The cost of money and the price of stocks
The summer quarter began with North Americanmarkets having fully erased their steep decline oflate-2018 and principal benchmarks reaching newhighs in the process. We’re not aware of anyonepredicting such a powerful start to the year, onewhich saw the S&P 500 post its best first half inmore than two decades and the Dow log itsstrongest June in 81 years, though we do recallseveral experts calling for continued trouble and,in more than a few cases, the bull market’soutright demise.
Setting aside the capacity for stocks to humblethose who ply at short term predictions, a lookback at the past six months is worthwhile to get asense of what might have sparked such a sharpturnaround and to see if the reversal providesany insight into broad investing conditions andoptimal portfolio structure. As it turns out,though, almost none of the things that werebothering investors at the end of last year wereresolved in the first half of 2019 and severalactually deteriorated:
Geopolitics – while Russia and North Korearemain vexing as ever, China grew morebelligerent in recent months, flexing its muscle inHong Kong and adopting an even more bellicosetone toward Taiwan; Iran leapt to the front burnerof concern as well, restarting its nuclearenrichment program and downing a US drone indisputed airspace.
Trade – Brexit terms remain unresolved and thefinal cleaving of Britain from the EU is now thatmuch closer, ominously set for Halloween of thisyear; USMCA (the replacement for NAFTA) is stillunratified and receiving new resistance from theDemocrat-controlled House of Representatives;and, most importantly, the US and China have yetto reach an agreement in their trade standoff,with new tariffs having been added since thebeginning of the year.
White House – the President’s pace of chasingstraw men and paper tigers through theTwittersphere has not subsided and he shows nosign of shifting his energy from personal battlesto policy development.
Earnings – the lift in share prices wasn’t driven byan earnings surge, as profit growth is expected tobe slightly negative for S&P stocks in the secondquarter and only marginally better in Q3.
About the only thing that has changed in favourof stocks is the price of money. It’s likely that themost significant contributor to the plunge inequity sentiment last fall emanated from thebond market, as markets began to price in thepossibility of a sustained bump in inflation. Atthat time, the yield on the 10-year US Treasury
Bond rose above 3.2% for the first time in morethan seven years and strategists began to talkabout an extended period of tightening policy bythe US Federal Reserve to keep economy-wideprices in check. Since then, however, inflationreadings have been soft and global growthexpectations have cooled. This change in outlookcaused the yield on the 10-year to recede by wellover a third to 2% by the end of the secondquarter, a significant move over any time horizon,let alone a six-month span. Though we can’t saywith certainty exactly how much the fall in bondyields contributed to the rebound in stock prices,it was undoubtedly a meaningful factor.
The level and direction of interest rates areimportant for stocks for a number of reasons, notthe least of which is valuation: if six or eightpercent can be earned on a guaranteed note,
The charts above plot North American earningsyields (black line) against 10-year governmentbond rates (red line) over the past 30 years. Asyou can see, earnings yields have tended tohover in the 4-6% range over the past threeinvestor expectations for stock performance aregoing to be commensurately high; if just 2% isavailable in the bond market, though, stocks arelikely to be priced to offer a lower absolutereturn. Currently, the companies comprising theTSX and S&P indices trade at about 17x trailingearnings, meaning that for every dollar ofcorporate income generated over the past 12months, the market is requiring a new purchaserof shares to pay about $17. If we flip this ratioaround and divide 1 by 17, this gives us anearnings yield of just under 6%, which might notsound like an extraordinary return on its own buthappens to be very attractive compared withwhat’s now offered on alternatives. In fact, thepositive spread between the earnings yield onNorth American equities and Canadian and US10-year government bond rates has rarely beenas high as it is now:
decades (notwithstanding short-lived spikes andtroughs), while bond rates have been on apersistent downward path. It’s also notable thatfor roughly the first half of the period, the incomerate on Canadian and US 10-year governmentbonds exceeded that implied by corporateearnings and prevailing share prices (grey shadedarea), but around the turn of the millennium therelationship flipped, with government bond ratespassing decisively below earnings yields (blueshaded area). This condition continued to expandover the ensuing decade and a half, so that theadvantage for stocks is now substantial in bothabsolute terms and relative to history.
This stretched relationship might help to explainwhy markets suddenly reversed course this yearand why declines since the 2009 bottom havebeen marked by their brevity. Not long aftermarkets retreat and investors digest whatevernews item or collective worry has precipitated thedrop, they seem to reassess relative value andconclude that, compared with the traditionalalternative, stocks look pretty attractive. If interestrates stay low for an extended period and,perhaps more importantly, if investors begin tobelieve that such a state will be long lasting, theimplications for stock valuations and prices couldbe significant. At the very least, it seems logicalthat low bond yields would provide a measure ofdownside support to stock prices and, for thepast decade at least, this appears to have beenthe case.
The low rate backdrop carries additionalimplications for stock investing and assetallocation. First, as mentioned, the decline inbond yields from last fall was spurred by a dropin consensus expectations for global growth. Thisis important because in a low growthenvironment, earnings appreciation is naturallyharder to come by and so companies which areable to provide this to investors becomecomparatively more attractive. During both thelong but historically tepid economic recoveryfrom the depths of the sub-prime crisis and in themost recent market rebound, dynamic areas suchas technology and internet retailing have led theway, while slower growing sectors like utilitiesand commodity producers have fallen behind. Atthe same time, the value stock sub-index in theUS has trailed the growth benchmark by asignificant margin, with strategists repeatedlycalling for a reversal of this trend that neverseems to come.
For the most part, cheap stocks tend to be capitalheavy – utilities with massive power generatingplants; auto makers and other industrials withcomplex manufacturing facilities; and commodityproducers with lots of property, heavyequipment, and exploration gear. A pure valuemanager’s interest is piqued when he or she canbuy such assets for pennies on the dollar, leavinga supposed margin for error on investment inclassic Benjamin Graham style. If money is free (ornearly free), though, and such fixed assets can bereplaced or replicated with minimal financingcost, perhaps they’re not worth as much as theyonce were. In such an environment, maybebrands, networks, market share, and innovationare where the real value is. In the recent past, themarket has said that this is so.
The thirst for growth and the desire todeemphasize fixed capital can also be seen in thebehaviour of individual companies: Walmartwants to retail like Amazon, Disney wants tostream like Netflix, and Marriott has entered thehomeshare space, hoping to capture some ofAirbnb’s ‘virtual’ success. Each of these moves isnotable not only because of its progressivenature, but because they are all “capital light” – inother words, each is designed to generaterevenue without the costly burden of a bricks andmortar retail store, a sprawling theme park, or atowering hotel.
Within DM portfolios, we see this dynamic in thefortunes of stocks like JP Morgan Chase and Visa,both of which are very well-run providers offinancial services. The first is an exceptionaloperator in banking and corporate finance but, inaddition to its proven acumen and renownedmanagement team, a purchaser of its shares getsexposure to 5000 or so branches which requireongoing maintenance and periodic refurbishmentto maintain customer appeal and which aresubject to rising rents and other tenancy issues.
The second, on the other hand, owns a dominantglobal payments system which is essentially runon computing power in office space which can besituated in whichever jurisdiction offers the bestmix of cost and logistics. While both companieshave outperformed the broad market over thepast decade, Visa’s edge has been extraordinary,with the stock besting the S&P 500’s return by afactor of nearly four through the 10-year span.
The questions raised in this commentary are thetype we ponder every day in the stewardship ofyour assets. Unfortunately, in investing there arefew definite answers, only possibilities andprobabilities. The wider we cast our research net,however, and the more factors we consider, thebetter we’re able to weigh potential outcomesand construct portfolios that strike an effectivebalance between opportunity and risk. Amongstthese inputs, we expect that the level anddirection of interest rates and the ability ofcompanies to generate strong growth with‘capital light’ business models will continue tomeaningfully impact both equity markets and ourportfolio allocations for several years to come.
All the best of the summer on behalf of the entire Dixon Mitchell team!