State of the Investment Markets, May 2016
Bob Landaas: Brian, it’s been a pretty bumpy year so far. As you know, we got off to a terrible start in January, one of the worst in modern history. By the middle of February, stocks were down 10%. We had a 14% recovery since then. And now you look four months into the year, stocks are up give-or-take 2%; bonds are up 2% – a pretty interesting start to the year.
Brian Kilb: Yeah. What a difference a day makes, right, Bob? If you go back to attitudes in the middle of February and compare them to where we are today, a much different feel for things. If the year continues to play out this way, I think maybe we’ll have some pleasant surprises ahead of us.
Bob: It’s interesting to see how the most conservative stocks have done the best, pretty much the mirror opposite of last year. Large blend: 3M is up 12%, Comcast is up 10%, Oracle is up 12%. If you look at the large value: Caterpillar, up 17% for the year; AT&T, Verizon up 12%, 13%. And you compare and contrast that to the growth stocks, down 1%, 2%, 3% for the year. It’s just the mirror opposite of what we saw last year.
Brian: What a great reminder for investors, Bob, to keep their eye on the prize over the long run. Last year, large cap growth stocks up 5%, 6% in some cases as a category. Value, this year, is taking that kind of advantage over growth.
And there’s a rotation. Things that are cheap eventually come back, things that get a little pricey sometimes fade to their appropriate levels. I like the balance of the market right now where there’s some opportunities that remain in growth, but value looks pretty attractive right now.
Bob: One of the more interesting things about that, Brian, in my opinion is that as you know, markets don’t die of old age. They typically die because of excess. Investors tend to migrate in the latter half of a business cycle, in a market cycle, to the more aggressive growth stocks.
So, the very fact that value is in play right now tells me that this market has got some legs yet, that the market is defensive by orientation, with investors flocking to the blend and to the value stocks. That tells me that the period of excess is yet to come. So, I think it’s actually good news for the markets that value is outperforming right now.
Brian: I think it’s interesting, too, in the broader context of things, how many people talk about the market being expensive right now, and I don’t find that to be the case.
It might be a little bit pricey. You’re talking about price-to-earnings ratios in the 17 neighborhood. Historical norms are 14-15. But, you talk about pricey markets at the end of cycles! You go back to before the financial crisis, price-earnings ratios in the mid-20s. You go back to 2000, where the dot-coms blew up, you were in the mid-40s. That’s expensive. Again, maybe a little bit pricey right now, but interest rates are low. I don’t see market valuation as being a huge challenge in the months ahead.
Bob: Well, there’s two things that are just a little bit different this time around.
Number one is interest rates are very low. A lot has been written over the years that the markets can support higher P/Es, as you well know, in a low interest rate, low inflationary environment.
Number two, the problems with P/Es is that they cut it off after 12 months. So, there’s lagging P/Es and then there are forward P/Es – the ones that we’re normally interested in. And it only goes out, as you know, 12 months. The point is earnings are expected to go up 14% next year, but if you do a 12-month forward P/E for the markets April of ’16, April of ’17, you’re not going to see a lot of the upward movement of earnings in the latter part of next year.
So, you need to temper the P/Es, at least at this point in the business cycle. Low interest rate, low inflationary environment has shown in the past that the market can support higher multiples.
One of the concerns that I have right now is, as you know, earnings aren’t supposed to turn positive until the second half of this year. Markets normally anticipate events six to nine months in advance, so the markets are looking into the fall and saying, “We like what we see.”
But, we’re still at negative earnings at the end of the first quarter. It’s why they assume that earnings are going to be down 7% year-over-year. A lot of that was because of the oil and gas industry, and the banks have yet to lift off. I thought it was pretty interesting to see the rally in the bank stocks the last couple of weeks because the news wasn’t worse than what the street was anticipating.
Brian: Bob, it’s interesting when you talk about data in the context of people and how they feel and their confidence levels. Business spending hasn’t been strong. Consumer spending hasn’t been great, either.
I think a lot of that has to do with people living in the moment and reading the news about current earnings – which we all know is a byproduct of what’s happened in the past – and people reading current events, news or other things that might make them anxious or unsettled.
I do think if we continue to have some stability and continue to have some progress beyond lower oil prices, beyond the dollar strengthening, as it has over the last three years, and get some stability moving forward, that you’re going to see changes in confidence. And you’re going to see consumers spend a little bit more. And you’re going to see businesses re-engage, too. And that cycle will become self-fulfilling.
Bob: Brian, you and I have been very frustrated over the last couple of years. The fact that oil prices are tied at the hip to stock prices is pretty frustrating, in my opinion. Last May, stocks peaked out a little over 18,300 on the Dow. Oil temporarily hit $70 a barrel. As I mentioned, just briefly, oil plunged to $26 a barrel in February and took the market down to 15,500. We’ve seen a 60% recovery in oil since the middle of February, up to give-or-take $41 a barrel.
Twenty years ago, as you know, the developed world used the majority of the world’s oil. Now it’s just the mirror opposite. The emerging world uses the majority of the oil. So, when China slowed, the emerging markets slowed dramatically, and because of that their demand for oil plunged.
Pretty frustrating for us, I think for everyone, in driving stock prices either higher or lower. It’ll be pretty interesting once we break that pattern. Anecdotal evidence, at least in the last month, suggests that maybe oil and stock prices are going to go their separate ways.
Brian: It’s interesting, in a similar way, to look at the connection between the bond market and the stock market, which has also normalized over the last week or two. We saw a rally in yields and a suffering of bond prices last week when stocks did pretty well. We haven’t seen that for a while, either. So maybe two patterns – what I would call normal patterns – that we haven’t seen in a long while, that perhaps are telling us something more consistent in the future.
Bob: I think that’s one of the more interesting things about the markets now is the fact that intermediate- and long-term bond yields fell after the Fed raised rates on December 16th.
Typically, when the Fed raises short-, intermediate-, long-term rates all go up in tandem. This time around, short rates went up. Intermediate and long yields actually fell, flattening the yield curve, which was really helpful for bond investors. I found that interesting.
No one thinks the Fed’s going to raise this month. It’s highly anticipated that the Fed is going to raise in June. Based on how the markets reacted this winter to the Fed increase in December, I think it’s all but a non-event.
Brian: Yeah. Hard to think that we won’t have a pretty flat yield curve for a long time. If the short side of the yield curve starts to raise a little bit and normalize, it doesn’t seem like inflation’s a big issue. It doesn’t seem like the long end of it’s going to go anywhere for a while.
Bob: Brian, the last thing I want to talk about just briefly is the U.S. dollar. The dollar rallied 9% on a trade-weighted basis last year. It’s weakened 4%, give or take, so far this year. Last year, the stronger dollar served as a significant headwind to U.S. earnings. It’s not a coincidence that the stock market started to recover in February at the time when the dollar started to weaken.
It’s not normal that we have divergent monetary policy around the world. We’re raising rates. Everybody else – European Central Bank, Bank of Japan, Bank of China – are lowering rates. At some point in time, we’ll be done with that. The dollar weakness is going to be a huge boost to U.S. earnings. I think that’s, to a large degree, the reason why the pros think earnings are going to go up give-or-take 14% next year.
Brian: Yeah. The dollar weakened 4.2% in the first quarter, the most since 2010. I think it’s hard for some people to get their arms around currency and what it does to global economics and finance.
I think that head wind has been significant. Even if it stabilizes – it doesn’t even have to weaken – it’s going to have a significant impact on earnings going forward.
Bob: I think everybody needs to be a little patient. The market could get a little sloppy this spring and summer until earning turns positive in the fall. When I take a look at the fundamentals of interest rates and earnings, I’m pretty encouraged about what I see for the next couple of years.
Bob Landaas is president of Landaas & Company.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
(initially posted April 29, 2016)