Contact Us
Font Size: A A A

 
Learn more
Sam

Chairman's Corner

Sam Stewart, Chairman of Wasatch Advisors and President of Wasatch Funds, weighs in on investing practices, the market, and our portfolios.

letter to shareholders

Seems Like Déjà Vu, All Over Again

DEAR INVESTORS: Baseball Hall of Famer Yogi Berra once proclaimed, "It's de ja vu, all over again." Yogi wasn't referring to soaring stock valuations, which continue to break...  click to read more 
(January 8, 2018)

Monday January 8, 2018

Seems Like Déjà Vu, All Over Again

DEAR INVESTORS:

Baseball Hall of Famer Yogi Berra once proclaimed, “It’s déjà vu, all over again.” Yogi wasn’t referring to soaring stock valuations, which continue to break into new territory on an almost daily basis. But déjà vu, all over again seems to be an apt description of my repeated messages about extended markets over the past few years.

For just about any market force that might normally be expected to derail the status quo of continuing growth, an opposing force has emerged to keep the expansion on track. Technological efficiencies have put a lid on consumer prices. Aging Baby Boomers seem to buy long-term bonds anytime yields perk up. Yet more bullish economic data and governmental reforms drive stock prices higher despite already lofty valuations.

What we’ve been witnessing is a high-stakes balancing act that’s been sustained for nearly a decade now. Investors might be forgiven if they’re beginning to feel less like consciously daring tightrope walkers performing without a net and more like construction workers casually straddling steel beams—just another day on the job.

However, déjà vu can be a double-edged sword. While familiarity can engender a sense of security and well-being, anyone who’s experienced true déjà vu knows of another side. When you feel like you’re reliving an exact moment in time, you can’t help but wonder when the spell might be broken.

ECONOMY

The U.S. economy’s vital signs are strong. U.S. gross domestic product (GDP) grew at a healthy 3.2% clip during the third quarter. In addition, the economy added 148,000 jobs in December, which was the 87th consecutive month of job growth—the longest on record. And the headline unemployment rate for December came in at 4.1%, the lowest in 17 years.

Puzzlingly, this continued historically low unemployment rate hasn’t translated into wage pressures that might stoke inflation, which in November stood at only 2.2% versus the year-ago reading (and only 1.7% if we exclude volatile food and energy prices). There may be a number of factors keeping inflation subdued, including cheap goods from overseas, automation in the workplace, and even Boomers’ retirement savings falling short—leading these older, more productive workers to spend additional time in the labor force.

My assessment of the economy today is déjà vu of my assessment a year ago. The economic expansion is a year older—it had gone on for 91 months then, and it’s now lasted 103 months. Thus, by definition, we’re one year closer to a presumed downturn in the business cycle. However, as I’ve noted in prior messages, we’ve already been “Waiting for Godot” (recession) for a long time and still there are no signs of its coming.

With the U.S. economy operating at near capacity, there’s potential for inflationary overheating. But I’m not seeing signs of that yet. In fact, I’m hard-pressed to identify a catalyst that’s threatening to knock the economy off its current trajectory of steady growth.

Sure, the Federal Reserve raised its benchmark interest rate three times in 2017. But those increases were rather perfunctory, as much because the Fed could rather than because it had to in order to combat inflation. I find it quite interesting that the Goldman Sachs Financial Conditions Index has eased all year in spite of the Fed’s rate increases. This means that it will take still more Fed rate increases in order for them to begin to “bite” the economy—as other central banks around the world still have their foot on the gas pedal.

There are, of course, many exogenous shocks that could roil global economies and financial markets. Deutsche Bank Research recently sent out a somewhat disconcerting note describing “30 risks to markets in 2018,” which included a Fed-style normalization by the European Central Bank, North Korean saber-rattling, a crash in cryptocurrencies like bitcoin, and the unpredictable actions of President Trump. These risks comprise an impressive list, and I wouldn’t discount any of them too deeply.

But it’s worth noting that in the preceding 18 months, global economies and markets went through some fairly big shocks—including natural disasters, actual and potential terrorist attacks, uncertainties regarding central-bank policies, very harsh geopolitical rhetoric, and especially surprising voter decisions in the U.S. and Britain. These events also had stock and bond holders on edge. Yet the markets hardly missed a beat.

MARKETS

Even though equity performance can be a leading indicator, most stock-market troubles have their origins in the macro economy. Moreover, since I don’t see any dark economic clouds on the horizon, who am I to say the stock market’s record run is over? And what a run it’s been so far!

In the U.S., the large-cap S&P 500® Index advanced 6.64% for the fourth quarter and 21.83% for the 2017 calendar year. The technology-heavy Nasdaq Composite Index was also quite strong, up 6.55% for the quarter and 29.64% for the year. The Russell 2000® Index of small caps rose more modestly, up 3.34% for the quarter and 14.65% for the year. Growth-oriented stocks performed better, with the Russell 2000 Growth Index up 4.59% for the quarter and 22.17% for the year. Value-oriented small-cap stocks were the relative laggards, with the Russell 2000 Value Index up 2.05% for the quarter and 7.84% for the year.

U.S. bond markets also gained, as the intermediate-term Bloomberg Barclays US Aggregate Bond Index inched up 0.39% for the quarter and 3.54% for the year. The long-term Bloomberg Barclays US 20+ Year Treasury Bond Index rose 2.55% for the quarter and 8.98% for the year.

International stock markets were generally even more robust than those in the U.S. The MSCI World ex USA Index moved up 4.23% for the quarter and 24.21% for the year, while the MSCI Emerging Markets Index advanced 7.44% for the quarter and 37.28% for the year.

To understand just how stellar financial-market performance was in 2017, consider the 145 stock, bond, municipal, U.S., foreign, target and commodity indexes found on Morningstar.com. All but 13 were positive for the fourth quarter. And all but five were positive for the year.

Perhaps even more impressive than the outright market performance during 2017 was the relentless consistency of returns. For example, through December, the S&P 500 Index was on a streak of 14 consecutive months without a negative month. And the maximum peak-to-trough drawdown for the Index in 2017 was only about 2.8%.

Moreover, stocks still don’t appear overbought relative to bonds. The average “earnings yield”—calculated as the inverse of the price/earnings ratio—stands at approximately 4.5% for the S&P 500 Index, versus a yield of about 2.4% for the 10-year Treasury bond. In terms of the premium for taking equity risk, that seems about right to me. As a result, stocks and bonds are roughly at equilibrium in my view.

Even with an economy that’s holding up reasonably well and with stocks appearing to be fairly valued vis-à-vis bonds, the remarkable strength shown by equities over the past year is puzzling and presents some tough choices for investors—especially if you’re worried about the ominous foreshadowing of déjà vu, all over again.

Is it time to get out of stocks altogether? With no dark economic clouds visible on the horizon and stocks priced appropriately relative to the equity risks, that course of action hardly seems prudent. What’s more, the new tax legislation and regulatory reforms could provide stocks with a second wind.

Because U.S. companies haven’t exactly been starved for cash during the past several years, it’s not necessarily the lower corporate tax rate itself that’s likely to usher in a new wave of company investment. Rather, there are specific provisions in the tax legislation that accelerate how capital expenditures are amortized. These provisions could indeed persuade management teams to pull the trigger on new equipment purchases. Look for that impact mostly among industrial companies.

What about taking profits on those stocks that have run up the most, and investing the proceeds in lower-quality stocks? After all, if high-quality shares have rallied to fair value, aren’t there bargains to be had in lower-quality names that have lagged the rally?

That brings me back to the earlier point about the longevity of the economic expansion. Even though it’s hard to pinpoint exactly what could finally derail the global economic juggernaut, history shows that something always does. In addition, the closer we get to the end of the expansion, the more I want to avoid lower-quality stocks. So I’m sticking with a cautiously bullish posture, and I’m willing to pay up—within reason—for high-quality companies. But by no means am I becoming complacent. Instead, I’m looking for trouble spots to emerge.

For the time being, barring an unexpected crisis, I see continued support for stocks. I have less conviction regarding bonds, which may feel the pinch of modestly higher interest rates. But for stocks, in addition to the potential tailwinds already discussed in this message, there’s also a cohort of previously shell-shocked investors who pulled out of the market during or immediately after the global financial crisis almost a decade ago. I believe many of these investors have been watching the equity run-up from the sidelines, and some are gradually capitulating by getting back into the stock market—which could lend additional support for prices.

WASATCH

With equity markets broadly rallying around the world and active managers often struggling to keep up with their benchmark indexes, we’re pleased that our portfolios generally performed well in the fourth quarter and in the entire 2017 calendar year. Historically, our portfolios have tended to lag a bit during strong up markets, and have tended to outperform when markets get rockier. So, we were particularly gratified for Wasatch to do so well overall in 2017’s go-go environment.

We devote a lot of time and resources at Wasatch to developing our culture—the character of our people and the quality of our investment processes. That being the case, we’re proud to relaunch our previously U.S.-focused Large Cap Value portfolios as Global Value portfolios, with longtime Wasatch portfolio manager Dave Powers in charge of the effort.

There wasn’t any one factor or story that accounted for the generally strong performance of our portfolios in 2017. We just continued to apply our investment discipline, and our portfolio companies for the most part delivered solid revenue and earnings growth. As we enter 2018, we have a greater sense of caution because the end of 2017 has brought us one year closer to downturns in the economy and in the markets. That said, it’s entirely possible 2018 will be another year of déjà vu, all over again.

With sincere thanks for your continued investment and for your trust,

 

Sam Stewart

 

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.

CFA® is a trademark owned by CFA Institute.

© 2018 Wasatch Advisors, Inc. All rights reserved.

DEFINITIONS

Someone who is “bullish” or “a bull” is optimistic with regard to the stock market’s prospects.

Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.

The global financial crisis, also known as the financial crisis of 2007-09 and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

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/earnings (P/E) ratio, also known as the P/E multiple, is the price of a stock divided by its earnings per share.

Valuation is the process of determining the current worth of an asset or company.

Financial conditions indexes, like the Goldman Sachs Financial Conditions Index, summarize different financial indicators and, because they measure financial stress, can serve as a barometer of the health of financial markets.

The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks.

The Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 2000 Value Index measures the performance of Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values.

Source: Frank Russell Company is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. This is a presentation of Wasatch Advisors, Inc. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. Frank Russell Company is not responsible for the formatting or configuration of this material or for any inaccuracy in Wasatch Advisors, Inc.’s presentation thereof.

The Nasdaq Composite is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The Nasdaq was created by the National Association of Securities Dealers (NASD) to enable investors to trade securities on a computerized, speedy and transparent system, and commenced operations on February 8, 1971.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.

The MSCI Emerging Markets Index captures large and mid cap representation across 24 emerging market countries. With 839 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 developed market countries—excluding the United States. With 1,020 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indexes. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS) (agency fixed-rate and hybrid adjustable-rate mortgage [ARM] pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (agency and non-agency).

The Bloomberg Barclays US 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 indexes.