Choppy markets continued in April. After all the large swings, the S&P 500 ended with a modest gain of 0.4% for the month, leaving the index down 0.4% for the year. Developed international markets beat domestic stocks with the MSCI EAFE index gaining 2.4% in April. Emerging market equities, feeling currency pressure and geopolitical tensions, pulled back in April but show small gains for the year.
While equity markets were largely flat, interest rates resumed their upward trend. The yield on the 10-year Treasuries briefly surpassed 3% for the first time in over 4 years. Higher oil prices and stronger wage growth are forcing inflation expectations higher. Commentators point to a 3% yield as a critical level, or “line in the sand,” for the stock market. These psychological cutoff points are rarely as important as the speed at which prices move. We view this move up in inflation expectations and interest rates as part of long-term normalization in the bond market and a sign of a healthy economy.
Earnings for the first quarter started off on a strong foot. With 81% of companies reporting, 79% have beat expectations for Q1. Earnings growth accelerated to 24%, putting this quarter on pace for one of the strongest on record, according to FactSet. And yet, the market has failed to gain traction on the better-than-expected numbers. Instead, investors have focused on the negatives; talk of peak quarter, higher input costs, and compressing profit margins are overshadowing the record setting earnings. Is this cautious commentary part of the endless effort to reduce expectations only for management to beat them next quarter or does this reflect genuine concern? As much as anything, the lackluster market mood reflects some buying fatigue surrounding stocks.
At this stage in the cycle, it is natural for investors to question if this is as good as it gets, looking at the glass half-empty. While it’s true this has been one of the longest recoveries on record, economic recoveries don’t die of old age. Despite the geo-political concerns (which seemingly always lurk), companies continue to perform, hiring continues, and consumers continue to spend, giving us some comfort amid all this noise.
Focus on Quality
A large number of different factors, or characteristics, influence stock performance over time. Numerous studies have identified four primary factors driving stock returns – quality, value, momentum, and size. We believe a focus on quality is particularly important in the current market environment. The stocks of high-quality companies hold up better during periods of market stress and offer greater odds of long-run survival. But what is “quality,” how is it defined, and how should it be incorporated into an equity portfolio?
We have researched and employed a number of different quality measures over the years, including the amount of debt, the ability to service debt, and metrics to assess liquidity. Recently, we have settled on a broader analysis of quality using a method first credited to Stanford Accounting Professor Joseph Piotroski. His method breaks financial strength into three components: profitability, leverage and liquidity, and operating efficiency.
Profitability metrics gauge how well a firm can generate earnings and assesses the quality of those earnings. Companies that generate actual cash – as opposed to solely accounting income, which may not always translate into cash for shareholders – are looked at more favorably. Companies able to reduce debt, have ample means of funding operations, and rely less on outside financing are viewed as healthier. Lastly, high rates of operating efficiency signal the strength and expertise of management.
Any robust stock selection method should not rely on or be overly sensitive to a single indicator – particularly when it comes to reported accounting data. This approach attempts to aggregate metrics across a range of quality and financial strength measures, and in doing so, identifies firms that are in a general position to withstand the threats of competition and the swings in the economy.
We believe financial soundness of a company may be particularly important now. Overall valuations in the market are above average, while some individual companies trade well below historical levels. It may be reckless to focus solely on value as a strategy. Are cheap companies the result of poor management decisions or declining business prospects, or have quality businesses been overlooked for other reasons? Marrying quality with other measures of value can help separate the wheat from the chaff.
What It All Means
Anxiety is elevated in the financial markets. Interest rates are pressured by higher reported inflation and gains in commodity markets. While the Federal Reserve passed on raising rates at its meeting this week, how they deal with rising near-term inflation will be a focus for markets going forward. Anticipation of three additional rate hikes this year should more or less be baked into financial market expectations. If they signal a move to a faster pace, the market could feel some further indigestion. Unproven faces on the Fed’s board only adds to the consternation.
It’s rarely productive to believe one can see the future too clearly, especially when it comes to investing. Still, geo-political and domestic political risks abound. Combined with the prospect of higher rates, short term risk is elevated, and with that, we think the chance of a meaningful correction in stocks is possible. While rising inflation and interest rates can suppress stock valuations and prices in the short term, the reemergence of inflation is not all bad and is generally associated with a growing economy and stock market over time. So, without the benefit of a reliable crystal ball, we will stay the course with stocks and continue to fine tune the portfolio around high quality companies to help manage risk.
Contact us at 865-584-1850 or info@proffittgoodson.com
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