Slip slidin’ away
Slip slidin’ away
You know the nearer your destination
The more you’re slip slidin’ away.

          Lyrics and Music by Paul Simon, 1977

“It should be pointed out that the experience of bond investors as a class had been relatively unsatisfactory throughout the period since our entry into World War, so that for the years prior to 1928 there had been developing a realization that bonds did not afford sufficient protection against loss to compensate for the surrender of the profit element.  The years 1917 – 1920 were marked by a tremendous decline in all bond prices as the result of war financing followed by the postwar inflation and collapse.  The later recovery was not without its many individual disappointments, chiefly because the bulk of bond investment had previously been made in the railroad field and the credit of the carriers had on the whole been declining during most of the period in which numerous industrial companies had been showing extraordinary improvement.  Even public utility bonds had been adversely affected from 1919 to 1922 by the postwar increase in operating costs, as against relatively inelastic rates.”

Introduction
Security Analysis
By Benjamin Graham and David L. Dodd, 1934

“In the 1920s, a prime market influence was a book by Edgar Smith called ‘Common Stocks for Long Term Investment’.  It was a brilliant and important book.  Mr. Smith’s main point was to advocate the benefit to corporate growth of the application of retained earnings and depreciation.  Thus capital appreciates.  The book was perhaps influential in changing accepted multiples of 10 times earnings to higher multiples of 20 to 30 times earnings. 

            But people have often paid too much for assumed persistent growth, only to find out that a general economic decline, an act of war, or a series of government controls will change either the appraisal of the growth rate or change the growth rate itself.  Rarely can securities be valued correctly at over 15 times earnings, because rarely is there any clear prospect that a company’s earnings will grow sufficiently in the future to make it worth that price.  We know that there are exceptions, but they account for perhaps 1% of the cases.  So the odds are against you when you pay a very high multiple.”

The Roy Neuberger Almanac
By Roy R. Neuberger (Founder Neuberger & Berman) in
Classics: An Investor’s Anthology
Edited by Charles D. Ellis, 1989

For investors, the Year 2018 looks very different than 2017 and 2016.  For those two years, markets went straight up with no interruptions, a highly unusual event. In fact, markets performing like that have occurred less than 5% of the time over the past 150 years.  However, investors poured more and more money into the markets via ETFs and Index Funds, assuming that this was the norm.  In addition, they added significantly to their fixed income holdings of bonds at a point in time when long term interest rates stood below levels that occurred during most of the Great Depression. With this as a backdrop, 2018 came as bit of a shock.  Through April 30, the S&P 500 performance is down ~1% and daily swings of 2% or more have become commonplace.  In addition, 10 Year Treasury yields have risen from 2.40% at Year End 2017 to 2.95% currently.  For the typical 60/40 stock-bond allocation, there has been nowhere to hide in the public markets.  And overseas investing performed no better: the Shanghai Composite fell over 6%, the FTSE 100 fell almost 2%, and the Mexican Bolsa fell almost 4%.  Foreign bonds have seen pressure as well.  For example, German 10 Year Bund yields have risen from 0.42% to 0.56%, Philippine 10 Year Bond yields increased from 5.70% to 6.22%, and Indian Bond yields rose from 7.33% to 7.74%.  The only markets delivering positive returns were those in Latin America, as Brazil’s economy finally began to have traction for the region. Unless the public investor miraculously allocated funds to Chilean Bonds and the Brazilian Bovespa solely and hedged any currency risk, the First Quarter produced a less than desirable outcome.

Interest Rates coupled with the actions of the Federal Reserve comprise the fundamental issues facing investors.  For the past few years, spreads between the interest rates corporations pay and those on government bonds have compressed.  This benefitted companies as they could issue debt at extremely low levels to fund massive stock buybacks.  So, even though US 10 Year Bond Yields rose from 2.25% in January 2016 to 2.95% currently, BAA interest rates fell from 5.45% to 4.65%.

However, spreads bottomed earlier this year, as the following chart demonstrates:

And from a historical perspective, stand well below levels reached during periods of slowing growth and/or recession:

As the above graph makes clear, Spreads of 2.50% – 3.50% are not unusual.  And should spreads return to 3.00%, the midpoint of the above range, with US Treasuries yielding 3.00% or more, BAA Bond Yields easily could head up to 6%+, a level seen as recently as 2011.

While, on the surface, this provides a headwind for bonds only, as a growing economy should produce rising earnings for most companies, BAA Interest Rates stand as the critical discount rate with which to value equities.  So, as earnings turned upward over the past two years and BAA interest rates fell, not only did the value of a company increase due to earnings, but multiples expanded as the discount rate fell.  On top of that, investors benefitted from a large corporate tax cut.  A simple example will make this clear:

As the above Table makes clear, not only did investors benefit from rising earnings, but from a significant uplift in valuation due to the drop in BAA interest rates.  And to finish off the Ice Cream Sunday with a cherry on top, the Congress provided large corporate tax cuts.  While the real world is not quite so neat, directionally the table explains much of the moves of the past two years.

However, for investors, this uplifting, feel good movie appears in the rearview mirror.  What shows through the front window, hurtling at them at 60 miles per hour, is a thriller with rising rates and the prospect of decelerating earnings growth.  Suppose, earnings rise at 10% per year over the next two years but rates rise 0.5% per year as spreads return to normal.  Then investors might experience the following results:

In other words, Earnings could grow, but valuation would not.  On top of this, the markets would likely produce a normal amount of volatility. So, at the end of two years, investors would experience an unbelievable rollercoaster, fitting of Six Flags, leaving them right back where they started, but with a queasy feeling in their stomachs.  In other words, they would see those returns, Slip Slidin’ Away.

And, if investors were to cry: “Say it ain’t so!”, history would laugh at them.  In January 1960, after a similar rise during the 1950s, the S&P 500 stood at 58 and the Dow Jones stood at 685.  And while they both increased nicely over the next two decades in nominal terms, when adjusted for inflation, both indices fell significantly in real value between 1960 and 1980.  This is similar to what occurred from 1930 to 1950 and from 1900 to 1920.  During all these time frames, the economy grew and corporate earnings rose meaningfully.  For the average American, living standards grew significantly alongside the economy. But stocks fell in real terms.

For the past decade, Wall Street massively outperformed Main Street, producing a historic bull market, similar in magnitude to those during the 1950s and 1990s.  However, for the average American, living standards barely stand above where they stood in 1999, almost two decades ago. And while Wall Street profited handsomely over the past decade, Main Street did not.  However, the sands of time are shifting.  Policies to aid Main Street stand front and center, as politicians respond to voters demanding their share of the pie.  As a result, economic growth is now approaching historic rates with the average American seeing their living standards rise once again. And with the US government needing faster growth to fund all the promises made to citizens, faster growth will follow, further helping the ordinary citizen. For the country, this will stand as a return to normal and a positive.  For the average American, she or he can look forward to finally participating in the fruits of economic growth over the next decade to bequeath a better place for her or his children.  However, with these forces in ascent, this could look like a return to the 1960s for Wall Street, a decade Wall Street does not extol, which was followed by the 1970s, a decade Wall Street would like to forget.  And for the average investor loaded up on Index Funds and Indexed ETFs, taught that indexing stands as the optimal investment choice, life could turn out very differently than they expect.  They could face a decade or two of flat performance, similar to what investors faced in 1910, 1960, and 2000.  And instead of enjoying the fruits of the Eisenhower years, this could look like The Revenge of Main Street starring the Average American who overcomes adversity to triumph, leaving equity investors to cry over their beer as the economy outperforms the markets.

(Data from Federal Reserve of St. Louis, Bureau of Labor Statistics, and US Census Bureau coupled with Green Drake Advisors analysis.)

 

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