Economic Commentary | Third Quarter 2018

The market resumed its ascent this quarter, with the best results for the S&P 500 index since the fourth quarter of 2013.  In August, the bull market set a record for longevity at 3,453 days, surpassing the prior record which ended with the tech bubble bursting in 2000.  This longest bull market ever has been largely fueled by five companies termed the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google/Alphabet) along with an unprecedented era of cheap money, thanks to the heroic efforts by the Federal Reserve and the US Treasury to pull this country out of the great recession ten years ago.  For the three months ending September 30, 2018, the large cap S&P 500 index gained 7.7%, the mid/small cap Russell 2000 index rose 3.6%, the international MSCI EAFE index was up 1.4%, and the emerging markets MSCI EM declined by 2.0%.

The continued extension of the stock market reflects gains in the broad economy, as US GDP gained 4.2% for the prior quarter while the manufacturing sector hit a 14-year high.  Corporate earnings were another standout this quarter, as 80% of companies beat earnings expectations ~ the highest rate since Reuters began tracking this data in 1994.  The labor market was also a highlight, as US employers created 643,000 new jobs between June and August, despite the unemployment rate of 3.9% nearing the lowest rate since 1969 and well below full employment.  In early July, the number of job openings exceeded the number of unemployed people in the US for the first time since the Bureau of Labor Statistics began performing the Job Openings and Labor Turnover Survey in 2000.  Job openings in the US are now at a record high of 6.8M jobs versus 6.1M unemployed workers, a dynamic which pressures wages higher in order for companies to lure employees.  We are seeing this play out in the data, as employees are earning 2.9% higher wages than they were one year ago.  As a result of more people being employed while earning higher wages, consumer confidence reached 18-year highs.

While better earnings prospects for US workers led to greater demand for housing, we saw a cooling off in the housing market this quarter on supply side constraints.  Materials prices were higher for new homes due to the tariffs imposed by the Trump administration, existing homes were put on the market at higher prices that outstripped homebuyers’ income gains, skilled labor was in short supply, and mortgage rates crept upward, all serving to dampen buyers’ enthusiasm.

Despite a host of disappointing earnings in the latter part of July, many of them from tech names, the market powered higher.  Consistent with this decoupling of stock market values from actual earnings is the environment for IPOs this year.  Investors have been ravenous for new IPOs in tech and biotech, whether the companies have actual earnings or not.  Through September 30th, 83% of the newly listed companies this year lost money in the twelve months leading up to their IPO.  This is the highest proportion on record; for comparison, the prior record was in 2000 during the tech bubble, when 81% of companies going public had made no money in the prior year.  This is a cautionary sign of a market in which investors are too eager to take on risk, suggesting market euphoria, which makes us grateful to have our clients’ portfolios conservatively positioned.  In our recent conversations with our portfolio managers, many are reporting that their underlying portfolio companies are surpassing their most optimistic operating results, yet these successes have remained unrecognized in stock price movement.  Ultimately, as investors have learned over and over again, the price of a stock must eventually reflect the company’s ability to generate earnings rather than how sexy other investors find those companies.  As our managers at Brandes recently stated, “…fundamentals always matter and in the fullness of time, no business is independent of economic realities or pesky measurements such as earnings, profits, and return on equity.”

Value Investing on Trial

Value stock investing has historically provided superior returns and lower risk than growth stock investing, an enduring phenomenon often summarized as the “value premium.”  Although we are in the midst of the most significant underperformance period for value investing historically, the long-term trend of value outperformance remains intact, and the value premium can be expected to carry on in the future.  Despite its appeal as a higher performing approach, there are two major challenges with value investing as a strategy.  We handle these challenges in two very clear ways on behalf of our clients.

The first major challenge to value investing lies in identifying true value stocks.  The term “value trap” is applied to the subset of the stock universe which is priced cheaply for a valid reason related to some fundamental deterioration that may not be obvious to most investors.  An index fund of value stocks will hold value traps alongside the stocks that are priced at truly attractive levels.  Rules-based, quantitatively-driven funds, to the extent that they fail to incorporate flexible rules with experienced human oversight, will fall victim to similar traps.  Minimizing the impact of value traps requires a highly experienced management team contributing the elbow grease necessary to truly understand the fundamental source of value in an investment.  This may include identifying likely catalysts to spur the recognition of a stock’s fair value, or it may be based on conviction in the existence of intrinsic value combined with both ongoing diligence and patience to recognize when the market has come to terms with that intrinsic value.  This need for active management by experienced teams is what has driven us to seek out the best value managers in the business, to carefully allocate client capital among those managers, and to maintain regular communication with those managers to ensure that they continue to execute a strategy for our clients consistent with the role for which they were hired.  Our average lead manager is over 60 years old, with more than three decades of value investing experience from which they can draw in trying times.

The second major challenge with value investing is the tendency for investors to give up in the face of adversity.  History has shown us that value investing works consistently, but it does not work all of the time.  There have been long periods of value underperformance that can discourage investors to the point of capitulation, usually abandoning value stocks in favor of whatever has worked well recently.  We are deep into such a period now.  Using monthly data from the Fama/French US Value Research Index compared with the US Growth Index, from mid-1926 through August of 2018, there have been three distinct market periods featuring at least 10 years of growth stocks outperforming value stocks:

  • The transition from the roaring ‘20’s through the Great Depression, from March 1927 through May 1940.  Growth stocks outperformed value stocks by 5.1% per year during this period of just over 13 years.
  • The cycle leading up to and ending with the late-1990’s Tech Bubble, from December 1988 through June 2000.  Growth stocks outperformed value stocks by 3.4% per year during these 11 ½ years.
  • The current period beginning with the lead-up to the financial crisis, from April 2007 through August 2018 (the extent of the data set) and continuing now.  Growth stocks have outperformed value stocks by 5.2% per year during this period of greater than 11 years.

Importantly, what happened next?  Those who remained with their value strategies through the Great Depression saw their stocks outperform growth stocks by 22.0% per year for the first 5 years, from June 1940 through May 1945, and by 11.7% per year for the first 10 years, from June 1940 through May 1950.  Value had fully regained its lost ground in under four years and didn’t look back, as illustrated below:

Those who remained with their value strategies through the Tech Bubble saw their stocks outperform growth stocks by 16.1% per year for 5 years.  Value had fully regained its lost ground in just six months.  Value outperformed growth by 6.5% per year for 10 years, though this 10-year number is hampered by the start of the next growth supercycle in 2007.

We only have about half of an illustration so far for the current cycle:


What does the next phase look like?  It is very hard, and contrary to human nature, to maintain confidence in a strategy that has underperformed for a decade.  As value investors are giving up, their resultant sales of value stocks and purchases of growth stocks are contributing to a widening performance gap in a destructive cycle.  Once only the truly stalwart value investors remain, value investing will once again have its day, and the longer it takes, the greater the possible reward to those patient investors who have stuck it out.

This pattern is, in fact, a necessary feature of the long-term value premium – it has to be hard to stick around for the reward, otherwise the value premium would have been driven away by excess invested capital in value stocks.  One of our primary roles as financial advisors is to help our clients “stick to their guns,” maintaining the discipline to be one of the stalwarts that is ultimately rewarded for enduring the challenges of this value underperformance cycle.  It is by-and-large an easy job, because our clients are patient people, in part by the mutual selection process that has brought us together.  But the magnitude of the performance gap in the current growth supercycle is the greatest ever seen, making this power-through element of our role all the more crucial.  We remain personally invested alongside our clients in our carefully selected, active value managers, and we maintain our recommendation to all clients to stay their course despite this difficult stretch.

Value underperformance has been an important factor in our clients’ relative returns, but not the only contributor.  On a year-to-date basis through September 30th:

  • Large cap growth has bested large cap value by 13.7%, based on S&P 500 growth and value indices.
  • Mid and small cap growth has bested mid and small cap value by 8.7%, based on Russell 2000 indices, while mid and small cap stocks have on average returned little more than large cap stocks (the typical size premium has been non-existent).
  • Domestic stocks have bested developed market international stocks by 12.0% in US dollar-adjusted terms, based on S&P 500 and MSCI EAFE indices. This extends the longest-ever domestic outperformance streak to 130 months.
  • Developed international market stocks have bested emerging market stocks by 8.1% in US dollar-adjusted terms, based on MSCI indices.
  • The US dollar has strengthened by 3.1% versus a trade-weighted basket of foreign currencies, impacting those managers who do not hedge currency risk.
  • Highly-priced US stocks have continued to find even higher valuations, with the FAANG stocks gaining 31.5% in the first three quarters of the year, leaving all other asset classes in the dust.
  • Money flows have added to the capital base managed by passive strategies, bolstering their valuations through the virtue of high demand for their underlying stocks, while net reducing the capital managed by active strategies, with a commensurate reduction to active management valuations through low demand.

All of these factors have contributed to a drastic underperformance of our investment strategy.  The year-to-date period has been a microcosm of the past 11 years.  And this will go on and on until it doesn’t.  We plan to be there to reap the rewards when it doesn’t.

The next logical question is, “what might bring about an end to this growth supercycle?”  While one can rarely pinpoint such a catalyst until well after the fact, there are several factors in today’s economic landscape that may well bring about this reversal.  The two most obvious potential causes are: 1) the escalating trade war between the US and China, and 2) the steady return to more normalized interest rates.

While the Fed has the ability to shift monetary policy by raising or lowering the Fed Funds rate at the shortest end of the yield curve, market forces ultimately determine longer-term rates.  These longer-term rates indicate the extent to which people are baking in inflation expectations…if a bond investor expects future inflation, then he or she will demand a higher interest rate to offset the loss to purchasing power caused by inflation.  While the Fed has methodically raised rates on the short end, rates on the long end have remained persistently low, with the 30-year Treasury hovering around 3%.  However, in recent weeks, we are finally seeing some pressure on long rates, with the 10-year Treasury reaching 3.2% and the 30-year Treasury reaching 3.4%.

Not only is the US Fed raising rates, but central banks around the world are doing the same as their economies recover from the global financial crisis.  As we have said for several years now, we are eagerly awaiting normalization of interest rates, particularly on the long-end, so that investors will shine a spotlight on those companies that are skillful allocators of resources and are not overly leveraged with the plethora of cheap and easy money.  The Fama/French capital markets data referenced above supports this expectation:  historically, the best performing group in an environment of falling interest rates is large cap growth stocks; however, when rates are rising, small cap value stocks are the superstars.

While we cannot predict with any sort of accuracy what will cause the end of this cycle, nor exactly when it will end, we are confident that value will return to favor.  We are committed to helping our clients stay the course in order to reap the benefits that will be awarded to those of us who persisted through this difficult stretch.