PIM has entered a period of transition back to keeping regular office hours. By the end of April, all PIM staff will be working from our Redmond offices at least three days per week. We look forward to hosting our valued clients for in-person meetings at your convenience.
In 2020 PIM joined the Pledge 1% movement. Our first charitable gifts, in 2020 and 2021, went to establish a memorial scholarship fund in the name of one of our founders, Mr. Frank Bosone, who passed away in 2019.
We assumed that going forward we would wait until closer to the end of each calendar year to select the charity we wished to support and determine an appropriate gift amount. This year, however, we were compelled to complete our annual charitable gift early.
In March, PIM donated $10,000 to the Doctors Without Borders General Emergency Relief Fund, which is largely, or entirely focused on Ukraine at this time. Among the determining factors when selecting Doctors Without Borders is that more than 85% of charitable donations are put towards global programs (1995-2020 statistic). This is a remarkably high effective rate for a charity.
The following market commentary is lengthy and detailed. It may be more technical than some prefer. But the economic and geopolitical environment is more complex than normal and thus, requires a greater understanding of the factors that influence the short and intermediate-term possible outcomes.
We start with a discussion of market valuation methods. We then move to an explanation of what’s going on right now. We conclude with a discussion of what our analysis suggests may be next.
Often in our client communications we declare that the market is somewhere between cheap and expensive. This is generally, and practically, true. Elevated stock prices are sustainable with supportive underlying economic factors and growing corporate profitability. Conversely, falling stock prices eventually find a support level, a level at which good companies are undervalued and capital flows back in to take advantage of the discount. Underlying our general comments about cheap versus expensive market prices, there exists considerable technical detail.
Accurately determining equity valuations has frustrated investors since equity trading first started under the buttonwood tree in the 18th century. Fun fact: the 1792 Buttonwood Agreement was arrived at by 24 market participants and memorialized basic rules and regulations to facilitate trading. Some refer to this event as the birth of the modern financial system.
Six Nobel Prizes in Economics have been awarded for developing models that have brought greater insight into our ability to quantify market behavior. Yet no one model or theory completely explains market valuations without drawbacks and caveats.
Understanding the true value of the equity market is vitally important in today’s environment. The global economy is dealing with a series of critical matters that have caused a correction in the S&P 500 (a decline of > 10%) and the worst quarter in the global bond market since the 1970s. War in Eastern Europe, a lingering pandemic, rapidly increasing interest rates, a hawkish Federal Reserve, a flat yield curve, a negative fiscal shock and the fastest food and energy price increases in forty years are the main issues effecting capital markets. Even with these challenges, equity markets can be attractive, but only at the right price.
There are many, many ways to determine the fair price of a stock or stock index. P/E (price to earnings ratio), CAPE (cyclically-adjusted price to earnings), Enhanced CAPE, Equity Risk Premium, PEG ((price/ earnings)/growth), Inelastic Markets Hypothesis, and more. The list is long. While some models are better than others for certain uses, no one model is consistently accurate and timely throughout the business cycle.
The most commonly used valuation metric is the P/E ratio. We quote this figure often as a rough gauge of market health. This ratio is simply the price of an equity or index relative to its earnings, typically over the past twelve months. P/E is insightful because it is based on earnings, and earnings drive long-term value. The ratio allows one to compare a firm or index to its own history or other assets to determine the relative attractiveness of the investment.
P/E ratios are timely and easily calculated. Unfortunately, the ratio is volatile and can send the wrong signal, as it does not take shifts in earnings momentum into account. Most importantly, the ratio fails to account for the quality or growth potential of corporate earnings. A company that can grow earnings in a weak market, or faster than the overall economy, is more valuable than one that cannot, though it may appear overpriced using P/E as the standard.
The Cyclically Adjusted P/E ratio addresses the volatility drawback inherent in the standard P/E ratio by looking at ten years of inflation-adjusted earnings. Including ten years of earnings history reduces volatility, but it is no longer timely and fails to adjust for accounting changes that have developed over longer periods of time. This critique is especially true over the past decade, during which there has been a great deal of financial engineering and improved operating efficiency throughout US companies. Operating earnings from ten years ago will not reflect improved efficiencies gained in the recent past.
According to the standard P/E ratio, the S&P 500 has been expensive for the past 9+ years. According to the CAPE ratio, the S&P 500 has been expensive for the past 30 years. This “expensive” S&P 500 has posted annualized returns of 14% over the past decade. Neither ratio considers the relative attractiveness of alternatives to the stock market, such as bonds. Neither ratio can reflect supply/ demand dynamics (such as the fact that the supply of publicly traded equities has been declining while investor demand has been increasing). Further, US companies are simply more efficient today. Profit margins, in aggregate, are at all-time highs, and earnings are more stable. Headwinds include a multitude of economic and monetary factors as well as geopolitical tensions and uncertainty.
Our Chosen Model
One advantage of using the standard P/E or CAPE ratios is that the information is readily and publicly available. Even with their limitations, they do provide some measure of relative equity market value.
There are more sophisticated models, developed by high level academics and practitioners in the world of finance and economics. They are not publicly available and not free of charge. Our internal, ongoing analysis leverages one such model, which incorporates the classic drivers of value (earnings, buybacks and dividends) while also accounting for increased bond yields, a risk premium for added geopolitical threats, equity supply and demand dynamics, and a host of other variables.
Conditions for strong growth are moderating in key areas. Consumer demand, the labor market and the housing market are all cooling to some degree. To an extent this is expected and is already priced into the market. Whether the magnitude and pace of change in these growth rates are enough to undercut analysts’ forecasts is yet to be seen.
Consumer demand is slowing, which was one of the reasons for our portfolio adjustments at the beginning of the year. US consumers are in a tough spot. The household savings rate is now below its pre-pandemic level. Wage growth, after adjusting for inflation, has been negative for the past year. After adjusting for inflation, retail sales have fallen or been flat for three of the past four months. Due to recent spikes in food and energy costs, consumers will be forced to divert spending from discretionary items towards staples. The University of Michigan Survey of Consumer Sentiment is currently at its lowest level since 2011. Consumer expectations for the future are also at an eleven-year low. Lower levels of consumer demand and confidence limit the ability of businesses to sell products and services, thereby slowing inflation and growth in areas outside of food and energy.
After nearly a year of false starts, the workforce participant rate is slowly increasing. The impetus does seem to be related to the increased cost of living. 20% of new hires in the February jobs report cited economic reasons for their return to the workforce. More people in the job market does tend to slow wage growth. In response to tight labor markets during the pandemic, businesses have been making capital investments to lower their need for new workers. As result, productivity growth is running at 2%, the fastest rate in a decade outside of the pandemic affected year of 2020. An increase in workforce productivity may not be met with increased job openings in the coming months if it also coincides with slowing economic growth due to weak consumer demand. The February ADP jobs report showed that small businesses with fewer than 500 employees, who tend to be more sensitive to economic conditions and who make hiring decisions faster than large firms, reduced the number of employees by 78k. This marked the first contraction in employment for small businesses since April of 2020.
The housing market is showing early signs of cooling. Sales are declining on a volume basis, largely due to the substantial increase in mortgage rates. The average 30-year mortgage rate is now 4.4%, up from 3.25% in January of this year. The number of homes on the market has returned to pre-pandemic levels (33% increase in 12 months), and the median sales price of homes has declined in two of the past three months. Sales volumes declined by 4% in February. Home prices seem unlikely to materially fall due to demographic factors and chronic under building of new homes, but the number of sales is likely to continue its decline, which presents a headwind for economic growth.
There are alternatives to single family homes. Multifamily housing construction starts are at a 47 year high. The added supply of apartments will offer people an alternative to home purchases, a needed option since affordability ratios are at a 16 year high. The median home sale was $400k last month. Increased availability of rental units and increased mortgage costs should relieve pressure on the housing market, which just posted a 19% price gain (year over year). The Case-Shiller Housing index hit a record all-time high in March after adjusting for inflation.
It's tough to make predictions, especially about the future. – Yogi Berra
As negative as the data points above may seem, it is important to realize that the economy is roughly one year removed from the fastest quarterly growth rate in nearly forty years. The rate of growth should be slowing now that the government and Federal Reserve are no longer vigorously supporting the economy. The policy response to COVID involved six trillion dollars of government spending to support the real economy and five trillion worth of Federal Reserve programs to support financial markets.
As these policy accommodations come to an end, GDP growth is expected to slow from 5.7% in ’21 to 2.8% in ’22. The first quarter of this year is expected to be particularly slow. The Atlanta Fed is estimating just 1.3% growth on an annualized basis for the first quarter. This datapoint is used in our analysis.
It is too early to know if we are headed for a normal economic slowdown, which on average occurs every 3.5 years, or a more pronounced slowdown that will lead to a recession. The futures market holds some insight into this question. Futures contracts tell us what prices market participants expect in the future for items important to the global economy. The prices of food and energy are good examples.
Crude oil is estimated by the futures curve to be 22% less expensive in one year, a very rare occurrence. Soft commodities, things you eat, are expected to be 10%-20% cheaper a year from now. The Fed is expected to increase interest rates quickly this year and modestly in ‘23, but lower rates in 2024. Simply put, the market expects commodity prices and interest rates to normalize over the next couple of years. Despite all the distortions of the pandemic and war in Ukraine, the market is assuming that the economy will avoid recession and will eventually return to the trends that prevailed in 2019.
Good financial models tell you what economic factors and forecasts are driving the market and to what extent or level of sensitivity. Our analysis suggests that the S&P 500 is approximately fairly valued now, and that the US economy will slow significantly, with roughly a 60% chance of a soft landing. A soft landing is the term used to describe when an economy cools from a rapid growth pace to normal trends without falling into a recession.
The primary determining factor is the rate and pace of interest rate increases by the Fed. At this point the market is expecting 8-9 quarter point rate increases over the coming twelve months, with an 80% chance of a one-half point increase this summer. These actions will cool economic activity and inflationary pressures, which is the Fed’s goal. Hopefully the pace and magnitude of interest rate hikes are appropriate for prevailing market conditions such that policy goals are accomplished without pushing the economy into recession.
In the meantime, while this unfolds, we will maintain the somewhat defensive investment management posture detailed in our last communication. This earnings season will be important to re-anchor expectations as investors assess margin compression, growth, and gain a better understanding of the status of the global supply chain.
The main body of this edition of our News Release presents data reflecting a period of economic and geopolitical uncertainty. It may be helpful to remember that this too shall pass. We don’t know when. It may also be helpful to remember that even if a recession is around the corner, periodic recessions are normal, occur from time to time, and also shall pass.
In light of current conditions, we offer a friendly piece of advice. Avoid overexposure to financial media. We live in a digital age. The aim of those presenting information is to get us all to click on a link. The primary strategy to accomplish this aim is dramatic headlines. Everyone does it.
Just this morning (4/4/22), there was an article in the Wall Street Journal, headlined: “JPMorgan CEO Jamie Dimon Says Big Risks Loom For the US Economy.” The first sentence of the article suggests that Mr. Dimon is preparing for “dramatic upheavals.” But the first full paragraph reads: “The head of the nation’s biggest bank offered a largely upbeat view of the economy’s health in his annual letter to shareholders Monday.” It is very easy to become first triggered by the headline, then more concerned after reading the opening sentence, then simply confused by the first paragraph. The article then goes on to summarize the issues outlined in this document but in far less detail. Best to avoid the seesaw of emotions that the purveyors of digital media fully intend for you to experience.
The CEO of Vanguard, Jack Bogle has voiced or penned many famous quotes. One seems particularly relevant today: “Time is your friend. Impulse is your enemy.” This is true and good advice. So let’s all enjoy Spring (whenever it actually arrives) and exercise the patience that this moment requires of us.