INSIGHTS

On August 11, 2014

Viewpoints from AAM - How an Historical Perspective Can Help with Today’s Market

Jorge Augustín Nicolás Ruiz De Santayana was a Spanish-American philosopher, poet and literary critic. He was born in Madrid, Spain in 1863 and died in Rome, Italy in 1952. He spent several years in America and is most commonly known as George Santayana. His works focused mainly on the human spirit, art and religion.

Like many philosophers, much of his work has been condensed into pithy sayings and many of his quotes have been used in allegories/parables to provide intellectual heft to an author’s assertion. His most famous quote is, “Those who do not remember the past are condemned to repeat it.” One could use Santayana’s remark in many ways when criticizing a specific human behavior. Historians, political pundits and yes, even investment “strategists” have used his prophecy to bemoan a course of action they oppose.

It is worth considering Santayana’s maxim when analyzing today’s stock market. Investor sentiment shifted from a risk-averse stance earlier in the year to a more aggressive one in the latter part of the second quarter. We are amazed at how quickly some investors returned to “risk-on” investments despite an environment of negative gross domestic product (GDP) growth, “just OK” earnings and heightened geopolitical concerns. Single issues such as Iraq, Ukraine, Argentina and even economic malaise in Puerto Rico could have negatively impacted stocks by 5% to 10%, instead, the market shrugged off these challenges and remains at or near all-time highs.

Many think the shift occurred when the European Central Bank (ECB) engaged in their form of quantitative easing in an effort to stimulate the European Union (EU) economy. The ECB wanted the EU banks to increase lending and forced them to charge interest on deposits. So far, these efforts have been unsuccessful; banks are incentivized to purchase sovereign debt since regulators consider it “risk-free”, while bank loans are viewed squarely in the “risk” camp. Thus, EU banks promptly took the new capital and bought bonds, yields on most sovereign debt declined.

Others believe the shift occurred due to expectations by some of a substantial pick-up in economic growth after a terrible winter. We hope this happens, considering the most recent GDP report indicates the U.S. is on track for a negative -2.9% annualized growth rate (a full 3% less than the Bureau of Economic Analysis original estimates). It was, in fact, the worst quarter for GDP growth since the recovery began in June 2009 and the weakest first quarter GDP since 1982. Some are concerned that factors besides the weather were responsible for the lack of economic activity, notably the Affordable Care Act, which caused health care spending to decline -1.4% versus estimates of a +9.9% increase. While the most recent GDP reading was extremely disappointing, there are signs of growth and we believe a recession is unlikely.

One such sign was June’s strong jobs report, which was encouraging, however we expect it will not be enough to make a big impact on GDP in 2014. In fact, Bianco Research reported that 80% of job growth came from “unskilled” labor: “19% are part-time jobs, 16% are temporary jobs and 45% are low wage jobs. That is why we see big job growth, no wage growth and poor GDP. So, (there is) no pressure on (the) Fed (Federal Reserve Board) to do anything new...for now.” If we experience +3% growth in every quarter remaining in 2014, annual GDP year would be 1.5% at best!

Whiffs of inflation are also becoming more prevalent as food, energy, healthcare and housing costs/prices (in several areas) have increased. Though facts prove people are paying more for less – and wage pressures are still minimal – these higher costs of living are not viewed as “inflation” by the Fed. Instead, Fed Chair Janet Yellen says: “The data we're seeing is noisy.”

From a market perspective, regardless of the reason, low-quality stocks with high price-to-earning (P/E) ratios and non-dividend payers roared back in May and June after suffering weak year-to-date (YTD) returns. Sentiment is now bullish and investors seem to be complacent. Equity indexes drifted higher and higher while the Market Volatility Index (VIX) and trading volume paradoxically went lower and lower. In fact, the current VIX is lower than it was on June 30, 2007 while margin debt, buybacks, U-6 unemployment and the S&P 500 Index (SPX) YTD return are all higher. Remarkably, as of June 30, 2014, SPX has gone 1,001 days without a 10% pullback¾the longest run since July 1984 to August 1987 (1,127 days).

We have previously discussed how “valuations do not matter – until they are all that matters.” This chart emphasizes current S&P 500 Index valuations versus their longer-term averages. Almost all are outside of their historical norms. Even Noble Prize economist Robert Shiller concurs: “The Shiller CAPE P/E (cyclically adjusted P/E) ratio is unusually high right now. Historically, it hasn’t been this high many times in history, just 1929, 2000, 2007.” (Please read those dates again.)

Remember: “Those who do not remember the past are condemned to repeat it.” Sorry, Janet, these facts are not “noise.” The historical comparisons are obvious and ominous. Does anyone hear an alarm bell ringing?

Bahl & Gaynor has a contrarian bias. We get nervous when the entire investor class seemingly believes the same thing. Remember, almost every pundit/economist predicted higher interest rates, strong GDP, a rejuvenated Europe and superb earnings per share (EPS) growth in 2014. We, conversely, predicted lower rates and weaker GDP, said Europe would struggle and expect so-so EPS growth. Who hit the nail on the head?

Looking ahead, sentiment can shift quickly. Investors should not be surprised if stocks sell off as they typically do in the summer months. Catalysts could include weaker-than-expected second quarter earnings, lack of GDP growth, surprising Fed actions or further geopolitical unrest. If a correction occurs, the S&P 500 may stumble 5% to 10%. It will likely be “nasty, brutish and short,” but probably not like 2008. Instead, we expect stocks should recover quickly, producing a “V” shaped market, which suggests a buying opportunity should the long-predicted correction happen.

We believe being conservative is the best course of action. It seems rational to us to consider reducing allocations to expensive, low-quality, non-dividend stocks that have had a great run and shift to higher-quality companies with strong balance sheets, attractive valuations, and increasing dividends¾especially since these types of companies have, on average, just started to outperform.

George Santayana had another great quote that received less publicity, yet neatly summarizes our logic: “Nonsense is so good only because common sense is so limited.”

Bottom line: Investors embraced risk in 2Q 2014 and are now seemingly bullish and complacent. Bahl & Gaynor does not recommend an aggressive investment approach. Valuations for non-dividend stocks are at or above 2007 levels and historical norms. Economic growth is paltry and geopolitical risks are increasing. We believe an allocation to high-quality dividend-paying stocks is worth considering, given our expectations for volatility to increase more than expected.

CRN: 2014-0801-4343R 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com

The information contained herein is obtained from Bahl & Gaynor and believed to be reliable. The information is not warranted as to completeness and accuracy and is subject to change without notice. The foregoing has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security.

The views expressed in this commentary are not necessarily that of AAM.