State of the Markets
The second quarter started out quite strong with international and emerging market stocks posting strong gains in April. However, escalating concerns about Greece and China resulted in a mid-quarter reversal of this forward momentum.
Most equity asset classes closed the quarter with fractional gains. However, fixed income gave up almost 2% as the trend that pushed bonds to irrationally low yields finally reversed itself, leaving the bond market essentially flat for the year.
The total returns for major asset classes are below.
In the Headlines – Greece, China, and Puerto Rico
The news cycle has been full of daunting headlines over the past several months as Greece negotiated over its debt and austerity programs, the Chinese stock market suffered a steep correction, and Puerto Rico admitted its inability to make good on its extremely high levels of public debt.
There is no question that these are serious issues, especially for those directly affected by them. However, we would argue that the actual impact they have on us as investors is minimal compared to the level of attention they receive in the media. To put these issues in perspective:
Greece (and to some extent the rest of Europe) has painted themselves into a corner and is left without any good options. However, the problem is limited to Greece, as opposed to 2010 when there were significant risks of financial and economic contagion. In the end, we believe that whether Greece stays in or leaves the Euro, the effects will be minimal, and the market’s reaction to this drama has supported that conclusion. Ironically, so far this year, European stock markets have handedly outperforming U.S. equities.
The Chinese stock market has been on a roller coaster ride - up over 100% at one point and now down 30% from the peak (but still up significantly for the year). In some ways this reminds us of the U.S. in 2000 or even 1929 – huge volatility driven by retail investors trading on margin. While this makes for impressive headlines, it has little impact on your actual investments for several reasons. The volatility exists in the Chinese “A-shares” which are primarily owned by Chinese nationals. Our exposure to China is through Hong Kong-listed names, which have experienced dramatically less price volatility on the upside as well as the downside. Our exposure is also relatively small at about 1 percent of total assets in most diversified portfolios.
Recently, the governor of Puerto Rico declared the commonwealth’s high level of debt unsustainable. This implies a default or restructuring of $72B in outstanding bonds. The chart below compares the Puerto Rican debt load (relative to per capita income) to other states and puts the situation in perspective. It only takes a glance to determine that Puerto Rico is not a credit worthy borrower.
Economically and fiscally, this is a disaster – another government promising a level of benefits and support that could not be sustained. While these issues affect us greatly as taxpayers and citizens, the effect on investors is limited to those who own risky, high-yield Puerto Rican municipal bonds, which we do not. Our philosophy regarding fixed income has always been: If you own bonds for safety, then make sure you own safe bonds. This has served us well.
Current Valuations and Long-Term Returns
Possibly more concerning than the headlines referenced above, is the current valuation of the U.S. stock market and what that could mean for expected returns over the next decade or so.
There is no question that stocks in the U.S. have continued to get more expensive as markets have risen over the last five years, but there are questions about whether current valuations are excessive and whether this will result in another “lost decade” of subpar returns .
Opinions differ on this matter. Some very thoughtful investors view the market as extremely overvalued, while some view the valuations as perfectly reasonable.
In the current environment, high profit margins, low interest rates, and changes in accounting methods can make many backward looking valuation methods look exceedingly expensive, while numbers looking forward seem quite reasonable. And therein lies the disagreement.
To help bring clarity to this discrepancy, we point to Morningstar’s valuation work depicted in the graphic below. Because Morningstar does unbiased forward looking valuation work on thousands of individual companies around the world, they are in a unique position to aggregate this data and produce a comprehensive valuation of each stock market country by country.
Morningstar has the U.S. stock market overvalued by a mere 4%. This is much smaller than many pundits claim and confirms our belief that the U.S. market is at least fully priced (as we would expect it to be under most circumstances), but not as overpriced as some naysayers believe.
So while we don’t think valuations are very out of line, we would expect a moderately overpriced market to deliver moderately lower returns in the future. This is a result of the extended low interest rate environment and likely applies to all asset classes – stocks, bonds, real estate, etc. – as well.
We may be in a low return environment, but we don’t believe we can use this information to time the market. What we can do is plan for it by making conservative assumptions in our planning work and using probability analysis to make sure your financial plan considers a range of scenarios (including ones where future returns are lower than normal) while still meeting your long-term goals.