If Inflation Is Fizzling Out, Can Profits Be Far Behind?

For decades, experts at the US Federal Reserve, academic economists and portfolio managers have been at war with inflation — the phenomenon of price increases without commensurate productivity gains. Investors and policymakers alike hate inflation because it robs consumers of buying power and discourages money flows into long-term investments for fear that their value will be eroded. The remedy for inflation in past cycles has been for central banks to raise interest rates in order to cool off growth and end speculative investing, thus curbing broad-based consumer price increases. Usually inflation flare-ups occur a couple of years into a cycle, or at mid-cycle at the latest.

This time, the cycle is getting old — very old — but inflation remains surprisingly tame, running well behind previous US cycles. Meanwhile, similar patterns are playing out globally. Chinese inflation is slowing. The eurozone, despite growth that has exceeded expectations, has seen disappointing inflation data of late. Japan is a similar story. Even the UK— which has seen a post-Brexit-vote inflation spike on the back of a weak pound — has witnessed a downtick in prices, according to recent data.

Pricing power and inflation linked

Inflation is inextricably linked to companies’ pricing power. And in the late stages of a cycle, it is usually the ability to raise prices that drives revenues up against a base of fixed costs, expanding profit margins. But inflation remains well contained in much of the developed world, limiting companies’ ability to raise prices.

This time around, the lack of inflation may mean trouble for a market that is more expensive than 90% of previous market periods. As the old saying goes, it is priced for perfection. But already we’ve seen that June US retail sales have disappointed, that car sales and prices are weak and that apartment rents have started to flatten out. This lack of pricing power could negatively impact future sales growth, and could become an increasing discomfort for a market that has known only quarter after quarter of rising stock prices.

Global Equity

One of two problems

In my view, the market faces one of two problems going forward:

  1. Historically, inflation and corporate borrowing rise during the late stages of a business cycle. This levers up returns to shareholders — for a while. But at some point, usually before the economic data roll over, the market loses upward momentum and share prices fall because of a deadly combination of tighter monetary policy, decreased investment and flagging profits. If companies lever up, the cycle typically follows its normal course toward decay and recession, since companies usually increase leverage at precisely the wrong time. And history tells us that risky assets like stocks and high-yield corporate bonds tend to fare very poorly during economic downturns. In fact, the typical decline in the S&P 500 Index during a recession is 26%. That’s a serious hit to anyone’s nest egg.
  2. However, this cycle looks atypical, given the lack of late-cycle inflation pressures. So if subdued inflation continues to retard pricing power and profit growth, then most companies likely won’t live up to earnings expectations, and stock prices could suffer as a result.

Miracle solution?

Is there a solution to the above two problems? Perhaps inflation comes back, pricing power returns and central banks don’t choke off the moderate global economic expansion now underway. But that’s an outcome I’ve not witnessed during my entire career. Alternatively, we could assume that things really have changed and that the business cycle can extend indefinitely. Or that the US Congress will cut taxes enough to spur a resurgence in economic growth.

However, I’m not buying the notion that business cycles are a thing of the past. Nor am I buying that politicians can make much of a difference. Since I’m not expecting any miracles, I’d rather focus on preserving the huge market gains — on the order of 300% — made since the market low in 2009.

For investors and business cycles, age matters

For investors, age is essential in determining how much risk one can assume. For business cycles, one can say the same. The average business cycle lasts five years, and the cycle we are in today is eight years old. The longest cycle on record is 10 years, so history suggests we’re getting late in the game. The later we get, the more the risks of the cycle coming to an end rise. This is especially important given the aging of the global population. Investors, on average, need to take less risk today than they did a decade ago, and should be particularly mindful of the potential for the cycle to end at any time.

Against a backdrop of aging global demographics, slow economic growth and record-high debt levels, investors would be wise to exercise caution rather than taking risks at this late stage of the business cycle.

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

 

Past performance is no guarantee of future results.

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 to purchase any security or as a solicitation or investment advice from the Advisor.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

Into Thin Air

Flying in a helicopter over lake mead in Arizona. View is from behind with a view of lake mead near the grand canyon. Time of ay is sunset or sunrise with a beautiful view and blue sky. Copy space on right. Can be flipped.

Despite growing political risk and high valuations, the stock market—like the Energizer Bunny—keeps going and going, grinding upward. I believe that markets can still move higher, and there are good reasons for the ongoing rally—namely, strengthening global growth, and stronger widespread earnings. Still, most traditional valuation ratios indicate that stocks are expensive (particularly in the U.S.) and future returns are likely to be muted.

So where does that leave us going forward? History does provide some interesting insights about how markets perform in the periods when U.S. stocks are expensive—and how investors can think about ways to position their portfolios.

To begin, how expensive are stocks in the U.S.? The current Shiller cyclically adjusted price to earnings (P/E) ratio of the S&P 500 is over 29, well above its long-term average of around 17. But to put that number in perspective, the same measure was in the 40s during the dotcom bubble and has exceeded 30 less than 4% of its entire history going back to 1881. Other valuation metrics tell a similar story: Stocks are expensive, although it is not clear that they are yet in bubble territory. The lights are arguably flashing yellow, but certainly not red. It is also worth remembering that value is a poor short-term indicator of market performance.

Still, historically, when valuations have been at these levels, performance in the next few years has been significantly lower. When the cyclically adjusted P/E of the S&P 500 has been greater than 28, average annual returns over the next three years has only been 0.7%. In short, while the outlook for U.S. stocks is hardly bleak, investors should expect significantly lower returns over the next few years than what they have become accustomed to in recent years.

Having said that, there are areas of the market that have outperformed the S&P 500 in relatively expensive markets. Minimum volatility strategies, particularly dividend growers, and broader world allocation strategies all outperform the S&P 500 in periods when the cyclically adjusted P/E ratio exceeds 28.

High Valuation Performance

Since the end of the financial crisis and the beginning of the current bull market, the market environment has been unique. Significant easing by global central banks, historically low yields, sluggish economic growth, demographic factors—all have resulted in a market environment unlikely any seen in decades (if ever).

In short, no one can be sure how various asset classes will perform, if or when the current bull market loses steam. But it is unlikely the broader S&P 500 will continue to be the workhorse it has been in the recent past, and being more selective will be key going forward.

For example, strategies that look for growth with a broader mandate and that thoughtfully manage risk will play an important role. This is for several reasons: First, such strategies can build portfolios from the bottom up and therefore be very granular when gaining exposure to various markets (and avoid the more egregiously overvalued parts of the market.)

In addition, these strategies can shift between regions. Today, for example, emerging markets, Europe and Japan all look more reasonably priced than the U.S. All of these factors suggest a more effective approach toward navigating the current period of high valuations.

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. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

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 July 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.

Stocks and Bonds: Two Markets Telling Different Tales

Compass

In the months following the 2016 US presidential election, US stock and bond markets moved inversely, both anticipating a pickup in economic growth. Equities rose smartly while bond prices fell, pushing yields higher, anticipating that faster growth would eventually lead to an uptick in inflation. But in the last few months, the stock and bond markets have begun to tell very different tales. Stocks have moved up unblinkingly, and bond prices have moved up as well, driving yields lower. The bond market is telling a story of lower growth and lower inflation ahead. But no one’s told this slowdown story to the stock market. It assumes nothing has changed.

The reflationary expectations that helped set stocks alight and send interest rates higher last fall have subsided significantly. In particular, hopes for a stimulative policy mix from Washington have faded as Congress and the White House find themselves sidetracked by scandals. Despite those waning hopes, equity markets have extended their advance, setting multiple record highs along the way. However, US 10-year Treasury note yields have fallen roughly a half-percentage point from their post-election highs. Why are markets telling two different tales? Let’s try and figure out which one is right.

Market’s narrow focus a worry

While I mainly focus on fundamentals like earnings growth and free cash flow generation, at times I find it useful to also take a look at technical factors. And the technical that jumps out most clearly to me at the moment is the narrow breadth in recent months of the market’s latest rally. That advance has been largely fueled by a handful of glamorous, well-known, mega-capitalization technology companies. Indeed, a recent sell-side analysis shows that nearly 40% of this year’s gain in the S&P 500 Index can be linked to just four stocks. Narrow advances have historically tended to be a warning sign. Looking back at similar periods in history, we see periods where, when just a few names led the market, outcomes tended to be less favorable than when market breadth was broad, such as earlier in this business cycle, when many stocks in the major averages were supported by record levels of free cash flow. As a technical matter, bad breadth is a cautionary sign.

Bond bull still breathing?

Long-term interest rates have been trending lower for more than three decades, but somewhat of a cottage industry has developed around predicting the bull market’s demise. And those calls reached a crescendo shortly after the election, predicated on inflation’s return, fueled by a synchronized upturn in global economic growth, low levels of unemployment and a stimulative policy mix from Washington. But markets have reassessed that call in recent weeks, sending Treasury yields lower on the back of dimming prospects for tax cuts and infrastructure spending, sluggish US growth and few signs that tight labor markets are leading to above-trend wage gains. In essence, the bond market may be trying to tell us that slower growth lies ahead.

So which market is right? While it is far too early to forecast that a recession lies ahead, forward indicators suggest we may see a mini down cycle in the not-too-distant future, not dissimilar to the three or four dips we’ve seen within the present eight-year expansion. To me, this suggests investors may want to be cautious in putting new money to work in “risky” assets such as equities and high-yield bonds.

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

 

Past performance is no guarantee of future results.

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 to purchase any security or as a solicitation or investment advice from the Advisor.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

What’s Behind the Tech Selloff

A stack of table and chairs in a pale blue room

On the surface things appear calm. The S&P 500 remains within 1% of its all-time high and volatility is still barely half the long-term average. However, under the surface things may be starting to churn.

Since last Friday tech stocks have been sold hard, with few obvious catalysts. For example, at the lows on Monday Netflix (NFLX) was down over 10% and Apple (AAPL) off 8%. What is going on?

1. An abrupt reversal of this year’s momentum trade.

In a throwback to the late 1990s, tech has once again become a momentum play. The reversal in tech is part of a broader reversal in momentum stocks, a style in which tech features prominently. Using the MSCI USA Momentum Index as a reference point, it is instructive that Microsoft (MSFT) is the biggest name, with a 5% weight. At the industry level, semiconductors, software and computers represent three of the top four industries.

2. Multiples are much higher.

Bulls can rightly point out that tech valuations pale in comparison to the surreal levels of the late ’90s. Still, multiples have been rising fast. The trailing price-to-earnings (P/E) for the S&P 500 tech sector is up over 35% from last year’s low. At nearly 25x trailing earnings, the sector is the most expensive it has been since the aftermath of the financial crisis, when earnings were depressed. On a price-to-book (P/B) basis, valuations are even more extended. Large cap U.S. technology companies are trading at the highest level since late 2007.

3. The surge in growth has made the entire style expensive.

The surge and recent drop in technology needs to be viewed through a prism, which is: As investors have reconsidered the “Trump trade,” they have reverted to two investment themes–yield and growth. This has left U.S. growth stocks very expensive compared to value stocks. While tech valuations may not be in bubble territory, the ratio of value to growth multiples is starting to bear an eerie resemblance to the late 1990s. As of the end of May, the ratio—based on P/B—was just below 0.33. This is roughly 1.5 standard deviations below average and close to the all-time low of 0.31 reached in February of 2000, right before the tech bubble burst.

Growth vs Value

In some ways, the recent selloff resembles the “quant crash” of 2007. Similar to today, levered funds were seeking to juice returns in a low volatility world while crowding into momentum names. Whether the current disruption is eventually viewed as the first crack in the edifice, as was the case in ’07, or just a temporarily blip in a long-running bull market, remains to be seen. What is clear is that the narrow pursuit of a few story stocks has left the market more fragile than top-line indicators would suggest.

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.

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 June 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.

Thoughts on U.S. Market Valuations

Dividend Payout Ratio

At the Chartered Financial Analyst (CFA) Institute Annual Conference in Philadelphia last month, there were a number of conversations with dour outlooks for the future of U.S. equity markets. The center stage of the conference featured a debate between Yale Professor Robert Shiller, designer of the CAPE (cyclically adjust price-to-earnings) ratio, versus my mentor, Professor Jeremy Siegel.

Shiller has a more subdued outlook for future returns than Siegel, who is a bit more optimistic. Jack Bogle also presented at the conference and suggested we’ve seen strong gains in the markets over the last 35 years that resulted from valuation expansion, and hence also had a more subdued outlook. Bogle’s model was fairly simple: take the 2% dividend yield on the market today, add in his personal estimates of 4% earnings growth, and subtract 2% from speculative market activity or his anticipation of a decline in valuation ratios over the coming decade, and you come up with an outlook for 4% returns over the coming decade. If we assume there is 2% inflation, this would lead to just a 2% real return after inflation. Note that this is largely similar to Shiller’s outlook for returns.

One chart that I think is not talked about enough in the context of valuation changes on the market is the dividend payout ratio of the market. I show a smoothed 10-year average dividend payout ratio in the spirit of Shiller’s 10-year smoothed earnings for the CAPE ratio. Prior to 2000, the dividend payout ratio averaged 60%. Since 2000, the dividend payout ratio has averaged 40%. This change in the nature of how firms reinvest their earnings, conduct stock buybacks, and pay dividends is absolutely critical to the future earnings growth we are likely to get.

CAPE EPS Growth Rate

Those who assume that earnings growth rates will revert to some historical average growth rate when firms paid out 60% of their earnings as dividends are assuming that all this money not being paid out—used for either buybacks or other reinvestment in business—is being completely wasted. That is an incorrect assumption, in my view.

This chart looks at the rolling 10-year and 20-year earnings growth rates of the CAPE earnings per share (EPS) that Bob Shiller uses to make his dour forecasts on the market. If these numbers were to “mean revert,” that would be a cautionary tale for the markets. But in my view, the earlier declining dividend payout ratio means we are likely to see upside changes to these earnings figures. What is possible?

Changing dividend payout ratios have already translated to better earnings growth. Prior to 1982, the average dividend yield on the U.S. equity market was approximately 5% per Shiller’s data, and we had an average dividend payout rate of nearly two-thirds of earnings paid out as dividends. With only a third of earnings reinvested, firms were still able to achieve earnings growth of 3.3% per year.

Shiller Data

Since 1982, payout ratios declined to an average of 51.1%, while at the same time firms started conducting stock buybacks. The average EPS growth during this period of reducing dividend payout ratios was an increase of 160 basis points (bps) per year, from the previous long-term average of 3.3% per year to 4.9% per year.

When we look at the last 20 years, and particularly the last seven, we see consistent signs of 2% dividend yields with 2% net buyback ratios. These net buybacks are going to continue to support earnings growth for the 10-year look-ahead period. These firms have locked in future EPS growth because they reduced their shares outstanding.

Returning to the table above, where I showed the earnings growth since 1982 as being higher than the previous 110 years, the current dividend payout ratios are consistent with an even further drop in the payout ratios from their average since 1982. I can see a case that earnings growth picks up even from that 4.9%-per-year mark that we had for the period 1982–2016. It would not surprise me to see earnings growth of 6% to 7% per year over the next decade.

Dividends Buybacks

The standard pushback is that firms are just leveraging up to conduct buybacks—that interest rates are at historical lows, leading to higher margins than are sustainable. The reverse case is that the changing composition of companies—into higher-margin businesses that have more revenue abroad with lower tax rates than in the U.S.—also means margins may not be mean reverting anytime soon either. Of course, no one knows how the future will unfold, including me.

The charts above caution anyone relying on historical patterns of earnings growth trends from overextrapolating them into the future. Professor Siegel looks at the current earnings yield of the market associated with a 20 price/earnings ratio and thinks 5% is a pretty good indicator of long-term, after-inflation real returns. Add in inflation of 2% and you get 7% nominal returns. This is a touch below their historical 6.5% to 7% that he showed in Stocks for the Long Run as being the historical return to U.S. equities, but it is not dramatically different. I think his model for looking at the markets makes more sense than some of these more dour predictions—for what that’s worth.

Jeremy Schwartz is the Director of Research at WisdomTree Investments.

 

Important Risks Related to this Article

Dividends are not guaranteed, and a company currently paying dividends may cease paying dividends at any time.

Two Reasons to Skip the Market’s Joy Ride

Finance

There are two primary reasons to be cautious about investing fresh capital in today’s richly valued US equity markets, in my view. The first reason is shaky pricing power — or top line growth — for companies in the S&P 500 Index. The second is the low level of investment that large companies are making in their collective futures.

Typically, when you get beyond the midpoint in a business cycle, pricing power improves as inflation kicks in. Revenues grow quickly, outpacing cost increases. In previous cycles, once inflation took hold, publicly traded company revenues grew faster than the US economy. However, fully eight years into this cycle, S&P 500 Index revenues have struggled to keep pace with the economy as a whole, with many industries struggling to raise prices. Recent price cuts in the telecom and auto industries have underscored this point.

There’s a notion that inflation is indeed on its way back and that energy prices, rents and wages will begin to rise. Top line inflation has been rising in the United States and abroad, but it hasn’t occurred as quickly or as dramatically as forecasters thought. One reason inflation is being held back is the departure of much of the leading edge of the baby boom generation from the workforce. Workers in this demographic are often among the highest paid workers in the labor force, and they are being replaced by younger, lower-paid workers, suppressing wage inflation.

Another factor suppressing inflation is new oil drilling technologies. Oil prices are a big determinant of inflation in the developed world. And while there is growing demand for energy, ever-lower production costs, combined with ample US reserves, are creating a virtual ceiling on prices.

Rent (or its equivalent) is a big part of the government’s inflation calculations, accounting for upwards of 30% of the consumer price index. Earlier in this cycle, there was underbuilding of housing units in the United States in response to the excesses of the last cycle. But years have passed, the population has grown and there has finally been a supply response. Large amounts of new square footage have been built — and continue to be built — in many US cities, resulting in slowing rent hikes.

Back to the future?

In addition to weak pricing power and some disappointment that Washington has been slow to roll out promised reforms, there is yet another problem investors must contend with: a lack of investment in the future. This cycle has been noted for historically weak spending on property, plant and equipment. And capital expenditures in the private sector have traditionally been closely related to future growth, specifically in jobs, profits and return on assets. No one is sure why spending on long-lived assets has been so weak, but given the rise in profits in recent years, we should have expected better spending. If this cycle is going to be prolonged, it cannot be done on consumption alone. In my view, there needs to be a commitment to factories, machines, computers and software to prolong the cycle. However, at present, there is no apparent catalyst to higher spending on long term assets, assets that in turn would lift declining US productivity.

I’d accept the current narrative of further gains ahead if I could see the route to better profits through strong pricing increases and committed spending on future growth, but I don’t see that route. So far, first quarter 2017 profits look good in both the United States and in Europe, but will this run of good numbers be sustained without improved pricing power or additional capex as the year wears on? Lots of earnings growth will be required in the remaining three quarters of 2017 to make the current market price/earnings ratio seem reasonable. Consequently, I remain cautious with new monies.

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

 

Past performance is no guarantee of future results.

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 to purchase any security or as a solicitation or investment advice from the Advisor.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

Reflation Moderation

digital image

Back in late 2016 it seemed terribly simple. Growth and inflation would rise on the back of U.S. fiscal stimulus. Investors would buy cyclical companies, particularly U.S. small caps, and sell bonds. Four months later, the reflation trade, while not quite dead, seems less a sure thing.

Cyclical commodities that soared in late 2016 have struggled this year. Commodities, the U.S. dollar and Japanese stocks are some of the worst performers year-to-date (see the chart below). At the same time those assets that faded as investors embraced reflation have rallied, including gold, emerging markets and the Japanese yen. Even low yielding European bonds have found a bid. What happened?

Markets got ahead of themselves

YTD Asset Performance

Many asset classes rallied as if a fundamental shift in the growth/inflation paradigm was a foregone conclusion. Investors assumed Washington would effortlessly churn out an assortment of pro-growth measures: tax reform, fiscal spending and deregulation. When the reality proved much harder, disappointment set in. Trades that were predicated on faster U.S. growth, such as a stronger U.S. dollar, have fallen the most. After surging more than 10% to a multiyear high, the dollar has retraced nearly half of the move and is back to mid-November levels.

Real economic data have not kept up with “soft data”

By now most have noticed the divergence between the “hard” data, which measures actual economic activity, and the “soft data,” which mostly tracks surveys. While measures of positive economic surprises have risen sharply, most of the improvement is from soft data. Job creation, wage growth, hours worked, retail sales and core inflation have all decelerated. Although the economy appears solid, evidence of a pickup remains elusive.

Many asset classes were stretched even before the rally

The rally in risky assets was only the latest in a bull market now comfortably into its ninth year. Many asset classes, notably U.S. equities, have benefited from years of rising valuations. Large cap U.S. stocks were already trading at 20x trailing earnings in July of 2016. The subsequent rally pushed the multiple up towards nearly 22x, a seven-year high.   With the air coming out of the reflation trade, what should investors expect next? The good news is there is little evidence of a pending recession. The economy, both domestically and globally, is solid with less deflation risk than a year ago. That said, investors will want to consider a more balanced portfolio, one that includes assets that offer income, from both equity and credit, equities tied to secular growth themes and even a bit of U.S. duration and gold. Markets are a bit less frothy than they were in January, but valuations are still elevated and volatility unusually low. And as we’ve seen, it is not as if the risks in the world have gone away.

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.

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 April 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.

Why Value Is Still a Value

Cheap, Piggy Bank, Recession.; Shutterstock ID 285751541

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.

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.