Tuesday July 7, 2015
If Only it Were That Easy
I was recently interviewed by a Bloomberg News reporter who wanted to discuss the stock market’s elevated PEG ratio (price-to-earnings ratio relative to growth rate — essentially the market price of growth). She wanted to know whether I thought the high PEG ratio implied the market was about to crash. If only it were that easy for an indicator to predict the direction of stock prices.
My response to the reporter was two-fold. First, I acknowledged that the PEG reading was above normal. But second, I noted that historically low levels of interest rates (as discussed last quarter) justify more expensive stocks. If you can barely garner any return on savings accounts due to low interest rates, why should you expect to receive a generous return on stocks?
There’s a relationship between interest rates and stock prices because investors compare the returns from owning bonds to those from owning stocks. After the Global Financial Crisis (GFC) that ended in 2009, many investors sold stocks and bought bonds as they deemed stock returns too risky. These investors preferred the perceived relative safety of bond returns. More recently, however, some investors have reversed course as the strong returns on stocks have dominated the relatively paltry returns on bonds.
Regarding equity-market performance during the second quarter of 2015, stocks generally gave up gains late in the quarter partially on concerns over the troubles in Greece. The S&P 500® Index inched up 0.28%. And small caps, as measured by the Russell 2000® Index, rose 0.42%. Bonds also had a wild ride. The intermediate-term Barclays Capital U.S. Aggregate Bond Index lost -1.68%, and the long-term Barclays U.S. 20+ Year Treasury Bond Index took a pounding as it declined -9.07%. While these quarterly numbers only represent short-term fluctuations and are not necessarily indicative of longer-term trends, bond-market performance should alert investors to the potential for principal loss if interest rates continue to rise. This risk is discussed further in the “Economy” section.
In this quarterly message, I want to raise the possibility that we’ve entered a new era that may offer meager returns on both stocks and bonds. Note the word “possibility.” My purpose in writing is not simply to declare a new era, but to explore the ramifications in case the markets and the global economy are making significant transitions.
One factor that makes me consider the idea of a new era is the sluggish growth rate the global economy has experienced since the GFC ended. Most economists find the slow recovery of the past several years to be a conundrum. Extraordinary stimulative measures have been employed around the world. In fact, the combined amount of stimulus far exceeds the amounts of stimulus that were applied to spark prior recoveries. By all historic precedents, the global economy should be booming. Instead, global economic growth remains anemic.
Some commentators have concluded that the slow growth rate is the “new normal.” The slower growth rate embodied in the new normal may be reflective of a different economic regime. Because slow growth generates diminished demand for capital investment, it isn’t surprising that slow growth also generates low interest rates.
What is surprising to many investors is that slow growth has coincided with strong stock returns for the past several years. Why have stock returns been so robust, while the economy has been so weak? If we have indeed entered a new era, the strong stock returns of recent years reflect a shift from bargain-priced stocks just after the GFC to expensive, low-returning stocks that could be characteristic of a new era. The journey from bargains to expensive prices has been rewarding, but the arrival at the destination “expensive” has likely signaled the end of high stock returns.
A second factor that makes me consider the possibility of a new era is the continuing transition of the economy from a primitive system based on natural resources to a modern system based on intellectual capital. Prior to the Industrial Revolution, the economy was primarily based on extracting resources from the ground, mostly by farming. Food was produced using human and animal power to work the soil. Heat was supplied by burning wood and coal. Poverty was the common condition of mankind. People lived from hand to mouth, and had little ability to generate the savings that provide a shield from nature’s vagaries.
The Industrial Revolution changed everything by introducing machines, which were able to magnify human and animal productivity to such a degree that, for the first time, people were able to generate sufficient savings to insulate themselves from natural fluctuations. These “seed corn” savings were invested in building “better, faster and cheaper” machines, which in turn led to more savings in a virtuous cycle culminating in today’s general prosperity.
As machines continually became better, faster and cheaper, they incorporated increasing amounts of intellectual capital. Arguably the primary machine in today’s economy is the computer, which depends almost entirely on intellectual capital. The productivity gains and associated capital abundance are almost unimaginable.
Today, a mobile phone has many times the capabilities of the computers used by NASA to send the first man into space. Facebook* can add thousands of users a day without a corresponding increase in infrastructure. And once Microsoft** develops its software, the company can deliver that software to customers at virtually no additional cost. Likewise, the value of these companies has more to do with customer relationships and brand names than with equipment and production facilities.
As an increasing share of the economy becomes dominated by service-oriented and technology companies, I believe the relative demand for financial capital will continue to fall. This is because these companies are dependent on intellectual capital (which requires minimal fixed investment) and they generate so much cash that they can not only self-fund their growth, but they can also return generous proceeds to their owners.
At a time when we’re seeing diminishing relative demand for financial capital in our modern economy, the supply of financial capital is increasing. Globalization has brought industrial and technological revolutions to most parts of the world. Correspondingly, global savings are exploding. For example, the savings rate in Indonesia exceeds 30%.
While all of these savings are searching for a “home,” available homes are declining due to the modernization of the economy. More supply and less demand equals lower interest rates and lower returns on savings. Just as the demand for savings is declining, so is the demand for equity investment, which is another type of financial capital. This implies that the returns to equity shareholders will also be reduced if we’ve entered a new economic era.
A quick review of economic statistics reminds us that we remain in a slow-growth environment. For the first quarter of 2015, U.S. real gross domestic product (GDP) actually shrank 0.2%. While some of this contraction can be attributed to unusual seasonal factors, first-half growth is still expected to be only 1%. And for the 23 quarters since the recession’s trough in June 2009, growth has averaged a subdued 2.2% annual rate.
On the positive side, our economy continues to add jobs. June’s unemployment rate came in at 5.3%, which was a seven-year low. Perhaps more importantly, hourly private-sector wages rose 2.3% in May from a year earlier, the largest percentage gain since the summer of 2013. In June wages rose 2%, close to May’s increase, which may be an early sign that wage growth is finally gaining momentum.
Outside the United States, developed countries are generally growing even more slowly — but at least they’re growing. In the eurozone, real GDP growth is under 1% and is not expected to go above 2% at least until 2017. Nevertheless, I’m hearing from the executives of many European companies that they’re pursuing more business initiatives and making larger capital expenditures in anticipation of future growth. Although it will take a while for these actions to be reflected in higher revenues, profits and GDP, the threat of painful deflation has greatly diminished.
Based on the positive, albeit muted, economic trends and the potential for rate increases by the U.S. Federal Reserve, longer-term bond yields spiked upward starting in April. My last quarterly message discussed this possibility. I wrote, “… of all the economic factors that make investors pause, some of the most concerning to me are the levels of interest rates around the world.” At the time of that writing, interest rates as reflected by 10-year government bond yields for several countries were at their lowest levels in recorded history — going back almost 500 years for Dutch bonds, more than 100 years for Swiss bonds and over 140 years for U.S. bonds.
Even after the spike in bond yields during the second quarter, interest rates remain at very low levels relative to historical figures. One of the downsides of a new economic era would be the added sensitivity of bond and stock prices to relatively small changes in interest rates. If rates rise just to moderate levels, bond values will fall much more than many investors realize.
For example, 10-year U.S. Treasury bonds currently yield about 2.4% and if the yield rises to 4%, investors would lose approximately 13% in the value of the bonds — negating about five years of interest income. Even more dramatic, 20-year U.S. Treasury bonds currently yield about 2.8% and if the yield rises to 4.5%, investors would lose over 20% in the value of the bonds. Stated another way, for a 2.8% current yield on 20-year Treasury bonds, investors are risking a loss of more than 20%. That doesn’t sound like a good deal to me. Overseas, where interest rates are even lower in many countries, the risks are that much greater because a rate increase from a low level hurts bond values more than that same rate increase from a higher level.
If we are in a new economic era, where does this leave us as investors? Interest rates will probably fluctuate between moderate and low levels — just not as low as we’ve seen recently. My reason for this outlook is that I expect we’ll continue to experience slow economic growth and benign inflation in most countries around the world. Regarding inflation, just consider the drop in energy prices from a year ago. It seems to me that advances in technology have allowed energy production to match changes in demand relatively quickly. As a result, barring a crisis such as a major disruption in the Middle East, I anticipate that at least the energy component of inflation will remain in check.
In thinking about equities, I recall Mark Twain’s famous quote, “History doesn’t repeat itself, but it does rhyme.” The notion that today’s high PEG ratio implies a stock-market crash reflects a view that history will repeat itself. I’m more inclined to believe stocks will stay at higher overall valuations and we’ll get smaller periodic corrections that may never be deep enough for the more bearish prognosticators to get fully invested.
Despite a recent pullback, China’s Shanghai Composite Index has risen almost 100% during the past year. In addition, this overall optimism has spread to stocks traded in Hong Kong, as reflected by the Hang Seng Index. At Wasatch Advisors, we think two main factors have spurred the optimism regarding China and Hong Kong.
The first factor has been the development of the mutual market access (MMA) program, which established two-way stock-market availability between mainland China and Hong Kong. The MMA program was announced in April 2014 and was launched in November 2014. The second factor has been monetary stimulus by the People’s Bank of China (the central bank). In addition to cutting interest rates, the central bank has lowered reserve requirements, which should promote lending by Chinese commercial banks.
At Wasatch, we believe many investors underestimate China’s ability to innovate and the global competitiveness of Chinese companies in the most technologically advanced industries. Having said that, there are also reasons to be cautious regarding Chinese stocks — including the speculative nature of the price trends — which have led the Wasatch emerging-market portfolios to be underweighted in the country for several years. For printed material on our views regarding China, please contact us.
With sincere thanks for your continued investment and for your trust,
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.
© 2015 Wasatch Advisors, Inc. All rights reserved.
Someone who is “bearish” or “a bear” is pessimistic with regard to the stock market’s prospects.
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) ratio 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.
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 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. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell indices. Russell® is a trademark of Russell Investment Group.
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.
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.
The Shanghai Composite Index, also known as the SSE Composite Index, is a stock market index of all stocks (A shares and B shares) that trade on the Shanghai Stock Exchange.
The Hang Seng Index is a market capitalization weighted index of 40 of the largest companies that trade on the Hong Kong Stock Exchange. The Hang Seng Index is maintained by a subsidiary of Hang Seng Bank, and has been published since 1969.
You cannot invest directly in these or any indices.