Q2 Message from the Chairman: Running in the Sand(July 07, 2014)
With the beach season upon us, I think it’s appropriate to characterize the current state of the U.S. economy as running in the sand. There’s been a lot of work for not much progress. To see just how difficult it’s been for the economy to gain traction, you need look no further than the movement in gross domestic product (GDP). Real (inflation-adjusted) GDP, which had been expanding at a historically slow pace for a post-recession recovery, actually contracted at a 2.9% annual rate in the first quarter of 2014. Although this decline appears to reflect the harsh winter’s impact on business and does not signal the onset of another recession, the decline is indicative of just how choppy the current recovery has been.
At the same time, stocks have generally been riding a wave of optimism. Excluding some recent declines in micro-cap equities, most U.S. stock indices and sectors were positive for the second quarter, for the year-to-date and for the 12 months ended June 30, 2014. International stocks have also been gaining. While China and Japan have been volatile and the targets of some pessimism, the majority of international indices — including those in emerging and frontier markets — have been positive for the quarter, year-to-date and 12 months.
Even most fixed-income securities have cooperated, with bond indices across maturities and sectors generally moving up during these periods. For many investors, the price appreciation in fixed-income securities (prices go up as interest rates decline) may be the biggest surprise of all, given that it seemed likely interest rates would rise when the Federal Reserve (Fed) began tapering its program of quantitative easing. And although bond prices did fall when the taper was first announced, prices have generally climbed throughout the taper itself, which is now about half complete.
Since the end of the global financial crisis, I’ve been bullish on equity markets — although I’ve become more cautious in the last two years. While I’ve been relatively comfortable in maintaining my exposure to stocks as I’ve become more cautious, I’ve also been relentless in examining every position for potential risks — trying to uncover problems with each company, its business, its market and its competitive landscape. For the portfolios I manage, those positions that I think pose higher risks have been pared back or exited altogether. In this environment, I see no room for complacency. To prosper going forward, I think we must keep asking ourselves, “What could go wrong?”
When you’re running in the sand, it seems that for every step forward, you’re also slipping backward and moving sideways a little as the sand shifts under your feet. Unemployment in the U.S. improved during the second quarter — dropping from 6.7% in March to 6.1% in June. Unfortunately, part of the improvement we’ve enjoyed in the unemployment rate has been due to discouraged job-seekers exiting the labor force. In addition, even though short-term interest rates are near zero, the Bureau of Labor Statistics reported that consumer prices rose 0.4% in May, the biggest monthly increase in more than a year. And the May reading of the Consumer Price Index jumped 2.1% from a year earlier, which continued the trend of rising year-over-year increases.
The good news/bad news theme also applies to stock valuations. Today’s low interest rates seem to support current — and even higher — valuations. But lackluster corporate-profit reports call for lower valuations. Similarly, the 2.9% annualized contraction in real GDP for the first quarter followed a mediocre 2.6% increase in the fourth quarter of 2013. While I agree with most observers that the first-quarter contraction was probably a one-off event due to the harsh winter, GDP is at best moving forward grudgingly. Since the current recovery began about five years ago, the economy has grown by slightly better than 2% annually, well below the 3.5% annual growth rate that preceded the recession. The current recovery looks even worse when compared with other post-recession recoveries, which experienced growth rates in excess of 4%.
On a brighter note, domestic demand and consumer spending have maintained their upward trajectories. The Conference Board’s Consumer Confidence Index rose from 82.2 in May to 85.2 in June, the highest level since January of 2008. The rising trend in new-home sales also appears to have gotten back on track. And manufacturing activity in the U.S., as measured by the Institute for Supply Management, has continued to hold up well. After four consecutive months of acceleration through May, manufacturing growth slowed only slightly in June.
While I normally confine my discussion to the U.S. economy, my focus on “What could go wrong?” has led me to consider the potential impact on the U.S. from problems arising elsewhere. The U.S. is in a better position than Europe and Japan. Europe’s economic growth is extremely slow and is showing little sign of acceleration. June’s Eurozone Purchasing Managers Index was at a seven-month low of 51.8, which indicated that both services and manufacturing activity were disappointing. As I noted in a previous message, there are structural problems in Europe that I believe create significant risks. These problems include high levels of youth unemployment, potential deflation, and the elusive goal of creating fiscal integration that benefits all European countries.
Similarly, in Japan, Prime Minister Shinzo Abe is still struggling to address the country’s long bout with high debt and entrenched deflation. If his strategy of currency devaluation fails to reignite the economy, Japanese consumers will inherit the legacy of reduced purchasing power due to higher prices, but no corresponding increases in paychecks. Further, high prices are added burdens on Japan’s growing population of retirees.
China continues to deal with challenges related to overbuilding and the transition from a government-led economy that relies heavily on exports to a market-led economy that focuses on satisfying Chinese consumer demand. Nevertheless, China represents the second-largest economy in the world, and is still growing faster than most other countries.
India has also experienced challenges, including the emerging-market crisis last year. But since the recent elections, optimism is running high. If newly elected Prime Minister Narendra Modi and his Bharatiya Janata Party can bring about real improvements in government corruption, deficit financing, inflation and poor infrastructure, India’s large population and talented workforce could help restore stronger economic growth.
Regarding issues around the world, I’m most concerned about the political and military tensions in Russia and the Middle East. In addition to the tragic human suffering in these regions, the tensions could cause energy prices to rise — which would adversely affect consumer confidence throughout the world. Higher energy prices function like tax increases, putting significant drags on global economies. While the crisis in the Middle East is not likely to end soon, near-term positive developments in Russia are more probable. And such positive developments could improve growth prospects not only in Russia, but also in other parts of the world.
While I don’t want to come across as too gloomy about the global economy, I do want to highlight that with today’s buoyant markets, it’s imperative that we try to track down every source of potential risk.
An investor focused solely on the financial markets would have little reason to suspect that global economies have been facing headwinds. As described earlier, stocks and bonds have been riding a wave of optimism. The S&P 500 Index posted another record high and finished the second quarter with a return of 5.23%. This was the sixth-straight quarter in which the Index advanced. An indication of positive investor sentiment regarding global markets, the MSCI All Country World Investable Market Index returned 4.84% for the three-month period. Though many smaller-cap stocks also did well, the Russell 2000 Index, up 2.05%, was adversely affected by volatility in April and May that especially hit stocks with the highest valuations — biotech, software-as-a-service (SaaS) and social-media companies, for example.
While the divergences among global economies and the financial markets are somewhat disconcerting, I remain cautiously bullish regarding stocks, which I think will continue to advance for a few main reasons. First, although U.S. economic growth has not been much of a tailwind for stocks, at least the economy has not been contracting on a year-over-year basis (leaving aside quarterly aberrations). So I should be able to find companies that can expand their market share and earnings, even in a slow-growth environment.
Second, today’s extremely low interest rates make stocks appear more attractive relative to bonds. Since the U.S. economy probably won’t grow much above a 2.5% annual rate in the near term, I don’t expect the Fed to raise interest rates substantially. In fact, Fed-induced increases in rates probably won’t come until the economy is expanding at over 3% per year. By that time, the economy should be providing a better environment for stocks to grow into their valuations.
Third, the indicators of stock-market psychology that I follow remain mostly favorable. The only significant negative indicator is the number of new market highs versus new lows. The relatively fewer new highs may point to the waning stages of a bull market. While a market top and an ensuing setback will occur eventually, such conditions do not appear to be close at hand. In fact, there have been reports that foreign investors, in aggregate, have been rotating out of U.S. bonds and into U.S. stocks. While cyclically adjusted price-to-earnings (CAPE) ratios remain somewhat high by historical standards, the previously mentioned corrections in areas such as biotech, SaaS and social media have taken some of the frothiness out of the stock market.
I believe most investors understand the risks involved in stocks. But because bonds have generally been in a bull market for decades and because many bond investors expect relative safety, I’ve made a habit of warning about the risks in longer-term bonds. The caveat is that the timing of interest-rate increases and corresponding selloffs in bonds are very difficult to predict. While the Fed’s efforts to hold down short-term interest rates may tend to also suppress longer-term rates for the time being, investors in longer-term bonds should understand the potential dangers of eventual increases in rates from today’s very low levels. For the second quarter, the intermediate-term Barclays Capital U.S. Aggregate Bond Index rose 2.04% and the long-term Barclays U.S. 20+ Year Treasury Bond Index rose 5.06%. While investors in bonds of similar durations might be very pleased with such attractive quarterly returns, these investors should also consider how they would react to negative returns of similar — or potentially much greater — magnitudes.
My investment outlook and portfolio decision-making have not changed materially over the past several quarters. Like we’ve seen so far this year, I continue to expect periodic “air pockets” in which stocks drop precipitously and then recover. I’m holding a little more cash in the portfolios I manage (Wasatch Strategic Income and Wasatch World Innovators) as a way to potentially take advantage of attractive buying opportunities. I’m also particularly interested in companies paying dividends that I think will be sustained or increased over time. Finally, I’m operating under the philosophy of, “When in doubt, throw it out.” This means that I’m pruning from my portfolios those companies in which valuations are excessive and those companies in which I see signs of declining profits. While overall corporate profits and margins have been rising over the past few years, I’m starting to see this trend reverse in some areas — which means that stock-picking will become even more important.
During the current market environment in which many investors are increasingly focused on valuations, we’re seeing heightened interest in the Wasatch Small Cap Value portfolios managed by Jim Larkins. Jim first became involved with the development of a value philosophy and process even before the strategy was formally launched in 1997. A Research Analyst to start, Jim became a Portfolio Manager in 1999 and is now one of the longest tenured portfolio managers at Wasatch. What makes Jim’s story so interesting, and what differentiates these portfolios from many of their peers, is Jim’s perspective as a value manager in a growth shop. While Wasatch also offers Large Cap Value and Micro Cap Value portfolios, the Small Cap Value portfolios were our first to embrace a value style of management.
Jim is sometimes asked what it’s like to work alongside a team of mostly growth managers. He says the team gives him a leg up on the competition because he often has substantial research that provides him with an edge, particularly when a former growth stock stumbles and suddenly finds itself in value territory. These so-called Fallen Angels, along with Undiscovered Gems and Quality Value Companies, comprise the holdings typical of the portfolios. We have created a white paper that provides a detailed discussion of Wasatch Small Cap Value portfolios. I think the paper presents an interesting look at the philosophy and process Jim employs to research and evaluate each investment he makes for the portfolios. If you’d like a copy of the white paper, please contact us.
With sincere thanks for your continued investment and for your trust,
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Someone who is “bullish” or “a bull” is optimistic with regard to the stock market’s prospects.
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.
The cyclically adjusted price-to-earnings ratio, commonly known as the CAPE or Shiller P/E, is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation.
The Conference Board is a global, independent business-membership and research association working in the public interest. It counts approximately 1,200 public and private corporations and other organizations as members, encompassing 60 countries. The Conference Board convenes conferences and peer-learning groups, conducts economic and business management research, and publishes several widely tracked economic indicators including the Consumer Confidence Index.
The Consumer Confidence Index (CCI) is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
The Consumer Price Index (CPI), also called the cost-of-living index, is an inflationary indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The CPI is published monthly.
The Eurozone Purchasing Managers Index (PMI) is a weighted indicator calculated from manufacturing indices of output, new orders, employment, suppliers’ delivery times and stocks of purchases. The service sector survey asks questions on business activity, expectations of future business activity, the amount of business outstanding, incoming new business, employment, input prices and prices charged. The Eurozone Composite Index is calculated combining the results from the manufacturing and services sector surveys.
“Fallen Angel” is a Wasatch term for a company with a solid long-term growth history and outlook whose current earnings have gotten off track.
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.
“Quality Value” companies, as defined by Wasatch, have usually been through a sustained turnaround, are experiencing modest growth, or have exposure to deep cyclical or commodity swings.
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.
“Undiscovered Gems” is a Wasatch term for companies that have little or no coverage by Wall Street analysts.
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 and is a commonly used measure of common stock total return performance.
The MSCI All Country World Investable Market Index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of large, mid, and small cap companies across developed and emerging markets throughout the world.
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 indices. 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 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 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.
You cannot invest directly in these or any indices.