November 2014
Interest Rates
The below graph of the 10-year Treasury rate over the past century puts current interest rates in a clear historical context. From 1946 to 1976 – a period of 30 years – interest rates steadily rose from 2.19% to 7.74%. Interest rates then experienced a sharp uptick in the late 1970’s and early 1980’s before receding to a historically normalized level. Current rates are at lows not seen since the 1940’s. The graph clearly illustrates that rates are not likely to go lower, but rather to rise. The wider bond market tends to move in conjunction with Treasury rates. From 1945 through the late 1970’s the average annual return in the bond market was about 3.5%. From 1980 through 2012 the average annual return for bonds was closer to 8.5%. A bond gains in attractiveness, and therefore value, when its interest rate is higher than the current market average. Conversely, a bond declines in value when its interest rate is lower than that of newly issued bonds. Bonds issued at today’s low interest rate will be less attractive than bonds newly issued at higher future rates, meaning these bonds and the funds that hold them are expected to decline in value. Given rates are likely to gradually move upward – reverting to more typical historic levels – bonds will not provide the strong anchor position investors have experienced for several decades. Considering these projections, we would be more cautious on bonds over the next 5 years.
Source: www.multpl.com
Stock Market Valuations
Many of us remember the stock market decline following the extended technology market advance in the latter half of the 1990’s. By the late 1990’s many investors only wanted to own technology stocks. This caused the price to earnings ratio (P/E) of the S&P 500 Index to climb to around 30 near the end of 1999, compared a longer term average of 17.[1] To date 76% of U.S. corporations that have reported 3rd quarter earnings, reported above analyst expectations. This is above the long-term average of 63%.[2] In a few weeks the market will be moving its focus on 2015 earnings. Currently the updated P/E ratio on estimated 2015 S&P 500 earnings is about 15.72. While a number of pundits speak about an overvalued market, the P/E ratio contradicts this negative market assessment.
Purchasing Managers Index (PMI)
PMI has continued to move up this year, as we reported last month. Data reported at the end of October showed a 2.4% monthly increase to 59.0. The index was originally developed by Herbert Hoover as a quick and reliable monthly survey and early indicator of the health of the economy. Below are a few comments from respondents of the latest survey. [3]
“Holiday orders are exceeding seasonal forecasts. Customers are demanding additional quantities above prior orders. Fuel costs and other positive signals appear to be creating demand above normal.” (Food, Beverage & Tobacco Products)
“Weakness in commodity prices very positive on our business.” (Fabricated Metal Products)
“Outer body material changes in the auto industry means new equipment and manufacturing growth.” (Machinery)
Media
Media often steer dialog to the more negative aspects of any story. Human beings have a genetic hardwired response to run from fearful events. The news media understands this impulse well and many outlets rely on fear to some degree in order to hook an audience. While fear responses originated with reactions to predators in the wilderness, it does not end with our move to modern societies. A person investing for retirement who is uncomfortable observing their account balance decline on a day-to-day basis is often responding to this same danger stimulus. It can be difficult to sort probability from possibility in all manner of situations. Part of our responsibility as your advisors is to help filter out media noise and provide relevant market information to help you decide what real risks are for you, versus possibilities that are unlikely to ever occur in reality.
A recent perusal of financial headlines was cause for mirth within the office. You may have recalled the oil price spike in spring 2012. Article titles from the time called up scenarios of doom and gloom. One would think a decline in oil prices, as we are currently experiencing, would result in happy headlines. Not so. According to various articles oil prices are “swooning”, “slipping”, “sliding”, etc. Here are a few headlines related to the drop in oil prices:
Falling oil prices put pressure on Russia, Iran, Venezuela – Washington Post 10/20/2014
Oil Prices: Will the slide hurt the US shale boom? – The Christian Science Monitor 10/23/2014
Is the Cascade in Crude Overdone? – Investing Daily 10/24/2014
Oil Prices Slip on High Supplies – Wall Street Journal 10/24/2014
Markets are constantly in flux. Every change results in a mixed bag of winners and losers. The media has a habit of focusing on the losers and forgetting, or downplaying, the winners in any given situation. While this attitude may help make it easier for us to identify situations to avoid or alter, it often leaves us without the knowledge of positive gains from changes in economic events.
Master Limited Partnerships (MLPs)
In mid-October we saw MLPs in the oil & gas pipeline sector incur higher than usual market volatility. Energy Transfer Partners a large pipeline company, was trading around $64 a share on October 6th. By October 15th it had traded down to $53.50. Just a week later it was back above $64. Many other pipeline stocks experienced similar price moves. During this time period we saw a broad market selloff of more than 5%, with oil prices sinking 12% in October and more than 25% since the summer season.[4] Markets were driven down by heavy selling in the broad energy sector as investors were concerned about profitability of oil & gas exploration companies. Hedge funds further contributed to the selloff in MLPs as some were forced to sell in order to cover their margin balances.[5] The benefit of MLPs in the pipeline sector is that their profits come from transporting oil and gas, not exploration, meaning profits are less dependent on higher oil prices. We believe the October selloff in oil and gas pipelines was an overreaction and has since corrected itself. We maintain our belief that pipeline MLPs are a strong longer-term position providing steady income.
Summary
We tend not to hear from clients during market advances, but see an increase in client contact during market pullbacks. When viewing account balances on a daily or weekly basis one must keep an appropriate perspective, knowing investments are meant to be held for a longer time period. Declines are common in the stock market, and many are short lived with little fundamental relevance. Do you recall the pullback of August 2004? How about June 2006 or September 2011? While each of these declines did affect investors at the time, these temporary pullbacks have faded from memory for the long-term investor. Our office had been expecting the market correction we recently saw for several months. We feel this pullback is now over and are looking forward to what corporate earnings, GDP, manufacturing data, and other economic metrics are indicating – a period of mode
[1] www.multpl.com S&P 500 PE Ratio
[2] Thomson Reuters, Proprietary Research Earnings Aggregates, (October 31, 2014)
[3] ISM, Manufacturing ISM Report on Business, October 2014
[4] Morningstar
[5] Virtus Investment Partners, What Happened to MLPS, October 15, 2014