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Royce Funds Charlie Driefus - Will a Rise in Rates See a More Lasting Move to Quality?
Posted by: Canadian Value (IP Logged)
Date: May 1, 2014 09:43AM
Within small-cap, as measured by the Russell 2000 Index, non-earners, low return on equity (ROE), and non-dividend payers all outperformed in the first quarter. The good news was that late March saw signs of a re-emergence and shift back to the kind of quality names that we like.
Until the last day of the quarter, more than half of the names within the S&P 500 Index were down at least 5% from their 2014 highs while 20% were down at least 10%. This was a minor pause, not a major buying opportunity.
For sure, the market had been acting tired, with rather narrow gains. Through March 28, 2014, roughly 171% of the point gain in the S&P 500 came from the top point contributors, compared to only about 20% in 2013. The market is no longer broad but much more selective, which should be good for active managers.
On March 19, 2014, Janet Yellen, the new Chair of the Board of Governors of the Federal Reserve System, said, "The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
It will be appropriate to maintain the current range of the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's two percent long-run goal and provided that longer-term inflation expectations remain well anchored."
This quote allows for much wiggle room, especially in terms of time. In the same press conference, Yellen mentioned that interest rates could rise "in six months or so" following the end of quantitative easing. Was it intentional to release this negative assessment now to get it out of the way?
Yellen significantly reduced uncertainties (intentionally or not) when she mentioned this "six-months or so" time frame. Investors have now passed three consecutive psychological hurdles: Fed tapering, the end of QE3 (the third round of quantitative easing), and the time frame of rate hikes. This good news may lift equities even higher.
Clearly, the Federal Reserve meeting on March 19 had an effect on the market. Even the possibility of the Fed raising rates fostered a move to more quality-like attributes in stocks. This could be seen quite dramatically in the Russell 2000. Indeed for the first time in a long while underperformance occurred among the smallest market caps, non-earners, lowest ROE, highest beta, lowest share price, high growth expectations names, as well as non-dividend payers. It was about time!
Our outlook remains positive. The U.S. is an oasis in a global sea of problems, essentially independent of other nations. In addition, we have a growing population, a more laissez-faire economic system, rule of law, plentiful inexpensive energy—indeed, an energy renaissance—a manufacturing renaissance, and within a few years, we believe, balanced budgets—both trade and fiscal.
A couple of years back I used the phrase "the best house in the worst neighborhood" to describe the U.S. compared to other investment alternatives. I now believe it is the best house in the best neighborhood. Steven Rattner, the former head of Lazard Frères and the head of the U.S. government's task force charged with bailing out the U.S. auto industry, seems to agree.
In an opinion piece in The New York Times on March 23, he wrote, "Most of the continent [Europe] just doesn't feel as if it's on the economic move. What ails its economies is a lack of what keeps the United States—for all of our problems—so high on the world's leader board: flexible labor markets, the culture of innovation, immigration, and a relatively light regulatory touch." Rattner went on to state, "German businessmen gaze wistfully at the United States with its free-flowing and cheap natural gas."
The U.S. remains the bright spot in the global economy. Foreign direct investment in the U.S. has rebounded, supported by our manufacturing and energy renaissances, restrained manufacturing unit labor costs, relatively inexpensive energy costs, ease of doing business, and strong domestic demand. If you sell in the U.S., you are increasingly likely to produce or manufacture here also.
I believe there is little likelihood of interest rates rising soon. However, that does not exclude the possibility. Dismantling the monetary policies implemented since 2008 will clearly take exceptional skill.
While taper talk started in May 2013, rate-hike talk started in February 2014. Remember that the S&P 500 rose about 10% from May 2013 through the end of February 2014.
Talk is often worse than reality. No doubt rate-hike talk will continue. We frankly dismiss much of the rate-hike worries because the economy shows no signs of either overheating or inflation.
The falling bond yields, particularly in Europe, but to some degree here too, have decidedly deflationary overtones. Could the real worry about the winding down of stimulus be recessionary and deflationary? Is the market saying that we should not worry about rising interest rates? Related to this, who among us would have forecast that REITs (real estate investment trusts) and Utilities would be among the best performing sectors in the first quarter of 2014?
One byproduct of the inexpensive financing provided by the rescues of 2008-2010 is that it prolonged the life of marginal firms, adding to the physical volume of production and therefore to the weight on prices.
Debt is deflationary to the degree that it promotes production. Despite deleveraging, central banks still worry about declining prices as they boost the real burden of indebtedness.
Recently real GDP was revised up to 2.6% year over year for 2013's fourth quarter, with an even lower benefit from inventory building. Therefore, this year's first-quarter real GDP has an even easier comparison to last year's 1.2%. The Fed reported that as of the end of 2013, U.S. household net worth was a record $80.6 trillion, which was some $11.8 trillion above the 2007 peak reached in the second quarter of that year.
Inflation—with the exception of food, particularly hogs, cattle, and coffee—remains restrained. We will continue to monitor the validity of the "one-off" thesis, which holds that weather and disease have caused some food items prices to spike.
Economic activity slowed during the winter months due to adverse weather conditions, though otherwise it appears that the U.S. economy continues to improve without causing inflation.
We are still of the belief that stronger top-line growth will have a magnified bottom-line impact via much higher-than-expected incremental margins due to lower break-even points.
Our twin budget and trade deficits are both improving. I believe it is likely that President Obama will leave office with a slight budget, as well as a trade, surplus if the economy stays on its current course. The resulting stronger dollar should put further downward pressure on commodity prices.
Any inflation scare, which could result from the temporary boost in the prices of food staples caused by recent droughts and cold weather, will be self-correcting.
The list of countries that could potentially cause problems for the rest of the world are all low in terms of global GDP (the percentage of global GDP follows each): Turkey, 1-1.5%; Argentina, less than 1%; and Venezuela, less than 1%.
The market contagion we have seen has really been within the emerging markets, and not between emerging and developed economies. Domestic economic data points have been quite steady given all that has occurred.
The glass half full interpretation of this would be a Goldilocks view. As the creation of the U.S., the Fed underweights high-frequency events in favor of longer-term macro issues. It also underweights international items unless there is a direct effect on the U.S., and even there the reference point is its impact on U.S. household wealth and spending.
It is true that, if emerging market events cause either economic or financial stability risk to the U.S., the Fed might act, but it is legally bound to focus on the U.S. and will not function as a global central bank.
Jason Trennent of Strategas recently posed an interesting question: "What is the net present value of a stream of cash flows discounted by negative real interest rates?" Obviously, this cannot be answered. However, it does get us back to the T.I.N.A. (There Is No Alternative) asset class argument in favor of equities. Multiples can go higher, with almost all valuation metrics below their 15-year averages.
With inflation (and inflation expectations) low, there is reason to remain bullish. From 1950 forward, the average trailing 12-month P/E for the S&P 500 has been 17.9x when inflation is between 0 and 2% and 17.2x when inflation was between 2 and 4%. Therefore, while not table-poundingly attractive, I believe valuations are not yet in bubble territory.
A bubble will likely occur at some point, but from higher valuation levels than we are currently seeing. Bubbles do currently exist, however, in industries such as biotech and in asset classes such as junk bonds. At these levels, equities are certainly more exposed to unforeseen exogenous events that could shock them.
Does this possibility argue for more emphasis on high-quality dividend growers or potential growers? It might, but we think investing in such companies is a reasonable decision regardless.
Small-cap quality continues to look inexpensive despite solid performance in March from the Russell 2000. Within the Russell 2000, 444 companies are not expected to earn money over the next 12 months—131 are biotech and/or pharmaceuticals companies. In the first quarter, about 45% of IPOs were in biotech. Not a single one reported positive earnings and half had no revenues.
Even with these pockets of overvaluation, P/E ratios are not excessive for the market overall given low inflation and interest rates. Of course, there too is the rub: What is the proper P/E ratio when 10-year Treasuries yield 2.7%? As we have stated many times, we are in totally uncharted waters.
I am neither a market technician nor am I so inclined. However, there are some whom I respect. They are telling me that the base of the market's high is narrowing, composed of fewer and larger-capitalization stocks. Historically, this has not been a good sign.
To the extent that the market is re-calibrating towards a more normalized interest rate environment as a result of recent Fed communications, it may be a good sign that this too has already been factored in.
Recall that the Fed has kept interest rates near zero since December 2008. The developed world's central bankers are still very accommodative. The old adage, slightly modified, of "don't fight the central banks" still rings true.
After the initial noise and alarm surrounding Fed Chair Yellen's comments of possibly hiking interest rates "six months or so" after the end of tapering, the two-year Treasury note, arguably the most sensitive to rate hikes, is now around 2.8% compared to a year-to-date range of 3.03% on January 2 to 2.57% on February 3.
Perhaps the sign that we are in bubble territory will come when the Nasdaq Composite crosses its March 10, 2000 high of 5048.62. As of March 31, 2014 it stood around 4,220. There was plenty of bubble talk about the Nasdaq in 1999, yet from August 1999 through March 2000, the Composite doubled before it peaked. The takeaway is that bubbles are only proven after they pop.
Another traditional sign, and thus why the rate of the two-year note takes on such significance, is that bull markets usually don't end until the yield curve inverts—when shorter-term rates rise above longer-term bond yields.
This looks unlikely to happen for quite some time. March should be a good reminder of fear and greed—greed on March 10, 2000 and fear on March 9, 2009.
Further in defense of the idea that we are not yet in bubble territory is that the market cap weighted next twelve month P/E ratio for the 50 largest S&P 500 companies in March 2000 was 57.4x; in March 2014 it was 19.5x.
Even if valuations seem elevated, they are being backed up by earnings to a much larger extent than was the case in 2000. Everything is better, but hardly any market participants seem happy. This is hardly evidence of euphoric conditions.
The incremental margin thesis continues to intrigue us, particularly when most are saying that margins are too high and must revert to the mean. Interestingly, as of now, margins for the S&P 500 increased in the fourth quarter of 2013 on both a year-over-year and quarter-over-quarter basis. Part of this was due to constrained labor costs and technological innovation.
All this results in our belief in lower break-even points and thus higher operating margins—indeed much higher margins—once revenues advance more quickly.
Margins for the S&P 500 have been expanding consistently since the financial crisis. Many have been expecting this to reverse. We still believe that as long as the U.S. economy continues to gradually improve we will see further expansion.
The big reveal may very well be that earnings—thanks to lean and mean management and thus large incremental margins—may surpass expectations over the next few years. The manufacturing renaissance is a margin story, and that is still underway.
I like to invest in the unfashionable areas of the market because of their depressed valuations—it's the contrarian in me. You can only imagine how pleased I was, then, to read the following [url="]excerpt+from+an+interview+with+Robert+Shiller[/url], a Sterling Professor of Economics at Yale University, in the spring 2014 Wall Street Journal Money magazine.
When asked if he thought of himself as "someone smart enough to pick winners in the stock market," Shiller responded, "I've always believed in value investing. Some stocks just get talked about, and people pay all sorts of attention to them, and everyone wants to invest in them, and they bid the price up and they are no longer a good buy. Other stocks, they are boring. There is no news about them—they are making toilet paper or something like that—and their price gets too low. So as a matter of routine, you buy low-priced stocks and sell high-priced stocks."
Wise words, in my opinion.
Guru Discussed: Chuck Royce: Current Portfolio, Stock Picks
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