Fourth Quarter Letter
Perhaps the best argument that one can make for stocks is that many hold doubts about the continuing bull market. The reasons for these doubts are understandable, as the economic recovery has been anemic and growth has slowed significantly – likely leading to lower profits in the future. As a result, corporations have aggressively cut costs, increased productivity and preserved cash – pushing profit margins to historically high levels.
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Despite these record profit margins, corporate earnings have been roughly flat over the past year. As a result, market price appreciation is coming from higher multiples paid on stagnant earnings. According to Adam Parker, Morgan Stanley’s chief U.S. equity strategist, there have only been three periods in the past four decades when the price-to-earnings multiple (P/E) on the S&P 500 rose as much over a two-year period. In each case, the market continued to rise for at least another year. In other words, if stocks are expensive, momentum has previously made stocks even more expensive.
Retail investors are certainly starting to believe in the current market rally. Total flows into equity funds in 2013 should equal inflows from the past four years combined – about $450 billion. Of course, once investors start chasing returns, they can push the stock market higher. In the short run, bullish momentum often creates its own self-reinforcing cycle. Unfortunately, higher prices usually turn investors into speculators who tend to buy rather than sell at the top. Jeremy Grantham, the fund manager who founded GMO in Boston, fears that the Federal Reserve’s reign of “excessive stimulus” will continue and “the path of least resistance for the market will be up”. From our perspective, timing bubbles has historically been an extremely dangerous investment strategy that has been disastrous for those who have chased the market’s upward momentum.
Underpinning the market’s upward march is the Federal Reserve’s near-zero interest rate policy which turns five years old next month, the longest period without a rate increase in history. With more than $3 trillion of asset purchases, market enthusiasts seldom mention that the market’s rally over the past five years correlates closely with the increase in the size of Federal Reserve’s balance sheet. The central bank buys bonds in an effort to push up asset prices and keep interest rates low. We believe this flawed practice significantly distorts market-based asset prices.
The price action of stocks trumps fundamentals, as investors are now granting some of the highest valuations to companies that struggle to produce profits. Amazon trades at roughly 1,300 times reported earnings and the market values Netflix at 197 times net income. Further, a Goldman Sachs index of companies with weak balance sheets has rallied 45% this year, almost doubling the gain of companies with stronger balance sheets. In 2013 these low-quality outperformers include stocks such as Tenet Healthcare (+29.7% in 2013), which has the highest debt-to-equity ratio of all healthcare companies in the S&P 500. Micron Technology (+243% in 2013) tripled its total debt since 2011 to ten times annual free cash flow. Hewlett-Packard (+100.3% in 2013) also tripled its total debt since 2007 while earnings have been flat.
Initial public offerings are also back in vogue. Twitter jumped 73% in its first trading day and the unprofitable messaging service now carries a market value of $35 billion. Potbelly, a Chicago-based casual restaurant chain, and the Container Store Group, which sells storage products, both doubled on their first trading day. Facebook recently offered $3 billion to buy Snapchat, a mobile photo application company that generates no profits. Snapchat declined the offer, perhaps thinking they can sell to the next fool at a higher price.
In contrast to a five year stock market rally that has restored $14 trillion to market capitalization, employment payrolls remain 1.5 million below 2008 levels according to Bloomberg. Not surprisingly, lower employee compensation costs have allowed for near-record corporate profit margins. American workers struggle but investors benefit as reduced expenses and record low borrowing costs drive profits higher and underpin a 168% advance in the S&P 500 over the past 57 months. However, we do not trust these profit margins or this relentless market advance for the simple reason that we do not know if these gains are real or a monetary illusion.
Although the economy appeared healthy in May 2007, six short months later the economy entered the most severe recession since the 1930s. Perhaps the 2008 recession was so severe because the economic strength of 2003-2007 was an illusion created by easy money. In June 2012, the Institute for Supply Management (ISM) New Orders Index fell below 50 and remained below 50 during July and August of 2012. (A reading below 50 signals that the manufacturing sector is contracting and that the economy is entering a recession). In response, the Federal Reserve introduced “QE3” in September 2012. Although the decline in manufacturing temporarily stopped, the New Orders Index again slipped below 50 in December 2012. Notably, the Federal Reserve responded with “QE4” in early 2013.
Inflating the money supply is popular because it is impossible to distinguish between artificial strength and genuine economic strength in real time.
History repeatedly illustrates that once inflation appears it becomes difficult to control, as the combination of politics and economics create an unstoppable urge to print. And yet the Federal Reserve’s current strategy is to wait for significant price inflation to appear in the consumer price index (CPI) before tightening monetary conditions.
Today, everyone claims to have a strategy, including the Federal Reserve, governments, and investors. Naturally, endeavors seem more purposeful if there is a strategy behind it. Then again, no self-respecting investor or institution would dare admit that it does not employ some sort of strategy. If performance is poor, we often chalk it up to the lack of good strategy.
Sir Lawrence Freedman, in his book “Strategy: A History”, concludes that it may be better to look at strategy as a script which incorporates the possibility of chance events. The same can be said about a disciplined value investment strategy, anchored by a core philosophy which guides decision-making for the best long-term outcomes.
When sentiment reaches a peak, it has nowhere to go but down. When interest rates cannot go any lower, sooner or later they are likely to rise. When the last marginal buyer of stocks commits their cash reserves to stocks, the market is unlikely to keep rising at the same pace. As Warren Buffett once said, to invest successfully, one must be fearful when others are greedy and greedy when others are fearful. The long-term investor should also know when it is prudent to stand aside. To us, the evidence suggests that this is one of those moments.
The latest weekly survey of investment newsletters by Investors Intelligence found that bulls now outnumber bears fourfold, the highest ratio since 1987. Sentiment matters and current sentiment clearly indicates that bullish sentiment trumps any bearish concerns. There is no magical insight to this sentiment survey. Investors who feel positive buy more shares of stock. Once bears throw in the towel, new buyers become scarce and markets are more likely to go down. A range of sentiment measures at the moment indicate investor complacency. The Value Line survey of investment advisors reports that only 14.3% are “bearish” – the lowest level reported in the last 25 years.
Margin debt at the New York Stock Exchange now stands at the highest level in history – at 2.5% of gross domestic product (GDP). Margin debt, a reflection of investor sentiment, represents the amount borrowed against stocks to buy more stocks. The current level of margin debt now equals roughly 25% of the entire commercial and industrial loans outstanding in the economy. We believe that this is an accident waiting to happen and that Wall Street knows exactly what is coming: New equity issuance is running at the fastest pace since the 2000 bubble peak. Company insiders do not sell when stocks are cheap; they sell when stocks are expensive. Markets never handle large changes in sentiment well because everyone cannot sell at the same time. The combination of record levels of margin debt and so many investors simply following price action will eventually cause a rush for the exits. Unfortunately, sentiment cannot accurately serve as a guide to major turning points within the stock market.
In the long run valuation matters more than sentiment. Assuming that one is investing as opposed to speculating, initial valuation – or the price you pay for the investment – remains the single most important characteristic of whatever one elects to buy. Unfortunately, stocks have become very expensive – far more expensive than most people realize. At the risk of sounding like a broken record, “initial valuation” in the stock market is at a level consistent with very disappointing subsequent returns, if the history of the last 130 years is any guide.
The median price-to-earnings (P/E) ratio on the S&P 500 is now at a record-high level, surpassing its peak in 2000. Back in 2000, only a handful of large market capitalization names traded at absurd P/E ratios, which in turn pushed the average P/E to nearly 50. The median P/E better reflects the broad valuation of stocks. Investment research firm Value Line currently reports the lowest median three-to-five-year appreciation potential among the 1,700 stocks it covers. According to Value Line, there is less value in the market today than there was in 2000 or 2007.
Without fail, every time our stock market traded on a cyclically-adjusted P/E (CAPE) ratio of 24 or higher over the past 130 years, it has been followed by roughly a 20-year bear market. The evidence is clear, especially for the peak years 1901, 1929, 1966 and 2000. The CAPE ratio is more than 25 today. Other historically reliable gauges of value – like the CAPE – are also at record-high levels. Total stock market capitalization compared with U.S. GDP is at an all-time high. Market participants may argue with different measures of value, but collectively they paint similar pictures of an expensive market. The cyclically-adjusted P/E employs a 10-year average of reported earnings and has been a historically accurate indicator of future returns. The market capitalization-to-GDP figure and the median P/E figure concur with the cyclically-adjusted P/E. These valuation measures say the same thing: money broadly allocated into stocks today, at these valuations, will likely produce only limited future returns.
Too much money is going into stocks at prices that are too high and valuations that are too expensive. As a result, we believe that this is not the time to be chasing stocks. Ideally, the investor buys stocks when other people are selling them, not when everyone is buying them.
The actions of the Federal Reserve are directly and indirectly responsible for the rush into stocks and the subsequent multiple expansion on market earnings. The Federal Reserve’s interest-rate policy and its quantitative easing are potent yet ultimately unsustainable. As the passions of the crowd can change suddenly, there will come a moment– and no one will know why – when the market’s entire attitude changes. Greed will turn to fear. We know that we are better off as an investor if we are greedy only when other people are scared.
Right now, market participants are clearly not fearful of stocks. Compare today’s market to a game of musical chairs—you just want to make sure you can sit down when the music stops.
With kind regards,
Robert J. Mark
The opinions expressed are those of the Fund’s portfolio manager and are not a recommendation for the purchase or sale of any security.
The following companies mentioned in this commentary were not holdings of the Fund as of 12/31/13: Amazon.com, Inc., Netflix, Inc., Tenet Healthcare Corp., Micron Technology, Inc., Hewlett-Packard Co., Twitter Inc., Potbelly Corporation, Container Store Group Inc., Facebook, Inc., and Snapchat, Inc.
The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the Fund , and it may be obtained by calling 1-877-743-7820, or visiting www.castleim.com. Read it carefully before investing.”
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The risks associated with the Fund, detailed in the Prospectus, include the risks of investing in small and medium sized companies and foreign securities which may result in additional risks such as the possibility of greater price volatility and reduced liquidity, different financial and accounting standards, fluctuations in currency exchange rates, and political, diplomatic and economic conditions as well as regulatory requirements in foreign countries. There also may be risks associated with the Fund’s investments in exchange traded funds, real estate investment trusts (“REITs”), significant investment in a specific sector, and non-diversification. Technology companies held in the Fund are subject to rapid industry changes and the risk of obsolescence.
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