- Global growth expectations are tepid
- Interest rates are plumbing all-time lows
- Low interest rates are driving U.S. stocks higher
- Valuations are stretched
- Long-term future returns are expected to be low
- Investors still expect high returns
- Passive strategies are likely to disappoint
- The U.S. economic expansion should continue for at least another two years
- The U.S. bull market in stocks should continue
- Black Cypress portfolios are expected to rise further
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
Since our last commentary in January, U.S. stock markets have shrugged off a shallow industrial recession, slowing employment growth, “Brexit”, and a plethora of other negatives. The S&P 500 has risen over 15.0% since late January.
Negative expectations, positive market effects
Global economic growth is sluggish, to say the least, particularly abroad. That sluggishness, combined with negligible inflation, has helped drive interest rates worldwide to all-time lows. Government bond rates are negative in Germany, Switzerland, and Japan.
The low to negative rates in Europe and Japan are driving down interest costs in the United States. The 10-year U.S. Treasury bond yielded just 1.37% on July 8th, the lowest 10-year yield in the United States’ history. The Fed had hoped to raise rates a few times in 2016, but now even one rate hike is questionable.
And yet, U.S. stocks now rest at new all-time highs, despite a general lack of investor enthusiasm. Pessimism in worldwide growth, paradoxically, is helping drive the “safe-haven” U.S. equity market higher.
Today’s new highs are accompanied by rich valuations, which isn’t a recent phenomenon, as valuations have seemed lofty for quite some time. We, along with many other investors we read and respect, have held the belief that future long-term returns will be low. We’re a few percent away from valuation levels not seen since the tech bubble. The S&P 500 is trading for 20x trailing peak earnings, 19x forward earnings, and 27x Shiller earnings.
High valuations, in and of themselves, don’t portend an imminent market crash. In fact, we expect stocks to rise further while the U.S. economic expansion continues. However, high valuations have historically suggested lower future returns, a trend we expect to continue. Broad market U.S. indices, in our opinion, are priced to deliver somewhere between 3% and 5% per year over the coming decade. Fixed income securities will likely return even less than that. Government bonds probably won’t cover the rate of inflation. High-quality corporate debt should return less than 3.0% per year and junk bonds aren’t likely to deliver more than a mid-single-digit return.
Despite lofty valuations and all-time-low interest rates, most investors, even the “sophisticated” institutional kind, still expect average annual double digit returns from stocks and mid-single-digit returns from bonds over the next five to ten years. Most pensions and endowments, for example, continue to assume 8% annual returns in their planning, despite the fact that on average 40% of their portfolios are invested in fixed income securities.
With bonds, yield-to-maturity is a great proxy for future average returns. The Barclays U.S. Aggregate Bond Index, for instance, has a current yield-to-maturity of 1.88%. If 40% of a pension’s portfolio earns 1.88% per year, the other 60% of the portfolio has to earn over 12.0% per year to generate an average 8.0% return.
Buy-and-hold bond investors can forget about earning the historical average bond market return of 5.0% at today’s prices and yields. A bond trader might earn that, but bond holders mathematically can’t, because bonds have a set maturity date and are ultimately redeemed at par. The benefit of falling interest rates today, which translates into higher prices for bonds held, diminishes with the approach of maturity. Capturing the excess capital gain earned in bonds from declining interest rates requires liquidation before maturity. Otherwise an investor ends up earning the yield-to-maturity on the date of purchase. Passive investors will therefore earn at best the current yield-to-maturity.
And so stocks continue to be the best game in town. In 2006, an investor could purchase a 3-year Treasury bond and still earn 5.0% a year. Today, an investor would earn just 0.8% per year.
Interestingly, at a time when investors should be seeking genuinely active investment management for today’s risks of high valuations, low-expected returns, and a late-cycle economic expansion, they are instead turning to passive investing.
Passive vs. “active”
The investor exodus from active to passive strategies isn’t really a surprise. Investors often chase performance, and passive strategies have outperformed active strategies during this economic recovery. However, it is important to remember that passive funds, which track market indexes, will underperform their benchmark 100% of the time. A passive index fund that tracks the S&P 500, for example, owns the 500 stocks that make up the index and then charges a fee. By definition, it can never beat the index and will always underperform. Despite this inherent underperformance, passive investing has an appealing but specious narrative to support it:
Markets are efficient. That means no one can beat the market. Active managers charge higher fees than passive index funds. Therefore, they will, in aggregate, underperform the indices by their fees. Even if some managers can beat the market, no one can pick them beforehand. Therefore, just buy an index fund.
You can’t fault the logic, though we disagree with it*. The fact is that most active fundshave underperformed. However, such an assessment is incomplete. Most “active” funds are really closet index funds, owning hundreds of stocks–essentially what the index owns but with small, low-conviction adjustments. This approach amounts to (basically) a higher-cost index fund parading as active management. That type of fund will probably only match the market before fees and underperform it after. To beat the market, you must be different.
Our approach and positioning truly differentiate us from index funds and most “active” funds. Those funds own hundreds or even thousands of stocks. In contrast, we currently own 20, which were carefully selected based on our own independent research.
We methodically and repeatedly follow a logical process to find good companies at good prices. We research them diligently and only buy a company’s stock when we think the chance of losing money long-term is low and the probability of better-than-market returns is high.
In addition to the risk management inherent in our individual company research, we also manage downside risk through portfolio construction, proprietary economic research and analysis, and negatively correlated positions (when appropriate).
We are the epitome of active management.
Robo-advisors–a passive approach taken to the extreme–offer investors an experience limited to a website and a set of questions that usually can be counted on two hands. In just a few minutes of an investor’s time (and with no human interaction), these internet platforms claim to generate a low-cost portfolio specific to an investor’s risk tolerance and needs. It’s the latter part of that claim that will be thoroughly tested during the next bear market.
Will passive investors with robo-advisors, most of whom established their accounts during this bull market, stay the course in the face of inevitable market panic and economic turmoil? Or, will they lose all of the fee savings and more through bad decisions made at inopportune times? Time will tell. But do-it-yourself and robo investors have positioned themselves to be doubly disappointed. Their return expectations are far too high, and the confidence they have in their own resolve to stay disciplined–untested in this bull market–may prove foolhardy.
There are innumerable things a good advisor can do for an individual investor, but one of the most important is helping them avoid the choices, made most frequently during the depths of a bear market or towards the end of a bull market, that can permanently impair their wealth.
Individual investors shunning professional help and choosing do-it-yourself or robo investing, despite the group’s poor track record of buying high and selling low, is akin to not placing in a local 5k race and then deciding to train for the Olympics without a coach.
While risks to the economic expansion are evident, our research still indicates that the U.S. economy will continue to grow for at least another 18 to 24 months. While many of the same market voices continue to sound the alarm on an imminent U.S. recession, even after being wrong over and over again for much of the past seven years, we still see a recession as unlikely. But, we do believe we are late in this economic cycle, that is, a few years away from a recession.
Earnings, currently depressed by a decimated oil & gas sector and weak industrial investment, should rebound over the next year and will likely make new highs in 2017. And that’s bullish for stock markets, even when they are already expensive.
We expect our current positioning to generate double-digit returns until the completion of this economic cycle, besting broad markets in the process. Further, we expect to add the greatest amount of value in the middle of the next recession and any accompanying bear market, when our risk management practices, which have been largely unnecessary in this ever-rising bull market, really have a chance to shine.
Black Cypress celebrates 7 years
The end of June marked seven great years at Black Cypress.
It has been an honor to serve you.
Thank you for the trust you continue to place in us.
* Reoccurring bubbles are just one proof against efficient market theory.