Onward and Upward

Another quarter is in the books, and we find ourselves at the front end of a long and important earnings season. Thus far, results have been met with approval by analysts and investors, and the equity locomotive continues to chug relentless higher. The positive reception to earnings so far has been in no small measure bolstered by Fed Chair Yellen’s testimony in front of Congress this week. Yellen continues to pledge her undying support for the recovery while at the same time telling us that stock valuations don’t look excessive to her. Somewhat incredulously, however, she singled out a couple areas to watch. “Valuation metrics in some sectors do appear substantially stretched-particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.” The media were abuzz with the implications of Yellen’s new-found stock-picking prowess. For my part, I could only shake my head in astonishment.

For today’s commentary, I am attaching an excerpt from this quarter’s Farr View, which is being sent out to our clients as I speak. The full newsletter is available at our web site, http://www.farrmiller.com, which has been recently revamped. Please visit the site and let us know if you have any suggestions to further improve its utility.

Dow 17,000 is a “wow” and a “worry.” Both are understandable, but let’s make certain we pause to smell these valuable roses. Since March 2009, the Dow Jones Industrial Average is up more than 10,000 points. What an amazing feat! I have an original “Dow 10,000” hat worn on the floor of the New York Stock Exchange on the first day the Dow crossed 10,000. There was a circus-like celebration. I wore it again when we reemerged from the 2009 lows. I wonder if we may never see 10,000 again. Poor old, lonely hat.

The second quarter enjoyed better returns than the first with the S&P 500 up 5.23%, including dividends. Through the first two quarters, the S&P 500 produced a total return of 7.13%. If we break down the returns by industry sector, we find that the best performing sector through the first half was a rate-sensitive one: Utilities. The Utility companies within the S&P 500 index rose 16.4% (excluding dividends) during the first half. This should not be a big surprise given the fact that the yield on the 10-year Treasury bond fell from 3.03% at the end of 2013 to 2.53% at the end of the second quarter of 2014. In periods of falling interest rates, securities that pay investors relatively fixed interest or dividends tend to rise in value. Utilities stocks, as quasi-fixed-income investments, rose along with bond prices.

Now here comes the tricky part. Rapidly falling interest rates, such as we saw in the first half, generally signal deterioration in the economic outlook. But if the economic outlook has deteriorated, how can we explain the continued surge in stock prices? Even more confounding is the fact that the second-best performing sector in the first half was Energy – a sector generally considered to be very cyclical. If you’re asking yourself why a pro-cyclical sector such as Energy and a counter-cyclical sector such as Utilities can be the top two performing sectors in the first half, you’re on the right track. And as has been the case for years, we can blame the Fed for the disconnect and distortion.

The Fed continues its flawlessly executed (sarcasm intended) monetary policy by convincing investors that low interest rates are here to stay. The effect of its jawboning has been to force investors into riskier assets, thereby supporting housing and stock prices. The Fed is convinced that its experiment is working. For our part, we will reserve judgment until 1) the Fed has fully extricated itself from the private markets; and 2) we see signs that the economic recovery becomes more widespread. We are unconvinced that a policy amounting to lining the pockets of our most fortunate will result in acceptable job and income increases for the masses. Perhaps more important, we think it is outright wrong for the Fed to be opining on and manipulating stock prices.

Stocks aren’t cheap, and stock prices continue to outpace earnings growth. During the first half, earnings for the S&P 500 companies grew about 3.5% compared to the 6.1% increase in the S&P 500. This is a trend that has gone on for quite some time, and it cannot last forever. The S&P 500 Index is now selling for about 18 times trailing year’s earnings. Earnings growth in 2014 is expected to be modestly better than last year but should ultimately settle in the mid-single digits range over the longer term.

Higher P/E multiples usually accompany periods of low interest rates. In the late 1990’s, Goldman Sachs’ partner Abby Joseph Cohen argued that low inflation (in the 2% range) supported P/E multiples of 20-22x. It was a very bullish, euphoric time when good news was embraced as gospel and bad news was dismissed as nonsense. This type of blind faith in stocks will completely evaporate in bear markets.

As we have discussed many times over the past few years, today’s P/E ratios are understated due to the fact that the denominator, which is earnings, is being supporting by record high profit margins. Corporate margins are running high relative to history as companies have benefited from both unsustainable sources of revenue as well as unsustainably low levels of expenses. On the revenue side, companies have enjoyed outsized revenues resulting from massive government deficits as well as unsustainably low consumer savings rates. On the expense side, companies are enjoying lower tax and interest payments while also benefiting from excess idle factory capacity and labor market slack. If some or all of these margin-boosting factors prove to be temporary, investors should make adjustments.

The Cyclically Adjusted P/E Ratio (also known as the Shiller P/E for its originator, Robert Shiller), which uses average inflation-adjusted earnings from the previous 10 years as the denominator, is now running at over 26x compared to a long-term average of about 16.5x. I suppose it’s possible that margins can stay at high levels relative to the past, but 50% higher than the historical average?

For now, though, the party continues, and we maintain our cautious posture. As defensive managers we are already hearing early criticism that we should be more aggressive or even speculative in our stock selection. This is a sign, but perhaps not the definitive one. Capitulation wrought by impatience, complacency and greed can be an alluring siren’s song. Our best advice is stay the course and, at all cost, be disciplined.