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Q2 2017 Commentary

It was an exceptionally quiet first half.

Major indices continued to drift higher as investors continue to cling to hopes that policy changes will benefit corporate bottom lines.

Meanwhile, those corporate bottom lines are climbing – regardless of policy – up 20% over the last year. 

This corporate earnings number sounds encouraging, and partially explains some of the enthusiasm in markets.  But take a step back, and the relationship between prices and earnings is a bit more complicated.

Back in the third quarter of 2014, U.S. stocks were at all-time highs, and so were corporate earnings. Times were good.  But there were reasons to be concerned, as stocks were flirting with price/earnings multiples that had never been sustainable.

Around the same time, oil prices began their monumental decline, destroying earnings in the energy sector and putting a drag on S&P 500 earnings as a whole.  Here we are, nearly three years removed, and overall S&P 500 earnings have yet to reach their 2014 peak.  Though corporate earnings are flat over this stretch, the S&P 500 has managed to gain 23%.  In other words, the entire 23% gain over the last 2.75 years has come from multiple expansion rather than actual profit growth.  That multiple expansion began at already lofty valuations.

Another way to think about it: virtually all of these gains are the result of speculation.

This is not just a recent trend. P/E multiples have been climbing throughout the recovery. Since corporate earnings recovered from the recession in 2011, corporate profits have climbed just over 25%, yet stock prices have advanced over 80%.  Nearly two-thirds of the returns have come not from profits, but multiple expansion.

This does not mean that the entire bull market is on shaky footing.  The P/E expansion between 2011 and 2014 came with growing earnings, and stocks began that stretch at relatively low valuations.  Throw in an accommodative Fed, and that rally was well justified.

At today’s prices, however, markets have gotten ahead of themselves.  There is nothing wrong with markets getting ahead of themselves, but we have to be able to identify it when they do, and we must adjust our expectations accordingly.

There is a sense out there that since markets are climbing in the face of high valuations, they will continue to climb.  Essentially, high returns set expectations of even higher returns.  This is often confirmed in the short run, but the history of market returns tells us that as price multiples climb, future returns fall.  We have covered recent valuations at length in the past, but it bears repeating: these multiples have never been sustainable, resulting in negative returns more than a decade out.

Some will argue that we are in a new era, and comparisons to past “bubbles” are flawed.  Perhaps, but we don’t have to look too far in the past to see the types of risks this market holds.  After becoming expensive in late 2014, stocks suffered two rapid 10% crashes in late 2015 and early 2016.  The early 2016 correction actually brought stocks back below 2014 prices and in line within historically “sustainable” levels.  It was also a clear buying opportunity for this approach.

The dip did not last long, however, and stocks have rallied considerably since their 2016 lows.  To many, the fact that stocks have rallied is an indication of resilience.  To us, the decline was the more important data point, confirming that high valuations carry considerable risks and providing one more piece of evidence that, at these multiples, future buying opportunities are likely at lower prices.  Rising price multiples are built on confidence, which recent history has shown can erode rapidly.

Our investment approach is built around the high probability opportunities associated with investing in high quality stocks when they are available at a discount.  Today, those opportunities are scarce.  Rather than chase prices higher, the strategy in these instances is to aggregate liquid capital and await opportunities.  Those opportunities always come. 

Opportunities can present themselves in a number of ways.  Though we believe that stocks are significantly overvalued, our strategy is not based on valuation alone, and there is certainly data that could persuade us back into stocks in the meantime.  This too has happened in recent history, as our traditional domestic accounts were buying as sentiment eroded in the months ahead of the election.  We did so in the face of high valuations, even though stocks were down only 2.9%. 

This brings us back to perhaps the most extraordinary fact about the first half of this year: the dearth of entry opportunities.  The largest pullback in the S&P 500 this half was only 2.8%.  Thanks to a note from Bespoke Investment Group, we know that was the second smallest first half correction in the last 89 years (the average is closer to 11%).    

Like returns, investors generally expect calm to beget calm.  And like returns, they are not wrong in the short run, but eventually volatility will return.  When it does, probabilities suggest it will be to the downside, and we are preparing accordingly. We entered the quarter with the largest cash position in over a decade, and have only added to those cash holdings across strategies.

Though the general economic backdrop remains favorable, there are some signs that the momentum may be beginning to wane.  The Nasdaq closed the quarter over 3% from its recent peak, and recent weeks showed some clear divergences between quality stocks and the rest of the market – divergences which generally resolve through losses.  On the economic front, growth is persistent, but GDP estimates for the second quarter have been notably written down. The Citi Economic Surprise Index showed that most of the data over the past month came in below expectations.  Even in expansions, disappointment on this scale is generally accompanied by market pullbacks of at least around 4-5%. 

We are also seeing some cracks in investment returns.  Some popular alternative strategies have been posting losses, led by managed futures.  The strategy, widely touted as a low-risk uncorrelated hedge against equity losses, has just seen some of the worst losses since 2007.

None of these recent hiccups are overly concerning, and could surely be transitory.  Against a more pessimistic backdrop of high valuations and a tightening Fed, however, it is important not to let headline price action blind us from some of the less promising underlying data.

Equities may climb higher from here, but as they climb, so do risks. 

As the risk/reward landscape continues to deteriorate, we will likely continue to raise cash this quarter – protecting our clients’ assets against increasing market risks.


Robert B. Drach 

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