2015 was a lackluster year for the equity markets as the reversal of six years of unprecedented Federal Reserve monetary stimulus shifted from the elimination of Quantitative Easing “QE” to ending its Zero Interest Rate Policy “ZIRP”. Since the global financial crisis of 2007-9, the Federal Reserve’s stimulus stopped a financial meltdown and spurred a wealth effect through QE, where the Federal Reserve purchased of over $3.5 trillion worth of bonds, and ZIRP, where the Federal Funds rate was held near zero for seven years. These actions drove asset prices higher to levels that are overvalued.
With the removal of the monetary support programs and a market that is richly priced by most valuation measures, three scary news stories, in the first week of the year, jarred the markets with nearly an 8% decline in the S&P 500. The news reports of North Korea announcing the successful test of a hydrogen bomb, Saudi Arabia severing diplomatic ties with Iran, and China’s stock market collapsing again, on fears of major economic slowdown, gave markets a bitter taste of what life without an accommodative Federal Reserve feels like. Oil, which has been in a year and a half long 70% decline, fed fears of a global slowdown while adding selling pressure to equity markets with wobbly underpinnings.
With the S&P 500 off nearly 8% in the first two weeks of the year, the question of how to make money or not to lose money is the goal of this note. Valuations remain pricey based on the Shiller Cyclically Adjusted Price Earnings Ratio of 24 versus 16.66 average over the last 135 years. By this measure, markets could see 30% downside risk. However, interest rates are at historically low levels, with negative interest in Europe, which justify high valuations levels since there are no safe attractive alternative investments to be found. Based upon the so called “Fed Model”, where the S&P 500 is compared to the ten year Treasury, equity markets are attractively priced.
The two conflicted valuation methodologies are pictured below:
Shiller’s Cyclically Adjusted Price Earnings Ratio or “CAPE”, above, reflects a price earnings multiple for the S&P 500 over a 10 year period whose long duration seeks to minimize economic cycle volatility. Its current value of 24 is almost 30% over its average of the last 135 years.
By contrast, below is the “Fed Model” which measures the “Risk Premium” in the market by comparing the “earnings yield” of the S&P 500 (2016 earnings/S&P 500 price) = 6.19% to the ten year Treasury yield = 2.03%. Since stocks yield 4% more than bonds, you are well paid to take the risk of owning stocks versus bonds. However, if earnings do turn down and we enter a recession like that experienced in 2007-9 or 2000-2003, the market will be at risk to downside on the order of that defined by the CAPE analysis.
These graphics illustrate that earning stability is critical to keeping the market downside limited. Since the news flow has repeatedly raised the specter of a broad based economic slowdown, it is no wonder that the market has reacted in such a distinctly bearish manner year to date. It is our opinion that the S&P 500 peaked around April 2015, when discussions of ending ZIRP became the central focus of Federal Reserve policy commentary. Unlike 2000-2003, when the markets were vastly overvalued and the tech bubble burst, or 2007-2009 when the financial system witnessed multiple major financial institution bankruptcies and potential failures, we believe this market is in the midst of a traditional bear market cycle where downside risk from the market peak is 15-30% and where we have already seen a nearly 12% decline from highs in May 2015.
If the economy does turn down into a recession, then the risk is higher, but that is not our forecast. At this point we expect continued tepid economic growth around 2%. This growth should drive modest earnings growth in the S&P 500 which, with its 2% dividend yield, will allow for the stock market to grow its way back to a normal valuation level over the next few years as interest rates also normalize.
We are buying market dips, like this current one, when sentiment indicators are at unusually pessimistic levels. We like a couple investment strategies, for times like this, when sentiment is bad and the markets have experienced a pullback like the present one:
• We continue to like closed end funds at large discounts to net asset value.
• We continue to buy certain key technology stocks, on pullbacks, which offer a growth at a reasonable price profile and durable high growth businesses or franchises, like Apple Inc., Facebook Inc., and Alphabet Inc. formerly “Google”.
• On rallies we like buying AQR mutual funds managed by one of the quantitative greats, Cliff Asness. Their return profile has been positive in a difficult market and offer positive alpha with little market correlation.
o We will add to SJB–the ProShares Short High Yield ETF, since we believe that an awful lot of high yield bonds have been placed in ETFs and are not well structured to endure either a backup in interest rates or an economic slowdown.
• And finally, over the next two years, well positioned energy investments should be up multiples as we recover from this fierce bear market in energy. On the MLP side, we favor higher quality names like Magellan Midstream Partners, LP (MMP) and Enterprise Products Partners, LP (EPD) for more conservative investors. When oil finally bottoms, which might be this precise moment–with the Iranian sanctions being lifted–more aggressive MLPs including American Midstream Partners, LP, MPLX, LP, EQT Midstream Partners, LP and EQT GP Holdings, LP could provide significant upside, though carry a higher risk profile than MMP and EPD. General Partners of MLPs should also outperform as they had when the sector was growing, due to their less defensive asset portfolios than that of their LP children.
While we have been concerned for some time about market valuations and the Federal Reserve reversing its policy of unprecedented accommodation, we do not see this early year rout as the beginning of a major decline. In fact, we would buy this dip, and other pullbacks later this year, for trading bounces. We would sell rallies, add defensive funds and inverse ETFs when the sentiment returns to calm levels.
Our investment resolve comes from the belief that the Federal Reserve is petrified that if it allows the capital markets to implode, after the last six years of unprecedented accommodation, it would be viewed as incompetent. Consequently, if needed, the Federal Reserve will jaw bone the markets and return to accommodation should risks warrant providing additional support. Tactically, one can buy dips and sell rallies, while maintaining a more conservative profile for the rest of the year and generate a decent risk adjusted return in a market that started off in a historically poor fashion.