April 18th, 2016
“We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.”
—John Kenneth Galbraith
The Week Ahead
Existing Home Sales
Philly Fed Index
The S&P 500 ended the week up 1.7% and has returned 2.5% YTD. International markets (EAFE) rallied sharply, up 3.6% on the week, but remain down -0.9% YTD. The 10-year Treasury ended the week at 1.76%, up 4 basis points. Oil (WTI) closed the week up a bit, to $40.40/bbl.
Valuations – Looking Like the Porridge Is “Just Right”
The market has rallied rather sharply off its lows as the energy market is showing signs of stabilization for the time being and many companies prepare to release financial results of the first calendar quarter. Despite the recent strong performance, we remain cautiously optimistic about the potential performance of U.S. stocks through the remainder of the year. The chart below shows that, as of the end of the quarter, valuations do not appear overly stretched in a historical context. By some measures stocks (S&P 500) look slightly undervalued and by others perhaps slightly overvalued—but in general things seem reasonable. For example, the Shiller P/E—also called the “cyclically adjusted price-to-earnings ratio,” or CAPE—which is essentially a P/E using 10-year average earnings, is just about at its 25 year average and the Forward P/E is well within its historical range.
Knowing That We Don’t Know
Investing assets on your behalf requires us to make forecasts and estimates about the future. We have beliefs about broad market themes and prospects for the performance of individual investments. However, we are experienced—and humble— enough to admit that we don’t know exactly what will occur in the future. The one thing we can say with near-certainty is that we will not be precisely correct in our estimates. Rather, we use diversification and other risk controls to attempt to position our portfolios to perform relatively well in a variety of environments, even if they do not end up being completely in-line with our base-case. As the British philosopher and logician Carveth Read said, “It is better to be vaguely right than exactly wrong.” The reasonable valuations we note above give us confidence that the market should perform reasonably well and we would be happy to be “vaguely right” in this regard. While the global economic data continues to paint a mixed picture about future growth, there is nothing, in our opinion, that suggests a crisis is imminent nor is there anything that makes us hopeful that the market is about to go gangbusters.
Money Movement Observation
One thing worth noting is the obvious movement of money into the downtrodden materials and commodities sectors recently. It is hard to discern if this is a one-off sort of event or the start of something more meaningful as it relates to inflation, interest rates, and where we are in the economic cycle. Typically, materials and commodities tend to outperform in the later stages of an economic cycle. It is worth watching as there is significant short interest in these areas which could be the fuel behind a more sustained move in these sectors and may signal to the Fed a green light to move ahead with their stated goals of normalizing interest rates. You will see a fear of increased inflation rates begin to show itself in a steepening of the yield curve—specifically, the relationship between the 2-year Treasury and the 10-year Treasury. Typically, there is roughly a 180 basis point spread between the two. Currently, that relationship is approximately 100 basis points. If inflation fears were to begin to manifest themselves in the market, we believe you will see it in a selloff in the 10-year Treasury at a greater rate than you would in the 2-year Treasury which would migrate that relationship back towards the historical relationship of 180 basis points, as previously mentioned. What does it mean for you? Well, the short answer is we generally think a steepening yield curve is a signal of health in the economy and largely for you as an asset holder, a good thing. Banks in particular would benefit from a steepening yield curve and believe financials are an area of the market that remains largely undervalued. Materials have been in a secular downturn since the financial crisis began due in large part to the fear of deflation globally. A shift in that situation could mark the end of the deflationary fears that have driven market action which again, we believe would be a good thing for you as an asset holder. Stay tuned as we will surely be speaking to this again in the future.
As always, thank you for your ongoing trust in our management of your assets and please do not hesitate to contact us with any questions.
Mike Turner, CFA
Buddie Ballard, CFA
Darren Anderson, CFA