2019 Q3 Legacy Group Commentary

The third quarter brought a lot of movement in the domestic stock market but by September 30th the S&P 500 had not gone far from where it started the quarter. Geopolitical concerns continue to create a lot of uncertainty.  In the Q2 commentary, we mentioned the smoothing of trade negotiations between the US and China.  About 27 seconds after we hit “print,” President Trump announced the whole thing was falling apart.  This, along with Brexit drama, recession expectations and slowing corporate earnings growth, appear to have the market’s mood moving from cautious optimism to slight pessimism. 

Economically, the US and global economies continue to show signs of slowing.  Many countries across the globe are teetering on the edge of recession, defined as two consecutive quarters of GDP contraction.  Germany and the UK experienced economic contraction in the 2nd quarter.  Italy is also hanging on by a thread.  On the other side of the Atlantic, Mexico and Brazil both contracted in the first quarter and narrowly grew in the second quarter.  Checking in with the other hemisphere, Singapore and South Korea each had a quarter in the first half of the year where their respective economies contracted.   The slowdown in Chinese economic growth is also evident.  

Back at home, economic data is rosier but still pointing to a slowdown.  The US consumer is pulling their economic weight (almost 70% of US GDP) with continued strong spending.  In contrast, production and manufacturing activity both fell in the first and second quarter and the trend is expected to continue when Q3 numbers are reported.  With portions of the economy in a recession, it is reasonable to expect the rest to eventually follow.  That said, the strength of the US consumer – whose spending makes up 67% of GDP – will likely keep us out of recession territory for at least the next couple of quarters.   

Where’s the Value and Why it Matters

As we approach the turn of the economic cycle, we are continually reviewing portfolios to assess risk while we scour the financial markets for value.  Domestically, depending on what valuation metric is used, the US market is anywhere from slightly overvalued to highly overvalued.  If corporate earnings continue to fall, market valuations will become richer until the stock market reacts to the downside.  Looking internationally, European markets are also highly valued but not as much as the US.  That does not necessarily make them a better buy…they have a lot more fundamental issues than US markets. When we survey the entire world, though, the best value continues to be in emerging markets.  Admittedly, we have argued this position for some time (and we will argue a little more later in the commentary). We have also allocated our portfolios, in part, based on this position. 

Why pay so much attention to valuations?  Current valuation tends to be one of the largest determinates of market performance.  Increases in the price of a stock (and cumulatively, the stock market) happen for several reasons.  One is the performance of the company.  In the most basic terms, if a company manages to increase their revenue and their profits, the value of the company increases.  The other big factor is an increase in the price investors are willing to pay for those profits.  This measurement is called the Price to Earnings ratio (PE).  We have referenced this ratio many times over the years…let’s take a deeper dive into what it is and why it so important to consider.

Imagine you are a kid looking to get into the lemonade stand business.  You don’t want to start this lemonade stand from scratch (but of course the lemonade will be made from scratch…you can’t run a proper lemonade stand with Country Time) so you start looking at lemonade stands to buy.  After days of beating the streets on your bicycle performing due diligence on the local stands you narrow it down to two.  They are both perfect…on busy streets with lots of foot traffic, nice table set-up, a great chair to sit in and located under a shade tree.  There is only one difference.  The first makes $50 per day; the second makes $30 per day. 

You approach the owner of the $50/day stand and the young lady there says she’ll sell it to you for $1,000.  Next, you go the $30/day stand to talk to that kid.  He says he’ll sell it you for $270.  How do you determine which one is the better buy?  The most basic way is to look at the price of the stand relative to what it earns (Price-to-Earnings).   The owner of the first stand is asking 20x daily earnings for the stand: $50 x 20 = $1,000. The other owner is asking 9x daily earnings: $30 x 9 = $270.  Which is the better deal?  The second stand because at 9x vs 20x you can buy the second at a lower multiple of earnings.  Another way to think about this: it will take you 9 days to earn your $270 back on the second stand and 20 days to earn your $1,000 back on the first (lemonade stand season is short…that 11 days makes a big difference).  So you shell out your $270 and you’re in business.  

Our lemonade stand transaction is a simplified example of what happens in the stock market.  Just as the two lemonade stands were selling at different price to earnings (PE) multiples, individual securities sell at varying PE multiples and, cumulatively, varying stock markets (Dow vs S&P vs Emerging Markets vs Europe, etc) trade at different PE multiples.  Recognizing this is important because if an investor buys an investment at a lower PE their likelihood of making money through a phenomenon called Multiple Expansion increases. Multiples expansion occurs when the PE investors are willing to pay for a stock increases. Below is a basic example from John Neff’s book, On Investing.  Mr. Neff was the manager of the Vanguard Windsor Fund for over 30 years.  He had incredible success through his career, out-performing the S&P 500 by over 3% per year.   

In his example, he shows, with very basic math, why the price paid for an investment is critical.  His example has two identical scenarios

Static P/E Expanding P/E
Current Earnings Per Share $2.00 $2.00
Current Market Price $26.00 $16.00
Current Price/Earnings 13:1 8:1
Expected Earnings $2.22 $2.22
New P/E 13:1 11:11
New Market Price $28.86 $24.42
Appreciation 11% 53%

– same current earnings and same expected earnings – except for the price you pay for the stock.  His example demonstrates what happens to investment returns when you buy a stock at a lower PE and then the stock later trades at a higher PE.  The performance of the company is the same but when you purchase it at a lower PE it has more room for price appreciation.  In this example, a lot more room. 

So, that’s a nice example but how much does this come into play in actual market returns?  A lot.  In every bull market since 1900, multiple expansion has contributed over 50% of the total price growth of the stock market.  For example, from 1982 to 1999 the PE investors were paying for the market went from 9x earnings to 30x earnings.  This multiple expansion accounted for 52% of the price growth of the market during that time.[i]  But multiple expansion is a finite source of return. In each historical case, the market hit a point when it recognized that price increases based on further multiple expansion no longer made sense.  Think back to lemonade stand…you paid 9x earnings, $270, for the stand.  Would you have paid 20x at $500?  What if it was 30x at $900?  There will come a point, if you are not already there, where you will say, nope…that’s too much.  Investors essentially do the same thing with the market.

That is why there has been a strong correlation between the current market PE and future returns.  Historically, when the aggregate PE of the stock market is high, relative to its historical average, future returns for the following several years are lower relative than when current PE is low (yes, I have data to support this but I’m trying not to turn this into a journal article[ii]).  The reason? PE’s tend to be mean reverting. When there’s a triggering event that draws investors’ attention to high PE’s they start selling, they sell past the average PE to a low PE where the market eventually bottoms. 

GMO, a large institutional investor, maintains a 7-year Asset Class Real Return Forecast based, in part, on this concept of mean reverting PE’s. They look at current market values, make some estimations regarding future growth rates of earnings and profit margins and then come up with an expected return for each market.  Below is their most recent forecast.

The chart has a large spread between their expected performance of US Large Cap stocks and Emerging/Emerging Market Value stocks.  Most of this spread is due to the difference in current day valuations.  Over the last couple of years (2018 and 2019 year-to-date), Emerging Markets have continued to under-perform relative to domestic equities.  Earnings growth has been good but they have not had the returns from multiple expansion that domestic equities have received.  This has resulted in a large value discrepancy between Emerging Markets and Developed Markets.  Emerging Markets growth stocks have not been this cheap relative to US Growth stocks since 2002 (see chart below). 

In the 5 years following 2002, Emerging Markets out-performed domestic markets by a wide margin.  Will history repeat itself?  It’s impossible to say.  Remember the old Danish proverb: Making predictions is hard, especially about the future.  But there are a couple take-aways from the facts: First, domestic equities are facing heavy headwinds.  If return from multiple expansion is tapped out, or nearly so, the market will need to rely on revenue earnings growth and profit margin increases for return inspiring performance.  Not a very promising prospect when the economy is staring down a recession and profit margins (also mean-reverting) are close to an all-time high.  Second, it means domestic equities have a lot more room for multiple contraction.  In other words, in a bear market, they arguably have farther to fall.  Even though Emerging Markets are viewed as the riskier investment, right now, they may not be.    

In the late stages of bull market cycle, which is where we believe we are, is a time when few investors are looking at fundamentals for investment decisions.  The places where assets are over-priced are often the ones that get the most attention (becoming more over-priced) and the ones that are priced remain unfavored until some event – usually not a good one -makes people look around. When that happens, an old investing adage becomes topical again: Valuations don’t matter until they do and when they do, they are the only thing that matters.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


[i] Active Value Investing: Making Money in Range-Bound Markets by Vitaliy N. Katsenelson, page 55 for data through 2005.

[ii] Ibid, page 53 for data through 2005.

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