Executive Summary For 1Q2014
- The first quarter produced modest positive returns for diversified investors.
- The S&P 500 was up 1.8%, while International Stocks (MSCI All-Country ex-US Index) gained 0.6%.
- The US Aggregate Bond market also returned 1.8%, recouping most of 2013’s losses.
- Alternatives such as Gold (+6.5%) and REITs (+10.1%) led all major asset classes.
- Q4 US GDP grew at 2.6%, maintaining a slow and steady growth trend.
- The Fed continued tapering its bond purchase program, reducing monthly buys from $85 billion to $55 billion. New Chairwoman Yellen caused confusion by first suggesting short term interest rates may increase sooner than previously expected, then saying the economy is far from healthy and the Fed won’t back away from low rates.
- Looking ahead, valuations and sentiment surrounding US stocks are relatively neutral. Absent a compelling reason to reduce stock exposure, maintaining full strategic long term allocations remains prudent.
- Because we are likely in the second half of a bull market, big bets on specific market segments or individual stocks are less attractive on a risk/reward basis. Boring is better.
- The Tech sector, especially in the Bay Area, is starting to “feel” a lot like 1999. Under the hood the fundamentals are more solid, but caution is warranted.
- Economic numbers out of China continue to worsen, and a greater than expected slowdown is likely.
- The crisis in Ukraine and declining relations between Russia and the West could have dangerous long term implications for global stability, but short to mid-term market impact has been muted and will likely remain so.
First Quarter 2014 Market Recap
The first quarter of 2014 lacked the giddiness of 2013. But those who were properly diversified likely found themselves with satisfactory absolute results. After an uncomfortable January, the S&P 500 climbed its way back to finish up 1.8% for the quarter. US stocks again outperformed International, but Alternatives such as REITS and Gold led all major asset classes. The US Aggregate bond market matched the S&P 500, recouping most of last year’s losses and providing a reminder that bonds are generally a better option than cash for long term investors.
The US economy continued on a slow but steady growth trajectory. Q4 GDP grew at 2.6% and unemployment dropped to 6.7%. The Fed began tapering in earnest, reducing monthly bond purchases from $85 billion to $55 billion. All indications suggest Bernanke’s quantitative easing bond program will be wound down sometime in the second half of 2014, but that still doesn’t answer the question of what to do with roughly four trillion dollars of bonds on the Fed’s balance sheet. New Fed Chairwoman Janet Yellen gave contradictory comments on upcoming policy. First she indicated short term interest rates may start to rise by next spring, sooner than previously expected. However, on the final day of the quarter she said the economy remained “far from healthy” and required prolonged low interest rates.
After a pleasant absence from major geopolitical concerns in Q4, March headlines were dominated by unrest in Ukraine leading to Russia’s annexation of Crimea. Relations between Russia and the West were catapulted back to nearly Cold War status. So far the capital markets have not been terribly bothered by events in Ukraine, but the quarter ended with Russia reportedly massing troops and building supply lines along the border.
Facebook’s $19 billion purchase of WhatsApp raised a lot of eyebrows and caused many to ponder if equity valuations are grounded in reality. High momentum stocks like Facebook, Tesla, Chipotle, Twitter, and Biogen climbed steadily for most of the quarter before hitting a speed bump in the final two weeks when the fast money suddenly pivoted into more defensive names. The same was true of Small Cap stocks in general. It remains unclear if the recent pullback in high momentum market segments is just a blip or if it signals the winds are shifting.
Capital Markets Outlook
The current bull market turned five years old in March, and we haven’t had an official correction of more than 10% since 2011. Bull years are longer than dog years, so statistics say we’re in the second half of this run.
We’re not bearish, but we think it is a particularly good time to have a boring, well diversified portfolio at the asset class level and within stock allocations. The later years of a bull market tend to be the hardest to make money with specific market segment bets or individual stocks. This is because almost nothing is “cheap” and momentum stocks have more room to fall. Generally speaking, the leading categories of a bull market get hit the hardest when the bear arrives. The charts below are familiar to our investment clients, because we place a large emphasis on avoiding these scenarios in our managed portfolios. They demonstrate what happened to the Technology sector at the end of 1999 and Financials during the sub-prime crisis. Both grew to be huge weights in the S&P 500 (and often larger in individual investor portfolios). And both fell by 80% when the music stopped, causing serious pain.
In recent years, we’ve focused on four main drivers for global stocks:
1. Economic growth: The US economy managed another quarter of respectable growth and job creation. The harsh winter in most of the country has made more recent numbers difficult to evaluate, but we don’t see any reason to suggest a slowdown is near. A healthy housing market will be critical to supporting growth. In some regions, home prices are hitting new highs just seven years after the peak of the last “housing bubble”. That’s somewhat concerning for future sales volume, but for now low mortgage rates are keeping homes affordable in most areas.
Europe is a potential bullish driver in our view. The US is more nimble and was more aggressive with monetary policy, and it recovered from the financial crisis more quickly. But the Eurozone region has now posted three straight quarters of positive economic growth and seems to have escaped the prospect of falling back into recession. Growth is the best cure for credit woes of struggling countries like Italy, Spain and Greece, and even modest GDP acceleration should remove the risk of the European credit crisis resurfacing any time soon.
China, on the other hand, is losing momentum. China officially set its growth target for the year at 7.5%. This marks a modest slowdown from last year but would still be the envy of most of the world. We don’t trust any of the numbers released by China, so we think it is pointless to make specific forecasts other than to say we think a slowdown is likely to be more significant than most expect and could accelerate in the next year or two. A bad loan problem in China’s banks and the three trillion of local debt is starting to get more media attention, but we suspect the debt situation is actually much worse than generally acknowledged. Shanghai Chaori Solar Energy Science & Technology recently missed a bond payment, which was the first official corporate bond default in 17 years within China’s borders. It may be an isolated incident, or may open a Pandora’s Box.
A significant slowdown in China would have a negative impact on many parts of the global economy, especially materials and energy producers, but we’re not worried about a global liquidity crisis because China’s banks remain largely isolated from the rest of the international banking system. Western banks generally don’t lend to Chinese banks.
2. Valuation: Most valuation metrics for US stocks are neutral. The forward PE on the S&P 500 is 15.5x, relatively unchanged from last quarter. This is slightly above historical averages, but feels fair when normalized for interest rates. The earnings yield of the S&P 500 (the inverse of the PE) is 6.5%, and the dividend yield is 2.1%. Combined, these compare favorably to the 10 year Treasury yield of 2.7%. Small Cap US stocks are richly priced, and are unattractive from a valuation perspective. Valuations overseas are more compelling. The forward PE of the MSCI EAFE index sits at around 14x, with a dividend yield of 3%.
3. Sentiment: Sentiment is also mixed. Generally speaking, sentiment is an inverse indicator. Extreme confidence in stocks indicates investors have already piled in, which is bearish. Widespread fear means significant room for upside exists. We see both. Fund flows continue to indicate people are gaining confidence in the stock market, but there is also a common perception that prices are too high after last year’s gains. It would be unusual for a full-fledged bear market to surface amid such concern. A correction would be more normal.
4. Monetary Policy: The Fed is methodically reducing quantitative easing, which has many people concerned. We note that in the 80 years before 2008, one dollar invested in stocks turned into about $250, even with no quantitative easing. Yellen made contradictory statements during the quarter about the Fed’s intentions on interest rates. If the Fed does raise short rates early in 2015, it will be because the economy is doing relatively well. Otherwise, the Fed should remain accommodative. In our view, US monetary policy is not a reason for optimism, but neither is it cause for panic. In Europe, the ECB has more cards to play, including stepping up its own quantitative easing. More aggressive monetary policy there could provide a boost to the European economy and markets.
Bonds: We continue to expect interest rates will stay range bound in 2014 even with tapering underway. Central banks don’t want significantly higher long term rates and are determined to keep short rates near zero, at least for 2014. Bonds generally remain a better option than cash, in our view. Diversification across the yield curve and credit quality spectrum makes sense. Long maturity bonds are exposed to greater interest rate risk if yields do rise, while short maturity bonds yield too little to help much. A blend of both is the best bet.
Party Like its 1999? Tech / Internet / Biotech Lookout
“Party over, oops out of time
So tonight I’m gonna party like it’s 1999”
While Seattle, Austin and other cities are increasingly important, San Francisco and Silicon Valley remain the heart of the technology industry. And whether it’s the number of new startups or expansion of social media giants like Facebook and Twitter, this industry is booming. With our headquarters in Redwood City and San Francisco, we’ve got a front row seat. And what we’ve noticed, along with others, is that it feels a lot like 1999. For those who remember the aftermath, that can be a little scary. So is it really the same?
Let’s first consider what it was like fifteen years ago. Internet companies were hiring in droves and startups were popping into existence at a dizzying rate. Cheap financing seemed easy to obtain even if all you had was an idea written on a napkin. And there were mega M&A deals like AOL’s takeover of Time Warner, which remains the second largest buyout in history.
Companies were burning through cash as if it were going out of style – lavish parties were the norm and Super Bowl ads were commonplace. All this ignored that most companies lacked significant revenue and very few were profitable. None of this mattered to investors. They bought up stock in almost any dotcom company they could find, driving valuations to silly levels. At its peak, the Technology sector made up 34% of the S&P 500.
San Francisco and the surrounding Bay Area fed on the frenzy, which in turn bolstered demand for real estate and apartments. With an occupancy rate at over 98% (in San Francisco), some landlords were so selective they required multiple in-person interviews before even considering an applicant. According to the Office of Housing and Community Development, rent prices almost doubled between 1990 and 1999, with the average price of a one bedroom hitting $1,773 in September of ‘99.
And then the bubble popped. Companies began shuttering doors left and right. Technology employment levels in San Francisco fell by almost half in the years that followed. Stock prices plummeted. The Tech sector fell over 80% on a pure price level, and the S&P 500 fell almost 50% on a total return basis.
What’s it like today? There are similarities. For one, the technology industry is the primary growth engine of the Bay Area economy. According to research group SPUR, technology firms have accounted for 30% of job growth in recent years. And if you factor in the multiplier effect (the additional activity they create), they’ve accounted for virtually all of San Francisco’s employment growth since 2010. Almost two-thirds of the city’s new office space has been leased by technology firms, and it seems construction is underway at every corner.
The startup community is once again thriving. Parties reminiscent of 1999 are becoming more common. M&A activity is on the rise, and buyouts are occurring at hefty premiums. Facebook’s February purchase of WhatsApp for $19 billion was particularly eye-opening. With only 55 employees, that equates to over $345 million each. According to the Wall Street Journal, it was the largest purchase of a VC backed company.
The San Francisco rental market has been on fire for years, officially surpassing 1999 levels. According to Trulia, San Francisco registered the highest year-over-year price increase out of the 25 largest rental markets in December, rising 10.6%. In January, rent prices were up 12.3% over the previous year. The median asking price for a one bedroom is now over $2,800, well higher than 1999 even after accounting for inflation. Multiple surveys now peg San Francisco as the most expensive rental market in the country.
Is this another bubble ready to burst? Like any bubble or non-bubble, it is difficult to predict, but there are some reassuring fundamental differences. First off, the large technology firms learned their lesson from the dotcom bust. The sector now boasts some of the healthiest, cash-rich balance sheets in the world. Perhaps more importantly, stock valuations for the sector as a whole are in line with historical norms (on a forward P/E basis) and very close to that of the broader S&P 500. Within the startup community, obtaining financing is much more difficult than in 1999. Generally speaking, only companies with real revenues are getting serious funding, and this has forced companies to be more prudent with cash.
So for now, a crash like the one to start the last decade seems unlikely. For us San Franciscans, rents will likely continue to rise and restaurant reservations will be harder and harder to get. Still, another unhappy ending is not yet out of the question, especially in frothier niches like social media. Technology is again the largest sector in the S&P 500 at 19%. That’s a big bet on its own. And once again, we’re starting to see many individual’s portfolios with much more.
Did the Crisis in Ukraine Spark a New Cold War?
The situation in Ukraine is shaping up to be a major test of the Obama Administration’s foreign policy. Each day, new headlines emerge about Russian troop movements, increased sanctions and cold war rivalries. Russia views the annexation of Crimea as final. What’s not yet clear is if or how much further into Ukraine or other Baltic States Russia may advance.
The immediate roots of the conflict can be traced back to Ukraine’s decision in November 2013 to abandon its bid to join the EU, under increasing economic pressure from Russia. This was quickly followed by the announcement and quick acceptance of a $15 billion Russian aid package to Ukraine. Ukraine is vitally important to both Russia and the EU as a conduit for natural gas. 70% of Russia’s gas exports go to the EU, and half of that gas flows through Ukraine. The country’s abrupt shift towards Russian influence caused outrage among those who wished to see Ukraine join the EU and move outside of Russia’s control, and street protests began almost immediately.
After months of sporadic violence, protesters and western influence succeeded in forcing President Yanukovych to compromise and reform the constitution. After agreeing to sign it, Yanukovych unexpectedly fled to Russia, leaving a power vacuum in Kiev. He also left behind signs of extreme corruption, such as a mansion costing a reported $100 million to build. As the hastily created Ukrainian parliament attempted to realign Ukraine’s interests with the EU, the semi-autonomous, majority Russian-speaking state of Crimea announced a referendum on joining Russia instead. Simultaneously, Russian soldiers and militia members seized strategic assets throughout Crimea, including the airport, port, television stations and administration buildings. The referendum passed as expected and Russia immediately moved to annex Crimea and force out the remaining Ukrainian military.
Outside of Russia (which represents less than 0.5% of the world’s stock market by value), global capital markets have so far had a relatively muted response to the annexation of Crimea. NATO, which includes Russian neighbors Poland and Lithuania, has reiterated its articles of mutual defense. Doing so calls attention to the fact that Ukraine is not part of NATO and thus has no guarantee of protection. There is very little chance the US or EU will risk war to protect a non-NATO country and little chance Putin will risk the backlash from provoking a NATO country. US and EU sanctions on Russia and the threat of wider regional conflict have raised the prices of oil and gas, but that is likely to be temporary if Russia takes no further aggressive action. The EU needs Russia’s energy and natural resources and Russia needs the EU’s money.
But unfortunately a major rift has been created between Russia and the West, and if it worsens it will likely create a whole new set of economic costs and dangerous geopolitical risks for a long time to come.
Bill Harris, Craig Birk, and Kyle Ryan
The Personal Capital Advisors Investment Committee