2nd Qtr Newsletter- July 2019
The bull market and the economic recovery are now 10 years old. We are starting to see signs of weakness in leading economic indicators, and the Fed is now talking about the prospect of lowering interest rates later this year. This comes fairly quickly after the Fed evidently concluded, on December 19 of last year, its 4-year long tightening cycle. The U.S. is $23 trillion in debt with no sign of a balanced budget. The yield curve by some measures has inverted. While there are no U.S. bonds yielding below 0%, there are $12 trillion of foreign bonds yielding less than 0%; bondholders have to pay the issuer to hold their money. And now for the bad news…just kidding.
The graph below shows the S&P 500 Index for that 10-year period. You will notice it is bumping up against all-time highs set late last year and earlier this year.
The economy and the market travel in cycles. Graph #2 on the next page is from Howard Marks’ book, Mastering the Market Cycle, and shows a typical market cycle—the wavy line, that is. The smoother, upward-sloping straight line is a long-term trend line of corporate profits, dividends, and cash flow. Why must we live with the up-and-down market cycle instead of the beautiful smooth line? Investors are always either exceedingly optimistic, exceedingly pessimistic, or headed from one to the other. And that is because most investors are overly influenced by their own emotions… fear and greed. Where do you think we are in the cycle today?
Graph #3 is the S&P 500 for 2000 to 2010. You can see more pronounced market cycles than in the subsequent 10 years. In fact, you see two 50% bear markets and the worst 10-year market in history. The 2000 to 2002 market was the high tech wreck. 2007 to 2009 was the great recession which had to do with mortgages and leverage. Fifty percent corrections are not normal. These major corrections were preceded by very expensive, overbought markets. Valuations and market sentiment are not as stretched today.
The last display helps us keep track of our companies from a cash flow prospective. The blue line shows Home Depot’s cash flow declining for a couple of years after the housing recession and then showing consistent increases with cash generation of $12 billion last year. What did they do with their cash flow? They bought back $8 billion of their stock, paid a dividend of $4 billion and invested $2 billion into capital expenditures. You may notice they spent more cash than they generated. The $2 billion difference was made up by borrowing. They obviously believe their stock is attractive ($8 billion of buybacks is a lot of stock) and thus far, debt is not a problem but we are keeping an eye on it. As a percent of their profits and cash flow, their debt load is actually low.
The numbers at the top of the graph are the year-end price of the stock divided by cash flow. It is like a P/E ratio, substituting operating cash flow for earnings. It has averaged 16-17 over the 10 year period getting to a high last year of 22 and has corrected back to 16 in 2018. The numbers at the bottom are calculations of the annual total return of the stock. Coming out of the housing recession the stock was very strong but had a -7% return last year as the housing market (and the stock market) stumbled a bit.
The economy continues to perform well. We are well aware that the economy and the bull market are 10 years old. There does not appear to be a recession over the near term but sometime in the next couple of years we will probably have a soft or hard landing. One thing to keep in mind is the Presidential election next year. I am pretty sure the President would prefer not to have a recession muddying up his economic message.
What should we expect to happen going forward? Most likely, the U.S. will be bickering with some countries and fighting with others. We will all be sitting on the edge of our chairs waiting to see if the Fed changes its message from the prior meeting. And Home Depot should generate $10-12 billion more cash flow, increase their dividend and buy back a slug of their stock. If you’re feeling unsettled, give us a call. Reducing equity exposure is an option, although bond yields don’t exactly equate to instant gratification. We can get 2% on a 10 year Treasury bond or if you would like, -1% on a 10 year German bond.
Written by David Meyer