Autumn 2016: Taking stock of investments
Brian Kilb: Kyle, we’re three quarters of the way through the year. Pretty positive third quarter. Not much to complain about. Major markets, up 7% to 8% for the year. But in the third quarter, we had some different results in that the Nasdaq small cap – some of the riskier parts of the market – came back significantly. And yet, bonds held their own. Other major indexes did pretty well.
Kyle Tetting: Absolutely, Brian. I think it’s a really great thing to point out that those riskier assets have come back quite a bit in the third quarter. You look at things like high-yield bonds, which have been one of the main asset categories to have good performance this quarter. You mentioned growth stocks have had a really strong year overall, but especially this last quarter they’ve really come back. And so I think it’s really important to kind of take stock of where we are now after three quarters.
Brian: You know, a really difficult start to the year back in January, where we got punched in the face pretty good, but a pretty significant rally since then, and we find ourselves in a pretty good place as we head into the fourth quarter.
I think perhaps what captured my attention so far this year is what hasn’t happened. We had significant concerns in the beginning of the year about China. Results haven’t been great there but better than we thought, perhaps.
Monetary policy has been a concern throughout the year, and here we find the Fed in a position where we have a fair amount of confidence that increases in rates are going to be slow, stretched over a long period of time.
Global growth has been at risk throughout much of the year, and yet the Brexit and problems in Europe that we feared haven’t surfaced as bad as we thought. Other parts of the world have held their own.
Oil’s been a big issue throughout the year. And now we find some stabilization, OPEC making some comments about limiting production that will hopefully steady oil. A bunch of issues, Kyle, that we were really concerned about that haven’t come to fruition in the negative. We find ourselves in a pretty good place.
Kyle: Yeah. Bring it back to the end of the second quarter and that Brexit vote back on June 24, and we really thought that it could be a rocky stretch for a while, following what could have been a pretty big shock to kind of the global outlook for growth.
The reality was that for much of the rest of the summer, things were very quiet. So, you had a stretch of 42 trading days where the market didn’t move more than 1% in either direction. It’s highly unusual that we get a stretch that long that’s that calm.
And so, the past couple of weeks, towards the end of the quarter, we saw a little bit of increased volatility, but nothing compared to what we would typically see in the markets. It’s more of a shock because of how calm things had been.
So I think, that’s a big message from the third quarter as well is look at how calm things have been. Investors really took the summer off as far as things they needed to worry about.
Brian: Since the tough start to the year, I’ve had a lot of questions about why the rally, why the recovery. And I think the answer lies in getting back to interest rates and earnings, as always.
We now know we’re going to be in a low interest rate environment. Pretty sure we’re not going to have significant spikes or changes in monetary policy that will affect that in the short term.
And, as we look toward earnings, we have, what, 13% potential increases next year, as the analysts throw out those numbers right now. And significant returns expected for 2018, in terms of increases as well.
So as you sit here in the fourth quarter and you look ahead and you think, “Well, we’re going to have a low interest rate environment for a while – if those earnings come to fruition. That’s what the market’s reflected over the last few months and how we found ourselves in a pretty good place.
Kyle: Yeah, we’re going to get there. We’re going to get to that 13%, hopefully next year. I think the concern is still that there’s some question about what third-quarter earnings look like.
I think, in particular, while oil prices have finally stabilized here in the third quarter, it is those energy stocks which are going to continue to be a drag on the S&P earnings. So, we don’t expect that earnings to recover in the third quarter, but certainly you look ahead to the fourth quarter and beyond, and that’s when that earnings piece finally starts to contribute again.
Brian: Kyle, we talked a little bit about riskier assets earlier on, and as you look at the market over the third quarter, and I guess to some degree to year-to-date as well, you found the value stocks leading the charge early. Now growth of the Nasdaq up a bunch in the third quarter, small caps up a bunch in the third quarter. You find kind of a re-balancing of the markets in year-to-date. Not a great disparity between different asset classes.
Kyle: Yeah, you know Brian, I think you and I coined this term for the seminar, the “anti-growth at an unreasonable price” stocks. And that’s really what had led the way the entirety of the first half. And I think what was really encouraging, is that what we expect to happen, is that growth stocks lead the way in this phase of the economy. And that’s what we’ve seen in the third quarter.
The other piece you point out in the open is this idea that small cap stocks have started to rally a bit. So you look at what’s really done well, it’s the U.S. economy. It’s those small-cap stocks which really fully participate, as opposed to some of the bigger companies, which are a little bit more global-focused. You know, the rest of the world not doing quite as well as we are.
Brian: And yet, the emerging markets have kind of re-emerged. Are people anticipating what may happen down the road in the next year or two? Hard to tell. But again, in that thesis of riskier assets doing well in recent months, the emerging markets have participated in that as well.
Kyle: I think we still expect that the dollar can strengthen pretty substantially from here just on the back of the Fed raising the overnight rate. But what we’ve seen this year is that the dollar’s actually weakened a little bit, especially relative to emerging market currencies. So when you look at those emerging market investments, you take them from that local currency and you bring them back to the dollar, the returns look even stronger for investors, and that’s really what was a big contributing factor – especially in that third quarter, with emerging market debt and emerging market equity being the leading categories.
Brian: You know, Kyle, the first half of the year made a, surprisingly so, made a fair amount of money in bonds. People didn’t expect that interest rates continued to drop, and as a result, bond prices went up. Total return actually pretty attractive, maybe even surprisingly so in that first half. But we held our own in the third quarter. We didn’t see significant yield increases, which may have offset return with bond decreases – bond price decreases. And I think, so far so good, right?
Kyle: Yeah. We as investors have been told now since basically the recession that we needed to worry about rising interest rates, that our fixed income – our bond portfolio – was at risk because these rates were going to rise eventually and take out some of the principal from those bonds.
What we found is that even when the Fed did finally raise the overnight rate at the end of last year, bonds actually came up a little bit because, on the longer end of the yield curve, the bonds maturing in future years, the rates on those have actually come down – and especially early in the year. So in the third quarter, what we saw really is that those rates finally started to hold their own.
We saw the rate on the 10-year Treasury move up just a little bit in the quarter. Not enough to really wipe out any of the gains that we’d seen earlier in the year, especially when you factor in that a rising interest rate long-term is a good thing for bond investors because we can get a little bit better rate on what we’re buying on the fixed-income side. You know, really, we hope long-term, that that’s what we can see.
Brian: Kyle, I think when the Fed begins again to raise rates what it does it sends a signal to the markets that their confidence in a growing economy is sustainable. And I think that’s a good sign for all of us. Let’s get back to normal. Let’s get back to talking about interest rates and earnings and not so much Fed manipulation of monetary policy. And I think that, that’ll be a good sign for everybody.
Kyle: And, Brian, on the economic front in the third quarter, I think we got some pieces of news that suggest that we’re getting to a point where the Fed can return to normal, where we can start to bring those rates towards normal policy and not have to worry anymore about, okay, is the Fed or isn’t the Fed going to move, but rather just let them do what they’re going to do. So, you know, you look at the consumer, mostly good data from the consumer side of things in the third quarter. You look at housing, a really big piece of the overall economic picture.
Brian: As we look forward to the fourth quarter and next year certainly, I think, keeping our eyes on the consumer is going to be a big piece of the puzzle. I also think keeping an eye on businesses and spending will also be key to our progress going forward.
A lot of the cash, the boatloads of cash that corporate America’s sitting on has gone to stock buybacks. You know, in the end of the day, that doesn’t do a whole lot to help the economy. But when they start buying equipment and other things that do have a significant influence on a growing economy, that’ll be yet another sign. If we can get businesses and consumers spending, I think we’re going to have some good days ahead.
Kyle: And I do think it’s amazing how all that fits together with the rest of this conversation about performance. You look at the small-cap stocks, say versus the large-cap stocks. A lot of the growth in large caps has come from those buybacks, whereas the small cap stocks have had a bit more organic growth over the past quarter or so.
So I think it’s incredibly important to remember that when those companies start putting cash to work – they’re buying property, plant, equipment, technology from all of those other companies – it may come from one company’s balance sheet, but it moves on to another when it finally gets spent.
Brian: Well Kyle, the S&P up 7.8% total return for the year. We’ve got a quarter to go. I think, so far, we’d be happy with that. If you told me on January 1 that’s where we’d be right now, I’d be pretty pleased. So let’s see if we can hang on to that, maybe make a couple more bucks in the fourth quarter, finish the year strong, I think we’ll all call it a pretty good year.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
Kyle Tetting is research director and an investment advisor at Landaas & Company.
(initially posted Oct. 20, 2016)