Overstated Fears

Most every day there are multiple articles advising investors on how to prepare for the impending recession, or forecasting recession, or highlighting the vulnerability of record stock prices to the widely expected recession.  These articles reflect the need of the media to attract eyeballs and the desire of some pundits to garner attention.  Anyone can always appear wise offering advice for investors to be careful, especially when they don’t (or can’t) articulate what investors must actually do to be defensive.  In contrast, we see no imbalances that suggest an economic downturn is close at hand, yet the Fed is responding to a slower pace of growth by lowering interest rates, which further reduces the risk of recession.  We see equities as more attractive than bonds here, given the low rates, even as stock indexes are within a couple of percentage points of all-time record highs.

Late last week I read one article quoting a frustrated hedge fund investor complaining that investors are being irrational because the market was close to record highs.  Most likely, that guy was short stocks and losing money.  Another described the market as “stubbornly optimistic.”  But investors aren’t exuberant.  They’re cautious, at best, and at worst fearful, and they’ve been that way for some years now.

How else can one explain the multi-year outflows from stock funds and the flows into bond funds, even as interest rates are close to record lows?  Year to date, stock mutual funds have seen around $165 billion in outflows, while fixed-income funds have around $130 billion in inflows.  The fear driving those flows is quite understandable, since the media feeds into that on a daily basis.

It is also likely that many investors are just as frustrated as those hedge fund managers, who’re short.  Think about all the people who’ve pulled money out of stocks and watched the stocks rise to record highs, while they bask in 1.75% yields on 10-year Treasuries.  These investors are also taking very significant risks of bond price declines if interest rates rise at all, as they did over the past two weeks.  It must be very frustrating settling for a meager return for safety and suffering a price decline anyway, even as stocks rally.

In the meantime, stock prices are at record highs, but then, so are corporate profits.  Price-to-earnings multiples, however, are not even close to record highs.  In fact, the forward P/E multiple for the S&P 500 is very close to its 10-year average and significantly below the average for the S&P 495, excluding the 4 FANG stocks (Facebook, Amazon, Netflix, and the two Google–Alphabet—stocks).  A few very large companies skew the averages upward with their high P/E’s and large market weights.  Finding cheap stocks is not difficult, although finding attractive cheap stocks requires extensive research.  More than 100 stocks trade with price-earnings multiples around 8 or below—most of those should be avoided, but there are some diamonds in the rough.  At current valuations in the financials and energy sectors, for example, we think investors can do well with select holdings, although they may need to wait for them to come back into favor.  While they wait, they can easily find yield in major companies that exceed Treasury yields by a considerable margin.  All four money center banks, Citi, JP Morgan, Bank of America and Wells Fargo, and all the large integrated oil companies, Exxon, Chevron, Shell and British Petroleum, yield well above the 10-year Treasury and are likely to provide appreciation over that time span.  The large insurers, MetLife, Prudential, and AIG, are also cheap and yield more than Treasuries.

The greatest risk to the market, as usual, is the possibility of a recession, although as noted, we think that risk remains low in the near term. Some note that at more than 10 years in length, the expansion has set a new record for the U.S.  The longest expansion award goes to Australia, which managed to extend its last growth cycle without a recession to 28 years.  More importantly, the economy lacks excesses that might trigger a decline.  And as Byron Wien, Vice Chairman and noted strategist for Blackrock, has stated, the yield curve inverted due to the Fed supplying excess liquidity, which drove down long term interest rates.  It did not restrict liquidity to drive up short term rates.  Credit remains cheap and abundant, so firms borrow to lock in inexpensive financing.

Economic growth is more sluggish overseas than in the U.S., although Europe, Japan, and China are also maintaining pro-growth policy stances.  Tariffs may disrupt trade flows and it is as yet unclear that the trade war is close to ending.  So there is some risk here.  It is helpful that the U.S. is far less reliant on trade at roughly 8% of GDP versus much higher percentages for our trading partners.  Still, companies have become defensive and are spending less on capital investments out of caution.  While the trade war has taken some wind out of the sails of the expansion, it has not tipped the economy into recession and is unlikely to do so unless such policies become significantly more aggressive. The current environment points to moderate growth continuing, which underlies our positive view towards stock prices.