Equity markets were a tad schizophrenic last week, though not overly so. There were some decent intraday reversals, but ultimately strong performance on Monday and Thursday led to a weekly gain of nearly 1% in the S&P 500. Small Capitalization stocks (i.e. Russell 2000) and the tech-heavy Nasdaq Index performed even better, generating gains of 2.5% and 1.8% respectively. Internationally the picture was mixed as Japanese and emerging market equities rose, while European stocks declined by 0.6%, likely because of nervousness concerning the French election over the weekend.
As it turns out, the nerves were unwarranted (at least for now) as Emmanuel Macron (an advocate of the European Union) and Marine Le Pen (a euroskeptic and far-right politician) received enough votes to move into a runoff election on May 7th. As of right now, markets are relieved by the outcome and risk assets are in rally mode. European equities are up 3% – 4%, while U.S. equity market futures are implying gains of 1% or better in the U.S. It should be a good day for risk assets, which provides an interesting backdrop for the discussion below.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Pacific Market — The definition of the adjective “pacific” is peaceful in character or intent. By most accounts, equity markets since the Financial Crisis can be described as pacific, exhibiting relatively low volatility and outstanding returns like boating on the Pacific Ocean in the summer time…. smooth and easy sailing. Yet, is this eight-year period unusual in a historical context? The answer to that rather simple question has important, tangible implications for investors both in terms of future return expectations and their approach to asset allocation. This is especially true as the Fed begins to shift monetary policy from ultra-accommodative to normalization. This short missive summarizes the results of two broader research efforts to infer how the path forward may evolve for equity markets.
If you are in a rush, I’ll provide the conclusion up front to save you some time. Equity market behavior since the Financial Crisis has been highly unusual, if not unprecedented. As such, investors should expect comparatively lower returns and higher volatility going forward. To understand the basis for this conclusion, please see the information provided below.
Study 1 – S&P 500 Return and Risk
This analysis was completed internally at Covenant and compares market behavior in the 18-year pre-crisis period extending from January 1990 to December 2007 to the post-crisis period from March 2009 through March 2017.
Sources: Zephyr StyleAdvisor and Covenant Investment Research
It is immediately evident from the results shown in the table that the Pre-Crisis and Post-Crisis eras are very different with regard to investment performance. The S&P 500 has generated annualized returns in the Post-Crisis period that are nearly twice as high as the Pre-Crisis period. At the same time, overall volatility levels (represented by Annualized Standard Deviation of monthly returns) have moved lower.
Higher returns combined with lower volatility have caused the Sharpe Ratio (a measure of risk-adjusted returns) to move dramatically higher in the Post-Crisis period. Indeed, in the Post-Crisis era investors have been rewarded with 3x the return for every unit of risk as compared to the Pre-Crisis era. For comparative purposes, a hedge fund strategy with a long-term Sharpe Ratio greater than 1.0 is considered a resounding success and would make the strategy a top-decile performer. On the contrary, it is highly unusual for any equity index to generate a Sharpe Ratio of greater than 1.0, as the long-term track record of the S&P 500 confirms.
Study 2 – Positive vs. Negative Months
The second analysis was conducted by a well-known hedge fund firm. The firm reviewed monthly returns of the S&P 500 since 1928 and separated the data into two periods: January 1928 – February 2009 and March 2009 – March 2017. The firm then segregated monthly performance into the following categories:
· Large Negative (S&P monthly return below -2%)
· Moderate (S&P monthly return between (-2% and +2%)
· Large Positive (S&P monthly return above +2%)
The firm found that in the Post-Crisis era there have been 40% fewer Large Negative months than were found in the Pre-Crisis era. Moreover, there has been a spike in the number of Large Positive months vs. Moderate Months.
This shift in the composition of monthly performance has resulted in a materially higher ratio of Large Positive months to Large Negative months. In the Pre-Crisis era, Large Positive months occurred at a rate of 1.5:1 (1.5 Large Positive months for each Large Negative month), but in the Post-Crisis era, that ratio has jumped to nearly 3:1. To quote the manager, “…the recent low incidence of large negative months is unprecedented in the almost 100-year history of the S&P 500 that we looked at.”
Bottom Line: Per the data from these two analyses, Post-Crisis performance of the S&P 500 has been characterized by higher annualized returns, higher risk-adjusted returns, and far fewer large negative months as compared to the Pre-Crisis era. All of this has occurred while the Fed has pursued an ultra-accommodative monetary policy. The chart below compares the size of the Fed’s balance sheet and performance of the S&P 500 since 2006.
Sources: Bloomberg and Covenant Investment Research
While the evidence presented above may be regarded as circumstantial (as is often the case with drawing conclusions from financial data), the preponderance of the data is too strong to dismiss outright. If in fact, the Post-Crisis era represents an anomaly and not the “new normal” market environment, logic dictates that the return profile for the S&P 500 should revert to its longer-term average state now that the Fed is moving to normalize policy. To be clear, this conclusion does not imply the market will experience a “crash” (nor does it preclude one from occurring either), rather it simply suggests that investors should expect comparatively lower returns (than during the last eight years) with more volatility going forward. This may have already begun, or it may be calendar quarters away. We won’t know until after the fact, but there is compelling evidence that the sailing will not be as smooth going forward.
Even with growing uncertainty about the new administration’s policy priorities, geopolitical risks (North Korea and China, Syria and Russia) are beginning to steal the headlines. These risks, along with relatively weak domestic economic data releases last week, helped create a bid for defensive assets and selling pressure on risk assets. Domestic equities declined for the second consecutive week with the S&P 500 falling a little more than 1%. In Japan, the Nikkei Index fell 1.8%, marking a 6.6% decline in the last four weeks. International developed and emerging markets managed marginal gains between 0.1% – 0.2% for the week and remain the best performing geographies year-to-date. The yields on both the 10-year (2.24%) and 30-year bonds reached five-month lows with the latter breaking down through the 3% threshold to close at 2.89%. Gold rose 2.5% and the VIX Index jumped to 15.96. Given all that is going on in the world, including domestic politics, it has been a bit of a head-scratcher that the VIX Index (which is a market-based measure of stock volatility over the next 30 days) has remained so low for the last few months. Keep in mind that a VIX of approximately 16 is not particularly high. While the 24% rise in the VIX Index from 12.87 one week prior is noteworthy, market expectations for stock volatility remain well below the 20-year average of 21.5.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Having just completed our quarterly Investment Committee meeting, below are a few observations about the state of the economy. We will elaborate on these points and more in our quarterly Economic Review and Outlook later this month.
Overall: Houston, we may have a problem. The disconnect between sentiment indexes and hard economic data has not closed – consumer confidence and small businesses optimism indexes remain elevated, but where’s the beef (i.e. economic activity)? Risks of recession are rising, and while these are notoriously difficult to predict with precision, we believe there is a better than 50% chance of one occurring in the next two years (other economists we respect are assigning either a higher probability or shorter timeframe to the next recession). As the chief brain behind a hedge fund said “It’s better to be approximately right, than precisely wrong” and there are clouds gathering on the economic horizon.
Personal Income and Consumption: With consumption comprising approximately 70% of GDP, our resident economist Sean Foley likes to say, “If you get the consumer right, your GDP estimate will be in the correct zip code.” For several quarters, consumption growth has outpaced the rise in Disposable Personal Income. Hence consumption has been fueled by an unsustainable combination of withdrawing from savings accounts and increased borrowing. On that last point, it’s worth noting that Consumer Debt as a percentage of Disposable Personal Income is now higher than in 2007 (see chart). Much of this is student debt that, by law, cannot be discharged (aka “forgiven”) in a bankruptcy and this debt must be repaid over time. Dollars paid to reduce debt are not dollars spent on goods and services, which impacts consumption levels and GDP growth.
Sources: Federal Reserve and Foleynomics
It looks like reality is beginning to assert itself in the first quarter as the savings rate started to mean revert and revolving credit levels moved lower. Given the lack of income growth and reduction in other sources for spending, it is not surprising that consumption levels disappointed in the first quarter and that overall real annualized GDP growth will end up being only around 1% in Q1. Going forward, it appears that the wind will be in the face of the consumer:
- Average Hourly Wages are in the midst of a weakening 6-month trend
- Recent sequential data suggests slowing growth in Disposable Personal Income
Construction: Overall the construction sector is healthy, but the strongest growth is likely behind us. New single family home sales as well as single family housing building permit levels are consistent with growth over the last several years. Multifamily permits are weakening after a long period of strong growth. New housing inventory continues to be tight as developers learned their lesson about speculation following the Financial Crisis. Tight inventories support higher prices. Speaking of which, housing affordability remains an issue as only 32% of existing home sales are to first-time buyers (the long-term average is closer to 40%).
Inflation: Nothing to see here, move along. As forecast, measures of inflation are beginning to ease following a data-induced move higher in the first couple of months this year. Indeed, the headline Consumer Price Index (CPI) declined 0.3% in March to 2.4%. If you recall, oil prices bottomed in early 2016, so year-over-year comparisons of the CPI produced an illusion that inflationary pressures were building in the economy earlier this year. For example, in February the CPI reached 2.7% after remaining below 2% from July 2014 until December 2016. Core CPI (which strips out energy and food prices) is less susceptible to volatile swings and has hovered around 2% since the beginning of 2016. Importantly, Core Personal Consumption Expenditures (the Fed’s favored measure of inflation) remains at 1.8% year-over-year, below the Fed’s long-term 2% target. Absent a major fiscal stimulus policy from the government, inflationary pressures will remain at bay.
Risk assets kicked off the second quarter on a modestly soft note, as domestic equities declined less than 0.5% for the week (following flattish domestic equity performance in March). Small capitalization stocks (which were a major beneficiary of President Trump’s election) were an exception, falling 1.5% (as measured by the Russell 2000). International developed markets moved lower as well as the Europe, Australasia and Far East (“EAFE”) Index declining 0.6%. Emerging and Frontier market equity indices, however, were a relatively bright spot rising 0.6% and 1.7% respectively, and remain amongst the best performers year-to-date. The yield curve continued to flatten, with the yield on 2-year bonds rising 0.03% while the yield on 30-year bond ended the week basically unchanged. Precious metals were mixed (Gold +0.4%, Silver -1.3%). Despite a strengthening US dollar (+0.8%), WTI Crude moved higher by 3.3% to end the week at $52.29 per barrel.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Tax Time – Tax season tends to produce feelings of frustration, if not outright anger, at the IRS and government for scraping off a healthy portion of our annual income. Of course, most people understand that some level of taxation is necessary to provide funds for federal, state and local governments to provide defense, education, and social support – government programs associated with advanced societies. Nevertheless, a lot of people feel they are paying away too much of their income for these services. Yet, as a nation, U.S. citizens bear lower taxes than any industrial country, except for Ireland. In fact, U.S. taxes and social security contributions are more than 10% lower than the average of 21 other industrial countries and have remained relatively stable between 25% – 28% of GDP since 1990. [Sources: BCA Research and the Organization for Economic Co-operation and Development (OECD), an intergovernmental economic organization founded in 1960 with 35 member countries.]
Source: BCA Research
It is also worth noting that the form of U.S. taxes is different than in other OECD member countries. The U.S. relies heavily on taxing income and business profits to fund government services as opposed to consumption-based taxes (i.e. a value add tax or “VAT”) employed by other OECD members. In fact, the U.S. is the only industrial country without a VAT. Indeed, taxes on goods and services in the U.S. account for only 18% of government tax revenues vs. the 33% average for other OECD countries.
So, if U.S. citizens pay less into the system than other developed countries, why do so many our friends, and family members feel overtaxed? The answer likely lies in how corporate and personal income taxes are applied. For purposes of brevity, I will focus only on personal income taxes (though there are notable distortions in corporate taxes as well). The following data points are based on data from 2014, the most recent year in which detailed personal income tax data is available.
Sources: IRS, BCA Research, Covenant Investment Research
As the graphic indicates, 55% of tax filers paid 100% of IRS tax receipts in 2014. As reportable earnings increased, so did the tax burden such that 4.2% of the nation’s taxable citizens paid 62.8% of total income taxes in 2014.
On average U.S. citizens bear a relatively low tax burden compared to our industrial counterparts, yet distortions in the way income taxes are applied skews the burden to high earners which is why so many people feel over-taxed. BCA Research suggests one possible solution is to begin employing a consumption-based tax and using the proceeds to reduce the marginal tax rate on high earners. The regressive nature of a VAT (i.e. disproportionately penalizing low income households) could be addressed by excluding certain items such as food, energy and children’s clothing. This may not reduce the overall tax burden of high earners (as they tend to choose to consume more), but it would more evenly spread government program funding amongst the populace.
Syria – President Trump’s decisive move Thursday night to respond to Syria President Bashar al-Assad’s use of a lethal nerve gas on its citizens was widely lauded by both political parties in the U.S. and many of our international allies. Saying that the situation in Syria is complex, is an understatement. If you are interested in gaining a better understanding of the major players within and outside of Syria’s border, I highly recommend this short, five-minute video: https://www.youtube.com/watch?v=NKb9GVU8bHE
Friday marked the end of a solid first quarter for risk assets. Although gains in March were fairly muted for domestic stocks, year to date the S&P 500 is up 6.1% (inclusive of dividends). Meanwhile, higher beta international equities (as measured by the EAFE Index) and emerging market stocks (MXEF Index) accelerated past domestic equities in March, recording gains of 3.4% and 2.5% bringing year-to-date performance to 7.9% and 11.5%, respectively. Despite some intra-quarter volatility, bond yields were relatively unchanged, though the yield curve flattened slightly as measured by comparing the quarterly change in yield on the 2-year bond +0.07% vs. the 30-year bond -0.06%. Precious metals were also flat in March, though year-to-date gold has risen 8.9% and silver 14.7%. On the back of rising rig counts in the U.S., WTI Crude gave up gains earned over the first two months of the year to close the first quarter down 5.8% at $50.60 per barrel.
Engineered Higher – The stock market rally since 2012 has been impressive. The Russell 3000, representing a broad swath of corporate America, rallied 79.3% (ex-dividends) in the five years ending 2016. Typically, equity moves of that magnitude are accompanied by improving corporate profitability as investors are willing to pay higher prices for stocks when earnings streams are growing. However, the Bureau of Economic Analysis’s most recent release of total corporate profits for 2016 (after tax and with inventory and capital consumption adjustments) shows a strikingly different picture. Indeed, annual total corporate profits have remained relatively flat for the last five years, declining by approximately $8.1 billion, or -0.5% from 2012 to 2016.
Earnings per share (“EPS”), on the other hand have risen approximately 17.6% over this timeframe from $51.15 in 2011 to $60.13 for the Russell 3000 Index. How do earnings per share rise in spite of flattish profits? Financial engineering.
Financial engineering of corporate balance sheets includes share buybacks and mergers that reduce the number of outstanding shares and the denominator in the formula EPS = Earnings / Shares Outstanding. In a simplified example, assume fictitious company ABC had 100 shares and total profits of $100 in 2012, meaning that the EPS is $1.00 per share ($100 profits divided by 100 outstanding shares). Fast forward to 2016 and assume that total profit remained the same at $100, but that management had approved and implemented a share buyback program that reduced total shares by 5% (i.e. the repurchase of 5 shares). Even though profits were identical to that of five years prior, the EPS equates to $1.05 per share ($100 profit divided by 95 shares outstanding) giving the illusion that profits grew by 5%.
Financial engineering alone does not explain the impressive rise in equity index prices over the last five years. In fact, a large portion of the market’s appreciation can be explained through expansion of the Price to Earnings (P/E) ratio. That is, investors have been willing to pay ever-higher prices (the “P”) for each unit of earnings (the “E”) per share. For the Russell 3000 Index, the PE Ratio increased by 52.5% from 14.5 at the beginning of 2012 to 22.1 by the end of 2016. Applying this actual multiple expansion to our fictitious company ABC, the stock price which was $14.50 per share in 2012 (=$1.00 EPS x 14.5 P/E multiple) would have been worth $23.26 per share by the end of 2016 (=$1.05 EPS x 22.1 P/E multiple) – an increase of 60.4% due entirely to financial engineering (reduced share count) and multiple expansion. Real versions of this hypothetical example have played out across stock market since 2012.
Of course some companies have increased actual earnings since 2012, but as the data above illustrates, on an aggregate basis Corporate Profits are at the same level as 2012. The stock market’s rise over this timeframe is, in large part, courtesy of extraordinarily accommodative monetary policy from the Fed and other central banks that provided fuel for both financial engineering and expansion of the P/E multiple. There is nothing inherently wrong with that, and in fact, it was an implicit (if not explicit) goal of the Fed to stir “Animal Spirits” through accommodative policy that would increase asset valuations, make people feel richer, and in so doing encourage consumers to spend money to grow an economy that is 70% consumer based. Yet, financial engineering and multiple expansions cannot continue indefinitely. Companies do not possess infinite cash for stock buybacks and there is a long history of cycles in which the P/E multiple expands and contracts.
Stock markets are inherently forward discounting mechanisms, meaning that they are priced today based on expectations of future events, including cash flow available from earnings. It’s clear from both the rise in the market over the last several years, and the current P/E multiple, that investors are expecting better earnings growth than has been realized over the last five years. Time will tell if investors’ expectations will be validated. Given the recent history of actual earnings and the high expectation levels (i.e. the P/E multiple), it would seem prudent to avoid putting all of one’s financial eggs in passive, domestic equity index ETFs and mutual funds.