It is often not easy to be value investors. Even before the U.S. stock market recently corrected violently from near all-time highs, many stocks were languishing. Clearly those in the commodity sector from the extensive commodity rout in energy, base metals, precious metals and food products. The Commodity Research Bureau’s commodities index is back at the recession level of '09. The U.S. industrial sector is also down this year and looking attractive. Indeed, the resource heavy Canadian stock market is one of the worst performing in the developed world this year.
Disinflation is in the air and central bankers, concerned about the potential for deflation, are in stimulative mode.
And yet, simple supply and demand economics would suggest that low commodity prices should increase demand and diminish supply. Many commodities are below their all-in cost of production which will discourage additional supply. And, we believe those forces will ultimately, hopefully sooner than later, cause commodity prices to start to rise again, helping the depressed shares of their producers. Oil prices are up over 20% from their recent lows. Value investors are often driven to what is temporarily unpopular and cheap, with less potential downside risk relative to upside potential. Trading off risk for patience. Looking not just at the stock market but at the market for stocks. Value investing 101.
Central bankers everywhere are focused on the deflation signs and wish to have their currencies lower to stimulate exports and inflation. And this in a world of ultra-low interest rates in most of the developed countries. In the U.S., the rate on the 10-year bond is now at 2.16% compared to the dividend yield of 2.23% of the S&P 500. We believe the bull market in bonds is likely ending, especially if inflation picks up.
Global economic growth for 2015 is estimated by the IMF to be only 3.3%, with weak global demand. But the combination of low interest rates, currencies and commodity prices could ultimately be stimulative of growth, spurring inflation generally.
The Eurozone’s growth was somewhat weaker in Q2 with slower growth in Germany and poor output in France, so the E.C.B. will continue its stimulative quantitative easing. And unemployment in the Eurozone dropped slightly to 10.9% in July. Japan is improving from its increased quantitative easing and the low Yen, contracting in Q2 less than expected. China, the second largest economy, which has seen its growth slowing from weaker exports and factory output, and where stock market volatility has been scary, just devalued its currency, lowered interest rates and its reserve requirement, and is likely to see further government policy easing to assist its economy and stimulate inflation.
While Canadian GDP growth was slower in the first half, clearly affected by low oil prices, the lower loonie should help with improved trade numbers. July exports were up 6.3%, the biggest monthly gain in many years, shrinking the trade deficit and improving the growth outlook. Annual inflation also rose in July to its highest level since December, also helped by the lower currency.
On the other hand, the strong U.S. dollar, up about 20% since mid-2014, is impeding U.S. companies with foreign exposure, and the potential for a Fed rate increase in September, or later this year, will not be helpful. Q2 annualized U.S. GDP growth of 3.7% was better than anticipated but helped by higher inventories which could be a drag on future growth. Housing, consumer spending, durable goods orders and employment are improving, though wage growth remains at multi-year lows. Household net worth is at a record high. Existing home sales were up 2% in July. July retail sales were higher, and automakers reported stronger than expected sales. Manufacturing weakened but the U.S. trade deficit fell in July as exports rose, notwithstanding the global growth slowdown.
The U.S. stock market was overdue for an outsized correction, but it likely won’t result in a bear market. Positively, S&P 500 companies have strong balance sheets with $3.6 trillion in cash and marketable securities, to finance share buybacks, dividends, and to invest more when the opportunities are there. Earnings and dividends should continue to grow and, following the recent correction, the bull market should continue, particularly with attractive share prices, competitively low interest returns from bonds, high cash levels and bearish investor sentiment. And, insider buying has picked up, another positive indicator.
Our macros pillars—TEC™ and TRIM™—our economic composite and market momentum indicators—helped us remain bullish in the face of the recent market correction, as neither triggered alerts. Our economic composite, as tested for the last 50 years, typically signals well in advance of recessions. And, while the S&P 500 fell right to the bottom of its TRIM™line, it then inflected back up. Only in bear markets should one typically be overly pessimistic because the median corrective decline in bull markets has been about 6%, though, about every 2 years, a 10% or so decline takes place. The last decline in excess of 10% was nearly 4 years ago. With the markets fully valued and overdue for a setback, commodity prices having accelerated their decline recently, more signs from China of slowing growth and steep corrective days for the Chinese and other overseas markets, the U.S. and Canadian markets suffered a quick 13% pullback from their peak.
We continue to believe money will be treated the best in the stock market. At just below our assessment of its fair market value (FMV), the U.S. stock market has an earnings yield of about 6% versus 10-year bonds yielding about 2.16%. And, we are able to construct a portfolio of large-cap global equities with earnings yields well above the market’s 6%. Apple, Ford and Celanese, three of our latest purchases have earnings yields of 8%, 11% and 10% respectively.
Unlike the large cap North American stock markets, the small cap resource stocks (and now the large ones too) have once again been stuck in a bear market. One that stemmed from the high commodity prices post the Great Recession and the ensuing oversupply of various commodities rather than economic weakness, making the declines from 2011 difficult to predict. Now though, in the same fashion that commodity prices overshot to the upside, we are seeing an even more pronounced overshoot to the downside. Unless we are in the midst of a global deflationary slowdown, which results in an even higher U.S. dollar, and a major global economic dislocation, then we see a major inflection underway. Lower commodity prices will cut supply, while demand continues to grow, somewhat from the lowered prices themselves, which should boost commodity prices in the months ahead, especially since some have fallen unusually below the costs of production. This ought to help support the stock market in general. Earnings for the S&P 500 have been flat to down slightly. But, without the energy sector whose weakness is masking overall strength, they’re up about 9%.
Value Will Out
With central banks focused on growth and generating inflation, and their pedals to the metal, we believe the ultimate outcome will be inflationary growth, or even stagflation. But, inevitably, a boost for depressed commodities and the depressed share prices of their currently unpopular producers. A particular opportunity when the correction phase ends and the bull market resumes. Time to be contrarian. And patient value investors should clearly be rewarded.
Herbert Abramson and Randall Abramson, CFA September 4, 2015
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