2015 3rd Quarter Commentary

The stock markets have finally experienced the pullback that we’ve written about for the last 6 quarters.  The volatility that began in the sec ond quarter of this year sparked by concerns over Greece and Puerto Rico continued with a vengeance in the third quarter.  The last three months logged the largest decline in stocks in any one quarter in over four years with the S&P down 6.4% and the Dow down 7%.  Even after this decline, the markets are only down 5.3% for the S&P and 7.0% for the Dow for the full year.  Greece concerns disappeared from the headlines and were replaced with worries about Chinese economic growth, Fed interest rate hikes and fallout from the drop in commodity prices.  The volatility escalated with a collapse in the price of Chinese equities on August 24th which precipitated the biggest loss on the Dow in 4 years.  On a side note, the Chinese market has fallen roughly 40% from its high on June 12th, but up until that point the Chinese stock market had been up almost 63% in 2015!  For the year, the Shanghai Index is down roughly 3.8%.  A 63% increase in the index is obviously something that is not sustainable so while a pullback seemed inevitable, the speed at which it took place bordered on panic.  The Chinese debacle reignited fears surrounding the world economy and its dependence on monetary stimulus.  Driven by concerns related to China (and emerging markets in general) the expected rate increase from the Federal Reserve was postponed.  The market perceived this decision as a ‘no confidence vote’ for the U.S. economy which triggered additional uncertainty for investors.  Hidden in all of this turmoil was a GDP number for Q2 that came in quite strong at 3.9%.  In the midst of so much negative news, this seemed to go unnoticed.

At this point in the economic cycle, the U.S. economy is plodding along at a decent growth rate although there are some conflicting signals from manufacturing readings. Based on various manufacturing surveys, growth slowed in September and could weaken further in coming months. Business optimism has slumped to one of the lowest levels seen since the global financial crisis, probably from the effects of the stock market volatility we noted above. Dislocations in capital markets do not inspire confidence from businesses.  GDP growth is also becoming increasingly reliant on the services economy as manufacturers struggle against the strong dollar and weak demand in export markets.  We will continue to watch these metrics to see if they represent temporary weakness or the harbinger of a slowdown.

On the positive side, housing data continues to emerge from the multi-year recession. At 552k annualized units, new home sales set a new recovery high in September and were up 5.7% sequentially and up 20% year over year.  While job growth continues a healthy pace, the last two months were weaker than expected.

As noted already, the equity markets suffered a correction in the third quarter of 2015, the first such correction since August 2011.  After the S&P 500 peaked in July at 2,128 it fell to a low in August of 1,867 resulting in a 12% pullback.  Equity markets experienced a modest rebound the last few days of the quarter with the index closing out at 1920.  All told, the S&P 500 was down 6.4% for the quarter, and is now down 5.3% year-to-date.  Equity markets were impacted by both global economic concerns and the continued uncertainty on Federal Reserve interest rate policy.  China’s economy continues to expand at a slower pace while the country hopes to transition to a more consumption based model and away from production growth and infrastructure investment.

Emerging markets economies, heavily dependent on the sale of commodities to China, have also been impacted by the slowdown.  With commodity prices now trading lower than cost in many instances, production has fallen in order to meet reduced demand. The Fed mentioned in their recent decision not to raise interest rates that low commodity prices, and the downward pressure this puts on inflation, was one factor that influenced their decision.

In the third quarter of 2015, nine of the ten economic sectors in the S&P 500 posted negative returns.  Utilities, which benefit from low interest rates, were the lone positive performing sector during the quarter up 5.4% (although still down 5.9% year-to-date).  The Consumer Staples & Discretionary sectors were the next best performing sectors, down 0.2% and 2.6% respectively.  Discretionary stocks benefit from lower commodity prices; cheap gasoline puts more cash in consumers’ pockets.  Additionally, these companies derive the majority of their revenue inside the U.S. which means they are less exposed to foreign exchange headwinds.

The Energy, Materials, & Industrial sectors were three of the worst performing sectors during the quarter down 17.4%, 16.9%, & 6.9% respectively.  All three are directly impacted by lower commodity prices and reduced economic activity abroad.  The U.S. dollar has resumed its strength (+6.0% year-to-date), which negatively impacts these sectors along with any company that generates a majority of its sales and profits outside of the United States (chart below).  Concerns over drug pricing impacted Healthcare stocks during the quarter pushing the sector down 10.7%.

The price-to-USD Q3 2015earnings (P/E) ratio for the S&P 500 on 2016 earnings estimates is now 15x.  The forward multiple has come down a little with the market correction and is now roughly at historical averages.  With the market pullback, we are finding additional pockets of opportunity where the current pessimism in a company’s stock price is not a reflection of the long-term value of the business.  We continue to like the companies we are invested in and will look to take advantage of any market dislocations.

The flight to quality is a natural investor reaction in times of market pessimism.  Considering the economic uncertainty outlined above, it is certainly no surprise that fixed income assets like U.S. Treasuries, Agencies and AAA-rated securities appreciated as investors bid up the prices of safe assets in lieu of volatility.   While we do not claim to be expert “Fed watchers,” we do follow economic trends.  Our belief is that there is no compelling argument based on the recent economic data for the Fed to raise the Fed Funds rate.  Managing inflation and full employment are the two mandates of the Federal Reserve.  Inflation, as measured by CPI, came in at a very modest 0.2% year-over-year in September, and expectations for inflation are falling.  Energy and commodities prices are putting downward pressure on inflation, due to lower input cost as well as the resulting strength of the Dollar.  The unemployment rate has fallen to 5.1%. However, the underemployment rate (those employed part time for economic reasons or those not looking for work but have indicated they want a job) is stuck at a stubbornly high 10%.  The Fed desperately wants to normalize monetary policy.  For this “lift off” to be sound policy the economy must pick up steam.

The AAA sector of the Barclay’s U.S. Aggregate Index has returned 1.72% on a year-to-date basis.  Conversely, the BBB sector of the benchmark was ironically down 1.72%.  If you go further down the credit spectrum, the high yield market as measured by the iBoxx High Yield ETF (HYG), is down 3.72% for the year, with many commodity related issuers well into distressed territory.  While high yield tends to be more correlated to the stock market, this comes as no surprise.  However, complacency in this sector seems to have built up over the last few years and spreads appear to be reverting to the mean.

The U.S. Aggregate Index as a whole is up about 1% for the year.  For our taxable strategy we continue to find value in step-up agency notes with a 2% starting coupon.  We prefer maturities that are 2027 and shorter, with step-up schedules that move up faster than we expect the Feds Funds rate to increase.   To compliment this strategy we are adding higher coupon highly rated taxable municipal bonds, as we are able to build out a portfolio with AA and AAA bonds at rates higher than the corporate market can safely offer.  If the corporate market continues to underperform value will be created, and in fact we have invested in a select few corporate bonds in this latest sell off, however we are avoiding the corporate bond market in general, for now.

The tax free municipal market has been one of the best performing sectors of the year, returning 1.72% as represented by the S&P Municipal Bond Index.  We like the above market coupon structures in the 4.0% to 5.5% range with maturities in 2025-2030.  These are callable structures that allow us to achieve yields in the 5-7 year range well in excess of the comparable U.S. Treasury equivalent.

We have also received a few calls on why we are investing in bonds with the Fed threatening to “raise rates.”  Our view is that the Fed controls the short part of the yield curve, specifically interest rates corresponding to zero to two year debt.  We believe that the market/investors control the longer end of the yield curve and rates are driven mainly by inflation expectations and overall views on the economy.  With CPI at 0.2% and the Fed broadcasting their desire to raise rates, there is a strong argument for a “flattening” yield curve as short rates move up and long rates stay put.  While we do expect volatility once this process begins, longer term we believe that a Fed with a lot of room to raise rates and a $4.5 trillion balance sheet has all the tools it needs to fight increases in prices.

Corrections like this are not uncommon. It has simply been unusually long since we saw one of any size as we mentioned earlier.  For some helpful perspective, see the chart below.

As you can see, 10% corrections have been fairly common over the last 50-plus years.  Coming out of the 2008 financial S&P Corrections Q3 2015crisis we simply have not experienced them with the usual regularity.  As the third quarter ends we are beginning to get earnings reports from various companies.  This will help investors see which companies are executing and therefore which are priced accurately.  We will also begin to hear management expectations for the future.  With jobs getting harder to fill, wages rising modestly, low gasoline prices, low commodity prices/input costs, low interest rates and a lack of inflation there is reason to believe the US economy will continue to muddle along at a somewhat subdued pace.

We don’t live in a bubble, but it is possible for the smaller Asian countries and Japan, Brazil, Australia and Canada to go into recession while the U.S. economy continues to grow.  This “decoupling” occurred during the Asian financial crisis in 1998.  We have a strong service and consumption based economy.  The economies mentioned above are either commodity dependent and/or export dependent on China.  Another headwind that will pass after the fourth quarter is the lapsing of the strong dollar effect that started last year.  If you will recall, revenues of multinationals continue to be hard hit by strength in the dollar as they convert profits earned in foreign currencies.  Going forward, comparisons for year-over-year periods will become much easier and thus remove this earnings headwind we have experienced for all of 2015.