U.S. equity markets advanced in the quarter as concerns regarding the Brexit vote receded and a patient Fed added to the risk-on mentality. Small-cap stocks outperformed large-cap stocks during the quarter and are now sizeable outperformers for 2016. The forward price/earnings ratios for the S&P 500 and the Russell 2000 are now virtually identical, and we find it less likely that small-cap stocks will continue their run of outperformance through year-end. From a sector standpoint, technology was a standout, with the sector rising over 10% and the tech-heavy NASDAQ index also up nearly 10%. Other cyclical sectors including industrials, financials and energy also outperformed during the quarter. Market participants withdrew from utilities, consumer staples, and REITs as valuations became extended and longer-term interest rates rose. In fixed income, interest rates rose slightly at the long-end of the curve and credit spreads tightened. Commodity prices were mixed with oil falling slightly while gold moved higher.
Given the continued absolute low level of interest rates, a number of well-known financial market experts have suggested that some sort of “new normal” exists where investors should expect subdued returns across asset classes for an extended period of time. We agree that the elevated price levels across asset classes make it unlikely for investor returns to match historical levels. Regarding fixed income, an investor that purchases a newly issued 10- year Treasury note with a 1.75% coupon can expect a maximum annual return of 1.75% if the note is held until maturity. This expected return is well below historical averages and certainly well below the average return for fixed income investors over the prior 35-year bull market. Additionally, the required rates of return for other asset classes have also declined in this period of low interest rates. Although the calculations are more challenging for equity investors, investment websites suggest the current required return for U.S. equities is between 7.0% and 8.0% (well below historical levels). In order for equity investors to earn an amount above this required return, either actual cash flows must be higher than initially forecasted or equity investors in the future must demand an even lower rate of return. With corporate profits falling for four consecutive quarters and interest rates already near historically low levels, this scenario seems increasingly unlikely. Thus, while we agree that returns are likely to be below average, we contend that the current market environment remains far from normal. While the population of our country is aging and venture capitalists seem increasingly focused on innovations in social media that decrease rather than increase productivity, we see little reason why the required returns investors demand across all asset classes have declined other than the low absolute level of interest rates. Once central bankers end their exceptionally easy monetary policies, return expectations across asset classes will likely increase to historical levels. This return to normality will not happen overnight and will most likely be delayed as long as possible.
It is not lost on us that a re-pricing of risk as a result of higher interest rates would result in lower asset prices and wealth destruction as bond prices fall and equity investors demand additional returns for the same capital investment. Additionally, many of the groups that would presumably benefit from higher interest rates would also initially suffer. Individuals in good financial condition would collect additional interest on their savings, but their owned assets (especially the equity in their home) would likely decline in value as higher mortgage rates make housing less affordable. Banks that have endured a long period with low net interest margins would still need to navigate a period where they must pay more interest on their short-term deposits and also manage additional delinquencies as borrowers must make higher interest payments on floating-rate borrowings. Insurance companies and pension funds would see the present value of their liabilities decline with higher rates, but the value of their fixed income and equity assets would also likely decline. Additionally, economic growth would likely be negatively impacted as fewer capital projects would be pursued and the negative wealth effect would result in less consumer spending. These potentially painful ramifications of a higher interest rate policy provide central bankers with many allies as most market participants do not want to see the good times end. While the remedy will not be enjoyable, the pain taken today to restore risk-aversion to historical levels would help ensure a more stable financial environment and higher long-term economic growth.
At the risk of allocating too much discussion to discount rates, we wanted to briefly share an academic view on the topic. In a traditional discounted cash flow (“DCF”) model, the future free cash flows generated by a company are discounted at the company’s weighted average cost of capital (“WACC”). The WACC is derived by taking the riskfree rate (typically the yield on a 10-year or 30-year government bond) and adding an equity risk premium. This discount rate is applied to all future free cash flows of the company regardless of whether the cash flows are generated tomorrow or 50 years in the future. However, the yield curve in the fixed income market is usually upward sloping, with investors demanding additional return to own long-term bonds rather than short-term bonds (as shown in the first figure below). The convention of equity investors to discount all cash flows at the same discount rate ignores evidence from the fixed income market that cash flows received far in the future should be discounted at a higher rate. In addition, it seems likely that the equity risk premium should also increase for long-dated cash flows, as predicting the relevance of a company or industry many years in the future becomes increasingly difficult (an illustrative example of the current estimated WACC and a theoretical discount rate curve is provided below). While we will leave the topic for any interested readers in academia to explore, this apparent discrepancy in discount rates could provide one explanation for the historical outperformance of value companies over growth companies (with growth companies generate a higher percentage of their free cash flow in the out years).
[us_separator] The above post has been excerpted from a recent letter of Gate City Capital Management.
Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2015 has undergone an Audit by Spicer Jeffries LLP. Performance for 2016 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014. The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.