By The Advocates
Reiterating Our Outlook For US and Emerging Market Stocks
Q3 2018 Quarterly Letter
Our Investment Mission is to help families live their values by earning a consistent, long-term rate of return in excess of inflation, as required in their wealth plan.
Given the negative headlines concerning emerging markets in recent months, there are several points worth highlighting based on our additional research and analysis in this area. The primary takeaway is that EM equity valuations continue to look attractive, and their longer-term growth outlook remains intact.
The Recent Divergence Between 
EM and US Stock Returns is Not Unusual
In 2017, EM stocks gained 31.5% and outperformed the S&P 500 by 10 percentage points. That has sharply reversed this year, with US stocks beating EM by roughly 20 percentage points. This type of volatility and this level of divergence in relative performance is not unusual. It is common for US stocks or EM stocks to outperform the other by double digits over any 12-month period, as shown in the chart on the previous page. In more than one-third (36%) of the rolling 12-month periods from January 1988 through August 2018, EM stocks beat US stocks by a margin of 10 percentage points or more. Conversely, US stocks beat EM stocks by a 10-percentage-point or more margin in another 36% of the rolling 12-month periods. So, over shorter-term periods it’s actually pretty rare for both markets to perform similarly. However, over this entire 30-year period, the annualized returns for EM and US stocks were an identical 10.8%.
EM STOCKS
While there are always multiple factors behind short-term market moves, there were two dominant headwinds facing EM stocks in the third quarter: the intensifying trade conflict between the United States and China, and the strength of the US dollar. While neither of these factors presents new or material threats to our analysis of EM stocks, they have impacted our portfolios’ short-term returns given the magnitude by which they have lagged US stocks so far this year.
However, there are several points worth highlighting that give us confidence in our assessment that EM stock valuations are cheap and their attractive long-term return potential remains intact:
- Our base-case continues to be that a full-fledged trade war is unlikely as it is in neither country’s best interest, despite the fact that we may be living in a world with an overhang of trade tensions for a while. It’s also not clear US stocks would be less impacted than EM stocks given the former’s global presence.
- US dollar strength has hurt dollar-based foreign stock returns, but longer term, there are reasons to think this will reverse. We believe the fiscal stimulus of tax cuts at a time when the US economy is strong will cause fiscal deficits and debt levels to rise—both potential headwinds for the US dollar.
- Economic crises in Argentina and Turkey have made headlines, but these countries’ economies and financial markets are small. We see little risk of contagion to other emerging markets. In contrast to previous EM crises, the fundamentals of most other EM countries are much healthier in terms of debt levels, trade balances, dependence on foreign capital, foreign exchange reserves, etc.
- Within our normalized-earnings framework, we apply the historical discount EM stocks have traded at compared to US stocks and they are still attractive. EM stocks are even attractive after adjusting for sector differences between US and EM markets.
US STOCKS
As for US stocks, no one knows exactly when this confounding, record-longest US bull market will end. Despite their unattractive fundamentals, it’s certainly possible US stocks will continue to be favored by investors over the short term. Remember, in the short run the stock market is a voting machine but in the long run it is a weighing machine. However, S&P earnings growth expectations are now exceedingly high, and the US economy is operating at or near full capacity and full employment. These are unsustainable conditions, and the direction in which they will move next is likely negative for stocks.
Our portfolios’ tactical underweight to US stocks is based on conclusions drawn from our fundamental research on historical stock market valuations, earnings growth, and corporate profit margins. From current price levels, our base-case expectations for US stock returns over the next seven years are around 2.7%.
No matter how we slice it, our analysis suggests the US market is the most expensive major stock market in the world. As a result, it presents one of the biggest risks to our portfolios. This is why we have diversified our portfolios’ stock exposure by investing in foreign markets that, in contrast, look significantly cheaper and offer a much stronger medium- to longer-term growth outlook. But these positions come with additional shorter-term risk, as we’ve seen so far this year.
For those of you who would like more granular information, in the Appendix of this letter, we review the key valuation and earnings growth assumptions that underlie our base-case expectation of roughly zero percent return from the US stock market over the next five or so years from current price levels.
In Closing
We strongly believe that a key element of our investment process and edge is our discipline in maintaining a multiyear perspective rather than over-reacting to short-term price volatility, performance swings, daily news flow, and other behavioral triggers. It’s easier said than done, though, especially amidst an unprecedented stock market run and a seemingly unending string of unnerving geopolitical headlines. Rest assured, we remain ever-vigilant in analyzing new data and information, and if our analysis warrants a change in our views or portfolio allocations, we will act.
By our way of thinking, being an “investor” is synonymous with having a long time horizon. In the financial markets, almost anything can happen in the short run because market prices are driven more by investor sentiment, unpredictable events, and human herd behavior. But as you extend your investment horizon, market returns are determined by economic and business fundamentals (earnings and dividends) and valuations (what you pay for those earnings and dividends).
Our analysis suggests the US market, on a relative and absolute basis, is the most expensive major stock market in the world and, as a result, presents a poor return-versus-risk tradeoff. As such, this is reflected in all our portfolios.
Based on our normalized-earnings framework mentioned above, EM stocks are currently and significantly cheap relative to their US counterparts. Looking at normalized valuations another way, according to Research Affiliates, prior to the 1997–1998 EM Asian crisis, the EM CAPE (cyclically adjusted price-to-earnings ratio) was trading at a premium to the US CAPE. Today, EM stocks trade at a very large discount: an EM CAPE of 13x compared to 30x for US stocks.
EM equity valuations are attractive, and their medium- to longer-term growth outlook remains intact. But these positions come with additional shorter-term risk. Poor investor sentiment and capital outflows could potentially trigger an adverse feedback loop between emerging markets and economic fundamentals. However, this has always been a risk with emerging markets, and we take it into account in our portfolio construction and risk management. China debt-deleveraging, trade wars, and a resulting growth slowdown are additional nearer-term risks.
But we are longer-term investors. While balancing the short-term risks, we are currently assessing whether the recent EM downturn and divergence with the United States offers an attractive opportunity to increase our allocation to EM stocks. The same holds true for our tactical position in European stocks. We continue to analyze new data and information, and if our analyses warrant a change in our views, we will.
As always, we appreciate your trust and welcome questions.
Respectfully – Kurt Box, CFP®, AIF
Market and Portfolio Recap
Market trends in the third quarter were largely an extension of what we’ve seen so far this year, with a stark divergence in return between US stocks and foreign stocks. Larger-cap US stocks hit new highs in late September and gained 7.7% for the quarter, while smaller-cap US stocks gained 3.6%. Developed international stocks gained just 1.2% in the quarter, while emerging-market stocks (EM) fell 1.7%.
The US market was propelled by continued strong profit growth, thanks in large part to the Trump corporate tax cuts, and is now beating emerging markets by roughly 20 percentage points through the end of September. This level of divergence in relative performance is not unusual. It is common for US stocks or EM stocks to outperform the other over any 12-month period. Just last year, EM stocks gained 31.5% and outperformed the S&P 500 by roughly 10 percentage points. That has sharply reversed this year.
In fixed-income markets, the 10-year Treasury yield rose to 3.05% at the end of September, flirting with a seven-year high. Consequently, the core investment-grade bond index had a negative return in September and was flat for the quarter. Credit-sensitive segments, on the other hand, performed well, with floating-rate loans gaining 1.7% for the quarter.
Asset Class Changes:
We made a small shift in our Asset Allocation this quarter. This included flattening holdings of Gold Mining stocks across investment portfolios, eliminating our small positions in Commodity Agriculture and Multi Asset and adding slightly to Foreign Stock and Emerging Markets.
Appendix
Our Valuation Assumptions
Our base case price to earnings (P/E) multiple is based on observed historical valuation levels since 1950 during periods of low and stable inflation. This is key because while the cyclically (business cycle smoothing) adjusted P/E ratio is only 16.2x during all periods, it is 21.2x during these periods of low inflation (defined as -1% to 4%). For our optimistic scenario, we use the higher end of these periods at 31x. In our bearish scenario we use 13x.
Our Earnings Growth Assumptions
Our primary framework for S&P 500 earnings is based on estimating earnings growth relative to a long-term average earnings trendline growing at a constant rate of about 6%. We view this trendline as the normalized earnings power of the market—looking through the ups and downs of the business cycle. This 6% trend earnings growth is also consistent with long-term nominal US GDP growth.
Our base-case scenario assumes earnings will revert to the long-term trend over the next five plus years. To the extent companies are currently “overearning” relative to this trendline, our estimate of five-year plus forward earnings growth will be lower than the 6% annual trend growth. If current market earnings are below trend, our five-year growth expectation would be higher than 6%.
Our analysis currently indicates that US companies are overearning by about 10% based on reported earnings as of June 30, 2018. Earnings are 16% above trend if analysts’ third quarter (through 9/30/18) earnings expectations are correct. (Actual third quarter earnings get reported in the fourth quarter.) Consequently, in our base case, we model US market earnings growth to be just slightly sub-par over the next five years.
In our bear-case scenario, we derive earnings five plus years out by assuming S&P 500 profit margins revert to 6%, which is close to post-1980s averages. We assume S&P 500 sales grow at an annual rate of 4%, which is about the long-term average. In comparison, the S&P 500 profit margin is currently nearly 10% and year-over-year sales growth is 8.5%. So there is a large drop from current levels in the bearish scenario, even though we don’t believe our margin and growth assumptions are that pessimistic.
Finally, in our bull-case scenario, we assume earnings overshoot their normalized trend level by 20% five plus years out. This has happened periodically in market history. This outcome implies profit margins remain at historically high levels and US companies also achieve near historically high sales growth over the next five years. This scenario generates estimated market returns in the high single digits over the next 5 years, still quite decent. This outcome is possible but unlikely in our view given how late we are in the cycle.
We are Getting Late in the Market Cycle, But the Timing of the Turn is Always Uncertain
No one knows exactly when this record-longest and second-strongest US bull market will end. But that doesn’t stop lots of investors from fooling themselves into thinking they will see the signs before the rest of the market and be able to time their exit with minimal damage. It’s a nice fantasy, but that’s not the way markets work in the real world.
We don’t invest based on short-term market predictions or hunches. Our current underallocation to US stocks is based on our five plus-year tactical asset class analysis (described above) within the context of an even longer-term strategic allocation, consistent with each portfolio’s overall risk objective. However, below we discuss several reasons to think the shorter-term outcome for the US market may not be so rosy either.
As is often the case at turning points in financial markets, it is precisely because the recent cycle for US stocks has been so strong and market participants view the United States as the best game in town (or as economist David Rosenberg recently put it, “the smartest kid in the detention room”) that the outlook for the next phase of the cycle is darkening.
S&P 500 earnings growth expectations are now exceedingly high, and the US economy is operating at or near full capacity and full employment. These are unsustainable conditions, and the direction of their next material move is likely negative for stocks.
The tight labor market has finally translated into wage increases. History and economic theory suggest wages will continue to rise. This could negatively impact corporate profit margins and earnings growth. It could also cause companies to raise prices, which would stoke further inflation and force the Fed to tighten even more. Neither outcome is good for stock prices.
The recent rise in the dollar is likely to be another headwind for US multinational corporate profits, as it was in 2015 when the dollar rose. Trade wars, if they continue to escalate as they seem to be, will also have a depressing effect on sales growth and margins—both negative for earnings. The fiscal stimulus from the tax cuts has goosed corporate earnings growth this year, but those benefits will fade next year (barring further cuts).
This huge fiscal stimulus during a period of full employment is unprecedented, and according to most reputable economists, ultimately counterproductive. Along with tariffs and wage growth, it also has inflationary implications. This in turn suggests the Fed will continue to raise interest rates. The Fed is projecting four more rate hikes through the end of 2019. Even some previously dove-ish 
Fed officials are indicating they are on board for continued hikes. In conjunction with the Fed’s plan to unwind another $600 billion in bonds from its balance sheet next year, the table is potentially being set for monetary policy tightening consistent with those that have triggered past recessions. And we know that US recessions have always been accompanied by equity bear markets.
Coming back to S&P 500 earnings, they have been very strong over the past year, supporting the US bull market. But market earnings expectations are now very high likely too high for the market’s own good. For example, BCA Research calculates that analysts expect the average S&P 500 company to grow earnings at an annual rate of 17% over the next three to five years. In BCA’s words, “This is wildly optimistic.” As the chart to the right shows, this forecast is topped only by the 19% growth forecast at the height of the tech bubble in 2000, just before that bear market began.
Ned Davis Research makes a similar point. Their analysis indicates that periods of very strong earnings and forecasted earnings growth are associated with poor subsequent stock market returns. As shown in the chart below, the S&P 500 is now in the high-expectations/low-return zone. This may seem counter-intuitive, but it is how markets operate, particularly at the extremes: when investors are extremely bullish, the market likely already reflects that optimism in current prices and valuations. The potential for actual earnings to disappoint those bullish expectations is high.
If earnings growth does fall sharply next
year, it may be accompanied by a drop in valuation multiples as well. In other words, a lower valuation multiple on a lower-than-expected earnings number. This would be a reversal of the “double-positive” effect the market has experienced from both strong earnings growth and higher valuations applied to those earnings. Capital Economics notes the market price-to-earnings ratio has tended to fall when earnings estimates have been revised down ahead of, or during, an economic slowdown. Rising interest rates from Fed tightening could also have a depressing effect on valuation multiples as higher interest rates offer more competition to stocks and reduce the discounted present value of corporate cash flows. There is certainly plenty of room for US market valuations to drop relative to history.
If the consensus earnings expectations for March 31, 2019, are accurate, it implies US companies will be overearning at that point by nearly 30% relative to our estimate of their long-term normalized potential. In the post–World War II period, this has happened only 7% of the time (based on quarterly earnings data). It’s possible, but not how we’d want to bet.
So, in US stocks, we have an asset class that is currently overearning, expected by the consensus to grow earnings even further above normal over the next year, and historically expensive on most reliable valuation metrics. That’s not a recipe for good returns looking forward.