One thing we know is the financial crisis of 2008 created incredible opportunities to own assets of all types at incredibly low entry points. That was 7 years ago but seems like yesterday to investors who experienced the gut-wrenching feeling of opening a quarterly investment statement and seeing the damage wrought by the market sell-off.
So what now for the next 7 years? After Fed stimulus at a magnitude never seen before (but now reversing) and stock and bond rallies in the US that rival any in history (but now struggling to hit new highs), how should a portfolio be invested?
At Clear Rock, we believe in long-term investing and don’t try to time the markets. However, sometimes markets go through transition periods and we are in one of those today. Despite what we view as sluggish economic growth, the US has been the standout for global growth over the past few years. Earnings growth has fully recovered and corporate profitability measures have exceeded prior peaks. Investors have also been willing to pay higher and higher premiums for those growing earnings, pushing valuation multiples on fundamentals like earnings, revenues and cash flows to or near historical highs. The stock market pause of the past year reflects a turning point for growth of fundamentals – with disappointing earnings at a level not seen since 2009. Valuations however, have remained elevated, which in lies the problem. Fundamentals need to pick up soon to justify the high price currently assigned to financial assets of all types, most particularly stocks.
Investors have always made a judgment between the attractiveness of stocks versus bonds: the promise of capital appreciation with stocks or stability and income with bonds. Stocks have had an unfair advantage over the past 7 years but bonds have also performed well. Unfortunately, normalization of interest rates (higher) is likely to lead to lower bond prices, so future returns on bonds will have a hard time matching what they have produced recently. To make matters worse, today’s longer maturity bond yields are unlikely to cover the loss in purchasing power that inflation may one day bring again. More attractive areas in the bond market include municipals with short maturities, corporate bonds with attractive premiums, as well as some areas of the mortgage market and emerging market debt. Navigating exposures within the bond market will be more difficult over the next few years but good returns are possible, just not as easy as it has been in the last few years.
Stocks have benefited from a recovering economy, spurred in large part by extremely low interest rates. From a global perspective, US equities have led the rest of the world to an extent not witnessed before. Here, too, we seem to be at a transition point where past performance is unlikely to continue. The relative economic strength of the US has pushed up the dollar versus other currencies which made US stocks look even better. Unfortunately, dollar strength is the primary reason earnings are now as weak as they are. We think US stocks will consolidate their gains over the next few years, which likely means limited upside while fundamentals catch back up with current high valuations. The good news is that the likelihood of entering into a recession, which seemed like a real possibility just a few months ago, appears to be less likely today.
Investable options within stocks include large, small, growth, value, US, and non-US as well as niche strategies focusing on sectors and themes. Broad areas that appear most attractive today include large cap, value, and non-US stocks. The growth style has had strong momentum but appears to be fading and small cap stocks are broadly overvalued. Non-US stocks in places like the UK, Europe and Japan offer an opportunity to benefit from some of the same trends that pushed US equities to new highs, namely: massive stimulus from central banks, extremely low (even negative) interest rates, and improving corporate profitability levels that finally appear set to recover from post crisis lows. Currency movements have negatively impacted investments outside the US but the pain of this adjustment is mostly behind us now. Developed market earnings growth has picked up as foreign companies benefit from this new found competitive pricing advantage for global exports. Last, emerging markets have been through a rough few years tied to the commodity pricing cycle that has collapsed. EM countries were both the biggest producers (Brazil) and the biggest consumers (China) of commodities and the reversal of fortune has taken a toll on investment sentiment in these countries.
For most of the world, lower energy prices will serve as a powerful and long-lasting stimulus. The shale boom created in Texas has temporarily turned into a bust, but Texas ingenuity will have an impact on the global economy which is enormous.
So for the next 7 years, we must be diligent in our pursuit of attractive risk-adjusted returns. Our belief that traditional portfolios of 60/40 stocks/bonds is likely to disappoint or at least provide less return than the last 7 years pushes us to think a little more creatively on the right mix of investments that will meet the goals of each individual Clear Rock client.