Why Value Is Still a Value

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For much of the post-crisis period investors consistently craved growth stocks. They did so for the same reason they favored stocks with a healthy dividend: Both income and growth were scarce commodities for much of the past eight years. However, with yields rising and economic growth at least stabilizing, this began to change in the second half of 2016 when classic dividend plays stumbled while value started to come back into vogue. However, these trends stalled in January, raising the question of whether the recent preference for value has further to go. My view is that it does, primarily because value still appears cheap relative to growth.

The notion of the “value of value” seems a bit redundant, but it is important when assessing style preferences. While value stocks, by definition, will trade at a lower valuation than growth stocks, the valuation spread moves over time. Based on the price-to-book (P/B) metric, since 1995, value stocks, as defined by the Russell 1000 Value Index, have typically traded at around a 55% discount to growth stocks.

During the tech bubble growth stocks became more expensive, pushing the value discount to more than 70% at the market peak in 2000. Conversely, prior to the bursting of the housing bubble, it was value that looked expensive. The rally in financial shares, which typically command a higher weight in value indexes, drove the value discount down to around 45% in 2006. The chart below illustrates this, showing the ratio of the value P/B to growth P/B. A relative ratio of 0.55, for example, translates into a value discount of 45%.

Russell 1000 Value Growth

As financials started to come under pressure and the extent of the housing bubble became clear, investors started to demonstrate a strong preference for companies that could grow their earnings regardless of the economic environment. This preference for growth manifested in the outperformance of both stable growers, like defensive consumer staple companies, as well as technology firms benefiting from secular trends. As a result, value has gone from a 45% discount to growth in late 2006 to a 65% discount today.

While value was even cheaper in early 2016, today’s discount still places the growth/value spread more than one standard deviation below the long-term average. In other words, value stocks still look attractive relative to growth.

To be sure relative cheapness is not a guarantee of relative outperformance, but to the extent that value stocks are cheap and the economic outlook is improving, value has a reasonable chance of continuing its run.

For investors, the challenge is that the latter condition, i.e. better growth, is somewhat dependent on whether Washington can conjure up a reasonable and timely stimulus package, including tax reform. A stumble in such efforts is likely to revive old concerns over secular stagnation and push investors back toward old habits, namely a preference for yield and stable growth. However, even a modest package that raises growth expectations stands to benefit the cheapest segments of the market.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

3 Ways to Not Be Stupid with Your Bond Portfolio

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It may be early in the new year, but it’s never too early to talk about mistakes. I know, I know, there has hardly been time to make any in 2017… yet. But I am not talking about breaking that resolution to not eat sugar, or binge fewer TV shows. I am talking about common investment mistakes people make in their portfolios.

When I talk to investors, both professionals as well as those who work outside finance, three mistakes seem to come up again and again when it comes to how bond portfolios are managed. Now I know what you are thinking: Matt, most people don’t go around talking about their bond portfolios. That’s true. But when I hear people talk about investing in general, I often hear at least one of these behavioral mistakes mentioned.

Mistake 1: Forgetting what your fixed income investment is for.

When you buy a bond or a bond fund, you need to answer a simple question: What role does fixed income play in your portfolio? The typical answers are: a) diversify equity risk, b) pursue income, or c) help protect principal. And, many investors look to their bonds to do more than one of these things. The right answer can vary depending on your age, income needs, risk tolerance, and a host of other factors. No matter what the answer is for you, stick to it. Don’t be tempted by the latest hot investment trend or what your neighbor is investing in. Stay the course; invest in a way that matches your investment goals.

One important caveat: In today’s market it can be difficult for your bonds to achieve any one of those goals above, let alone all three at once. The 10-year Treasury note is currently yielding 2.45% (as of 1/31/2017, source: Bloomberg), and while it provides diversification against equities, that’s not a lot of income. You can get over 5% on some high yield investments, but you may sacrifice some portfolio diversification and take on more return volatility. This was not always the case. Think back to 2006 when the federal funds target rate was at 5.25%. Back then a 3-month Treasury bill yielded 5% (source: Bloomberg). That’s income and low volatility. Today’s market doesn’t offer the same opportunities. So be precise with what you want your fixed income investment to do. Hold realistic expectations, and stick with your goal. Which brings me to….

Mistake 2: Making investments that don’t match your goals.

This may sound simple, but you would be amazed at how often people get this wrong. Let’s say, you are in retirement and have managed to build a nice nest egg. You want your bonds to help protect your principal, maybe provide a little income but mainly not lose much value. If that is your goal, emerging market (EM) debt may not be the right place to put a big chunk of your money. EM debt can be a great source of income potential in a diversified portfolio, but not when you are looking for low volatility. A short duration bond fund may be a better option.

A good way to avoid making this mistake is to pause after you have built your portfolio. Before you invest it, take another look and ask yourself a few questions: Did the investments you ended up selecting match your investment goals? Do they fit together well in the portfolio? This is a simple but invaluable step to make sure you stay on target with your goals.

Mistake 3: Abandoning bonds when interest rates rise.

Too often investors are tempted to act if their investments are falling in price. And typically when interest rates rise, prices of bonds and bond funds fall. The temptation to jump ship can be especially strong with exchanged traded funds (ETFs) because you can watch prices intraday, just like a stock. If this is your tendency, I would suggest you think about your long term goals when you check your portfolio. ETFs provide transparency and trading freedom, but that doesn’t mean you should trade and rebalance more frequently. Don’t let the availability of information distract you and steer you away from your plan.

And most importantly for your bond ETFs, know that rising interest rates may actually be good for long-term investors. You are probably thinking: Wait, what? How can that be if rising interest rates cause the prices of bonds to fall? Turns out this is how bond math works. When interest rates rise, the price of your fund at first drops. But then the fund begins to reinvest cash flows at the new higher yields, which would steadily boost income. Over time, this increased income can potentially offset the initial price decline. An intermediate fund with a duration of five years may recover price loss from rising interest rates in about five years. And after five years the fund may continue to be investing at higher yield levels, potentially resulting in higher returns. So if you are a long-term investor, you may actually want interest rates to rise.

That is all for today. In future posts I will dive deeper into each of the three mistakes and provide more detail on how to help avoid them. Until then, stay off the couch and stay off the sugar.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

In today’s environment, consistent investment performance and low fees are critical to achieving your goals. Click here to learn more.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Diversification and asset allocation may not protect against market risk or loss of principal. There is no guarantee that any fund will pay dividends.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This document contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

©2017 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Will Tax Reform Hurt Tax-Exempt Bonds?

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Tax reform is high on the agenda of the new administration, leading to speculation about what changes could mean for the outlook for tax-exempt municipal bonds. The two areas of focus: A reduction in tax rates for both corporations and individuals, and the elimination or capping of muni tax exemption.

Lower individual taxes … and a grain of salt

The hard truth: Lower individual tax rates reduce the value of a municipal bond’s tax exemption. For example, a drop in the top tax rate from 43.4% to 33% means $4,340 in annual savings would be reduced to $3,300. And to the extent that lower tax-exempt benefit mutes the demand for municipal bonds, market valuations could suffer.

To that salty dose of reality I would add two important provisos:

  1. The individual tax code is very complicated and politically difficult to amend, even under one-party control. Change may well come, but not likely in 2017 as Washington focuses on the comparatively easier task of corporate tax reform.
  2. A cut in individual tax rates would cause some adjustment in muni pricing (read on for our estimate). But the market has seen similar, and even more dramatic, tax changes before. The top marginal tax rate was reduced from 50% to 28% in 1986 and from 39.6% to 35% in the 2000s. And, under current conditions, muni investors still reap an after-tax benefit over taxable bonds, even at a 33% tax rate.

Muni Yields

Tax exemption not dispensable

The tax exemption of municipal bond interest is a key draw for issuers. And while it may be deemed alterable, we don’t see it as dispensable. States and municipalities rely on municipal debt as a low-cost, efficient way to finance capital improvements and fund infrastructure. The federal government hurts itself if it impedes state and local ability to create jobs, sustain their economies and improve the quality of life for Americans. As such, we see the elimination of muni tax exemption as highly unlikely.

Other proposals center on capping the tax exemption at 28%. The odds of such an outcome are anyone’s guess.

Importantly, however, our analysis suggests that any market correction to overcome a 28% cap on the tax exemption, or a drop in the highest tax rate from 43.4% to 33% for that matter, would be manageable. By our estimates, the market might need to offer some 15 basis points (front end) to 50 basis points (long end) in higher yield to compensate for the reduced tax benefit. See the chart above. The market has digested adjustments of this magnitude in the past without a material change to the overall demand dynamic.

Corporate tax reform as an offset

Notably, corporate tax reform could be an important offset to any or all of the above. Current law allows companies to deduct interest payments on bond income. Under reform proposals, that benefit may be repealed to compensate for lower corporate tax rates. This could conceivably lead to lower corporate bond issuance. Munis, in turn, would become a greater source of supply for income-seeking investors. The associated uptick in demand would mute the effect of other tax changes.

There’s another wrinkle, however: The impact of corporate tax reform could vary for banks and insurance companies (relatively large holders of munis) depending on where corporate rates settle and what happens to the Alternative Minimum Tax, or AMT. This could have a negative impact on their need for municipal bonds.

Ultimately, “tax reform” is a series of potential scenarios featuring many variables and offsetting factors. Which reforms are implemented and to what degree will determine the extent of the market impact. Uncertainty is perhaps the only certainty. But this we can say with enough confidence: Munis will retain some tax-exempt benefit—and there will always be an appetite for that very unique feature in an investment asset.

Peter Hayes, Managing Director, is head of BlackRock’s Municipal Bonds Group and a regular contributor to The Blog.

In today’s environment, consistent investment performance and low fees are critical to achieving your fixed income investing goals. Click here to learn more.

 

Investment involves risk including possible loss of principal. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2017, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Leaning Against the Wind

Wind

There has been a great deal of excitement in the markets since the US elections late last fall, but in my experience, changes in presidential administrations have never extended or accelerated an aging business cycle. As the current expansion nears its eighth birthday, it’s important to note that the average business cycle lasts five years and the longest cycle in history lasted 10. Global growth has accelerated modestly in recent months, but we’re seeing few signs that this upturn is anything more than a momentary uptick in a cycle replete with fits and starts. Here in the United States, we see faltering real income growth, eroding profit margins and soft signals from some forward economic indicators. Against this backdrop, I feel it is important for investors to think about the importance of conserving principal should the cycle come to an abrupt end.

Do we think the nearly eight-year rise in equity prices and valuations is justified? Most decidedly, yes. Since March 2009, the S&P 500 Index has had a total return of approximately 250%, driven by two primary factors: First, super-easy global monetary policy in the wake of the banking crisis, which drove down returns on safe assets to the point where risky assets became a much more compelling proposition than is typical. Second, expanding profit margins — margins have been running 80%–90% higher during this cycle than their long-term average — and improving cash flows

However, both these pillars are starting to erode. Central banks are becoming less accommodative. The US Federal Reserve is in the midst of a tightening cycle, and pressure is building on the European Central Bank and others to taper their quantitative easing programs. Profit margins are eroding too as the pushback against globalization prompts multinational firms to cut back on their use of cheap overseas labor. Furthermore, higher costs of capital are being felt as interest rates rise. While weak capital expenditures have kept profit margins robust, they also reduce future productivity growth. Once rock-solid corporate balance sheets have weakened of late as debt as a percentage of assets and debt as a multiple of available cash flow have both risen to levels last seen before the peak of the US housing cycle in 2007. These factors call into question the ability of companies to increase profits enough to justify today’s lofty valuations.

While there could be more stock gains ahead, an investor’s entry point has a significant influence on subsequent returns. Entering the market at today’s S&P 500 price/earnings multiple of 21 times previous 12-month earnings gives investors little cushion should the present market ebullience fade, especially when one considers that the 40-year average P/E multiple is closer to 16 times. Small-cap and value stocks are even pricier, approaching all-time-high price/earnings multiples. History suggests that subsequent returns have been weak when shares are purchased at higher-than-average multiples. Further, since the end of World War II, the average price decline from the stock market’s peak during a recession is 24%, according to Ned Davis Research, and is sometimes much worse. For example, during the global financial crisis, the S&P 500 declined nearly 57% before bottoming in March 2009.

As noted at the outset, the market began to rally this fall as the global economic outlook brightened, and the rally intensified with the election of a new president who promised a reflationary policy mix of tax cuts, infrastructure spending and regulatory reforms. Among my greatest concerns is that the market is now priced for perfection and is ignoring myriad risks while embracing the reflation narrative. President Trump’s agenda faces the reality that Washington moves slowly in the best of times and not at all in the worst. Even once legislation is passed, it can take months or years to launch infrastructure projects — given extensive permitting and environmental processes — which dilutes their stimulatory economic effects. With congressional elections every two years, the new president, realistically, only has about an eighteen-month legislative window to get his top priorities enacted before representatives begin focusing on their reelection campaigns, bogging the system down further. Markets seem to be working under the assumption that significant economic stimulus will be felt this year. I think it will be later and smaller than the markets have priced in.

Lastly, predicting the demise of business cycles is tricky, but here are the warning signs I look for, and all are now evident to varying degrees:

  1. Decaying profit margins and profit share of GDP
  2. A marked increase in mergers and acquisitions
  3. A rise in interest rates
  4. A strong US dollar
  5. A “story” that justifies extending the market’s advance despite deteriorating fundamentals
  6. A lack of private sector investment
  7. A significant increase in corporate and consumer credit

While I can’t predict whether the market will rise or fall in 2017, investors may want to focus on capital preservation given current historically high valuations. Hard-won gains have been achieved during this extraordinary cycle, but further near-term gains may prove hard to come by.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

Volatility Divergence

Big fishing reels on a boat in the ocean. These reels are used to catch big game fish such as Mahi-mahi, dorado, tuna, sailfish, swordfish sharks and marlin. They are used in tropical and cold water oceans.

Back before the holidays I highlighted what I thought was an unsustainable trend: low equity market volatility. Since then, U.S. equity market volatility has continued to decline; last week, the VIX Index—a commonly used measure of equity volatility—dropped below 11, the lowest level since the summer of 2014, before the U.S. travel ban-related selloffs sent the index climbing earlier this week to near 13. Still, the VIX is very low by historical standards, and this is occurring against a backdrop of considerable political uncertainty. What is causing this and can it continue?

Equity investors are enjoying an unusually tranquil start to the year, particularly in contrast to last January. Benign credit markets and a more robust economy deserve much of the credit. As I’ve written about in the past, equity markets rarely struggle when credit conditions are benign. This is why high yield spreads explain approximately 60% of the variation in the VIX. Back in late October high yield spreads were already low, at around 470 basis points (bps). Since then they’ve moved even lower, falling below 400 bps for the first time since the summer of 2014. As tighter spreads indicate more confidence, one would expect volatility to fall, albeit not quite to these levels.

The second factor driving volatility is economic growth, or more accurately, expectations for growth. This time last year investors were worried about another recession. Today they are raising their estimates for growth. Since the election, 2017 U.S. consensus growth estimates have increased by 0.2%. Most leading indicators suggest that despite political uncertainty, both U.S. and global growth are firming. Historically, expectations for accelerating growth generally coincide with lower volatility.

What’s the catch?

Investors outside of the U.S. equity market are not quite as sanguine. Currency traders, for example, are experiencing more volatility. The CVIX, which measures currency volatility, remains in the middle of its six-month range and approximately 10% above the autumn low. Treasury volatility, measured by the MOVE Index, displays a similar pattern and is roughly 25% above the October bottom (see the accompanying chart).

Volatility Markets

A similar dynamic is visible in non-U.S. equity markets where volatility is low but starting to rise. The European equivalent of the VIX, the VSTOXX, has bounced in recent days. While still very low, the index is up more than 15% from the January bottom. Having spent most of last week in Europe, I can report that investors there are more and more nervous, both about U.S. politics and increasingly their own. With pivotal elections scheduled in Germany, France, the Netherlands and possibly Italy, Europe has the potential to once again be a source of anxiety.

Back in the U.S., despite protests and rising uncertainty, optimism over tax cuts and deregulation are offsetting concerns regarding trade and immigration at the moment. This may continue to work, assuming Washington delivers on the aforementioned stimulus and reform. In the absence of that, today’s low volatility looks odd in the context of an increasingly uncertain backdrop.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.