Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

January 2017

Thanks to a rollicking year-end post-election rally, the stock market is up big time, and who can doubt that buyers are correct in thinking that happy days are almost here again! Surely unleashed animal spirits can only mean that a return to vibrant growth is nigh! Perhaps now the captains of industry will regain their optimism and overcome a reticence towards investing in their businesses that for too long could only be assuaged through massive debt issuance and share buy-backs. Just maybe, at long last, real earnings will come through and justify those bonuses and stock option awards.

All sarcasm aside, it is true that 2016 ended on a surprisingly high level of optimism in the markets. In the midst of such cheer on Wall Street, it is easy to forget that the year began in a very different mood. The S&P 500 equity index suffered its worst start to a year in its history—down 10.5% year-to-date at the low point in February. Globally, equities lost $5 trillion of value in the year’s opening weeks.

Indeed, a year ago there were good reasons to be concerned about the world’s economic and financial health. The possibility of a slowdown in the U.S economy increased uncertainty about the course of interest rates and the fate of the banking sector, still under a cloud from the financial crisis. Additionally there was doubt about China’s ability to maintain its robust growth rate; China’s demand for commodities, technology and other goods to support its increasing prosperity had helped to prop up global economic activity during the fragile period following the financial crisis. Fears of repercussions from a collapse in petroleum prices to about $27 per barrel depressed sentiment, and a rash of bankruptcies in a debt-laden oil sector added to fears about banks’ exposure to energy industry lending. Banks—seemingly at the epicenter of every financial crisis real or imagined—saw their stock prices fall 18% at their mid-February lows.

It was a nail-biting year for politics as well. Britain’s “Brexit” referendum on European Union membership in late June loomed large during the year’s first half. The negative result at first shocked stock markets—with European banks hit especially hard—and roiled currencies. Stocks promptly recovered, however, as markets realized that changes in Europe’s financial system and trade links would not occur quickly, and fears for the worst might not be realized at all. An increasingly nasty political fight in the U.S. also added to market unease, as did the usual suspects—Middle East conflict, terrorism, and aggressiveness on the part of former Cold War adversaries.

As the year progressed, market action reflected the flow of news. Developments in the global bond markets were extraordinary. A “flight to safety” phenomenon led to very low yields in the European government bond sector; at its peak last summer fully $14 trillion of debt traded to yield the purchasers a negative return.* Switzerland’s entire stock of sovereign debt traded at a negative yield at one point. Such conditions do not go unnoticed. Corporations, seeing an opportunity to raise capital at a historically low cost, issued a record amount of debt in 2016, as the “low for long” interest rate environment persisted through the year.

Interestingly, despite the discouraging rout in January and February, equities gradually recovered, overcame various upsets (such as the Brexit vote) and by the end of the third quarter had produced average gains for holders. The S&P 500, in fact, enjoyed its biggest rebound from a significant decline since 2009. Some improvement in business profitability, and perhaps a dawning realization that not all was lost in the world, increased demand for equities. Industrial and financial issues, shunned at various times in the preceding months, came to life. The perverse tendency of stock markets to rise in spite of worrisome news and depressed sentiment was in full display.

The real fireworks for stocks began when the results of the U.S. election became known. Prices in after-hours markets initially plunged, but buying began in earnest before exchanges opened the next morning as buyers realized that a new, “unified” American regime was likely to promote highly stimulative fiscal and tax policies. Banking shares, shunned for so long, were among the top beneficiaries as promises of lightened regulation helped improve sentiment towards banks. Stimulative actions by governments tend to increase inflation and, in turn, interest rates—already on the rise due to Federal Reserve rate decisions, as well as market conditions. Short-term treasury bills, for example, offered their highest yields since 2008. Following the election, longer-term rates rose significantly as well: the yield on the ten-year treasury note rose to about 2.5% after having hit a low of 1.3% last summer. A higher-rate environment permits banks to lend money more profitably. (Mortgages, a banking staple, now cost homebuyers over 4%, up from about 3.3% earlier in the year). Small wonder that banking stocks rose 22% in the post-election period.

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Despite a little weakness in the waning days of December, the popular equity averages finished the fourth quarter with solid gains, after hitting new highs as well: the Dow Jones Industrials and S&P 500 gained 8% & 3.3% respectively in the final three months of 2016. Annual returns came to 16.5% & 12%. The averages broke a string of records over the course of the year, and even “Dow 20,000” looked like a shoo-in for a while. As frequently happens, industry sectors that had been viewed most negatively earlier in the year produced some of the better results by year-end. The aforementioned banks were a standout. Energy, too, proved resilient. Helped by a production curtailment agreement among major oil producers towards year-end, the commodity’s price rose 50% in 2016. After being pummeled at the beginning of the year, energy-related equity indexes rose 24% for the year. In the markets for commodities themselves, oil was not alone in showing strength—sugar, gas, soybeans, and copper gained more than 10%. Even coal, shunned by all, saw a doubling of prices following production cutbacks in China.

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From a long-term perspective, the eighth year of recovery after the financial crisis was a good one. Investors who maintained their cool in the dark days of 2008-09, buying when stocks were on sale, and holding their positions through the years rather than fleeing the equity markets as so many have done, have been suitably rewarded. As the saying goes, one should “never let a good crisis go to waste.” Markets consumed by fear and loathing occur infrequently; commitments made at such times, when valuations are deeply depressed, can serve the bold and patient investor well for a lifetime.

While 2016 was a good year for owners of stocks, market volatility also produced some reasonably good opportunities for buyers who were nimble enough to jump at bargains. The year’s turbulent opening weeks depressed valuations, notably in the finance- and commodity-related sectors. Likewise, the swoon after Britain’s Brexit vote produced some notable discounts, especially in European shares. As usual, focusing on the value of stocks, instead of worrying about what might or might not happen in the future, revealed some interesting candidates for purchase.

As the New Year begins, however, we face the all-too-familiar challenge of determining what to do next. The fourth quarter market bounce brought already stretched equity valuations to levels seldom surpassed in the last 90 years, according to at least one valuation measure, the “CAPE” index, which values equity markets on long-term average earnings, thus smoothing short-term fluctuations in profitability. While such valuation measures have little predictive power in the short term, they have tended to successfully highlight periods of elevated risk that have preceded times of market turmoil and weakness, such as 1929 and 1999. It is best not to ignore these indicators and to be cognizant of risks. Pockets of opportunity are now few and far between.

Interest rates, having risen significantly in recent months, present another challenge. While higher rates could be a welcome relief to many looking for reasonably “safe” income, they can represent a headwind for stocks. Higher rates resulting from stronger economic growth may be relatively benign, since higher growth tends to be good for stocks as well. But with the latter already trading at record highs, one now faces a question familiar to all with experience in dealing with securities: how much good news is already priced into the markets?

The answer can never be known with precision and is, instead, a matter of experience and judgment. With markets at record highs, and enthusiasm rising, our experience tells us that “what to do next” is the same as what we always do: patiently and painstakingly continue our search for opportunities.

 

*For those who wonder why anyone would buy a bond that would pay you back less than you put in, think of it this way: if you had a billion dollars in cash, you couldn’t exactly stuff it in a mattress. You’d have to pay someone to store it, and someone else for insurance. It’s far more efficient and less bothersome to let the government take care of these services.

 

Dennis Butler, MBA, CFA