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Deflation Elation
Most global equity markets advanced between 3% and 5% this quarter, with few exceptions – small caps lagged and some emerging markets (China, Korea and Chile) posted negative returns. While commodities were down slightly, as reflected by the 1.6% drop in the S&P Goldman Sachs Commodity Index, gold rallied 17.5% amid expectations for more stimulus globally, a weaker U.S. Dollar and prolonged trade war tensions. World bond markets performed well this quarter, and have done exceptionally well year to date as interest rates have fallen precipitously and credit spreads remain tight. From a fundamental credit quality and inflation perspective we see little room for improvement, and are therefore cautious about future fixed income returns and the longer term “risk-free” rates that drive equity valuation models (where a company’s equity price is the present value of its future cash flows). As we discuss on page two, this doesn’t mean stock indexes will fall, but it might augur leadership changes within.
A few additional return highlights: For the quarter ended June 30, the S&P 500 rose 4.3% and is now up 18.5% year to date. While the Russell 2000 Index (U.S. small caps) gained 2.1% on the quarter and 17.0% through June, small caps have underperformed large caps (S&P 500) by 13% over the past year as investors continue to hide out in larger, more stable growth stocks. The MSCI All Country World ex USA was up 3.0% QTD and 13.6% YTD, the MSCI Emerging Markets Index gained 0.6% and 10.6%, and the MSCI Europe Index rose 4.5% and 15.8%. After such a strong start to 2019, one-year trailing performance has improved, though any managers who both navigated extreme volatility by minimizing losses in Q4 2018, and captured significant upside this year, are standouts. From an equity risk factor perspective, Quality and Minimum Volatility were the most rewarded characteristics through the extreme gyrations of the last twelve months. Value, however, continues to lag other factors and frustrate many investors both this year and twelve months trailing. The pain is significant – the chart below tracks the last five years’ performance of the MSCI World Growth Index vs its Value counterpart. Further, the valuation spread between the two is now the widest it has been for seventy years1.
Is It Different This Time?
The characteristics that define Value stocks include key ratios such as price-to-earnings, price-to-book, price-to-cash flow, and EV-EBITDA that are favorable relative to industry peers. Over time, if metrics improve and anomalies are discovered and repriced, investors theoretically should get compensated. While it is true that Value has outperformed Growth over the long term, their relationship is complicated and variable. A lot depends on a variety of less predictable external factors – like interest rates. All stock prices are heavily influenced by interest rates, but Growth equities are more so and tend to do much better when rates are lower (see chart below, wherein Value fairly consistently underperforms the S&P 500 during periods when rates decline). If interest rates are dropping because of disinflationary forces and tepid growth expectations, we see Growth companies becoming rarer, more sought after, and more expensive. Finally, there is a disruptive element as new technologies get incorporated at a faster rate – a “haves vs have-nots” booster rocket beyond simply supportive monetary and fiscal policy (compare Amazon to Sears). If you are wondering why foreign markets have lagged the U.S. despite their dramatically lower interest rates, a relative lack of cutting-edge innovation is one possible reason.
Chart of the Quarter: Interest Rates and Value Stocks
Our relative underweight to Value has been a topic of discussion in recent asset allocation meetings as we attempt to avoid “recency bias,” or a tendency to project recent trends into the future. We are always looking at the range of possible return drivers, some of which may be lacking either due to relative underperformance or by choice. In the coming months we may decide to fill in the Value gap, at one of the more attractive entry points in history.
Endnotes
1 AB Bernstein. March 2019.
Sources of graphs and data not specifically cited: FactSet and Blackrock.
Referenced indexes in U.S. Dollars, unless otherwise stated. All equity returns include dividends. All return data through June 30, 2019 unless otherwise stated.
Disclaimer
North American Management Corp. (NAM) is an SEC registered investment adviser located in Boston, Massachusetts and St. Louis, Missouri. The information presented above reflects the opinions of NAM as of July 31, 2019, and is subject to change at any time based upon market or other conditions. These views do not constitute individual investment advice and there is no representation that any of the statements or predictions will materialize. This letter should be read alongside NAM’s quarterly report and is meant to provide clients with additional updates regarding our strategies with allocations to individual stocks (Aggressive Growth, Global Growth, Global Moderate Growth, Global Conservative Growth, Global Tactical Income, and Global Moderate Tactical Income) and Mutual Fund/ETF-only strategies. Please note, if you are not invested in certain strategies or do not hold all of the securities therein, this summary may contain information that does not apply to you. The data in this report is taken from sources that NAM believes to be reliable. Notwithstanding, NAM does not guarantee the accuracy of the data. Any specific investment or investment strategy can result in a loss. Asset allocation and diversification do not ensure a profit or guarantee against a loss. Past performance is no guarantee of future results.
Most global equity markets advanced between 3% and 5% this quarter, with few exceptions – small caps lagged and some emerging markets (China, Korea and Chile) posted negative returns. While commodities were down slightly, as reflected by the 1.6% drop in the S&P Goldman Sachs Commodity Index, gold rallied 17.5% amid expectations for more stimulus globally, a weaker U.S. Dollar and prolonged trade war tensions. World bond markets performed well this quarter, and have done exceptionally well year to date as interest rates have fallen precipitously and credit spreads remain tight. From a fundamental credit quality and inflation perspective we see little room for improvement, and are therefore cautious about future fixed income returns and the longer term “risk-free” rates that drive equity valuation models (where a company’s equity price is the present value of its future cash flows). As we discuss on page two, this doesn’t mean stock indexes will fall, but it might augur leadership changes within.
A few additional return highlights: For the quarter ended June 30, the S&P 500 rose 4.3% and is now up 18.5% year to date. While the Russell 2000 Index (U.S. small caps) gained 2.1% on the quarter and 17.0% through June, small caps have underperformed large caps (S&P 500) by 13% over the past year as investors continue to hide out in larger, more stable growth stocks. The MSCI All Country World ex USA was up 3.0% QTD and 13.6% YTD, the MSCI Emerging Markets Index gained 0.6% and 10.6%, and the MSCI Europe Index rose 4.5% and 15.8%. After such a strong start to 2019, one-year trailing performance has improved, though any managers who both navigated extreme volatility by minimizing losses in Q4 2018, and captured significant upside this year, are standouts. From an equity risk factor perspective, Quality and Minimum Volatility were the most rewarded characteristics through the extreme gyrations of the last twelve months. Value, however, continues to lag other factors and frustrate many investors both this year and twelve months trailing. The pain is significant – the chart below tracks the last five years’ performance of the MSCI World Growth Index vs its Value counterpart. Further, the valuation spread between the two is now the widest it has been for seventy years1.
Is It Different This Time?
The characteristics that define Value stocks include key ratios such as price-to-earnings, price-to-book, price-to-cash flow, and EV-EBITDA that are favorable relative to industry peers. Over time, if metrics improve and anomalies are discovered and repriced, investors theoretically should get compensated. While it is true that Value has outperformed Growth over the long term, their relationship is complicated and variable. A lot depends on a variety of less predictable external factors – like interest rates. All stock prices are heavily influenced by interest rates, but Growth equities are more so and tend to do much better when rates are lower (see chart below, wherein Value fairly consistently underperforms the S&P 500 during periods when rates decline). If interest rates are dropping because of disinflationary forces and tepid growth expectations, we see Growth companies becoming rarer, more sought after, and more expensive. Finally, there is a disruptive element as new technologies get incorporated at a faster rate – a “haves vs have-nots” booster rocket beyond simply supportive monetary and fiscal policy (compare Amazon to Sears). If you are wondering why foreign markets have lagged the U.S. despite their dramatically lower interest rates, a relative lack of cutting-edge innovation is one possible reason.
Chart of the Quarter: Interest Rates and Value Stocks
Our relative underweight to Value has been a topic of discussion in recent asset allocation meetings as we attempt to avoid “recency bias,” or a tendency to project recent trends into the future. We are always looking at the range of possible return drivers, some of which may be lacking either due to relative underperformance or by choice. In the coming months we may decide to fill in the Value gap, at one of the more attractive entry points in history.
Endnotes
1 AB Bernstein. March 2019.
Sources of graphs and data not specifically cited: FactSet and Blackrock.
Referenced indexes in U.S. Dollars, unless otherwise stated. All equity returns include dividends. All return data through June 30, 2019 unless otherwise stated.
Disclaimer
North American Management Corp. (NAM) is an SEC registered investment adviser located in Boston, Massachusetts and St. Louis, Missouri. The information presented above reflects the opinions of NAM as of July 31, 2019, and is subject to change at any time based upon market or other conditions. These views do not constitute individual investment advice and there is no representation that any of the statements or predictions will materialize. This letter should be read alongside NAM’s quarterly report and is meant to provide clients with additional updates regarding our strategies with allocations to individual stocks (Aggressive Growth, Global Growth, Global Moderate Growth, Global Conservative Growth, Global Tactical Income, and Global Moderate Tactical Income) and Mutual Fund/ETF-only strategies. Please note, if you are not invested in certain strategies or do not hold all of the securities therein, this summary may contain information that does not apply to you. The data in this report is taken from sources that NAM believes to be reliable. Notwithstanding, NAM does not guarantee the accuracy of the data. Any specific investment or investment strategy can result in a loss. Asset allocation and diversification do not ensure a profit or guarantee against a loss. Past performance is no guarantee of future results.
