The past three months provided investors with plenty of anxious moments. For this we can largely thank geopolitical events in Russia, South America, the Middle East, Scotland and Asia. In the U.S., economic activity seemed to merely tread water, while the Federal Reserve continued to teeter between doing something and nothing at all for the "foreseeable future" - which perhaps best translates to do nothing until the unforeseeable becomes a problem.
All told, investors probably feel fortunate U.S. markets ended the quarter roughly unchanged, particularly as this wasn't how it felt at times. In late July, there was a nervous market decline before better than expected earnings reports prompted a rally through mid-September to new all-time highs, only to succumb to renewed selling through the quarter-end.
It's now earnings season once again, and it's already shaping up to be the market-moving event of 2014, not just because earnings are supposed to drive company share prices, but because it has the potential to make or break the most recent downtrend in the market.
Since June 30th, analyst revisions to third quarter earnings have largely been lower, with year-over-year estimates declining from 9% to 6.5% currently. While this is fairly common, as analysts typically exercise greater caution at quarter-end, there are some additional factors that have played a role as well. One being the late quarter surge in the value of the dollar. Given the high exposure of large U.S. multinationals to foreign economies - which also seem relatively weak compared the U.S. economy - this potentially sets up many companies to report weaker than expected foreign earnings. A second current point of concern is the sharp decline in oil prices, which directly impact energy sector earnings.
There are some positives to take from last quarter however. The first being that businesses have stepped up their pace of investment, which is essentially why we own shares in businesses. Another is the continuing decline in oil prices. While oil prices will certainly take the luster off energy sector earnings, for other sectors which are large users of energy, such as a industrials and materials companies, they should benefit in the form of lower input costs. With consumer energy prices also moving lower, retail sectors could benefit from consumers' increase in discretionary spending power.
So, the question becomes, what should investors do? Probably nothing. Many may feel compelled to do something, such as make changes to their investments, but odds are they will be based more on emotion than reason. Even if the geopolitical and Fed uncertainty isn't much clearer in the months ahead, and even if, for one reason or another, the economic or earnings backdrop softens, investors who will fare best will be those that keep their wits about them, staying focused on where true investment value comes from.
Many commentators are citing the recent all-time market highs as a reason for caution. They haven't been sounding the overvaluation alarm, which probably owes to the market's valuation (price-to-earnings) being lower now than at the beginning of the year, at 16.4x versus 16.9x, respectively.
More often than not what we're hearing is that a correction (or a decline of -10%) "is due," as it has been more than three years since the last one. In the hands of the media, which has a clear bias toward sensationalizing the negatives that are in sync with the market’s direction, these claims appear meaningful. The key to successful investing however, is to separate out opinion that corresponds with the market's direction - and merely sounds smart at the time - with what drives stock prices over the long-term.
Ultimately, the success of the stock market is driven by how valuable individual companies become; driving this are the returns that businesses earn, and for how long. In our view, commentators are confusing price with value. If achieving all-time highs in price were a reason for caution toward stock market exposure, then investing in the market would amount to nothing more than an effective sideways investment strategy.
The reality is, many companies haven't been creating much value over the past several years, as evidenced by their growing stockpiles of cash and preference for stock buybacks, even while achieving record levels of profitability. If companies aren't able, or willing, to invest in their future at meaningful returns (let alone record profitability), their businesses will quite simply create less value; impairing economic growth and the attractiveness of the stock market. However, if more companies are making more investments at sustained high rates of return, the present backdrop of uncertainty could prove a springboard for a meaningful market advance.
Another facet to consider is that investors-at-large still aren't participating to a large degree in the equity market. This probably sounds as though it too flies in the face of recent market commentators' thoughts, suggesting that because the market is at or near all-time highs, equity investors may go into retreat. In fact, when you look more closely at what the market has actually done, and the level of participation by individual investors, it's hard to see that they have done anything but retreat over the past several years.
To this last point, individuals did add to their equity exposure in 2013, the first year of net inflows in the previous five, as proxied by net new investments into U.S. equity funds of $18 billion. To put this number in perspective however, over the 2007-2012 period investors pulled $615 billion from U.S. equities, while moving more than $1.1 trillion into bonds. So far this year, investors have reverted to their old ways, withdrawing more in 2014, than had been put into equities during all of 2013 - meaning that investors-at-large are still negative contributors to equity demand - a trend that goes all the way back to 2007!
There are a lot of uncertainties in today's market. Some may or may not be adequately addressed in the upcoming earnings season. However, with many companies' share prices having already been pushed lower of late, we think that to some degree, this is being "priced in." The opportunity for long-term investors will lie in respecting current price volatility while remaining focused on where true investment value comes from.
All told, we are respectful of the many investment concerns at present, though we remain acutely focused on tangible investment opportunities, those that are durable, and made by companies to foster the long-term growth of their respective businesses. We believe those companies focused on growing their businesses have an immense opportunity verses those that aren't even trying.
It is these specific opportunities that we believe will be the most highly rewarded exiting today's uncertain backdrop, built upon solid fundamentals and rising valuations commensurate with specific investment success.