A number of years ago we wrote an article entitled “The Future Looks Different” in which we illustrated how the future often unfolds differently than popular expectations. As humans and especially as investors, we tend to project the future by extrapolating the past, we fail to expect the unexpected and conversely we fail to unexpect the expected. Usually, neither our greatest hopes nor worst fears come to pass, and we live our lives, and make investment decisions, caught up in the ambiguity between the two extremes.
Consider that just three months ago, oil was at $75 a barrel with the consensus belief that it was headed even higher as a result of increased global demand, geopolitical instability, shrinking inventories and bad weather. Today oil is under $60 a barrel with the expectation that it is headed lower. Oil and gasoline inventories are robust.
Three months ago, the 10 year Treasury note yielded 5.2% with the expectation that short and long-term rates were headed higher as a result of inflationary pressures. Today, the 10 year note yields 4.5%. Many investors now believe that the Federal Reserve is “done” raising rates and that, if anything rates may be headed lower.
Everyone expected the economy to slow, and it has, but while inflationary pressures have abated, and the housing market has clearly slumped, the consumer hasn’t rolled over and played dead. They seem to have gone shopping instead, boosting retail sales numbers beyond expectation. Over the years, the American consumer has defied all predictions of demise, the equivalent of a chain-smoking, heavy drinking, hard living person who outlives his doctors and everyone else. Some day, the borrow-and-spend lifestyle will come to an end, but evidently not today.
Meanwhile, and by contrast, business spending has been moderate over the past few years and corporate balance sheets are flush with cash. A boost in capital spending by businesses on technology and productivity improvement would provide additional stimulus to the economy and to information technology companies in particular.
The reversal of fortune on both inflationary and interest rate expectations has been good for stocks overall. Since June 30th, the S&P500 has climbed 5.2% while the Dow Jones Industrial Average and NASDAQ gained 4.8% and 4.2% respectively. Smaller stocks faired less well than large stocks, with the Russell Midcap losing 1.4% and the Russell 2000 remaining unchanged. Developed international markets were up slightly with the EAFE index rising 1.8% and emerging markets regained much of the ground lost in the prior quarter, with Asian stocks performing particularly well.
So does this change of course signal a new and enduring direction for the economy and markets – namely soft landing, benign inflation, moderating interest rates, and positive earnings growth – or a temporary respite from secular forces that will continue to challenge the economy and markets for years to come?
History suggests the answer is both and neither, depending on the time frame one considers. We are not economists, political scientists or market gurus and do not attempt to invest in near-term moves of the market up or down. Instead, we take a long view, preferring to focus on finding specific opportunities and imbalances that offer value and opportunity relative to specific and more general challenges and risks.
From our standpoint, the worldview is mixed. The risks are higher but that does not mean that they will materialize. Bad situations often lead to unexpected outcomes and obvious problems often beget unforeseen solutions. The investment markets tend to focus on near-term and dramatic events while ignoring subtle and gradual change. And so, as contrarians at heart, it doesn’t surprise us that we are suddenly awash in oil and gas where shortages were predicted and that falling interest rates have displaced rising interest expense. It does surprise us that investors seem complacent about events in the Middle East, focusing more on the latest corporate or political scandal.
Higher risks, even if they don’t materialize, do justify a higher equity risk premium and suggest lower multiple and valuation levels. With this perspective, we do not see stocks as particularly cheap nor expensive, but do see pockets of opportunity and risk.
Although we have seen some signs of life, we still think very large capitalization stocks, especially among the ranks of technology, diversified industrial and consumer companies offer the greatest value and opportunity. Many of these companies were formerly high flying growth stocks in the late 1990s and now sell at historically low valuation levels. In addition, since a large percentage of their sales are international, they offer an inexpensive and indirect way to invest offshore. These companies are all investing heavily in emerging markets and should participate in their long-term growth and success.
We also believe in maintaining a meaningful allocation to international stocks, especially developing economies like China, India and Brazil. While they have had a strong run and may suffer declines in the near-term, these economies should drive global economic growth in the coming decade and we expect their share of global GDP to increase significantly. Global capital flows should follow suit. Again, in the near-term, a good closet way to maintain exposure while reducing volatility is to buy domestic large capitalization stocks.
Finally, although we counsel broad market exposure, we would deemphasize small and medium capitalization stocks. In a slowing economy, which is still our view, and with higher overall levels of risk and uncertainty, these stocks are most vulnerable to corrections.
Jurika, Mills & Keifer