Federal Reserve to the Rescue
How would you expect the stock market to perform in a country experiencing slowing GDP growth, disappointing retail sales and a negative corporate earnings outlook? There is a wide range of possible answers, but the most obvious choice certainly would not be that stocks would experience their best quarterly performance in a decade. Yet that is exactly what occurred with the U.S. stock market (S&P 500 Index), up 13.7% in the first quarter. To add to the perplexity, this stellar performance comes on the heels of a fourth-quarter rout in stocks, where major indices declined almost 20% from their peaks. When looking to the economic fundamentals for answers, they do not appear to be either weak or strong enough to warrant these kinds of drastic moves.
So if the economic data was neither bad nor good enough to result in such sharp swings, what was the culprit? The below chart shows the stock market’s recent performance against the backdrop of the Federal Reserve’s (“Fed”) drastic change in interest rate policy:
Based on how the stock market reacted to comments made by the Fed, the clear conclusion is that the stock market has become dependent upon low interest rates (i.e., low borrowing costs) to drive it higher. When rates rose sharply in the fourth quarter, the market swooned, only to recover when the Fed made a U-turn on policy following weaker than expected
economic data. Instead of the planned, steady increases in interest rates, the Fed is now promising to be more “patient” with interest rate increases. While it seems counterintuitive, we are in an environment where bad economic news is perceived as a positive sign for stocks since
it will give Fed policymakers an excuse to keep interest rates lower for longer. Lower interest rates mean cheaper borrowing costs for companies and consequently higher profits.
While we normally summarize index performance in a table format, we feel that the below bar chart comparing the performance in Q4 2018 to Q1 2019 better illustrates the recent whipsaw that investors have experienced across most major asset classes:
This information is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. All indexes are unmanaged, and an investment cannot be made directly in an index. Index returns do not include fees and expenses. Please see disclosures at end of this commentary for general definitions of indices.
Given the strong recovery in stocks in the first quarter, stock valuations have skyrocketed back up to near all-time highs. The below chart looks at the average price-to-sales ratio, which compares a company’s stock price to its revenue, for stocks in the S&P 500 Index. It clearly indicates how expensive stocks have become.
Source: Bloomberg. P/S Ratio: Market Value per Share / Sales per Share
With stock valuations disconnected from the fundamentals and bond yields back down in the basement, where can investors find returns with reasonable levels of risk? In our fourth quarter client communication, we discussed our core beliefs as they pertain to managing our clients’ portfolios. When evaluating a new opportunity, these beliefs revolve around risk management (properly evaluating the risk/return tradeoff), true diversification (finding drivers of return that are significantly different than what we already own), and adequate cash flow, especially in the current low-interest-rate environment. These tenets hold firm not only during the market volatility of the fourth-quarter, but even in strong recovery periods like early 2019, when investor “FOMO” (fear of missing out) is naturally at its strongest.
In recent years, these beliefs have steered us toward opportunities in the private lending space, specifically in cash-flow-focused assets with adequate collateral. We recently approved a new strategy in this space that looks to provide capital for social infrastructure projects related to private nonprofits, 501(c)(3) organizations and other entities authorized to issue private activity and tax-exempt bonds. Consistent with our thesis in other private lending strategies, this strategy takes advantage of the supply/demand imbalance in the marketplace for creditworthy loans. The regulatory and market changes in the aftermath of the financial crisis have created a capital shortage in these segments of the market, and, consequently, those willing to lend in the space can command higher yields and stronger collateral and controls. Examples of these market segments include:
There are meaningful demographic trends supporting growth in these segments, which disconnects them somewhat from the performance of the broader economy. Therefore, we believe these segments of the market are relatively recession-proof and unaffected by stock and bond market dynamics, making them particularly attractive in the current environment. The social nature of the projects also allows them to qualify for tax-exempt status in most cases, and the fund manager expects the majority of the income generated to be federally tax-free.
While the majority of funds in the private lending space are private vehicles, this strategy will be offered in a mutual fund structure where there are quarterly liquidity windows as opposed to daily liquidity. The less liquid nature of the strategy is what allows investors to capture the illiquidity premium associated with investing in these private securities. Investors are essentially trading market exposure and risk for illiquidity risk. We find this tradeoff to be attractive in the current market environment and feel that it makes a lot of sense for certain client portfolios where some level of illiquidity is appropriate for long-term investing.
Please do not hesitate to contact your Morton Capital wealth advisory team if you have any questions or would like to review your portfolio or financial plan in more detail. As always, we appreciate your continued confidence and trust.
Morton Capital Investment Team
Disclosures: This commentary is mailed quarterly to our clients and friends and is for information purposes only. This document should not be taken as a recommendation, offer or solicitation to buy or sell any individual security or asset class, and should not be considered investment advice. This memorandum expresses the views of the author and are subject to change without notice. All information contained herein is current only as of the earlier of the date hereof and the date on which it is delivered by Morton Capital (MC) to the intended recipient, or such other date indicated with respect to specific information. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information. Any performance information contained herein is for illustrative purposes only.
Certain private investment opportunities discussed herein may only be available to eligible clients and can only be made after careful review and completion of applicable offering documents. Private investments are speculative and involve a high degree of risk.
The indices referenced in this document are provided to allow for comparison to well-known and widely recognized asset classes and asset class categories. Q1 returns shown are from 12-31-2018 through 03-31-2019 and the Q4 2018 returns are from 09/28/2018 through 12-31-2018. Index returns shown do not reflect the deduction of any fees or expenses. The volatility of the benchmarks may be materially different from the performance of MCM. In addition, MCM’s recommendations may differ significantly from the securities that comprise the benchmarks. Indices are unmanaged, and an investment cannot be made directly in an index.
U.S Large Co Stocks: S&P 500 Index U.S. Gov’t 1-3 Yr Bond: Barclays U.S. 1-3 Yr Treasury Bond Index
U.S. Small Co. Stocks: Russell 2000 Index Commodities: Bloomberg Commodity Index
Developed Int’l Stocks: MSCI EAFE Index Emerging Market Int’l Stocks MSCI EM Index
U.S. Bonds: Barclays U.S. Aggregate Bond Index US Large Value: Russell 1000 Value Index
U.S. Large Growth: Russell 1000 Growth Index
Past performance is not indicative of future results. All investments involve risk including the loss of principal. Details on MCM’s advisory services, fees and investment strategies, including a summary of risks surrounding the strategies, can be found in our Form ADV Part 2A. A copy may be obtained at www.adviserinfo.sec.gov.