Recent autumn plunge but bulls seem to continueSubmitted by Antaeus Wealth Advisors on October 14th, 2014
- Average credit card debt among U.S. consumers: $10,902. (MagnifyMoney, July 2014)
- Percentage of American small-business owners who say they would still become a small-business owner if they had to do it all over again: 84%. (Gallup, July 2014)
- Median cost for 4-years of tuition at a private U.S. medical school: $286,806. (Duke University, July 2014)
- Number of additional primary care physicians needed in United States by 2025 compared to 2014: 51,880. (Robert Graham Center, July 2014)
- Office buildings’ vacancy rate as of 12/31/13: 16.7%. Apartments’ vacancy rate: 4.2%. (Reis, Inc.)
- Default rate for high yield bonds as of 09/30/14: 2.1%. Average since 1988: 4.0%. Interest rate spread between high-yield bonds and 10-Year U.S. Treasuries as of 09/30/14: 3.6%. Average spread since 1988: 5.9%. (J.P. Morgan Asset Management)
- Percentage of Medicare’s costs paid for by tax revenue in 2012: 44%. Average percentage paid by tax revenue from 1967 to 2000: 75%. (Barron’s, Bill White, July 21, 2014).
- Federal debt per U.S. household: $139,000. (White House Budget Office, June 2014)
- In 39 of the 50 U.S. States, the highest paid state employee is a college basketball or football coach. (The Economist, August 2014)
- Amount of goods and services America purchased from foreign countries above and beyond what foreign countries purchased from America between 1992 and 2012: $8 Trillion. (U.S. Census Bureau, James H. Boudreau)
- Annual amount a worker earned on minimum wage, working 40 hours per week for 52 weeks, in 2013: $15,080. Annual pre-tax value of welfare benefits in Massachusetts in 2013: $42,515. (The Work versus Welfare Trade-Off: 2013, Michael D. Tanner and Charles Hughes)
- Trailing 20 year average Price-Earnings (P/E) ratio for technology stocks: 26.3. Ratio as of 09/30/14: 19.3. Trailing 20 year average P/E ratio for utilities stocks: 14.9. Ratio as of 09/30/14: 18.9.
- S&P 500 trailing 12-month P/E ratio at the peak in 2000 (10-Year Treasury Yield = 6.2%): 29.9. At the peak in 2007 (10-Year Treasury Yield = 4.7%): 17.4. As of 09/30/14 (10-Year Treasury Yield = 2.5%): 18.4. (J.P. Morgan Asset Management)
- Percentage of the world’s natural gas produced in the United States, the largest natural gas producer in the world: 20%. (U.S. Energy Information Administration)
- Number of times Argentina has defaulted on its sovereign debt in its 198-year history: 8. (Fordham University)
- Federal government’s spending on Social Security for fiscal year 2014 ending 10/01/14 (up 4.5% vs. 2013): $836 billion. Spending on defense (down 4.9%): $580 billion. Spending on Medicare (up 2.1%): $487 billion. Spending on Medicaid (up 11.4%): $294 billion. Interest on the public debt (up 5.4%): $271 billion. (Brookings Institution)
- 2003 – 2013 increase in the Consumer Price Index (CPI): 26.7%. Increase in medical care expenses during the same period: 43.1%. Increase in college tuition costs: 79.5%. (Department of Labor)
“Valuations metrics in some sectors do appear…stretched, particularly…for smaller firms in…social media and biotechnology., July 15, 2014
Antaeus agrees with Janet Yellen that we appear to be in the latter stages of this bull market that started in 2009, and that small-company stocks, especially those in certain sectors, have a higher risk of drawdowns relative to their big blue chip cousins. That said, overall the various metrics that we monitor paint a neutral (e.g. real interest rates, yield curve) to bullish (e.g. strong momentum, narrow “TED” spread, solid manufacturing jobs, low inflation) scenario for stocks; although the VIX – a measure of implied volatility in the S&P 500 – has climbed recently.
Returns have been rather tepid across the capital markets thus far in 2014, with a recent autumn plunge. As of 10/13/14, year to date the total returns (price appreciation + dividends) of various indices included: Barclays Aggregate Bond Index +7.3%; S&P 500 Index +3.2%; Gold +1.9%; MSCI Emerging Markets Index +0.5%; MSCI Europe Australasia and Far East Index (-4.6%); and Silver (-10.1%). Oil prices, as measured by Brent crude, have fallen significantly (-18.7%).
Concerns and Threats
The rhetoric and behavior of central banks – such as that of the European Central Bank (ECB), Federal Reserve (Fed) and Bank of Japan (BOJ) – continue to move markets. In short, the influence of low discount rates on driving equity valuations is significant. In our opinion the biggest threat to stock prices is simple: a drastic change in the accommodative policies of one of the large central banks. Much of the recent volatility, for example, is attributable to concerns that Germany will resist the implementation of policies by the ECB to check the recession plaguing some of the European Union’s peripheral countries.
Rising interest rates are a second potential threat to the prices of various asset classes, including stocks, bonds and real estate. The Fed’s “quantitative easing” program ends this month; and it expects a target rate 1.25% to 1.5% by 12/31/15 based on notes released following its mid-September meeting, suggesting perhaps 5 rate hikes of 0.25% over the next 14 months. Further, persistently low interest rates have led to a yield chasing game with a narrowing of credit spreads (i.e. difference between the yields of Treasury bonds and lower rated bonds) to levels last seen in 2007. These spreads naturally will expand if the Fed starts to hike rates. In other words, investors, as usual, are taking on risk at precisely the moment when they are least likely to be compensated for it.
Due to this hunt for income, certain assets look expensive to us, such as utilities stocks. Though real estate is a core asset class belonging in most portfolios, with annual acquisition capitalization rates (the ratio between net rental income and the purchase price) for core commercial real estate down to approximately 7.2% today from 9.0% in 2009, the margin for error has decreased significantly. Similarly, record issuance of high yield bonds and leveraged loans over the past few years gives Antaeus pause because if defaults rise, many investors will regret having such large allocations to speculative bonds. Even worse, because banks no longer take on inventory in a post 2008 world, “on the run” bonds could fall in value precipitously.
While the overall valuation gap between equities and investment grade bonds remains intact – with the latter more expensive on a relative basis – market corrections are normal after lengthy bull markets. Though U.S. corporate earnings have been fabulous over the past 8 quarters, top line corporate earnings have been unimpressive as of late. In short, we believe that a pull-back in stocks would be healthy, and would present a buying opportunity for the long-term investor.
If accommodative policies by the ECB and BOJ continue to expand, we see opportunities in European and Japanese small-capitalization stocks, provided one is ready to sell when the punch bowl is pulled. Further, in Japan, many corporations have approved shareholder-friendly structural reforms. While it has become more difficult to find high-quality U.S. companies trading at a discount to their intrinsic value in the wake of 2013’s roaring U.S. stock market, Antaeus also believes that U.S. housing starts will pick up, benefiting certain stocks with earnings tied to housing.
Antaeus finds a compelling case for owning Emerging Markets (EM) stocks over the next five years, partly because investors have taken down their allocations and expectations to a very low level. That said we are reluctant to significantly increase allocations until the fall-out of China’s shadow banking system plays out. China’s growth has slowed down significantly due to a credit bubble, over-building and a more mature economy (i.e. consumption based vs. export based). Further, a more hawkish Fed and stronger U.S. Dollar could hurt EM stocks, especially stocks in countries with large current account deficits and in countries dependent on foreign flows of capital.
Relatively low oil prices are an important consideration as well. Low oil prices translate to lower costs for corporations, and thus higher earnings, with the exception of the earnings of oil companies. Because of falling global consumption and America’s massive amounts of shale oil, oil prices have fallen significantly over the last 12 months despite ongoing conflicts in the Middle East. This drop in prices also helps consumers, which is important in the United States where roughly 70% of our economy is driven by consumer spending.
Our base case for the next 5 years is 7% average annual total returns for U.S. blue chip stocks (and 2% average annual returns for investment quality bonds). Corporate profits and balance sheets are healthy, economic growth is steady, and we anticipate an eventual flow from bonds and cash to equities by investors. Further, despite being several years into recovery, the rebound in capital spending by U.S. businesses remains light, suggesting that the economic expansion has plenty of runway. Antaeus may increase our base case for stocks if annual U.S. Gross Domestic Product (GDP) growth hits “escape velocity” of 3%+ in 2015, and reduce it if GDP growth falls below 2.0%.
Today’s elevated stock valuations indicate that strategic stock selection – as opposed to broad based index investing – may play an important role in generating returns over the next few years. Higher interest rates also historically have reduced stock correlations, providing fertile ground for stock pickers.
In terms of bonds and fixed-income, flexibility is critical because we may be at an inflection point where growth in the U.S. economy, and changes in the Fed’s policy, drives interest rates higher. With today’s low yields and bonds trading at premiums, Antaeus believes that combining a high quality bond ladder (capital preservation) with strategies that give portfolio managers the ability to avoid hugging the Barclays U.S. Aggregate Bond index (opportunistic) is a prudent course.
Long-Term Possibilities to Ponder
- With urbanization taking place in China over the past 14 years – much like it did in Japan 40 years ago and in South Korea 20 years ago – we expect China to settle into a long-term, stable, and slower growth pattern. By 2042 China probably will have as many elderly per capita as Japan does today. (David Altman, New York University)
- Divergent futures are developing in Europe, and the European Union ultimately may disintegrate as an economic entity. The fall out of such a breakup is hard to predict – think massive volatility – and this risk is one of many reasons why Antaeus recommends having “black swan protection” in investors’ portfolios.
- Broad-based wealth brings stability (people have too much to lose). The magic numbers seems to be $8,500 in 2005 dollars per capita for stability, and many Latin American countries are getting close (but not in Argentina or Venezuela).
- To avoid Basel, Sarbanes-Oxley, Dodd-Frank and other laws, a large financial black market may arise in areas like the British Virgin Islands, Cayman Islands and Liechtenstein. The unintended consequences of the new laws are that the safety nets provided by the more transparent traditional financial centers (e.g. London, New York) may not be sufficient.
- The world is still highly levered after 30 years of credit expansion, which may mean slower growth than investors have experienced over the past 30 years.
An unwillingness to avoid deficits and profligacy in general – i.e. not balancing the books, not living within one’s means – ultimately is dangerous. As such, we continue to monitor America’s trade deficit, entitlement spending, federal debt (which we believe needs to stay below 100% of GDP), and consumer debt levels. We also are mindful of inflation, which may be the ultimate outcome of the Fed’s policies over the past 6 years.
As humans, investors tend to be obsessed with short-term investment horizons. In rising markets, diversification may feel painful; but, as Warren Buffet famously said: “what the wise man does in the beginning the fool does in the end.” While cash feels annoying most of the time, it is like a seat belt: vitally important during crises. Further, because black swans and negative tail events are unpredictable and often arrive suddenly, fundamental diversification is a critical component to protecting a family’s wealth.
Few decisions can wipe out wealth as fast as succumbing to the temptation of The Big Mistake: buying high and selling low. If you start feeling anxious about volatility in the markets, we encourage you to call your lead advisor at Antaeus.
Evan P. Welch, CFP®, AIF®
Chief Investment Officer
Antaeus Wealth Advisors, LLC
October 14, 2014
Disclosure: Indices mentioned are unmanaged and it is not possible to invest directly in an index. No single strategy can assure profit or guarantee against loss. Past performance does not indicate future returns. The opinions expressed in this commentary are solely those of Antaeus Wealth Advisors, LLC and are based on information believed to be reliable; however, these views may change as information changes or becomes out of date.
c 2014. Antaeus Wealth Advisors, LLC. ALL RIGHTS RESERVED. Proprietary Content. May not be reproduced in any form without written consent.
 The Fed’s notes change every month, so these expectations are subject to change. The Fed also seems to be more concerned with deflation today than inflation.