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Commentary

Friday
Jul282017

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 

Wednesday
Apr122017

Q1 2017 Commentary

At this time last year we were reflecting on a quarter dominated by fear.  2016 started as one of the weakest on record, and though markets had recovered by the end of the quarter, investors were clearly rattled. 

This year we are reflecting on a quarter dominated by optimism.    

In February of 2016, according to the survey from AAII, investors were less optimistic than they had been at the financial crisis lows.  Contrarily, the latest consumer confidence numbers from the Conference Board show significant hope.  The percentage of respondents expecting stocks to be higher in twelve months is at its highest level since January of 2000 – just two months before the tech bubble peak. This March also saw newsletter writers reach their most bullish levels since 2005. 

One year and a 30% rally (from the February lows) can change a lot.

Not only have stocks risen notably, but they have done so with little in the way of declines.  It has been more than nine months since the S&P 500 saw a 5% pullback.  By some measures, markets are off to the calmest start since 1965.   

Following the price trends and accompanying headlines can give one the impression that there is plenty of conviction in the markets.  More specifically, there seems to be certainty around the widely-accepted narrative that deregulation and tax reform will boost equity values.

All else equal, anticipated policy changes are indeed likely to increase earnings. The lofty expectations are also buoyed by some harder numbers: Q4 earnings growth was up over 6% for the quarter –  the strongest quarter in three years.

Combining expectations with already accelerating growth, there is a rather convincing argument to own stocks.

The narrative has been validated in the short term, but what if markets have overshot reasonable expectations?    

For an illustration of how expectations can leave investors jilted, we need to look no further than the “Trump trade.”  In the immediate aftermath of the election, it seemed probable that the winners under a Trump administration would be those sectors that benefitted most from his campaign promises, namely financials, materials and industrials. Between election day and the inauguration, these sectors outperformed the market by 9.5%, 15.5% and 3.2%, respectively.

Those investing in these sectors on inauguration day, however, have seen those sectors notably underperform – lagging the S&P 500 by 1.4%, 10.9% and 1.8%.

The lesson here is that even if narratives remain in place, prices matter. 

We have discussed prices (valuation) at length in this commentary before, and we will likely do so in the future, but we will keep it short this quarter.  Based on some simple metrics, stocks are at historically unsustainable levels.  In fact, to be valued at the previous “sustainable” valuation peak, prices would have to fall between 12% and 18%. To be valued at the average “sustainable” level, they would have to fall over 30%.

Stocks are expensive.

On top of valuations, we continue to be worried about headwinds posed by the Fed.  The central bank is accelerating its pace of interest rate hikes and could begin winding down their balance sheet by the end of the year.

These are the same concerns noted in the last commentary, and our actions in the face of these concerns have not changed. 

Clients across all Time Overlay approaches continued to reduce equity exposure in the first quarter.  As we reduced market risk, the result was a fairly quiet quarter in terms of asset moves.  Clients have less market exposure than at any point since 2007, and we anticipate continued reductions in equity exposure should investors continue to bid up stocks. 

This caution should not be interpreted as pure pessimism.  In fact, even absent effective new legislation, we see no reason that economic growth should not continue to trudge along. But even if fundamentals hold up, expectations and prices remain worrisome.

Though markets can continue to rise against valuation and central bank headwinds, the risks are high, and probabilities for sustainable price appreciation are no longer on our side.

We will remain vigilant – patiently awaiting probabilities to move in our favor before investing additional capital.

 

Robert B. Drach

 

Saturday
Feb042017

Q4 2016 Commentary

2016 will go down as quite a historic year.

We had a highly significant election, which was followed by a notable equity rally (more on that below), but things were historic from day one.

As you may recall, equity performance at the start of 2016 was the worst on record.  Just twelve trading days into the year, the S&P 500 was already down over 9%.  Stocks languished for weeks, bottoming a couple of percentage points lower. 

The rapid drop set the tone for countless headlines questioning the implications of such a start.  Data tells us that the start of the calendar year has very little bearing on subsequent returns, but the data does not always make for the best headlines.  Instead, the widespread fear mongering spread to the public, who sold stocks at a brisk pace.  The erosion of confidence was so rapid and dramatic that sentiment survey results showed less optimism in mid-January than during the darkest days of the financial crisis. 

We bought into the brief, panicked decline, which rapidly reversed.  Equities were back into positive territory by mid-March.   

After that, 2016 turned fairly quiet.  We had the brief Brexit-fueled panic in June, but from March through September, stocks generally climbed slowly higher, settling at record highs.  The rise allowed us plenty of opportunities to capture profits, and by the third quarter, clients saw their smallest allocation to stocks since 2007.

When we last updated clients in October, we had just begun buying again.  Even though valuations remained high, stocks had lost momentum and investor confidence once again began to wane.  These trends continued until the Friday before the election.  Investors were pulling money out of equity funds, option implied volatility was climbing, Put/Call ratios spiked – investors were seeking protection in a dramatic fashion.  At the same time, the CNN Fear/Greed index was showing the most fear since the January/February decline.

It is no surprise that investors were scared.  Heading into election week, major investment banks issued dire warnings about the threat of a Trump presidency.  Meanwhile, stocks put together a nine day losing streak – the longest since 1980. 

Though the total price decline was shallow, sentiment was flashing a clear buy indication.  In the two months ahead of the election, our domestic accounts increased their market exposure to near 70% – still a somewhat conservative position, but taking on more than twice the market exposure we had late in the summer.   

While we would like to take credit for a brilliant election call, this was not an election call at all.  This move was based purely on price movements and the underlying shifts in investor sentiment.  Absent a Presidential election or any other major event, we would have interpreted and acted upon the data the same way. Of course, the sentiment shifts were largely election driven, but we took an agnostic approach to the election itself, instead choosing to capitalize on any clear opportunities that would result from markets’ interpretations of expected/realized outcomes.

From our perspective, the post-election rise in equity prices was a not clear-cut consequence of the actual outcome of the election, but largely an unwind of the anxieties that built ahead of the election – anxieties that were likely to unwind regardless.

Certainly there is price action that can be attributed to the election outcome, namely the rise in financial stocks, small-caps and commodity related names, but post-election relief was likely a strong component of the broader action. 

Though the averages have been quiet in recent weeks, we have seen some ebb and flow in leadership, allowing us to capture profits in select positions.  This will likely continue into early 2017, with our short-term goal being a return to a conservative, low market exposure position on par with where we stood this past summer.

We are simply not inclined to maintain high market exposure in an environment of high valuations and a tightening Federal Reserve. 

There is plenty of temptation to latch onto narratives on the implications of a Donald Trump presidency.  It is my personal opinion that President Trump presents a flattening of the risk curve.  In other words, there are higher probabilities of above average and below average outcomes, depending on which fights he chooses to pursue and the dispersion of his successes and failures. 

Our data driven view does not include my personal opinion, however, and we will wait for any consequences of the Trump presidency to play out in our data sets before taking associated actions.  Anything else would be speculation – something that does not comport with our investment approach.

Though tax cuts and deregulation should be net positives for stocks, there are plenty of headwinds building.  With many significant data sets pulling in different directions, we anticipate 2017 to be another year that will reward patience and restraint.  I will continue to work hard to protect our clients’ capital as we see which influences prevail.

Wishing you all a happy and prosperous New Year,

 

Robert B. Drach

Managing Member

Drach Advisors LLC

Saturday
Oct152016

Q3 2016 Commentary

Equities put together a decent quarter, more than doubling the gains from the first half of the year. 

 Virtually all of those gains came just in the first two weeks of July.  Since then, things have been remarkably quiet.  For the rest of the quarter, the S&P 500 traded in a 3% range.  That is a historically tight trading range (stocks have been more volatile in 99.5% of comparable time frames).

 All of that quiet has left many scrambling to find some place to make money.  We, on the other hand, spent most of the quarter on the sideline.  We entered the quarter with the lowest stock market exposure since 2007, and broadly maintained that stance though mid-September.   

The most significant concern for us this year has been stock valuations.  With a brief exception early in the year, the S&P 500 has been trading above 20 times record earnings.  This is a price multiple that has never been sustainable in the history of the American stock market.  I have written about valuation concerns at length in past commentaries, but it is worth repeating: any time equity multiples have climbed this high, stocks have eventually seen lower prices.  Additionally, after reaching such loft valuations, stocks have always underperformed Treasuries over the next decade (or longer). 

This is not the type of investment environment to be optimistic about.

Despite these long term concerns, we have been adding to our equity exposure in our traditional Time Overlay accounts over the past few weeks. 

In the last quarterly commentary, I stated that we will be waiting for the markets to come to their senses or present opportunities.  With valuations remaining excessively high, markets certainly have not come to their senses, but amidst the quiet, they have been providing some clear isolated opportunities. 

By mid-September, we saw broad (if shallow) weakness among quality stocks.  Several of those names looked particularly attractive, giving us a chance to move equity exposure in standard accounts closer to 50%. 

The three stocks that account for most of increased exposure are Casey’s General Stores, The Hershey Company, and JM Smucker.  Aside from being out-of-favor discounted quality stocks, there is something that all three names have in common:  low beta.

Beta is essentially a measure of market risk.  The three companies mentioned above have betas of 0.22, 0.27, and 0.48, respectively.  Any stock with a beta below 1.0 generally moves less than market does.  In other words, if we do face any sort of intermediate term weakness, probabilities suggest that these stocks, on average, will only lose about one-third of what the broader market does. 

These are precisely the types of names we are most comfortable owning in a high-valuation environment.  We also continue to hold onto quality stocks with low-valuations and high dividends.

Though valuations and rising interest rates are major long term concerns, the current market has plenty going for it.

Many of the positive points outlined last quarter remain in place today.  The domestic economy continues to grow at a slow but steady pace. There is little sign of a recession on the horizon.  Despite sitting near record highs, investors remain very skeptical about this market, as evidenced by sentiment surveys and massive outflows from equity funds. This type of broad pessimism is generally positive for stocks.

Fundamentally, earnings improved in the second quarter and likely grew again in the third quarter – putting a bottom in the earnings recession (for now).  This is of some relief, considering our emphasis on valuations. Most of our analysis, however, is actually built on an optimistic return to 2014s peak earnings; so, while a rebound in earnings would be good for market confidence, we have a long way to go before it impacts our outlook.

Considering the amount of conflicting data we are currently dealing with, it is futile to predict the next market move.  Accounts are largely positioned to take advantage, whichever way equities move.  Should markets move higher on strong economic news and growing earnings, we will not hesitate to lock in profits, and could find ourselves holding even more cash than we did at mid-year.  Should stock falter on Fed-fears, the election, European dissolution or valuations, we remain prepared to take advantage of further discounting, as accounts across all strategies continue to hold significant cash positions.

As we head into the final quarter of the year, we can anticipate the financial media will do their best to sow uncertainty and fear about the future.  The majority of it will be noise.  At the end of the day, our investment decisions are modeled on data, not talking heads.

Monday
Jul182016

Q2 2016 Commentary

The stock market seems just fine. 

Of course there are plenty of worries in the financial world, but if your perspective is that of a domestically based equity investor, there is not much to complain about.

While stocks have given investors some headaches over the past year, including two brief 10% crashes and a two day 5% post-Brexit decline, domestic equities have been quite resilient.  On a quarterly basis, the S&P 500 closed at a new all-time high.  If you look at daily prices, we closed the quarter only 1.5% below record highs. 

Any lingering frustration with recent market activity comes from investors who may be a bit too used to above average returns.  Even including the S&P 500’s marginal decline last year, stocks have posted annualized returns of 16.7% since the market low over seven years ago.  That is more than double the historical average rate of return.

Since 1950, the only times that we have seen domestic market runs that long and strong were the bull markets of the 1980s and 1990s.  Historically, speaking, investors should be very happy about where they sit today – atop one of the strongest bull markets in history.

Unfortunately for those who are not yet satisfied, runs this strong have never been sustainable. 

Each time stocks have posted similar gains over a similar stretch they have corrected at least 11% (declining an average of 24%) – regardless of valuation. 

Whether you are elated or exhausted by recent moves, we continue to see this market as both expensive and overextended. 

At this point last quarter, we were largely dispelling the vast array of negative storylines that had been fueling market anxieties.  Having profited from those anxieties and once again taken a more conservative position, one would think that we may be inclined to similarly dispel the more positive narratives.

However, we have no issues with many of the ongoing storylines.  The economy seems to have gotten over a hump, and there are no signs of a recession on the horizon.  Sentiment remains depressed and there is plenty of cash on the sidelines.  Earnings are expected to rise this quarter for the first time since 2014.  Globally, central banks remain extraordinarily accommodative.

These are all positive catalysts, but they do not justify markets trading at their current multiples.

We have covered the details extensively in past commentaries, but it bears repeating: every time that stocks have traded at similar levels, it has paid to walk away from the stock market and park money in Treasuries for a decade or longer.  This dour analysis is actually based on an optimistic expectation that we can return to record earnings levels rather quickly. While analysts believe this is probable within a year, we remain skeptical of such estimates, which are pricing in 25% earnings growth over the next nine months.

If these estimates turn out to disappoint, the probability that equities break from historical precedent becomes even slimmer.

Though slim, there is a chance that markets surprise us.  We are in very historic times and have been surprised by the persistence of phenomenon such as negative interest rates.  Throw in a Fed that is increasingly looking amenable to accommodative policy (even in a growth environment), and there remains a possibility that things are different this time.

Weighing these probabilities, accounts across all strategies are targeting close to 35% investment. Because of our concerns, this is the lowest target investment level since 2007; but because of unprecedented central bank action and other positives, this is more aggressive than we would typically be based on valuations alone.  Should equities break to new highs or simply offer us opportunities to exit individual positions, we could easily see our market exposure drop below 20%.

We continue to employ the strategy that allowed us to capitalize on both of the major declines of the last year. Our positioning provides us the flexibility to take advantage of market pullbacks, whether they resemble the numerous speed bumps of the last several years or something more significant.  The exposure we do have is to the some of the more reasonably priced, higher yielding areas of the market.

Though the second quarter was a bit quieter than the first, the fallout from the Brexit vote proved that there is plenty of anxiety in the market.  We would not be surprised to see stocks move dramatically in either direction out of fear, whether it is the fear of losses or the fear of missing out on gains. 

Despite fundamentals, it would not be unheard of for stocks to rally significantly in the intermediate term. Though such a move would not be a surprise, it is not the most probable scenario, and would only leave equities looking more overextended.

Going forward, we will remain patient – waiting for markets to present opportunities, or, better yet, come to their senses.

This quarter, Drach Advisors will celebrate its tenth anniversary as an independent investment advisory firm.  I am very grateful to all of you who have chosen to grow with us over the years.