Brexit surprise, now bubble territory?
Only a few short months ago, we were writing about the markets plunging 10% over anxiety of a Chinese devaluation, only to then rebound shortly thereafter. In even quicker fashion, markets apparently discounted the odds of Britain leaving the European Union (EU) as they heavily sold-off on the news and briefly fled to safety, fearing “Brexit” would have global repercussions. But in what seems to have been the blink of an eye, the S&P 500 index has already rebounded and is posting fresh records as it pushes to new all-time highs. Ironically, these are records that one might have expected to witness if there had been no Brexit. These recent surprises continue to validate our stance that stock market prices are inherently unpredictable in the short run, even if, like Marty McFly from the “Back to the Future” movies, you possessed the ability to view tomorrow’s newspaper.
Whether the market was correct in reacting negatively, or correct in rebounding, is yet to be determined as the long-term implications of Brexit are unpredictable. Even if the U.K. is hurt in the near to medium term, we believe that the initial fears were probably overblown since the U.K. represents 2.4% of the world economy and about 4% of U.S. exports, or about 0.5% of U.S. GDP . Additionally, we believe it’s likely that the U.K. and the EU will seek rational outcomes and negotiate trade agreements that maintain free trade and reasonable levels of travel and migration. In fact, while we don’t necessarily expect this outcome, we wouldn’t be surprised if Brexit actually ends up benefitting both parties in the long run as it’s possible the U.K. enacts policies that are very pro-business and actually induce more corporations to relocate, and the vote may serve as a wake-up call to the EU resulting in economic reforms elsewhere. But, overall, we don’t fret about these affairs too much because we believe we own great, mostly acyclical companies that sell products all over the world.
The knee-jerk reaction in the markets after Brexit is also coming at a time when short-term bonds in France and Italy are in negative territory and Germany has become the first Eurozone nation to sell 10-year bonds at a negative yield, now joining Japan. The less bonds yield around the globe, the more market participants tend to reach for yield in riskier investments such as junk bonds and bonds in emerging market countries. This increased demand drives up these bonds’ prices to levels that we worry leave investors with an inadequate cushion against future defaults, let alone inflation. The search for yield is also causing money to flood into defensive stocks that investors believe can serve as bond substitutes. Utilities are the best example of this phenomenon, as evidenced by their 23.2% YTD return at quarter end, compared to the 3.8% YTD return for the S&P 500.
This recent strong performance of defensive stocks has caused some to ask us if stocks in general, and defensive stocks in particular, are in a bubble. On the surface, stocks do appear relatively expensive, with the S&P 500 currently trading at the historically rich price of approximately 20x earnings, and they are potentially even more expensive than they first appear because profit margins might be stretched (if the business cycle turns down, or historically low interest rates and taxes creep up). In fact, one might think we must be in a bigger bubble than the “Nifty Fifty” era of 1972 because, back then, the S&P 500 had a slightly lower P/E ratio of around 19x earnings. However, when you look under the hood, in 1972, blue chip stocks such as McDonald’s, Disney, and Johnson & Johnson sported P/E ratios of 86, 82, and 62 , respectively, compared to 23, 18, and 23 today. Also, consider that, in 1972, the long bond was competitively priced with a yield over 6% compared to an earnings yield of roughly 5.25% on the broad market (the inverse of the 19x P/E ratio). Recently, the 10-year U.S. treasury recently touched 1.34%, making the broad market look relatively inexpensive with an earnings yield near 5%. We are certainly not claiming stocks are cheap, particularly not on an absolute basis, as we believe they are priced to deliver returns far below what investors have experienced in the past. But neither are we calling a market top as we recognize these lower returns may still be acceptable to the average market participant given the alternatives. Regardless, the good news is that we’ve learned we don’t need to accurately predict the direction of the market in order to experience healthy returns. All we need to do is identify companies that have favorable long-term economics and then wait patiently to own them when they are being offered in the market at reasonable prices.
As the stock market continues its seven year bull-run streak since bottoming in March of 2009, we are cognizant that good times such as these cause many to think investing is easy and you need not worry much about risk of loss. In this low interest rate environment, yield starved investors seem to separate fundamentals and valuation and are willing to pay nearly any price for yield. While many of the businesses we own produce dividends, we recognize that not all dividends are created equal as they are simply a derivative of cash flow. Thus, rather than focusing on dividend yields when we analyze businesses, we focus instead on how much cash flow a business currently produces relative to its current price, how robust we believe that cash flow is likely to be to future technological change and economic turbulence, and how fast it is likely grow over time. And while we cannot predict the market direction in the short run (nor are we aware of investors who reliably produce excellent results attempting to do so), if we assess the aforementioned cash flow characteristics correctly, we are confident that the value of our businesses should continue to grow over time. Thus, even if the market gyrates as it stews over China, Brexit, or the timing of the Fed’s next interest rate hike, eventually, we believe this growing value will be recognized…so long as we are patient.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation nor an offer to purchase or sell any particular security nor were they selected based on profitability. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not necessarily reflect current recommendations nor do they represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Data presented was obtained from sources deemed to be reliable, but no guarantee is made as to its accuracy. S&P stands for Standard & Poors. All S&P data is provided “as is.” In no event, shall S&P, its affiliates or any S&P data provider have any liability of any kind in connection with the S&P data. Past performance is no guarantee of future results.