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Litman Gregory Investment Commentary


Third Quarter 2018

Quarterly Benchmark Returns
Market Recap

The divergence in global stock market performance we highlighted in the second quarter widened in the third quarter with US stocks gaining and emerging-market (EM) stocks falling. The US market was propelled by continued strong profit growth, thanks in large part to the Trump corporate tax cuts. S&P 500 operating earnings per share grew 27% year over year in the third quarter—compared to their 6% long-term annualized growth rate—and a record-high 80% of S&P 500 companies reported earnings that beat the consensus expectation. Record levels of share buybacks (estimated by Goldman Sachs to reach $1 trillion for 2018) were another support for the US market. Putting it all together, the S&P 500 index hit a new high in late September and gained 7.7% for the quarter (Vanguard 500 Index). Smaller-cap stocks gained 3.6% (iShares Russell 2000 ETF).

There are always multiple factors behind short-term market moves, but the intensifying trade conflict between the United States and China was an important one for foreign markets and EM stocks in particular in the third quarter. Another factor was the US dollar, which appreciated against other currencies during the quarter. This was a further drag on foreign stock market returns for dollar-based investors. For the quarter, EM stocks fell 1.7% (Vanguard FTSE Emerging Markets ETF). Developed international equities fared better, posting a slight gain of 1.2% (Vanguard FTSE Developed Markets ETF). European stocks gained 0.6% (Vanguard FTSE Europe ETF).

In the fixed-income markets, the 10-year Treasury yield rose to 3.05% at the end of the third quarter, flirting with a seven-year high. As such, the core bond index had a negative 0.5% return In September and was flat for the quarter (Vanguard Total Bond Market Index). However, credit-sensitive segments performed well, with floating-rate loans gaining 1.8% for the quarter (S&P/LSTA Leveraged Loan Index). For the year, floating-rate loans, to which we are tactically allocated, are up 4%, compared to a 1.7% loss for core bonds—a meaningful divergence that has benefited our portfolios.

At the end of September, the Federal Reserve raised the federal funds rate 25 basis points (0.25%) as expected to a range of 2% to 2.25%. The futures market is now discounting a fourth rate hike this year in December but doesn’t (yet) fully reflect the Fed’s own forecast of three more hikes next year.


Quarterly Portfolio Performance and Positioning Recap



All our globally diversified portfolios have meaningful strategic allocations to developed international and EM stocks. Our portfolios also currently have a modest tactical overweight to European and EM stocks and are underweight to US stocks. This positioning was beneficial in 2017, when foreign markets outperformed US markets. But so far this year, it has been a drag on returns as US stocks outperformed international and EM markets. Considering this performance divergence, we include further details on our outlook and analysis for EM and US stocks after this positioning recap.



Our balanced portfolios have a large allocation to actively managed, flexible bond funds as well as floating-rate loan funds. In the third quarter, these funds contributed positively to portfolio returns and outperformed the core investment-grade bond index. This is also true for the year-to-date period and the past several years. We continue to expect these positions to outperform over the next several years, particularly if interest rates continue to rise. The performance of our actively managed core investment-grade bond funds was also positive for the quarter. These managers have all outperformed the core bond index over our longer holding periods as well. We hold these core bond funds as risk mitigators in the event of recession or some other shorter-term “risk-off” scenario.



Our balanced portfolios also continue to hold liquid alternative strategies funds that we believe improve our portfolios’ long-term risk-adjusted return potential. These strategies have different risk and return drivers than traditional stock and bond funds. We believe these alternatives are particularly attractive from a tactical perspective given our current expectation of low to very low returns for core bonds and US stocks. These positions are funded from a mix of core bonds and stocks (depending on each portfolio’s risk objective). Our lower-risk arbitrage strategy funds were flat, in line with core bonds and outperforming foreign stocks but trailing US stocks. Our position in a diversified basket of trend-following managed futures funds had a small positive return for the quarter.


Reiterating our Outlook for US and EM Stocks



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

EM vs US Stock Valuations

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 to the right. 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%.

A Full-Fledged Trade War is Unlikely

The prospect of an expanding trade war between the United States and China intensified in the third quarter and has caused investor sentiment to turn against emerging markets all year. Uncertainties remain, but our base case continues to be that a full-fledged trade war is unlikely since it’s in neither country’s interest. It’s also not clear that US stocks will be less impacted by a trade war than EM stocks given the former’s global presence. At the least, we may be living in a world with an overhang of trade tensions for a while.

US Dollar Strength Is Likely to Reverse Longer Term

A strong US dollar, as we’ve seen lately, lowers EM stock returns for US dollar–based investors and negatively impacts emerging markets with dollar-denominated debt. Longer term, we believe the fiscal stimulus of tax cuts at a time when the economy is at or near full employment will cause fiscal deficits and debt levels to rise. This should be a longer-term headwind for the US dollar and a positive for EM stocks. Undervalued currencies are also a potential tailwind for emerging markets over the medium to longer term.

The Risk of Broad-Based EM Contagion is Low

Economic crises in Argentina and Turkey have made headlines. However, these economies and their financial markets are very small, and we see the risk of contagion to other more meaningful emerging markets as low. In contrast to the late 1990s EM crisis, most other EM countries’ fundamentals are healthier: they have better current account balances, better debt coverage, lower dependence on foreign capital, floating rather than fixed exchange rates, and higher foreign exchange reserves. The rapid growth and high level of private sector debt in China is a potential source of concern. But we have factored this risk into our scenario analysis and modeling and believe EM stocks should outperform US stocks over our multiyear investment horizon even if such a scenario were to play out.

EM Stocks’ Higher Cyclical Exposure Does Not Negate the Valuation Case

Emerging markets have historically had greater exposure to cyclical sectors and have historically traded at a valuation discount to the US stock market. We continue to apply this discount within our normalized-earnings framework for assessing EM stock valuations and still find them attractive relative to US stocks. EM stocks are attractive even on a US-equivalent sector-weighted basis, trading at a 20% discount to US stocks.

For more details on our current thoughts on EM stocks, read our dedicated article >



Given the ongoing US bull market, we thought it would be useful to revisit the rationale for our tactical underweight to US stocks. Our portfolios’ positioning is a function of our medium-term (five-plus-year) assessment of US stocks’ return potential, which we model across a range of scenarios and sub-scenarios we think have a reasonable likelihood of playing out.

Below, 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. Incorporating bearish and bullish scenarios generates an expected return range of negative 9.4% to positive 8.0% annualized for the US market. To put these estimates in historical context, since 1950, the S&P 500 has generated an 11.1% average annual five-year (60-month) return, and the range of returns over rolling five-year periods has been negative 6.6% to positive 29.6%.

We Expect Five-Year US Stock Returns to Be Far Below Average

Our Valuation Assumptions

Before the 2008 financial crisis, our fundamental assumptions for key asset classes were dictated by post-1950s financial market history, with more emphasis on post-1980s data. However, when the housing bubble burst and the financial crisis hit, we believed the private sector—households and financial institutions—had reached their capacities to borrow and lend and that the US economy was likely facing either an acute or chronic period of deleveraging. This led us to study the US deleveraging cycle of the 1930s and, knowing history does not exactly repeat but often rhymes, we concluded this was not a normal business cycle/recession and that deleveraging would most likely lead to a subpar economic recovery relative to historical norms. The slow recovery would be a headwind for corporate earnings. Investor sentiment would be depressed and aversion to owning risky assets would be high. This would be reflected in lower valuation multiples for stocks.

As a result, in our base-case model for equity returns, we initially used a 15x price-to-earnings multiple on our estimate of normalized earnings. This was in line with the market’s long-term historical average, but lower than the 18x to 20x multiples typically seen since the 1980s.

Given the economic unknowns at the time and the potential for further large market declines due to a full-blown debt-deleveraging cycle, we believed (and still believe) this was a prudent approach to balancing the potential risks and returns: neither assuming the world was coming to an end, nor that this was a typical cycle and everything would soon return to the “old normal.”

In early 2014, observing the deleveraging process had progressed in a surprisingly benign fashion—due largely to unprecedented monetary stimulus in the form of QE—we raised our base-case scenario valuation multiple to 17x. We gave more weighting to the post-1980s history but factored in some unique risks and uncertainties looking forward; for example, we didn’t (and still don’t) know how disruptive the Fed’s ultimate unwinding of QE will be on financial markets. This remains the valuation multiple we apply to our base-case normalized earnings estimate. For our optimistic scenario, we use the higher end of the post-1980s average of 20x. In our bearish scenario we use 16x, which is reasonably generous in our opinion.

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 years. To the extent companies are currently “overearning” relative to this trendline, our estimate of five-year 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 subpar over the next five years.

In our bear-case scenario, we derive earnings five 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 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, 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-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).

Fed Tightening and Recessions Often Go Hand-in-Hand

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.

Analyst Earnings are Wildly Optimistic

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 BCA chart below 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.

High Forecasted Earnings Growth Associated with Poor Future Returns

Ned Davis Research (NDR) 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 the first NDR chart below shows, the S&P 500 is now in the high-expectations/low-return zone. This may seem counterintuitive, 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.

US Stock Valuations Exceed Historical Highs by Some Measures

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.


Concluding Comments

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).

No matter how we slice it, 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, we have a meaningful underweight to US stocks in all our portfolios. We also believe skilled, fundamentally driven active managers can add a lot of value relative to market indexes in this next phase of the cycle.

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. As always, we continue to analyze new data and information, and if our analyses warrant a change in our views, we will.

In terms of our other portfolio exposures, our floating-rate loan and flexible fixed-income funds continue to add value. We like their prospects looking forward, particularly in an environment of rising rates and potential inflationary pressures—and as we get later in the economic and credit cycles. With corporate debt levels at all-time highs and the quality of the investment-grade bond universe at all-time lows (e.g., half of the investment-grade corporate sector has the lowest-quality BBB rating), it is particularly important to invest with experienced and risk-conscious managers. Importantly, these managers also have the flexibility to invest in less efficient fixed-income sectors where they can still find some relatively attractive investments without taking undue risk. They can also vary their overall portfolio risk exposures in response to what the markets are offering in terms of yield and total-return potential. Right now, these managers are positioned more defensively than normal across the board.

Our liquid alternative investments have much lower risk than US stocks but have been no match for them so far on the return side of the equation. We expect to see their risk management and portfolio diversification benefits shine when US stocks experience their inevitable correction and bear market. We also think these alternative strategies can generate around mid-single-digit annual returns, which is attractive relative to what we currently expect from a comparable mix of stocks and core bonds.

As always, we thank you for your continued trust and confidence.

—Litman Gregory Investment Team (10/4/18)

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