The market posted another positive quarter, with the S&P 500 returning almost 3%. In recent years, Q2 has witnessed a “growth problem,” in which softening economic data prompted investors to sell stocks. But this year that did not happen, as the data actually improved. While new job creation is less than some would like to see, there has been a clear acceleration over the past six months.
Inflation remains low, but house prices are increasing, both of which are providing a boost to our largely consumer-driven economy. Inflation has been kept in check by commodity prices leveling off and by the lack of wage growth. When you think about it, the lack of inflation and the strength in home prices can be attributed to simple supply and demand. The increase in commodity prices last decade naturally led to increased exploration and investment, which, along with technological advances like fracking, has increased supply, which has brought down prices. In addition, the relative lack of bargaining power of labor (essentially due to its worldwide oversupply) has restrained wage growth, a critically important factor in keeping inflation, and inflation expectations, subdued. On the housing front, the crash in home values five years ago caused an extreme decline in housing starts (new supply); it took a while, but this slowdown in new construction eventually helped prices in the sector recover: Home prices were up 15% year over year in May, which has all sorts of positive implications for the economy.
Most people are aware of the current natural gas boom in this country, but fewer are familiar with the changing dynamics of the oil market. Due to discoveries in North Dakota and Texas, US crude production is expected to grow to an average of 7.4 million barrels per day this year, versus 5.0 million in 2008. That’s a 48% increase in just five years, and it has brought domestic production to a level that is almost equal to our imports. Who would have thought that would be the case?!
Eventually, changes to our energy infrastructure should allow us to better take advantage of the domestic energy boom. The proposed Keystone pipeline, which would transport oil sands from Canada and the northern US, was rejected by President Obama last year but may be approved in the near future. Also, despite the objections of those who believe we should keep our bounty, we would expect many liquefied natural gas terminals to be converted in order to facilitate exportation of the commodity.
All of this is positive from an economic standpoint, as it boosts GDP, creates jobs, reduces our dependence on foreign energy, and helps keep prices down.
The pedestrian gains in stock prices mask how interesting a quarter it was. We have talked in past commentaries about the hunger for yield and how it was driving up valuations of companies that pay large dividends (utilities, consumer staples, REITs) as well as various types of bonds (Treasury, investment-grade corporates, high-yield). All of these had become, as they say on Wall Street, a crowded trade, and crowded trades always have sharp reversals eventually. With economic data improving and the Fed talking about “tapering” its bond purchases, yield-oriented investments dramatically underperformed in the quarter. This underperformance occurred both while the market was ascending and while it was declining, the latter being unusual. You may recall that in the first quarter, a strong market was led by defensive sectors (the more yield-oriented ones), also an unusual occurrence.
Not only have we largely avoided the yield plays, but we have focused somewhat on “anti-yield” plays, the purest of which may be the financial sector. Empirical Research Partners published some astounding data on the sector. For example, as far back as the records go (1929), the returns of financial stocks have never been as negatively correlated with those of Treasury bonds as they have been in recent months, and the current level is far more extreme than it has ever been. Similarly, the (negative) correlation of returns of financial stocks and utilities stocks (which tend to have high dividend yield) are close to 85-year extremes, and the relative price-to-book ratio of the financial sector to the utility sector is close to 60-year lows. To us, these data points suggested a crowded trade and that financial stocks remained very attractive. As you might expect, with the yield plays selling off in the quarter, the financial stocks, which have been largely unloved, shined.
One of the oft-repeated rationales for purchasing bonds at such elevated prices (low yields) is that if you hold the bonds to maturity, you won’t lose money (assuming no default risk). While this ignores the possibility of a negative real (after inflation) return, this is technically true in an absolute sense. But it has not kept investors from running for the exits en masse, as, seeing the losses in supposedly safe holdings, they pulled a staggering $61.7 billion (net) from bond funds and bond ETFs in the first 24 days of June. This partial-month total shattered, by about 50%, the previous one-month record of outflows in October 2008. As stunning as these numbers are, they represent just a fraction of the net amount that has flowed into bond funds/ETFs since the beginning of 2009: $1.3 trillion. Much of these inflows came in the last year or two when yields were at their nadir (prices at a peak). Since the 30-year Treasury yield bottomed in mid-2012, the return on this instrument, considered safe by many, has been negative 16%, one of the worst stretches for bonds in the last 70 years. (Because the duration is so long, the return was significantly worse than for shorter-dated maturities, and for the typical bond fund, but returns on these vehicles were poor as well.) In the meantime, the return of the S&P 500 over the past year, a period preceded by investor outflows from stock funds, was over 20%. A significant amount of investor capital appears to have been plowed into an asset class (this time, bonds) at its peak, a behavior the market, unfortunately, has witnessed time and time again.
While some of the air has been let out of the yield bubble, we believe there is more to go, and time will tell how long the process takes to play out. All else equal, if the economy continues to make progress, it should allow the Fed to move toward tighter policy, which should continue to reduce the appeal of higher-yielding investments.
Best regards,
Mark Oelschlager, CFA
Portfolio Manager
Oak Associates, ltd.
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