The optimism from the first quarter was sustained into the second but interestingly, volatility has also increased on the back of a rising market and stronger economic data. What would cause this volatility? The financial media is hyper-focused on the next move of the Federal Reserve. Measuring the pulse of Ben Bernanke and making short term market calls has become a full time occupation for many. These days we hear a lot of chatter about “Fed tightening” and a new word has even entered our lexicon, “tapering.” It seems tapering has become the new “sequestration” for market participants. Just as the conventional wisdom projected apocalyptic effects of the budget battle earlier this year and the subsequent spending cuts due to sequestration, conventional wisdom today frets over what the Fed will, or will not do relative to their ongoing bond purchases. Ultimately we believe the underlying weakness or strength of the U.S. economy is going to drive interest rates, stock and bond prices and we believe the Fed will be able to successfully navigate their exit strategy.
We believe the underlying strength of U.S. economy is real and while it has been helped by artificially low interest rates, the core of our economic strength is not based solely on Fed actions. The private economy appears to be growing at a decent rate. However, the public economy (government spending) has been shrinking which has been a headwind to GDP. There are many things going right in the U.S. economy that explain the recent stock market appreciation: resurgence in the energy sector (oil and natural gas), manufacturing, increases in productivity and a real improvement in housing are underpinning our strengthening economy.
In the energy sector, oil production in the U.S. this year has increased 17% over 2012. Domestic oil production is exceeding imports for the first time in decades and the infrastructure build-out around this industry is quite robust. On top of this, the supply of natural gas has continued to grow at a rapid pace and is a cheap form of clean energy for American businesses. Chemical plants, fertilizer plants, and many other manufacturers that depend on natural gas as an input are taking advantage of abundant gas at cheap prices. Over a longer period of time we expect to see new manufacturing facilities and infrastructure built to make use of this clean, cheap energy that will drive demand and add to overall economic activity.
Additionally, housing continues to strengthen. According to the Case-Shiller index, U.S. home prices in April posted their highest year-over-year gain in seven years (11.6% and 12.1% for the 10 and 20-city indices), and the highest monthly gains in the history of the index (2.6% and 2.5%). On top of this, new home sales increased by 29% in May from this same time last year. At 476,000 units, this is the highest level of new home sales activity since July 2008. Moreover, the 10.3% annual gain in the median sales prices represented the ninth month out of the last ten that prices posted a double-digit increase. Nationally, we should average 1.5 million new homes every year in order to keep up with population growth. We have not started that many homes since 2006 as we worked off a huge oversupply from the housing bubble. The majority of this oversupply has been depleted over the last 4 years and housing starts are rising. Simple supply and demand should keep this sector growing for some time to come. As we’ve mentioned in previous letters, the many products and labor-hours that are inputs to new home construction make the housing industry a powerful component of economic growth.
In the manufacturing sector, shipments of durable goods in May increased $2.8 billion or 1.2 percent to $229.7 billion, the third positive reading in the last four months. These shipments and orders for manufactured durable goods in May were at their highest levels in more than five years, going back to January 2008. Total domestic annualized vehicle sales have also been trending higher this year touching the 12 million vehicle mark for the first time since 2007. According to Morningstar, auto sales and production are now running at over 90% of pre-recession levels while the number of workers employed directly by the auto industry is currently running at just above 70% of its highs. This demonstrates a significant increase in productivity which bodes well for future manufacturing and employment growth.
Stocks closed out the first half of the year on a volatile but strong note, with the S&P 500 recording the best first half since 1998, up 13.8%, with dividends included. Although the indices declined in June, the second quarter closed with a positive return of 2.9%. The previously mentioned discussion of Fed tapering caused the market to fall from its peak on May 21st and volatility increased dramatically into the end of the quarter. In our letter last quarter we thought that the market had room to consolidate. While the velocity of these moves is not what we expected, it also does not cause us concern.
Unlike last quarter where all 10 economic sector returns were positive, this quarter it was an even split. On the positive side were the Financial, Consumer Discretionary and Healthcare sectors. Conversely, Utilities, Materials and Energy sectors led to the downside. One of the themes following the meeting of the Federal Reserve and the ensuing uptick in the 10 year Treasury yield was the selloff in slow growth, high dividend stocks. This “theme” was most evident in the Utilities sector and for the quarter, that sector declined 3.7%.
A recurring question we been asked by numerous clients is whether or not we think the stock market is in a bubble like the late 90’s. The comparisons are easy: the index levels are similar, we had the best first half since 1998 and (until recently) volatility has been very low. In 1999 the S&P was trading at 1469, a level seen most recently in May. In our opinion, that is where the comparison ends. The P/E (price to earnings ratio) in 1999 was 33; today it is roughly 14. The dividend payout in 1999 was around $16, today it is almost $30. The earnings of the S&P 500 in 1999 were $53. Today it is approximately $100. In summary, the market is at the same nominal level but with half the P/E ratio, twice the dividend payout, and twice the earnings power. Add to that the massive share repurchase programs currently in place for many companies and it is hard to argue there are any valuation similarities at all.
With that said, please don’t interpret that we are in “perma-bull” mode with the expectation that the market is on an endless trajectory upwards. As we mentioned in our last letter, the market has moved very far, very fast and the economy needs time to catch up. Additionally, major domestic and geopolitical issues persist which could cause future shocks. Some of these include:
- Perceived tightening actions from the Federal Reserve
- Continued economic struggles in China
- Revolution in the Middle East (primarily Egypt)
- A re-igniting of the European Debt Crisis (Portugal this time?)
- ObamaCare sticker shock and its effects on consumption and employment
These risks are real, but in the end we believe the economy will continue a slow and steady march upward, thus supporting stock prices in the longer term. The main point of this analysis is that we believe the market is not grossly overvalued as some have suggested.
The bloom finally came off the rose for bonds in the second quarter. Federal Reserve Chairman Ben Bernanke told Congress on May 22 that the expansive monetary policy tool of bond purchases could begin to be tapered off over the next several Fed meetings if the economic outlook (primarily employment) showed sustained improvement. This triggered a somewhat knee-jerk reaction by bond mutual fund holders to sell their shares. During the second quarter there was a net withdrawal from bond funds of $36.7 billion, one of the largest on record, according to the Investment Company Institute trade group. In previous meetings, the Fed indicated its goal of reducing the unemployment rate to 6.5% from the current 7.6%. There does not appear to be a problem with inflation at the moment, as measured by the Personal Consumption Expenditures index (the preferred Fed index for inflation). In fact, the PCE registered nearly a 50-year low reading. Low inflation expectations are generally good for bonds. However, if employment picks up dramatically then the largest buyer of Treasury and Mortgage bonds (the Fed) will start to move to the sidelines. There seems to be quite a mixed view on the path of interest rates currently.
The 10-year Treasury yield increased from 1.85% from the first quarter to 2.49% to close the second quarter. The yield on 30-year Treasury bond increased to 3.5% from 3.1%. As a reminder, when interest rates rise, bond prices fall. The overall bond market as measured by the Barclays Aggregate Index was down 2.4% on a total return basis for this time period. We would not expect this pace of yield increases to persist; however, only the upcoming economic data can paint a clearer picture. In the meantime, we are keeping the duration of our portfolios more conservative than the market by investing in step-up Agency notes and intermediate corporate bonds. As every day passes the yield on the step-up notes will increase, which should partially offset any potential major spikes in the yield curve.
Municipal bonds also sold off during the quarter. We are managing the interest rate risk by purchasing above market coupon structures with maturities in the 2025-2030 range with intermediate call dates in the range of 2016-2019. We are also seeing opportunities to purchase deep discount lower coupon bonds that have been hit particularly hard; some are trading with prices in the $80s that were issued at par only a few months ago. We are maintaining our duration of roughly 80% of the market duration at this time in most portfolios. Credit quality continues to improve as many state budgets have returned to pre-recession levels.
In our last quarterly letter we noted that the most likely case going forward is for some level of consolidation before we head higher. While this quarter experienced some consolidation, we do not think this line of thinking has yet to run its course. In other words, we continue to believe the most likely scenario is for some additional level of consolidation before we head higher. We would not be surprised at all to experience negative stock and/or bond returns for Q3 and would view negative returns as a normal process in the investing cycle.
That said, a sound investment discipline is critical to long term success. It is also why following short term trends can be very dangerous to your long term financial health. Amidst the uncertainty, we have seen enough economic momentum to support our conviction that investing in the right mix of stocks and bonds will yield ample appreciation in the months and years to come. We will continue to watch the global economic and political indicators and invest accordingly. We acknowledge that predicting the future is a losing game. We strive only to prudently manage potential outcomes. As always, we are grateful for your continued support.