Investing In Action: Valuation Insights

 

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Fourth Quarter 2017

Happy New Year from Wealth Management at Century Bank! We hope this letter finds you well. It seemed like 2017 had a decade’s worth of newsworthy events packed into twelve short months. Despite all the political polarization, rising geopolitical tensions and a scaling back of easy monetary policy, capital markets had a banner year. Volatility was subdued throughout 2017 and stock markets rewrote the record books as the bull market marched on....

President Trump campaigned on the idea that he wanted to shakeup the political establishment in Washington D.C. From an investment perspective, we were concerned at the beginning of 2017 that any shakeup would knock the bull market, already in its late stages, off course. While the shakeup of “traditional politics” continues, the only shakeup in the markets seems to have been a reawakening of the “animal spirits”, exemplified by a soaring stock market, rising consumer confidence and business investment.

Global stocks, as measured by the MSCI ACWI Index, outperformed the S&P 500 for the year, posting returns of 23.97% and 21.83%, respectively. Over the fourth quarter though, the S&P closed the gap with its global counterpart, advancing 6.64% vs. 5.73%. Equity markets were in the spotlight this past year, and deservedly so, but both US and global fixed income markets posted positive returns despite the tremendous continued flows into stocks. The Bloomberg Barclays US Aggregate Bond Index returned 3.54% for the year while the Bloomberg Barclays Global Aggregate Bond Index returned 7.39%. Performance for fixed income markets mirrored the equity markets in the fourth quarter, as the US index made up some ground on the Global index posting a return of 2.24% compared to 2.02%.

By taking a closer look at the performance of the S&P 500, it is quite clear why equity investors have enjoyed the last decade. It is also apparent why concerns continue to mount about how richly valued stocks have become. The S&P’s 5-year annualized return of 15.8% is 48% higher than the index’s average annual return of 10.68% since 1971. What’s been fueling this bull market? For starters, inflation has not posed the challenge many pundits warned of following the Fed’s quantitative easing program. Given this low inflationary backdrop, the fact that a large part of the market’s return has been driven by “multiple expansion” is not a surprise. “Multiple expansion” refers to the increase in the price-to-earnings ratio of of the S&P 500. The P/E ratio over five years has increased 51.75%. In other words, at the end of 2012 investors were paying $14.82 for every $1 in earnings and at the end of 2017 the same earnings were being valued at $22.50. If inflation accelerates, or earnings growth does not live up to expectations, stock valuations will increase further.

The Federal Reserve continued to normalize rates in 2017, raising the Federal Funds rate three times over the course of the year—including once in the fourth quarter. The Fed’s tightening was not the only major development on the US monetary policy front: President Trump nominated Jay Powell to succeed Janet Yellen as Chair of the Fed. Powell will now head up an institution that has seen significant turnover in the Board of Governors over the last year. President Trump will have substantial influence over additional changes to the Board’s composition, which will ultimately determine the future direction of monetary policy.

As we look ahead at 2018, we pose three questions that we believe encapsulate some of the most important factors for investment opportunities and challenges in the near term.

Will equity markets ascend higher even as the unprecedented monetary accommodation of the last decade recedes?

Empirical studies of what the unprecedented quantitative easing program did (and did not do) to financial markets will persist for years, if not decades. Equity markets though, can likely write their conclusion now on the era of accommodative policy, which saw countless new records as corporate profits soared. In the US, normalization of monetary policy continued, yet the S&P 500, Dow Jones and Nasdaq posted double-digit returns in 2017. Keys to watch for in 2018 are how markets react to a more broad-based pullback in monetary stimulus and the effects of the Fed’s balance sheet reduction. If yields continue to rise in the US, investors who piled into stocks in search of higher yields may return to traditional fixed income investments which could lead to a cooling off in equity markets. However, if central banks take a more cautious approach than markets currently expect in 2018, a continuation of the equity market melt-up is certainly possible.

Will corporate tax cuts in the US supercharge growth and further spur a synchronized global recovery?

The GOP-led Congress got a big win in the last weeks of 2017 by passing tax reform legislation, the first major overhaul of the tax code in decades. A legislative victory is one thing—the real focus should be on whether it will be enough to jumpstart GDP growth and propel the world’s largest economy to new heights. Our belief is that the tax overhaul will provide a short-term boost to the economy, but its effects will peter out by 2019 and 2020. Since equity markets are forward-looking, strong jobs and GDP numbers to start 2018 could drive stock markets higher, at least for part of the year. However, if the effects of the economic stimulus from the tax bill seem like they will be short-lived, the second half of 2018 may see a true retreat in equity markets—something that was absent last year.

Geopolitical tensions filled the headlines in 2017 but were largely ignored by financial markets. Can that defiance continue in 2018?

Politics were hard to ignore in 2017. After an intense US Presidential election in 2016, followed by high-profile elections in Europe this past year, every event, both global and domestic, appeared to strike a political chord. Overall, markets embraced the good news emanating from the political sphere (business friendly policies, tax cuts, etc.) and frankly ignored or downplayed the bad (North Korea, rising debt in China, anti-globalization rhetoric, etc.). Will this persist? Booming corporate profits and the overall synchronized global recovery of 2017 outweighed many of the geopolitical tensions that popped up throughout the year. If this recovery falters due to renewed weakness in Europe, the debt bubble in China bursting, or increased trade frictions, it will become increasingly challenging for markets to climb higher.

Last year was certainly one to remember, but a single calendar year will not change our investment approach. With equity markets off to a hot start in 2018, we will continue to pursue opportunistic equity exposure where we see pockets of value. On the fixed income side, we will continue to favor shorter duration over longer duration securities as rates rise. And finally, we will continue to keep some dry powder in our portfolios to take advantage of any pullbacks or compelling buying opportunities that present themselves.

Carl Hall, CFA
Chief Investment Officer

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Third Quarter 2017

We are now three-quarters of the way through 2017 and capital markets continue to impress us—in both good and bad ways. US stock markets posted multiple record highs over the course of the quarter with the S&P 500 returning 4.48%. Global equities, as measured by the MSCI ACWI Index, were up 5.18%. Both the Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays Global Aggregate Bond Index posted positive returns for the quarter, up 0.85% and 1.76%, respectively....

These strong quarterly numbers are right in-line with the indices’ year-to-date performances.  Since the beginning of the year, the S&P 500 Index has returned 14.2% while global equities have returned 17.2%. The two bond indices previously mentioned have posted total returns of 3.14% and 6.25%.  With another full quarter left in the year, there may be more record highs on the horizon for equities—although there are a number of factors that could derail the bull market before year-end: tightening monetary policy, gridlock in Congress, uncertainty in Europe and rising debt in China.

The Federal Reserve will proceed with its balance sheet reduction program, shrinking asset holdings acquired in unprecedented fashion following the financial crisis. The winding down of the balance sheet will be gradual, however it too will be unprecedented.  Any unexpected effects could disrupt equity markets and potentially put near-term rate hikes on hold. At the Fed’s most recent meeting, policymakers provided guidance for December with the intention, as of now, to raise the Fed Funds rate another 0.25%. It would be the third rate hike of 2017, matching the Fed’s year-end 2016 forecast (there will be multiple inflation and jobs data reports between now and the December meeting, which could of course force the Fed to alter its plans).  President Trump will also likely name Janet Yellen’s successor, if he does in fact replace her, by the end of the quarter. A reappointment of Yellen would provide a sense of stability and continuity to markets. While a reappointment of Yellen is possible, Trump may want someone that is both dovish and in favor of some financial deregulation such as Jerome Powell. Other potential candidates include former Fed governor Kevin Warsh, Stanford economist John Taylor and the Director of the National Economic Council Gary Cohn.

Over the course of the quarter, multiple attempts were made to repeal the Affordable Care Act, with the most recent attempt, the Graham-Cassidy bill, failing to come to an official vote.  While some Republican Senators want to keep the focus on health care, the majority are ready to turn to tax reform and revisit health care at a later date. Trying to pair both tax reform and health care into a potential 2018 reconciliation bill (in order to take advantage of the easier-to-clear hurdle of a simple majority to pass legislation) would not only be complex and messy but, it could also significantly hamper the reform of the tax system that many have called for.

Concerns about a rushed legislative process and lack of bipartisanship on healthcare, combined with President Trump’s eagerness to be a dealmaker, raise the possibility that tax reform could be more successful than ACA repeal efforts.  Highly ambitious and in control of both houses of Congress and the White House, Republicans are looking to revamp not only individual tax brackets and deductions but also the corporate tax code. A major tax overhaul will be challenging: the last one happened under President Reagan. Nevertheless we remain optimistic that some tax legislation will be formalized by year-end that encourages investment and puts more money back in the American consumer’s pocket.

There was no shortage of major global developments over the last three months. Angela Merkel won reelection in Germany, although it will likely be much tougher for her to govern than in the past.  Traditional parties, including Merkel’s Christian Democratic Union, were weakened significantly while the rise of the AfD party demonstrates a changing tide in European politics. Although anti-Euro and anti-immigration parties did not win control of the governments in France or Germany this year, they are gaining influence: AfD received enough of the vote to have representation in the Bundestag. What does all this mean for the greater global economy? It means that Europe as a bright spot of growth this year may not last if Merkel’s power is stifled and the continent’s growth engine is slowed. Furthermore, France’s Emmanuel Macron has set ambitious goals both for his country and the European Union, the success of which may determine the trajectory and stability of the bloc.

Much like policymakers at the Fed are increasingly wary about weak inflation in the US, the European Central Bank’s policymakers are also dealing with inflation below target levels. The US has already begun the process of paring back the monetary stimulus provided in response to the financial crisis while Europe’s monetary easing continues.  Changes to ECB monetary policy may be on the horizon though as unemployment falls and confidence rises. ECB policymakers will decide later this month whether or not to scale back bond purchases in 2018.  Any pullback in stimulus raises the risk of choking off inflation and growth too early—something ECB officials are keenly aware of after prematurely raising rates in 2011.

Standard & Poor’s downgraded China’s credit rating from AA- to A+ in September, citing increased financial risks in the country. The debt-fueled growth in China is nothing new, but it continues to reach new heights. According to the Institute of International Finance (IIF), China’s household debt-to-GDP ratio hit a record high of 45%+ in the first quarter of this year. More recently, in August, the International Monetary Fund (IMF) warned that China’s rapid debt growth could lead to another financial crisis. There have been stretches where the Chinese government has sought to rein in credit growth but the spigot of liquidity can only stay closed for so long: officials are continually trying to strike a fine balance between reducing leverage and maintaining a certain level of economic growth.

In last quarter’s letter we mentioned North Korea’s ICBM launch in early July.  The rogue nation continued its belligerent behavior in the third quarter and the markets’ reaction was fairly muted. There were a few trading sessions where equities moved lower, haven assets rallied and volatility spiked—all of which were short-lived. Once again, the complacency conundrum in financial markets continues.  This complacency, in conjunction with the lack of market volatility in 2017, reaffirms our belief in building diversified portfolios with a focus on downside protection.  Our downside protection across various strategies may mean we leave some return on the table in the short run. However, we are prepared to increase risk exposures following a market dislocation, assuming we see more compelling valuations and fundamentals. 

Carl Hall, CFA
Chief Investment Officer

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Second Quarter 2017

Both the Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays Global Bond Aggregate Bond Index posted positive second quarter returns, despite posting negative returns in June. The US index has returned 2.27% year-to-date, including a 1.45% return in the second quarter. The Global index has returned 4.41% year-to-date (as of June month-end), including a 2.60% return in the second quarter. Both the US index and Global index posted slightly negative returns in June, -0.10% and -0.09%, respectively. The extent to which central banks around the world embark on tighter monetary policy will be a key driver to the bond market’s performance in the second half of the year.

The Federal Reserve once again raised the Federal Funds rate by 0.25% last month, the third straight quarter in which it has done so. While the Fed was expected to raise rates, this rate hike has been scrutinized more than others due to the lack of inflation present in the first half of 2017. Fed Chairwoman Janet Yellen has argued that the tepid inflation numbers are transitory, and whether or not this is in fact true will become more apparent in subsequent quarters. The Fed also laid out a plan to normalize its balance sheet by reducing the amount they will reinvest as US Treasuries and mortgage-backed securities mature. The start date for balance sheet reduction is not finalized, but will likely begin later this year in addition to another 0.25% Federal Funds rate increase. Compared to the size of the balance sheet ($4.5 trillion) the initial monthly reduction of $10 billion is small, however it represents another step towards ending a historic period of easy monetary policy following the 2008 financial crisis.

After the election in November, equity markets soared on the hopes of expansionary fiscal policy via tax cuts and increased spending. So far, little progress has been made on either, and anything substantial is likely going to happen in 2018 at the earliest. Tax cuts are certainly a major focus for Republicans and increased infrastructure spending could be the one area of bipartisanship in Washington. However, it seems that the administration’s focus on health care, immigration and trade will consume the rest of this calendar year.

It has been a year since the Brexit vote, and despite Theresa May’s commitment to leaving the EU, Europe as a united continent looks stronger now than it has in recent memory. Emmanuel Macron’s victory in the French presidential election provided the most significant boost to continued European integration in a time when populism is making inroads across the world. Macron’s victory may also signal the beginning of a new era: the election of a young centrist candidate from a brand new political party at the expense of the old guard. If Macron and his party can implement their agenda, their successful strategy could serve as a blueprint for candidates in other nations frustrated by political deadlock and sluggish growth. In the short-run, equity markets have responded positively to his victory and it should calm fears of European disintegration.

As Macron’s popularity and power rise, Theresa May has been significantly weakened relative to when she took over as Prime Minister. A disastrous result in June’s snap election combined with multiple domestic tragedies have placed an ominous cloud over May and her Brexit negotiations just as they have begun. Uncertainty regarding Brexit, combined with aging populations across the continent, bad loans at banks piling up, and new concerns about Greece’s finances, are more than enough to keep economic growth now, and down the road, limited. However, with a Macron-led Europe paired with signs of inflation taking hold and business confidence rising, Europe can remain an area of relative stability in uncertain times.

Elsewhere on the global front, perhaps “complacency” should be the word of the year for financial markets. On July 4th, North Korea announced to the world it now has the ability to launch intercontinental ballistic missiles (ICBM). US intelligence officials confirmed the successful launch of the ICBM, which flew 1,700 miles into space and posted a 37-minute flight time. Financial markets did not blink. Frankly, we find this puzzling. To some extent, the degree of complacency may be tied to the fact that index-based exchange traded funds now own 37% of the S&P 500. (Some experts believe this may be driving valuation distortions as there is less and less price discovery.) Regardless, it is as if the market is saying “don’t worry, he will never actually nuke another country”. Let us all hope Mr. Market is correct on this one.

The sun is shining and it appears to be smooth sailing across global financial markets despite underlying concerns regarding valuations, geopolitical risk and a changing monetary policy landscape. That said, we construct portfolios with a mind towards durability. While we are happy to be profiting from the rising markets, choppier seas will not catch us off-guard.

Carl Hall, CFA
Chief Investment Officer

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First Quarter 2017

The Fed raised rates again in March with the target Fed Funds rate now at 0.75-1.0%. It is anticipated that this rate hike will be the first of a few this year but as we have come to learn, the plan Fed policymakers present in one quarter can be significantly different from the actual changes in the policy rate in subsequent quarters. If inflation continues to take hold, it can be expected that the Fed will respond with another hike or two this year. However, there are no shortage of external factors that could put additional rate hikes on hold in 2017. No matter what happens the rest of the year regarding monetary policy, we have already witnessed something this year that had not happened since before the financial crisis: increases in the Fed Funds rate in consecutive quarters.

Despite the strong start to the year in US and global equity markets, the torrid pace slowed down in March. The S&P 500 returned 0.12% in the final month of the quarter while the MSCI All Country World Index rose 1.22%. US markets continued to rise in the quarter following the inauguration of President Trump. Similar to the post-election stock market rally at the end of 2016, the performance in US markets is largely attributable to the new administration’s pro-business rhetoric: tax cuts, regulatory reform and infrastructure spending. Some have said the pro-business talk has revived the “animal spirits” in the US. While it certainly seems like markets have become increasingly confident in the future business environment backed by strong hiring numbers and consumer confidence surveys, we are a little more skeptical. In our view, the post-election rally that continued into the first quarter of this year “priced to perfection” the anticipated pro-growth policies that Trump would pursue with the help of a Republican-controlled House and Senate.

In a way, March was a wakeup call for markets as investors seemed to realize that talking about major tax overhaul and spending plans is much different than implementing such legislation. The discrepancy between campaign rhetoric and legislative change was highlighted by the House’s plan on repealing the Affordable Care Act. The infighting that surrounded the bill in the House, combined with Senators proclaiming the bill would be dead on arrival and an ambivalent President, made clear that any legislative changes would be challenging to accomplish. Even in a best-case scenario, legislative change takes time. The health care debate showed that large-scale overhauls not only will take time, but may not come to fruition at all, or be much smaller in scale that Trump campaigned on.

Tax reform is another big-ticket item that Republicans want to tackle early on, but even if Trump is more personally invested in tax reform than he has been with health care reform, the task is still monumental. Even if some Democrats are convinced to support a tax reform bill because of middle class tax cuts for example, they are unlikely to provide the bipartisan support needed before the 2018 midterm elections to minimize the chance Trump gets a big “win” in the first part of his term. This supports our belief that stock markets, already sitting at high valuations, got ahead of themselves early in the quarter and this was followed by a slight pullback at the end March. In sum, while we are hopeful for a pro-growth corporate tax reform bill, we are not anticipating a major change just yet—although any progress towards one in Congress might be enough to guide equity markets even higher.

On the short-term horizon, increased market volatility may be in store for the second quarter of 2017 for a number of reasons. First, if the Fed raises rates again investors may be enticed to move money out of equities and into higher-yielding US Treasuries. Additionally, if economic growth in Europe continues to pick up, European debt may begin to look more attractive relative to yields over the last year, which could also draw money out of stock markets.

On the flipside of positive economic growth in Europe however lies the potential for destabilizing effects if Marine Le Pen wins the French presidential election. Her anti-Euro, pro-nationalism platform could serve as a knockout punch to the European Union. Based on current polling Le Pen has been gaining momentum recently, although she is still likely to lose to Emmanuel Macron. The French election, set to begin later this month, may be the biggest event with serious market-moving potential on the calendar for both the quarter and the entire year. If 2016 taught us anything, though, it is that unexpected outcomes in political events may send markets down in the short-term but that they have yet to derail the US equity bull market. The French election may prove to be different, but US equity markets have been resilient over the last 5 years. The escalation of conflict in Syria may also provide a case study in geopolitical driven volatility in the short-run that is outweighed by stronger market fundamentals over the course of the year.

Constructing durable asset allocations remains our primary focus, given all of the various economic and political puts and takes. We will also continue to take advantage of market dislocations during periods of uncertainty when we believe compelling opportunities present themselves.

Carl Hall, CFA
Chief Investment Officer

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Price vs. Value

A Good Starting Point

P/E ratio analysis (both absolute and relative valuation) is not a silver bullet when it comes to stock picking. All else equal, it is of course better to pay less for a stock (or any ‘widget’) than more, so the ratio provides a 'quick and dirty' snapshot. At the very least it provides a starting point in the valuation process. It is worth noting that the P/E only considers the accounting earnings a company reports; at the end of the day what really matters is cash flow generation. Even better than cash flow, a firm’s free cash flow profile is a more quantifiable way to understand management's historical and future value-creation (or destruction) acumen. P/E market data is bountiful than other more nuanced valuation metrics.

Data Viz in Action

A nice way to communicate the meaning and hopeful value of any quantitative data is through data visualization. In particular, violin plots allow us to visualize the full distribution of historical valuations along with additional insights we consider when seeking index-level and stock-specific insights. Century Bank's Wealth Management Group has turned to the 'R' software environment for statistical computing and graphics. R is the global 'lingua franca' for data scientists. We believe possessing even the most fundamental understanding of its value empowers us to communicate often complex investment concepts in a more intuitive and user-friendly way for clients.
Below is a violin plot for the S&P 500 TR index:

Data Source: Bloomberg©

Initial Interpretation

Right away we can see the index’s month-end P/E has been between 15.2 and 18.2 50% of the time (last 10-years). How do we know this? Each horizontal line represents 25% of the observations so the observations between the top line and bottom line represent 50%. Furthermore, we see there is a tighter clustering between the middle and top lines, or 17.08 & 18.24. The width of the violin plot reflects the data observation frequency. But what about the most recent month-end valuation? What does the valuation look like today as compared to the last 120 observations, spanning 10-years? Is the market trading where it usually does, on average? By adding a statistical summary function we can now see March’s month-end P/E level:

Data Source: Bloomberg©

Layering the Analysis

First we learned about the distribution of the month-end P/E ratios. Now, adding some more code, we see the most recent month-end level. The interpretation is that based on this metric, the index is more expensive than usual. Given the fact the yellow dot is in the top quartile, we can conclude “the market has been cheaper at least 75% of the time compared to today’s valuation”. Going one more step, we finally add a vertical red line that spans “two standard deviations” from the average valuation. Without getting too detailed about what this means, it can be summarized as follows: the top of the red line represents the most expensive 2.5% occurrences while the bottom of the red line reflects the cheapest valuations. We are currently trading at the top of the line:

Data Source: Bloomberg©

Cleaning it up

We all like a nice looking chart, so let’s add the “Economist” theme to the plot and include attribution and a quantitative summary:

Data Source: Bloomberg©

Summary Statistics: Price-to-Earnings Ratio for the S&P 500 TR Index®
Min. :12.04
1st Qu.:15.23
Median :17.08
Mean :17.04
3rd Qu.:18.24
Max. :24.24
Last :21.76
Data Source: Bloomberg®

Conclusion

Aside from reassuring the readers that we are not trying to psychoanalyze them with an inkblot interpretation, the above discussion shares our valuation analysis process. As we stated above, a high P/E does not mean “sell stocks”. What may explain today’s high levels? First, the data we are looking at is ‘trailing P/E’ data. P/E ratios reflect future expectations. The “Trump Bump” has driven valuations higher because the investment community believes there will be corporate tax cuts, regulatory easing, and greater capital mobility. From our perspective, we currently believe there is more downside risk than upside potential given how difficult it is to legislate any change in D.C. As a result, our focus is to focus on companies with strong balance sheets and ones with superior cash flow generation. At the asset class level, it means ensuring we assess relative global valuations while constructing portfolios with a defensive posture should volatility rise.

Carl Hall, CFA
Chief Investment Officer

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