Every time the stock market falls 3% or 4%, investors start to act like we’re staring at an oncoming locomotive. Though, each train has been the sort from Mr. Toad’s Wild Ride–not really a train at all, just bright lights and sounds meant to scare us.
The S&P 500 index marked another all-time-high on September 19. It has since declined, falling as low as 1,820.66, some 9.8% lower. Back in September, the vast majority of market participants focused on a robust U.S. economy, earnings growth, and the hope for the continued steady ascent of stock prices. By mid-October, just four weeks later, investors began to fret about global economic weakness, the end of quantitative easing in the U.S. and its possible negative impact, Ebola, and international hostilities. Nothing of relevance had changed, only perceptions. The U.S. equity market is still priced to deliver low long-term returns and yet the near-term backdrop for higher equity prices remains in place.
Broad market valuations are stretched. We’ve talked about this ad nauseum. P/E multiples may not appear particularly rich, but that’s because earnings per share (the denominator in the P/E ratio) tells you little about its underlying composition. Corporate pre-tax, pre-interest (operating) margins are currently above-average due to underemployment, wage stagnation, and operational efficiencies gained in and after the last recession. Operating margins are vulnerable to both competition and business cycle-induced pressures and therefore both above-average and below-average readings should be normalized over a period of years. If operating margins were to revert to their historical average while interest costs and tax rates remained constant, the trailing P/E multiple of the S&P 500 would be over 20 times.
Corporate interest costs and tax rates are at or near their respective historical lows, bolstering profits even further. When you combine high operating margins, record-low corporate interest costs, and near-record-low tax rates you get record net profit margins and earnings per share. The sustainability of net profit margins then, and therefore the implied normalized valuation of broad equity markets, is to be critically considered. For now though, investors can probably get away with neglect and ignorance because the economic landscape remains favorable and the underlying composition of earnings per share isn’t likely to change for some time.
Housing construction continues to improve and would have to rise another 50% to reach historical levels of annual production. Auto sales have rebounded and continue to post solid growth. Employment trends are encouraging. Inflation is low. Monetary policy is loose and will remain fairly accommodative for another couple of years. Energy costs have declined. And importantly, there aren’t yet any notable excesses (outside of certain financial markets) that have accompanied prior economic and market inflection points.
Our overarching investment thesis remains intact: the next two to three years should be favorable for both earnings and stock prices while the long-term expectation for equity indices is a low-to-mid-single-digit average annual return at best.
As the U.S. economic expansion continues, pre-tax, pre-interest margins should remain fairly robust and might actually expand further. With inflation subdued, the Fed can maintain low interest rates for at least another couple of years, likely more, keeping corporate interest costs down. Net profit margins therefore aren’t likely to fall until the next recession, which, by various metrics, still appears two to three years away. Longer-term, pre-tax, pre-interest margins will likely mean revert while interest rates (and therefore interest costs) will rise. This will materially slow earnings growth for the latter part of the decade. This is why the near-term outlook looks bright but the long-term return expectation is subdued.
The above is an exercise in logic that assists us in executing our strategy. Having an understanding of the broad market and the macroeconomic backdrop allows us to invest with an additional layer of knowledge–and therefore conviction–and importantly, to know when not to invest.
Our long-term expectation for broad market returns is not to be confused with our expectation for our strategy’s expected return. We own 17 world-class companies whose businesses and stock prices aren’t bound by the same constraints of stock indices, index investors, or excessively diversified holders of equities.
What about market volatility then? So long as the macroeconomic picture is favorable and suitable investment options are available, volatility is to be expected, tolerated, and capitalized upon. Market volatility is the friend of the patient, creating opportunities.
For instance, the market recently declined about 10% and allowed us to add a new position in a fantastic business whose stock was down 40% off its high.
As reminder, our strategy does not attempt to bypass normal market volatility such as we’ve experienced. When there is little evidence of a business cycle inflection point there simply isn’t a good probabilistic way to sidestep a possible decline in stock prices. Attempts to time markets based on price movements, headlines, and hunches inevitably lead to unnecessary taxes, higher trading costs, and most often, losses on capital deployed. Such speculation isn’t inherently evil, but market timing is best left to the gambler–not an investor.
Since inception, our net-of-fee performance has outperformed the Russell 1000 Value by nearly 1.0% per year and “value” mutual funds by nearly 3.0% per year.
Black Cypress Long-Only and Black Cypress Opportunistic are both up 7.1%, net-of-fees, year-to-date; Black Cypress Long/Short is up 7.3%, net-of-fees, year-to-date.