We hope this letter finds you well. As we mentioned a few quarters ago, our quarterly letter is now separated into two sections, a brief overview of market returns and key news items, followed by a “Deeper Dive”, a more detailed view regarding one theme we find of particular interest. We hope you enjoy both.
The first quarter of 2016 has indeed been a rollercoaster ride. The broad equity indexes fell more than 10% during the first 6 weeks of the year followed by a rebound of similar size. Most indexes are still down 4% or more from their highs of last year but have strengthened recently. For the quarter, the S&P 500 and Dow Jones Industrials increased 1.3% and 2.2%, respectively, while the NASDAQ Composite declined 2.4%.
Interest rates declined noticeably for the quarter. The yield on 10-year Treasuries ended at 1.78% compared to 2.27% at year-end.
IN THE NEWS
This quarter we would like to highlight a few news items that we believe are noteworthy. The first is the possibility of Britain exiting the European Union, more commonly referred to as “Brexit” in the financial press. The European Union, or EU, is composed of 28 countries and has its own governing body and central bank. Britain represents 18% of the economy of the EU, second only to Germany in its contribution, so an exit from the EU would be impactful by any measure. Some positive reasons for Britain remaining in the EU include more clout to negotiate trade agreements and its status as an EU country makes it more attractive for outside corporate investment. Some of the counter arguments are the difficulty in reaching a trade agreement when 28 countries are involved with differing interests. In addition, the number of regulations in the EU and administrative costs for compliance are high with some estimates suggesting the cost at several percentage points of GDP. If Britain were to exit, it is almost guaranteed that a favorable trade agreement with the EU would be reached quickly as Britain is a very important part of the European economy and an agreement would be in everyone’s best interest. We will know more soon as the vote on the referendum is scheduled for June 23 this year. As the date approaches, polling data is likely to lead to increased volatility in some capital markets. The next meeting of the Federal Reserve is in June and we suspect that the “Brexit” vote in the same month may cause the Fed to delay any rate hike at that meeting in order to reduce volatility in the capital markets.
Another bit of news that has ruffled some feathers as of late is the discussion of negative interest rates. During a recent testimony before Congress, Janet Yellen, Chairwoman of the Federal Reserve Bank, responded to a question about the possibility of negative interest rates in the US. She stated that the Fed had not researched the issue fully and that she was not confident such a move would be legal in the US. The Fed raised interest rates in December by a quarter of a point and in March indicated that it believed two more such increases would occur in 2016. By contrast, a recent report by Deutsche Bank shows that 40% of government bonds of European countries are trading at negative interest rates. Such an environment helps to explain the strength of the US dollar despite our low rates, as investors seek to move money to higher rates and thus boost demand for dollars. At the moment, we do not believe the US will face negative interest rates anytime soon as it seems the Fed has indicated such a move would be a last resort.
HOW DOES THIS AFFECT OUR INVESTMENT THINKING?
As noted in our last letter, our expectations for returns of the US equity market are driven by the earnings expected of companies in 2016 and the amount that investors are paying for these earnings. The ratio of a stock’s price to its earnings (price/earnings ratio), the P/E ratio, is an indication of value and expectations for a given stock. Indexes representing the overall stock market such as the S&P 500 Index can also have a P/E ratio when earnings and prices from the companies in the index are aggregated. For the S&P 500 index, the P/E ratio has risen even more on the recent bounce in the market due to the disappointing earnings from various companies. As trailing earnings growth has slowed, the “E” in the P/E ratio has declined while the “P” (price) of stocks bounced from the lows in February. The average P/E of the stocks in the S&P 500 is now 27, a high historical level, and up slightly from last quarter.
With the P/E of the overall market at such a high level we continue to be cautious about future returns. A focus on individual stocks is more important than the overall market but there are other forces that may be at work here. Fundamental factors, such as earnings and revenue growth, are very important to investing returns but the motivation of investors to buy or sell stocks is the ultimate factor. This sentiment of investors can be driven by fundamental factors but it may also be driven by other elements that are harder to measure. In the late 1990’s, for example, the broader equity indexes continued to rise well past any reasonable valuation. One such “non-fundamental” factor for US investors could be the lack of investment alternatives. If the Federal Reserve is not likely to raise rates significantly over the next year, according to their March statement, then there are few alternatives for investors seeking income or even modest returns. One indicator of sentiment or market participation that we review is market breadth or the percentage of stocks that are participating in the move when the market is rising or falling. The rise from February to March was incredibly strong in terms of breadth and looks far more like what would happen at the beginning of a new upward trend. At the same time, expectations for earnings growth in 2016 have begun to decline as companies reported more muted earnings growth in Q4 and we believe those expectations may remain muted for some time. This conflict between fundamental information and market sentiment makes navigating the equity markets more difficult.
Data in the last few quarters suggests that profit margins have probably peaked which leaves sales growth to drive earnings improvements for most companies. This weaker backdrop has led to sizable declines in certain industries even while the S&P 500 Index remains roughly where it was in November, 2014. Within these beaten down industries, we are beginning to find some interesting companies at attractive valuations and are excited about their prospects. The equity market is much like the ocean in that what you see on the surface is not always indicative of what lies underneath. Fishing in the right spot is important. To that end, we are especially attracted to good companies that have declined in the last few quarters but are strong financially with defensible businesses.
In late March, the Federal Reserve indicated that they would be more cautious about raising interest rates in 2016, after suggesting two increases of a quarter of a point might occur. The fact that interest rates have been very low for an extremely long time makes any potential changes in rates ahead harder to interpret. This time it really is different so a healthy dose of humility and caution are warranted.
We welcome your thoughts and comments and are honored that you have chosen MONTAG to manage your investments. We hope the additional material, focusing on corporate profit margins, is useful to you.