Q: What factors have driven market performance in the aftermath of the Global Financial Crisis and what factors do you think investors will focus on going forward?
A: In the past few years, investors’ focus on central banks providing liquidity has been extraordinary. Fundamentals have also played a key part in the recovery of the equity market. We believe fundamentals have been attractive, but we think investors’ focus on liquidity has been misguided with the U.S. Federal Reserve having lost control of interest rates. In December, the Fed raised the fed funds rate, the first increase since June of 2006.
This decision followed the central bank’s earlier actions to end quantitative easing. Despite the December increase, Treasury bond interest rates declined early in 2016, which illustrates that market forces and not the Fed are in control. As the Fed continues to normalize rates and becomes less of a driver of investor sentiment, we believe investors will increasingly focus on corporate fundamentals and determine that stocks are the best option in the investment world.
Q: Why haven’t more investors embraced equities?
A: Recent uncertainty resulting from the change in Fed policy has driven volatility in equity markets, which can be unsettling for investors. At the same time, I think investors who have flocked to bonds and cash subscribe to a faulty premise that the drop in oil prices and a decline in earnings among energy companies will cause massive losses among banks that have exposure to commodity producers and companies that provide services to the energy sector. Many investors are viewing those fears from the perspective of having weathered the failure of global financial institutions during the 2008 Financial Crisis.Investors may eventually realize that banks are unlikely to experience a financial contagion, or a repeat of 2008 and 2009. The banking system in the U.S. has been shored up considerably since the crisis and banks are much stronger now than in the years leading up to that event. During those years, banks expanded their balance sheets with excessive exposure to real estate securities right up until the crisis. They had also loosened lending standards for consumers and businesses that were overextended with debt that was held on banks’ balance sheets. When the real estate market finally burst, banks paid a heavy penalty. Banks today have stronger balance sheets, with tangible common equity being the highest it’s been in over 30 years, and lending standards are much tighter. Risks of losses and a dislocation of the bond market, furthermore, have been shifted to a substantial extent to the bond market. The real estate recovery, meanwhile, is continuing at what we believe is a sustainable pace, aided by consumers who have reduced their debt service to rates not seen in 30 years.
I believe that investors will eventually conclude that the bond market is in a bubble. Even Bill Gross, who is nicknamed “The Bond King,” has expressed concerns over the bond market and has shortened his portfolio duration. Corporate bonds are trading at the equivalent of approximately 19 times earnings and government debt is trading at more than 30. The S&P 500 index, in comparison, is trading at a P/E of 15.2 based on forward earnings expectations compared to a median P/E of 16.0 since 1995. The S&P also has an earnings yield of 6%. Today, the S&P 500 earnings yield is higher than an investment grade bond. That is very rare from a 50-year point of view. Clearly, there is, in my view, little reason to believe that U.S. equities and equities from many other countries, including emerging markets, are overvalued.
Q: What other characteristics are likely to make equities appealing among investors?
A: We maintain that corporate fundamentals are strong. That is especially true with what we consider the core of the U.S. economy, which includes technology, consumer discretionary, financials, health care, and industrials. More specifically, S&P 500 earnings per share ex energy and materials grew 6.3% last year and are expected to grow at a similar rate this year. Growth has occurred despite a currency headwind of several hundred basis points over the past couple of years. A potential investor handoff from bonds to equities may also be driven by investors’ attraction to the potential for corporations to increase their dividends as earnings grow. Most bonds, of course, provide a fixed payment over their lifetime.
With those points in mind, we continue to have an optimistic view of equities. In one possible scenario, equity valuations relative to bond valuations would move closer to historical standards and earnings growth expectations would materialize. If those changes occur, the S&P could generate returns in the mid-teens compounded over two years.
Q: What other tailwinds for equities exist?
A: Declining oil prices have weighed heavily upon equities, but we think lower energy costs will be a net positive for the economy by cutting expenses for businesses and consumers. Energy cost savings, combined with a tight labor market supporting both wage increases and rising home values, are likely to support increased consumer spending. With new housing starts considerably below historical averages, the residential real estate recovery is likely to continue, in part because many millennials have delayed buying homes, which has created pent-up demand.
The scope and rapid pace of innovation in the U.S. is also a positive for equities, especially when viewed from a historical perspective. As discussed in Alger’s “The Impact of Innovation Deflation,” white paper and podcast, new products are quickly capturing market share, thereby helping corporations to grow their earnings while creating cost savings for consumers and businesses. Kitchen stoves, which were introduced in 1750, took 187 years to reach 50% market penetration and washing machines took approximately 60 years.
Today, innovative products gain traction in the blink of an eye with smartphones and social media reaching the 50% threshold in 16 and 9 years respectively.
Q: What are the possible consequences for investors who sell equities during periods of market volatility?
A: Investors who have been selling equities during market downturns may be making a very large mistake. The Global Financial Crisis illustrates the likely downside of selling equities during market declines with hopes of avoiding additional losses. Many investors sold at or near the market bottom and then failed to get back in the equity market quickly as stocks recovered. The Global Financial Crisis is a reminder that market corrections can be painful, but they can also be short lived, with the decline of 2008 and 2009 lasting less than nine months.
Q: Will the transition of investors focusing on fundamentals instead of central bank liquidity have any impact on active versus passive investing?
A: We believe market conditions are likely to be favorable for active portfolio management. At Alger, our in-depth research seeks leading companies that are likely to grow earnings by benefiting from large-scale changes, including unprecedented levels of innovation. At the same time, we seek to avoid old-school companies, such as brick and mortar retailers. Broadly speaking, those retailers are quickly losing market share to industry disrupters, including online retailers. Market benchmarks don’t discern between winners and losers of innovations and other trends, so passive investors may miss attractive opportunities that rapidly arise as a result of change and also have exposure to companies with outdated business models and weakening earnings.
Since we at Alger seek companies that are capable of growing their earnings, our portfolios tend to be weighted toward the most innovative and most promising growth parts of our economy, such as technology, health care, and consumer discretionary sectors, while being underweight energy and materials relative to the S&P 500. The difference is even more significant when compared to value indexes, which tend to have even less exposure to innovative and growing sectors of the U.S. economy. Additionally, as investors shift their focus away from central bank liquidity and increasingly seek companies with strong corporate fundamentals, the disparity in performance among companies that are capable of growing their earnings and companies that are losing market share to industry disrupters is likely to widen. The shift in investors’ focus to fundamentals is likely to be highly beneficial for investors like Alger and our clients.
In one possible scenario, equity valuations relative to bond valuations would move closer to historical standards and earnings growth expectations would materialize. If those changes occur, the S&P could generate returns in the midteens compounded over two years. as investors shift their focus away from central bank liquidity and increasingly seek companies with strong corporate fundamentals, the disparity in performance among companies that are capable of growing their earnings and companies that are losing market share to industry disrupters is likely to widen. The shift in investors’ focus to fundamentals is likely to be highly beneficial for investors like Alger and our clients.
Dan Chung is CEO and chief investment officer of Alger Funds.