S. dollar during the year. Had we been invested to a greater degree in export-driven companies, the effects of the currency declines would have been smaller, as exports from emerging markets tend to get a boost from a stronger dollar. We still believe that companies serving local consumer demand in emerging markets will do well over the long term. But we have also been finding a greater number of attractively valued exporters, pharmaceutical companies for example. In addition, we’ve taken positions in stocks that we like in countries with trade surpluses. We expect these investments to provide somewhat more balance to our emerging-markets holdings, which should be helpful during periodic currency volatility.
With sincere thanks for your continued investment and for your trust,
A bull market is defined as a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as the result of an economic recovery, an economic boom, or investor psychology.
Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.
The price-to-earnings (P/E) multiple, also known as the P/E ratio, is the price of a stock divided by its earnings per share.
Quantitative easing (QE) is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Valuation is the process of determining the current worth of an asset or company.
The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index. The Russell 2000 is widely used in the industry to measure the performance of small company stocks.
The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged but is a commonly used measure of common stock total return performance.
The Barclays Capital U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market, including government and corporate securities, agency mortgage pass-through securities, and asset-backed securities. To be included in the index the security must meet the following criteria: must have at least one year to final maturity, regardless of call features; must have at least $100 million par amount outstanding; must be rated investment grade or better by Moody’s Investors Service, Standard & Poor’s, or Fitch Investor’s Service; must be fixed rate, although it can carry a coupon that steps up or changes to a predetermined schedule; must be dollar-denominated and must be nonconvertible. All corporate and asset-backed securities must be registered with the SEC; and must be publicly issued.
The Barclays U.S. 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.
You cannot invest directly in these or any indices.
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Information in this document regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.