Download Hope Has Never Been a Winning Investment Strategy PDF

UNCOMMON SENSE
September 2016
Hope Has Never Been a Winning Investment Strategy
by Michael Arone, CFA, Managing
Director and Chief Investment Strategist
for US Intermediary Business Group
Figure 1: 5-Year Nominalized Index Performance
Index Level (100=09/09/2011)
220
200
180
160
You believe that easily which you hope for earnestly.
140
— Terence
120
After enduring five consecutive volatile Augusts, market
participants cheered the dog days of summer 2016. US stock
markets were branded by low trading volumes, little volatility
and new market peaks — a trifecta that investors warmly
embraced. On August 11, the three major US stock market
indices — Standard & Poor’s 500, Dow Jones Industrial
Average and Nasdaq — did something they hadn’t done since
December 31, 1999. All three indices closed at all-time highs.
After failing to simultaneously close at all-time highs for
200 consecutive months, the rare feat was achieved for a
second time less than a week later on August 15. (See Figure 1.)
Meanwhile, the CBOE Volatility Index (VIX), a market estimate
of future equity volatility, reached its lowest level in more than
a year on August 19. Additionally, US stock markets rallied
strongly on August 29 — interestingly, on a day with the lightest
trading volumes for all of 2016.
The lazy, hazy days of summer, indeed! And yet, oddly, in spite
of all this action combined with the strong post-Brexit rebound
that continued the seven-plus year bull market in US equities,
investors don’t appear euphoric. Instead, they seem quietly
confident, fingers crossed that the upswing continues.
100
Aug
2011
2012
2013
— Dow Jones Industrial Average Index
2014
— S&P 500 Index
2015
Jul
2016
— Nasdaq Index
Source: Bloomberg Finance LP as of 09/07/2016.
Past performance is no guarantee of future results.
Index returns are unmanaged and do not reflect the deduction of any fees or
expenses. Index returns reflect capital gains and losses, income, and the
reinvestment of dividends.
Dazed and Confused, but Back to Reality
As we transition back to school and back to work with a renewed
seasonal sense of purpose and summer dreams begin to fade,
investors may begin to question just what drove stocks’ summer
surge and whether the bull market will continue.
Certainly, the massive recovery in corporate profits
significantly contributed to the rebound in US stock prices
during this bull market. After bottoming in the first quarter of
2009 during the global financial crisis, earnings for companies
in the S&P 500 increased each year from 2009 to 2014. And
the powerful tailwinds of unprecedented monetary policies,
historic levels of share buybacks and investors’ willingness
to pay up for future growth further supported the market’s
climb to all-time highs.
Importantly, however, earnings peaked in the third quarter
of 2014. Year-over-year earnings growth has been negative
for each of the last five consecutive quarters. And it is looking
Hope Has Never Been a Winning Investment Strategy
more likely that the third quarter of 2016 will be the sixth
consecutive quarter of negative year-over-year earnings
growth. (See Figure 2.) According to TrimTabs Investment
Research, US company stock buybacks are down 21 percent in
the first seven months of 2016 compared with the same period
a year earlier.1 The interest rate environment may be shifting,
too. After a dismal May jobs report combined with weaker than
expected economic data this past spring, the probability of a
Federal Reserve (the Fed) rate hike by December stood at less
than 10 percent on June 30. Yet, today, after a hearty rebound
in the employment figures and improved economic data, the
probability that the Fed hikes rates at least once by December
stands at nearly 53 percent.2
With the tailwinds of earnings growth, share buybacks
and emergency monetary policies turning into headwinds,
it appears that recent US stock market highs have been
propelled largely by price-to-earnings multiple expansion.
Said differently, markets are climbing higher based mostly
on investors’ eagerness to pay higher prices for stocks today
in the hope that they will be rewarded with better returns in
the future.
With US stocks near all-time highs and valuations stretched,
I believe there are four great hopes boosting investors’
confidence and driving today’s stock market to new heights:
1. Government austerity is over, and monetary policy will
pass the baton to aggressive fiscal policy.
2. Increased fiscal spending will spur business confidence
and more specifically, business fixed investment.
3. A surge in government and business spending will
bolster US GDP growth.
4. The powerful one-two punch of easy monetary and fiscal
policy will end the so-called earnings recession and
support the recent run-up in stock valuations.
You Spent What on School Supplies?
Fueling investors’ first hope for more aggressive spending,
earlier this year, Canadian Prime Minister Justin Trudeau
unveiled a new $46 billion infrastructure spending plan over
10 years to revive sluggish growth in Canada’s economy, rich in
energy resources. Not to be outdone, the Japanese government
announced a $45 billion fiscal spending plan this summer.
Meanwhile UK business leaders are urging Philip Hammond,
UK Chancellor of the Exchequer, to deliver a “bumper” fiscal
stimulus in his upcoming autumn statement, saying the Bank
of England can do little to revive post-Brexit confidence on
its own.
In the US, Democrats and Republicans up for election
are promising voters huge increases in fiscal spending and
government infrastructure projects. Democratic presidential
candidate Hillary Clinton has promised to spend $275 billion
on US infrastructure projects. The Republican nominee,
Donald Trump, has vowed to at least double whatever
Clinton has promised to spend on infrastructure.3
As the usefulness of monetary policy power has waned, it is
becoming clear that government austerity is dead. Fiscal
restraint ended in the US late last year. Politicians on both sides
of the aisle reached agreements on a budget deal, a highway
infrastructure bill and several tax extenders intended to boost
tepid business spending. As a result, discretionary spending by
the US government is expected to increase this fiscal year for
the first time since 2009. Regardless of which US presidential
candidate wins the election, politicians are gearing up for fiscal
spending action.
Investors should recognize that this newfound commitment
to spend by their elected officials creates some challenges .
Most importantly, where will the money to fund all these
infrastructure projects come from? Historically, the
government has borrowed more, taxed more or both to
fund additional spending. Given that the US is already overly
indebted (see Figure 3), this may have negative implications
for interest rates and the US dollar as borrowing and budget
deficits accelerate.
Figure 2: S&P 500 YoY Percent Change in Sales and Earnings
%
20
14.62
12.02
15
8.09
7.47
10
6.56
4.53
5
-1.46 -3.30
-4.10 -3.60
-6.79 -3.98
-8.03 -1.89
-3.94 -0.51
CQ2 15
CQ3 15
CQ4 15
CQ1 16
CQ2 16
-1.82
1.54
0
-5
-10
 S&P 500 Earnings
CQ3 16
CQ4 16
CQ1 17
CQ2 17
 S&P 500 Sales
Source: Bloomberg Finance LP as of 09/07/2016.
State Street Global Advisors
2
Hope Has Never Been a Winning Investment Strategy
Figure 3: Projected US Budget Deficit as a Percent of GDP
Figure 4: NFIB Small Business Optimism Index
%
Index Level
110
3
20 Year Average: 96.9
7/31/2016: 94.6
105
100
0
95
-3
-6
-2.46
- 3.21
- 3.11
- 2.61
-3.03
-3.34
90
-3.63
- 4.13
- 4.12
- 4.00
- 4.34
- 4.56
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Source: Congressional Budget Office. Accessed 09/07/2016.
Somebody Has to Have Better Notes
The second great investor hope is that all this spending on
infrastructure projects will bolster sluggish business
confidence and fixed investments. The Federal Reserve’s Open
Market Committee pointed out in its July statement that job
growth has been quite strong of late, but weak business fixed
investment is holding back the US economy. Simply stated,
businesses are not investing in plants, property and equipment.
This has largely been the case since the end of the Great
Recession except for a brief period in 2012. Capital investment
by businesses has actually become a drag on GDP growth.
That’s very unusual for periods in which the overall economy is
growing, and especially when employment growth is so strong.
In addition, July’s measure of small business optimism rose
one-tenth of a point to 94.6, a meager increase showing no
real enthusiasm for expansion, expected sales and making
capital outlays, according to the National Federation of
Independent Business (NFIB). (As shown in Figure 4, the
long-term average is 96.9.) “Small business optimism was
pretty much unchanged during the month of July and small
businesses continue to be in maintenance mode,” said NFIB
Chief Economist Bill Dunkelberg in a July press release.
“Uncertainty is high, expectations for better business
conditions are low, and future business investments look
weak. Our data indicates that there is little hope for a surge
in the small business sector anytime soon.”4
I hope investors are right and that an influx of new government
spending gives corporate America the confidence to begin
spending again. My concern is that without their help,
economic growth will remain underwhelming.
I Was Told There Would Be No Math
The formula for GDP is: GDP = C + I + G + (Ex - Im), where “C”
equals spending by consumers, “I” equals investment by
businesses, “G” equals government spending and “(Ex - Im)”
equals net exports, that is, the value of exports minus imports.
State Street Global Advisors
85
80
Sep
1996
2000
2004
2008
2012
Jul
2016
Source: Bloomberg Finance LP as of 09/07/2016.
That leads me to the third great investor hope driving US
markets higher. Spending by consumers, although slower
compared with past economic recoveries, has been positively
contributing to GDP growth. But as the world’s largest and
wealthiest nation, and with the US dollar as the world’s reserve
currency, the US is doomed on net exports. So that leaves us
investments by businesses and government spending to spur
growth. Investors are hopeful that these nascent trends will
reveal themselves in better GDP figures. As of early September,
the Atlanta Federal Reserve GDPNow model is forecasting third
quarter US GDP growth of 3.3 percent, well above recent actual
GDP figures.
Settling for the Gentleman’s C
Providing a backdrop for hope number four, the second quarter
earnings season just concluded and the results weren’t great.
Earnings for companies in the S&P 500 Index fell 3.9 percent
year-over-year. It was the fifth consecutive quarter of yearover-year negative earnings growth for S&P 500 companies.
According to Bloomberg, this is the first time since the third
quarter 2008 to third quarter 2009 period that the index has
suffered five consecutive quarters of negative earnings growth.5
In addition, for the third quarter, 77 companies have issued
negative earnings per share (EPS) guidance and 33 have issued
positive EPS guidance.6 That’s a potential red flag for third
quarter earnings season.
Yet, despite the earnings growth gloom, investors remain
hopeful that the so-called earnings recession is close to ending.
The current forecasts for third quarter earnings call for a more
modest decline in year-over-year earnings growth, followed
by a more notable rebound in fourth quarter profits. The
typical quarter sees companies in aggregate report better-thanexpected numbers, with the average margin of upside around
four percent. As a result, there is an outside chance the earnings
recession ends in the third quarter. Investors believe that the
prolonged contraction of corporate profitability will conclude
3
Hope Has Never Been a Winning Investment Strategy
Figure 5: Change in Private Investment and Government Consumption YoY
% Change YoY
14.3
15
12.7
12.1
9.6
10
9.3
8.1
7.0
5.6
5
4.3
3.7
4.7
5.6
4.1
3.4
4.5
1.3
0.3
0
-2.3
-5
Mar
2011
-1.6
-3.1
-3.7
5.5
-3.0
Dec
2011
 Gross Private Domestic Investment
-2.0
-1.6
-2.2
Sep
2012
-2.8
-2.8
-3.0
-1.4
-2.0
-2.8
3.8
3.8
1.2
2.0
1.8
2.22.6
-0.3
1.9
0.7
0.2 0.4
-0.7
-3.4
Jun
2013
Mar
2014
Dec
2014
Sep
2015
Jun GDPNow
2016 Forecasted
Q4 2016
 Government Consumption Expenditures and Gross Investment
Source: Federal Reserve Bank of Atlanta. Accessed 09/08/2016.
by the end of the year. Their faith is strengthened by the
realization that we are moving beyond the effects of the oil
crash and US dollar surge that took a bite out of earnings for
much of the last year.
we figure out how to pay for this new spending. And that may
spell additional trouble. The remaining three great hopes may
occur, but only marginally. Of course, this will disappoint
investors because they hoped for more and have priced in
better outcomes.
Could Less Bad Really Be Good?
Hope has no part in an investment strategy. Allowing emotions
— whether hope, fear or greed — to dictate how you invest can
be especially problematic during an uptick in volatility. Only
when investors face the failure of their four great hopes to live
up to their inflated expectations will stock prices and valuations
come back to reality. In the meantime, investors should look for
growth at a reasonable price. Buy growth — just do not overpay.
Seek companies and exposures that have a long-tested ability to
increase shareholder value through consistent cash flows and
stable balance sheets. By pursuing growth, but avoiding high
flying boom or bust growth stocks, we heed Ben Franklin’s
warning that “He that lives upon hope will die fasting.”
Mixing the wisdom of Alexander Pope with that of the Rolling
Stones, I’ll conclude that hope springs eternal, but you can’t
always get what you want. Summer’s high flying markets
certainly resonated positively enough with investors to get
them to part with their capital at a time of stock market highs
and stretched valuations. And, certainly, the 2016 market
illustrates that optimism pays. Investors who sold US stocks
during January and February have missed out on an impressive
rally. But where will investing based on hopes for a better
tomorrow lead us? Today, with the market and stock market
valuations having gotten ahead of the reality, investors are
happy to pay for future perfection that may not develop so
perfectly. However, if the growth that investors are so willing
to pay up for doesn’t materialize, we may continue to see bouts
of volatility reset expectations.
Of the four hopes I’ve outlined, I’m betting on just one
summer dream coming to fruition this fall. Whether Clinton
or Trump is elected in November, I believe Washington’s
politicians are gearing up to increase spending. In fact,
according to Strategas Research Partners, every US President
dating back to John F. Kennedy passed significant fiscal policy
during his first two years in office.7 Of course, Washington is
currently gridlocked. As Figure 6 illustrates, although
presented legislation has been rising, compared to the last 12
Congressional terms, the current Congress has had the fewest
number of laws enacted (219) versus an average of 402 per term.
The markets may also be underestimating the potential
impacts to US deficits, US dollar and higher interest rates as
State Street Global Advisors
Figure 6: Despite an Increasing Amount of Bills and
Legislation, Congress is Enacting Fewer Laws
Enacted Laws
Bills & Legislation (thousands)
700
16
500
12
300
8
100
4
0
1993
— Enacted Laws
1999
2005
2011
Present
0
— Bills & Legislation
Source: GovTrack.us, September 9, 2016.
4
Hope Has Never Been a Winning Investment Strategy
1
Glossary
2
Brexit An abbreviation of the term “British Exit,” which refers to the UK referendum
on June 23, 2016, that resulted in the country’s decision to withdraw from the
European Union (EU). Under Article 50 of the EU’s Lisbon Treaty, a country that votes
to leave the common market has 24 months to do so.
TrimTabs Investment Research. September 1, 2016.
Bloomberg. September 7, 2016.
3
Rappeport, Alan. “Donald Trump Proposes to Double Hillary Clinton’s Spending
on Infrastructure.” New York Times. August 2, 2016. Accessed September 1, 2016
at:http://www.nytimes.com/2016/08/03/us/politics/trump-clinton-infrastructure.
html?_r=0.
4
National Federation of Independent Business (NFIB). “Small Business Optimism
Levels Off in July.” August 9, 2016.
5
Bloomberg. September 7, 2016.
6
FactSet. August 26, 2016.
7
Clifton, Daniel; Lowe, Jeannette and Rosenberger, Courtney. “Policy Outlook: Fiscal
Policy Alpha Update.” Strategas Research Partners, LLC. August 23, 2016.
Dow Jones Industrial Average is a price-weighted average of 30 significant
stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
Earnings Per Share (EPS) A profitability measure that is calculated by dividing a
company’s net income by the number of shares outstanding.
Nasdaq refers to the Nasdaq Composite, an index of more than 3,000 stocks listed
on the Nasdaq exchange that includes the world’s foremost technology and biotech
giants such as Apple, Google, Microsoft, Oracle, Amazon, Intel and Amgen.
S&P 500 Index A popular benchmark for US large-cap equities that includes 500
companies from leading industries and captures approximately 80% coverage of
available market capitalization.
ssga.com | spdrs.com
For public use.
State Street Global Advisors One Lincoln Street, Boston, MA 02111-2900.
T: +1 866 787 2257.
Important Risk Information
The views expressed in this material are the views of Michael Arone through the
period ended September 9, 2016, and are subject to change based on market and
other conditions. This document contains certain statements that may be deemed
forward-looking statements. Please note that any such statements are not
guarantees of any future performance and actual results or developments may differ
materially from those projected.
Investing involves risk including the risk of loss of principal.
Past performance is no guarantee of future results.
The information provided does not constitute investment advice and it should not be
relied on as such. It should not be considered a solicitation to buy or an offer to sell a
security. It does not take into account any investor’s particular investment objectives,
strategies, tax status or investment horizon. You should consult your tax and financial
State Street Global Advisors
advisor. All material has been obtained from sources believed to be reliable. There is
no representation or warranty as to the accuracy of the information and State Street
shall have no liability for decisions based on such information.
The whole or any part of this work may not be reproduced, copied or transmitted or
any of its contents disclosed to third parties without State Street Global Advisors’
(SSGA’s) express written consent.
Standard & Poor’s®, S&P® and SPDR® are registered trademarks of Standard &
Poor’s Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow
Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been
licensed for use by S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain
purposes by State Street Corporation. State Street Corporation’s financial products
are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their
respective affiliates and third party licensors and none of such parties make any
representation regarding the advisability of investing in such product(s) nor do they
have any liability in relation thereto, including for any errors, omissions or
interruptions of any index.
State Street Global Markets, LLC, member FINRA, SIPC, One Lincoln Street,
Boston, MA 02111.
© 2016 State Street Corporation. All Rights Reserved.
ID7600-IBG-21192 0916 Exp. Date: 09/30/2017