Risks in the Current Market EnvironmentSubmitted by Queen City Capital Management on September 6th, 2016
While the equity markets here in the U.S. have cooled off over the last year or so compared to their strong run through 2014, they still remain near their all-time highs. Between a Federal Reserve manipulated low interest rate environment, an ongoing profits recession, and extended valuation levels, concerns have mounted over the sustainability of the current move higher in equity prices. While we don’t necessarily feel a selloff is imminent, it’s important to be more diligent in your portfolio positioning in this type of environment, making sure that risk levels are appropriate for your financial situation and you are not falling into the trap of searching for higher returns amidst the low interest rate environment that overly expose you should a market downturn occur.
Globally, roughly one-third of all government bonds are trading at negative yields, while three-quarters are trading below 1%. Central banks both here and abroad in an attempt to stimulate growth, have pushed interest rates near zero and driven yields on government debt to below normal levels via quantitative easing that has soaked up much of the demand for higher quality bonds. While the central banks had hoped that ultra-low interest rates would entice more consumption, the early evidence is pointing to consumers increasing their savings rate rather than borrowing and spending. In addition, these artificially low levels skew fundamentals and force investors into riskier asset classes, driving them to higher valuations. While this has helped the markets in the short-term, the party won’t likely last forever.
In a recent Wall Street Journal Article (Market Math Doesn’t Add Up, August 29, 2016), a study by New York University’s Stern School of Business showed that through the first two quarters of this year, corporations have returned back 112% of their earnings to investors in the form of dividend payouts and stock buybacks. This means they actually had to borrow to achieve this feat. The historical norm is closer to 82% over the last 15 years. In addition to the unsustainability of this borrowing, albeit at historically low rates, this also means firms aren’t reinvesting their profits for future growth. This can be seen by the current low capital expenditure growth and contracting productivity levels. In addition, with earnings growth expected to remain low, maintaining the dividends and share purchases that have helped prop up the market will become more difficult.
The equity markets have also experienced a negative correlation to profits of late, meaning we’ve had six straight quarters of a profits recession where earnings have dropped while stocks have continued to rise. While profit growth is expected to pick up over the next year, with the current weak global economic environment, only moderate growth should be expected. Low interest rates, all else being equal, allow the markets to stay higher for longer than they would be in a normal (i.e. non Fed manipulated) interest rate environment. Assuming volatility remains suppressed, the fundamentals will continue to lose relevancy as interest rates stay at these low levels.
While many have argued for the merits of the TINA (There Is No Alternative) trade that favors investing in stocks over bonds, and in particular higher dividend paying areas of the equity markets, the fact remains that at absolute levels, bond yields remain too low and stock valuations too high in the current economic and profit environment to remain enticing. With this backdrop we believe returns will remain subdued, with risks to the downside unless profit growth improves. With that said, economic data continues to point towards the U.S. economy staying out of a recession over the next year, which minimizes the chances of any major bear market selloff in the equity markets. In this environment we believe it prudent to become more risk averse, as the upside potential is more minimal compared to the downside risks. Diversifying into areas of the market with better valuation levels, such as overseas, and having exposure to low correlating alternative investments will help temper any market draw-downs along with providing future return potential.
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All opinions and estimates constitute the firm’s judgment as of the date of this report and are subject to change without notice. This is provided to investment advisory services clients of Queen City Capital Management, LLC. It is not intended as an offer or solicitation with respect to the purchase or sale of any security. Investing may involve risk including loss of principal. Investment returns, particularly over shorter time periods are highly dependent on trends in the various investment markets. Past performance is no guarantee of future results.
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© Copyright September 2016, Queen City Capital Management, LLC. All rights reserved. Updated 09/16.