Pendleton Street Advisors

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Investment Commentaries: First Quarter 2016


Index Returns 1st Quarter Trailing 12 Months
S&P 500 US Large Cap Index 1.33% 1.68%
MSCI All Country World Stock Index 0.43% -4.28%
Barclays Capital Aggregate Bond Index 3.03% 1.97%
US Core Consumer Price Index - (Inflation) 0.58% 2.13%

After an initial downturn in January and early February, markets ended the quarter marginally higher. The S&P 500 index of large capitalization US stocks declined as much as 10.5% below where it started the year, while the Russell 2000, an index of US small capitalization stocks, declined as much as 16.4% before returning to within 3% of where it started the year.

In line with our recent communications, we viewed short-term volatility as a source of opportunity. As prices declined and became more attractive relative to fundamentals, we carefully re-deployed cash we had raised through late 2015 and early 2016 across both equities and bonds. We expect markets to be similarly volatile going forward for a variety of reasons we discuss below, and will continue to seek opportunities and maintain readiness to act on those opportunities.

In total, stocks did not end significantly higher or lower in the 1st quarter; but, there was marked disparity amongst economic sectors and sub-categories within markets. For example, amongst US equities, large cap outperformed small cap, and value stocks outperformed growth stocks. Across sectors, the widest difference was between Healthcare and Utilities which returned -5.6% and 15.5%, respectively – a difference of 21.1%.

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The issue for stocks going forward is whether valuation lines up with price. Our methodology is based on the idea that the value of any financial security is equal to the sum of future economic profit (i.e. earnings, cash flow, etc.) discounted by a required rate of return. Based on that, we can break value down into three components that inform our view of valuation vs. price: (1) Profitability, (2) Growth, and (3) Cost of Capital.

 


I. Profitability

Our View: Neutral

In aggregate, profit margins [1] of non-financial corporations in the US have been above the long-term average every quarter since 2010, and had been over 1 standard deviation above the long-term average since 2012. In the 4th quarter of 2015, profit margins declined to 11.27%, which is still above the long-term average. Margins for companies in the S&P 500 declined also. In both cases, declining profitability is attributable to sectors that are heavily influenced by commodities prices: Energy, Basic Materials, and Utilities. Without commodities-dependent sectors, Operating Profit for the S&P 500 increased 7.74% during 2015. It is reasonable to assume that growth with and without those sectors in the larger economy would mirror the S&P 500.

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We discussed the state of commodities markets in detail in last quarter’s commentary. Following up, it remains clear that the shifts occurring in markets for oil and other commodities are structural, and will impact surviving commodities related companies for some time to come. There are signs, however, that commodities prices have leveled off, meaning that those sectors should have less of an impact on overall profitability going forward.
 


II. Growth

Our View: Neutral/Negative

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We touched on short-term profit growth above, but it is important to also examine long-term trends in growth. Since 1957, earnings growth has averaged 5.8% annually over 10-year periods. Similarly, growth on overall Non-Financial Corporate Profits has averaged 6.6% over rolling 10-year periods since 1957. While there are challenges to corporate profitability in the near-term, we expect long-term growth to be in-line with the historical norm of 5-7% annually.
 


III. Cost of Capital

Our View: Positive

Cost of capital is likely the most difficult factor to understand and quantify, and for that reason its importance is most-often over-looked. For stocks, it is a measure of how much return investors in aggregate require on an annual basis, over and above the return available on a default-risk free security. Lower cost of capital translates to higher value, because investors with a lower required rate of return would be willing to pay a higher price for the same dollar of return. The risk-free rate is usually represented by the yield on a 10-Year US Treasury note.

 
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If we use our current cost of equity capital estimate for the S&P 500 of 10.8%, and back out the current 10-Year Treasury note yield of 1.7%, then the equity risk premium (additional return required) investors have priced into equities is 8.9%. The average of that premium since 1957 is 6%. So using these figures, investors currently require 2.9% more (8.9% - 6.0%) return annually going forward than they have historically.

 

Based on our evaluation of these factors, we do not believe that equities in aggregate are significantly over or under-valued. While outlooks for profitability and growth are questionable, prices are already discounted via cost of capital to reflect some uncertainty. Changes that would influence our view in the short-term include a significant and rapid increase in market levels and/or interest rates, or a spread of declining profit margins into sectors less-dependent on commodities prices.

The bond market was calm relative to equities in the 1st quarter, with total return for the Barclays Aggregate bond index of 3.03% vs. -0.51% return in the 4th quarter of 2015. High-yield bonds continued to exhibit volatility more similar to stocks, while an index of long-term (20+ years) Treasury Bonds increased by 8.73% for the quarter. Long-term bonds historically exhibit much more price sensitivity to changes in interest rates than short-term bonds. Continuing strength for long-term bonds in the face of the Fed’s tightening monetary policy indicates that investors still place a high premium on perceived safety of bonds relative to other asset classes. We continue to view the price of that perceived safety as too-high, given that the yield to maturity for 20-year US Treasury bonds recently sank below the rate of inflation over the previous 12 months for the first time since records began in 1993.

Overall in client portfolios, we persistently seek out areas within equities and fixed income markets that are attractive relative to the broader markets on a risk-adjusted basis, while also remaining diversified and rebalancing systematically to make sure that portfolio allocations are aligned with long-term objectives. We appreciate the trust you place in us as advisors, and look forward to speaking with you soon.
 

Matt A. Morley, CVA
Chief Investment Officer

  1. We define aggregate profit margins as Corporate Profits After Tax / Gross Value Added for US Non-Financial Corporations, with data obtained from the Federal Reserve Bank of St. Louis FRED database.

 
CommentariesMatt Morley