In the days of sail, mariners dreaded passages that took them through the so-called horse latitudes. These regions, roughly 30 to 35 degrees north and south of the equator, are frequently devoid of the reliable winds on which ships under sail relied. Ships could spend weeks or even months in these oceans, wandering without progress, seeking the scantest breath of air or ocean current to speed their journey. The origins of the term are murky, but historical accounts relate that sailors, panicked at the idea of never seeing terra firma again, would occasionally throw their horses overboard to preserve food and water for the crew. Emotion, poor discipline and inattention often became a greater threat to the ship’s safety than the lack of a following wind.
As we celebrate Labor Day and the unofficial end of summer, investors have sailed into the horse latitudes. Following the brief Brexit vote panic and recovery earlier this summer, since mid-July the S&P 500 has traded in a narrow range of 2150 to 2190, while the Chicago Board of Exchange Volatility Index (VIX) set a new low for the year in August. The equity market hasn’t had a daily move of greater than 1% since July 8 and has risen or fallen by more than 0.5% on just seven days.
In spite of this apparent malaise and dampened volatility, the S&P 500 has inched higher, establishing a new high in mid-August and posting a total return of 7.8% for the first eight months of the year. Smaller capitalization stocks bested that mark by rising 10.3% so far in 2016, and emerging markets (measured in U.S. dollars) led the way with a rise of 14.8%. However, as the nearby graph illustrates, on a trailing one-, three- and five-year basis, the S&P 500 index tops the league tables.
This gratifying performance comes in spite of a mounting list of challenges facing domestic equities, and the asset allocation group at Brown Brothers Harriman (BBH) continues to monitor these trends closely as we consider how to allocate client assets across markets.
The ultimate fuel for equity markets is corporate profits, and the fuel is running low. In this eighth year of an economic cycle, companies are finding it increasingly difficult to generate earnings growth. The benefits of cost cutting have waned, unit volume growth is hard to come by in an environment of modest GDP growth, and the absence of inflation makes it difficult to raise prices. This trifecta of headwinds has resulted in negative year-over-year earnings growth for the S&P 500 index for seven consecutive quarters. As the accompanying graph shows, bottom-up analyst estimates call for a rebound in earnings over the next few quarters, but we fear this says more about the innate optimism of security analysts than it does about the real likelihood of a strong earnings recovery.
The collapse in energy prices has something to do with this earnings recession, as woes in the energy industry have rippled through other sectors such as materials, mining and manufacturing. Those headwinds appear to be abating – at least on a year-over-year basis – and continued strength in the consumer sector ought to help earnings recover, albeit probably not at the pace indicated by forward consensus expectations.
Not every sector, industry and company is confronted with these challenges to earnings growth. Our continued allocation to equities is expressed through managers who seek to find businesses that can grow their intrinsic values through a combination of sustainable competitive advantages, robust free cash flow, pricing power and appealing rates of return on reinvested earnings. This combination of qualitative and quantitative characteristics is rare in this marketplace, which is why our managers tend to run concentrated portfolios. Concentration is a way of managing fundamental portfolio risk and a mark of investment discipline.
Rarer still is the opportunity to acquire these businesses at an appropriate discount to intrinsic value.1 Over the past five years, the price-to-earnings ratio of the S&P 500 has almost doubled from 12.1x in September 2011 to 22.1x at present as the rise in the price of the index has outpaced earnings. That level is by no means a peak, but at more than one standard deviation above historical averages, it is nonetheless rarified territory for market valuations.
Valuations do not exist in a vacuum, and an environment of low interest rates, modest inflation and few investment alternatives offers some justification for these levels. The value of any security, theoretically, is the net present value of the future cash flows it will generate. As interest rates fall, so, too, should the discount rate at which those future cash flows are discounted. Lower interest rates should support higher equity market valuations. Indeed, one common and simple valuation tool posits that the price-to-earnings ratio of the stock market should be the inverse of the long government bond yield. With the 30-year bond yielding 2.32% at the end of August, the implied P/E yield of the equity market would be 45x earnings.
Needless to say, we are uncomfortable relying too much on this argument and in no way believe that markets should trade at that valuation. In the first instance, our belief that true investment risk is the potential for a permanent loss of capital prompts us and our managers to identify an absolute margin of safety2 in each and every investment we make. This discount between price and value, whereas not a guarantee of downside protection, provides a valuation cushion unrelated to the valuation of the overall market. Second, we question whether the market level of interest rates truly captures market risk, as interest rate policy and quantitative easing have replaced the price discovery mechanism for what interest rates should be.
This combination of poor earnings growth and high valuations is worrisome, but we take some comfort as investors in the observation that what is true of the market isn’t necessarily true of each stock in the market. Although the S&P 500 index (as of September 2) is trading a scant 0.6% off its all-time high, only 35 of the 500 stocks in the index are trading similarly close to their highs. This is a narrowly led market, and the aggregate index levels obscure a different story as we look through the individual names in the index.
Seventy-nine index members closed last week at 20% or more below their 52-week peak prices. If we adopt that 20% litmus as a rough definition of a bear market, then 16% of the members of the index are trading in bear market territory. This by itself is not necessarily an indication of investment opportunity, but it highlights the observation that performance within the market is very different from the performance of the market. Parenthetically, this is one of the reasons that we prefer to allocate capital into equity markets using active managers. The ability to recognize and exploit valuation deviations within the marketplace is something that passive strategies do not offer.
Asset allocation at BBH takes into account market conditions and aggregate analysis, but as the preceding few paragraphs make clear, the top-down and the bottom-up don’t always correlate. Whereas the lack of earnings growth and lofty valuations make us cautious, our investment colleagues and managers continue to find appealing investment opportunities, so we remain committed to equities as an asset class.
We are, nonetheless, likely sailing in the horse latitudes of a lower return environment, which should come as no surprise after a five-year period in which the S&P 500 has compounded at an annualized rate of 15.5%. Without the fair winds of earnings and valuations, the overall market is likely to struggle to move higher.
Disciplined investing is always important, but particularly so in a period of modest returns in which investors can be tempted to stretch for return by lowering their investment standards or valuation requirements. Prudent risk management insists that we adhere to our discipline throughout a market cycle, regardless of the return environment. Don’t throw the horses overboard.
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
© Brown Brothers Harriman & Co. 2016. All rights reserved. 2016.
1 Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
2 Margin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.