INSIGHTS

On May 02, 2016

AAM Viewpoints - Significant Returns Are Never Comfortable

One of my favorite quotes from Mark Twain – one of my favorite authors – goes “History doesn’t repeat itself, but it does rhyme.” It appears that the nuance of this axiom is lost in the proliferation of the click-bait environment on the internet. The proliferation of social media and the communal attention deficiency disorder that comes as a result seems to only amplify the possibility of erroneous investing. The anxiety built up over the last 15 years where two equity crashes, a housing collapse and a deeper polarizing political environment only fuels the doomsday prepping which used to occur in more isolated scenarios.

We are no longer living in a “petri dish” economy and our analysis of historical events needs context. One example was a report from Tom Lee of FundStrat (via Business Insider) that U.S. investors have been massive net sellers of equities since 2001 to the tune of $2 trillion. Now that is a huge number, but its relevance is profound when you consider that the total U.S. market cap is $24 trillion – or the equivalent of roughly 8.3% of the entire market cap.

We have discussed this at certain times over the last few years noting the difference in the corporate equities owned according to the Fed Flow of Funds by households and its growth compared to general equity market returns. Since 2011, the total return in the Russell 3000 U.S. equity index is roughly 75%. In 2011, households owned $8.07 trillion in equity shares; at the end of 2015 it totaled $13.3 trillion. With the broadest market returns of 75%, one would expect the growth to total $14.15 trillion, or a 6% discount.

What I interpret this to be is that the household and consumer are on solid financial footing and we project it to improve as wages continue to strengthen. We continue to see some pressure on wages building and will move slowly through the system. One indicator of many we follow is the anemic growth in productivity and take a counter intuitive approach to it.

What we project is that there will be some reversion to the mean with longer-term productivity gains and wages will slowly grow in light of a productivity. This is the rhyming component of Mark Twain’s quote above rather than the history repeating itself.

One interesting note is the inverse correlation between interest rates and productivity gains that dominated prior to 2007. It now seems to be more correlated moving forward where rates and productivity may actually move higher together. One other tidbit that was published by the Kansas City Fed was that the recent anemic gains in productivity is due to the increased service sectors importance and the downtrodden mining sector where productivity is nearly twice the average.

Another rhyming component will be the recovery and growth of housing. This trend started several years ago when housing collapsed and has been ascending at a steady rate ever since. We still believe we are in the beginning stages of a long-term recovery in housing. The residential sector is underbuilding relative to demand and has been for some time and as a result, the growth in real estate prices has had an historic impact on household balance sheets. Over the last 60 years, homeowners have averaged 36% (conversely 64% equity to value) loan to value regarding their homes. Currently, they stand at 43%; however, at its low in 2009, loan to value stood at 63%. There is no point in U.S. history when this level was ever approached. The rebound has been as pronounced as we’ve seen, yet there have been some dragging forces on growth in real estate prices. One dragging force is that the supply of the labor pool that once built houses has gone away; secondly, banks who are flush with cash have been tepid in lending due to low interest rates and morphing regulatory forces that force them to make liquidity preservation their highest priority. Compared to even four years ago, we are down about 540,000 homes available, according to Trulia. This underbuilding should keep the prices in homes moving upward, if not an oscillating trend for some time to come.

With households’ financials in a much stronger state than has been seen in some time, corporations appear strong as well. Though much as been written about earnings and the energy sector, one need only look at the U.S. dollar’s influence on these sectors and the reversal to date. Context was lost in the prognostication of the U.S. dollar’s continued rise in 2016 without much historical review of Fed actions and asset price reaction. This combination has been historically a buying opportunity. Here are some points to consider in the macro environment for broader corporate strength:

• In the G4 (United States, Euro zone, Japan and Britain), the positive spread between cash flow and Cap Ex spending is as wide as we have seen as other periods of 2002 and 2010. Over the last 45 years, the MSCI World equity index has averaged 7.8% gains annually, while the three-year periods following 2002 and 2010 averaged 18.8% and 14.01% respectively. The growth in these areas has a positive influence on broader markets and economies.


• Expectations are that global bond supply could be down anywhere from 10 – 20% this year, perhaps perpetuating an already ridiculous amount of bonds trading at negative yields. Consider that roughly 30% of all sovereign debt is trading at negative yields and a total of 27% of the entire Bank of America global government bond index is in negative yields as well. If companies were strained we would see increased net supply, not less.


• One indicator that has gotten a little bit more news lately is the lack of commercial paper issuance by corporations. When commercial paper issuance increases, the corporate issuer is strained a bit more than today to meet daily activity needs. Currently we are over 50% of what the peak was in the fall of 2007 and also spiked at the end of 2000. After the market crash of 2000, commercial paper declined 21% and then rose 70% to its peak in 2007. This correction was of a more significant nominal and percent difference and has only grown nominally. We have yet to see any increases in commercial paper and could be years away from seeing this approach past high levels.

Although there are an abundance of people calling for historic crashes – or at minimum, an imminent recession – consider that the recovery from once-in-a-generation recessions are long and unsatisfying. We continue to see tremendous opportunity in certain areas in domestic and international equities as well as commodities and gold over the next few years. Significant returns are never generated when investing is comfortable. When the opportunities come, remember Warren Buffet’s quote:

“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”

CRN: 2016-0502-5323R

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 https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.