The second quarter of the year finished off in a very similar fashion to the way the first quarter did: with strong positive returns. All the major stock indices for both quarter and year to date periods were up sharply. As we now look into the second half of the year, we’ll need to reconcile the positive stock & economic data against the more somber bond market.
Now into the beginning of the third quarter, equities continue breaking through all time highs. The positive economic news hasn’t stopped, either. Unemployment remains incredibly low, inflation continues to be stable, and the threat of a tariff war hasn’t translated to downward pressure on stock prices. Yet, at least.
Interestingly, the US Treasury yield curve is inverted, as the yield on short term notes is higher than the yield on longer term bonds. As I wrote about last quarter, long term bond yields reflect the market’s long term economic outlook. And with longer term yields under pressure, there continues to be a disconnect between what the bond market and stock market are signalling. Bond markets appear to believe a recession is on the horizon, while the stock market is plowing ahead and not looking back.
Elsewhere in the world, stocks in developed international and emerging economies were both up, but trailed the US. We’re now at a point where the valuation spread between US and non-US equities is the largest it’s been in over 40 years. In other words, stocks from non-US countries are the cheapest they’ve been compared to US stocks for a very long time. This is one of the reasons I advocate for a globally diversified portfolio, and urge my clients to maintain a balanced approach. It’s far more likely, in my opinion, that US stocks will underperform international stocks over the next decade.
Although some negative trade news shook US stock markets in May, April and June were strong enough to push equities higher on the quarter. The trend here has not changed: large cap has outperformed small cap, and growth and furthered its dominance over value.
“Cap” is investing jargon (which I’ve been told not to use…..sorry) for capitalization size. Equity “cap” size is simply the number of shares in existence multiplied by the price at which they trade. The larger the cap size, the larger the company.
For large cap stocks, FAANG stocks continue to lead the way. On the year they are up substantially:
Facebook is up 51.32%
Amazon is up 30.8%
Apple is up 28.43%
Netflix is up 17.72%
Google is up 8.29%
Note that these five leaders are also very “growthy” companies. Each is growing as fast as they possibly can. They have new products, services, and ideas that they bring to market in their respective industries. Rather than distribute a portion of their earnings back to shareholders, these companies reinvest aggressively back into their own operations.
Over long periods of time, value tends to outperform growth, and small cap tends to outperform large cap. (This has been true over the last 100 years, at least). The market we’re in now is bucking that trend. The five companies above are doing very interesting things in the world, but my take is that much of their success is driven by easy monetary policy. With interest rates so low for so long, a large portion of the cash that’s been injected into the economy has found its way into these five behemoth tech companies.
Counter argument here is that we’re in the middle of a paradigm shift. As the world continues to evolve technologically, as the story goes, growth companies would end up outperforming value. This is certainly a possibility, but the argument sounds eerily similar to what we kept hearing before the tech bubble popped in 2001: “Don’t worry about cash flow, earnings, or valuations. We’re in a new era.”
As virtually every teacher, professor, mentor, boss, or investment book has ever taught me, this time is not different. It’s never different. The companies, products, and problems they solve are different, but the fundamentals are not. Thinking it’s different this time will lead you toward a bad outcome.
Will large cap and growth names continue to pace the market and trounce small cap and value? It’s possible. But I’m not betting on it.
International & Emerging Markets Stocks
Equities elsewhere in the world also posted strong gains on the quarter - but not as strong as those here in the US. Large cap & growth also outperformed small cap & value in developed international markets, but in emerging economies value pulled ahead on the quarter.
Outside the US stocks are on sale. Valuation metrics for non-US markets as a whole, Europe, Japan, and the emerging markets are all significantly below their respective 25 year averages. The CAPE ratio (cyclically adjusted price to earnings ratio) is one such measure. Similar to the standard P/E ratio, where low numbers indicate cheap shares & higher numbers indicate expensive, the CAPE ratio spreads earnings out over a 10 year time period. In doing so the measure removes short term volatility, and offers a “cleaner” look at the value of a security or index.
Currently we have the following CAPE ratios for stock markets across the world:
Emerging Markets: 15.4
Developed Europe: 18.7
Emerging Europe: 9.7
Emerging Americas: 19.7
Emerging Asia-Pacific: 15.8
Some will make the argument here that the US should have a higher valuation. We have the strongest, most diverse, and most resilient economy in the world, right?
True, but according to Meb Faber, the long term average CAPE ratio for both US and developed international markets is 22. The fact that the US is above this mark & the rest of the world is below tells me that the trend will reverse at some point.
U.S. Fixed Income
Whereas the US stock markets haven’t flinched in the face of a potential trade war, the bond markets are retreating. The best example of this is the yield on the 10-year US government bond, which started the quarter at 2.41% and ended at 2.00%.
With bonds, prices move inversely to yields. And with a tariff fight in the wings, bond investors have flocked to safer assets like US government bond issues. This buying demand drove up the price of these bonds trading in the secondary market, pushing yields down. Further, when considering new bonds the US Treasury will issue in the future, the government doesn’t need to pay as high an interest rate when there’s more demand for the asset.
While stocks are soaring, the bond markets are telling a more sobering story. Looking at the chart below, you’ll notice that the graph as of 6/30/19 shows an inverted yield curve. Short term interest rates (shorter than one year) are actually higher than both five and ten year rates. Historically, inverted yield curves have been strong, but not perfect, predictors of recessions. As short term interest rates are set by the federal reserve bank, longer term interest rates are good proxies for the bond market’s economic expectations.
Real estate investment trusts (REITs) were one of the few asset classes where US assets underperformed non-US assets. For both areas, Q2 gains were modest. US REITs gained 0.82%, whereas non-US REITs gained 2.64%. These are strong gains for only a three month period, but still substantially lower than the very strong first quarter. US REITs are up 16.67% year to date, while non-US REITs are up 14.68%.
Much of these strong year to date gains probably has to do with yield spread, arising from REITs’ tax & entity structure. Real estate investment trusts are afforded tax free status if they agree pay out most of their net income to shareholders as dividends. Because of this REITs typically have substantial dividend yields.
When interest rates are low, the spread between a REIT payout and what you’d command from a risk free government bond tends to be high. Yes, there is always more risk involved when investing in a REIT. But for the millions of investors in the world scrambling for yield amid our low interest rate environment, this is often a palatable option.
When interest rates rise, the spread between a risk free government bond and a risky REIT narrows. Investors are not compensated as greatly for taking on additional risk, and many typically decide to liquidate their REITs and revert to bonds. With short term interest rates creeping higher, REITs begin to have more downside risk.