We often talk about cycles when discussing our investment philosophy and tactical asset allocation approach. This is because financial market and economic history is a series of multiyear cycles—albeit in the case of most stock markets and economies it is cycles within a very-long-term (secular) growth trend. These cycles, we believe, are driven by natural human group or herd behavior. And since we don’t think human behavior is going to evolve much over the next few decades, we expect markets will also continue to behave cyclically.
The existence of market cycles creates significant risks for investors who ignore them (i.e., the “this time is different” syndrome) and great opportunities for disciplined long-term investors. But while this time is rarelydifferent when it comes to investing, neither do history and cycles repeat exactly in terms of timing, duration, or magnitude.
Howard Marks, co-founder of the hugely successful investment firm Oaktree Capital and the author of many insightful investment memos over the past 25 years, often emphasizes the importance of understanding cycles. He uses the metaphor of a pendulum to describe market behavior, as summarized in the following excerpt from his 2011 book, The Most Important Thing.
Investment markets follow a pendulum-like swing between:
• euphoria and depression [greed and fear],
• celebrating positive events and obsessing over negatives, and thus
• overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world.
Marks notes that the oscillation of the investor pendulum is similar to the up-and-down fluctuation of economic and market cycles in that while the occurrence of the pendulum-like pattern is extremely dependable in most markets, one never knows exactly how far the pendulum will swing, how long it will stay at one extreme or another, or what might cause it to reverse.
It is impossible to consistently and accurately predict exactly when a cycle will turn or when the pendulum will start to swing back the other way or how far it will go at the extremes. But with our longer-term analytical framework and forward-looking assessments that are informed by and grounded in market history, we can position our portfolios to benefit from the cyclic swings of the pendulum. This requires having a long-term perspective and the discipline to stick to your process and consistently execute it over time, especially when the cycle and pendulum are swinging to extremes.
Recent Market Cycles
In recent years, our portfolios have been positioned for a turn in some market cycles that haven’t yet changed course, namely our tactical underweight to U.S. stocks versus foreign stocks, and our exposure to value or cyclical stocks (i.e., businesses that are more sensitive to the broader economic cycle). While this has negatively impacted our short-term performance, we remain confident the current market cycle will turn. The charts below show the relative performance cycles for both of these markets.
|Source: Morningstar. Data as of 2/29/2016. Foreign stock returns tracked using the MSCI World ex USA Index from 1970 to 1987 and the MSCI ACWI ex USA Index from 1988 onward.|
|Source: Bureau of Economic Analysis. Data as of 12/31/2015.|
U.S. Versus Foreign Stocks—Our portfolios are positioned with the view that over our five-year tactical investment horizon, U.S. stocks are likely to deliver underwhelming returns (low single digit), while developed international and emerging-markets stocks are poised to produce much higher returns. This has been a headwind to our portfolio performance as the current cycle of U.S. stock outperformance versus foreign stocks now ranks as the longest relative performance streak for U.S. stocks since the inception of the international stock index in 1970.
Here are just a few points that illustrate why we believe this cycle will eventually turn in our favor:
U.S. profit margins (and earnings growth) have been coming down, as we expected. But margins are still high relative to history and are likely to continue lower if and as wage pressures continue to build as the labor market tightens. Higher interest rates (and therefore higher corporate borrowing costs) would also be a negative for margins. Current corporate profit margins have been negatively correlated with futureearnings growth. That is, historically high profit margins are associated with low five-year forward earnings growth and vice versa. If topline revenue growth remains subpar and profit margins decline, earnings growth will remain under pressure.
Meanwhile, on the valuation side, we see little room for market-multiple expansion in the United States. The 12-month trailing price-to-earnings ratio for the S&P 500 is 24x, and the 12-month forward P/E ratio is 18x (using analysts’ consensus forward earnings estimates). These are both historically high levels. Our base case scenario assumes the P/E multiple contracts over time, bringing it in line with longer-term historical averages. Putting it all together, it means poor expected returns for U.S. stocks.
In contrast, developed international and emerging markets are almost a mirror image of the U.S market, with below-normal earnings and the potential for faster earnings growth from current levels. We also expect valuation multiples to expand somewhat from current levels as earnings improve. On this point, one additional supporting factor is that foreign markets have already suffered a steep decline, as if the markets expect a global recession even though it isn’t at all clear we are in such a recession or about to fall into one—although that’s one reasonable near-term scenario. In other words, at the low in February foreign stocks had discounted a lot of negative news, setting them up for a potential rebound if actual events turned out to be no worse (let alone better) than expected, which seems to be what we’ve seen over the past month.
|Source: Morningstar and Kenneth French. Data as of 2/29/2016. Data prior to 1979 is from Kenneth French’s database. Value is defined as high book-to-market ratios and growth as low book-to-market ratios. From 1979 onward we use the Russell 1000 Value Index and the Russell 1000 Growth Index.|
Value (Low-Multiple) Versus Expensive (High-Multiple) Stocks—In another unusually long market cycle, this has been the longest run of underperformance for value stocks on record going back to 1930, at nearly 10 years (outlasting the six-and-a-half years of the Internet/tech stock bubble). The flipside has been that on the other end of the style spectrum, expensive growth and momentum stocks have had unusually strong returns.
The chart also shows that over the long term a value investment approach has meaningfully outperformed a strategy of buying expensive (high-multiple) stocks. But there are cycles. Value investing has had several periods of significant underperformance. The inability of most investors to stick with a value approach during such cyclical reversals is likely what enables the “value premium” to persist over the long term. And the short-term performance-chasing tendencies of most investors pushes the pendulum still further.
So both of these cycles have been headwinds to investors like us who are valuation-driven and look at things on a longer-term “normalized” basis (i.e., based on reasonable estimates of earnings and valuations through an entire cycle as opposed to overweighting a single point in time that may reflect unsustainably high or low earnings). As such, we have been underweight (expensive) U.S. stocks and have found (cheaper) foreign stock markets more attractive in terms of their expected returns relative to risk. In addition, many, though not all, of our active fund managers have a long-term value approach as well and have lagged the broad market benchmarks at least in part due to the factors highlighted above.
Consequently, the reversal in the markets starting in February may mark a change from a cyclical headwind to a tailwind for our tactical positioning, as well as for many of our active equity managers. From the February 11 low, the MSCI ACWI ex USA Index is up 13.2% beating the S&P 500 by 21 basis points. Emerging-markets stocks have rebounded 17.7% (and are up 21.9% from their January low). The MSCI ACWI ex USA Value Index has jumped 14.5%, beating the MSCI ACWI ex USA Growth Index by more than two-and-a-half percentage points. European and emerging-markets stock indexes also have larger exposure to cyclical and traditional value sectors (such as financials, materials, and industrials) than the S&P 500. (Compounding both of these effects, our deep value, actively managed emerging-markets fund is up a whopping 30% from its January low, after suffering a huge drawdown over the previous year and half.) Our flexible and absolute-return-oriented fixed-income positions have also performed nicely since the market lows, gaining anywhere from 2% to 7%,while the core bond index returned less than 1%.
Will Recent Market Trends Sustain?
We have started to see references by several market strategists and investors to the potential for a so-called reflation cycle to kick in. James Paulsen, chief investment strategist at Wells Capital Management, recently laid out a scenario in which the recent market reversals may be the beginning of some new cyclical trends.
In a nutshell, Paulsen argues that if oil prices have bottomed and the current rebound to around $40 per bbl (or higher) is sustained, it may have significant repercussions on a wide range of financial markets. Because the U.S. dollar has been inversely correlated with oil prices for the past 15 years, higher oil prices imply a weaker dollar (or at least minimal further appreciation). This would represent a major change from the strong-dollar trend of the past two years.
In addition, Paulsen hypothesizes that with the U.S. economy near full employment, wages and inflation are likely to continue to rise (barring a recession), thereby pressuring corporate profit margins, earnings growth, and U.S. stock valuations. (We’ve been highlighting this risk to U.S. earnings growth expectations for a while now too.) This should also lead to higher inflation expectations and higher U.S. interest rates. Rising rates would not be good news for core bond prices, but would likely be positive for our non-core fixed-income funds.
This reflation scenario also suggests many of the most popular investment themes of the post-financial-crisis U.S. bull market—such as defensive and growth stocks outperforming cyclical value stocks, and U.S. stocks beating foreign stocks—could be reversed during the balance of this recovery.
To be clear, this isn’t a prediction of what will happen over the near term, but we think it is one plausible scenario among many that could play out. And while we use a short-term (12-month) time frame to run “reasonable worst case” stress-test scenarios as we manage our portfolios against various downside risks, it is nice to sometimes look at a “reasonable best case” and acknowledge the shorter-term “upside risks” to our portfolios as well.
Markets are cyclical, and for the past several years our portfolios have been facing some meaningful cyclical performance headwinds given our tactical asset class positioning and, more broadly, our long-term, active, valuation-driven investment approach. As discussed above, the sharp reversal in the markets beginning in the middle of the first quarter may indicate the market pendulum is starting to swing in our favor.
Even if the recent positive market trends turn out to be short term or reverse course, we remain confident that our disciplined investment process and risk-management process, consistently executed over time, will pay off over the completion of this full cycle, and through future cycles as well.
It is impossible to consistently time short-term market moves, trends, and reversals. As always, patience, discipline, and fortitude remain key to achieving one’s long-term investment goals, and to avoid getting swept away by the pendulum’s unceasing swings.
—Litman Gregory Research Team (4/1/2016)