Uncertainty defines the prevailing market sentiment. In the wake of the Nice, France terrorist attack, the attempted coup in Turkey, the British exit from the European Union, and the highly partisan and unpredictable presidential election, investors feel little reason to invest in an equity market that is expensive by traditional valuation metrics. This bull market cycle has been driven by unprecedented global central bank accommodation and fueled by stock buybacks. Were it not for ten trillion dollars’ worth of in foreign government bonds trading with negative interest rates, equity markets would certainly decline.
In a world of streaming news and continuous market commentary, it is wise to remember that you do not have to do anything. Frequent trading is most successfully executed by quantitative computer programs. Great investors have shown that investing is a business of patience where keeping ones powder dry and waiting for those rare opportunities and mispricing’s is how real wealth can be attained.
Given the historically low interest rate environment, two asset categories offer attractive investment opportunities: closed end funds (CEFs) and Master Limited Partnerships (MLPs). Closed end funds offer the ability to buy a portfolio of assets at a discount to net asset value (NAV). Buying stocks at 90 cents on the dollar is a mundane but compelling investment strategy that even Bill Gross uses in his “unconstrained bond fund”. We quantitatively sort for discounted CEFs with high yields and then sort for outstanding investment management, timely sector exposure and/or shrewd investment strategies. This process offers several thoughtful alternative to traditional income investments.
Master Limited Partnerships are energy utilities with tax advantages. MLPs benefit from owning pipelines and stable fee based assets with negligible commodity risk in normal commodity markets. In 2014-2016, crude oil experienced a three standard deviation bear market, where the generally stable businesses MLPs typically own came under great market stress as certain subsectors within the energy complex experienced severe financial pressure. Now, nearly six months following the nadir in oil prices, the energy sector is restructuring, bankruptcy risk is declining, and security prices are firming. While oil could experience a pullback, MLP yields are so high relative to historic yield spreads, they still make attractive investments as the sector recovers from an historic decline. We recommend investing in MLPs directly to capitalize from the corporate tax free status of the MLP structure. Sadly approximately $100 billion in MLP assets under management are trapped in MLP funds which then impose a corporate tax of approximately 30% that is easily avoided through direct MLP investment.
The Great Tug of War.
While valuations are high by historic standards (See below “Average of Four Valuation Indicators” courtesy of Advisorperspectives.com) the historically low interest rate environment provides a compelling counter argument to the valuation case against equities. The “Federal Reserve Model”, shown in the second chart below, shows the quantitative comparison between the earnings yield of the S&P 500 and the yield on the ten year US Treasury Note. Specifically, S&P 500 combined current and forward earnings divided by the S&P 500 price gives you an earnings yield of 5.61%. This earnings yield compares very favorably to the 1.56% yield of the ten year US Treasury Note.
What has been concerning has been the declining earnings for the S&P 500 for the last three quarters shown in the second chart. In the 2000-3 and 2007-9 major bear markets and their attendant recessions were clearly driven by earnings declines of 50%. Consequently, continued negative earnings could telegraph an unfolding recession and significant market risk. With the improving energy sector, earnings will begin to compare against easier comparisons and the energy earnings drag will turn to improving earnings momentum. This is probably why the market is hitting new highs in spite of a terrible news cycle. However, there is a second key macro factor which also is helping the stock market.
The Federal Reserve Model
Last year, at this time, expectations were for the Federal Reserve to raise interest rates and this led to a strong dollar. Since nearly half of S&P 500 corporate sales are international, a strong dollar hurts S&P 500 earnings. Consequently, earnings estimates last year, which were hurt by a strong dollar. Now reported earnings are going to compare against easier earnings as the negative currency impact begins to reverse. These two factors appear to be leading to a flattening and reversal in the earnings trend and a market rally could begin to unfold assuming all other factors remain the same.
While the news may be unsettling, there is no immediate reason to worry. We may have market pullbacks where adding to equity positions make sense. However, we can find attractive investments and build portfolios with 8% yields, which makes good sense for retired investors when there are so few attractive yield alternatives.
Sincerely,
Tyson Halsey, CFA