The market has lost one of its pillars of support
Julian Edelman, star wide receiver for the New England Patriots, was recently asked what advice he’d been given by his father, Frank. “Go back to the fundamentals of life. Life’s hard, but it’s simple,” he replied. Fundamentals matter in life and in markets.
Sometimes we overcomplicate the financial world, focusing on central bank policy, elections, technical trends and fund flows. But the focus should be on the fundamentals: Over long periods of time, buyers want their money where there is abundant — and growing — cash flow.
That cash flow, whether measured by net profits, margins or return on equity, is the ultimate driver of stock prices. Investors are willing to accept price volatility in return for access to those cash flows. It’s that simple. The current US business cycle will go down as one of the greatest free-cashflow cycles in history.
Companies threw off huge amounts of excess cash by making clever use of technology, tapping cheap labor and taking advantage of declining energy prices, the low cost of capital and the resumption of modest global economic growth. In the wake of the global financial crisis, the market was skeptical for several years, and stock prices grew much more slowly than profits and cash flows.
At the same time, the central banks of the world, dissatisfied with slow economic growth and low inflation, indirectly supported the stock market with extraordinarily accommodative monetary policies. We had a market that was supported by two pillars: high profits and low yields. Both pillars have contributed to the rally from the post-crisis S&P 500 low of 666 to around 2,150 today.
However, lately there has been a turn in the markets, and not for the better. The building blocks of long-term market advances, growth in cash flow and profits, have weakened. Falling commodity prices, slowing world growth and eroding pricing power are contributing to the earnings malaise. Company revenues are no longer exceeding economic growth, and cost-cutting efforts have plateaued.
Selling, general and administrative expenses have been rising in most sectors, as have labor costs, while pervasive weakness has spread to most market sectors as year-over-year profit growth has stalled. For six years, one of history’s great market advances had the fundamental support of an efficient and growing private economy along with the tailwind of low interest rates in the bond market, the principal alternative to stocks. But now we are left with but one pillar of support, built on a shaky foundation of central bank liquidity.
In a low-interest-rate world, there is a school of thought that stocks offer the best and only investment alternative. That’s scary to me. I’m comfortable in a world that has two pillars of support, but not in a world where the more important of the two is eroding. What happens when the central banks are no longer supplying us with low yields? Can the markets still advance without either profits or low yields? I doubt it. Euphoria is not yet driving the market, thankfully, but that may not be far off.
Often, late in business cycles, high spirits drive the market to unsustainable highs. The present eight-year-old cycle is already the third longest in history, while the longest cycle in the last century was ten years. While I hope that the fundamentals return to robust health, until there is convincing evidence of this, slowly stepping away from this fast-paced market may be the safest course. Where to go? High-grade corporate bonds are not a perfect asset class, but they may be able to offer a portfolio resilience, with historically lower volatility than stocks and enough anticipated return to merit investors’ attention.
James Swanson, chief investment strategist at MFS Investment Management