2019 was an outstanding year for the stock market, with the S&P 500 Index rising 31.5%, its best performance since 2013. This was a pleasant contrast to a 4.4% loss in 2018. Since the end of 2009, the total return of the the S&P 500 (gains plus dividends) is 257%, or 13.6% per annum. On a price-only basis (no dividends), the index has risen a total of 190% or 11.2% per annum. Over the ten-year period, higher corporate earnings growth accounted for about 80% of the S&P 500’s price gains, while higher equity valuations (e.g., P/E ratios) were responsible for 20%. In 2019, higher valuations accounted for all of the gains as corporate earnings declined.
Higher equity valuations over the 2009-2019 decade were driven largely by declining interest rates, which in turn reflect the near absence of inflation during the same period. As reported inflation hovered persistently below the Fed’s target of 2%, the Fed felt comfortable pumping liquidity into the economy, believing that by pushing interest rates lower, it could stimulate economic growth and goose inflation a bit higher towards its target. While the Fed did manage to stimulate growth, it did little to push inflation higher. In many ways this created the perfect environment for equities: steady earnings growth and a low starting valuation that has moved higher as the Fed has engineered declining rates in the context of minimal inflation.
As we have written several times over the last 10 years, inflation has been kept down by the twin forces of globalization and technology (particularly digital technology). These forces are not going away, and in fact, digital technology is becoming increasingly pervasive throughout the economy, dramatically increasing efficiency and lowering costs in industry after industry. We do not see this trend abating.
The key question for 2020 and beyond is whether inflation can overcome the dampening effects of continuous technological innovation and demographics and at long last begin to accelerate, thereby forcing the Fed to withdraw liquidity and raise interest rates. This question is vastly more important, and certainly more fundamental, than the obvious noise about tariff wars, Brexit, Mid-East conflicts and probably even the U.S. election. While we do not forecast an inflation breakout, we do think there are several ways inflation could return. Potential drivers of inflation include:
1) Tight labor markets that lead to rising wages, causing businesses (that can) to raise prices.
2) Tariffs raising the prices for affected goods.
3) Acceleration of global economic growth sparking commodity inflation.
4) Persistent Mid-East turmoil leading to higher oil prices, although growing US supply provides a nice offset.
The reason the inflation question is so important from an investment perspective is that equity valuations are inversely correlated to interest rates. Therefore, as interest rates drop as they did from 2009-2019, P/E ratios rise. Conversely, when interest rates start to rise, P/E ratios are likely to fall. Interest rates, of course, are positively correlated with inflation. So if inflation begins to accelerate, interest rates would likely rise, which should cause P/E ratios to decline. In the absence of countervailing earnings growth, this would likely result in declining equity prices.
We continue to expect relatively modest economic growth, coupled with steady, low inflation, so interest rates should hold steady around today’s historically low rates. If this materializes, there is a real possibility that the stock market, or at least certain parts of it, could move significantly higher. Even though valuations have risen over the past ten years, they are not as high as they theoretically could be in such a low interest rate environment. The possibility of a significant equity melt-up is, therefore, not to be dismissed. Conversely, should the economic recovery falter and corporate profits come under pressure, a stock market correction would likely ensue, even absent a rise in inflation and interest rates. A third option is the emergence of inflation within an economy that continues to grow. In this scenario, inflation would likely dampen earnings growth and, as noted previously, would almost certainly result in lower valuations. At this point, it is impossible to say with confidence which direction the market will take, but we feel a continuation of the status quo is most likely.
Given the uncertainties and the longevity of both the economic recovery and long bull market, we continue to favor leading, dominant companies, especially those enjoying secular tailwinds. Such companies are likely to grow in any macro-environment and as such prove rewarding investments over time. As always, we seek to invest in these companies at attractive prices due to some near-term cloud that temporarily depresses their valuations. Below are two examples of additions to the portfolio that not only fit our target profile, but that also give us positive exposure to a rising rate environment (should inflation begin to accelerate).
We purchased Schwab, the leading discount broker platform in the U.S.. Schwab’s earnings and stock price had suffered from a decline in rates, a flat yield curve and fears over the demise of trading commissions. Our analysis of the company’s prospects suggested the market was being far too negative given the probability of continued moderate economic growth and Schwab’s market dominance. While not central to our investment thesis, Schwab’s earnings would increase rapidly in a rising rate environment.
We also added Progressive, a dominant provider of automotive insurance in the country. Progressive’s shares have declined due to increased loss ratios (cars are getting more expensive to fix), but these cycles typically lead to higher insurance pricing and an acceleration of earnings growth. Similar to Schwab, higher rates are not part of our thesis for earnings growth, but with a large book of short duration bonds, Progressive would certainly benefit from a higher rate environment.
We want to thank all of our clients for the trust you have placed in us and wish all a very happy, healthy and prosperous New Year.
Sincerely,
John Osterweis
Past performance is no guarantee of future results. Index performance is not indicative of fund performance. To obtain fund performance call (866) 236-0050 or visit osterweis.com.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The Fund’s holdings and sector allocations may change at any time due to ongoing portfolio management. As of 12/31/2019, the Osterweis Fund held 3.1% and 2.0% of Schwab and Progressive respectively.
The corporate earnings cited are trailing 12-month earnings per share after extraordinary items.
Price-to-Earnings (P/E) ratio is the ratio of the stock price to the trailing 12 months diluted earnings per share (EPS).
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. One cannot invest directly in an index.
Earnings growth is not a measure of the Fund’s future performance.
Holdings and sector allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities by the Osterweis Fund or Osterweis Capital Management.
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© Osterweis Capital Management
© Osterweis Capital Management
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