Happy New Year to one and all!
After a rather anemic 2015 in stock and bonds, we hope that 2016 will be better. We see some positive scenarios for stocks but many more concerns.
First the positives:
- More Fed easing in the form of negative interest rates or “helicopter” money could keep the market levitating longer.
- If Saudi Arabia decided to cut production and increase the oil price, that would help energy stocks but might hurt consumer stocks.
- A weak economy may weaken the USD which might increase exports and revive Emerging Markets.
- China may grow faster by devaluing its currency.
Now the rest. The Fed has held short-term rates near 0% for over seven years now. While this has driven stock prices and valuations to lofty levels, it also has unintended consequences. We wanted to explore those, as after seven years, they may become more manifest.
Very low interest rates lower the interest cost of large ticket items like cars, homes, furniture, earth-moving equipment and warehouses. Changes in interest rates have been used by the Fed to jumpstart the economy in slow times and slow the economy in over-heated times. These rate changes generally created short-term economic bursts to help the economy along. They work much like a Memorial Day sale or back-to-school sale, but for big ticket items that are financed. They work as long as there is a significant interest rate to cut.
In 1990, the Fed Funds rate stood at 8.25% and the Fed eventually cut rates to 3% to jumpstart the economy. In 2000, the Fed Funds rate stood at 6.5% and the Fed eventually cut rates to 1% to jumpstart the economy. Both times the Fed needed to cut rates by over 500 basis points to stimulate the economy.
In 2007, Fed Funds stood and 5.25% and the Fed cut rates over 500 basis points to 0%. Currently Fed Funds stands at 0.25% on its lower bound. With the economy limping along at 1% growth, should we fall into a recession, the Fed does not have 500 basis points to cut rates like it did before.
Remember that cutting rates acts like a sale. But if you cannot cut rates, the prices stay the same and there is no short-term boost. Imagine Macy’s having a 0% off sale. It probably would not drive additional sales.
If you can’t lower interest rates, what does a central bank do to increase demand? One option is to lower the value of your currency through Quantitative Easing (QE). This should increase exports which should increase internal demand. This is what Japan and Europe have been trying to do. However, everyone cannot do it at the same time. Lately even China has begun devaluing its currency to improve the exports of its overbuilt industries.
Let’s look at Japan’s experience with QE and currency devaluation.
Japan’s QE and devaluation caused a short term increase in production for 2013, but by 2015, it had worn off. In 2013 the JPY per USD went from around 80 to around 100. When that began to wear off, another round of QE began in late 2014 that drove the JPY down to 120 per USD. Short-term gain, long-term pain. Household spending has been soft for some time.
Remember that cutting rates acts as a short-term boost. In the US, after 7 years of near 0% interest rates, the impact has worn off. Also, all of the demand that was pulled forward is exhausted and there is now less potential demand going forward than before cutting rates.
Currently the Atlanta Fed’s GDPNow model expects about 0.7% GDP growth in Q4. The consensus usually starts the quarter at about 3.0% growth and revises lower as the quarter ends. Near 1% growth is about stall speed for an economy.
Also note below that Inventories have begun to build up. GDP calculations count the production as GDP, so there is an upfront benefit. If the products do not sell through to consumers and inventory builds, GDP will not be impacted until production slows. When productions slows, we usually end up in a recession. The last two times the Inventory-to-Sales ratio was this high, we were in recessions.
When inventories build, there is usually too much supply. To bring supply and demand back into balance, prices are usually cut. As can be seen in the Bloomberg Commodity Index, commodity prices have been falling for a few years and are at the lowest since the turn of the century.
Orders are a leading indicator for GDP. Orders are usually cut as inventories increase. Over the last 20 years, when orders were this weak, we were in recessions.
When orders slow, usually production is cut or prices are slashed. This usually leads to a drop in profit margins. Note how inflated profit margins are compared to the average for the past 40 years. Margins could fall 40% and still be “average” for the past 40 years.
Imagine what that means for stock prices. If margins are 40% above average and reverted to the mean, earning would generally fall 40%. If multiples stayed the same, that would be quite a drop. But we are also at the second highest valuation for large stocks and the highest for the median stock.
A large negative corporate financing gap (cash flow minus cost of ongoing operations) has signaled prior recessions. It also impacts a company’s ability to issue debt to buy back its shares.
Squeezed operating margins on highly levered companies leads to higher yields. Note that CCC yields are higher than 2011 when Europe was in extreme trouble. Some may attribute this to the trouble in the oil patch. But oil related companies make up less than 15% of the index.
And it’s not just in Energy. Yield spreads have increased ex-Energy. Higher yields on weaker credits tend to impact stronger credits as well.
Another area of weakness is trucking. 2015 freight rates were much lower than 2014.
So we see plenty of concerns on the horizon: weak GDP, weakening corporate margins, High Yield debt spreads widening, orders falling, inventories-to-sales growing. We would expect soft EPS growth in the US, which should put pressure on valuations going forward.
International is much the same. As mentioned above, Japan has weak growth at best, despite huge levels of QE.
Weak European loan growth explains much of Europe’s problems. European GDP growth is very weak as well.
China continues to slow.
Remember that it was China’s devaluation that surprised the market back in August, sparking an equity sell-off. It was thought that China still had strong growth until the devaluation threw cold water on that notion. But China had to play nice until it was added into the IMF’s SDR currency basket in December. With that behind it, China is free to devalue their currency to try to jump start its exports. However, with global demand soft, will there be export growth at lower prices?
For the fourth quarter, the Forester Value Fund reported a return of -1.0% compared to the Morningstar Long/Short category return of +1.6%. The underperformance was primarily driven by the depreciation of the put options. The equity portion of the fund returned +7.3%, outperforming the S&P 500’s +7.0% and the Russell 1000 Value’s +5.6% return.
The fund’s largest equity positions as of 12/31/2015 are UnitedHealth Group, Kroger, and Jarden.
UnitedHealth Group’s (NYSE:UNH) insurance business is performing well as 2015 medical cost trends were at the low end of expectations. However, the Individual Exchange business (related to the Affordable Care Act) is not performing well and the company is deemphasizing that segment. Their Optum division (non-insurance services) are benefitting from secular tailwinds as there is strong demand for services to control escalating health care costs. Finally, the company recently acquired Catamaran, securing their position as the 3rd largest PBM (Pharmacy Benefit Manager). The deal is highly accretive. We believe the shares should continue to perform well.
Kroger (NYSE:KR) is an exceptionally well-run grocery chain. They have consistently gained market share due to their on-trend product offerings, relentless focus on customer experience, and data analytics capabilities which allow them to maximize gross profit by optimizing price and promotion. Their Simple Truth private brand is a line of value-priced organic foods. The brand reached $1 billion is sales just two years after launch. Kroger’s efforts to improve freshness in produce and meats have paid off, with robust sales in those departments.
Jarden (NYSE:JAH) is a manufacturer of consumer products including Coleman coolers, First Alert fire alarms, Yankee Candles and Crock-Pot slow cookers, to name a few. They have a successful track record of acquiring ‘neglected’ brands, investing in them, expanding their distribution, and adding value as a result. In December the company announced they will be acquired by Newell Rubbermaid. The transaction is expected to close in the second quarter of 2016.
We try to produce the best risk-adjusted returns available. As risks have increased, we have increased our protection. If risks subside or are priced in, we will gladly reduce our protection. But until the market more fully reflects these risks, we will remain cautious.
Thomas H. Forester
CIO and Portfolio Manager
For more complete information on the Forester Funds, including charges and expenses, obtain a prospectus by calling 1-800-388-0365 or visiting www.ForesterValue.com. The prospectus should be read carefully before investing.
The foregoing does not constitute an offer or recommendation of any securities for sale. Past performance is not indicative of future results. The views expressed herein are those of Thomas Forester and are not intended as investment advice.