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You Must Be In To Win

by Catherine Trinder Miller, August 15, 2017


"If one is going to invest at times like this, investment professionalism -- knowing how to bear risk intelligently, striving for return while keeping an eagle-eye on the potential adverse consequences - is the absolute sine qua non."

- Howard Marks, Founder, Oaktree Capital Management,
From his book, The Most Important Thing, Illuminated

As I sit down to write you this letter, the headlines scream, "North Korea Now Making Missile-Ready Nuclear Weapons…"1 "Trump Threatens 'Fire and Fury' Against North Korea…"2

I am once again reminded of the constant uncertainty we face as investors. There are so many factors outside our control. It’s human nature to dislike uncertainty. Financial markets deplore it. While the “War of Words” is unlikely to result in the “War of Worlds,” the North Korean situation is complex and likely to persist for some time. History has shown that market pullbacks driven by geopolitical shocks are typically short lived. Your best defense is asset diversification customized to your specific needs and goals. Engaging in psychological warfare trying to time your exit and reentry into financial markets is never a winning strategy. As so aptly stated by Tadas Viskanta 3,

"Market timing is a gateway to cash addiction."

The cost of this addiction, and inaction, can be enormous. When adjusted for inflation, cash is a money losing proposition. At current low interest rates, there is no uncertainty surrounding this purchasing power loss. It is assured.

The opportunity cost of risk aversion in the latest economic cycle has been huge. For perspective, US equities generated a staggering 236% in cumulative returns from March 1, 2009 to July 31, 2017.4 What's equally interesting is the 90% cumulative returns generated by high-quality US Investment Grade Bonds over the same period.4 These generous bond returns were achieved with almost half the volatility of US stocks.5 Those sitting in cash paid a steep price for inaction.

As financial media and pundits sound alarm bells that valuation is too high, future returns too low, complacency pervasive, we caution that the same case for cash could have been made several years ago. Fast forward to today, the economic cost of this cash positioning would have been large.

Understanding how to bear risk intelligently is essential in the current environment. While history seldom repeats, it frequently rhymes.6 So what can we learn from history to guide our investment decisions today?

What do current prices imply with respect to future returns?

Without question recent strong U.S. equity performance has pulled forward future returns. Yet cries of excessive valuation in the US equity market we believe are overdone. Underlying the powerful price appreciation post-election is a strong fundamental picture. Corporate earnings are accelerating. Year to date, manufacturing, capital spending, and earnings are all strengthening (See Exhibit 1).7 Sales growth in the U.S. is tracking at the strongest level in six years.8

Based on expectations for S&P 500 earnings 12 months forward, the market is trading at 17.7x.9 Wharton's Jeremy Siegel, a leading global economist, has calculated the median P/E ("Price/Earnings") ratio since World War II at 16.7x, a slight discount to current levels.10 Yet interest rates today are much lower than in the past.

Siegel next looked at post WWII periods when the 10 year US Treasury yield was less than 8% (it’s 2.21% today11). The average P/E is 19x in these medium to low rate periods, so today’s 17.7x is lower than the long-term average in similar interest rate environments.10

In February of 2017, Warren Buffett was quoted saying, "We're not in a bubble territory or anything of the sort." In fact, "measured against interest rates, stocks actually are on the cheap side compared to historic valuations." It appears that Buffett and Siegel’s views coincide.

While major policy shifts, particularly healthcare, have been an uphill battle, the early stages of regulatory relief are already being felt across corporate America. Anticipation of corporate tax reform and potential repatriation of offshore capital has also fueled improving business sentiment. As Trump endeavors to deliver on his promises, particularly those of tax reform, repatriation, and regulatory easing, corporate relief in these areas is likely forthcoming. Most would agree, his political future depends on it.

Future Return Prospects Increasingly Bright Outside the U.S.

Recent manufacturing data (PMI) show economic expansion pervasive globally including major developed and emerging economies. Corporate earnings growth is improving across regions with some of the strongest growth expected out of Europe and the Emerging Markets through 2018 (See Exhibit 2).13 In recent months, emerging markets have enjoyed the added tailwind of a weakening US Dollar.

Developed international equity market valuations show stark undervaluation at almost 33% below long term average real returns.12 (See Exhibit 3). The political picture has stabilized with concerns of an EU break-up subsiding. The combination of countries earlier in the economic cycle, with fewer political headwinds, accelerating corporate earnings, trading at large discounts to historical price averages, paints a compelling investment opportunity in the developed and emerging international markets.12

Recognizing the demographic challenges faced by the U.S. in coming years, including an aging population and shrinking workforce, international investments are likely to play a larger role in diversified equity portfolios.

The Greatest Risk

The greatest risk to your success is not having a plan aligned with your goals that you can stick with, especially in periods of market volatility. Perhaps the next greatest risk is not reaching your goals because risk-aversion keeps you out of the markets. Diversification is essential and must be customized to meet your needs.

We are watching inflation closely. While inflation is low, the Federal Reserve (“Fed”) has more flexibility to gradually increase interest rates. Accelerating inflation could push rates higher faster; this scenario presents risk to both stock and bond returns. Yet in today’s persistently low inflationary environment, we see no immediate signs for alarm. Geopolitical or policy risks are frequently high and largely unpredictable. We must always be prepared for this uncertainty through appropriate diversification. We are prepared. And we are certain, you must be in to win.

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

- Benjamin Graham, The Intelligent Investor

Footnotes:
1 Warrick, Jody, Washington Post, August 8, 2017
2 Baker, Peter, The New York Times, August 8, 2017
3 Tadas Viskanta is the founder and editor of Abnormal Returns
4 Morningstar. The US Equity market is represented by the S&P 500 and Investment Grade Bonds are measured through the Bloomberg Barclays US Corporate 7-10 Year Index. Data is from March 1, 2009 - July 31, 2017 and does not include the reinvestment of dividends. 5 Morningstar. Standard deviation of Bloomberg Barclays US Corporate 7-10 Year Index vs. S&P 500, 10 years through 7/31/17.
6 Mark Twain
7 Capital Group, Mid Year Outlook 2017, p. 2
Exhibit Notes: Bureau of Economic Analysis, Bureau of Labor Statistics, FactSet, International Monetary Fund, Thompson Reuters. GDP is the actual 2016 and estimated 2017 GDP growth, as reported by the IMF. Earnings growth is year over year S&P 500 earnings growth in 1Q16 and 1Q17, as reported by FactSet. Retail sales is year over year change on 4/30/16 and 4/30/17. Capital expenditure growth is the year over year growth of U.S. manufacturing non-defense shipments, excluding aircrafts, on 4/30/16 and 4/30/17. Manufacturing PMI is the manufacturing component of the 5/31/16 and 5/31/17 PMI reports.
8 Blackrock, Mid Year 2017 Update
9 J.P. Morgan Asset Management, Guide to the Markets, p. 4, July 2017
10 Siegel, Jeremy, The Future For Investors, Data from 1954 – Present
11 Data as of 8/11/17.
12 Riverfront Investment Group, Quarterly Chart Pack – Price Matters, July 2017
Exhibit Notes: Riverfront Investment Group, MSCI. Data from January 1970 through May 2017. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Investments in international and emerging markets securities include exposure to risks including currency fluctuations, foreign taxes, and regulations and the potential for illiquid markets and political instability. The MSCI EAFE index measures the equity market performance of developed markets, excluding the US & Canada. MSCI presents the data for this index in terms of US dollars and in terms of local currencies. The chart above reflects index data in terms of US dollars.
13 Goldman Sachs Asset Management, Market Know How, Q317, Data as of July 31, 2017
Exhibit Notes: Equity earnings growth expectations is the simple average of the fiscal year 2017 Goldman Investment Research (GIR) forecasted earnings per share (EPS) growth and the fiscal year 2018 forecasted EPS growth.

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Catherine Miller and Teri Benson and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. No investment strategy can guarantee success. Past performance may not be indicative of future results. Investing in the energy sector involves special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary.

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