Monthly Outlook: September 2016

Markets seemed to be on vacation in August as low volume and low volatility ruled the day. For the month, U.S. stocks (S&P500) lost a scant 0.12% and international stocks (EAFE) sagged by 0.21%. U.S. Bonds (with interest) lost a mere 0.32%. On the one hand, investors have to ponder fundamental data that mostly supports the notion of a slowing or, at least, slow‐growth economy. On the other hand, it’s also clear that global central banks remain committed to stimulus plans and, through their asset purchase programs, provide a supportive floor to prices. It’s a Dr. Doolittle Pushmi‐Pullyu market (do little indeed!) But markets don’t typically remain flat for long. We could handle either outcome – up or down – but this sideways and stuck action isn’t helping anyone.

Fundamental Outlook

Investments are supposed to represent the present value of future cash flow streams, adjusted for risk and perceptions, and compared to alternatives. That is, fundamentals are supposed to matter. Let’s look at stocks. According to the facts at S&P, earnings have actually been declining for seven straight quarters. They peaked in 3rd quarter 2014 at $114.51 and have steadily declined about 14% to $98.29 for 2nd quarter 2016. That’s abysmal and proves that corporate America is actually struggling. And yet stock prices have moved higher over these past seven quarters. As a result, valuations are back to overvalued levels seen at prior peaks like 2007, 2000 and even 1929.

What about bonds? Well, fundamentals here are also peculiar. Interest rates are at historical low levels with the U.S. 10‐year treasury rate at 1.5%. You have to go all the way out to 30 years to get 2.2%. But where the bond fundamentals get weird is when we consider the narrow yield spreads across all asset classes. The yield spread is ridiculously low and suggests investors are not differentiating assets for their risk. In other words, as investors are starved for yield, they’ve been buying anything and everything that has an interest rate or dividend regardless of risk.

Once government bond rates went too low, investors bought corporate bonds, and then junk bonds, and then REITs, and then stocks. Now prices are high for every asset class and yields are all very, very low. But we all know there is a big difference between the risk of U.S. treasuries and stocks.

Central Banks Impact

Since the financial crisis of 2008, global central banks have tried to stimulate the economy through policies of low interest rates and asset purchases. Their hope, plainly stated, is that they can induce people, companies, and governments to borrow money and do something productive with it (start a business, hire people, etc.). We certainly have a lot more debt than we did in 2008 but it’s arguable how much has been put to productive use. U.S. government debt has grown from $10 trillion to $20 trillion, corporate debt is back to near‐record highs but a lot of it has been used to buy back stock and not for new factories or jobs, and individuals have more debt used for college tuition, houses and cars. An honest debate can be had over how effective these stimulus programs have been to actually reinvigorate the economy.

But one effect of the stimulus plans is clear. Financial assets including bonds, stocks and real estate have been inflated higher because 1) investors reach for yield without regard to risk and 2) investors believe the government asset purchase programs provide a floor to downside risk. So investors buy every dip because they “know” that the central bank will keep the markets from falling. And herein lies the challenge for a portfolio manager. From a fundamental and valuation perspective, the risk is certainly there and one should trim back exposure to reduce portfolio risk. But considering the powerful central bank policies and asset purchase programs, the uptrend party continues and one should stay invested and ride the wave. We think the prudent action, for now, is to trim a bit of the riskiest holdings, maintain some core holdings, and remain diligent for changes to central bank policies. Markets don’t stay flat for long.